A report published by The Financial Times on Wednesday indicated that China’s State Administration of Foreign Exchange (SAFE) was disturbed about the instability in the euro zone and that the government was re-thinking its investment position in the zone.  The report indicated that China would pullback from its hefty investments in euro zone and especially in its bond holdings in the zone’s peripheral economies, Portugal, Italy, Ireland, Greece and Spain, commonly called the PIIGS.  The report sent world equity, commodity and currency markets into a tailspin as investor’s sought safe havens.

SAFE manages China’s reserves controlled by the central bank.  Those reserves include approximately 630 billion euro zone bonds.  In the past 18 months, China has increased its euro zone bonds while decreasing its large investments in the U.S.  The move toward diversification has worked well for the euro and more recently for other Asian economies and emerging commodity economies.  Currently, China has more than $2.4 trillion invested in foreign reserves.

China’s reserves have increased rapidly in recent years as exports continue to outweigh imports, which are tightly controlled by the government.  The trade surplus is critical to the nation’s stability.  The diminishing euro could be viewed as a threat to China’s trade surplus.  On Wednesday, the euro fell below the $1.22 mark and settled at four-year lows.

SAFE has been holding meetings with many international bankers over the past few days.  These meetings have raised speculative tensions about SAFE’s future plans.  As a matter of policy, the investment actions and strategies of SAFE are not revealed, but the uneasiness surrounding the euro does not appeal to the agency.

Geithner Tries to Unify Euro Zone

The news from China came as U.S. Treasury Secretary barnstormed from the U.K. to Germany in efforts to calm nerves and unify finance ministers in the sixteen member European Union and the U.K.  Rumors persisted that Greece would default on its sovereign debt and the euro members were revisiting the prudence of the 110 billion euro pledge to bailout the country.

Against the dollar, the euro has fallen 8 percent this month alone.  What was perceived to be a sovereign debt crisis is now considered to be a banking crisis.  Geithner pushed for a series of stress tests designed to increase transparency for the zone’s banks.

Geithner’s meetings included talks with the U.K. a dinner meeting with European Central Bank President Jean-Claude Trichet and another meeting with Axel Weber, the head of Germany’s powerful Bundesbank, who is adamantly opposed to the one trillion dollar bailout plan. 

Earlier in the day, Geithner’s had a tense meeting with German Finance Minister Wolfgang Schauble, a strong critic of U.S. investment policy.  Conservative Germany is critical of the U.S. financial regulation but is the zone’s biggest economy and most important member of the bailout contributors.  German independence is marked by their recent ban on certain short selling, a policy that is unlikely to change.

After his meeting with Schauble, Geithner commented that, “I think we all agree we want more conservative restraints on capital and leverage.”  Schauble acknowledged that the U.S. and its European partners were opposed to the country’s ban on naked short sales of euro sovereign bonds, credit default swaps and protected financial shares.  Germany insists outside speculators worsened the euro zone crisis by betting against the euro.

Italy and Spain Join the Frey

Just as China announced it was not reviewing its euro position, Spain reported that its announced austerity cuts had passed its legislature by the slimmest of margins, one vote.  The country’s cuts will save 15 billion euros over two years.  Opposition to the austerity plan has been especially vocal among the country’s labor unions.

Meanwhile, Italian Prime Minister, Silvio Berlusconi, obtained approval from his cabinet for a 25 billion euro budget cut.  Publicly criticized, Berlusconi defended his package saying, “The sacrifices required are indispensable to save the euro.  For years, Italy, like many countries in Europe, lived above their means.  We are all in the same boat.”

Portugal and Greece have already gained approval for their plans.  Some cuts have already been implemented by Greece but the public debate rages on. 

China’s announcement that The Financial Times report was inaccurate and Geithner’s statement that Europe and the U.S. agreed financial regulation was necessary but should not limit recovery quelled global marketplaces.  The European equity markets gained 2 percent but the euro still hovered in the $1.23 range.

After a brief pause, the world’s Central Banks (or at least those in Asia) have begun to once again accumulate foreign exchange reserves. I’m not one for hyperbole, but the figures are downright eye-popping: “Reserves held by 11 key Asian central banks totaled $2.625 trillion at the end of August, up from $2.569 trillion at the end of July, according to calculations by Dow Jones Newswires.” Most incredible is that this total doesn’t even include China. whose reserves could exceed $2.3 Trillion by now.

The credit crisis was initially marked by a collapse in trade and an exodus of capital from Asia, as western consumers tightened their wallets and investors flocked to so-called safe havens. As developing countries fought off currency depreciation, forex reserve levels plummeted. Less than a year later, trade has already picked back up, investors have returned en masse to emerging markets, and Central Banks are once again sterilizing capital inflows so as to mitigate upward pressure on their respective currencies. [Chart Below courtesy of Council of Foreign Relations.]

“Taiwan and Thailand, the most aggressive in defending the U.S. currency, have logged record-high reserves every month since December.” Japan, whose reserves are the second highest in the world (after China), is the lone holdout. As the Forex Blog reported yesterday, the newly elected Democratic Party of Japan will pursue an economic policy that depends less on exports, and has pledged to stay out of the forex markets.

The prospects for further reserve accumulation remain reasonably bright, as emerging markets lead the global economy towards recovery. “The outlook for key Asian economies is improving faster than that of developed economies. For the time being, this should accelerate flows into these markets, making it harder for central banks to keep their currencies in check.”

While China’s economy is no exception, its nascent recovery is being driven by capital investment, government spending, and (ultimately?) consumer spending. As a result, it is forecast that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year…that ratio will drop to 24.5%.” If such an outcome obtains, it will almost certainly lead to a slower accumulation of reserves.

While this is all well and good, the more important question for most (forex) analysts is how these reserves are being held. The vast majority of these reserves are still denominated in US Dollar assets, and in fact, the proportion may have risen slightly since the beginning of the credit crisis. Asian Central Banks are particularly biased towards the Dollar, which accounts for 70% of their reserves, compared to the worldwide Central Bank average of 64%.

Moreover, it doesn’t look like plans are afoot to change this trend anytime soon. China has maintained its push (though less vocally) to turn the Chinese Yuan into a global reserve currency, declaring that its capital markets and currency controls will open accordingly to facilitate such. It is in preliminary talks with Thailand for yet another currency swap agreement, to supplement the $95 Billion in such deals signed since December. For its part, the Bank of Thailand has insisted that the Yuan is not even close to challenging the supremacy of the Dollar: “You have to accept that the dollar is going to be a reserve currency for quite some time. You don’t have any alternatives.”

Even China, despite its rhetoric, remains committed to the Dollar. The only talk of diversification in Chinese investment circles is in regards to what kinds of US assets they should invest in, not whether they should be invested in the US or somewhere else. Said the manager of China Investment Corp, which has a mandate to invest nearly $300 Billion of China’s FX reserves, “The risk of a decline in the dollar risks was more of a national issue for China than for CIC because its capital is in dollars.”

This last quote inadvertently confirms that the role of the Dollar as the world’s reserve currency is being treated as a political issue, when in fact it is a financial economic issue. In other words, while many countries want to limit the influence of the US by limiting the power of the Dollar, their Central Banks are stuck with it because it remains the most practical, and advantageous option. Dumping it would be akin to punishing themselves.