Wednesday 14 March 2007

How to spend China's foreign reserves - more US treasuries?

Following on from the previous posts it appears that China is no longer happy to receive such a poor return on its billions of dollars of foreign exhange.

This is a wise move but the ramifications of a systematic move away form US treasuries and into other currencies and assets may be serious. More than simply the bottom line return needs to be considered, not least the exchange rate between the $ and the RMB. Any appreciation in the RMB against the $ will have a knock on effect on exports to the US and thus employment.

This interview with Jin Renqing is telling.

China's Giant New Investment Agency
On Mar. 9, China's Finance Minister Jin Renqing unveiled a government plan to overhaul the way the country manages its massive $1.07 trillion stockpile of foreign exchange [forex] reserves, the biggest in the world. China's forex holdings are gargantuan for any country, let alone a developing one. They are also growing at clip of about $20 billion per month thanks to the country's massive trade surpluses.

Beijing has typically held about 70% of its reserves in U.S. dollar assets. However, now the plan is create a new state agency to divert more than $200 billion in funds to invest in all sorts of higher-yielding equity assets and perhaps strategic energy assets around the world or even some select social programs at home.

Nobody knows for sure, and details on the new agency remain sketchy. Its name has not yet be chosen, nor has a timetable been disclosed for when the new policy will get underway. However, the amount of money involved is bound to be felt globally. Here are a few of the possible implications.

Will this mean more downward pressure on the U.S. dollar?

No. China will continue to hold the bulk of its reserves in U.S. dollars initially, regardless of how it intends to spend those reserves. While China has eased back on its demand for U.S. Treasury bills, it has been spending more on other types of U.S. agency paper, such as mortgage bonds. Hence its demand for U.S. dollars is relatively unchanged, and the impact on the U.S. exchange rate will be minimal.

Does this mean China will stop buying U.S. Treasuries?

That's unlikely, too. Wu Xiaoling, deputy central bank governor at the People's Bank of China, said the central bank will continue buying U.S. Treasuries with its reserves. However, the policy shift will probably mean that a smaller proportion of China's export earnings will be recycled into the Treasury market.

In fact, even before the announcement of a new investment agency to manage China's FX reserves, Beijing financial authorities have been gradually diversifying into other low-risk investment vehicles denominated in euros and yen. This trend is bound to continue and could put upward pressure on U.S. Treasury bill yields if other foreign investors don't make up the difference.

What will this new entity look like?

It is expected to be modeled after Temasek Holdings, the investment arm of the Singaporean government. Over the years, Temasek has made strategic investments in large Singaporean listed companies as well as foreign companies engaged in telecommunications, property, financial services, and pharmaceuticals. [It is actually a huge investor in mainland Chinese banks.]

China's investment arm will definitely aim to get a rich return on investment, but its decisions will also be guided by political and strategic considerations. China is likely to focus on large equity stakes in oil and gas concerns, minerals such as gold, and possibly shipping assets. But while Temasek has about $85 billion in assets under management, China is expected to have a war chest worth between $200 billion and $220 billion. China has previously injected $70 billion of its reserves to shore up ailing state-controlled banks.

Who will run the new state investment arm?

Lou Jiwei, a former deputy minister of finance who, early in March, was promoted to a cabinet-level position at the all-important State Council, is expected to head up the new investment agency. Lou was instrumental in arguing for diversification of China's foreign exchange earnings. He is likely to hire some foreign professionals with good experience in portfolio risk management.

Will the new agency face opposition to its overseas purchases?

That's probably a given, since Chinese companies have been thwarted by foreign governments in proposed takeover deals viewed as sensitive. China National Offshore Oil Corporation, or CNOOC's, failed takeover run for Unocal in 2005 and Haier's unsuccessful bid for Maytag are two examples that come to mind.

China is likely to focus on acquiring assets in resource-rich emerging economies such as Indonesia, the Philippines, and Africa, where it's less likely to face opposition. So don't expect the Chinese to go on a buying spree similar to the Japanese, who snapped up trophy assets such as Rockefeller Center in the 1980s. The Chinese are keen to fly as far below the radar as they can -- for now.

But does that preclude minority equity investments?

In fact, buying shares of listed resource companies would be a good natural hedge for China. For example, while China may not be able to acquire mining conglomerate BHP (BHP) outright, it can at least benefit as a shareholder. So while China's voracious appetite will drive commodity prices up, the country can benefit from higher prices through dividends on its equity holdings.

What sort of return will the new agency be looking for?

Something well in excess of 6%. The agency will likely raise renminbi by selling bonds and then using proceeds to purchase reserves from the central bank. As things stand now, its internal borrowing costs are about 3%. If you factor in an expected RMB appreciation of 3% per year, then total cost of funds is about 6%.

Will the new agency be transparent about investments and returns?

Don't bet on it, says HSBC China economist Qu Hongbin. "This will easily be one of the largest asset management companies in the global market. The last thing you want to be is transparent as to what you buy and sell."

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