One of the financial developments which is iconic for the past 5 years is the vast outflow of US dollars as a foreign

currency reserve to Asia. As a matter of fact this development is still ongoing and increasing every year. Whereas Japan used to be the main holder of USDs as a currency reserve in Asia, China has overtaken it to become the world largest holder of US dollars. (MF, 2011) It is obvious that Chinas rapidly growing economy, with already the second largest GDP in the world, could have inflicted this process. However, the fact that they have a quickly growing economy by itself does not necessarily result in increasing USD reserves. In order to get a complete picture of what moves this development an extensive analysis of its respective exchange rate regime and balance of payment is required. This can subsequently be used to look at future developments with corresponding issues. China as worlds largest US dollar reserve holder It was not until the late nineties that Chinas reserve holding started growing rapidly. Since then it has grown by more than 1000%. Whereas in 2001 China held over 200 billion US dollars worth of foreign reserves, this amounted to over 3 trillion US dollar in 2011. (Trading Economics, 2011) Table X shows this development more detailed. The main reason that it was able to build up these large reserves were its economic policies. Mainly encouraging domestic savings and heavily focus on exporting.

Today China is the largest holder of Foreign exchange reserves worldwide. Remarkable is that China alone holds more FX reserves than Japan, Russia, Saudi Arabia, Taiwan, Brazil and South Korea combined. This is illustrated in figure X.

The Peoples bank of China, which is the central bank in China, does not make the exact amount of US dollars known to the public. However, financial analysts estimate the percentage to be around 70%. (Frankel, 2007) As mentioned before, one of the main factors allowing China to build up this vast stock of US dollars is it increasing Balance of payments surplus. Chinas balance of payments is shown in table X2.

What is immediately noticed is its vast current account balance surplus. One might think this is offset by a high financial account deficit, however this is largely the effect of the high levels of domestic saving. A good example is the large amount of US securities purchased every year by the Chinese government. (Morisson, 2011) So it is clear that China has the resources due to this large balance of payments surplus. However, this does not explain yet why it holds these FX reserves, mainly US dollars. For an explanation we have to look at its foreign currency exchange rate regime. Chinas exchange rate regime It was during the 1997 Asian financial crisis that the Peoples bank of China decided to maintain a fixed exchange rate regime. In this period many Asian economies suffered heavily from high inflation and a rapidly depreciating

currency, such as Indonesia and South Korea. In 1997 China started out by pegging its currency (RMB) to the US dollar. However since 2005, it decided to change this to a basket of currencies ( one would expect USD, EUR and JPY ) and allowed small fluctuations. Even though this was announced to be a managed floating system, it was still very close to the extreme of a fixed exchange rate with frequent interventions. (Morisson, 2011) This can be seen by the fact that the average monthly intervention after this change was 18 billion US dollar instead of 19 billion US dollar. In the beginning of 2010 and again in 2011 the Peoples Bank of China announced that it would allow its currency to fluctuate more against the trading currency; the US dollar. The result is shown in figure X3.

One can clearly see the tight peg of the RMB vis--vis the US dollar up until June 2010. During the past 12 months ( Nov 2010 Nov 2011 ) the RMB appreciated 4.49%. However in the past few months it has proven to be fairly stable around 6.4 RMB/USD. However what is much more interesting to see is figure X4. Contrary to rational believe, China did neither made a tight peg to the Euro or the Japanese Yen. This would have made sense since these are major trading partners of China. Indeed after some international pressure China published the 11 currencies which were included in the basket; this included the Euro and Japanese Yen. (Cappiello, 2008) However, more importantly it did not made public the weights assigned to these currencies. As the figure shows both the Euro and the Yen are very volatile vis--vis the RMB compared to the US dollar. Regression analysis has shown that the major currencies in the basket, next to the US dollar, are currencies of other Asian developing economies such as the South Korean Won and the Malaysian Ringgit.(Morisson, 2011) Very interesting here is the fact that these currencies are not directly floating against the US dollar. This implies that indirectly this way the Chinese

central bank is very closely monitoring its currency against the USD.

Issues with the Chinese exchange rate regime Several issues for world economy and Chinas economy are worth mentioning which are solely related to this exchange rate policy. These are not to be confused with possible issues of Chinas large holdings of US dollars. Firstly, its exchange rate policy restricts Chinas monetary policy and has resulted in macroeconomic fluctuations in especially 2003-2005. This reached its climax in Q3 2002 when the interest rate in China amounted to -4%, which caused a loan-demand boom. (Goldstein, 2006) Secondly the artificially low set exchange rate causes China to have a competitive advantage in exports. This is mostly proclaimed to be a problem for the world economy, especially the United States. However, many financial specialists think that even if the exchange rate would be adjusted China would still have a big comparative advantage in manufacturing. (Goldstein, 2006) Furthermore, the fact that the RMB is undervalued will stimulate large investments in tradable goods. This will appreciate the real exchange rate which will result in less profitability in tradable goods. Chinese banks will suffer from this. Chinas foreign currency reserves We already explored the vast amounts of foreign currency reserves of the Peoples Bank of China at the beginning of this section. We also recognized that a major part of these reserves consists of US dollars. Furthermore we investigated its balance of trade and its exchange rate regime. These combined lead to a vicious circle, with an important role for the US dollar as its main foreign currency reserve. The vicious circle, as the term says, does not specifically start anywhere but is rather a process which is initiated and maintained by the system. The

