from Follow the Money

Maybe the US data is capturing something – Chinese and Korean reserve diversification

April 15, 2008

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The head of the People’s Bank of China says that China is seeking to diversify its reserves.

``China is seeking to diversify its foreign exchange reserves,’’ Zhou said yesterday, without elaborating. 

Of course, Zhou also said that the market now plays the dominant role in the determination of China’s exchange rate, a view which is hard -- in my view -- to square with record central bank purchases of foreign exchange.

Diversification could mean one of three things:

-- Adding new currencies to China’s reserve mix

-- Diversifying the kind of dollar assets China holds

-- Reducing the share of China’s reserves held in dollars

One and two are possible without changing the dollar share of China’s reserves. Deciding to hold say a few New Zealand dollars need not imply a reduction in the overall share of China’s reserves held in dollars. Shifting from Agencies to corporate equities need not reduce the dollar share of China’s reserves.

There is at least some evidence that China reduced the dollar share of its reserves – though there are enough holes in the US data that it is hard to know if the growing gap between China’s reported dollar holdings and its total foreign assets reflects a fall in the dollar share of China’s reserves or a growing gap between China’s total US dollar and what appears in the US data. But if China has reduced the dollar’s share of its reserves over the past two years, Europe really has cause to be annoyed. Growing Chinese demand for euros could have contributed to the euro’s rise and the RMB’s ongoing depreciation v the euro – a depreciation that does much to explain continued strong Chinese export growth.

Korea recently disclosed that it has diversified its reserves – reducing the dollar’s share of its reserves to 65% and broadening the type of assets that it holds. The Bank of Korea reports that:

Its investment portfolio last year included government and corporate bonds, asset-backed securities and common stocks. Investments in common stocks are managed by the Korea Investment Corp., the country’s manager of sovereign wealth funds.

Investments in treasuries, bonds issued by state-run entities and corporate bonds took a lion’s share of its investment management ― treasuries accounted for 35.5 percent, bonds by state-owned companies 28.8 percent, and corporate bonds 15.4 percent.

Investments in asset-backed securities accounted for 11.6 percent, followed by stocks for 1.3 percent.

But the central bank noted that it has been increasing its securities investments. Investing in bonds is considered safer than stocks, but investing in stocks gives higher returns in the long-term, analysts say.

``We have been diversifying our investment portfolio to offset risks concerning foreign exchange by seeking products that give higher yields with the country’s foreign reserve holdings,’’ said the central bank.

This confirms something that has long been apparent in the TIC data – namely that Korea was shifting out of Treasuries into riskier assets.

If Korea can offer this kind of detailed disclosure, I don’t see why others cannot follow suit. By investment in state owed companies, I presume Korea is referring to government sponsored enterprises like the US agencies. That would be consistent with the US data on its holdings.

The US data suggests that China has about equal amounts in Treasuries and Agencies. The US data though does not suggest that China has followed Korea’s lead and placed 25% of its dollar portfolio in corporate bonds and asset backed securities. Korea seems to have been more aggressive than China in diversifying both the currency composition and asset mix in its reserves, with mixed results. Buying riskier US assets probably hasn’t paid off; shifting away from dollars did.

Korea though has also reduced its intervention in the foreign exchange market and allowed its currency to move more than most in Asia -- something that likely made it a bit easier to adjust the currency composition of its reserves.

For what it is worth, I am now lowering my baseline estimate for the dollar share of China’s reserves from around 70% to a 65% to 70% range. The recent survey data just didn’t push Chinese holdings up enough for me to be confident that around 70% of China’s reserves are still in dollars. But barring better data/ a bit more disclosure on China’s part, I don’t have total confidence in adjustment my estimate downward either.

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