China’s yen for yen

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One of the most important questions facing currency markets these days is: What’s China up to? How Chinese policymakers decide to invest their staggering $2.5 trillion in reserves can have a huge impact on currency values worldwide. Making matters more perplexing, Beijing usually doesn’t let us in on what those decisions are, and the world’s traders have to read the tea leaves of international market movements to come up with some educated guesses.

But recently, China has given us a couple rare peeks into the state of its currency holdings. Those glimpses prove just how much power China has gained over the fate of national currencies – but also the tough job preserving its national wealth has become.

Take a look at China’s new interest in the yen. Japan’s Ministry of Finance announced this week that China added nearly $7 billion in yen-denominated financial assets in July. Nearly all of those purchases are believed to be Japanese government bonds. In all, China has bought a record amount of yen assets this year. What does that mean? China is very likely attempting to further diversity ifs currency holdings, especially due to the rough ride the euro has had this year amid the region’s debt crisis.

But more importantly, China’s new yen for yen is having a big impact on the Japanese economy. The yen touched its strongest point against the dollar in 15 years this week, raising fears in Japan that the expensive yen will hurt the competitiveness of Japanese exporters and slow an already shaky economic recovery. China’s yen purchases are likely one reason why that currency is strengthening. As The Wall Street Journal pointed out, China’s moves on the yen aren’t big enough to have a major impact on its value – but fund managers have begun to follow China’s lead on currency strategy, and could well be following Beijing in building up holdings of yen as a result. That clearly shows the kind of influence Beijing is having on world currencies these days. To a certain extent, Beijing can play a key role in deciding what happens to the world’s major currencies. Move over, George Soros.

But that power is a double-edge sword. China’s currency holdings are so massive that attempts to diversify them can potentially hurt as well as help the government’s efforts to preserve their value. This is particularly true on the dollar. China has been reducing its gargantuan holdings of U.S. Treasuries, which fell to $844 billion in June from $900 billion in April. (China, however, remains the largest foreign owner of Treasuries.) But that doesn’t mean Beijing is dumping the dollar. In my opinion, that’s unlikely to happen anytime soon. Doing so would undermine the value of China’s own dollar stash. If China’s relatively minor moves on the yen can play a role in determining that currency’s value, just imagine what would happen if China tried any significant, short-term change in its position in dollars. And since China’s biggest trade surplus is with the U.S., more dollars keep coming in, forcing Beijing to continue to invest in dollar assets.

That’s why China’s currency reserves remain overwhelmingly in dollars, despite its persistent efforts to diversify. We got a rare look into what the structure of China’s holdings might be in a recent report in the China Securities Journal, an official newspaper. According to the report, 65% of the reserves are in dollars – or some $1.6 trillion. Of the remainder, the report claimed 26% were in euros, 5% in British pounds and 3% in Japanese yen. Thus, despite China’s shifting priorities in bond purchases, its wealth is still primarily U.S. dollar wealth. And that makes the country very vulnerable to any meaningful shift in the value of the greenback.

China’s solution to this currency conundrum is: its own currency, the yuan. Beijing is striving to get the yuan used more widely in global trade and finance. Russia announced this week that yuan-ruble trading will begin in the country by the end of the year. That’s a relatively symbolic move – for now. Still not fully convertible, the yuan is a long way off from becoming a major international currency. But as long as Beijing keeps taking baby steps in that direction, we can be sure that the yuan will come to play a very significant role in global currency markets down the road.

All of this highlights one of the great trends of the next 20 years – the rise of the world’s emerging markets as not just powerhouses in manufacturing and global consumption patterns, but in global currencies, investment and finance as well.