China's Reserve Policy Once Again

Geoff Dyer and Andrew Balls of the Financial Times try to read what China's demand for dollar-denominated securities will be in the next two years. They, of course, succeed only in reaching new and higher levels of bafflement:

FT.com / World / Asia-Pacific - Questions grow over China%u2019s forex strategy : By Geoff Dyer in Shanghai and Andrew Balls in Washington. Published: January 6 2006 19:13 | Last updated: January 6 2006 19:13: China’s foreign exchange regulator raised more questions than it answered with a statement on Thursday evening about a possible change in its strategy for managing the country’s burgeoning foreign currency reserves.... The spectre of Asia’s central banks deciding to diversify away from their dollar holdings has long threatened a sharp drop in the value of the US currency.... Economists estimate that as much as 75 per cent of China’s reserves are held in dollar assets.... But market reaction yesterday to the announcement was limited. China-watchers pointed out that the statement on Thursday evening did not come out of the blue, but followed comments by government officials and academics questioning the wisdom of China’s reserves management strategy....

Foreign investors have continued to be willing to finance the US current account deficit at very low interest rates in spite of the foreign exchange losses they suffered during the dollar’s decline from 2002-04. This has made it easy for the US to finance its current account deficit, which has risen above 6 per cent of gross domestic product and requires the US to import more than $2bn of capital from abroad every day.... [T]he size of the US current account deficit, the prospect that the end of the Federal Reserve’s campaign of interest rate increases is in sight, and the possibility of a slowdown in the US economy may lead to renewed pressure on the dollar, some economists forecast. In such an event, the International Monetary Fund and the World Bank have warned that developing countries face potentially large losses on their holdings of dollar reserves. Diversification makes sense for individual countries, including China, but may cause trouble if a number of countries try to do it at once.

Comments

[anne]

Now, I have not the slightest idea what currency policy will be in China this year or the coming year but but but when currency caution by China has been such a boon for so long carrying her with barely a ripple through devaluation surges of the 1990s, when economies and international stock markets have fared so remarkably well for all the currency complaints of last year, I would expect the same caution by China.

China's economic policy makers have been remarkably adept for years from assuring infrastructe development to foster development in easing market strains to knocking down inflation without using modern monetary policy, while the Chinese growth is fostering growth elsewhere. What an interesting period.

[Ian Whitchurch]

Yeah, but what does "caution" mean in these circumstances ?

If even elements of the Chinese state decide that caution = diversification, then things could get ugly fast (ie if a US bond issue fails to clear ... is this credible ? I've seen low numbers for private bids on US treasuries, but it's not my field).

[anne]

http://www.calvorn.com/gallery/photo.php?photo=6002&exhibition=7&u=99|1|...

Purple Sandpiper
Barnegat Light, New Jersey.

Hi Ian :) The sense I have of the inherent caution in policy is that both China will continue indefinitely to be a significant buyers of American bonds. Japan will follow and I expect a significant amount of resource money, oil and gas, to be used to buy American bonds. Diversification can gradually be achieved by as gradually adding to purchase of European bonds. Domestic economists seem comfortable that the purchases can be indefinitely stabilizing, international economists worry quite a lot.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=3920&exhibition=67&u=11682|6|...

Rock Pigeon on Rock
New York City--Central Park, Harlem Meer.

Brad Setser, who is awfully sharp, can easily prove how unstable for China gaining American debt must be, yet it has not been. China has opted not to use modern monetary policy for inflation control, rather than direct market interference. The idea is that there is enough systematic flexibility to allow for a local slowing or recession in the midst of a national boom, and the boom can as such be controlled.