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28th May 2022

Chinese 'currency swap' would further strengthen euro

If China was to gradually replace its dollar reserves with other currencies such as the euro, a further rise of the common European currency against the dollar will take place, experts warn.

On 7 November, Cheng Siwei, vice-chairman of the standing committee of the National People's Congress, said that China needed to diversify its $1.43 trillion of foreign exchange reserves, replacing the dollar with "stronger currencies" in order to offset the losses caused by the weak dollar.

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Taking into account the current strength of the euro, it is considered likely that Mr Siwei was making a reference to the euro - among other currencies, such as the Canadian dollar.

Experts agree that any 'currency swap' – selling off dollars, and buying euros and other currencies - would result in a further rise of the euro.

"If China does move away from US dollar assets in any significant way, the most likely direct short term effect will be continued downward pressure on the US dollar," Duncan Freeman, researcher at the Brussels Institute of Contemporary China Studies (BICCS), told the EUobserver.

"With regard to Europe in the short term that will tend to intensify the problem of the dollar falling against the euro, which will make US exports more competitive against exports from the euro zone," he added.

Dr Alan Ahearne, scholar at the Brussels-based Bruegel think tank, expressed a similar view, but added that Asian currencies should also appreciate instead of only the euro.

"Ideally, Asian currencies should also strengthen. This would make a falling dollar much more tolerable for Europe. While the euro would still rise against the dollar, it would fall against Asian currencies. Such a fall would be an acceptable adjustment. The current situation is unfair and undesirable," he told the EUobserver.

Currently, China is holding its currency - the renminbi - broadly stable against a basket of currencies, including the euro and the dollar.

"It's very clear that the renminbi is undervalued because China is rapidly accumulating foreign exchange reserves, which is a very strong hint that that a currency is undervalued," Dr Ahearne explained.

European finance ministers share this view, and have called on China to let its currency float more freely on exchange markets.

Not a quick swap

Mr Siwei's comments are only the latest sign that China is considering gradually decreasing its relative reliance on the greenback.

Other government officials have on other occasions made clear that a diversification of currency reserves could be in the interest of the East-Asian economic giant.

"The government has been criticized in China for failing to achieve an adequate return on its reserves by investing them in US treasury bonds. It is also faced with the problem that the value of its US dollar assets is falling," Mr Freeman explained.

While a Chinese currency swap is expected to occur sooner or later, it is expected to be only a partial and gradual one, as a quick and complete replacement would hurt it.

"The result [of a quick and complete currency swap] would be worldwide economic crisis. The Chinese are not so stupid that they would do something like this," Mr Freeman said.

"Any major move out of US dollar holdings by China would result in the collapse in the value of dollar assets like treasuries. This would destroy the value of China's remaining holdings of dollar assets," he added.

According to Mr Freeman, there would be a second result - the immediate need of the US government to up its interest rates massively in order to be able to finance its deficits.

Such a course of action would most likely result in a stock market collapse and economic recession in the US, which would lead to a steep decline in Chinese exports to the US and other economies.

"The Chinese are well aware of the consequences of their actions, which is why they have never proposed taking any action like this," he concluded.

Dr Ahearne, focusing on the impact on the European economy, said that a quick sell off of dollars would result in a very abrupt rise of the euro, soaring to unprecedented levels.

While Mr Siwei does not possess any say over China's monetary policy, his comment nevertheless drove the euro to a new record high – a bit more than $1.47 was needed to buy one euro.

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