China's dilemma
Beijing wary of doing anything to provoke further US dollar decline
Having amassed a vast amount of foreign reserves valued at about US$1.33trillion, China is caught between a rock and a hard place by the steady decline in the value of the greenback on global foreign exchange markets.
On the one hand it would like to hedge against the erosion of value the dollar's decline causes for its foreign reserves - an estimated US$700billion of which are held directly in long- and short-term dollar assets, chiefly US treasuries; but on the other hand any large-scale selling of the dollar by the People's Bank of China in favour of the euro, for instance, would trigger even sharper falls in the exchange value of the dollar as it is dumped from China's reserves.
The appreciation of the yuan by nearly 9 per cent against the dollar since China switched to a managed float for its currency against a trade-weighted basket of currencies in July 2005 has, by these measures, already wiped about US$63billion off the value of its reserves.
Over the same period of little more than two years, the euro, on the other hand, has gained in value against the yuan.
In July 2005, it took 9.79 yuan to buy one euro, whereas today it requires 10.84 yuan - an appreciation in the euro-yuan exchange rate of 10.7 per cent.
It is small wonder then that mainland officials have periodically signalled their frustration with this state of affairs, dating back to 2004, when China Business Weekly reported that China was looking to diversify out of US dollars.
China Business Weekly also cited China's chief foreign exchange regulator, Guo Shuqing, who said the make-up of the country's foreign exchange cash holdings would be altered to include more European and Asian bonds, given concerns over a weaker US dollar.
In April this year, Xia Bin, director general of the Finance Research Institute at the Development Research Centre (a post that carries cabinet rank), suggested China's reserves ought to be deployed not into US treasuries, but into the purchase of bonds issued by a new foreign exchange reserve investment company that in turn could use the proceeds to invest offshore.
In August, China Daily reported that Mr Xia believed China could use its foreign reserves as a 'bargaining chip' in talks with the US. The point was underlined by comments from He Fan, an assistant director at the Chinese Academy of Social Sciences, who said: 'China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the dollar as a reserve currency. Russia, Switzerland and several other countries have reduced their dollar holdings.
'China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciates dramatically, which might lead to a mass depreciation of the dollar,' according to the China Daily report.
So. The intention is clear. China would like to sell-down its US dollar holdings and the euro would be the most likely beneficiary.
But the dilemma facing mainland policymakers is how to accomplish this without shooting themselves in the foot and triggering a sharp fall in the value of existing US dollar assets.
