China doesn't seem to be moving out of the dollar yet

China not yet moving
away from dollar;
diversification story
masks rise in its
Treasury holdings in 2006

By Wanfeng Zhou
CBSMarketWatch.com
Thursday, November 16, 2006

http://www.marketwatch.com/news/story/story.aspx?siteid=mktw&guid=%7B17E...

NEW YORK -- China's reserve-diversification story remains very much in the spotlight in the currency market, yet there's little evidence that the world's largest holder of foreign-exchange reserves is selling U.S. dollars, analysts said Thursday.

The dollar briefly came under pressure overnight after Wu Xiaoling, deputy governor of the People's Bank of China, said that China had been buying yen for its foreign-exchange reserves, but recovered when she went on to say that China had held the yen for years.

The comments come after Zhou Xiaochuan, governor of the People's Bank, said last week that China has very clear plans to diversify its reserves, which now stand at more than $1 trillion, and is considering lots of instruments. His comments sent the dollar sharply lower and gold sharply higher.

Zhou later clarified his remarks, saying that there'd been no change in Beijing's diversification plan and that the central bank was not selling U.S. dollars.

About 72% of China's reserves are denominated in U.S. dollars.

It seems clear that Wu "was not announcing a new policy initiative," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. So as "cooler heads prevailed," in Chandler's view, "the dollar bounced back."

Furthermore, "in an environment of increasing reserve accumulation, diversification of reserves is not zero-sum -- the purchases of yen or euros for example, do not necessarily mean dollar sales," he said.

The Treasury Department's international capital-flows report released Thursday bear out that argument. The TICs data showed that while net long-term capital inflows into the U.S. fell to $65.1 billion in September from a revised $114.4 billion in August, Chinese holdings of Treasurys rose again in September to $342.1 billion from $339.1 billion in August.

In fact, the TICs data indicate that "Chinese investors have been net buyers of U.S. Treasurys every month since last November," Chandler said.

China's Treasury holdings have actually increased by about $38 billion since November 2005, the data show.

Obviously, China has the potential to heavily influence the currency market and wallop the dollar if it were to come out with a statement signaling aggressive buying of the yen, said Matthew Strauss, senior currency strategist at RBC Capital Markets. "It would have a major impact ... because of the size of China's reserves," he said.

However, precisely because the Chinese government knows of that potential, "it's highly unlikely that they'll ever come out with such a bold statement."

What's more, if China were to significantly reduce its purchases of U.S. securities, "it would put the yuan under some significant pressure to appreciate," Strauss said.

China has been buying large amounts of dollars over the past several years to prevent exactly that.

Kathy Lien, chief strategist at FXCM, cautioned that while the trend of Chinese purchases of U.S. securities remains "positive," foreign investors' waning interest in U.S. assets will make the large U.S deficit a growing problem over the long term.

"Right now, the strength of the U.S. dollar is supporting demand," she said. "But once we start to see meaningful dollar weakness, if the economy continues to deteriorate, then the outlook for falling yields as well as a falling U.S. dollar will encourage central banks to pile out of U.S. dollars."

With most of the attention on foreign-exchange reserves revolving around China, very little is said about Japan, the largest holder of Treasurys, which continues to quietly reduce its own holdings. Japan held $639.2 billion worth of Treasurys in September, down from $672.8 billion in the same period a year ago. Meanwhile, Treasury holdings by offshore Caribbean centers hit their lowest level in September since February 2004

A number of countries, including Sweden, the United Arab Emirates, Qatar, Italy, and Russia, announced plans this year to diversify their reserves away from dollars. The Russian, Swiss, and New Zealand central banks also said recently that they were increasing their holdings of yen.

Ashraf Laidi, chief foreign-exchange analyst at CMC Markets in New York, said a more dollar-friendly version of the diversification story suggests that "central banks will acquire more non-U.S.-dollar assets in their new accumulation, rather than outright selling of their existing dollar reserves, which would be detrimental to the currency value of these holdings."

But while central banks' reserve diversification is negative for the dollar, "it's unlikely to drive the dollar on a day-to-day basis," said Strauss.

The U.S. currency will maintain its status as the dominant reserve currency thanks to its liquidity and the large amount of trade conducted in dollars. "So far it has not and it will probably not have a major negative impact, driving and establishing a negative dollar trend," he said.

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