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Foreign Exchange

Drop in Chinese FX reserves points to further dollar strength

China’s massive foreign exchange stockpiles dropped for the first time in more than a decade in the final quarter of last year, as fears over global growth and a slowdown in Chinese growth prompted investors to pull money out of the country.

Figures released by the People’s Bank of China revealed that foreign exchange reserves stood at $3.181 trillion at the end of December, down $20.55 billion from the end of September. That marked the first quarterly loss since 1998, at the peak of the Asian financial crisis.

The news represents a watershed for the dollar, since it implies that reserve-manager diversification away from the US currency is set to become less of a drag on its value.

The exact composition of China’s reserve holdings is a state secret, but it is believed it holds 60-65% in dollars, compared with 20-25% in euros.

In the past, strong growth in reserves has led to persistent upward pressure on EURUSD, as reserve managers such as China rebalance the currency allocation within their portfolios by selling a portion of incoming dollars.

“No reserve growth means there is no need to diversify,” says Simon Derrick, head of currency research at Bank of New York Mellon. “It is not a coincidence that the euro struggled against the dollar in the last few months of 2011.”

Part of the drop in China’s reserves was due to valuation changes, given the effect of the sharp drop in the euro on the value of China’s holdings in the single currency.

However, worries over growth were also a factor and reflected in a fall in reserve holdings across the region as foreign investors repatriated capital in the closing months of last year.

Bank of Tokyo-Mitsubishi UFJ’s measure of reserve change for the top eight Asian reserve holders, excluding Japan and China, revealed a drop in reserves of $53.5 billion during the quarter.

“That’s a lot less rebalancing-related dollar selling by Asian central banks, and adds to the factors supporting the dollar against major currencies like the euro,” says Derek Halpenny, head of currency research at BTMU.

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