China is facing a problem virtually unique in history: it has too much money, and doesn’t know what to do with it.
The country enjoys an unprecedented level of foreign-exchange (FX) reserves, with US$3.2 trillion socked away as a result of a combination of insatiable export-fuelled economic growth for more than a decade and a tightly controlled currency.
Much of this money has been placed in US Treasuries, traditionally the world’s ultimate safe-haven location. Beijing owns an estimated US$1.16 trillion of US Treasuries, making it comfortably the largest creditor to the world’s largest economy.
It also leaves it with most to lose should confidence in the US to begin to falter. And that’s exactly what happened on August 5, when credit rating agency Standard & Poor’s (S&P) cut the nation’s hallowed AAA rating to a mere AA+.
Ironically, the immediate impact of the drop was a rally in Treasuries. The reason for this was a flight to safety – apparently logic or irony factors little into the knee-jerk reactions of the market.
But this was bad news for China nonetheless. The downgrade has underlined the risk of holding US dollar assets, and the fact that the US has since looked increasingly likely to embark on yet another round of quantitative easing has served only to leave China more exposed to the value of its dollar-denominated assets falling.
“The renminbi is appreciating [against the US dollar], which already makes the dollar look much less attractive; and with the recent downgrade dollar assets seem a lot riskier,” says Craig Turnbull, chief executive of Agincourt Capital in the US.
The ideal solution for China would be to materially reduce or diversify itself away from its exposure to US dollars. That is something that Beijing policymakers have increasingly understood. The trouble is how best to do it without causing a run on the very US dollar assets that Beijing already owns.
The most obvious means for China to raise its holdings of non-dollar assets is to invest more into the world’s next-largest debt markets: Japanese government bonds (JGBs) and euro-denominated bonds.
Over the past few years, Beijing has been raising its exposure to both markets.
According to Japan’s Ministry of Finance, Chinese investors bought about ¥1.3 trillion (US$16.94 billion) of Japanese bonds and notes in April. Beijing has typically invested more than ¥100 billion per month into JGBs, but it appears to have recently boosted this amount. The country’s monthly JGB purchases touched ¥200 billion in March before hitting an historic high in April.
It’s hard to envisage why Beijing would buy more JGBs for anything other than an attempt to diversify its assets. It’s certainly not likely to be for absolute gains, given the miniscule returns offered by JGBs in the zero interest-rate country.
“Diversification away from the US dollar is said to be a reason why China has bought Japanese assets, given the low yield on Japanese yen-denominated assets,” says Osamu Takashima, a FX strategist at Citi.
Apart from JGBs, Beijing has been continuously snapping up eurobonds – although the central government is being very tight-lipped about the quantity it is buying.
In April, China’s ambassador to the European Union (EU) Song Zhe said that China owned “several billion euros” of bonds sold by Greece and Portugal, and might embark on another round of purchases of sovereign debt in the euro area, as part of its strategy to bolster the EU economy and to diversify away from investments in US debt.
Last October, China’s premier Wen Jiabao also said the country had bought “a large quantity” of eurobonds and would continue to do so.
China already held €25 billion (US$36.3 billion) of Spanish sovereign debt, up from €6 billion in 2009, Spanish Prime Minister Jose Luis Rodriguez Zapatero said on April 15, at the end of his Asian tour. China’s investment represents the equivalent of 12.5% of Spanish debt in foreign hands, according to public data.
Yet, in the wake of the eurozone debt crisis, these investments may not look safe either. China may well stand to lose more money by buying into the troubled eurobonds. The current volatility is certainly enough to give the country pause in its diversification efforts into such debt.
Aside from conducting more sovereign debt investments, the Chinese government has also encouraged its own sovereign wealth fund to buy overseas assets.
China Investment Corp. (CIC) was established in September 2007 to seek higher returns from riskier investments, and it was seeded with US$200 billion from the country’s FX reserves to do so.
It has since bought assets on a fairly regular basis. On August 10, CIC agreed to acquire a 30% stake in French energy company GDF Suez’s exploration and production business for US$3.15 billion, diversifying its investment mix and securing energy capacity for the world’s second-largest oil consumer.
Readers at this point might wonder, why didn’t Beijing chuck a whole lot more money at CIC or other investment bodies?
It could have done, of course, given its fat war chest. But Beijing would not be easily convinced to do so.
“It all boils down to the roles and the functions of FX reserve. It just doesn’t operate in the same way as an investment fund does,” explains Chia Woon Khien, head of local markets strategy, emerging Asia at Royal Bank of Scotland (RBS).
