In the mid-19th century, people in China dreaming of wealth may have thought of Gold Mountain, or Gum Shan, the Cantonese name for California. Tens of thousands of Chinese flocked there, seeking their own claim to riches.

Now, in 2008, wealth-seekers don’t need to leave home, the Chinese are actually sitting on the new Gold Mountain – China’s 1.68 trillion dollars in foreign currency reserves held as of the end of March: $1300 for every man, woman, and child. In a country where GDP per capita is still less than $2500 (additional source), that’s no small change.

Yet, in much the same way as the miners of the 1800s were lucky to see a small gold nugget at best, so too does China’s populace sit upon a mountain of gold that is nonetheless maddeningly out of reach. China is not doing enough to control its foreign exchange reserves, and needs a new way to deal with them, and fast, or it is likely to continue to suffer the main ill of having too much money: Inflation.

The Story of Foreign Reserves

A country, especially a developing country such as China, needs foreign reserves. To simplify matters, in order to facilitate trade amongst diverse nations with their own currencies, the world needs a common representation of value. Historically that was gold. Today, gold has been supplanted by several reserve currencies such as the US dollar, Euro, and the Yen, and the value of those currencies is ultimately backed by confidence in the goods and services produced by those countries.

Developing countries, in order to trade, need that foreign currency, and typically have several months of reserves on hand to cover the average cost of imports. Every prudent country needs a few months’ reserves for a rainy day; eight to ten months worth could be considered extremely cautious. China had sixteen months of reserves available to cover its $91 billion in imports in January. The People’s Bank of China on April 11th announced the official size of the reserve at 1.68 trillion dollars as of the end of March 2008. And the country is getting richer faster than ever before, with reserves growing 40% more in March than the same period last year.

A second reason to have reserves is to be able to defend the home country currency from speculative attack in the foreign currency markets. For example, Thailand could have used a few more dollars back in the 1997 Asian Financial Crisis, but China does not allow convertibility of the RMB, which curtails the majority of currency speculation, thus making this point moot.

Finally, reserves are used to cover foreign debt. China’s estimated $363 billion plus of foreign debt at the end of 2007 is nothing to scoff at, but SAFE will not be bouncing any cheques. In fact, China has the largest foreign reserves in the world, nearly double those of number two Japan. So, what gives, China? Why the massive foreign reserves?

China’s Big Piggy Bank

China does not actually hold wads and wads of cash, like a high-roller hitting Macau’s new casinos. Most of its funds, especially those denominated in US dollars, are in the form of US Treasury bills and other long term securities. T-bills have a notoriously low interest rate because they are seen as the safest investment available. With China holding an estimated $466 billion in T-bills alone (full data, 2), earning interest in the low single digits (even hitting a 50-year low at recent auctions), parking so much money in low-yielding securities means China is literally leaving billions in potential investment income on the table.

Couple this opportunity cost with the depreciation of the US dollar against major world currencies and China’s US dollar holdings are looking even less attractive. Given the consensus estimates that China’s total foreign reserves are comprised of about 70% dollar-denominated securities and cash, and that the depreciation in the US dollar over the last year has been about 14% against both the Euro and Yen, those Chinese reserves in US dollars have lost about 100 billion in spending power. Of course, China’s Euro and Yen holdings have increased buying power, but not in proportion as only about 30% are in non-US dollar assets. With such low interest rates and the passive depreciation of its US dollar holdings, China is anxious to look for other ways to spend its growing fortune.

Enter the CIC

The China Investment Corporation, a 200 billion dollar sovereign wealth fund, was created in late 2007 to funnel some of China’s foreign reserves into more profitable investments. Its size is not exceptional among other global funds from Norway, Abu Dhabi, or even Singapore’s, but the speed with which it was formed makes it the new kid on the block and is seen as a carpetbagger by many countries, but chiefly the US, which fear the CIC is merely an extension of Chinese government policy abroad.

In early April, the genial president of CIC, Gao Xiqing, appeared on the US news program 60 Minutes. In a not-so-hard-hitting interview, Gao pinned down the fear foreign governments seem to have of CIC, saying “Immediately after we announced our existence, then the U.S. Government, some European governments, all came out and said, ‘okay, we think of this as — this is a dangerous — we need to do something about it. They probably want to control us. They probably want to do something bad about us,’”

These fears have stymied CIC’s investment plans. To date they’ve made only two major investments. First, a three billion stake in US private equity firm Blackstone Group, and a five billion dollar investment in Morgan Stanley at the peak of the sub-prime mortgage crisis. Not bad for six months, and only 192 billion to go.

Perhaps answering calls to speed up the pace of investment, other Chinese government entities are buying foreign assets, such as SAFE itself, which last week announced that it had accumulated about 1.6 percent of French oil firm Total S.A.’s shares, worth about 3 billion dollars. Let’s see, that only leaves, oh…. 1.67 trillion.

(Update: 4/16/08 This story showing how CIC has quietly accumulated a one percent stake in British oil producer BP. Note to China: If you’re trying to reassure the world that your SWFs are not just an extension of national energy security policy, you might want to diversify a little more. What’s next? A one percent investment in Exxon?)

With all that gold not being spent somewhere productive, the Chinese government needs to consider a new policy that will impact foreign reserves more quickly. One may hope that the new Gold Mountain won’t turn out to be the illusion it was for so many Chinese more than a century ago.

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Jason Inch

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