Issue of the year?

In 2007, reserve diversification is going to be the dominant theme in the forex market, and because Japan and China hold the highest reserve amounts, they are the countries to watch.

Japan is unlikely to change its reserve composition much, if at all, for the simple reason it is a nation with no defense capability that relies on the U.S. for its external defense.

As for China, what’s the probability of a one time sale of a large chunk of dollar assets? It’s not zero, even though such a sale would drive down the value of the remaining assets and also the value of trade payments in the works.

This is the “golden goose” argument. The Chinese know if they take actions that result in the devaluation of their best export customer’s currency, their trade surpluses will fall. Last year that surplus was $102 billion and it’s on track to exceed that this year, (possibly reaching $168 billion). China favors export industries that provide factory jobs for tens of millions of workers, not to mention the millions more flocking from the countryside to cities looking for factory jobs.

On the U.S. accounts, the reckoning looks a little different. The U.S. deficit can’t be attributed entirely to China, of course, but it’s a big piece of it — 41 percent ($24.37 billion) during November, for example. Through November, the total deficit with China was $190.63 billion, meaning this year will almost certainly surpass last year’s deficit of $201.66 billion. How can China have a total surplus of $102 billion when its surplus with the U.S. is $202 billion? Easy — it’s spending some of the surplus outside the U.S.

Whether we are talking about China’s $100 billion surplus or the U.S.’s $200-billion deficit with China, the numbers are “too big” by anyone’s reckoning, and the rising trend is bothersome because it points directly to bad pricing in currencies.

This is hardly a secret. In August 2005, China revalued its currency (the yuan) by a little more than 2 percent in one day and moved to a series of smaller daily moves that as of mid-December 2006 added up to less than 5.5 percent total. This is a mere drop in the bucket and inspires virtually no change in the trade dynamics. How much should China revalue to equilibrate trade?

Estimates range from a modest (and achievable) 10-15 percent to a more commonly quoted 35 percent. Last year, U.S. Senators Schumer and Graham came up with a “needed” yuan appreciation of 27.5 percent. That’s the amount of the tariff on Chinese goods they proposed then withdrew under pressure and promises from the Treasury Secretary.