Last month, to the joy of many in the foreign exchange market, the dollar finally broke out of the narrow range it has been trading in all summer against the euro. The shift came after Zhou Xiaochuan, the People’s Bank of China governor, was reported as saying that although China had had “a very clear diversification plan for several years”, the central bank was now considering “lots of instruments” for investment purposes.
Many believe that with China’s foreign currency reserves now thought to be exceeding $1 trillion and growing at about $20 billion a month, the country is now poised to start actively diversifying. However, so far there has been no sign of such changes and Zhou has replied in the negative when asked if the central bank has been selling dollars.
But a growing view is that China is now looking for investments that provide higher yields than US treasuries. This could conceivably be other US-denominated debt, such as corporate and mortgage-backed bonds, which would lessen any potential sell-off in the dollar.
Charles Dumas of Lombard Street Research wrote recently in a research note entitled “The Asian savings glut is structural” that China’s investment in foreign assets is now so large that any shift would almost certainly move the global markets. Particularly of concern would be a rapid shift into euros, but with China holding so many US-denominated assets, it would make little sense for it to prompt a sudden dollar depreciation. Speaking at the third Euromoney forex Forum in New York in November, Philip Poole, global head, emerging markets research, at HSBC, said that the reality is that China will almost certainly not start selling dollars aggressively for at least another year.
China’s large current-account surplus, significant inward foreign direct investment and big inflows of speculative capital over the past couple of years are all reasons why the country’s reserves have ballooned. China has prevented the yuan from strengthening, despite this inward flow, by consistently buying up surplus foreign currency.
China’s official reserves already far exceed what is considered necessary to ensure financial stability, and their size is now causing problems. The central bank has excess liquidity, which is increasing the risk of higher inflation, asset-price bubbles and imprudent bank lending. But, if China continues to run a trade surplus and to control its currency via its managed float, reserves will continue to increase. Where these funds are invested has become a fundamental issue for global economic stability.
In some recent research, Derek Halpenny, senior currency economist at the Bank of Tokyo-Mitsubishi UFJ, stated that while dollar sentiment had clearly deteriorated, there was still little evidence of diversification. China is resisting pressure from all sides. Internally, people are aware of large reserves and their low returns. Externally, China knows the global impact that selling dollars could have. Political and global implications are, for the moment, acting as a deterrent to sell dollars.
It is perhaps in response to these fears that Zhou stated China was, “sticking to the existing policy”. Beijing has pledged to use its reserves in a manner that will not destabilize global markets. Given this prospect, the IMF has predicted that China’s reserves will reach $2 trillion by 2010.
As a solution, some economists have suggested that China should stockpile gold reserves or physical commodities. Having six months-worth of oil reserves might be sensible but physical commodities have no yield, and generate costs. Another option is that China adopts a Government [of Singapore] Investment Corporation (GIC) model for future reserves.
The GIC model boasts 9.5% returns a year on its capital. HSBC’s Poole says he thinks “this will be the model going forward for countries with large reserves”. GIC invests reserves in equity and bond markets throughout the world. It also has a real estate arm that holds investments in the developed world.
Lee Kuan Yew, chairman of GIC, has commented on how infectious this model has been. He noted that China and South Korea had already copied its modus operandi. However, for China to develop this arm there is a need for change. In Singapore the model has been successful because it is independent from the government. The Chinese government, which has with no tradition of letting public sector entities act autonomously, is unlikely to abide by a policy of non-intervention for such successes to be achieved.
For the moment, a widespread view among economists is that China is acting sensibly by not selling current dollar-based assets and by looking to invest future reserves in different products to those it currently holds.
Time will tell if it can accommodate the changes needed to help maintain dollar stability and simultaneously improve returns on reserves.