Positive Signs for the Dollar from China's FX Reserve Growth

Reserve growth and diversification is in the spotlight once again as China's Q3 reserve growth figures were released, coming in at $141bln, one of the largest quarterly gains on record. September inflows alone were $61.8bln. Adjusted for valuation, it is conceivable that capital inflows have accounted for a significant portion of FX reserve growth in China.

The surge in reserve growth calls into question how diversification by the world's major reserve holders is proceeding at this stage. China may have stepped up its purchases of non-US assets over the past few months, but will not be doing so in a destabilizing fashion. According to Treasury data, China's purchases of Treasuries are now a bit more volatile compared to previous quarters and the pace of buying is clearly declining.

However, this does not suggest any rapid move away from the US as a reserve currency in the foreseeable future, due to the lack of alternative assets available amongst other potential reserve currencies. Also, the US remains its largest export market, a market that cannot be replaced in the coming years. That gives the Chinese a powerful incentive to keep buying US debt and remain fundamentally cooperative in supporting the dollar, political rhetoric aside.

China's main concern is the devaluation of the dollar due to the Fed's asset purchases. Treasury purchases will end soon and it remains to be seen how it would affect net holdings amongst sovereign names. China may have been able to offload some of its current holdings at preferable prices due to the surge in demand during the financial crisis, while the Fed has been a willing buyer on the other side of the trade. However, compared to cumulative holdings, these changes are still minuscule and China may be resigned to the fact that it cannot engage in significant diversification of existing assets without causing major disruption.

At present, USDCNY stability and strong reserve growth suggest China is no closer to moving back towards a floating regime anytime soon. Recently released trade numbers are welcome news for the domestic economy, but the result may be further reluctance on the part of authorities to move away from an export-oriented growth model.

This is good news for the dollar as it means CNY gains will be closely managed in the future, while other economies with managed regimes will be reluctant to allow appreciation of their own currencies for fear of losing competitiveness. We saw this happen recently when a number of Asian nations, seeking to exploit the yen's recent strength, bought dollars in order to weaken their own currencies and make their exports cheaper versus Japan's.

In the long run, the dollar will face secular downside pressures but the pace is likely to be much more measured than what the market is expecting.

Disclosure: The author is long dollars.

Comments

[Robert Mart...:]

Cliff,
Good article.

A agree that a "controlled" decline in the U.S. dollar is in the interests of both China and America. Unfortunately, an orderly decline is as rare as a unicorn in capital markets: As hedge funds and other investors build up bearish bets on the U.S. dollar, the decline will accelerate, and won't be orderly.

What's more, the U.S. has to worry not only about capital flows with China, but also about the federal balance sheet. The budget deficit is out of control, and Medicare/Social Security will start to add materially to it in 2012. These programs are a huge headwind, an intractable political problem, and will make it very difficult for the U.S. to "grow out" of its deficits while still honoring its obligations.

Because of these reasons, I believe that all investors need inflation hedges and U.S. dollar hedges in their portfolios, as I note here: seekingalpha.com/artic...

Thanks for the update!
Rob

Oct 15 11:18 AM

[Cliff Wachtel:]

Excellent points, thanks, Cliff

Oct 16 03:20 AM

[adan:]

a weaker dollar is just another inflation, eating away at our purchasing power and store of wealth -

when the majority of people realize they gain the least, and pay the most proportionately, for the benefit of exports and the market, when imports and the economy are more important (to that majority) -

then politicians will sense it's time to shift away from the lobbists, if they want to be re-elected....

Oct 17 11:11 AM