- Investors perpetually fear China's oodles of foreign currency reserves—primarily in US dollar-denominated assets.
- Chinese policymakers have few currency options to park their cash in. The US dollar is the only currency both stable and deep enough to suit their liquidity needs.
- Global investors shouldn't fret either way, since currency moves balance out over time.
During the 2008 Summer Olympics in Beijing, the Chinese hosts dominated with more gold medals than any other nation. Leading up to the Games, many countries threatened to boycott the still-communist empire. But that all turned out to be rhetoric—just about everyone participated. Same is true for the US dollar's status as the global reserve currency: Many potential deserters talk a bit, but none act. Chief among them is China, who holds trillions in dollar-denominated assets and talks a tough game, but hasn't budged. Still, investors perpetually worry China might abandon the US dollar for other currencies. But, at least for the foreseeable future, the dollar's primacy is about as sure as a Michael Phelps' swimming victory.
Since export-oriented China massages its currency to keep its exports cheap, China ends up with piles of foreign currency reserves. While the People's Bank of China (their version of the Fed) doesn't officially publish their currency holdings, their estimated $768 billion in US Treasuries (first quarter 2009) represents their largest holding. Despite regular calls for the world to move away from the dollar as its reserve currency, officials yesterday verbalized what's been in practice for years: The US dollar remains China's only realistic option.
Nearly half of Chinese exports stay in currency fragmented Asia, and its next largest export markets are Europe, the US, and Japan, in that order. China has not broadly diversified away from the US dollar since Europe, and other Asian countries are not viable options. China imports more from its smaller volatile Asian neighbors than it exports to them, and holding significant Asian currencies could actually raise Chinese import costs. Japanese bonds tend to yield no interest, making them less attractive.
The UK lacks the girth necessary to hold much of the massive Chinese piggybank, and the recent Standard & Poors UK credit warning highlighted UK weakness. That leaves continental Europe, which just last year seemed promising, but Europe's shaky legs don't inspire confidence, and China recently purchased US Treasuries. (And it's worth noting the dollar held up better than most other currencies during the 2008 financial crisis.) Like it or not, the US dollar remains the only currency stable and weighty enough to hold Chinese reserves.
But what if policymakers are wrong, and the Chinese convert their US dollars into foreign currencies anyway? The answer depends on how quickly they convert. A fast conversion would be Chinese economic suicide, as their exports would likely plummet and economy flounder. No wonder Chinese advisors strongly, and publicly, recommend against it. But a slow conversion—moving exchange rates imperceptibly—wouldn't necessarily be the end of the world. The idea of a world currency regularly surfaces but would take decades to implement. (Just think how tumultuous, arduous, and lengthy the process was just to get the euro off the ground.) If the Chinese (and others) slowly move away from the US dollar over the years (and again, it's highly unlikely right now), the US would then hold the same currency reserve status the Europeans, Japanese, and British have today. Is that so bad? We don't think so.
More importantly, global investors needn't lose sleep over exchange rate moves, which even out over time. Shifts in exchange rates can hurt firms in one region while helping those in another. When one part of a properly diversified global portfolio zigs as the other zags, the totality doesn't necessarily get whacked. Global investors should think of exchange rate moves like shifting money from one pocket to the other. Currencies ultimately amount to different flavors of money. China ran a smooth Olympic summer, and we can expect similar level-headedness managing their currency reserves. Expect a lot more jawboning in the meantime, but China certainly won't disqualify themselves this early in the game.