When global media reported at the end of March that China does not intend to keep adding to its stockpile of foreign exchange reserves, markets reacted with panic: the dollar fell sharply against the yen, the latter gaining a brief fillip from its lack of prominence in China’s $1.2 trillion reserve holdings. And frenzied conjecture about the implications of the alleged move became the order of the week.
Much of that reaction was based on incomplete information, lost in the hasty retelling of the initial report.
Lost in transmission
What was almost universally omitted was the context of the original interview with Emerging Markets. In it, China’s central bank chief Zhou Xiaochuan set about clarifying the rationale behind the Chinese government’s newly proposed investment management agency.
As a matter of policy, Zhou explained, the government does not want, over the medium term, to continue stockpiling foreign exchange in the People’s Bank’s reserves, but rather aims to invest a portion of future capital inflows through the new institution.
“Many people say that foreign exchange reserves in China are already large enough. We do not intend to go further and accumulate [foreign exchange] reserves,” Zhou said. Crucially, he added that the new agency will focus on maximizing profit, as opposed to the “traditional” goal of building up a liquid cushion for financial security.
China’s central bank, through the State Administration of Foreign Exchange (Safe), invests its reserves in low-risk, low-yielding dollar-denominated bonds. Beijing wants to put some of that money to productive use.
“[The government] is shifting the focus more onto the profitability side rather than on safety and liquidity,” the “traditional” aims of reserve management, he said, adding that “we can cut a small piece of the reserves for the new management agency.” Zhou did not say how much would be channelled to the new agency, though analysts estimate it will manage between $200 and $300 billion.
Of course, China must continue buying most of the foreign exchange flowing into the country to keep its currency from appreciating. The bulk of that build-up is a result of mopping up dollars from China’s burgeoning trade surplus, which nearly doubled in the first quarter of 2007 from a year earlier, to $46.4 billion.
Analysts have described the idea of redirecting inflows from future months as especially shrewd, since the foreign exchange would be off the central bank’s balance sheets, and so would no longer be counted as reserve assets. In this sense, the US and others would also find it harder to target China as a currency manipulator, because the central bank’s reserves would appear stable rather than rising.
Nevertheless, the severity of the market’s reaction to Zhou’s comments is testimony to the unprecedented significance of China’s reserve stockpile – the world’s largest - and the sensitivity of the market to the merest hint of a change in its strategy.
Premier Wen Jiabao said earlier in March that the new agency would not have any impact on US dollar-denominated assets. But all eyes will remain firmly fixed as more details of China’s rapidly developing reserve strategy come to light.
Reserve jump
The question again came into sharp relief in April, when the government announced China’s reserves had grown at the rate of $1 million a minute in the first quarter of 2007, or by more than half the total increase of the previous year.
“We’re shocked,” said UBS Asia chief economist Jonathan Anderson in a note at the time. “From trend reserve growth of around $20 billion a month in 2006, January, February and March rolled in at nearly $50 billion a month, or $140 billion for the first quarter as a whole. This is more than just a jump. The magnitude and abruptness of the acceleration are simply stunning.”
The central bank says the unwinding of swap agreements between the PBOC and Chinese commercial lenders resulted in foreign exchange coming back onto its books.
The question is whether the surge is a “one off or a sign of things to come,” Anderson tells Emerging Markets. “My sense is it will slow up, but by how much we don’t know.”
Agency Structure
Either way, the 37% surge in total reserves over the last year coincides with China’s moves to set up its investment fund. “[The new agency] is going to get very big very fast,” says Stephen Green, China economist at Standard Chartered, referring to the proposed strategy of funnelling future capital inflows into the fund.
Lou Jiwei, a former vice minister of finance, is tipped to head up the new ministerial level agency, which will be one of the world’s largest investment funds. The Abu Dhabi Investment Authority, with $700 billion under management, is currently the biggest, but, with China’s current trajectory, that could change fast.
Anderson says there are several drivers behind the new fund. “They need to diversify their holdings, and they need something to take the pressure off the People’s Bank on a flow basis, to avoid the central bank doing all the heavy lifting,” he says. “This will also be a resource bid – a fund to go out and buy up resources.”
Zhou told Emerging Markets the agency could incorporate structural elements from Singapore’s Temasek Holdings and Government Investment Corporation, the Korean Investment Corporation, Norway’s central bank, the Kuwait Investment Corporation and Saudi Arabian Monetary Authority, among other state investment agencies. The agency’s preparatory team is “going to come back and apply its international experience to domestic considerations,” Zhou said.
But he noted that ideas for how the agency will manage reserves are not yet “very clear”, leaving open the possibility that Chinese authorities will also seek asset management expertise from foreign firms.
“Given their lack of expertise in asset management, I’d expect them to start very slowly,” says Standard Chartered’s Green. “Lou has a mandate to increase returns on reserves, but that’s not easy. The larger the pool of money, the harder it is to manage.” Green reckons they will need some experienced fund managers to help them.
A senior central bank official recently said that the planned agency should issue special Treasury bonds to raise money from domestic investors and use the proceeds to buy foreign exchange reserves from the central bank to invest abroad. Xiang Junbo, a deputy central bank governor, also said the government should invest some foreign exchange reserves abroad in low-risk bonds and some in state banks, policy banks or commercial banks to help expansion abroad.
In terms of where the agency should invest, Green says, “It probably makes sense to do a little bit of everything [bonds, equities, banks, natural resources, etc]. You’re going to get a whole lot of lobbying to do a lot of different things.”
Of course, it’s not just a matter of finding the right investments. Finding the right management expertise will be key.