Dilemma over dollar reserves

Of the $3.2 trillion in reserves managed by the State Administration of Foreign Exchange, about $1.1 trillion are in US Treasuries, according to US Treasury International Capital System figures. After Standard & Poor's (S&P's) downgraded the US sovereign credit rating, many Chinese commentators, policy advisors and economists have argued more aggressively that China should diversify its massive foreign reserves, a large part of which now is in US dollars.

Such people are either urging China to diversify its foreign reserves away from US dollars to other currencies or suggesting that it move more quickly to asset classes such as commodities. Among the reasons cited for this are "the risk of US government default is rising", "there will be a significant reduction in the purchasing power of Chinese holding of US Treasuries or US dollars", "the forthcoming QE3 (third quantitative easing in the US) will exacerbate US inflation and force a devaluation of the US dollar", and "it is an opportunity for China to speed up its yuan internationalization".

But China's reserve management strategy should not change drastically from its current path of gradual diversification. A sudden acceleration to diversify China's reserves away from the US dollar now is practically difficult, and could well be dangerous for China as well as the global economy and financial markets.