When China experienced an export boom and a large influx of foreign direct investment a decade ago, the People’s Bank of China intervened in the foreign exchange market to ease the appreciation of the renminbi. The PBoC exhausted liquidity by raising the reserve ratio of commercial banks. The reserve ratio peaked at 21%, and China’s foreign exchange reserves reached $4tn in the process.
In mid-2014, capital started to flow to the US market in anticipation of the Federal Reserve’s interest rate increases. As a result, the dollar began to appreciate against all other currencies. The PBoC’s response was to reverse its previous measures: the dollar reserve was drawn down to meet the demand in the foreign exchange market and avoid a sharp depreciation of the renminbi. Liquidity withdrawals were sterilised by cutting the reserve ratio to unlocked funds for banks.
By early 2016 China had lost around $800bn of its foreign exchange reserves compared to the mid-2014 peak. A cut of the reserve ratio by the PBoC in March 2016 triggered another round of capital flight. Market sentiment towards the renminbi was already negative, and the cut by the central bank was regarded as signalling broad easing. The Fed’s rate increases have triggered a chain of extraordinary PBoC responses.