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That, at least, is how I read Premier Wen's statement at the Party's financial work conference. Wen:
China [will] take "comprehensive measures" to attain balance in its external payments while "actively exploring and expanding channels and modes for the use of foreign exchange reserves."
Like James Areddy of the Wall Street Journal, I suspect "exploring and expanding channels and modes" doesn't necessarily mean selling US dollar bonds and buying euro-denominated bonds, pound-denominated bonds or even bonds denominated in Australian dollar and Korean won. Nor does it necessarily mean that a higher share of China's new reserves will be invested in currencies other than the dollar, though that might be part of the goal.
What is does mean is that China is looking to shift away from a model where all -- or nearly all -- of its foreign assets are managed by a single institution (SAFE). Especially when that institution holds, I suspect, a portfolio that consists of a bunch of relatively similar instruments -- dollar and euro-denominated Treasury bonds and dollar and euro-denominated mortgage bonds.
China is looking to set up an investment agency that can make equity investments. Perhaps more than one. The People's Bank of China wants to expand Central Huijin (the investment vehicle that manages the PBoC's investment in the state commercial banks), the Finance Ministry wants its own vehicle and no doubt there are other ideas floating around as well.
Richard McGregor spells it all out in the Financial Times:
... In five to 10 years, Beijing could preside over one of the world’s largest and most powerful investment agencies. The debate [over how to use China's reserves] thus far has irritated some economic policymakers who testily point out that the reserves cannot simply be spent as they represent assets on the central bank’s balance sheet. The government, or some agency under its control, would have to account for the funds in some fashion, perhaps through the issuance of bonds to the People’s Bank of China. ...
The government will take some time to sort through the bureaucratic competition developing round a plan to establish a state body to oversee any investment of the reserves. Huijin has long been discussed as a potential vehicle but the Ministry of Finance, which sees the reserves as its to manage, is battling to establish a role for itself in any new agency.
Some changes in the management of China's reserves make sense now that China has so much money. China shouldn't have all its (foreign) eggs in one institution, and that institution shouldn't have all of its eggs in what might be considered relatively similar baskets. But decentralizing the management of China's foreign assets may also pose a few challenges -- not the least a challenge to the maintenance of China's peg.
Interesting, these changes will mean that, over time, China's foreign assets will be managed in ways that resemble the way that the GCC countries now manage their collective foreign assets. The GCC's foreign assets aren't all managed by a single institution for one. And the GCC invests in equities as well as debt.
China and the GCC states both peg to the dollar. And, interestingly enough, they both probably have roughly a trillion dollars in foreign assets. We know China has that much -- a bit more actually, as China's official reserves don't count the $60b that the PBoC shifted to Central Huijin, the holding company that manages the PBoC's stake in the three big state commercial banks. And the Gulf states presumable have at least that much. Abu Dhabi's investment authority (ADIA) is rumored to have around $500-600b (or more), Saudi Arabia's Monetary Agency has over $200b in foreign assets, Saudi pension funds have a bit more and both Kuwait and Qatar's investment authorities are not poor. Throw in Dubai's various investment vehicles and the private fortunes of various princelings, and the total easily tops a trillion.
And in some sense, China and the GCC states collectively have a fairly similar portfolio. Both have relatively little official money on deposit in the international banking system (here, the GCC states differ from Russia, Algeria, Libya and Nigeria). And both have relatively small amounts of direct investment abroad: Dubai's various acquisitions and the investments of China's state oil companies have attracted a lot of attention, but the actual flows are pretty small.
Both essentially hold a portfolio of foreign securities. But that is where the similarity ends. The GCC's foreign assets are:
- Managed by many different institutions -- largely because the GCC itself is composed of independent states each of whom manages its own money
- Invested in equities as well as debt.
- Managed, at least in part, by external fund managers. China supposedly makes use of external managers for some of its holdings of emerging market debt, but that is a small fraction of its portfolio.
- At least some GCC institutions likely have less dollar exposure than the SAFE. At least that would be my guess. I would bet that at least one of the investment authorities has less than say 70% of its assets in dollars. Though I would also bet that the Saudi Monetary Agency has more than 70% of its assets in dollars, so I am not sure that the GCC's overall dollar exposure is substantially lower than China's overall dollar exposure.
You could argue that ADIA dominates the GCC's external portfolio, since it may have about half of the stock of the GCC's foreign assets (setting aside the private asides of the princelings). But ADIA presumably makes far greater use of external managers than SAFE -- and in any case, it doesn't dominate the flow -- both the Saudi Monetary Agency (SAMA) and Kuwait's Investment Authority likely received a larger influx of new money to invest in 2006. SAMA got about $70b in 2006, KIA may have received as much as $40b. And $70b is about a 1/3 of the total increase in the GCC's foreign assets.
