ChinaÆs external assets reach $1.55 trillion, says Fitch

As ChinaÆs foreign exchange reserves and other external assets continue their inexorable rise, all eyes are on the governmentÆs new foreign exchange investment agency.
According to a new report by ratings agency Fitch in Hong Kong, Chinese holdings of US Treasury securities amounted to $350 billion at end-2006, and Fitch estimates that a further $230 billion has been spent on US Agency bonds.

According to the report, average monthly net purchases of US Treasuries have been unchanged for the past two years while net purchases of US Agency bonds are rising.

Since 2004, the average annual addition to foreign-exchange reserves has been
$220 billion, says the report.

ChinaÆs external assets refers to official foreign exchange reserves, direct investments abroad, deposits in foreign banks, portfolio investments and lending to non-residents.

"Even with the overall increase in US Treasury and Agency bonds, the share of these investments in China's reserves is in decline, as reserves are growing more quickly," says James McCormack, head of sovereign ratings at Fitch Ratings in Hong Kong, the author of the report.

But the fact that Chinese holdings of US assets are rising in absolute terms could allay fears about China diversifying out of the dollar, even if in relative terms, the proportion held is shrinking.

The question observers are asking is how the governmentÆs intentions concerning these large holdings (which amount to roughly the amount of the US current account deficit) will affect the dollar.

Despite the recent rapid increase in ChinaÆs foreign assets and the consequent absolute increase in US asset holdings, MacCormack did not necessarily agree that the dollar would be unaffected.

ôIf reserve accumulation slows, putting $200 billion a year in non-US-dollar assets might actually cause a reduction in their gross US dollar holdings, and that could affect the dollar," says MacCormack.

$200 billion is the unconfirmed sum which has been mentioned in several quarters as representing the initial transfer from the forex reserves to the planned foreign exchange investment agency. Other observers see no reason why the ChinaÆs external asset accumulation should slow û at least not without a major re-engineering of the currency regime.

According to Paul Cavey, China economist at Macquarie Bank, fears of dollar destabilisation will be mitigated by the fact that the Chinese government will likely retain most of the reserves in the traditional form of liquid foreign currency reserves (ie US treasuries), to protect the currency in case of a crisis, for example.

Cavey points out that ChinaÆs foreign exchange mountain is due to the government converting huge currency inflows into currency outflows, mainly US dollar assets. This is the only way to keep the currency stable.

Cavey adds that any significant diversification out of dollar into new asset classes by the investment fund will be limited by the inability of most places around the globe to absorb ChinaÆs forex pile.

ôThe entire GDP of Africa, excluding the Republic of South Africa, is smaller than that of ChinaÆs forex holding,ö he says. In effect, the US treasury markets are the only markets deep and liquid enough to cope with ChinaÆs cash problem.

Cavey also points out that ChinaÆs population is benefiting, even if only indirectly, from the transfer of capital from China to the US. ôThis capital is fuelling American demand for Chinese exports, which helps keep Chinese workers employed and getting a decent living. ItÆs an obvious win-win situation,ö he says.
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