China Wants to Diversify Reserves

One of the major explanations for the dollar's sharp dip over the past ten days is China's very public expression of support for the euro and a desire to see Europe overcome its sovereign debt crisis. In terms of both talk and money, China faced down the euro shorts when the single currency broke down through 1.30 and was looking decidedly fragile.

Although European officials will be incredibly grateful for China's (almost) divine intervention at such a vulnerable time, there are some broader ramifications with respect to their dollar stance that Asia's largest economy needs to consider very carefully. Yes, it is perfectly understandable that China wants to diversify its $2.9trln war-chest of fx reserves, in order to reduce its dependence on the dollar. We were reminded of this desire yet again yesterday, when a Chinese researcher opined that more euros and yen were needed in the country's reserves.

However, for such a big holder of the greenback, making its dislike of the dollar so transparent and obvious reduces the value of its reserves, which in turn represents a drain on the economy. In addition, it makes life much easier for other market participants; if China is consistently a large seller of dollars, then any trader or hedge fund manager is much less likely to adopt a long dollar position. China is of course not alone in terms of its dollar stance - other Asian central banks with substantial fx reserves, alongside Russia too, have made it plain that they will continue to reduce their dollar exposure as well.

It is not an easy situation for the world's second largest economy. China is accumulating dollars at a much more rapid rate than it would like as the anemic growth rates being recorded in the major advanced economies and the policy of deliberate dollar debasement being pursued by the US Federal Reserve attracts huge capital inflow, mostly in dollars. Allowing such a narrowly held currency as the yuan to appreciate in response to this capital inflow is potentially risky, as it would likely engender further speculation that the currency will revalue. China's endeavors to open up both the current and capital accounts is an intelligent response, but it needs to go further and be implemented faster.

Some final well-intentioned advice for China: be careful what you wish for with respect to the dollar.

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