China has enough dollars but maybe not enough oil and gold


The Trillion-Dollar Question:
China is Grappling With
How to Deploy
Its Foreign-Exchange Riches

By Richard McGregor
Financial Times, London
Monday, September 25, 2006

It operates out of a nondescript office tower in Finance Street and, shortened to its English acronym, "SAFE," sounds like one of those fictitious shadowy organisations from a Sixties spoof spy show. But the Beijing-based State Administration of Foreign Exchange has a serious, real-world job -- to manage China's towering stack of foreign currency holdings.

Once this would not have mattered much outside China's borders, but the country's swelling trade surpluses and large capital inflows have given SAFE an investment pot to rival global fund management giants. Within the next few weeks, China's reserves are due to top $1,000 billion -- a record for any country, let alone a developing nation like China.

But it is not a moment everyone in China will be celebrating, especially the officials at SAFE and their masters at the People's Bank of China, the central bank. "One trillion is a big amount, but it is also a hot potato," says Ha Jiming, chief economist at China International Capital Corp., the country's largest investment bank. "If it is not well managed, any erosion of value will be a source of shame for whoever is responsible for it."

The mountain of foreign currency has been generated by years of inward foreign investment, then speculative capital inflows, and, more recently, a swelling trade surplus that has deluged the country with dollars. Normally this dollar excess would bid up the renminbi but, to keep the value of China's currency stable, the central bank has bought virtually all the incoming foreign currency and managed the money on its own balance sheet.

In Washington, China's reserves have become Exhibit 1 in its charge that Chinese intervention in foreign exchange markets has kept its currency artificially low, making it harder for the United States to export and thus reduce its trade deficit. The currency issue was raised again by Hank Paulson, U.S. treasury secretary, on a visit to Beijing last week. In China many agree the currency needs reform but, they counter, there is little Beijing can do to stop the accumulation without changes in the U.S. economy.

"China has found a niche as the world's manufacturing centre, which has simply transferred Asia's exports into China through a kind of processing trade," says Li Yang, of the Chinese Academy of Social Sciences. "The United States has been a huge beneficiary of this but it doesn't want to acknowledge it. Instead, it plays up its own problems to get other countries to subsidise them."

The huge value of the reserves has bought to the surface an intense debate within China itself about how the country should manage and even spend the funds. Two top leaders, Wen Jiabao, the prime minister, and Zeng Qinghong, a vice president, both discussed the reserves for the first time in public comments this month.

Mr. Wen said the increase had "improved China's overall national strength and international payment capability," though he also acknowledged the downside: the way the reserves flow back into the local financial system and feed the distorted structure of the economy.

Mr. Zeng said China "would take comprehensive measures to avoid further significant growth" in the reserves. Zhou Xiaochuan, governor of the central bank, was even blunter in impromptu comments to reporters. Asked about the reserves, he replied: "We have enough."

Under pressure internationally to let the renminbi rise and stop accumulating dollars, China in July last year allowed a one-off 2.1 percent appreciation of its currency against the dollar and promised to introduce a more flexible exchange rate regime. But halting the dollar buying spree seems unlikely. Since the one-off move last year, Beijing has tightly controlled the renminbi, allowing an increase only of about another 2 percent.

Beijing's critics say present policies make further accumulation inevitable, describing the matter as out of the central government's control if exchange rate policy is not changed. "If you have a basically fixed exchange rate, you cannot choose your levels of reserves," says a Beijing-based foreign economist.

There are no signs of any near-term change in exchange rate policy, for a number of reasons. At the top of the list for many senior officials is their fear of the impact of a rising exchange rate on coastal export industries. The loss of any jobs there would be felt just as keenly in poorer inland provinces, which rely on remittances from migrant workers employed on the coast.

Two other considerations stand out. Significant sections of China's policymaking elite remain convinced that Japan's lengthy recession had its roots in a large revaluation of the yen forced on it by the United States in the mid-1980s.

"Japan's 15-year recession was very much related to their failure of management of the exchange rate. We will not allow this to be repeated in China," says Mr. Li from the social sciences academy, who is an adviser to the Chinese government. The central bank also argues that a flexible renminbi must await the development of a domestic currency trading market, still in its infancy.

Managing the huge growth in reserves is proving to be high-wire act for SAFE and the People's Bank. In buying such a huge stock of dollars, the central bank has had to pay in renminbi and to "sterilise," or offset, the inflationary impact of this money in China's domestic economy, by taking it out of circulation.

To soak it up the central bank has has to issue short-term securities, most of which have a maturity of one year and some even less. That means the authorities are under ever increasing pressure to turn over their holdings, which were worth 2,903 billion renminbi ($367 billion, £193 billion, €286 billion), by the end of August.

The securities are bought by state banks, which have excess cash and few other places to park it. "The cost of sterilisation is being shouldered more and more by Chinese banks," says Zhong Wei, chief editor of the official China Foreign Exchange Magazine.

