China has more to gain by diversifying forex reserves

China's foreign exchange reserves grew by around $200 billion (139 billion euros) during the first four months of the year, says a recent report in the Financial Times quoting estimates from Standard Chartered Bank Plc. The same report also says that bulk of the new inflows has been invested overseas in non-US dollar assets.

Such a move clearly indicates that China is diversifying its forex basket and reducing its excessive dependence on the US dollar and turning to other assets like Eurobonds.

Diversifying forex reserves is a natural phenomenon when a nation's forex reserve base starts expanding. Different investment strategies have to be adopted at different thresholds to maximize the returns. So it is natural that nations will adopt different investment strategies for $100 billion, $1 trillion and $3 trillion.

For instance when the forex reserves reach $100 billion, the government may adopt a strategy of putting "all eggs in one basket", or rather makes its currency totally binding to the greenback. When foreign exchange reserves reach $1 trillion, the government may go for a moderate diversification.

But if foreign exchange reserves exceed $3 trillion, the re-deployment of the reserves becomes even more vital as it is related to not only currency appreciation then, but also to issues like higher profits and lower overhead costs.

The main problem that China is currently facing is that its foreign exchange reserves have been growing far too quickly. The reserve amount in 2010 was almost the same as the total import volume in the past 24 months, which is about five times the short-term external debt and 26 percent of the M2 money supply measure.

Since the present system and economic situation make it difficult for China to stabilize the size of its foreign exchange reserves, it is imperative that it needs to be readjusted.

There are also some historical reasons that necessitate such a shift. China currently holds more than $1 trillion worth of US Treasury bonds. But with the fiscal situation in the US not showing much of an improvement, buying up more US debt would prove to be a risky proposition. Other risk factors like the possible quantitative easing policy and an uncertain bank rate policy complicate matters further.

Therefore China's situation is fairly awkward, and it certainly needs more multi-asset allocation to resolve most of its historical problems.

At the same time, there is also a broad political significance in purchasing more Eurobonds.

The fiscal situation in Europe is facing severe challenges and it is not exactly the right time to make investments in the continent. Though some European nations are comfortably placed vis--vis their debt situation, others may still need more time. There are issues like budget equalization and economic growth that hover as dark clouds in Europe even as inflation edges toward the "warning line" at 2 percent. The European market is still under the negative interest rate, and rate hikes will further erode bond values.

By buying Eurobonds at such critical juncture, China can gain immense political goodwill and also promote its idea of a multipolar world. China can also clear up external misgivings on its growth and create a better external environment for stable economic development.

Even as these reasons call for an urgent rejig of the forex reserve basket, there are also other factors that the government needs to bear in mind before undertaking such moves.

China's debt shopping in Europe has been confined to some individual nations. For example China now holds nearly 13 percent of Spanish debt. It is unwise to make such huge investments in any one nation, as its overall value is small when compared to the whole of Europe.

It is also not enough for China to diversify its reserves by just buying up Eurobonds. The nation should try to increase the value of its European investments by using instruments like hedging and short selling to unlock maximum values for its investments and minimize risk.

By resorting to only bond purchases, China will also invite comments such as "a poor country lending money to a rich country". China should rather consider more investments in goods, resources and technology development so that it can maximize the returns from its forex reserves.

The author is an independent economics commentator.