A timely reminder of how China’s recent investment in London’s Thames Water underscores the country’s dire need to earn some yield from its FX reserves, from Natsuko Waki at Reuters:
| China’s sovereign wealth fund’s move last week to invest in London water supplier Thames Water puts focus on potential overseas investment in the year of Dragon from China’s central bank PBOC, which plans to create a $300 billion vehicle to invest in Europe and the United States. |
Waki reckons agonizingly-low US Treasury yields have added impetus for Chinese state-owned funds to up their overseas exposures, hot on the heels of an apparent Reuters scoop in December that the People’s Bank of China’s will set up a $300 billion SWF fund to invest in higher-yielding overseas assets, an as-yet unconfirmed report:
| After Reuters reported on the plan in December, the PBOC and State Administration of Foreign Exchange (SAFE), which manages reserves, have been mum. A tiny drop in the country’s reserves, still standing at $3.18 trillion, brings only a small comfort to the world’s largest reserve holder as it struggles with low returns on its sovereign debt portfolios in U.S. Treasuries (earning almost nothing) and euro zone sovereign debt (under growing risk of further ratings downgrades). China, which regularly intervenes in the FX market to keep a lid on the yuan exchange rate to keep its exports competitive, is suffering ”negative carry” — the difference between the cost of intervention and its overseas investment. This is how the negative carry arises: The People’s Bank of China buys U.S. dollars in the FX market. When it intervenes, it pumps yuan into the domestic banking system. This extra liquidity, if left, can cause inflation. The PBOC therefore needs to mop this up by issuing “sterilisation bonds”. The sterilisation is not cheap. As foreign reserves keep accumulating, the PBC has to issue more debt for sterilisation purposes, which may drive up the interest rates on the PBOC bills. |
First, a refresher on the economics. A couple of years ago, a consensus emerged that FX accumulation in BRIC economies could no longer be justified on the basis of risk insurance, given the size of the arsenal and the fact they became net foreign currency creditors. Instead, the consensus opinion held that the warchest represented their bid to limit exchange rate volatility/appreciation – at the cost of low financial returns on FX assets, or potentially a negative carry, thus, underscoring the need to establish sovereign wealth funds. Over the past decade, China has by and large managed to dodge the negative-carry bullet, according to Chenying Zhang of the Wharton School at the University of Pennsylvania, as cited by Waki.
| [Zhang] argues that the PBOC’s income from foreign reserves investment has exceeded its sterilization cost consistently from 2003 to 2010. Zhang, in her paper, estimated the PBOC’s cost of sterilization and compared it with its income from the foreign reserves investment from the period 2003 to2010. She finds that China’s FX reserves have to drop around 36% (or to put it in another way, the RMB has to appreciate by more than 50% against the US dollar) before it fails to cover the sterilization cost of the PBOC. |
But that’s based on a June report. Since then, UST yields have tightened further while Fed asset purchases have flattened the long-end of the yield curve, heaping on pressure to generate FX returns, while nominal RMB appreciation in the coming years increases the structural risk of financial losses on reserves.
Few analysts manage to pull together what this all means like the justifiably ubiquitous Michael Pettis, finance professor at Peking University. Writing for Emerging Markets in October 2010, Pettis explored the Pboc’s delicate balancing act in the context of China’s repressed financial system.
| If the renminbi appreciates by as little as 2% a year, in other words, the PBoC must run a negative carry. Every further 1% increase in interest rates, or additional 1% rise in the value of the renminbi, erodes its capital by at least $25 billion. If over the next two years China sees a combined appreciation and interest rate increase of 10% – the absolute minimum that China must do to slow down the worsening domestic imbalances – the PBoC’s net indebtedness would rise by over $250 billion, or roughly 5% of the country’s GDP. These kinds of number quickly add up. |
In other words, the PBoC’s balance sheet itself is constrained in creating a structurally higher interest rate regime, a necessary endeavour since:
| Many years of cheap borrowing have created a dependency on low interest rates among state-owned enterprises, local governments and other creditors (not to mention the banks themselves), all of whom are directly or indirectly funded by long-suffering households. |
In sum, the extent to which China successfully deploys its FX reserves in higher-returning overseas investments could influence its monetary policy framework, and with it, the country’s growth model.
