After increasing relentlessly for two decades, China’s foreign exchange reserves started to decline about a year ago, and during the crisis month of August 2015 they plummeted alarmingly. Seen by many investors as a signal of waning confidence in the credibility of Chinese economic policy, a collapse in the reserves is now taken as one of the prime reasons to dump risk assets on a global basis. As the balance sheet of the PBOC shrinks, investors fear that “quantitative tightening” will be triggered in developed bond markets, and worry that a credit crunch will occur in China itself.

These concerns are not entirely without foundation but a confidence run on the renminbi is still unlikely. Much will depend on whether the Chinese authorities can shed their cloak of secrecy sufficiently to lay out a clear strategy for the reserves, the exchange rate, monetary policy and the necessary clean up in the domestic banking system. If the right strategy emerges, confidence can be restored, because China is very far from being an insolvent nation.

How did China get here? The rise in foreign exchange reserves started way back in 2001, and proceeded at about 40 per cent a year in the mid 2000s. After that, the rate of increase has gradually slowed, and the reserves peaked at almost exactly $4 trillion in August 2014. Throughout this long period, China ran a large current account surplus, and a private sector capital surplus, but did not want the exchange rate to rise too rapidly. The authorities therefore smoothed the inevitable exchange rate appreciation by buying dollars and building reserves. The rise in the reserves was not so much a deliberate policy choice, more the automatic result of policy decisions elsewher.

The real exchange rate rose by about 40 per cent after 2007, and by 2014 it had eliminated the persistent undervaluation that had for so long annoyed the US and the rest of the international economic community. This changed the dynamics of the balance of payments, reducing the current account surplus to 2 per cent of GDP from a peak of 11 per cent in 2007. The interest “carry” trades that had sucked private capital into China also started to unwind as the market recognised that the currency was no longer undervalued, and that Chinese interest rates would fall sharply if the economy experienced a hard landing.

In the past 12 months, private sector capital outflows have proceeded at a generally orderly pace, but have still forced China to reduce its reserves by $400 billion in order to prevent a precipitous dro in the exchange rate. It was not until the PBOC announced an adjustment to its exchange rate mechanism on 11 August, triggering fears of future devaluation, that the capital outflow hit crisis proportions. During August, the reserves dropped by $94 billion on the official figures, and many analysts think that disguised intervention in futures and options markets increased the genuine figure for currency support to over $170 billion last month.

Clearly, such a rapid rate of reserve depletion would, if continued, administer a large global shock to asset markets as China’s holdings of foreign bonds are reduced. Furthermore, when reserves decline, the official sales of dollars for renminbi reduce local currency liquidity in the domestic financial system. Although the impact of reserve changes on domestic liquidity can in theory be offset by “sterilisation” activities by the central bank (such as changing banks’ reserve requirements), in practice sterilisation does not seem to have been fully successful in either direction.

Recent IMF research shows that large scale capital inflows have frequently triggered domestic credit explosions, and it is reasonable to suppose that capital outflows could cause an unintended tightening in domestic financial conditions in China. Indeed, the graph on the left suggests that this is already happening.

Whether the Chinese credit squeeze continues depends on two factors: the future course of private capital outflows, and the attitude of the authorities to the exchange rate. The higher the capital outflows, and the more determined is the PBOC to prevent a large devaluation, the greater the depletion in the reserves will be.

Some analysts are optimistic that the pace of capital outflows will slow down automatically in the near future. Nomura estimates that much of the “hot money” that entered China after 2010 has now exited the country. For example, they suggest that the outstanding stock of foreign loans previously taken out by Chinese banks to finance domestic lending has already been cut in half, from a peak of $887 billion a year ago. If so, the capital outflow could soon start to abate.

The problem, though, is that this all depends on confidence. Even though there are still tough regulatory controls on capital outflows, there has been considerable leakage in the form of illicit flows that appear as “errors and omissions” in the official statistics. According to the IMF, capital outflows are likely to be much larger than inflows when capital controls are eliminated.

Furthermore, if Chinese citizens lose confidence in the financial system, the capital outflow could become much larger, as firms and households seek ways to avoid currency controls. In many emerging markets, such activities have led to a “sudden stop” in capital availability to the economy during crises.

Fortunately, there is no sign yet that this is happening in China, and really no need for it to happen in the future. On almost any basis, China’s unencumbered liquid reserves are much greater than liquid liabilities. In fact, there is a strong case for arguing that the present situation should be used as an opportunity to reduce excess reserves (see Joe Gagnon).

Excess reserves cost money, because the income earned on foreign assets is generally less than the interest paid on the domestic liabilities held by the central bank as part of its sterilisation operations. Furthermore, at times when the exchange rate is strong, it is difficult to bring the reserves home to refinance the troubled domestic financial system because this would lead to an undesirable overvaluation of the renminbi. The paradox is that the reserves can only be used when the exchange rate is weak.

To restore domestic and international confidence, China needs several policy changes at once: much easier domestic monetary policy; more open international capital markets; a freely floating, but not collapsing, exchange rate; and a recapitalised domestic financial system. If such a package were announced in a transparent and coherent manner, then an orderly drain on the reserves could come to be viewed as part of the solution, not part of the problem. But China’s economic policy regime is not there yet.