China is CURRENTLY out of the required level of reserves

Responses we receive when discussing the FX reserve levels of China are filled with reverence: ‘No country in the world has ever achieved $4 trillion in FX reserves by running such enormous trade surpluses with the rest of the world.’ While true, this analysis fails to frame the proper context of the larger situation. When a host country has a large industrial base, enormous money supply (M2), and large import/export business, there is a certain amount of liquid reserves that are required to run the day-to-day operations of the country (think working capital). Over the years, the IMF has fine-tuned the formula used to calculate this ‘reserve-adequacy’ metric. It can be best calculated as follows:

Minimum FX Reserves = 10% of Exports + 30% of Short-term FX Debt + 10% of M2 + 15% of Other Liabilities

For China the equation is as follows: 10% * $2.2T + 30% * $680B + 10% * (RMB 139.3T / 6.6) + 15% * $1.0T = $2.7 trillion of required minimum reserves

According to Bass, China’s reserves are “already below a critical level of minimum reserve adequacy.”

“In other words, China is CURRENTLY out of the required level of reserves needed to safely operate its financial system,” Bass wrote. “The view that China has years of reserves to burn through is misinformed. China’s back is completely up against the wall today, which is one of the primary reasons why the government is hypersensitive to any comments regarding its reserve levels or a hard landing.”


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