CIC’s Thames Water deal puts focus on Chinese reserves bind
China's repressed financial system has heaped on the risk that the central bank will soon sit on large losses on its FX holdings, a fillip for SWF-led investments
A timely reminder of how Chinas recent investment in Londons Thames Water underscores the countrys dire need to earn some yield from its FX reserves, from Natsuko Waki at Reuters:
|Chinas sovereign wealth funds move last week to invest in London water supplier Thames Water puts focus on potential overseas investment in the year of Dragon from Chinas central bank PBOC, which plans to create a $300 billion vehicle to invest in Europe and the United States.|
|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 countrys reserves, still standing at $3.18 trillion, brings only a small comfort to the worlds 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 Peoples 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 PBOCs income from foreign reserves investment has exceeded its sterilization cost consistently from 2003 to 2010. Zhang, in her paper, estimated the PBOCs cost of sterilization and compared it with its income from the foreign reserves investment from the period 2003 to2010. She finds that Chinas 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.|
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 Pbocs delicate balancing act in the context of Chinas 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 PBoCs net indebtedness would rise by over $250 billion, or roughly 5% of the countrys GDP. These kinds of number quickly add up.
In other words, the PBoCs 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 countrys growth model.