exporting competitive advantage which China possesses is partially a result of its low, fixed currency. Due to this policy China is able to get a large balance of trade surplus. This happens mainly through its current account, where its exports significantly exceed its import. This should be an obvious logic, since the undervalued currency makes export cheap and import expensive. As a result the Peoples bank of China builds up a vast amount of surpluses. However, these balances are necessary since its policy to maintain the RMB relatively fixed to the currency basket ( implicitly mainly US dollars ) is very costly. So what does the Peoples Bank of China do in order to keep a managed float against the dollar? If, for example, there is an upward appreciative pressure on the RMB vis--vis the US dollar it can intervene by buying US dollars on the market. It would buy these US dollars with RMB, this would increase supply of RMB and decrease supply of US dollars. This would appreciate the US dollar and depreciate the RMB. In fact, according to many financial specialists, China is known to be the only country which is capable of moving the value of the US dollar as it wishes. (Morisson, 2011) What is important to note here as well is that not all balance of trade surpluses are spend on intervening in the market. Furthermore, China purchases vast amounts of US treasuries as an investment.

Potential issues Chinas large holdings US dollar reserves These issues can range from problems for the Chinese economy, the US economy or even the world economy. However, since this concerns the worlds two largest economies one would expect any issues to affect the world economy in any way. One of the increasingly growing problems for the Peoples bank of China is that it cannot forever keep such a tight peg to the US dollar. Once this peg is loosened, the strongly expected appreciation of the RMB will cause a huge capital loss. This is a result of the dollar losing value, while this currency is such a large portion of its total reserves. Predictions prospect that a 20% increase appreciation of the RMB vis--vis the US dollar, could amount to a capital loss being equivalent to 8 percent of its GDP. (Cappiello, 2008) Of course there is also a very important political dimension, provoking protectionists systems globally. From the United States perspective, one of its major issues is its growing dependency on China. With such large holdings of US dollars, China could basically decide which way the US dollar should move. However, of course it is not in their best interest to disadvantage the US economy, since this would be felt in China as well. Another potential issue is arising in the United States. Over the past years the United States has proven to be more and more

dependent on China for buying its bonds and securities as to finance their debts. This is one of the main reasons why the United States has managed to keep its interest rates relatively low and diverse attention away from its debt issues. Who knows what would have happened otherwise? Maybe the United States would have had the same situation as currently in the Eurozone. However, another financial crisis in The United States would have catastrophic effects on China as well. Therefore it is in Chinas best interest to keep investing in these US bonds and treasuries. However, this cannot continue forever, and this is noticed by China as well. After the downgrading of the United States credit rating by Standard and Poor the Peoples Bank of China has published that it wants to diversify its reserves away from the US dollar. This is of course a powerful message sent to the market, that is why many Chinese economists recommend that this should be down very carefully and gradually. (Yihao, 2007) Many even doubt if right now (with the debt crises in the Eurozone and possibly US) is the time to do this. However, China realizes as well that the risk with holding such a large portion in US dollar is increasing every day and diversifying into a wider portfolio is more recommended. Therefore it finds itself in a complicated situation. There could be several issues which arise if diversification would happen to fast. First, selling large parts of their US dollar reserves would send a signal to the world market and could initiate panic selling. This could lead to a crash of the US dollar with increases in US interest rates. Besides the obvious negative effects for the US economy, this would hit the world economy and Chinese economy as well. First of all its exports would plummet and furthermore its remaining US dollar reserves would lose a large part of its value. (Cappiello, 2008) Second, it is important to ask what alternative China has. More specifically it is the lack of depth and liquidity in alternative currencies. Many of these have fixed income markets and this would be a problem for China if one considers the size of its demand for reserves. (Goldstein, 2006) This problem would be even more accurate right now, since an important alternative of the US dollar is the Euro. After the US financial market the Euro market is the most liquid, however several European governments are rated with a higher default risk than the United States itself. Of course, overall the debt crisis in the Eurozone is something which does not exactly improve its liquidity. Third, it is predicted that an abrupt diversification away from the US dollar would result into an even larger buildup of reserves. Because of the deprecation expected in the US dollar, speculation would start towards revaluation of the RMB. Through the inflow of hot money this would increase its reserve balance potentially also in US dollars. (Morisson, 2011) A final reason why China would opt for a faster diversification is the fact that their tends to be an inflationary relation between the reserve currency home country and the reserve holder.(Yihao, 2007) This means that an higher inflation in the

United States would result in a higher inflation in China as well. Predictions show that inflation in the United States is increasing in 2012. Overall China is facing an interesting dilemma. Not diversifying means a risk it faces which is possibly increasing every day. However, diversifying to fast could mean not only domestic economic problem, but could also potentially cause a financial crisis in already financial volatile times. In the next part we will look at viable alternatives.

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