China to diversify foreign exchange reserves
(China Business Weekly)
Updated: 2004-05-08 09:12

China is looking to diversify its foreign exchange reserves out of US dollars, according to its top foreign exchange manager.

China's chief forex regulator, Guo Shuqing, said in a recent Financial Times interview the make-up of the country's US$440-billion forex cash pile was being altered to include more European and Asian bonds, given concerns over a weaker US dollar.

The mere thought of China offloading some of its vast US Treasury holdings is enough to send shivers down investors' spines, risking a further deterioration in the already-bloated US current account deficit and more dollar weakness.

But, analysts are advising them not to panic.

"It is easy to get carried away with how much they are diversifying. Certainly they are, but we are talking about a very conservative central bank, and they will only be doing it very gradually," said James Malcolm, foreign exchange strategist at JP Morgan in Singapore.

"If you look at the accumulation of reserves, some of that will be going into euros, but a lot will be staying in dollars. There is talk of more bailouts of State banks later this year, and that would argue for a build-up of dollars."

Others put Guo's comments in the context of a long-running process of China seeking a broader mix for its currency reserves.

"They have been shifting in this direction for some time," said Mary Davis, currency strategist at CSFB in London.

"Aggregate IMF (International Monetary Fund) data from 2002 showed a clear shift out of dollars into euro- and sterling-denominated instruments. They are doing this on an ongoing basis, and only an abrupt change would have major implications."

Analysts agree a shift in the currency regime to link the yuan to a trade-weighted basket of currencies, rather than a simple dollar peg, would have little impact on the management of China's forex reserves.

In earlier comments, Guo said China wanted to move to a floating system that would link the yuan to a basket of currencies. He did not give a timetable for the switch.

A basket would include at least the euro and yen, in addition to the US dollar, and up to seven other currencies, including those of China's main Asian trading partners.

Analysts have stressed this would not necessitate a change in the composition of reserves to reflect currency weightings in the basket.

"There is a strong incentive for the central bank to hold some forex reserves in the most liquid currency, as they want to be able to react quickly in the forex markets if necessary," analysts at Goldman Sachs wrote in a research paper earlier this year.

That means Chinese authorities are likely to maintain a large portion of their reserves in the world's most liquid currency, the US dollar.

The choice of a particular basket in the forex regime should not have any influence on the allocation of excess reserves, suggest Goldman Sachs' analysts.

A shift to a more flexible system would help release some of the upward pressure on the yuan.

That, in turn, would give Asian countries more scope to allow their own currencies to strengthen. They have been intervening in their own currencies to contain gains against the falling US dollar to maintain trade competitiveness in relation to China.

In that respect, Asia could be where the biggest currency moves are seen after a Chinese forex system shift.

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