Although the news does not appear center-stage in any of the major media outlets, a recent analysis by the United States Treasury Department indicates that China, with $3.2 trillion in foreign-exchange reserves, is rapidly diversifying its currency portfolio away from the U S. dollar.
In absolute terms, China’s dollar holdings continue to increase – by $115 billion over the past twelve months – but the percentage of dollar holdings declined from 65 percent in July 2010 to a decade low of 54 percent in June 2011. During that one year period, U.S. securities accounted for a mere 15 percent of the overall increase in China’s foreign-exchange reserves.
If this pattern continues – and most especially if it accelerates – yields on U.S. Treasuries will inevitably increase, and borrowing costs will rise across the United States economy. If China chooses to diversify into euros, then the dollar-euro exchange rate will move adversely against the United States, and the cost of U.S. imports from Europe will increase.
China’s move to diversify the foreign-exchange portfolio is not necessarily harmful to the United States. Yields on U.S. Treasuries are unhealthily low at this time. As yields rise, so pressure will increase on the U.S. federal government to rein in its deficits. As interest rates rise more generally, investment decisions will tighten and marginal projects will be rejected. The long-term rate of growtrh of the economy may well increase under such circumstances.
But in the short-term, expect some increased turbulence across the financial markets.