Can China Really Diversify Away from the USD?

When QE2 hit the world, Chinese bank officials found themselves scrambling to find ways to fight the inflow of foreign investment to their country. Huh? Why would they do that? Isn’t foreign investment GOOD for the economy?

Ahh, not quite young padawan… Too much of something is always bad, and foreign investment is not excluded from that! If too much money flows into China, it could trigger uncontrollable inflation and lead to huge asset bubbles.

Quantitative easing programs also tend to “cheapen” currencies, in this case the USD, which puts China’s huge USD-denominated holdings in danger. Take note that more than 60% of China’s foreign reserve is made up of USD-denominated assets!

The People’s Bank of China (PBoC), in an effort to protect China from the possibility of inflation and asset bubbles, has been consistently increasing the required reserve ratio (RRR, or the minimum amount of money that the bank must hold on to with respect to customer deposits and notes) of commercial banks.

The RRR currently stands at 18.5%, which is its highest level in like… uhh… ever! Market junkies say that the direct approach at managing market liquidity showed China’s determination control price pressures, and its cautiousness at tightening monetary policy.

China has also been slowly diversifying its FX reserves to reduce its exposure to the USD. In fact, in the first seven months of 2010 China added more than 25 billion USD worth of short-term yen holdings. It has also more than doubled up its Korean debt holdings in 2010, stocking up a total of 5 billion USD worth of long-term won papers by October 2010.

But really, does China have any other choice than the dollar? Given the high dollar share of its FX reserves, China will find it very difficult, if not impossible, to truly diversify.

For one, China keeps its currency, the yuan, pegged to the U.S. dollar. What this means is that the yuan is only allowed to appreciate (or depreciate) within a very tight range (+/- 1%) against its counterpart. Because businesses aren’t prone to constantly fluctuating exchange rates, it makes trade between China and the U.S. easier and more predictable.

Imagine you’re a business owner in the U.S. who imports a lot of raw materials from China. Wouldn’t you rather trade in an environment where your costs are 100% set in stone than in an environment where prices are constantly changing?

If the U.S. dollar were to suddenly drop in value, it would lead to an increase in purchasing costs, making you less profitable. You may even take your business elsewhere if costs become too high!

China realizes this so they make sure that their prices are always competitive. The easiest and probably the most affordable way to keep the dollar high with respect to the yuan is to buy dollars from the open market.

Also remember that the U.S. Treasury market is the biggest government bond market. It provides relatively higher liquidity and security, which means transactions costs are very low. This makes it very appealing to investors.

Besides, do you really think China would rather invest in euro zone assets given Europe’s sovereign crisis? I don’t think so. The gold market can be a good alternative for its foreign exchange reserves, but it isn’t as big as the T-bill hood which makes it more volatile and risky.

So for y’all naysayers out there, worrying that China is going AWOL on the dollar as its major reserve currency, you may want to take it easy. There’s no denying the dollar’s safe-haven status and it looks like the Chinese will be sticking with it for quite some time.