Dollar Going Out With A Whimper, Not A Bang — So Far

Last year the US ran a $272 billion trade deficit with China, which means we sent the Chinese that many extra dollars in return for the clothes, toys and iPhones they sent us. This lopsided relationship has been in place for a long time, allowing (or requiring) China to accumulate about $1.7 trillion dollars of various kinds of US paper.

From China’s perspective, this is a good deal in the short run but potentially a bad one longer-term. And lately the world has been wondering what they would do with all this low-yielding, rapidly-depreciating currency. The worst case scenario had them reacting to US deficits and debt monetization by converting their dollars into real assets at pretty much any price, sending the value of the dollar through the floor and igniting a currency crisis or hyperinflation.

Optimists dismissed the above as unlikely, since traders would see the change in strategy coming and front-run China by dumping dollars immediately, decimating the value of China’s remaining reserves. So the only option for China — and Japan, Saudi Arabia and other big trade surplus countries — is to keep playing the game by accumulating dollars in order to protect the value of their current reserves.

But there’s a lot of policy room between unrestrained accumulation and complete abandonment of the dollar. A surplus country can, for instance, keep accepting dollars but convert a growing share of them into other currencies or hard assets, over time lessening the dollar’s relative importance. This, it turns out, is exactly what China has been doing:

China’s Share of Reserves in U.S. Dollar Dives

By Tom Orlik and Bob Davis

Beijing—Fresh U.S. Treasury data suggest that China has lost its taste for investing as much of its $3.2 trillion in foreign-exchange reserves in U.S. dollars and may be increasing its holding of euro-denominated securities during a time that a debt crisis has roiled European markets.

Economists have long warned that if China started to cut back its purchases of U.S. securities, U.S. interest rates could climb, damaging the U.S. economy. China’s diversification of its vast reserves, however, hasn’t caused disruption so far, partly because of strong global demand for U.S. securities as a safe haven during troubled times.

Overall, foreign demand for dollar securities has remained strong; foreign holdings increased $1.8 trillion, or about 17%, to $12.52 trillion over 12 months to June, according to the Treasury data.

But the data, which provide one of the very few clues about how China invests its reserves, suggest that the percentage of dollar holdings in China’s foreign-exchange reserves has fallen to a decade-low of 54% from 65% in 2010. Purchases of U.S. securities equaled just 15% of the increase in China’s foreign-exchange reserves in the 12 months, down from 45% in 2010 and an average of 63% over the past five years, according to calculations based on information published by the U.S. Treasury and the Chinese government.

Some economists said China’s move was well-timed. “It would be optimal for China to adopt a contrarian strategy and pick times when the dollar is strong to aggressively diversify the currency composition of its reserve portfolio away from the dollar,” said Eswar Prasad, a China scholar at the Brookings Institution.

China won’t say how it invests its foreign-exchange reserves, which have grown rapidly over the past decade. Beijing has used its control over the exchange rate as a key plank of its development strategy and has racked up immense trade surpluses. That requires China’s State Administration of Foreign Exchange to invest the proceeds overseas. In the past, SAFE has hinted that about two-thirds of its stash is held in U.S. securities, a percentage that generally has been in line with annual data collected by the U.S. Treasury.

The new Treasury data suggest China has begun to rapidly diversify its portfolio of currencies. “It clearly indicates China’s intention not to put all eggs in one basket,” said Lu Feng, director of Peking University’s China Macroeconomic Research Center.

China has many reasons to try to reduce its exposure to the dollar. They include very low yields paid by Treasuries and a vulnerability to U.S. decisions on managing its debt that could lead to inflation that would erode the value of those holdings. Last summer’s political debate over raising the U.S. debt ceiling sparked worries that the U.S. could default on some payments.

To arrive at the percentage of dollar holdings in China’s reserves, U.S. Treasury data on Chinese purchases of U.S. securities must be compared to Beijing data on its foreign-exchange holdings. That calculation is complicated by the impact of currency movements on the value of China’s reserves. Even so, it is clear that China is purchasing fewer dollar-based securities than it had in the past.

Treasury data show that China’s holdings of U.S securities edged up 7% up to $1.73 trillion as of June 30, translating into an increase of $115 billion from 12 months earlier. Over the same time, China’s foreign-exchange holdings increased by 30% to $3.2 trillion, an increase of $743 billion. Essentially, the pace of China’s purchases of U.S. securities didn’t come close to matching the pace of expansion of its foreign reserve pile, reducing the percentage of dollar holdings in China’s foreign exchange haul.

