China Pushes More Diversification In Foreign Exchange Reserves As Part of “Going Out” Strategy

China’s massive foreign exchange reserves are the largest in the world, comprising a total of $2,132 billion or $2.1 trillion dollars’ worth.  Of this amount, $1.5 trillion are held in US Dollar-denominated assets such as cash, bonds and treasuries.  When you do the math, about 71% of China’s total foreign reserves are in US Dollars.  As you can see, that’s not very diversified.  So whatever else, if just from a purely investment portfolio point of view, China needs to diversify its assets.

Recently, in addition to Beijing’s suggestions that the G20 consider reforms to the world reserve currency — which is currently the US Dollar and has been by decree since 1944 — Beijing has been pursuing a new economic policy which Mr. Wen Jiabao, the country’s premier, calls the “going out strategy.”

The “going out” of China refers to a two-pronged strategy that would see Chinese companies increasing their share of global exports and engaging in new investments and acquisitions overseas.  Importantly, perhaps not surprisingly, China’s foreign exchange reserves will be behind this new push.  According to Qu Hongbin, senior China economist at HSBC, “this is the first time we have heard an official articulation of this policy of using foreign exchange reserves to directly support corporations to buy offshore assets.”

Mr. Qu also said this is part of Beijing’s overall strategy to reduce its reliance on the US Dollar.

China’s Forex Reserves Between a Rock and A Hard Place

According to a BNN interview with Rachel Ziemba at RGE Monitor, China currently sits between a rock and a hard place.  On the one hand, they don’t want their currency to appreciate against the US Dollar, because that will hurt their export trade in the near and present term.  On the other hand, looking further into the future, China is clearly concerned about the strength of their investments if they’re sitting in dollars the value of which are being inflated away.

To chart a middle road between these constraints, China has been slowly diversifying “on the margins” by acquiring resource companies, gold bullion, and shifting to purchases of shorter-term US notes and treasuries, away from longer-term bonds and notes.  By focusing on the shorter term, China can help hedge its bets against the future of the dollar.

Basically, China is shorting the US Dollar, in its own cautious way.

Concern over the value of the US Dollar – in a climate of greater inflating strategies and deficit increases as large as those in WW2 – is no longer limited to “extremists” such as Peter Schiff or Marc Faber.  We’re now seeing reports from mainstream and lesser-known analysts expressing the same reservations and caution about US Dollar strategies.  James Rickards, senior director for market intelligence at Omnis, Inc., has blatantly referred to the prospect of the US inflating away its debts — in polite terms — as an engineering of a “wealth transfer” from China to the United States:

“if I back up a truck to your house, break in, steal all your valuables, and your computers and so forth, you’re going to call the police on me and I’ll be arrested as a thief.  That’s what we’re doing to China.  By inflating the dollar, and pursuing a program of inflation, it represents a wealth transfer from China to the United States, because the value of their assets goes down, and the value of our debt goes down.  And that’s what they’re deeply concerned about.”

But it’s not just China who needs to worry; US economists also rightly worry about the risk of the US continuing to depend on the willingness of foreign countries (mostly China and Japan, who are the biggest buyers) lending the US cash.  As Bill Tucker (CNN New York) reports, some see the need for Geithner’s visits to China and other Asian countries, assuring the U.S. creditors of the U.S.’ credit worthiness, as a sign of its economic vulnerability.  Basically the debt causes trouble on both sides of the hole – or mountain (whichever metaphor you prefer).

Size of Federal Budget Deficit: 11 trillion dollars and counting…

Size of U.S. Trade Deficit: 7 trillion dollars

Consequences of the massive debts?  At best, it’s going to come due over the next two generations and the U.S. standard of living all around will be lessened, according to Alan Tonelson of the U.S. Business and Industrial Council.

No matter what side of the fence you stand on, the picture doesn’t look pretty and it won’t be easy to deal with, even if the solutions are simple.  The US needs to produce and export more real goods rather than simply consuming the world’s goods and resources.  And other countries like China will have to be willing to take an export hit when their currency rises, rather than trying to artificially keep their currencies down.  Anything else is to stray from free market principles and will just cause economic problems elsewhere.

If you haven’t been paying attention to all of these developments, you might also like to read some recent updates I’ve written on China’s foreign reserves and the world reserve currency situation:

Supracurrency Coin Proposed As United World Reserve Currency (July 12, 2009)
Zhou Xiaochuan’s Proposal For World Reserve Currency is Accepted by UN (March 29, 2009)
US Dollar Reserve Status Up For Debate Ahead of G8 (July 5, 2009)

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Tagged as: China, foreign exchange reserves, foreign investment, forex, Renminbi, USD, world reserve currency