China prepares to spend $200 billion to buy stuff around the world


By Zhou Jiangong
Asia Times, Hong Kong
Saturday, February 3, 2007

SHANGHAI -- The Chinese government is taking action to implement a new policy of diversifying the disposal of the country's over US$1 trillion foreign exchange reserves that was initiated by the Central Conference on Financial Affairs three weeks ago.

The Ministry of Finance (MOF) is planning to issue yuan-denominated bonds to raise funds that will be used to "buy out" as much as $200 billion from the country's foreign reserve pool.

To take funds out of the foreign exchange reserves the government must pay the equivalent amount in yuan to balance the books.

At the current exchange rate, the total amount of yuan bonds to be issued by the MOF will be more than 1.5 trillion yuan. The ministry plans to sell the bonds to commercial banks, according to China Business News, a leading business newspaper based in Shanghai.

The $200 billion "bought out" from the foreign exchange reserves will then be injected into a new company to be set up this year to handle overseas investment with foreign reserves.

The new company, tentatively named National Foreign Exchange Investment Co., will be controlled by the State Council, China's cabinet. It will spend funds from the foreign reserves on mergers and acquisitions of overseas businesses, including foreign financial institutions. It will also target overseas energy assets and will likely acquire equities in the domestic markets, or even lend money to help finance domestic research and development projects.

Informed sources say that Lou Jiwei, currently vice minister of finance, will be appointed as board chairman of the National Foreign Exchange Investment Co.

The new company will be a ministry-level body and as such its creation needs to be rubber-stamped by the National People's Congress (NPC), China's parliament. According to Chinese law, bond issuance by the MOF also needs the NPC's approval. Therefore, both the establishment of the investment arm and the issuance of bonds are expected to be on the agenda of the NPC's annual session, which begins next month.

If the MOF decides to issue yuan-denominated bonds, which could happen this year, 1.6 trillion yuan would be taken back from the market.

The new company represents a victory for the Ministry of Finance in the battle for foreign exchange assets management. Some researchers close to decision-makers estimated that the new company could manage about $200 billion.

The new policy to diversify the disposal of the country's huge yet growing foreign exchange reserves is also bound to change China's current foreign exchange management regime, which is dominated by the State Administration of Foreign Exchange (SAFE).

According to the People's Bank of China, (PBoC), the central bank, the SAFE is responsible for the stewardship of the largest foreign exchange reserves in the world. It is estimated that over 60% of the reserves are invested in US Treasury bonds, with an annual return rate of about 3.5%.

It is risky to put all eggs in one basket. Also, the expected appreciation of the yuan is worrying the Chinese government. If the US dollars depreciate against the yuan by 5% this year, which is almost certain, the reserves will "shrink" by $50 billion against the yuan, equivalent to the amount of capital the Central Huijin Investment Co has injected into Industrial and Commercial Bank of China (ICBC), Bank of China (BOC) and China Construction Bank (CCB).

Such concerns finally prompted Beijing to decide to reform the management of its foreign exchange reserves.

It is now widely speculated in Beijing financial circles that the SAFE's dominance in the foreign exchange regime will be cracked. The MOF, along with the PBoC, will lead an emerging multi-tier foreign exchange reserve management system.

Meanwhile, the SAFE will also set up an overseas company to prudently invest in low-risk, long-term Treasury bonds and housing mortgage bonds denominated by the US dollar and the euro. The SAFE will still control at least 60% of the $1 trillion reserves after the diversification.

Central Huijin, nominally the PBoC's investment arm, will continue to manage tens of billions of reserve dollars it has injected into three of the "Big Four" state lenders: ICBC, BOC, and CCB.

This year, it is estimated that Central Huijin will inject about $25 billion to $30 billion into the last of the "Big Four," the Agricultural Bank of China (ABC), to help restructure it into a joint-stock corporate in preparation for going public. ABC's restructuring is to be decided at the Central Conference on Financial Affairs.

Reserve dollars have helped Central Huijin emerge as an empire of state financial asset control. It also controls the country's biggest securities brokerages and indirectly controls the biggest mutual funds. Central Huijin has just announced that it will inject $4 billion into the China Reinsurance Group to take a 92% controlling stake, while the MOF is taking the remaining 8%.

The National Social Security Fund (NSSF) headed by former minister of finance Xiang Huaicheng is also eyeing a slice of the foreign exchange reserve. But a suggestion that a chunk of the reserve be allocated to the NSSF was firmly rejected by Wu Xiaoling, the deputy governor of PBoC. In general, the idea of allocating part of the reserve to any existing financial institution or government department for the purpose of investment has been discarded.

The scale of the MOF's planned bond issuance is so huge that it has to be done phase by phase. In so doing, pressure on market liquidity can be alleviated. Although the market is awash in liquidity, the issue needs to be in line with monetary policy.

Some analysts suggest that the government adopt a Japanese practice: the Ministry of Finance issues home-currency denominated bonds to buy foreign exchange flowing into the country. The purpose of the policy is to separate the burgeoning money supply from the increasing foreign exchange reserves.

The Japanese Ministry of Finance is responsible both for fiscal policy and monetary policy. But the mandates of the MOF in China are limited to fiscal policy and the supervision of financial assets management. The PBoC oversees monetary policy. Yet the issuance of government bonds concerns both the country's fiscal and monetary policy. Therefore, it requires improved coordination between the MOF and the PBoC, whose relationship has long been tense.

The market is also worried that the MOF could incur losses from the operation since it risks holding hundreds of billions of US dollars that will likely depreciate in coming years. But analysts in Beijing policy circles believe that the government is considering hedging the risk.

They say that with the MOF's bond issuance, more than 1.5 trillion yuan will be drawn from the country's banking system to reduce commercial banks' liquidity.

However, some analysts point out the potential shock effect the operation could have on the stock markets. If 1.5 trillion yuan is absorbed by the bond issuance, the market could face a "liquidity shock."

Many concerns have surfaced: Can the markets bear the shock? Will the purchase of $200 billion be completed in one year or in three years? What will the terms of the bonds be?

Ha Jiming, chief economist at International Capital Corporation Limited, dismissed this concern. "Nowadays, liquidity inside the banking system is more than sufficient. If the government bonds are issued phase by phase, the due bank notes issued by the PBoC and the new base money from the purchase of the foreign exchange will allow the market to absorb the pressure."

If the 1.5 trillion yuan is drawn from the banking system in three years, the market could bear the impact on liquidity, many analysts say.


Zhou Jiangong is a Shanghai-based analyst on China's economic, political, and foreign affairs.

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