Why do growing Asian foreign reserves present a crisis for the Dollar?
*Financial Times, by Peter Garnham, November 16, 2006
“The risk of global central banks diversifying their vast foreign currency reserves away from the dollar has become a dominant theme of foreign exchange markets.
Analysts say the issue has even surpassed worries over the US current account deficit as the biggest millstone round the dollar’s neck.
The anxieties have been around for at least the past six months, with central banks from Russia, Switzerland, Italy and the United Arab Emirates announcing a cut in the proportion of dollars held in their reserves.
But it was last week’s announcement from China, the world’s largest holder of foreign exchange reserves, that its stockpiles had breached the $1,000bn mark that brought the issue to the forefront of the currency market’s investment agenda.
Global currency reserves have soared from $2,000bn in 2001 to $4,700bn, according to the International Monetary Fund. Furthermore, stockpiles are highly concentrated, with two-thirds of the world’s reserves held by six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.
“It is clear to me that the move through the $1,000bn level [in China] has marked some kind of watershed,” said Simon Derrick, currency research chief at the Bank of New York.
Analysts expected the announcement to trigger a debate about the value of the renminbi, which many of China’s trading partners believe to be undervalued.
But, in the event, it sparked a vigorous defence of China’s foreign exchange policy from Fan Gang, director of China’s National Economic Research Institute and a member of China’s monetary policy committee. Mr Fan said the real problem was an overvalued dollar, not only against the renminbi but also against all the leading currencies. Mr Fan’s remarks saw the foreign exchange market question whether China, which is thought to hold 70 per cent of its foreign currency stockpiles in dollars, was considering a fundamental change in its reserve allocation.
Speculation was then heightened when Zhou Xiaochuan, governor of the People’s Bank of China, said at a European Central Bank conference in Frankfurt last week that Beijing was “considering lots of instruments” to diversify its foreign exchange reserves.
Although the dollar tumbled after Mr Zhou’s comments, analysts were quick to point out that he did not actually say anything new.
But Mr Derrick said the very fact he was discussing the subject at all seemed to suggest it had become a key issue for the bank.
“The topic takes on even greater significance when you remember that other reserve managers, such as Russia, will undoubtedly take close notice of what China does when considering what to do now with their own reserves,” he said.
But while analysts said worries over possible central bank diversification were unlikely to recede in the short term, there had been little evidence of foreign official dollar sales.
Indirect bidders, which include foreign central banks, bought a greater share of the new 10-year note sold on November 9 than in any US Treasury auction since February.
Furthermore, the US Treasury’s International Capital report showed that Chinese investors had been net buyers of US Treasuries every month since last November. The report from August showed Chinese investors owned more US Treasuries than ever, with holdings of $339bn.
In any case, Marc Chandler, currency strategist at Brown Brothers Harriman in New York, said the market overreacted to Mr Zhou’s comments last week.
He argued it was unreasonable to expect a central bank to pre-announce its reserve allocation decisions, especially China, which is trying to prevent speculators from profiting from the adjustment of the renminbi. “Governor Zhou is unlikely to tell these same speculators that China is going to sell dollars, so they can sell in front of it.” Mr Chandler said the best advice was to react to what central banks were doing, rather than what they were saying.”
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