China's reserves: Golden dragon or sitting duck

By Edward Krowitz (China Daily)
Updated: 2007-06-07 10:22

To bring the US current account into balance, it is estimated that a depreciation of the US dollar anywhere from 30 to 40 percent is needed in real terms, equivalent to a loss for China of almost one year's worth of foreign exchange earnings.

The 2007 increase in China's reserves is estimated at $320 million. One source has called the amount held in reserves an enormous waste of resources that is not being put to use in alternative investments with higher returns, such as domestic spending on health care, pensions and education.

The plausibility of the plunge scenario taking place is the continuation in the unprecedented size of the US trade deficit, the largest in the world.

Deficits have risen by an annual average of $100 billion over the last four years, though moderating somewhat to 6 percent of GDP in the first quarter of this year. This deficit is financed by surplus countries, mainly in East Asia and the euro area, investing their dollars in US financial assets, mainly treasury bonds.

The question that comes to mind is how much longer will foreign investors continue this strategy before they too have a Wilie E. Coyote moment, suddenly realizing the dollar's value doesn't make sense and unload their holdings? At this moment, would China continue to place some $200 to $300 billion a year in an asset that might suddenly lose its value?

Some commentators, such as John Lipsky and Miranda Xafa of the IMF, take a contrary view.

They essentially agree with Charles de Gaulle on the alleged ability of the US to force the world to accept dollars and a low return on dollar-denominated securities because of the dollar's key currency status, a strong tradition of protecting private property, and its place as a safe haven in a stormy world.

This contrarian view maintains that, by correct measurement, foreigners don't own that much of the US economy, markets essentially have it right, and countries will continue to underwrite the US trade deficits indefinitely by continuing to purchase US treasury bonds.

The conclusion of this saga will be played out in international markets over the coming months and years with no action possible on the US side before a new administration takes office in 2009.

A large portion of Chinese savings - made possible by the sweat of its work force expended on accumulating the trillion dollars in assets over these years - hangs in the balance.

A sound investment strategy would caution against putting all one's eggs in a single currency basket. Dragons, together with their legendary golden hoards, have long since disappeared from the face of the globe, but many sitting ducks remain, getting turned almost daily into a roasted meal for someone else.


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