For China, it's better the dollar you know than uncertainty
Last week, the State Administration of Foreign Exchange (SAFE), the arm of the People's Bank of China charged with managing the country's foreign currency reserves, issued a statement in which it pledged to do a better job.
Specifically, SAFE boss Hu Xiaolin promised 'to improve the currency structure and asset structure of our reserves' and 'boost the yields of foreign exchange reserve assets'. In short, Ms Hu wants a bigger bang for her bucks.
Her statement sent tremors through the international financial community. Pundits stepped forward to argue that Beijing plans to diversify its foreign currency holdings, and that diversification necessarily means shifting out of US dollars and into other currencies, with potentially calamitous consequences for the poor old greenback.
Happily, they are wrong. Yes, it is true that China is looking to spread its foreign currency reserves around more. Over the past few years, Beijing has accumulated a massive stock of foreign exchange holdings, estimated to stand at more than US$800 billion at the end of last year. Most of this - probably about 75 per cent - is denominated in dollars.
Much of this money has been banked in the form of US treasury bonds, which are yielding about 4.36 per cent. That means the central bank earns a positive carry of just over 2 per cent a year compared with China's domestic interest rates.
Plenty of observers think this return is too low. Others point out the risk of holding such a concentration of reserves in a single currency, especially when America threatens to undermine the value of the dollar by running such large trade and budget deficits.
In an ideal world, Beijing would dearly love to hold some of that money in other currencies, and to put much of it to more productive uses. There is no shortage of suggestions, which range from buying euro-denominated debt, or gold or oil, to snapping up international companies, or repatriating capital to invest at home.
There are snags with all of these. Even buying euros is not a straightforward proposition. Any large-scale switch would force down the dollar, destabilising international financial markets and threatening valuation losses. In any case, the yield on euro-denominated government bonds is even lower than on US debt, and Europe, as a net creditor, simply does not have the same borrowing demand as the US.
Similarly, any attempt to buy significant amounts of gold or oil would send their prices soaring. If China were to increase its gold reserves from 600 tonnes to 3,000 tonnes as some economists have suggested, it would have to buy up the whole year's output of every mine in the world, and even that would only use up 5 per cent of its reserves.
Meanwhile, acquiring companies abroad can be fraught with problems, as CNOOC discovered last year, when it tried to buy Unocal of the United States. And repatriating reserves to invest at home does not work either. That would require converting them to yuan, which would defeat the whole object, and China has a problem with over-investment as it is.
So China has little choice but to keep buying US bonds. There will be some tinkering at the margin. SAFE will invest more money in US agency and high-grade corporate debt to earn a higher yield, but probably not all that much, because reserve managers are a cautious bunch, and the yields are not all that much better. Beijing will also buy some more euros where it can, and continue slowly to build up its strategic petroleum reserve.
Ultimately, however, most of the reserves will remain in dollars and stay invested in US government debt. That suits China fine. After all, Beijing has a vested interest in supporting the greenback and holding down long-term US dollar interest rates. That way Americans can continue to afford Chinese exports.