Portfolio Performance : +30.60%

US Dollar Barometer stands at +3.5

Bottomline : I continue to think that the equity market is bottoming out but we might see a rally only if the commodity market stops presurring the stock prices. The US Dollar has strengthened which might pressure gold and oil a bit.

In "Growth of China's foreign exchange reserve" by Zhang Shuguang and Zhang Bin, 2007

the authors examine the growth of the foreign exchange reserve impact on the balance of the Chinese central bank.

While the Chinese economy has been hailed for its success in maintaining high growth and low inflation over the past decade, structural problems, notably the excessive accumulation of the foreign exchange reserves have cast a shadow in the outlook for the country. China's foreign exchange reserves increased to $853.7 billion in February 2006, surpassing Japan to become the largest reserve holding in the world. The reservese exceeded $1 trillion at the end of 2006. At this rate, the Chinese reserves is expcted to hit $2 trillion by 2010.

Foreign exchange reserves are influenced by many factors, such as domestic economic structure, government policies and changes in the international economic climate. The effect of increasing the Chinese foreign exchange reserves on the national economy and monetary policy can be examined using the central bank's balance sheet. As demonstrated by the Balance Sheet of the Monetary Authority, the accumulation of foreign exchange reserves on the one hand increases the foreign exchange assets of the central bank, while on the other hand increases the base money and other reserves on the liability side. The additional base money is transmitted into the increase of money supply through the operation of the banking system and the money multiplier effects.

On the asset side of the equation, the bank's accumulation of foreign exchange reserves increases the proportion of foreign assets - with these growing rapidly, the bank has to limit the growth of domestic assets to stabilize the money supply and prices. Therefore, it is assumed that the central bank may keep the domestic asset level at the same level from 2005 to 2010.

Holding all other factors constant, the massive growth of foreign exchange reserves may lead to an increased supply of money in the market. To offset the money creation effect of the foreign exchange reserves, the Chinese central bank has started issuing trillion worths of bonds in 2003. Which means that the issuance of bonds is likely to increase in future. This will in return affect the structure and function of the domestic bond market in china. To attract commercial banks to buy up China's treasury bonds in future, they would have to increase interest rates, which will likely increase the cost of issuance of these bonds. If china allows the RMB to appreciate too much, it will have a dimishing effect on the FX reserves.

Another way to manage the growth rate of the reserves would be to compute the cost benefits of putting the capital to domestic use for the national welfare of the nation. Afterall, china has been lending resources to foreign countries for many years at the loss to the nation. That said, we measure the benefits of purchasing the US Treasury bonds and other bonds and deposits in foreign banks to the rate of return on domestic capital. Given that the US Treasuries have only given about 3-4% recently, it is more profitable for the bank to invest domestically. That said, the excessive accumulation of foreign exchange reserves is likely to incur substantial welfare losses on the chinese economy.