An employee shows Croatian kuna and euro banknotes at a currency exchange office in Dubrovnik, Croatia, on July 23. The euro is under increasing pressure on multiple fronts. Photo: Bloomberg
by David Brown
by David Brown

Euro is no safe haven as China seeks to reduce its dependence on US dollar

  • The euro has touched parity with the US dollar, and pressures such as the war in Ukraine, global energy crisis and credit woes could further dent sentiment
  • China appears to have few other good options as it seeks to allocate its massive forex holdings
With heightened geopolitical tensions in Europe, should China consider diversifying its currency risks away from the euro? The euro has already tested parity against the US dollar in recent weeks, and the big question is how much lower it might go as the odds stack up against it.
The war in Ukraine, global energy crisis and the risk of another European credit event could easily sink the euro back to its historic low versus the dollar if sentiment flounders again. But Beijing is stuck for choice as there are few places to turn other than the US currency, which might not be the best option when the longer-term intention is to limit China’s dependence on the dollar.

When international trading conditions become more challenging, global investors tend to mitigate risk by diving for cover into safe haven currencies. These include the US dollar, the Swiss franc and the Japanese yen.

During the recent market upheaval, the US dollar has stood head and shoulders above the field. This is thanks to lower proximity risk, the relative strength of the US economy and the fact the Federal Reserve has shifted to an aggressive approach of monetary policy tightening.

Thanks to the United States’ rising interest rate premium over other currencies, the dollar’s trade-weighted index against a basket of other major currencies has risen as much as 21 per cent since January 2021, as safe-haven demand has surged. Dollar bulls have been well rewarded for their risk aversion.

It is hard to ignore the dollar’s relative yield appeal. With the Fed looking likely to raise interest rates as high as 4 per cent by 2024 – and possibly higher if inflation difficulties persist – the dollar’s relative interest rate advantage will only get stronger. In the money markets, the dollar carries a 2.28 per cent premium over the yen, 2.35 per cent over the euro, and 2.53 per cent over the Swiss franc.

US dollar strength just means renminbi bulls need to look further afield

The Fed’s commitment to fast-tracking tougher monetary policy means a green light for a stronger dollar because the European Central Bank, Swiss National Bank and Bank of Japan are all struggling to wrestle their domestic interest rates up as quickly.

It is a similar picture at the long end of the bond market curve, as relative yield spreads remain equally supportive for long dollar plays. Ten-year US Treasury yields are trading 1.86 per cent higher than the equivalent-maturity government bonds in Germany, 2.34 per cent more than Swiss government bonds and 2.64 per cent higher than Japanese government debt.

With the US dollar offering such strong relative yield appeal and the currency looking set to go higher if safe-haven demand conditions persist, it’s a major quandary for global investors looking for alternative low-risk, high-yield currency plays. The bottom line is that you ignore the rampant dollar at your peril.
For Beijing’s currency reserve managers looking to allocate China’s US$3.1 trillion of official foreign exchange holdings, it’s an even deeper challenge, especially if the policy intention is to continue reducing US dollar dependence in the long term.

This policy already seems to be in play. According to US Treasury Department data, China’s holdings of US government securities fell below US$1 trillion for the first time since 2010, dropping to US$980.8 billion in May. It’s hardly suggestive of a fire sale, with official US Treasury debt holdings down only US$97.6 billion from US$1.078 trillion a year ago.

Beijing might wish to reduce its reliance on the US Treasury market, but finding an alternative remains a problem. China still needs to invest its sizeable overseas earnings from its trade surplus, which hit a record US$676 billion in 2021. This needs to be invested prudently at a profit, not a loss.

According to International Monetary Fund data, the US dollar’s share of global foreign exchange reserves has dropped to a 26-year low of 59 per cent. It remains the dominant market leader, though, well ahead of the euro’s 20 per cent share.

The Japanese yen, British pound and Australian and Canadian dollars don’t carry as much reserve currency allure, lacking sufficient market liquidity compared to the US dollar and the euro. Meanwhile, the euro seems beset by too many problems at the moment.

Beijing might just have to bite the bullet, hope the euro doesn’t sink much further and reap the benefits of a stronger US dollar in the meantime.

David Brown is the chief executive of New View Economics