Chinese currency reserve data for January showed another big decline of USD107.9bn, to USD3.230trn (released over the weekend).
Adjusted for valuation (reflecting changes in exchange rates versus the USD), the decline was slightly smaller at approximately USD92bn. It is still a big decline but smaller than the declines in December and August 2015.
The majority of the reduction in the reserves is likely to have taken place in the first two weeks of January, as there was significant depreciation pressure versus the USD following increased expectations of a devaluation. However, China managed to calm markets down by indirectly pushing up offshore money-market rates by draining liquidity and imposing reserve requirements on offshore banks (see FX Strategy: PBoC draws a line in the sand , 12 January, and FX Strategy: PBoC pulls out another weapon to defend CNY , 18 January).
We expect intervention to have calmed down and we believe China has managed to reduce capital outflows in February. Hence, we look for a smaller decline in FX reserves this month. China has found a new way to fight pressure on outflows by squeezing up money-market rates in the offshore market when pressure intensifies. This reduces the need for large-scale intervention. The smart thing about using higher offshore rates is that it does not hurt the Chinese economy much, as only limited funding is taking place in this market.
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