The statement by the People’s Republic that it plans to diversify its holdings of foreign currency reserves away from their heavy domination by US official debt looks, on the face of it, like a potentially large and disruptive step for global currency markets.

It follows the long-awaited decision by China last July that it was ending the pegging of the yuan to the US dollar and tying it more loosely to a basket of currencies. Both moves ought to spell, in simple language, dollar depreciation. Both sparked fears that the necessary adjustment of the global economy to the vast financial imbalances that threaten it would be bumpier than has so far been the case.

But like that move last summer, which resulted in only a 2 per cent revaluation of the yuan, this latest step is unlikely to produce a dramatic immediate shift in the financial relationship between the two countries or in global currency values.

The basic arithmetic of the US-China economic relationship remains a mutually beneficial one. The US has a vast current account deficit, which China helps to fill by buying US Treasury bonds. That has the dual benefit of keeping the US economy afloat on a sea of relatively low long-term interest rates, while protecting the value of the dollar, thereby ensuring China’s exports remain competitive (though controversial) in American markets.

China has an additional interest in propping up the dollar — with upwards of $250 billion in US official debt on its books, the Chinese central bank is not anxious to spark a dollar collapse.

So the move is, on both sides of the Pacific, another gentle, but welcome shift to a more normal economic relationship between the US and China. The US wants the yuan to fall a bit against the dollar, but nothing too dramatic.

It will surely then contribute a little more to the generally negative environment for the US currency this year. The dollar was one of the surprises of 2005, rising strongly against European and (unpegged) Asian currencies despite the large US current account deficit.

Short-term interest rate differentials were given the credit for that but that picture is now changing. US short rates are close to peaking, the tightening cycle is perhaps beginning in earnest in Europe and Japan. Above all, the US current account deficit stands at 7 per cent of GDP and is not going away. Against this background, China’s move yesterday looks like a prudent piece of anticipatory financial management.

BIG HOLDERS OF US TREASURIES

Japan $682bn

Mainland China $248bn

UK $187bn

Caribbean Banking Centres $114bn

Taiwan $72bn

Germany $64bn

Other $736bn

Figures as at October 2005. Source: US Treasury

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