from Follow the Money

Does China’s (de facto) dollar peg limit China’s capacity to diversify its reserves?

November 26, 2006

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The dollar hasn’t recovered from the Thanksgiving sell-off.   At least not in Asia.   The won is not as strong as it has been since Korea's own crisis back in 1997.   

Those with dollar exposure – particularly those who expected the dollar to remain in its comfortable band of this summer and fall (somewhere between 1.25 to 1.29 -- See Menxie Chinn's graph) -- have to be considering their options.   At least those who were surprised by the dollar's recent move.  Bloomberg:

The dollar's decline ``caught a lot of the market napping,'' said Gibbs (currency strategist at ABN Amro Holding NV in Sydney). ``A lot of people are not positioned as they would like to be.''

No one has more exposure to the dollar than the PBoC. But do they have any real alternative to adding to the dollar exposure rapidly so long as they basically peg to the dollar?  

I have long thought that this constrained China’s options.   But I was starting to get nervous.   The last really good data point that I have on the composition of China’s reserves comes from June 2005 (the US survey of foreign portfolio holdings).   It is getting a bit stale.    Everything else since then is an (educated) guess.

And with all the recent Chinese talk of diversification, I was starting to wonder if I might have under-estimated China’s ability to quietly reduce the share of dollars in its reserve portfolio.   So I was relieved to hear Guan Tao of SAFE complain of the difficulty making in major moves. Reuters:

"It is very difficult for these countries to make significant adjustments in their reserve asset portfolios," Guan told a forum, adding that that was his personal view and not a statement of SAFE policy.  (Hat tip tmcgee)

China presumably now holds more dollars it really wants.  But it also may have no choice but to add to its (already bloated) dollar portfolio at even faster pace that it has been so long as the dollar is under pressure.  At least so long as China wants to keep the RMB from appreciating against the dollar.  Remember, right now keeping the RMB from appreciating (by much) against the dollar requires pushing the RMB down against the euro.  

Of course, diversification can mean a lot of different things.

China almost certainly holds a more diverse set of currencies as part of its reserves than it did a few years ago.  And it also holds a more diverse set of financial instruments – think mortgage backed securities and emerging market bonds – than it did a few years back.   

So in some sense, China certainly holds a more diverse portfolio now than it did a couple of years agto.    On the other hand, China could have added more currencies and more instruments to its (rapidly growing) portfolio without reducing the dollar’s overall share of its portfolio.  And if the share of China’s reserves in dollars hasn’t fallen, in some deeper sense it hasn’t diversified. 

Which leads to the second point Guan Tao raises.   He argued that central banks would continue to be able to dampen volatility in the foreign exchange market.

"The U.S. buys cargo, and countries with a trade surplus buy U.S. treasuries -- they actually have no other choice," he said. "If I have a surplus on the trade account, if I have foreign exchange income, I can certainly invest part of it in non-dollar assets, but the size of the market for non-dollar assets is very limited so the great majority of foreign exchange reserve assets has to be invested U.S. financial markets."

Therefore, it was very unlikely that currency markets would see any massive selloff of dollars by countries with large reserves, Guan said.  "Given that U.S. dollar liquidity is currently mainly held by a few monetary authorities, we feel that the possibility of a big fluctuation in the dollar is very small -- at least for now," he said

If Guan Tao is talking about the risk of big fluctuations in the $/ RMB, he certainly is right.  If the PBoC wants to limit the possibility of big fluactions in the $/ RMB, it knows what to do. 

But what about the dollar/ euro?   Lots of folks in the market think central banks have played a role in dampening down volatility in the dollar/ euro, not just volatility in the dollar/ RMB.  Highly concentrated central bank positions are -- in this view -- a source of stability for the rest of the market.

Here is the logic – as I understand it. 

The The PBoC (and most other central banks) tend to buy dollars for local currency when they intervene.   Keeping the dollar share of their portfolio from rising consequently requires the ongoing sale of euros for dollars.   When the dollar rises against the euro, central banks often use the dollar's rally as an opportunity to sell dollars.  That dampens the dollar's move.   One example: the available data suggest that the world’s central banks bought a lot of euros in the first and second quarter of 2005.

Now consider what happens if the dollar is falling.   Those central banks that peg (more or less) to the dollar have to buy more dollars to maintain their peg.   And other central banks tend to intervene more.  Last week, both Korea and India reportedly bought dollars to keep their currencies from rising.

They could turn around and sell some of those dollars for euros.  But that would add to the pressure on the dollar.    Or they could hold on to the dollars they are buying, removing one source of demand for euros (the ongoing demand created as the PBoC shifts some of the $20b of dollars it buys every month into euros) from the market.   That too would tend to dampen the dollar’s move.   

But to dampen volatility in the dollar/ euro, central banks both need to buy more reserves when the dollar is under pressure and to hold more of those reserves in dollars.The aggregate data -- while incomplete -- suggests that central banks have generally done so.    

Call it waiting to sell dollars until the market conditions are favorable.   Or call it targeting a constant dollar share in your portfolio.  The result is similar.

The market certainly has come to expect that central banks will act as stabilizing speculators, buying dollars when others won’t. 

The world's central banks were probably sitting on more dollars than they wanted at the end of 2004.   But the combination of the Homeland Investment Act, rising fed rates and the defeat of the European constitution allowed many central banks to scale back their dollar holdings in 2005.  Central banks increased their euro and poud holdings dramatically in the first half of 2005.

At least that is what the IMF data suggests.   THe IMF data, though, is famously incomplete.  We know what central banks that report have done.  But we don’t know if the central banks that don’t report are doing something similar.   

I am doing some work with Christian Menegatti that uses the BIS data to try to fill in the gaps in the IMF data.  It suggests that a tiny bit of diversification.  There was a spike in pound deposits in q4 2005, and there was a spike in euro deposits in the second quarter of 2006.   Spikes that cannot be explained by looking at the countries that report data to the IMF.  

One note: the BIS data, though, doesn’t cover China, as the SAFE isn't a monetary authority.  The surge in pound/ euro deposits recently is coming from someone else. 

To be clear, the sums involved are still small ... too small to change the overall story.  The main story line is still that central banks are adding to their dollar reserves at an unprecedented pace, and providing nearly unprecedented financing for the US. 

But these side plots do hint that some central banks may now be holding more dollars in their portfolio than they really want.   And consequently they may not be terribly pleased to find that acting as “stabilizing speculators” requires that they add to their already large dollar portfolios.

I think Shinichi Takasaka (manager of foreign-exchange and financial products trading at Mitsubishi UFJ Trust and Banking Corp. in Tokyo) is only 1/2 right.  He argues: 

``Central banks in Asia are more concerned about their own currencies strengthening than they are about the dollar weakening, so this prevents them from selling the dollar aggressively,'' said Takasaka.

For most central banks, though, the question isn't about selling.  It is about buying.   The real issue is whether central banks will once again be willing to buy dollars agressively.  

The 5 trillion dollar question though is whether any of this prompts a major reevaluation of policy.    After all, a major shift in central bank policy is one potential source of a Wile. E. Coyote moment.  The 5 trillion dollar question though is whether any of this prompts a major reevaluation of policy.    After all, a major shift in central bank policy is one potential source of a Wile. E. Coyote moment.  

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