Diversification of China’s foreign exchange reserves into euro and yen: Is this good news?

- "It seems that the Chinese authorities want to inform financial markets and governments that they intend to diversify China's foreign exchange reserves from the dollar into the euro and the yen. Seemingly this can already be seen from the trend in exchange rates since the spring of 2010."
- "If this development is confirmed, it raises two questions:
• why would China diversify its foreign exchange reserves into the euro and the yen? The economic prospects in the short and long term are not better in the euro zone and Japan than in the United States; but the trends in debts and external assets may have convinced the Chinese authorities that the dollar will depreciate in the long term. Furthermore, if China now pegs the RMB to a dollar/yen/euro basket, a stabilisation of the RMB's exchange rate against the basket will clearly lead to purchases of yens and euros, instead of purchases of dollars. There may therefore be both a financial explanation and an explanation linked to the exchange-rate regime;
• are the effects of this change in the composition of China’s foreign exchange reserves favourable or unfavourable for the United States, the euro zone, Japan and China? The developments will be symmetrical: in the United States (where there is a need for external financing), the fall in the purchases of dollars would cause a fall in the dollar and a rise in long-term interest rates, which may be significant if the US external deficit must be reduced; in Japan and the euro zone (where there is no external borrowing requirement), an appreciation of the exchange rate and a fall in long-term interest rates."
- "The question is therefore whether it is better for the United States, the euro zone and Japan to have a weak currency or low long-term interest rates."
- "As regards China, weakening the RMB against the euro and the yen and strengthening it against the dollar may be dangerous as long as China's foreign trade and the reference prices of goods and commodities are denominated in dollars."
- "We believe that this development is:
• unfavourable for the United States, given the weight of its external debt;
• unfavourable for the euro zone, given the sensitivity of foreign trade to the exchange rate;
• not unfavourable for Japan, as the fall in long-term interest rates applies to a huge long-term debt."
- "This depends on the weight of foreign trade, its sensitivity to the exchange rate; the weight of the external debt, the long-term debt (public and private) and the sensitivity of investment to interest rates."

Natixis Flash Economics 410 20100824

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