China’s $2.5 trillion dilemma

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Oh, the trials and tribulations of sitting on $2.5 trillion. That’s how much China holds in foreign currency reserves. And in this period of market turmoil and economic uncertainty, what would you do with it? I can’t figure out where to put my far more meager earnings. I couldn’t begin to guess where I’d invest trillions.

China’s leaders are probably having a tough time of it as well. The name of the game in recent years has been diversification. Most of China’s reserves are likely in U.S. dollars. We don’t know exactly how much, since China doesn’t break down its reserves by type of currency. Fearful of placing all of its eggs in one currency basket, it has aimed to protect its national wealth by increasing its holdings of other currencies, thus creating a more balanced portfolio. That seemed to make sense. If you recall, not too long ago it was the greenback that was supposed to be knock knock knockin’ on heaven’s door.

Now – surprise – we have a euro crisis. The dollar is looking groovy. The euro is doing its best impersonation of Wile E. Coyote plunging from a cliff with an anvil tied to his back. That has only complicated the lives of China’s policymakers. And what they decide to do could have major repercussions for currency markets and the global economy.

That was made abundantly clear this week when a mere media report that China was rethinking its holdings of euro assets was enough to send the euro and global stocks tanking. The Chinese government later called the report “groundless” and markets reversed themselves. This episode clearly demonstrates the kind of power China now holds over currency values worldwide. How China chooses to invest its trillions will ripple through the values of global currencies and impact export competitiveness and job creation for countries throughout the world.

It also shows the dangerous position China has gotten itself into by amassing such a hoard of hard currency. China’s currency managers can very easily make their own worst fears come true. Ditch the dollar and watch the value of the greenback slump, and your national wealth with it. Ditch the euro because you think it’s in trouble, watch everyone else follow your lead, and lose money on your euros.

I’d be dumbfounded if China wasn’t reevaluating its position in euros right now. The general consensus is that the euro will keep giving up ground, perhaps all the way to parity with the dollar. My guess is that China in recent years has been collecting its fair share of euros as it attempted to balance its stash of dollars. Now it’s stuck with a bunch of rotting euros. China’s financial managers are like any investors – they want to preserve wealth and increase returns – and if they aren’t worried about their euros, I’d be worried about them.

China also seems to have been softening its attitude towards the dollar. Notice how quiet Beijing has gotten on the whole let’s-replace-the-dollar-as-a-world-currency mantra that was so popular last year. China has also resumed building up its holdings of U.S. Treasuries after a few months of reducing them. Again, like all investors, China seems to be engaged in a flight to safe havens.

Is Beijing learning anything from its experience with this little exercise in guessing currencies? What Beijing should be figuring out is that continuing to build up an ever bigger mountain of foreign currency reserves isn’t really getting the economy anywhere, that it needs to rebalance towards domestic demand to reduce its current account surpluses, and that it finally needs to reform its counterproductive currency regime to help that process along. Those steps would as well give more credibility to China’s desire to see its own currency, the yuan, more widely used in global trade and finance. But my guess is that Beijing will do the opposite. In times of stress, Beijing tends to get conservative and shy away from change. That means it’ll just have to figure out where to put more and more of its money. In a few more euros perhaps?