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This op-ed post was originally published in the Financial Times'  (paywall).

Inclusion in the SDR has turned out to be a pyrrhic victory, as China’s capital outflows have only accelerated.  China lost as much as $108 billion in foreign reserves in December, despite a record trade surplus of over $60 billion.  From its peak of nearly $ 4 trillion a year and a half ago, it is now left with $3.33 trillion in foreign reserves.

China’s stock-market bulls have been scratching their heads for a benign explanation of such a large drop in reserves. One explanation offered is that of valuation effects, as the euro depreciation reduces the value of reserves reported in dollars.

Valuation effects are relevant, but they cannot fully explain the loss in reserves. In fact the euro actually appreciated during December, turning valuation effects positive. In other words, the fall in reserves in December must have been even larger than the reported $ 108 billion (about $ 20 billion larger).

Others argue that China’s buying spree overseas is resulting in large amounts of capital abroad, but in fact foreign direct investment (FDI) into China is still bigger than outward FDI, so the net effect is an inflow of capital.

The third reason offered is that Chinese corporations are “optimizing” their debt portfolio by paying off foreign debt in dollars with new debt onshore.  Interest rates are now much lower on the mainland and expectations that the Renminbi would appreciate have vanished. While there is certainly truth in this, the amount of debt repaid can only explain some of the outflows.  Of the some $800 billion in reserves that China has lost in the last 18 months, China’s external borrowing shows that only about $100 billion of the loss of reserves can be explained by the repayment of foreign debt, at least until the second quarter of 2015 for which BIS’s data on external borrowing is available .

In sum, even taking into account the above mitigating factors, China’s loss of reserves is massive.  The key issue with the current level of reserves is not so much the coverage of imports, or even short term external debt, which is still ample, but the coverage of bank deposits, which stands at only 16% of the total.

In other words, if the demand for dollars were to increase aggressively in China, the reserves would only be able to cover a small part of the available liquidity.  Although China’s capital controls limit depositors’ ability to convert their savings into dollars, further liberalization of the capital account is becoming more and more difficult as demand for the dollar increases.

Acknowledging that the loss of foreign reserves reflects massive capital flight from China, the next question is whether the authorities’ recent actions offer hope that this trend may correct itself soon.

Unfortunately the authorities’ response offers little comfort that China will stop hemorrhaging reserves. There are two reasons for this: one related to the currency situation and the other to the speed of reform.

On the currency front, the People’s Bank of China (PBoC) surprised the markets the day after the SDR victory with a slight, but noticeable, depreciation of the Renminbi. Depreciation continued in the next few days, and the PBoC decided to unveil the weights of the currency basket that it argues it has been already following for some time.

It is unfortunate that the PBoC did not clarify this before entering the SDR. Instead, it promised the market stability in the Renminbi. In this context, the “depreciatory” signals from the PBoC necessarily heightened the market expectations for a further depreciation of the Renminbi.

The spread between the Renminbi onshore and offshore (CNH-CNY) widened to nearly 700 basis points in December, from 300bps in November. It peaked in January at more than 1100 basis points.  Such pressure on the Renminbi points to capital outflows continuing in the near future. On January 9 the PBoC stepped up intervention to reduce pressure on the currency.

In terms of reform, the Chinese Party Plenum last October was widely interpreted as a missed opportunity. First, the most important reform to increase China’s productivity and, thereby potential growth, the restructuring of state owned enterprises (SOEs) was hardly mentioned in the Plenum’s Communique. An ambitious growth target of 6.5% for the next five years was announced, which simply cannot be achieved if SOE reform is carried out as it will have a temporary but big toll on investment. The irony is that the lack of reform cannot ensure growth in the medium run either.

The real question is whether China is running out of options given the set of contradictory targets that they have given themselves. The capital flight stemming from the fear of additional exchange rate depreciation gives the authorities less room to support growth. In fact, capital flight constrains the PBoC’s ability to carry out additional interest rate cuts. However, corporations – many of which are highly leveraged – need lower interest rates in order to cope with their debt burden.

The only way in which the PBoC can maintain an independent monetary policy, and thus find the space to cut rates, is to reverse the steps taken towards capital account liberalization.  In other words, China will need to be much more closed financially which means not taking any more steps towards capital account liberalization or, even worse, reversing some. The decision taken by the PBoC on January 18^th to impose reserve requirements on RMB off-shore deposits (CNH) points clearly in that direction.

On the fiscal side, the dramatic fall in foreign currency reserves also limits the fiscal space of the Chinese government. In fact, a “mercantilist” view of foreign exchange reserves has prevailed in China for years, as they have been used as a “fiscal” transfer for specific state objectives, such as recapitalizing the state-owned banks.

All in all, Chinese authorities seem to be losing the leeway that they have enjoyed for the past few years. This is bad news for an economy which is decelerating rapidly, not only for cyclical, but also for structural reasons. As the room for policy support narrows, the need for structural reforms becomes even more urgent. However the ability of such structural reforms to cushion the short term negative impact on growth is decreasing.  It is unclear how we reached this point. Either the Chinese authorities lost the plot or, more probably, embarking in reform is simply much harder than we thought.