What If China Dumps Its Dollars?



By Palash R. Ghosh,
Standard & Poor's --

What would happen if the Chinese pull up stakes?

China and Japan are the two largest foreign holders of U.S. Treasuries.
However, the Chinese recently suggested they may diversify their
foreign exchange reserves away from the U.S. dollar/Treasuries and
allocate more reserves towards other assets, perhaps including U.S.
corporate debt, energy and commodities, and non-U.S. dollar-denominated
assets. Given the importance of Treasury sales to the U.S. economy,
securities markets, the dollar and interest rates, what would be the
impact of China's decision?

Most observers believe that China's possible move to diversify their
foreign exchange reserves away from U.S. Treasuries would probably
occur in such gradual increments as to soften any potential near-term
repercussions. However, as China's prominence in global economic
affairs surges, any modifications in its foreign exchange policy cannot
be ignored.

According to the U.S. Treasury Department, as of the end of November
2005, Japan and China together owned about $933 billion of the $2.17
trillion of Treasury securities held by foreign nations. Japan
accounted for about $683 billion, while China had $250 billion. The
U.K. was third at $223 billion. Though Japan's ownership currently
dwarfs China's stake, Beijing's rate of accumulation has been much
faster. China's total foreign exchange reserves, which amounted to
nearly $800 billion at the end of 2005, are expected to reach $1
trillion this year, likely surpassing Japan's total.

Generally speaking, says David Wyss, Standard & Poor's chief economist,
these Treasury purchases have kept the U.S. dollar high and U.S. bond
yields low. "This has been good for U.S. interest rates, productivity
and investment. But it's been bad for our trade deficit, he explains.
"In the long run, it has put the U.S. in an unsustainable position of
having a deficit that is much too high." For the first 11 months of
2005 the U.S. trade deficit totaled $661.8 billion, ahead of the $617.7
billion annual record set in 2004. Economists expect the U.S. trade
deficit to well exceed $700-million for all of 2005. Meanwhile, China's
trade surplus with the U.S in 2005 is expected to exceed $200 billion,
25% above the record surplus posted in 2004.

Wyss noted that Treasury purchases by Japan's central bank have
decreased substantially over the past year, although private Japanese
investors have more than offset that by acquiring substantial amounts
of U.S. corporate bonds. "In Japan's case, back in 2003-2004, they
feared the yen would drop too much in value and they intervened heavily
in the currency markets," Wyss said. "Then, Japan ceased intervening
over the last year or so -- but this didn't have much of a negative
impact on U.S. markets." In fact, the dollar rose about 14% against the
yen in 2005.

The Chinese, meanwhile, have been buying Treasuries at roughly the same
pace the past two years. "They have to accumulate dollars to keep the
yuan down relative to the dollar," Wyss explained. "But since China has
moved to peg the yuan to a market basket of currencies, instead of just
the dollar, it's logical for them move their foreign exchange holdings
to the same basket." Indeed, last July China enacted a 2.1% revaluation
of its currency by shifting from a dollar peg to a basket of
currencies, potentially permitting the yuan to rise against the dollar.
The yuan, in fact, rose a modest 2.6% against the dollar in 2005.

"The Chinese probably concluded they have far too much exposure to the
dollar, and that the dollar has peaked for this cycle, given the Fed
may be moving to a neutral position," says Paresh Upadhyaya, portfolio
manager and currency strategist at Putnam Investments in Boston. "Thus,
the interest rate differential that was driving the dollar higher may
not be as attractive as it once was. The risk is now the dollar may
begin to depreciate. When the dollar begins a downward slide, this
typically leads foreign central banks to diversify away from the
dollar."

In essence, both Japan and China are between a rock and a hard place --
by holding vast amounts of dollars/Treasuries, they depress the value
of their local currencies, thereby boosting their export business. But,
since they own so much U.S. dollar assets, by dumping them they could
hike the value of their own currencies and undermine their economic
growth.

Wyss concedes that any change in China's foreign exchange strategy
would represent a reduction in demand for U.S. assets. "Other things
being equal, this step by China would tend to push the dollar down and
drive bond yields up. So far, this hasn't happened since overall
inflows from private bond buyers now exceeds Treasury debt purchases by
foreign central banks. However, the Chinese have a lot of money
invested in U.S. Treasuries and they're probably tired of only earning
only 4% on it. If they move into other dollar assets, such as corporate
bonds, there would be little impact on markets. If they move into euros
or other international assets, there will be."

Higher bond yields would likely raise borrowing costs for U.S.
corporations -- an unpleasant scenario amidst the record budget deficit
if the U.S. economy were to start to slow.

It is estimated that more than 70% of China's foreign exchange reserves
are invested in U.S. dollar assets, including Treasuries. Axel Merk,
manager of the Merk Hard Currency Fund (MERKX), said if China were to
stop acquiring such large amounts of dollars with its reserves --
accumulating at about $15 billion every month -- it could impose
downward pressure on the dollar. The key to understanding the risk
posed to the dollar, Merk explains, is that the U.S. current account
needs to be financed daily. "Every day, foreigners need to acquire more
than $2 billion in U.S. dollar denominated assets -- soon $3 billion --
just to keep the dollar from falling. This can be done through the
purchases of U.S. bonds, or by buying assets outright."

In the event that foreign nations, including Japan and China, lose
their appetite for U.S. dollars, Merk's Hard Currency Fund will likely
"focus on currencies of countries that are less likely to manipulate
their currencies."

