China's record in forex reserves - Switch to fixed rate now

January 24, 2006

China’s foreign-exchange reserves hit $819 billion in 2005, a 25% increase over the year before and close to Japan’s foreign reserves of $847 billion. The reserves are held mainly in U.S. dollars, and are comprised of U.S. Treasury notes, foreign direct investment, export earnings and some speculative inflows.

Timothy Adams, U.S. Treasury Undersecretary for International Affairs, encouraged China to further revalue the yuan and allow it to appreciate. Last July, China tied the yuan to a fixed basket of currencies, which allows the currency to rise or fall by .3% a day. It appreciated 2.1%, only slightly. Many experts feel it should appreciate 20 - 30% to be at a more realistic value.

What it Means:
China’s possession of U.S. Treasury bills has kept our interest rates low, while supporting the value of the dollar. A strong dollar means a stronger yuan, since China has their currency pegged to always be lower than the dollar, so that they remain competitive. Their ownership of U.S. currency makes our economy vulnerable to their actions - if they started diversifying out of dollars, which they have been talking about, they could force long term rates higher and cause the dollar to fall.

Some politicians believe this would also cause our current account deficit to decrease. However, according to the IMF and the Chinese, if consumerism in the U.S. continued unabated, it would merely go towards other countries’ products, since these countries’ currency would still be low.

The positive effect that would occur regardless, however, is that Chinese businesses would be forced to sell to the consumers inside their own country...and they would then pressure the government to change policies, and to encourage Chinese consumers to buy more, and save less. This would reduce risks to the global economy over the long term, which is currently too dependent on exports to the highly leveraged U.S. market.

Action Steps:
Consider changing your interest-only or variable interest rate mortgage to a fixed rate, to lock in current lower rates. If China responds to these demands, and starts diversifying out of U.S. Treasuries, the Treasury will raise rates to attract more buyers. Fixed interest mortgage rates generally move with the 10 year Treasury bond rates, so you expect the cost of mortgages to rise, too.

Source: State Administration of Foreign Exchange, China Embassy, IMF