The smart euro-debt strategy for China

The smart euro-debt strategy for China

please download here: ChinaDaily_2010.6.1.pdf

 

Shortly after the euro’s chaotic decline against the USD on May 24, the Financial Times reported that the State Administration of Foreign Exchange (SAFE) of China was reviewing its $630 billion holdings of euro debts. The SAFE denied the report, saying, on the following day, that the report was “groundless” and affirmed it will continue to follow the principle of diversification in its foreign exchange reserve investments. The president of China Investment Group (CIC), which manages $300 billion in sovereign wealth, also affirmed the next day that CIC will continue to maintain its investments in the euro-zone.

The comments of CIC and SAFE should not be taken as posturing, but as an affirmation that both organizations will act accordingly. Since 2007, the euro zone has replaced the US as the largest importer of Chinese goods. In the first quarter alone, it already bought $65.3 billion of goods from China. It is also the second largest exporter to China, selling $127.7 billion worth of goods in 2009. More importantly, China’s net inflow of Euros resulted in a constant growth in foreign reserves. Inevitably, the euro is becoming more important to China’s foreign exchange system, so it is not in our interest to sell euro denominated debts to worsen the panic selling in the short run.

Dollar-denominated assets, mostly Treasury securities, are estimated to compose around 70 percent of the $2,447 billion foreign reserve managed by SAFE, which has grown 58 percent since the end of 1999. With the significant increase in volume, the shortcomings of a concentrated basket become obvious, especially in the aftermath of the financial tsunami. Amid the short-term strength relative to other currencies with capital fleeing for safe havens, doubts remain regarding the greenback’s capacity to assure its function as a store of value in the long run, given the huge US fiscal deficit. Flooding the market with more greenbacks makes it easier to finance the deficits than imposing higher taxes and cutting government spending.

With the series of downgrades of the sovereign bonds of the PIIGS countries by the credit rating agencies, concerns over sovereign bonds credit worthiness have escalated to panic selling. Investors choose to punish the poor financially disciplined PIIGS countries by abandoning their euro-denominated assets, including bonds that are backed by strong balance sheets. Take the German Bunds auctions in May for example: the targeted 7 billion auctions fell short by 1.55 billion.

On the other hand, appetite for US Treasuries increased in the past 5 months as the euro slid – an approximate 20 percent fall from its peak of 1.5122 against the dollar in December to the low of 1.2181 on May 19. Capital was also driven to other USD-denominated assets and pushed down US mortgage rates. The 30 year fixed-rate mortgage rate fell to 4.92 percent last week, its lowest since September 1985. In the midst of the euro crisis, the US federal government and US consumers are the benefit ting parties.

Nevertheless, it is neither in the Chinese nor the American’s best interest to witness further deterioration of the euro. First of all, the US private sector is holding billions of euro assets. Within the sovereign debts issued by PIIGS countries, the US banks together have been holding in total $97.7 billion in Spanish sovereign debt. A continuing free-fall of the euro might induce wave in the recovering global financial system. Moreover, the euro zone collectively is the largest trading partner of the US – in 2009 alone importing $220 billions of goods and services. President Obama has promised to double exports in 5 years, create 2 million new jobs and to limit the strengthening of the dollar in order to sustain the competitiveness of American goods.

The stability of China’s economy depends largely on global financial stability. That was the reason the central government continued to buy US Treasuries in the middle of the 2008 financial crises. It is in the long-term interest of China to diversify her foreign reserve holdings against the possible devaluation or depreciation of the greenback in the future.

China should seize the golden opportunity to strengthen the greenback to reduce the USD denominated asset exposure as well as to capitalize on the appreciation and to further diversify her reserves.

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