China's dollar dilemma worsens after US drama

Are China's trillions in foreign exchange reserve, money under the mattress? As Standard & Poor's downgraded US debt and Chinese rating agency Dagong cut US rating from A+ to A, there is growing disquiet about the way the forex reserve is deployed. China's foreign reserves totalled nearly $3.2 trillion (Dh11.74 trillion) by the end of June, rising 30.3 per cent year on year. Of this, $1.15 trillion was in US Treasury debt as of April end. And as the largest foreign holder of Treasuries, China was not amused by the high drama of Washington. The question is can China halt or even slow the momentum of the financial forces it unleashed two decades ago. China's overseas financial assets and liabilities have increased constantly over the past few years, boosted by increased foreign-exchange reserves and overseas investments. In fact, it has run a current account surplus and a capital account surplus almost uninterruptedly for more than 20 years. Inevitably, this has led to an accumulation of foreign reserves. It is clear now that running these surpluses is not in China's best interests. Article continues below Vulnerable For one, China holds a large stash of dollar-denominated foreign assets, as well as significant amounts of yuan-denominated liabilities. This currency structure of assets and liabilities makes its net international investment position very vulnerable to any devaluation of the dollar against the yuan. A strong reason why China resists any appreciation of its currency. Also, up until this year, China followed the "mandatory foreign exchange settlement" regime. Under that system, companies were required to sell 100 per cent of their foreign-exchange earnings to the central bank. The system began to change in 2002, when restrictions on opening foreign-exchange accounts were eased. In 2007, companies were allowed to retain foreign exchange within China for business purposes; since 2008, they could retain it for any reason. As of this year, companies are being allowed to retain foreign exchange outside China. Some Chinese economists strongly suggest that the yuan issued through the central bank's mandatory foreign exchange settlement regime is the "direct" reason for China's surging inflation. Other reasons There are other reasons too for the foreign kitty overflowing. The central bank buys up dollars and other currencies that come into the economy. In return, it issues yuan, because the Chinese currency isn't freely convertible. Foreign exchange keeps flooding in because China holds a long-term surplus in international payments. Analysts argue that issuing so much domestic currency as a result adds to liquidity and pushes up price levels. But now, the Chinese government has publicly admitted that its foreign-exchange reserves have exceeded its utility and there is need to slow down its growth and protect the value of the existing stock. The trouble is — lack of investment options. The structure of China's forex reserves cannot be adjusted any time soon, as the greenback remains a safe area for investment compared with other currencies. Also, supplies of other types of assets are just not large enough to digest China's huge forex reserves. In April, China bought bills worth $7.6 billion and in May $7.3 billion. The purchase reversed its previous stance when it offloaded US Treasury bonds for five consecutive months since October 2010. Diversifying Even though China's holding in US bonds has increased, their proportion in the country's overall foreign reserve is declining. Fearing over-dependence on the Treasury bonds, government-wealth managers — State Administration of Foreign Exchange (Safe) and China Investment Corp (CIC) — have been diversifying as rapidly as possible. Last year, they more than doubled their investments in major Japanese blue-chip companies, with combined stakes totalling more than $19.4 billion. However, the two entities purchased the stakes mostly through obscurely named Australian-registered investment vehicles, according to media reports. Safe Investment Co and CIC are the fourth and fifth largest sovereign wealth funds in the world. Currently, CIC is mainly responsible for the overseas investment of the swollen foreign reserves and is trying its best to diversify the basket. CIC increased its investment in private equity, property and infrastructure and is venturing into emerging economies, especially South America. In April, China's central bank started planning for new investment funds to diversify the foreign reserves in energy and precious metal markets.