China has us$819 billion in U.S.-dollar foreign exchange reserves, almost as much as Japan’s US$846.9 billion; Taiwan, Korea, Russia, India and Hong Kong combined have US$893 billion. Add them all up and you get US$2.6 trillion.

Purchases of U.S. treasuries by Asian central banks were key in keeping the US$ from falling further than it did in 2003 and 2004 — and in pushing it up last year when most analysts expected it to fall. China was far and away the biggest purchaser in 2005, increasing its US$ reserves by US$209.1 billion. Russia bought a net US$47.4 billion, while Japan increased its reserves by only US$2.4 billion.

At the same time, although on a much smaller scale, there have been big inflows of capital into Canadian stocks. In the three years ended Nov. 30, 2005, foreigners had increased their net holdings in Canadian stocks by $63 billion. Even though the inflows aren’t as large as they were during the tech bubble, when everyone wanted a piece of Nortel Networks Corp., they are still huge.

The question is: will these trends continue? Will Asian central banks continue to support the US$, and will foreign investors continue to boost their holdings of Canadian resources stocks?

National Bank Financial Ltd. in Montreal has concerns about the sustainability of both these trends. In Asia, there’s a risk that China will decide to diversify its foreign exchange reserves into other currencies. That would mean, at best, fewer purchases of U.S. treasuries and, at worst, some selling. The attractiveness of yen bonds, for example, is expected to increase as interest rates start rising in Japan, now that deflation appears to be at an end in that country.

The Chinese addition of more than US$200 billion to their US$ foreign exchange reserves last year is a huge amount given the size of China’s economy. At US$819 billion, China’s reserves are now equivalent to a staggering 42% of its GDP. That compares with Japan’s 18%.

However, China has an incentive to support the US$: China is under pressure from the U.S. to substantially appreciate the renminbi. The country can’t afford a big increase in its currency because it has to generate jobs for the millions of its citizens moving to the cities from rural areas. This could offset the desire to diversify its foreign exchange reserves.

China is also critical to the continuation of the resources boom that has fuelled interest in Canadian equities. NBF thinks oil prices will drop back to around US$45 a barrel this year, as the U.S. enters a period of sluggish growth caused by rising interest rates. With other commodity prices also falling back, resources share prices are likely to drop off as well — and that could lead to foreigners taking money out of Canada.

However, not everyone shares this view. Many analysts think oil prices will hover between US$50-US$55 a barrel, while some see them continuing to climb. It’s an open question whether resources stocks will under- or overperform indices this year.

There’s also an expectation that oil prices generally will be strong for at least five years and perhaps 10. Demand will stay strong as China and India continue to develop at a fast pace, and developing alternative sources of energy supply will take time.

The same can be said for base metals, for which China has huge demand. Thus, even if foreigners exit Canada to some extent this year, they may be back again fairly soon. IE