from Follow the Money

Finance as foreign policy

September 11, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The Financial Times seems to have found an obviously non-commercial investment by a sovereign state. And it didn’t come from a sovereign fund.

China’s State Administration of Foreign Exchange seems to have discovered that generating diplomatic returns is easier than generating financial returns. Jamil Anderlini of the FT:

In January this year Safe bought $150m in US dollar-denominated bonds from the government of Costa Rica as part of an agreement signed last year under which the Central American nation cut diplomatic ties with Taiwan (after 63 years) and established relations with the People’s Republic of China. The agreement .... explicitly links the foreign policy switch to China’s purchase of $300m in government bonds and a grant of $130m. In an exchange of letters from January this year between Fang Shangpu, Safe’s deputy administrator, and Costa Rica’s finance minister, Safe promised to buy government bonds under the terms of the 2007 agreement, but included a clause demanding Costa Rica take “necessary measures to prevent the disclosure of the financial terms of this operation and of Safe as a purchaser of these bonds to the public”.

China has long been willing to assist countries that refused to recognize Taiwan. But it generally hasn’t used its central bank reserves to do so. But if a country already has way more reserves than it really needs, well, it has new options. Anderlini:

"The purchase of US-denominated Costa Rican government bonds by China’s State Administration of Foreign Exchange (Safe) is the clearest proof yet that Beijing regards its $1,800bn in foreign reserves – the world’s biggest – as a tool to advance its foreign policy goals, as well as a potential source of income.’

I was particularly interested in the FT’s story for two reasons:

One, it suggests that SAFE is now something more than a traditional reserve manager. Investing in Costa Rican bonds and investing in equities (I suspect SAFE has a US equity portfolio, not just a British and Australian portfolio) are both signs that China believes it has more liquid reserve assets than it really needs.

Two, evidence that the world’s biggest creditor country is throwing its financial weight around should increase interest in my new Council on Foreign Relations Special Report which examines – or tries to -- the strategic implications of the world’s changing balance of financial power.

It is a big topic, and it is a big paper. I won’t try to summarize it fully here.

But one of the core arguments in the paper is that countries with lots of foreign assets do have options that are often not available to countries that have large foreign debts. Another is creditor countries are, at least on occasion, able to influence the policies – foreign as well as economic policies – of the countries that rely on them for credit.

A government’s ability to borrow big sums in times of need is an important strategic asset. Nial Ferguson’s work on Britain’s rose has made this clear.

But relying heavily on fairly small number of governments for large amounts of financing can also be a strategic vulnerability.

That though isn’t how the US typically thinks about its ability to place quantities of dollars at low rates with the world’s central banks.

The dollar’s status as a key reserve currency has traditionally been considered an unambiguous strategic asset for the United States. Central banks need reserves to guarantee their countries own financial stability – and in some sense they traditionally have needed to hold dollars far more than the US has needed other countries to hold dollar reserves. The asymmetries favored the United States. The US lived in a world where it didn’t need to hold reserves – and could count on other central banks’ need to add to their reserves for a (limited) supply of financing on very favorable terms.

I worry that this may no longer be the case. There is growing evidence that the countries now adding to their reserves most rapidly already have far more reserves than they need. The US runs the risk that it may be in a position where it needs other countries to add to their dollar reserves more than other countries actually need additional dollars. That potentially shifts the strategic calculus.

China’s willingness to link its willingness to buy Costa Rican bonds to Costa Rica’s “one China” policy is an example. China wouldn’t be as willing to buy less liquid Costa Rican dollar bonds (in the right circumstances) if it wasn’t convinced that it already has all the liquid dollar-denominated bonds it needs.

I’ll have more on my paper later. For now, though, I would be remiss not to note the FT’s leader – which calls for more transparency from central banks as well as sovereign funds, and also calls for China to adopt policies to reduce the pace of its foreign asset growth.

Safe’s dealings with Costa Rica do, however, demonstrate potential dangers. These show that it is ready to invest as a means of applying political pressure. They are also a demonstration of the great lengths to which Safe is willing to go in order to hide its positions. It is an opaque institution, without open oversight of its assets or objectives.

As with most other sovereign wealth funds – as well as some publicly owned companies and even some individuals enriched by petrodollars – not enough is known about Safe to be sure it could meet a serious “fit and proper persons” test for control of companies abroad. ….

China must realise that its ballooning foreign reserves are a problem. It should allow the renminbi to appreciate further against the dollar, reduce its current account surpluses and, above all, relax capital controls to allow private investors to invest abroad. It will be far easier for the rest of the world to absorb Chinese capital if it does not come wrapped up in ownership by the mighty Chinese state.

I agree. China financial integration with the world generates friction precisely is comes with the mighty Chinese state.

Indeed, I would argue that FT’s leader understates the challenge posed by the exceptional pace of China’s foreign asset growth. In addition to adding $476 billion to its foreign exchange reserves between June 2007 and June 2008, China added $205 billion to the central banks “other foreign assets” – bringing its total holdings of foreign assets to a little over $2027 billion. This isn’t a secret. The supporting data appears on the PBoC’s balance sheet (look at the fourth line from the top; the 2008 data is only available on the Mandarin site). Of course, some of the $680 billion increase in the PBoC’s foreign assets reflects the euro’s rise over this period. But around $600 billion of the $680 billion increase was real – and that total leaves out the funds moved to the CIC and the funds the CIC injected into the China Development Bank.

Unless there are far more fundamental policy changes, China will continue to accumulate very large quantities of foreign exchange – and, since it already has more dollars that it needs, it also has the capacity to use its reserves in creative ways.

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