The primary function of FX reserves, according to the IMF, is to demonstrate that a domestic currency is backed by external assets. This shows a country’s capacity to intervene in support of the national currency, and to assist the government in meeting its foreign-exchange needs and external debt obligations, to give a few examples.
Having said that, FX reserve investments have to be safe and liquid; buying equity stakes in an overseas company may not always be a safe bet.
The CIC has come under fire for losses it made from investing in Wall Street banking titan Morgan Stanley and private equity firm Blackstone Group. Share prices of both institutions plummeted after CIC’s high-profile stake purchases.
For all these efforts at diversification, China’s piggy bank remains distinctly full of dollar bills.
Analysts estimate that 60% to 70% of the country’s FX reserves continue to be held in US dollar assets, largely in Treasuries. They believe that a more ideal weighting would be for dollar assets to account for roughly 40% to 50% of China’s total reserves.
Instead, the quantity of dollars the country holds is growing. For all the grumbling about the US and the strength of its currency, China has increased its holding of US Treasuries for the last three months.
In June, the country increased its Treasury holdings by US$5.7 billion to US$1.17 trillion – despite the fact that global demand for US equities, bonds and other financial assets was weakening amid concerns around the US’s political deadlock over the debt ceiling, a situation which was not resolved until August 2.
The fact is that China is more exposed to the US dollar and US debt than ever before.
“If you look at the bigger picture, over a longer period of time, China’s Treasuries holdings level doesn’t change much on a yearly basis. China has been snapping up more US Treasuries recently, but it cut its holdings for some time earlier last year,” argues a Beijing-based China economist from a Chinese bank.
“It’s just a matter of bargain-hunting, buying at low prices,” he adds.
According to data from the US Department of the Treasury, China reduced its holdings in Treasuries between November and March, but has increased its purchases for three consecutive months since April.
The simple truth is that China has few other viable options right now but to invest into US dollar assets.
About 85% of FX transactions worldwide are trades of other currencies for dollars, according to data from the Bank of International Settlement (BIS).
The Organisation of Petroleum Exporting Countries (OPEC) sets the price of oil in US dollars.
Additionally, the dollar is the denomination currency of half of all international debt securities. More than 60% of the foreign reserves of central banks and governments is in dollars.
The greenback, in other words, is not just the dollar for the US. It’s the world’s currency.
Investing in alternatives
But in the longer term China will, for its own financial health, need to diversify its foreign-currency holdings beyond the standard liquid sovereign debt available.
The US debt level is approaching 75% of its GDP; the portfolio risks of staying in US Treasuries have increased. Foreign investors will be reluctant to put all their eggs in the dollar basket.
“To diversify risk [China] could simply increase holdings in euros, pounds, yen, and Swiss franc, buy Asian sovereign bonds, invest in stocks via SAFE [the State Administration of Foreign Exchange] or participate in direct investments via the country’s sovereign wealth fund,” says the Beijing-based economist.
SAFE is the unit of the People’s Bank of China tasked with supervising and managing the country’s FX markets; it also manages the country’s foreign-exchange reserves, gold reserves, and other foreign-exchange assets of the state. It is a savvy and experienced market investor.
RBS suggests that SAFE could consider alternate currencies, and emerging-market fixed-income products.
“Other currencies such as the Aussie dollar and the Swiss franc, in which emerging markets and presumably non-Japan Asia are underinvested, are likely to become favourites [for China],” says Sanjay Mathur, an economist at RBS.
He reckons that buying more gold is also a possibility. SAFE would not be the only Asian state body to do so. The Bank of Korea has bought approximately 25 tonnes of the precious metal over the past two months, marking its first purchases in more than a decade.
“With a depreciating US dollar, the value of gold [which is priced in US dollars] is only going to go up,” adds Mathur.
Agincourt Capital’s Turnbull echoes his view.
“China is very likely to move away from investing mainly in US Treasuries, and the European economies look pretty shaky right now. Investing in physical gold and other emerging-markets fixed-income products could be viable alternatives,” he notes.
Buying emerging bonds
It seems China would be well-advised to raise its investments into emerging-market bonds, and in Asia in particular.
At the end of 2010, Asia ex-Japan government and corporate bonds amounted to US$6 trillion – that was 9.3% of global bonds outstanding and 23% of the level in the US.
This level may seem small, but the pace of growth has been solid enough to facilitate reserve diversification.
