Countries such as China and those in the Gulf, which peg their currencies to
the dollar, risk inflationary pressure that has the potential to trigger serious
economic and social problems.

But any move to cut their links to the dollar could spark a run on the
currency that would undermine the value of their reserves.

Global currency reserves have soared from $2,000bn in the second quarter of
2002 to $5,700bn (€3,885bn, £2,780bn) in the corresponding period this year,
according to the International Monetary Fund.

Furthermore, two-thirds of the world’s reserves are concentrated in the hands
of just six countries: China, Japan, Taiwan, South Korea, Russia and
Singapore.

China tops the league, however, with the latest official figures showing the
value of its reserves at $1,443.6bn in July.

Many of China’s trading partners argue that this stockpile – which grew at
$40bn-$50bn a month in the first half of the year – has been caused by what they
believe to be an undervalued renminbi.

Most analysts say that the country’s reserves have continued to accumulate at
a rapid pace since July and that this explains the growing concern about the
dollar expressed by Chinese officials in recent months.

Yesterday the dollar plunged to a record low of $1.4813 against the euro.

Beijing does not reveal the currency composition of its reserves. However,
informed observers say the weightings of its various currencies roughly follow
the latest figures from the IMF.

Central banks which have revealed the make-up of their reserves hold on
average 64.7 per cent in dollars, 25.5 per cent in euros and the remainder in
other currencies such as sterling, yen and the Australian dollar.

China’s concerns were highlighted this week by Wen Jiabao, the premier, who
said the country had never experienced such pressure over its reserves and that
he was worried about how to preserve their value.

Hans Redeker at BNP Paribas says these comments are a clear indication that
China wants to slow down the pace of increase of its reserves.

Primarily driven by food prices, China’s rising rate of inflation currently
stands at 6.5 per cent. Mr Redeker suggests that a rising renminbi is now
favourable for the country as it will reduce import price pressure for food
products.

“The undervalued renminbi supplied the globe with excess liquidity while the
investment boom created demand for raw materials,” he says.

“This overvaluation [of raw materials] is now going to correct as China leads
its currency closer to its fair value and tighter domestic conditions slow
investment spending.”

While an appreciation of the renminbi would slow China’s accumulation of
foreign exchange reserves, it would not address the problems caused by the weak
dollar undermining their value.

Simon Derrick at Bank of New York Mellon says it is ironic that a large part
of the reason for the dollar’s fall can be attributed to central bank reserve
managers.

IMF data reveal that, in the second quarter of 2002, the dollar represented
71 per cent of central bank holdings, while only 19.7 per cent was held in
euros.

“All the available evidence indicates that the phenomenal growth in foreign
exchange reserves over the past five years has been accompanied by a notable
push to diversify away from the dollar and into the euro,” he says. “This
explains the rise of the euro.”

However, other analysts were less sure of the role played by central bank
reserve diversification in the dollar’s fall.

They say cyclical factors are the main driver behind the dollar’s 40 per cent
drop against the euro since 2002, arguing that the shift in reserve currency
allocations needed to drive the dollar so far would be much greater than the
shifts reported by the IMF.

Marc Chandler, at Brown Brothers Harriman, says central banks may well be
diversifying new reserve accumulation away from the dollar, but China’s recent
comments do not mean they are diversifying existing holdings. “What incentive do
they have to tip their hand, even if that is what they intend to do?” he says.

In any case, Mr Chandler believes it is unlikely that the Peoples’ Bank of
China has turned from the traditional role of a central bank to become a
currency speculator.