Compare that with China. SAFE dominates the stock, with over a trillion in foreign assets. Central Huijin has $60b -- and those seem to be managed much like SAFE's reserves. We know that the PBoC swapped $14b of its dollars with the commercial banks in 2005 ($6b initially, but more seem to have been done on sly -- the IMF reported a bigger total in the 2006 article IV). And, as Stephen Green of Standard Chartered noted in a recent research note, it may have done additional swaps in 2006. Those swaps effectively give some of the PBoC's dollars over to the state banks to manage -- whether by investing in foreign securities or making loans to Chinese companies looking to expand abroad. But the total stock cannot be that big. The state banks also have the funds that they raised in their offshore IPOs (at least $35b). But all these pools of money are tiny relative to the SAFE's $1 trillion.
On a flow basis, assets managed by the SAFE likely increased by $220b in 2006 (that is my estimate for valuation-adjusted reserve growth). Private purchases of foreign debt - likely purchases by state banks and other state run institutions -- totaled $45b in the first half of the year. But even if those flows continued in the second half (as seems likely), over 2/3s of the 2006 increase in Chinese foreign assets came from a single institution.
Over time, that is likely to change. The GCC countries have invested in Chinese banks. China would love to have more investment in the GCC's oil fields. The GCC countries have large equity holdings -- and presumably that includes investments in Brazilian and Indian and Russian and Turkish and other equity markets. China wants to follow suit. Fair enough.
It doesn't really make sense for one single institution to manage nearly all the foreign assets of 1.3 billion people. And it doesn't really make sense for the foreign assets of 1.3 billion people to be concentrated so heavily in US and European Treasury bonds and US and European mortgage-backed securities (some issued by "Agencies" and some private).
If it really wanted to, China could change its portfolio around pretty quickly -- without selling any of its existing assets. China's current account surplus likely will imply adding $300b to China's foreign assets in 2007. Add in a FDI inflows and perhaps some hot money, and Chinese official institutions could easily need to accumulate close to $400b in foreign assets.
No wonder folks in the market care what China plans to do with its money.
But decentralizing the management of China's foreign assets also poses some challenges. At least I suspect that it does.
Why? My guess is that the currency composition of China's external portfolio is constrained -- at least significantly -- by China's currency regime. China can sell dollars for euros and try to bring the dollar share of its portfolio down when the market wants dollars without driving the dollar (and thus the RMB) down against the euro. But if China sells dollars when the market doesn't want dollars, I rather suspect it would put a lot of pressure on the dollar/ euro, and thus on the RMB/ euro. China, in effect, likely has to, in aggregate, end up buying more dollars when the dollar is under pressure.
Call it maintaining portfolio balance -- the Chinese have to offset any rise in the dollar value of their existing euros and pounds by adding more dollars to their portfolio. Or call it not adding fuel to the fire. If you peg to the dollar, you end up having to buy (And hold) dollars when the dollar is under pressure.
So long as a single institution is managing the majority of China's foreign assets, it is easy to avoid any contraction between China's desired portfolio and its desired currency regime. That is to say that if China needs to keep most of its growing foreign assets in dollars to keep the dollar (and thus the RMB) from sliding v. the euro or another currency, SAFE presumably adds to dollar portfolio.
But if different institutions are managing slices of China's foreign assets, well, things get a bit more complicated. Say China sets up an investment authority with a mandate to invest in equities. And say it wants emerging market equities and European equities rather than US equities. And assume (and it is an assumption) that the resulting inflows are large enough to move the market, and put downward pressure on the dollar.
And the RMB.
If that is right, someone else in China would need to increase their own dollar purchases to offset the dollar sales (really reduction in the pace of increase) of the equity manager. Or someone would need to decide to allow the RMB to appreciate against the dollar. That might make life a bit more interesting.
My argument here is a bit speculative. But it boils down to an argument that more decentralized management of China's external assets -- and a more diverse portfolio -- may require a bit more currency flexibility.
That also raises another issue. The GCC also pegs to the dollar. If China is big enough to move the market, presumably the big GCC fund managers are too. If all GCC fund managers tried to limit the increase in their dollar assets, that presumably would put a bit of pressure on the dollar. And, following my argument about China, their asset allocation would work as cross purposes with their currency regime -- as the portfolio decisions of the investment managers would push the value of the GCC currencies down ... even as inflation was rising.
That may have happened. I certainly don't know what the Gulf did with its money. Or it is possible that some GCC countries remained quite keen on the dollar -- and the rapid growth of their dollar holdings offset less rapid growth elsewhere. But that is a topic for another time.
Note: this post was edited to add the Richard McGregor story/ quote after it was initially posted.