A Critical Overview of the Continuous Decline in China’s Foreign Reserves

Data from China’s State Administration of Foreign Exchange (SAFE) released on May 7 reveals that as of the end of April 2022, the country’s foreign exchange reserves stood at USD 31.197 trillion, a decrease of USD 68.3 billion from the end of March. Since the beginning of this year, the scale of China’s foreign exchange reserves has shown a trend of “four consecutive declines”. These include the month-on-month decline of USD 28.5 billion in January, USD 7.8 billion in February, USD 25.8 billion in March, and USD 68.3 billion in April. This corresponds to the decrease of 0.88%, 0.24%, 0.80%, and 2.14% respectively. The scale and magnitude of the decline in foreign exchange reserves in April were the largest this year. As China faces the impact of the COVID-19 pandemic and the “triple pressure (i.e., shrinking demand, disrupted supply and weakening expectations)”, concerns have been raised about the continuous decline in foreign exchange reserves.

There is a worry that changes in the internal and external environments will pose challenges to China’s economic stability.

Researchers at ANBOUND pointed out that the reasons for changes and fluctuations in foreign exchange reserves are complex. They not only reflect changes in the domestic economic structure but are also closely related to external geopolitical risks, international currency, trade, finance, and other factors as well. Henceforth, in the current situation, foreign exchange reserves and cross-border capital flows cannot be analyzed merely on a technical level, nor can conclusions be drawn solely based on capital outflow. Overall, we are dealing with a complex systemic problem that extends far beyond the responsibilities of foreign exchange reserve management, and analyzing it necessitates a broader perspective.

Since the start of the year, with the Federal Reserve tightening monetary policy and rising global inflation, China’s foreign reserves have been declining. On the exchange rate front, influenced by factors such as the Fed’s interest rate hike and the ongoing conflict between Russia and Ukraine, the U.S. dollar index increased by 4.7% in April to 103.0. Non-dollar currencies depreciated substantially against the U.S. dollar as a whole. This was also a major reason why China’s foreign reserves shrank in dollar terms in April. The relevant person in charge of SAFE said that in the international financial market, the U.S. dollar index rose sharply, while the prices of global financial assets fell significantly. Foreign exchange reserves are denominated in the U.S. dollar, and the amount of non-U.S. dollar currencies has decreased after converting to the dollar, which, together with changes in asset prices and other factors, reduces the scale of China’s foreign exchange reserves in the current month. In terms of asset prices, the international financial market has been volatile recently, with major financial asset prices falling sharply in April. These fluctuate the value of the stock of foreign reserves. From another perspective, this reflects the dominance of the U.S. dollar in the international financial and monetary system. To ensure the security of its own foreign reserves, China needs to take into account the current reality of the international financial system, examine both the advantages and disadvantages of diversification of foreign reserves, and avoid excessive changes in the stock of foreign reserves caused by the fluctuation of the U.S. dollar.

Within China, the change in the external environment in the first quarter has caused the RMB to devalue, resulting in an outflow of financial capital. While the foreign trade surplus under the current account has made up for the deficit in capital flows to a certain extent and the net inflow of funds has been maintained, on the whole, the outbreaks of COVID-19 have resulted in the economic slowdown of the country. This, in turn, has put pressure on exports. At the same time, the sharp fluctuation of the RMB exchange rate is prompting international capital to start flowing out of China. In the short term, this not only exerts further pressure on the RMB exchange rate but also creates a gap in overall external flows. Although the depreciation of the RMB is somewhat beneficial to commodity exports and continues to make up for the deficit under the capital account, the impact of the recent measures in tackling the novel coronavirus on the supply chain may make it difficult for commodity exports to recover in the short term. Therefore, maintaining a stable and orderly adjustment of the RMB exchange rate is of great importance to China’s foreign trade and capital flows, and to a certain extent, it will help in maintaining the balance of the increase in foreign exchange reserves.

Meanwhile, the intensification of geopolitical risks brought about by the conflict between Russia and Ukraine poses new threats to the security of China’s foreign exchange reserves in the long run. Europe and the United States have increased financial sanctions against Russia by freezing accounts and excluding Russia from the SWIFT mechanism, resulting nearly USD 300 billion of Russian foreign assets are being frozen. This “weaponization” of the international financial system is not only a potential threat to the security of China’s foreign reserves but also limits its opening to the outside world. Considering security issues from a purely technical standpoint would be insufficient for the stock of foreign exchange reserves. Chinese policymakers should also prepare for changes in the strategic landscape to bring foreign exchange reserve assets “onshore.”

It is still necessary for China to preserve a certain amount of foreign exchange reserves to maintain internal and external balance. This would be a necessary condition for its commitment to opening up and maintaining economic stability. Exchange rate adjustment and capital controls still play a fundamental role in maintaining the stability of foreign exchange reserves. In the longer-term, promoting the process of RMB internationalization and expanding its geographic influence will have new significance for China’s corresponding external cycle. Extending the RMB’s cross-border use, expanding the offshore renminbi market, and establishing a national credit system for the Chinese currency can serve as a “reservoir” for furthering its opening-up while avoiding volatility. Such an approach will be useful in maintaining a favorable external environment for China’s economy.

Final analysis conclusion:

China’s foreign exchange reserves will continue to decline as a result of the combined effects of internal and external complex factors in the context of the country’s economic slowdown. This suggests that the impact of external environment changes on China is gradually increasing. To stabilize foreign reserves and the RMB exchange rate, adjustments on strategic levels based on macroeconomics and geopolitics must be made in addition to technical issues such as foreign exchange management and financial stability.

Writer by Wei Hongxu
A researcher at ANBOUND, graduated from the School of Mathematics at Peking University and has a PhD in economics from the University of Birmingham, UK

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ANBOUND is a multinational independent think tank, specializing in public policy research, incl. economy, urban and industry, geopolitical issues. Est. 1993.