China on the razor's edge

As of last week, of the $2.273 trillion (Dh8.6 trillion) of foreign exchange reserves held by the People's Bank of China, as per the IMF, around 60 per cent — i.e., over $1 trillion — was held in dollar denominated debt.

Alongside, the dollar has declined dramatically in the past year. One useful measure of the dollar's strength is the US Dollar Index, which measures the value of the US dollar against a basket of currencies, with the euro (57 per cent), yen (14 per cent) and sterling (12 per cent) as the proportions. This index captures the opportunity cost of investing in the dollar, vis-à-vis other currencies.

Slump

Since 2001, when the index was at 120 (i.e., the dollar was stronger) and when the Chinese consumption of the US Treasuries began at a rapid pace — has today slumped to 72. So, over a decade, the value of the holding a single dollar has shrunk by 40 per cent. A stark calculation reported by premier Chinese news source Sohu.com, states "China is losing four aircraft carriers every percentage point appreciation against the dollar". At the same time, Chinese consumption of the American issued debt has continued to rise steadily at a clipped pace.

One well-known culprit in the media for this structural imbalance — where America ends up getting the goods and China the greenbacks — is the artificially low fixed yuan-dollar peg. At present, this rate operates within a managed floating band. On any day the yuan-dollar is allowed to float within 0.5 per cent of a prespecified rate. The reasoning for this is straight forward. In order to subsume an export driven growth agenda, the Chinese have artificially held the exchange rate low — which makes their exports cheaper. Beginning from a 2.46 yuan to a dollar in the early 1970s to the 6.8 yuan today, the Chinese have carefully skirted facing the exchange rate issue head on.

Not withstanding the fact that the media is wrong to fixate with the Chinese exchange rate policy solely — the policy mandarins in China are walking on what the Hindu text the Katho Upanishad calls "the razor's edge". On one hand, the Chinese hold nearly $1 trillion as the market value of the holding declines. On the other, the Chinese exchange rate policy is paramount to sustain further growth. The natural question is what the policy mandarins of Beijing would do next — given this curious balancing act required.

Recourse

There are principally three recourses — all of which affect global equities. First, the Chinese economy, as Premier Wen Jiabao described recently, suffers from the four un's: unstable, uncoordinated, unbalanced and finally unsustainable. One source of this macroeconomic stability is the unusually high savings rate. In 2000, the Chinese savings rate was 27 per cent while in 2008, it has risen to 37 per cent, according to Stephen Roach at Morgan Stanley. Better social security nets imply lowered savings rate — and thus greater internal consumption.

To provide greater, wider coverage and well-insured social security nets, the Chinese will invest in foreign financial assets which will diversify their risk. In essence, over the next five years the China will invest heavily in global equity and commodity markets.

Second, the Chinese will go through a gradual realignment of their foreign exchange portfolios by holding liquid currencies where the dollar will be a major, but not the preeminent holding. This allows them to mitigate the risk of importing inflation and avoid taking on greater sovereign risk.

Third, and most difficult politically, the Chinese administrators will invite global firms to expand deep into China to provide infrastructure, processes, and materials. Over and beyond further centralisation, this would allow Beijing to pay back in the dollars they hold presently, while getting "goods" for it.

For more than two generations of Chinese planners, the United States was "the heaven lake".

In the decade to come, as a new generation takes over, they will discover as one of the greatest Chinese poets Li Bai wrote in AD700: "There are other earths and skies". Other earths and skies to park their assets, that is.

The columnist works for a major European investment bank in New York City.