China's Influence on the Dollar

At the end of last year, China's foreign reserves had reached somewhere around $800 billion. This year for 2006, it will likely reached $1,000 billion (or $1 trillion) making this populous country the world's largest single holder of official reserves. According to FT.com, about three-quarters of these holdings are believed to be dollar-denominated assets.

This past Thursday, China's foreign exchange regulator made a statement about wanting to "optimise the currency and asset structure" of their country's foreign exchange reserves and to "actively boost investment returns." This was buried in the beginning of the year announcements for 2006. By reading the statement, it really had no concrete information, but economists believed it was a warning that China could shift away from investing into US dollars. However, market reaction has been limited.

With over $800 billion in foreign reserves, China can actually cause a substantial impact on global financial markets if it chose to move ahead and greatly influence the currency markets. If it decided to move away from the US dollar, it will undoubtedly place a lot of downward pressure on the greenback. Also, it would increase political sensitivities in Washington.

Please note that foreign investors have continued to be willing to finance the US current account deficit at very low interest rates in spite of foreign exchange losses they suffered during the dollar's decline from 2002 to 2004. This has made it easy for the US to finance its current account deficit, which is currently at more than 6 percent of GDP and requires the US to import more than $2 billion of capital from abroad every day.

If China wanted to cause massive havoc on the US dollar, it could choose to sell all of its dollar-denominated assets. Unfortunately, it would lead to a crash among most of the financial markets and a worldwide recession. But then you would need to find a buyer for all those securities, but the loss ratio would be way too high.

Realistically, China could become less willing to finance any more US securities so it will be much more harder for the US to find another country to help finance their account deficit. I am sure Japan, Taiwan, and South Korea could pick up the slack but their financial clout would only work for only a short-term period. The end result would be a downward spiral of the US dollar and pushing up US interest rates. For something happening on a higher level, US could be very concerned if China manages to persuade a majority of Asian countries to follow its lead in reducing their investment on holdings of US Treasuries.

One piece of good news for the US dollar, the latest Fed data shows that foreign direct investment increased from last year as well as an increase in private portfolio flows, so it meant that the US had to rely less on foreign central banks to buy their Treasury bonds.

However, both the International Monetary Fund (IMF) and the World Bank have warned that developing countries could face potentially huge losses on their holdings of dollar reserves.

Realistically, China would not immediately start dumping the dollar without causing a crash among the financial markets. It would take several months or perhaps over a period of a year or two to start changing its investment strategy with regards to the US dollar. It could slowly start to shift its reserves to the Euro and the Sterling causing the dollar to fall. It can also choose to be less willing to continue adding to its holdings of US Treasuries.

FT.com Article - Questions grow over China's forex strategy

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Posted by: Forex
Posted on: April 21, 2007 04:16 PM

As someone who makes a living trading the Forex markets, I can assure you that China has a strategy in place to reduce their dollar holdings, spurred primarily by the Fed's seeming unwillingness to deal with true inflation in this country. Our plan (which is to more or less remove any commodity in which prices are rising from the database of items which are used to determine inflation...gasoline and foodbeing the two biggies right now) leaves China with no choice but to dump the dollar in favor of a more stable currency, namely the Euro. I agree it won't happen 100% overnight, but it is happening right now and will continue for months to come until Chinese reserves are down to a level where the dollar's collapse won't inflict much pain on what has become the world's fastest growing economy.

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Posted by: forex trader
Posted on: May 20, 2007 08:32 AM

China yuan rises with their growing GDP.

I think the recent massive US interest rate cut shows that our government is not all that concerned about inflation. This in addition to China will put increasing pressure on the dollar and encouragement to gold traders.

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Posted by: Th0rest
Posted on: December 15, 2007 07:33 PM

After I have been active in Forex for over a year now, I did track US dollar a lot, since it was my primary target in pairs. About China's influence on dollar I can say, that yes, it has some influence, but influence of US on China is significantly higher! On the other hand, China is developing in a faster pace than anyone would like to believe. China is doing great and they are faster in reaching Millenium development goals than USA or EU.

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Posted by: Hendra
Posted on: January 1, 2008 05:54 AM

For all of China's growing influence, some analysts say people overestimate its actual power.

Albert Keidel, an economist with the Carnegie Endowment for International Peace in Washington, says China is still a relatively minor player in a market where $1 trillion worth of currency trades hands each day.

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Posted by: John
Posted on: January 25, 2008 02:41 PM

The analyst could be wrong. China economy are growing year to year.

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Posted by: forexmania
Posted on: April 4, 2008 12:20 PM

Agree with John . China will be the fastest growing economic in 2008

China has very big amount of USD. This means USA and China can't make a war in short time period.

I wonder how far this crisis can go.
If we could represent dollars as the empire state building.

China has all the floors above the ground and US has the basement only.

Thank you

Alexandros Delaportas

In the recent months I have been investing heavily in China and working with the Chinese Government to gain approvals for setting up a foreign entity there. The Chinese have shared with me that they are very interested in Investing in the U.S. heavily for 2008 & 2009. As a professional forex trader this is of interst to me as well. They are not only investing in the the U.S. but the are also investing heavily in the E.U. We now live in a very global economy that is tightly interwoven. There is no way they would just pull out all of a sudden just to cause our downfall. They need us to much just as we need them. However, there is more danger from political elections with following policy changes that could result in hurting thier investments. Then they would pull as much out and shift investment to other countries.

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Posted by: Steve
Posted on: September 25, 2008 06:52 PM

We are all so interdependent in the global economic world today. It only makes sense for China to see the dollar do well over the long run.

usd has falling down from the beginning of this month, time to sell usd.

For all of China's growing influence, some analysts say people overestimate its actual power, but still China economy are growing year to year.

I really doubt that China is not as powerful as it looks. They have a huge middle class ready to consume. With good regulations they could easily have the biggest economy.

nice post on forex

Thanks for this great post. A very helpfull summary I have to say. THX

I have been trading USD for a few year now. I must say that it is more volatile in this time of uncertainty in the financial market.

However, if USD does not have the massive support of the Chinese Government. I think that it can be worst. The main support that is able to hold the USD at a certain level is partly the help of China as it is the fastest growing economy in the world today, its trust and support for the USD is definitely a help to hold the greenback

I would support what "How To Trade Currency" has said. The debt figures would show you that US owes big debts to China. And really if China would not have given a support to US Dollar, things would have been worst. However, having said that, it also means that China is in a way try to stop a situation wherein all the economies get into a turmoil.

It doesn't seem to matter to China what people think of them and their communism ways, but their economy sure does seem to grow no matter what.

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