Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar. However, it is not easy for China or any other central bank to act on such concerns. China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens. Such a self defeating policy would clearly be unwelcome.
Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together. Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years. This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year. This process of diversification can hardly be labeled as rapid, however.
Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months. Fed custody holdings for foreign official investors have held up well. In fact, these holdings have actually increased over recent weeks. Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have also been strong over recent weeks. Taken together it provides yet more evidence that foreign official investors haven't shifted away from US bonds despite all the rhetoric.
Russia’s proposal to create a new supranational currency has dealt the dollar another blow but it was notable that India, China and South Korea were reported to express confidence in the dollar, stating that there is no alternative to the dollar as a reserve currency. Such comments highlight that despite political motivation to move away from the dollar it is no easy process.
The comments from India, China and South Korea, three of the world's biggest reserve holders reflect the growing concerns from official accounts about 1) dollar weakness getting out of control and 2) US bond yields pushing higher. Even though foreign central banks will continue to diversify the last thing they want to do is to destroy the value of their massive amounts of US asset holdings so don't expect a quick move out of dollars from central banks despite the rhetoric from Russia and others.
Russia has said that a debate about the dominance of the USD will take place when BRIC (Brazil, Russia, India and China) countries meet on June 16. Although the rhetoric from Russia may add to dollar worries the reality is that it is highly unlikely that any form of concrete plan will be easily developed to shift away from the dollar. Political motivations aside, even Russian President Medvedev admits it’s an “idea for the future”.