from Follow the Money

Don’t invest your reserves in euro …

January 9, 2006

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If you report their value to your boss in dollars.

That seems to be the lesson China's State Administration of Foreign Exchange learned in 1999.   I alluded to this story in my last post, but it is too interesting not to present in full.

Via Market News International, an interview with Li Yang, an economist with the Chinese Academy of Social Sciences  (CASS) and former member of the monetary policy committee under the People's Bank of China (PBOC):    

"The market certainly got the wrong idea from that one brief  comment from the foreign exchange administration," he said. "It's possible that China will diversify newly added foreign exchange  reserves, but it's going to be impossible for them to divest existing dollar-dominated assets."  ....  China currently holds around $800 bln in foreign exchange  reserves, and any selling by China could trigger massive fluctuations in the international market or competitive selling from neighboring countries and that in turn will hurt China," he said.

He added that China began considering diversifying its holdings as early as in 1999, but that US dollar-dominated treasuries and bonds are still the most desired assets under that strategy. "The US dollar is strong and the dollar interest rates are higher than those of other currencies," he said.

...     Bureaucratic considerations are also playing their part, Li said,  noting that SAFE [State Administration of Foreign Exchange] reports a dollar figure to central government leaders,  and that career-minded managers are not going to risk reporting  shrinking foreign exchange holdings to their superiors.

"It's calculated in US dollars so if its slides, the face value  isn't reduced," he said. "But if SAFE uses its existing US dollars to  buy other currencies, dollar strength could mean a reduction in the face value."

 

Li noted that a diversification strategy had been pursued by Li Fuxiang, head of SAFE from 1998 until 2000, during the run up and  immediately following the launch of the euro in 1999, and that China took a big hit after the new currency weakened sharply against the greenback.  Li had a strong expectations for the euro and purchased lots of European currencies even before it euro was formally launched," he said.

"But the euro fell significantly against the US dollar to a low point of 0.81 and that caused enormous losses for China's foreign  exchange reserves and put huge pressure on Li personally."

"It is the lesson that China's foreign exchange reserve managers  won't forget".  Li committed suicide in May 2000.

Not having to report losses to your boss is clearly one reason not to diversify your reserves, and so long as reserves are reported in dollars, that could well create a built-in bias for dollar reserves.  But I suspect Li let another cat out of the bag when he noted that central banks -- not just private investors -- care about interest rate differentials.  They like holding short-term dollars at 4.25 better than holding short-term dollars at 1.

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