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Foreign Exchange

China’s reserve shift may leave dollar vulnerable

Concern that China is poised to diversify its currency reserve holdings has meant some downward pressure.

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.

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