Paulson to visit China - Expect more volatility

March 7, 2007

On March 8, Treasury Secretary Henry Paulson will revisit China as part of ongoing U.S. efforts to “liberalize” China’s financial markets. In advance of this trip, China has announced several steps towards that goal:

1. China’s State Administration of Foreign Exchange (SAFE) will limit the amount of foreign currency that banks can borrow from overseas sources, forcing them to mop up foreign currency circulating within the country. SAFE will lower the ceiling on banks’ short-term foreign currency debt by 70%, starting in April.

Right now China has too much foreign currency because Chinese companies are exporting so much. These companies exchange this currency for yuan, forcing the government to print more yuan, which keeps the value low and keeping way too much foreign currency on hand, which dries up the supply and keeps foreign currency values high. This situation has been one of the primary causes of the strong dollar/weak yuan situation that Secretary Paulson is trying to correct.

2. China will establish a new agency to manage part of its $1.07 trillion in foreign currency reserves. Until now, China has invested most of this money in government-backed debt, including $300 billion in U.S. Treasuries.

This huge demand for U.S. Treasuries has helped keep interest rates low, and the dollar strong. China’s announcement to diversify an unknown amount out of Treasuries is an example of its attempts to liberalize its markets, per Secretary Paulson’s prior requests.

What Paulson’s Visit to China Means:
Secretary Paulson is focusing China on its foreign currency reserve problem, although this is something it knew it needed to address anyway. The two steps announced by China will gradually reduce excess liquidity, which will help to stabilize the stock market. These steps are part of a trend that will also put downward pressure on the dollar against the yuan.

Action steps:
Review with your financial planner your position in Southeast Asian emerging market mutual funds. Now may be a good time to shift towards developed foreign markets, such as Japan or Europe, which are more stable and could profit from a higher yuan value.

Source "China Takes Measures to Reduce Financial Firms' Foreign Borrowings", Wall Street Journal, March 2, 2007; “China Names Top Official to Plan Fate of $1 Trillion”, Wall Street Journal, February 16, 2007.

Learn more about China's role in the U.S. economy