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