After increasing relentlessly for two decades, China’s foreign exchange reserves started to decline about a year ago, and during the crisis month of August 2015 they plummeted alarmingly. Seen by many investors as a signal of waning confidence in the credibility of Chinese economic policy, a collapse in the reserves is now taken as one of the prime reasons to dump risk assets on a global basis. As the balance sheet of the PBOC shrinks, investors fear that “quantitative tightening” will be triggered in developed bond markets, and worry that a credit crunch will occur in China itself.

These concerns are not entirely without foundation but a confidence run on the renminbi is still unlikely. Much will depend on whether the Chinese authorities can shed their cloak of secrecy sufficiently to lay out a clear strategy for the reserves, the exchange rate, monetary policy and the necessary clean up in the domestic banking system. If the right strategy emerges, confidence can be restored, because China is very far from being an insolvent nation.

How did China get here? The rise in foreign exchange reserves started way back in 2001, and proceeded at about 40 per cent a year in the mid 2000s. After that, the rate of increase has gradually slowed, and the reserves peaked at almost exactly $4 trillion in August 2014. Throughout this long period, China ran a large current account surplus, and a private sector capital surplus, but did not want the exchange rate to rise too rapidly. The authorities therefore smoothed the inevitable exchange rate appreciation by buying dollars and building reserves. The rise in the reserves was not so much a deliberate policy choice, more the automatic result of policy decisions elsewhere.