A declining yuan alongside declining forex reserves is powerful evidence of significant capital flight. Investors, individuals, and corporations apparently wish to reduce their exposure to the Chinese economy, and that's why the demand for yuan is falling. This problem won't be solved until the dollar value of the Chinese money supply declines by enough to match the decline in the demand for yuan. That can be accomplished by 1) shrinking the monetary base and the money supply, 2) devaluing the yuan vis a vis the dollar, and/or 3) inflating the Chinese price level. Alternatively, China could take steps to boost confidence in the yuan (e.g., by allowing the monetary base to shrink) or boost the demand for yuan (e.g., anything that improves China's long-term economic growth potential).
China's forex reserves are declining because the central bank is selling its foreign assets (mostly held in dollar securities), in an effort to try to support the currency; in effect the central bank is accommodating capital flight. The fact that the currency continues to decline suggests that forex sales have not been sufficient to stem the decline. It's not too hard to see why: the central bank is not allowing the decline in reserves to shrink the monetary base, and indeed, the amount of yuan in circulation continues to rise. Ordinarily, capital flight that is accommodated by central bank sales of forex would result in a shrinkage in the money supply, and that shrinkage would eventually bring the supply of yuan back into line with the declining demand for yuan.
To make matters worse, the ongoing increase in the amount of yuan in China, despite the decline in the demand for same, means the central bank is selling dollar assets and buying Chinese assets, thus “degrading” the quality of the yuan and allowing the oversupply of yuan to continue. The central bank is not allowing capital flight to shrink the monetary base. Replacing dollar assets with yuan-denominated assets in the monetary base is eroding the effective quality of the yuan, and that does little or nothing to maintain confidence in the yuan.
China is not taking adequate steps to address the decline in the demand for yuan. This means that the problem of capital flight and the decline in the value of the yuan will continue, despite China's best efforts to physically stem capital flight. It also means that Chinese inflation is likely to rise. Unless properly addressed, these problems will persist, and they will further weaken the Chinese economy. That is not good for China or for the world. It's difficult to see how exactly this will play out, and what impact it could have on the U.S. economy.
A crisis is not likely imminent, however, since China still sits on a virtual mountain of forex reserves, and the dollar value of Shanghai Composite Index is up over 15% since January. But as John Cochrane muses, and today's WSJ op-ed points out, there are disturbing things going on that bear watching.
At the very least, this makes Trump's demand that China boost the value of its currency vis a vis the dollar a virtual impossibility.
The chart above summarizes the central facts. As it suggests, the persistence of capital flight is forcing the central bank to devalue the yuan.
Despite the yuan's decline in recent years, it is still very strong against a basket of trade-weighted, inflation-adjusted currencies.