How China's Holdings of Foreign Reserves Affect the Value of the US Dollar in Europe and Asia

By January 2009, China held almost US$2tn in foreign reserves. The present paper estimates the marginal effect of China changing its holdings of foreign reserves on the value of the US dollar in Europe and Asia. Because using traditional techniques to find this estimate would be inappropriate due to severe problems resulting from omitted variables, the present paper uses a new approach, bidirectional-reiterative truncated projected least squares, that has been proven to minimize problems associated with omitted variables. It is found that if China would sell 1 percent of its foreign reserves, then the value of the US dollar would fall by 0.44 percent. With such a large effect, China has an incentive to either not sell any of its US dollar reserves or sell all of its US dollar reserves.