But raising interest rates, thereby increasing the return to Chinese banks, is likely to have the effect of simply attracting more foreign capital -- and necessitating even more sterilisation.

"China needs to raise interest rates to slow investment but, with the fixed exchange rate, [officials] worry that an increase would attract even greater capital inflows," says Nicholas Lardy, of the Institute for International Economics in Washington. "Thus there is a trade-off. In the long run they are not likely to be able to maintain an undervalued exchange rate and slow the pace of investment growth at the same time."

For the government, the cost of sterilising the dollar inflow is more or less neutral. On the asset side of its portfolio, SAFE has a huge amount of foreign currency-denominated securities, mainly U.S. Treasuries, which make around 3 percentage points more interest than the domestic bills and bonds on the liability side. But any substantial change in U.S. interest rates could change that profitable equation quickly, and a fall in the dollar could produce a huge capital loss.

The composition of China's reserves is secret, but analysis of global funds data suggests that Beijing has not been able to diversify in any meaningful sense its reliance on greenbacks. Brad Setser, head of research at Roubini Global Economics, calculates that about 70 percent of the reserves are in dollars, mainly U.S. Treasury bills but increasingly in instruments such as mortgage-backed securities and even emerging-market bonds.

China's leaders have debated in private the need to diversify the reserve holdings away from U.S. dollars but have been strict in ensuring that their comments are not reported, lest they have an impact on nervous global markets. The need to diversity away from the dollar has become a kind of conventional wisdom. "China should rationalise the composition of its foreign exchange reserves," says CICC's Mr. Ha. "The current trend of international currencies points to reduced dependence on the U.S. dollar in the future."

But Mr. Setser says such speculation about diversification misses the point. "The real issue is the pace of increase in overall reserves," he says. "In my view, the renminbi is undervalued against most currencies and plausible reserve assets, so there will be capital losses for China no matter what currencies it holds as reserves."

Any capital losses incurred as a result of swings in currency values, even if they are only on paper, could make the central bank and SAFE the target of bitter criticism. This is hardly fair, as the central bank is simply an instrument of broader government policy, but such an apparent loss of national wealth is the kind of issue that could be whipped up on a volatile, populist internet. "It is becoming a huge government risk," says a foreign economist who has informally advised the Beijing government. "The central bank and SAFE do not want to be responsible for managing this amount of money."

The sheer size of the reserves has been the trigger for the new debate about how else the money might be deployed. According to some local analysts, Mr. Zhou's crisp comment -- that China has "enough" reserves -- is better read as one of a number of signals coming out of the central government that Beijing has settled on an amount it needs to set aside as reserves in the traditional sense, as a national insurance fund against financial risk.

Xia Bin, an economist at the Development Research Council, a think tank under the State Council, the cabinet, has suggested China needs about $700 billion in foreign reserves to this end. Other commentators have put forward broadly similar amounts. That leaves about $300 billion to be used at the discretion of the government for spending in other areas -- a substantial pot that is growing by about $20 billion a month.

Competing shopping lists to be paid for out of the reserves are doing the rounds in Beijing. Inter-agency competition is also heating up for control of the money, with both the central bank and the finance ministry laying claim to the cash.

"We have studied the external management of foreign exchange reserves in every part of the world," says Mr. Li. China has given particular scrutiny to South Korea's recent experiment to allow some of its reserves to be managed like a mutual fund, with advice from foreign banks.

China also likes the Singapore model, in which the Government Investment Corporation and Temasek Holdings were established to manage the country's foreign exchange reserves and the state's direct investments respectively. Pro-market reform officials clustered around the central bank in Beijing have already quietly built up what they like to call a "mini-Temasek," an entity known as Central Huijin Investment Co., which among other assets controls the majority of the shares in China's largest banks.

At the top of the semi-public shopping list funded out of existing reserves are raw materials, something confirmed by both Mr. Wen and Mr. Zeng. The reserves could, for example, pay for importing the oil to fill a long-planned strategic reserve, the tanks for which are near completion. The government is also considering whether to buy gold, considered a hedge against the potential of a falling U.S. dollar.

"I think it makes sense to transfer some of the wealth into real assets," says Andrew Crockett, a former head of the Bank for International Settlements and now president of JPMorgan Chase International. But doing it prudently may be beyond the abilities of Chinese bureaucrats at the moment. "I don't think the government itself would have the expertise to do this," says Mr. Ha.

Nearly one in five of Temasek's staff are non-Singaporean, plus the company hires in foreign banks as advisers. China would take a long time before it would be comfortable even with the relative openness that tightly controlled Singapore can manage.

If global markets do turn against China's reserve holdings, many locals might look abroad for scapegoats. That would be wrong, says China Foreign Exchange's Mr Zhong. "We cannot blame the U.S. Treasury," he says. "No one forced us to buy dollars."

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