S. Venkitaramanan

BEIJING'S State Administration of Foreign Exchange recently issued a statement that almost set the Potomac on fire. The institution, appropriately named SAFE, through its spokesperson, signalled a desire to diversify China's massive foreign exchange holdings away from the US Government bonds. SAFE's signal of change from the US dollar can make a profound change in China's attitude to exchange management and lead to sea-change in global finance.

According to press reports coming from Beijing and Washington, the Chinese reserves are at present nearly $818 billion and rising expected to reach $1000 billion in a few years. Of these reserves, the declared dollar holdings by China rose about $246 billion. If China shifts out of the dollar, it means it will have to sell its holdings for euro or yen, thus cheapening the dollar and raising the relative value of the euro/yen.

A dollar depreciation will inevitably result, whether the US desires it or not. Beijing holds the upper hand in this game and there is no way US Senators and Congressmen can resort to their usual way out and prescribe that China shall hold its reserves in dollars and shall not sell off its holdings, on pain of sanctions of various kinds.

The SAFE's warning to the Chinese central bank makes one think that what is good for the Chinese goose is equally good for the Indian gander, although the magnitudes of holdings are not strictly comparable. India has upwards of $140 billion in reserves, and a substantial part (?) is held in dollar bonds although the RBI is at its best in obfuscation when asked to reveal details of currency composition of reserves.

The short point is what SAFE has stated the investment of a country's holdings in a currency likely to depreciate is bound to adversely impact the value of holdings. SAFE's warning to those involved in the management of China's forex reserves is to look for more optimal ways of investment in short, to exit the dollar, at least partly.

SAFE's message is equally pertinent to India although India's potential risk of loss on dollar depreciation is less because we have a lower level of reserves. But it is nonetheless a grave warning, which deserves to be heeded. Apparently, the RBI has already taken some action to diversify its holdings.

In this age of right to information, it appears odd that we have to look to documents issued by the Federal Reserve on foreign holdings of the US' bonds. It will do the RBI a lot of good and no great harm to any other person or institution if it sheds its so-called right to confidentiality about the disposition of our reserves.

After all, the information is in the public domain so far as the US' Federal Reserve is concerned. Why should the RBI be so finicky about letting Indian citizens know what American authorities are already privy to? In any event, an analysis of whether India's reserves are held optimally is desirable.

The least we expect of a fund manager is to disclose how he or she distributes or allocates his funds. The RBI is a fund manager with a fiduciary role


the people of India. We have, therefore, a right to know whether the RBI has allocated its funds in the best assets, keeping in view both the risks and returns. At an appropriate stage, the RBI should also expose its reserve management to an audit by a competent fund management group, which should be globally well-known institution.

Since a lot rides on the competent management of forex reserves by the RBI, this is the least we can legitimately expect of its top management, committed as it is to the highest standards of transparency and fairness.

Whether India should contemplate following SAFE's advice to switch out of dollar holdings, at least in part, is a more tricky issue.

There remains an all important question of timing. If China exits dollars, India will necessarily follow. But, in the process, it will lose a first-mover advantage.

Again, its exit from dollar holdings cannot be total. To the extent it is partial, the resulting depreciation of the dollar, if any, consequent on India's sell-out of its dollar holdings will adversely impact the value of its residual dollar-denominated holdings.

These are complex issues of timing and size of transactions, which RBI has to finesse if it is to take up the exercise of moving out of dollars.

Perhaps, this is one more instance in which a coordinated approach with China may help, provided Beijing is willing. It is not only in oil that India and China can and have to work together.

The consequences of China's potential move of its reserves out of dollar can be surely significant. A dollar depreciation may be precisely what the doctors order for the US economy. But, President Bush may not welcome it, especially as the next elections approach. This is yet another challenge for Fed Chairman Bernanke, who may have to reckon with its effects both on the US' cost of living and interest rate, however good it may be for the US' balance of payments. Perversely, it will achieve one objective of the US law-makers - the appreciation of the yuan against the dollar, which is the reverse of dollar depreciation. China may well have played a deep strategic game in showing its hand in favour of thinking about moves of its abundant pile of reserves out of the dollar.

China may, by a simple act of moving out, say $100 billion of its reserves from the US dollar, precipitate a sharp change in the US economy, a rise in interest rate as well as domestic prices. President Bush may well think he had better sup with the Chinese than try to second-guess them.

At about the same time as SAFE came out with its warning, the

Financial Times

published an article by Prof Martin Feldstein of Harvard University in its issue dated January 10, 2006.

Prof Feldstein, who is one of the world's most astute economists, pointed out the trade-weighted value of the dollar must fall by at least 30 per cent to shrink the trade deficit of the US to a sustainable level of 3 per cent of GDP. He based this on historical experience of the US itself, which showed that in the eighties, current account deficits of less than 4 per cent of GDP triggered a 10 per cent fall in the trade-weighted value of the dollar. Today, the current account deficit of the US is higher, nearly 6 to 7 per cent of GDP.

Prof Feldstein has logically argued that the current interest rate differential in favour of US bonds does not seem nearly enough to compensate for the risk of the likely fall in the dollar over the next few years.

Investments in 10-year Government bonds receive only about one percentage point more on dollar bonds than on euro bonds and 3 per cent more on dollar bonds than on yen bonds.

Prof Feldstein argues that the dollar must fall faster than those small interest rate differences to prevent the current account deficit from increasing more rapidly than GDP. This means that dollar bonds will have eventually lower cumulative returns than investors get on bonds of other currencies.

That will, says Prof Feldstein, trigger a move away from the dollar. That this has not happened so far (barring SAFE's warning) shows that investors' believe that it is possible to benefit from the interest differentials before the dollar depreciate.

Prof Feldstein warns that the sanguine belief may reflect a serious misunderstanding of the magnitude and nature of the capital flows to the US.

I hope I have indicated how we have seen both a technocratic and semi-political view reflected in SAFE's signal indicating that China might shift its reserves from the greenback and Feldstein's academic arguments in favour of a dollar devaluation. Feldstein's is a more sophisticated cautionary message that the danger of a dollar depreciation is nigh.

Is it too much to expect RBI to heed these convergent views from the divergent sources that portend an accident waiting to happen, which can impact adversely the value of our forex holdings? I am confident that our reserves should be optimally managed is surely RBI's stand. It is not clear what action RBI has taken if at all to shift the reserves from being dangerously perched on a devaluing asset. It is necessary that RBI shares information at least in the broad contours of its disposition with the public at large.

Playing it safe is the least that we legitimately expect of the RBI. We are surely entitled to the right to be informed about how the disposition of the reserves achieves its purpose of low risk and optimum returns.

We need to be assured that the reserves are safe, not risking a definitely devaluing greenback and, to the extent it is technically possible, to insulate the reserves from a decline of the dollar, which China's move may lead to. That is what playing safe would mean.

(This article was published in the Business Line print edition dated January 23, 2006)
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