Nick Lardy, an expert on the Chinese economy at the Peterson Institute, noted that a fall in China’s holdings of debt issues by troubled mortgage giants Fannie Mae and Freddie Mac accounted for most of the decline. Over the period covered by the annual survey, China continued to add to its holdings of U.S. Treasurys, he said.

Monthly data on China’s holdings of U.S Treasurys has been seen as less reliable than the annual survey. But the Treasury has now introduced a new survey technique intended to improve the accuracy of the data. The latest numbers show China’s holdings of U.S Treasurys dropped to $1.15 trillion in December, falling $156 billion since the period covered by the annual survey. That suggests China’s diversification away from dollars may have continued in the second half of 2011.
As China has appeared to lose its dollar appetite between June 2010 and 2011, the greenback weakened 9.2% against a broad range of currencies according to the Federal Reserve. It has since risen about 3%, as the euro crisis deepened and the U.S. economy has shown signs of strengthening.

Where did the money not invested in dollars go? China’s SAFE won’t say. Officials at the foreign-exchange agency didn’t respond to questions faxed to them on Thursday.

But China’s leaders have made increasingly strong statements that they would like to help the 17-nation euro zone deal with its troubles. In February, Premier Wen Jiabao, speaking at the EU China summit, said “Europe is a main investment destination for China to diversify its foreign-exchange reserves.”

Klaus Regling, the chief executive of the European Financial Stability Facility—the euro-zone’s rescue fund for Greece and other financially troubled nations—was in Beijing in October for talks with SAFE. Regular talks have continued since then and EFSF documents show that Asia, apart from Japan—essentially China—accounted for between 14% and 24% of purchases for three EFSF bond sales worth €13 billion in the first half of 2011, before Mr. Regling’s trip to Beijing.

Stephen Green, China economist at Standard Chartered, said the majority of China’s increased investment in Europe has probably gone into core euro zone countries like Germany that boast relatively low debt levels. Chinese officials have privately made clear that they are wary of buying bonds directly from Greece, Portugal and other troubled European nations.
With Europe’s fiscal situation being even more precarious than that of the U.S., a shift of reserves into euros brings its own risks.

Mr. Green, the Standard Chartered analyst was acerbic in describing China’s choice between investing in the U.S. and Europe: “At least if you diversify into Europe, you are balancing your risks between two equally awful fiscal messes.”

Some Thoughts
Moving out of dollars and into euros, even via German bonds, is not, as the analyst quoted above points out, an especially high-percentage bet. There are two explanations here: 1) China doesn’t understand Europe’s dilemma, which is that either the eurozone falls apart — a bad thing for all European paper — or Germany takes the peripheral countries’ debt onto its own balance sheet via guarantees and direct aid, which is bad specifically for German paper. Or 2) China grasps Europe’s situation but is so desperate to get out of dollars that it’s willing to “diversify” into something just as bad.

But it’s not just euro-bonds that China is accumulating. They’ve been buying gold (only admitting it after the fact), and farmland and mines in Africa and Latin America. So the quality of their portfolio is rising as it shifts towards hard rather than financial assets.

As the article also notes, China’s scaling back of its dollar holdings in relative terms hasn’t caused the dollar to tank because the rest of the world is so troubled that money is flowing into dollars by default. This is probably temporary. Either the rest of the world gets its act together and begins to look safe again or the US is sucked into the maelstrom of a eurozone implosion or Middle East war or whatever. Or our ongoing debt binge finally gets the scrutiny it deserves and even in an unsafe world the US is discovered to be fundamentally unsound.

So for surplus countries the dollar’s recent exchange rate stability is a great chance to sell into strength and accelerate their diversification programs. Next year’s numbers will probably show another big shift out of dollars.

Why does it matter what China or any other country does with dollars the US has already created and spent? Because the foreign exchange markets are where the dollar’s value is determined, and the numbers are now huge. There are maybe $3 trillion in the vaults of just a handful of countries, all of whom want to protect their investment and none of whom trusts the US to do it for them. If China is seen as easing itself out of dollars without adverse consequence, then the other big dollar holders will be tempted to follow suit. The result: a growing number of sellers, which will eventually send the dollar down at an accelerating rate, which will cause the remaining dollar holders to panic and head for the exits. Trillions of dollars being converted to hard assets or euros and yen (or Mexican pesos or Brazilian real) all at once is a currency crisis that the Fed won’t be able to stop.