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Can China diversify its foreign holdings?

By Zhang Ran (China Daily)
Updated: 2009-07-13 10:46

Editor's Note: China holds about $2 trillion in official foreign exchange reserves and manages $200 billion to $300 billion in additional foreign exchange assets that are not counted as official reserves. An estimated two-thirds of these reserves are held in dollar-denominated assets, whose safety and valuation has apparently become an increasing concern for the Chinese government. Wang Tao, head of economic research in China for UBS Securities, talked about China's strategy to diversify foreign exchange assets in an interview with China Daily reporter Zhang Ran.

Q: As the current account surplus remains large, how might China diversify its rising foreign exchange reserves?

A: Following the global financial crisis and the highly expansionary monetary and fiscal policy currently pursued in the United States, China is concerned about the eventual depreciation of the US dollar, and/or higher interest rates in the medium term.

In the short term, there is not much China can do. But we think China will actively diversify its foreign exchange holdings over the medium term, although this may not involve selling down its dollar assets, especially US treasuries, in any significant amount.

We also expect the government to encourage outward investment to reduce the accumulation of official reserves while it continues to keep the exchange rate stable.

Q: Why are China's short-term options limited?

Wang Tao

A: In the short term, it would be difficult for China to move away from holding dollar assets, especially US treasuries, given all the constraints.

China is the largest official holder of US treasury and agency debt, and any significant move away from these holdings might drive down the value of the debt, which, in turn, would lead to losses for China's remaining large holdings.

In addition, it is also in China's interest to see a stable US dollar and an early recovery of the US economy. A sudden sell-off of US treasuries might lead to unwanted exchange rate fluctuations and a loss of market confidence.

Moreover, there are few alternatives to dollar assets in the short term. The main alternative for China's FX reserves would be other government bonds, including those from Japan and the United Kingdom.

However, US treasuries still have the most liquidity and are considered among the safest assets during the height of the crisis.

For a country with $2 trillion in FX reserves that are rising by about $20 billion a month, it is difficult to stop buying US treasuries when markets for most other assets are too small and not as liquid.

There have been discussions in China and abroad about the possibility of diversifying into gold and commodities.

We do expect China to increase its purchase of gold and other commodities over time, but these markets are just not big enough to make a meaningful dent in the structure of the overall FX holdings.

For example, if China decided to hold 5 percent of its current $2 trillion reserves in gold, it would need to buy more than 3,000 tons of gold, which is equivalent to about one year of world production.

For other hard commodities, the cost of storage is high and prices fluctuate wildly. There is just not enough of it compared to the size of the reserves or even the annual increment.

Q: What should China do to diversify its foreign exchange assets over the medium term?

A: Over the medium term, these constraints should not prevent China from doing all it can to diversify its rising foreign exchange assets. China can become less susceptible to the so-called "dollar trap", a position that perpetuates itself and limits China's own independent policy options.

Of course, the pace and degree of diversification is limited by the current global trade and financial system, where the dollar still dominates in transactions, asset holdings and official reserves.

Before an alternative is developed to challenge the central role of the dollar as the dominant reserve currency, we do not envision China holding less than 50 percent of its official reserves in dollar assets - even in the medium term.

We think the diversification might take place in two ways: first, by diversifying official reserves by holding a larger share of currencies and asset classes other than the dollar and US government and quasi-government debt; and, second, by diversifying the group of holders and managers of China's overall foreign exchange assets, leaving more in the hands of the corporations, the banks and individuals.

 Reducing the share of China's dollar assets in its overall foreign exchange assets may not require any significant net selling of US treasury holdings, given the expected large current account surplus in the coming years.

We expect a sharp fall in China's import prices this year and the decline of imports for processing exports, which accounts for half of the total exports. This would result in a current account surplus of $380 billion this year despite the sharp export decline.

Over the next few years, the large share of processing trade and policies promoting import substitution in the higher value-added industries would likely lead to persistent large trade surplus.

On the capital side, inward foreign direct investment has stabilized at a still sizable level ($80 billion to $100 billion a year), while the apparent other outflows that took place at the height of the financial crisis have dissipated.

Therefore, even under the assumption of substantially increased outward investment and other capital outflows, we would expect official foreign exchange reserves to rise by more than $200 billion a year in the next few years.

Since other currencies and assets are not as large and liquid as the dollar and US treasuries, we expect China to gradually increase the purchase and holding of all other asset classes - be it other G10 government and corporate bonds, gold, equity or commodities.

Q: Do you think that buying more assets in all other currencies is enough to achieve diversification?

A: Buying more assets in all other currencies may still not be enough.

Recent policy measures suggest that another important way in which China is trying to diversify its foreign exchange holdings is to reduce the accumulation of official reserves by encouraging capital outflows.

This means more outward direct investment and increased portfolio outflows, as well as more external lending by corporations and banks.