“Now it can be argued that the region [Asia] has only two ‘AAA’-rated economies, Hong Kong and Singapore, both of which are very small. China and Taiwan are ‘AA-” rated and Korea is ‘A’, but the point to bear in mind is that the decision to diversify is not contingent on US ratings alone,” says Mathur of RBS.
Of course, there are a number of obstacles including the incidence of transaction taxes, limited liquidity, and even capital controls. Despite these constraints, flows into this space have continued to grow.
Recently, Korea’s finance ministry said that foreign central bank participation in local treasuries had increased from 8% to 28% during the 12 months to July 2011.
“The Fed’s commitment to retaining its funds rate at near zero percent through mid-2013 is reason enough to be nervous on the US dollar,” Mathur adds.
The pain of the peg
Ultimately currency appreciation rather than investment diversification could be the best solution to China’s investment headache.
“China could look for a faster pace of renminbi appreciation to reduce further accumulation of FX reserves, and could encourage more outward investment and continue to promote internationalisation of the RMB,” says Jian Chang, economist at Barclays Capital.
For years Beijing has dragged its feet over allowing the renminbi to appreciate in order to protect export-reliant economic growth. But of late the need for the renminbi to become stronger has become pressing – particularly given the recent pledge from the US Federal Reserve to keep its interest rates near zero for the next two years.
That will surely push the already weak dollar downwards, placing even more pressure on the renminbi to rise. Beijing either has to let it do so or face seeing its US dollar inflows surge even more.
Normally, China might be tempted to match a weaker dollar by intervening to weaken its own currency too, to ensure its exporters stay competitive. But to maintain the peg, China needs to either buy more US dollars or create more renminbi.
Neither outcome looks appealing. The first measure would make China accumulate a now far less-alluring dollar, while further printing of the renminbi could fuel inflation.
A cheaper dollar also tends to push up prices of traded commodities, as countries that hold a stronger currency would demand more dollar-priced commodities, while the commodities producers on the receiving end would tend to supply less. Such a scenario would threaten to add to the resource-savvy China’s already-high 6.5% inflation, worsening the situation.
Raising the renminbi
The Fed’s recent pledge to keep its rates low for two years offers the perfect reason for Beijing to let its currency appreciate further and faster.
A stronger renminbi would make imported commodities more affordable, stem reserve accumulation, and put more spending power in the hands of businesses and consumers, even rebalancing the nation’s growth towards domestic consumption and away from exports, a critical goal of the Beijing government.
It’s a view that seems to be gaining official backing. A commentary in the state-owned publication the China Securities Journal on August 12th said that the government may rely more on strengthening its currency to ease inflation pressures, with the central bank cautious on raising interest rates because of the risk of attracting capital inflows.
Dariusz Kowalczyk, an economist at Crédit Agricole in Hong Kong, also believes Beijing is now more inclined to accept a faster pace of renminbi appreciation.
He suggests that Beijing is increasingly inclined to believe that it’s better to accept faster currency gains – and therefore weaker exports and weaker economic growth – than to bear the risk of continued fast accumulation of US Treasuries and European government debt.
Many officials in the capital may resist doing anything that hurts the country’s export sector. But while manufacturing activity is slowing, the latest data shows that retail sales and industrial production have been resilient. Despite worries of a weakening global economy, the trade surplus widened to US$31.5 billion in July, suggesting exports are still robust.
And if it needs to bolster economic growth, China can always release some of the 21.5% in deposits its banks have been forced to keep in reserve, or increase the country’s fiscal spending. Such options make a stronger currency less scary.
Attaining reserve currency status
It is clear that China wants to reduce its exposure to the US dollar, a currency that it increasingly distrusts.
The ultimate solution, as Barry Eichengreen, a prominent economic historian, argues, would be for the renminbi to achieve world reserve currency status alongside the dollar, or maybe the euro too.
Admittedly, China has a long way to go in winning the trust of international investors by making its domestic markets deeper and more transparent. The country would also need to scrap curbs on foreign access to the renminbi for purely financial purposes.
In the meantime, however, Beijing would at least want to stop accumulating the greenback by moving quickly to internationalise the renminbi, resulting in more trades and investments being settled in the Chinese currency.
Additionally, China is shifting from an export-led economy towards a domestic consumption driven economy. Both issues will serve to challenge and rock the dominance of the US dollar.
For the time being, Beijing has little choice but to maintain the mountain of US dollars that it owns. But Chinese officials have set 2020 as the deadline for transforming Shanghai into a first-class international financial centre. That will require a well-internationalised currency. And once it has that, China will not have much need to hoard US dollars.