Merk also believes a reduction in Treasury purchases by China would
lead to higher U.S. interest rates as bond prices fall. "There is
disagreement on how big an impact it would have," he said. "Fed
chairman Alan Greenspan has argued that foreigners mostly purchase on
the short end of the yield curve, where they have little influence on
the yield." He also noted that China buying fewer Treasuries will have
negative implications for the U.S. housing market. "Lower Treasury
purchases means less demand, which means bond prices fall and yields
rise," he said. "The government needs to offer a higher yield to sell
its debt. Higher yield means higher mortgage rates for home buyers, and
that is a weight on the housing market."

There would also be an impact beyond the dollar itself, Merk adds. "If
a foreign central bank purchases U.S. Treasuries, it is not so
different from the Fed purchasing Treasury notes from regional banks,"
he noted. "When that happens, banks receive cash and have increased
lending power. Foreign purchases of U.S. Treasuries are directly
stimulative to the U.S. economy, even before any impact on the yield
curve."

Upadhyaya contends that any diversification in China's foreign exchange
will be gradual and likely result in somewhat lower purchases of U.S.
Treasuries, "but it will not have much impact on U.S. markets or
economy." He believes, however, that the Chinese are clearly seeking
more attractive assets, perhaps energy holdings. "The Chinese have been
trying to build a strategic petroleum reserve like the U.S. has,
Upadhyaya said. "They may feel that energy prices will stay high for a
much longer period because of the supply/demand scenario. They may also
buy metals and other commodities, or maybe even European bonds."

Merk cited that China's highest profile move into energy assets was
state-controlled CNOOC Ltd.'s $18.5-billion attempt to purchase the
American energy company Unocal. Although that takeover bid failed, it
illustrated China's desperate and ongoing quest for foreign commodities
and natural resources -- they have also sought energy investments in
Canada, Latin America and Australia.

Kenneth Buntrock, portfolio manager of the Loomis Sayles Global
Bond/Instl (LSGBX), notes that China could shift some of their reserves
to pay for the country's enormous local infrastructure projects needs,
or even pour money into their nascent relationship with commodity-rich,
but undeveloped, African nations.

"The Chinese have subsidized their currency to sell cheap goods to the
U.S.," Merk said. "In return, they have accumulated billions of
dollars. Now they will find out whether these dollars are worth
anything at all as they try to use them to secure their future natural
resource needs. If disappointed, China and other Asian countries may
accelerate their diversification out of the U.S. dollar and into a
basket of hard currencies as well as gold."

Wyss points out, however, that U.S. fixed-income assets "still offer
more yield than, say, European bonds. But as the Federal Reserve stops
tightening and the European Central Bank continues to tighten for the
rest of the year, U.S. bonds assets may seem less attractive." Buntrock
indicates that among the five regions that offer 30-year bonds (U.S.,
UK, Euroland, Canada and Japan), U.S. bonds still provide the highest
yields, as well as the most robust bond market in the world.

China's neighbor Japan presents a different kind of challenge to the
U.S. economy. "Japan is a much larger holder of Treasures, so if they
made any change in their foreign exchange policy, that could have a
significant and immediate impact on U.S. markets," Upadhyaya says. But
this scenario is unlikely. The Japanese, he points out, have not
diversified their foreign exchange assets outside of U.S. Treasuries.

Buntrock concurs that Japan is unlikely to enact any changes in its
foreign exchange reserves. "The Japanese tend to be very conservative
in fiscal matters," he said. "Given that the yen is undervalued and
10-year Japanese bonds provide only a 1.5% yield, they'll focus on
foreign fixed income assets, particularly U.S. Treasuries, searching
for yield. The Japanese have no reason to diversify their foreign
reserves."

The bottom line, Wyss concludes, is that the U.S. "cannot continue
running this high deficit and offset it by borrowing from overseas. To
reduce the trade deficit, other countries have to be willing to reduce
their trade surpluses, and so far they've shown no willingness to do
that."

Though it's too early to determine the long-term impact of China's
foreign reserve diversification, the U.S. dollar could be affected if
the Chinese move from holding their reserves in dollar assets. In
general, currency calls are difficult to make for even experienced
investors and traders, but there are some instruments at their disposal
to take advantage of the direction of the dollar.

ProFunds Rising U.S. Dollar Fund (RDPIX) seeks to match the
performance, before fees and expenses, of the U.S. dollar index. Dollar
bears might prefer ProFunds Falling U.S. Dollar Fund (FDPIX), which
rises when the dollar index falls. Rydex Investments recently launched
two similar funds: The Rydex Srs Tr:Strengthening Dollar/H (RYSBX)
rises twice as much as the performance of the U.S. dollar index, while
its inverse, the Rydex Srs Tr:Weakening Dollar/H (RYWBX) falls twice as
much when the dollar index rises.

For direct exposure to foreign currencies, Franklin Templeton:Hard
Currency/A (ICPHX) primarily buys short-term money market instruments,
and forward currency contracts, denominated in foreign currencies. Merk
Hard Currency Fund, invests in a basket of hard currencies from
countries with strong monetary policies. Both are designed to protect
against depreciation of the U.S. dollar.



The U.S. Current Account Deficit* Year Current Account ($bil.)
Year-Over-Year Percent Change
2002 -$475
2003 -$520 +9.4%
2004 -$668 +28.5%
2005 -$817 (estimated) +22.3% (estimated)
2006 -$911 (estimated) +11.5% (estimated)
2007 -$922 (estimated) +1.2% (estimated)
2008 -$882 (estimated) -4.3% (estimated)
*Current account deficit is the trade deficit plus the net balance in
services, net income on overseas investments and net transfers.

SOURCE: Standard & Poor's

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