With Chinese reserves topping one trillion US dollars the question “what is next” becomes particularly interesting. Steven Jen of Morgan Stanley predicts that Chinese reserves will top USD 2 trillion by 2010, and the argument goes that now some 70% of reserves increase is due to current account surplus, while it was only 30% prior to 2005.

Steven Jen goes further and predicts that central banks will diverisify reserves with implications for currencies:

” According to our calculations, cross-asset diversification is not dollar-negative. In fact, the current currency composition of reserves is broadly consistent with the market caps of the major economies in risky assets. The exception here is that when central banks start to invest in equities, the JPY will be a major beneficiary. However, when central banks start to diversify across currencies, the currencies of BRIC (Brazil, Russia, India and China), the CAD, AUD, NZD and KRW should do particularly well, at the expense of USD, EUR and GBP. (…) Diversification into corporate bonds would benefit the KRW, CAD, AUD and NZD.”

He also indicates that it is more likely that central banks will diversify across assets classes than across currencies. This is an interesting argument, although there is no explanation why. Form the CAPM point of view, the first diversification strategies should be those which are uncorrelated with existing investment style, and it is well known that currency trade has a very low correlation with other asset allocation strategies. But maybe there are other, more important arguments, I would be interested to find out.

My other comment to Morgan Stanley forecast would be that if one predicts Chinese reserves at USD 2 trillion, it implies that one predicts at the same time US current account deficit to remain above 6% of GDP (or possibly that it may even deteriorate further) and that US internaitonal investment position will dip from negative 25% of GDP to negative 50% of GDP. Would markets be able to accept it? This is a a one trillion dollar question.

China daily has an article about USD1trillion in reserves and discusses the possible options, 25% Copernic summary is below:

“As official data flash up staggering US$1 trillion of foreign exchange reserves, China is debating whether the huge stockpile is a blessing or a burden and what to do with it.

The huge reserves are a reflection of China’s economic achievements since reforms began in the 1980s, but observers worry that an excessive, fast-growing stash will endanger currency stability and liquidity.

The rapid growth of reserves could fuel speculation on the appreciation of the Chinese currency, or Renminbi (RMB), said Tan Yaling, research fellow with the China International Economic Relation Association under the central bank.

The product of foreign trade revenue and foreign investment, China’s huge reserves are a target of international critics, who argue that the RMB should be revalued, saying that the undervalued yuan gives Chinese products a price advantage in international markets and hurts manufacturers from other countries.

However, some economists say the rapidly growing and reforming Chinese economy needs a huge reserve in order to protect itself against financial risks created by speculators and possible financial crises.

She said the government should consider diversifying the foreign currencies held in reserve, but added that it will be hard to challenge the dominance of the US dollar in the next three to five years, as the United States continues to set the pace for the global economy.

“The United States is the largest manipulator of foreign exchange rates,” said Liu Yihui, researcher at the Institute of Finance & Banking (IFB) with the major official think tank Chinese Academy of Social Sciences, noting that the superpower can eschew debt and provoke reserves losses in other countries by devaluing the dollar.

Zhou Xiaochuan, governor of China’s central bank, said Friday that China is pursuing a more diversified forex reserves portfolio, triggering a slump of the US dollar in exchange markets.”

I also noted that:

” As the debate rages on, China’s State Administration of Foreign Exchange (SAFE) has decided to recruit 30 more staff members for its Reserves Management Department, bringing the total number of staff to 200, according to the China Business News. Each of them is in charge of about US$5 billion. “