International reserve managers, notably China, have found themselves rattled by the U.S. debt ceiling debates. China's foreign exchange reserves are said to be worth $3.5 trillion, with roughly $1.2 trillion invested in U.S. government debt, official reports suggest. "They, therefore, have a vested interest in what happens with the U.S. debt ceiling debates," says Simon Derrick, BNY Mellon's Chief Currency Strategist.
The 2011 debt ceiling crisis and subsequent downgrade by Standard & Poor's heightened China's fears regarding the U.S. and its fiscal issues. The fear of reserve managers, of course, is that their respective countries would suffer great financial loss, should the U.S. find itself unable to service its obligations. The October 2013 shutdown of the U.S. government and Congressional posturing over whether or not to raise the debt limit has not helped matters.
Towards Liberalization Of China's Currency Policy
"What really matters is what China does next," says Simon. "Whilst clearly they would hope that the United States will deal with the fiscal story in a sensible fashion, the only way they can ultimately break the cycle of having to lend more money back to the United States is to liberalize their currency policy."
China has been moving towards the liberalization of its currency policy for the past two and a half years. Simon believes they will finally issue a plan in that direction by the end of this year. "Or at least a dirty float for the currency, probably some point between 2015 and 2016." But what effect will this have on currency markets?
From The Currency Perspective, Two Takeaways
Simon offers two important thoughts for currency markets to ponder, while awaiting China's next move towards liberalizing its currency policy:
- Currencies that have benefitted over time will probably not get as much support from diversification when liberalization occurs.
- Government bond markets that have benefitted from Chinese buying, specifically the U.S., may find themselves under pressure.
Furthermore, Simon suggests the U.S. government take action over the next two years to win back the confidence of international reserve managers. "If not, the problem will be that rising debt costs will start to become an issue." The resulting downward pressure on the U.S. dollar would heighten the fears of reserve managers even more.
All information as of October 2013
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