China's Pockets are Running Dry

As China's economic growth has slowed, some bullish investors have pointed to China's "deep pockets" as a way for the country to keep its economy growing. Yet, data published on Friday showed that China's supposedly deep pockets could soon run dry. During the final three months of the year, Chinese reserves dropped by 0.6%. Although this is but a tiny drop in the bucket for China, it could indicate the start of a disturbing trend for the world's fastest growing economy. As China's trade surplus falls, and investment funds begin to pull out of the country, it may be no surprise that China's foreign exchange reserves are falling. The country has managed to accumulate a large surplus by running a trade deficit for years. This has been a policy employed by many East Asian economies, like South Korea and Taiwan, who have worked diligently to maintain large trade surpluses and foreign exchange reserve stockpiles. This may have been motivated by the fallout from the 1997

, as the countries moved to build up their foreign exchange reserves in an effort to prevent a second financial crisis. In the wake of the 2008 financial crisis, China was able to finance a large expansion of its economy. It rolled out a $2 trillion stimulus program based on large-scale construction projects, which allowed

to continue to grow and create jobs for the millions of peasant laborers. Yet, some critics—notably short seller Jim Chanos—have alleged that China's aggressive government driven expansion has created a bubble in China—particularly in its property market. Regardless, China's large forex reserves are a focal point of the country's attractiveness. As China transitions into a consumption-based economy, it will likely be unable to continue to maintain such a large surplus, as its net exports will dwindle. Still, China is not quite there yet, but traders may anticipate that Chinese officials will work to keep their forex reserves intact. That might mean a change in China's currency peg, or additional easing. While officials in the US may be pushing China to strengthen the yuan, with the Chinese trade surplus dropping, Chinese officials may do just the opposite. If the yuan is depreciated, then Chinese goods may appear cheaper on foreign markets—thereby boosting China's surplus and allowing the country to maintain its forex reserves. Additional easing could also make foreign investment more attractive in China, and help the Chinese economy to continue to expand at a rapid pace. Thus, this news could be interpreted as a bullish sign for China—as it could coax the government into being more aggressive and thereby supporting investors. Inversely, the drop in forex reserves indicates a level of weakness in China's economy, and thus it could be seen as a negative.