What should China do with their reserves?

By THIS IS MONEY
Updated: 12:21 EST, 4 May 2011

So what would you do with US$3 trillion? Or more to the point what could the Chinese do with their reserves which currently stand at just a few million over this huge number?

There has been much talk of the need for this nation to recycle its reserves, but to a great extent it already has.

China has been one of the largest purchasers of US treasuries. However, this begs the question what happens if they want to recycle these reserves again – but this time outside the US?

This question is being actively discussed right now as the Chinese have a growing frustration at the value of their reserves being diminished with the weakening Dollar and the rising Yuan under the structure of the crawling peg.

To an extent, the Chinese are already on the hook. They may be rightly annoyed at seeing their reserves being eroded by currency moves (welcome to the real world of investment) but equally they cannot afford to have their largest trading partner have its economy go into a funk.

Despite the moaning on both sides (and it will get worse during the forthcoming elections) both the Eagle and the Dragon can't do without each other.

In fact, by some measures China's Yuan and the Hong Kong Dollar are the most undervalued currencies in the world, trading at discounts of 40% or more versus the US Dollar, based on the relative cost of McDonald's Big Mac hamburgers. This is the Big Mac Index.

McDonald's signature burger cost the equivalent of US$2.18 in China at the end of last year, US$1.90 in Hong Kong and US$3.71 in the US, according to The Economist's Big Mac Index.

China's discount has narrowed to 40% from 41% since then, owing to Yuan gains, while Hong Kong's pegged currency has kept its gap at 49%.

Still the Reserve Currency?

In 1944 the Bretton Woods Conference affirmed the position of the US currency as the reserve currency to the world, and although not the untarnished beast that it was, so it still remains – the world's reserve currency.

Though international trade denominated in US Dollars has fallen from its peak around 95% to about 55% today, the Dollar is still by far the most widely recognised and used international currency, with the Euro trailing at a distant second.

As a consequence of this leading role as well as the perennial US trade deficits, the Dollar is the most important national currency held in reserve by governments and their central banks.

For example 90% of Japan's foreign currency reserve is denominated in US Dollars whilst China, which holds the world's largest currency reserve, although not disclosing its proportion of $'s, is thought to hold more half of its total $3 trillion reserve in Dollars.

However, maybe this dominance will change. Just four years ago a new market was born when Yuan denominated bonds started trading in Hong Kong.

This is all part of the Chinese plan to internationalise the currency and in due course potentially even rival the mighty greenback. The market has been nick named the “Dim Sum” market but don't be fooled - these bonds are not bite-sized offerings.

Since January the equivalent in Yuan of around $2.9bn has been raised in 22 new issues including Unilever, and although still modest it is expected to be a lot more significant over the next few years.

With more issues to come and the general view that the currency will be allowed to rise albeit modestly, against the Dollar, then Dim Sum will become even more appealing than the real thing.