Talking Point

A little too reserved?

China’s forex holdings could buy all the land in New York, LA and Boston

A man with a high savings rate: China's Central Bank Governor Zhou Xiaochuan

Past $2 trillion and still counting…

That was the message when the People’s Bank of China released data recently showing that the country’s foreign reserves had hit $2.13 trillion at the end of June.

The real figure is actually a bit higher. Another $300 billion or so has been filtered away from the reserves proper, into the state-owned banks or as seed money for Beijing’s sovereign wealth fund, the China Investment Corporation (CIC).

Still, a couple of trillion goes a long way. Enough to bid on all the land and property in New York City, Los Angeles and Boston, according to the calculations of Eswar Prasad and Isaac Sorkin at the Brookings Institution. Alternatively, it would have bought you three quarters of Nasdaq, or 25% of the S&P 500, as at the end of June.

China’s stock of foreign reserves is now the world’s largest, and more than double that of second-placed Japan. And there is little sign of a slower rate of growth. The pace seems unrelenting: $81 million an hour, $1.95 billion a day, and $13.7 billion a week in the most recent quarter.

Why have reserves continued to accumulate?

Primarily because China’s central bank does not want a rapid appreciation in the yuan.

In fact, most WiC readers will be familiar with the underlying story. In recent years, reserves have ballooned along with China’s widening trade surpluses. As the economy continues to earn more from its exports than it pays for its imports, Beijing has to buy dollars to hold down the value of its currency, in order to maintain export growth and job creation.

Prasad and Sorkin say that between 2000 and 2008, surging exports were behind almost three quarters of China’s reserve accumulation.

So it is all about the trade surplus?

There are other factors too. Foreign reserves can be held as a matter of policy: as a bulwark against currency and banking crises, for instance. But in the Chinese case, the other major booster is the surplus on the capital account – from situations in which more investment flows into China than capital flows out. This contributed to an 11% share of reserve build-up from 2004 and 2008.

It’s worth pointing out that reserve accumulation can shift in shape. In the four years to 2004, for example, capital account surpluses made up a much bigger proportion of reserve growth (51%). And they may now be on the rise again. Indeed, if not, it is hard to explain why reserves are hitting records when export growth is actually declining. China’s trade surplus fell $35 billion in the second quarter. Some of this growth results from income on existing investments. But most analysts think “hot money” inflows – of at least $70 billion in the period – are a more significant factor. This is a sign of investors (many of them Chinese) trying to rush their money back into the country’s revitalised equity and property markets.

How are the reserves held?

It’s a state secret. So we couldn’t possibly say, even if we knew.

In fact, no outsiders know for sure, as the agency responsible for managing them – the State Administration of Foreign Exchange (SAFE) – does not provide a full breakdown.

Fortunately, it is possible to piece together the likely composition of China’s dollar-denominated holdings (70-75% of total reserves) from US Treasury department data.

This shows that the lion’s share (around 40%) is held in Treasury bills and bonds. In fact, the buying of Treasuries has increased this year, which seems a little strange given Beijing’s public ruminations on dollar weakness.

All the same, it looks like Treasuries are regaining some share from agency debt (Fannie Mae and Freddie Mac bonds, that constitute about a fifth of China’s dollar-denominated reserves).

The opposite was happening in the year to June 2008, when SAFE opted to pile into Fannies and Freddies at the expense of T-bills and bonds. But then came a realisation of the full horror of the US housing crisis, as well as the sudden fear that an assumed US government “backstop” guarantee for agency debt might not hold.

Hence the more recent shift away from “riskier” assets, including a preference for shorter-term bills rather than longer-dated bonds. SAFE is at least looking to play ‘reserve roulette’ with the safest Treasuries odds.

What about the remainder?

The remaining 15% or so of the dollar-denominated assets are held in equities, deposits and (primarily) corporate bonds.

Foreign analysts have been expecting equity investment to take up a larger share for a while, especially since the creation of the China Investment Corporation in 2007.

But the unforgiving investment environment and some early setbacks on stakes in Blackstone and Morgan Stanley seem to have taken the edge off some of the initial enthusiasm.

So what is China likely to do with its reserves in future?

For all the talk of an end to the era of dollar dominance, China’s options in the short-to-medium term look limited. If it shifts too forcefully out of dollar assets, it could trigger a run down in the value of its remaining holdings.

No doubt it will still try to diversify and it has already made some efforts to increase exposure to gold and commodities, as well as some SDR-denominated IMF bonds. There is also a sense in forex markets that it likes Australian dollars – largely for that currency’s close correlation with commodity prices.

It might well look to invest more in foreign equities too – which is precisely why CIC was established.

In recent weeks, the sovereign wealth fund has also been more active, with stakes in Teck Resources (a Canadian miner) and CITIC Capital, a Hong Kong based investment fund.

There was also an investment in Diageo, although it was completed by SAFE rather than CIC. In fact, the 1% stake in the UK drinks company has revived talk of a bureaucratic tussles between the new kid on the block (CIC), and the more long established SAFE. As the FT commented when it broke the story, SAFE has emerged as a “de facto rival” to CIC in the purchase of foreign equity stakes – having picked up stock in companies in Australia, the UK and France.

Insiders say that relations between SAFE and CIC are none too smooth. They even suggest that SAFE’s pre-crisis move into higher yielding US agency debt was a strategy to boost its own investment returns and persuade policymakers that a further reserve management vehicle (i.e. CIC) was unnecessary.

Bureaucratic rivalries aside, can we expect more of a risk-taking stance?

Recent CIC activity seems to indicate we are moving back into a more confident phase, in which portfolio investment is back on the table. The State Council may well have decided the risk profile of US government debt now makes equity investment more palatable.

Premier Wen Jiabao seemed to be saying as much in comments published last week, in which he promised a new phase of the “going out strategy” which would see the “utilisation of foreign exchange reserves”.

These could be comments aimed at a domestic audience frustrated by the talk of dollar dependence, reasons Brad Setser at the Council on Foreign Relations.

Such talk is certainly in keeping with the mood of growing nationalism in China.

Then again, there are also cautious voices too. The China Daily last week reported on a statement from PBoC governor Zhou Xiaochuan that the country’s foreign exchange reserve should not be regarded as “an investment fund” or profit source. “If the foreign exchange reserve can produce reasonable returns, it is good enough,” Zhou told an audience at Peking University.


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