China aims at dollar but Europe could get hit as euro soars

By Lisa Twaronite
MarketWatch.com
Wednesday, November 7, 2007

http://www.marketwatch.com/news/story/china-aims-dollar-europe-could/sto...

SAN FRANCISCO -- A renegade Chinese official took aim at the dollar Wednesday and sent it plunging against major currencies, but ultimately it will be Europe -- not the U.S. -- that could bear the brunt of the pain of its appreciating currency.

Cheng Siwei, vice chairman of the Standing Committee of the National People's Congress, was quoted by wire services as saying that China should shift more of its $1.43 trillion of currency reserves into "stronger currencies," such as the euro, to offset "weak" currencies like the dollar.

Cheng's reported clarification that he did "not mean China should buy euro" failed to prevent the dollar from dropping across the board against major currencies, and hitting a new nadir against the euro, which rose as high as $1.4730 in the wake of Cheng's remarks.

Most analysts said that Cheng, who is notorious for his off-the-cuff, market-moving remarks, was probably not expressing official policy. A rapidly plunging dollar isn't in China's best interest, because it erodes the return on the country's massive holdings of dollar-denominated assets.

However, a more gradually dropping dollar is in China's interest -- at least for the short-term.

Euro strength means European exports are more expensive and therefore less desirable in overseas markets, whereas yuan weakness gives Chinese imports a competitive edge in European markets.

So some analysts therefore took Cheng's comments as tacit admission that China has welcomed the dollar's recent downtrend against Europe's united currency.

"China's move today formalizes its mercantilist interest in a rising euro," wrote Charles Dumas, an economist for London's Lombard Street Research.

China's European Union-bound exports are now larger than those to the U.S., Dumas noted. Moreover, China's exports to the E.U. have grown by 37% this year, outpacing 17% growth for U.S.-bound exports.

"A rising euro enables China to move the yuan up against the dollar while it falls against the euro, improving China's competitiveness in its largest, fastest growing export market," Dumas said.

Cheng said Wednesday that a rapid appreciation of the yuan is not necessarily the right move, though he insisted that the country wasn't actively seeking a major trade surplus.

But the trend has not escaped the notice of European policymakers, who zeroed in on China and its currency at their meeting last month.

Jean-Claude Juncker, chairman of the Eurogroup of finance ministers, European Economic Affairs Commissioner Joaquin Almunia and European Central Bank President Jean-Claude Trichet plan to make an official visit to Beijing before the end of the year, and analysts expect the yuan to be at the top of their agenda.

To be sure, China, awash in liquidity and facing mounting inflationary pressure, can't afford let the yuan drop against the euro forever. Allowing its currency to appreciate would have the same net effect as a monetary tightening, and would therefore help prevent the economy from overheating.

But if China does nothing, Dumas said, "Europe could start to suffer real pain -- not just China's displacement of European production, but the broader deflationary impact of the rising currency."

China, whose holdings of U.S. Treasury bonds are second only to those of Japan, is already diversifying out of that asset. The latest data show its Treasury holdings were down 5% at a six-month low of $400 billion.

But overall, it would be "prudent to take the Chinese diversification story with a grain of salt," wrote Benjamin Reitzes of BMO Capital Markets Economics.
He said that according to estimates, China currently holds about 60-70% of its foreign exchange reserves in dollar assets, amounting to about $900 billion.

"If China were to start a fire sale of its U.S. dollar-assets, it would face prohibitive losses. A more likely scenario would be for China to stop accumulating U.S. dollars, not an outright sale," said Reitzes.

"We think the majority of China's currency diversification has already taken place. It seems Cheng was not speaking for the People's Bank," said James Malcolm, global emerging markets currency strategist at Deutsche Bank in London.

Malcolm added that it was a "ludicrous thing to say that a super-long term asset manager should buy more of the expensive assets."

In fact, Wednesday's dollar rout triggered by Cheng's comments might have even complicated whatever official policy China has mapped out for its currency.

"A sharp dollar decline would frustrate official attempts to allow the [yuan] to appreciate only gradually," according to Marc Chandler, currency strategist at Brown Brothers Harriman.

"It would not be surprising for some Chinese officials to again rap Cheng Siwei's knuckles and distance official policy from his statements," Chandler said.

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