China's Trade Surplus Almost Doubles as Reserve Diversification Rumblings Continue to Grow

LONDON (ResourceInvestor.com) -- Figures released earlier this month showed that China's trade surplus for January came in at $15.9 billion, up from $9.6 billion in January 2006. China's trade surplus for 2006 as a whole almost doubled to $177 billion, and it could well exceed $200 billion this year. This means that although China's foreign exchange pile already amounts to over $1 trillion, it continues to burgeon at a rapid rate, with bigger implications than many people realize.

The larger China's foreign exchange reserves become, then the greater will be the pressure on its government to find the most profitable way of managing them. The problem with this is that the People's Bank of China's current policy of holding its reserves primarily in dollars is plainly not a sound investment strategy.

Most observers now accept that the dollar must fall further; it is only a question of when and how far. Therefore the PBOC, by holding most of its reserves in dollars, is staring into the abyss of a huge loss when the dollar does fall.

Like any holder of an overwhelmingly large position in a given market the PBOC has a problem in that it will have difficultly divesting itself of its holding without significantly undermining the value of that holding and therefore precipitating the very same loss that it may wish to avoid.

So perhaps the only course of action for the PBOC, should it wish to minimize losses on its dollar holdings, is to attempt to gradually switch out of the greenback and into something else, and to do so before, or at least at the same time as, other major dollar holders.

The ranks of the latter are primarily made up of the other East Asian central banks; those of South Korea, Taiwan and Japan. All three will also be thinking about to minimize their own dollar losses and make the most of their mountains of foreign exchange.

The Bank of Korea recently said that it is looking in the direction of international blue chip stocks as a way of diversifying its sizable foreign exchange reserves, and it goes without saying that any sensibly composed portfolio of such would be only partly dollar denominated. It is also being said that the PBOC is considering a similar initiative.

Meanwhile, U.S. government officials and politicians of both stripes are mostly not even acknowledging that the dollar is overvalued.

Of course, harsh economic realities may not be what the U.S. public wants to hear about, but it seems that the country's policymakers are as guilty of being misguided as being unwilling to be bearers of bad tidings.

It is fair to say that the PBOC and the other East Asian central banks have not been sorry to see the dollar stay unnaturally strong over the past couple of years, as it has kept U.S. demand for the exports of their respective economies healthy. But as the proportion of East Asian exports accounted for by U.S. demand diminishes and overvalued dollars continue to accumulate in the hands of the region's central banks, attitudes are changing and a rush to alternatives could be in the offing.

In November, I penned a piece highlighting the issue of Chinese reserve diversification for RI readers.

Understandable secrecy on the parts of the PBOC and its equivalents elsewhere in East Asia mean that it is always hard to gauge the current state of play. But on the basis of the pronouncements that have been made and the whispers that can be picked up, it now seems that the speculation I wrote of in November is becoming fact.

So when will the U.S. government get real and start thinking about how to help the country adapt to the dollar's inevitable fall from its rickety stool?