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There is probably truth to the rumours of the Chinese monetary authorities’ intention to diversify currency reserves to the detriment of the US dollar, but the scope of the change should not be overestimated......

This is because China’s margin for action is limited. The increase in emerging countries’ currency reserves will translate into positive net demand for US and European government bonds in 2018.

In the past few days, some commotion was stirred up by a Bloomberg News report according to which the Chinese authorities in charge of investment in currency reserves have recommended reducing the weight of the US dollar, by slowing down or ending UST purchases. While the issue of a directive to this end has not been denied, SAFE (the authority which manages currency reserves) has commented that its choices are prompted by market considerations. 

As at October 2017, there was no real indication of such directives having been aggressively applied. When comparing the trend of currency reserves with US statistics on UST holdings by country, between January and October reserves grew by around 106 billion dollars, whereas USTs held by Chinese operators increased by 130.8 billion. It is also true that the Chinese authorities manage such a large a stock of reserves that they are well aware of their investment choices not being neutral in terms of their market impact, as also proven by the short-term reaction to the release of the Bloomberg news item. This limits their freedom of action, as overly brutal re-composition policies could lead to perverse effects on the value of the reserve stock through the movements of the dollar and of security prices.

Furthermore, as negative as their view on the market outlook may be, there is no question that currency reserves amounting to around 3,200 billion dollars will include a strong component in US dollars: there are few alternatives, considering that both the ECB and the BoJ are still aggressively purchasing government bonds, and that other countries have markets that are in no way comparable in terms of size and liquidity to the dollar and the euro, two currencies that are destined to retain a dominant role in the international monetary system in the coming years. 

Nor would re-composition to the advantage of gold reserves provide a solution. China effectively seems to have tested this option between 2015 and 2016, when the value of gold reserves increased from around 60 billion to 79 billion dollars. However, most of the increase reflected the fluctuations of the price of gold and, in any case, the value of gold reserves is actually lower today than it was in mid-2016 (stable net of price changes). Furthermore, the current level of 76 billion accounts for a risible share of the overall currency reserve stock, and there is no reason to think that its role will become more significant – also considering that gold reserves are not entirely fungible, when compared to currency reserves proper.

Therefore, in an environment in which the reserve stock is increasing, and the renminbi is appreciating, as was the case in 2017, UST purchases are unlikely to be fully discontinued. The re-composition may possibly accelerate in a reserve stock reduction phase tied to a new wave of capital outflows (when it could also be instrumental in curbing downward pressures on the renminbi), but the process would be very slow in any case. Possible negative repercussions on the balance of demand/supply on the Treasury market will be further mitigated by the positive trend of the stock of currency reserves in the other emerging countries, already evident in 2017 and expected to continue in 2018, at an almost unchanged pace of 200-250 billion dollars. This trend is fuelled less by the positive current account balance, which could in fact shrink, than it is by improving capital flows, both foreign and owned by residents.


Appendix
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