For the past two decades, China's primary monetary policy tool has been its currency peg. This is a legitimate, if rarely used, monetary policy strategy. In a currency peg regime, the central bank buys up any net inflows of foreign currency in order to keep those inflows from pushing up the value of its currency. Similarly, the central bank must sell foreign currency whenever there are net foreign currency outflows which would otherwise push down the value of its currency. Rising foreign exchange reserves are thus indicative of capital inflows, whereas a decline in forex reserves signals capital outflows.
As the chart above shows, China has been buying foreign currency (thus increasing its holdings of foreign currency) for most of the past two decades, AND it has been allowing its currency to appreciate. Until recently, China has been the beneficiary of massive net foreign investment inflows—so massive that even $5 trillion of forex purchases by the Bank of China weren't enough to stop the yuan from appreciating.
The Bank of China now holds about $4.7 trillion of forex reserves. However—and this is critical—China's forex reserves have not increased over the past 18 months, and have actually declined by about $300 billion since last summer. This means that China is now experiencing net outflows of currency, and that in turn is a sign that China is no longer a magnet for capital. Foreign investment is no longer flooding into the economy because the opportunities for excess returns in China have diminished significantly. The bloom is off the Chinese rose.
As the chart above shows, since 1994 the yuan has effectively doubled in real terms agains the currencies of its trading partners. The value of the yuan has finally appreciated to the point where a strong yuan makes the outlook for investment returns in China roughly equivalent to the returns, on a risk-adjusted basis, that can be found elsewhere. Capital is now largely indifferent to the investment opportunities in China relative to other places.
Not surprisingly, the slowdown in the BoC's accumulation of forex reserves coincides with a slowdown in China's economic growth rate, as shown in the chart above. Fortunately, it's not necessarily bad news that China's economy is no longer booming. Even after a significant slowdown in recent years, China's economy still is growing much faster than any of the world's developed economies. What's changed is that China is transitioning to a more mature economy, with slower and arguably less volatile growth rates going forward.
The bloom is off the Chinese economic rose, but that doesn't necessarily threaten the outlook for global growth. A bigger, more mature Chinese economy will be purchasing a lot more of the world's consumer goods and services, now that it is purchasing fewer of the capital goods and natural resources that were necessary during its boom phase.