Who wants to be a multi-trillionaire?

Based on the apparent pace of growth in China’s foreign reserves, the State Administration of Foreign Exchange may need to answer this question in a mere three months. Its answer should be an emphatic “Not China.”

In fact, SAFE’s next quarterly announcement of foreign reserves is not due until July but unconfirmed reports have been flying through state and foreign media (covering an unofficial number in China Business News interestingly) that China’s foreign exchange reserves increased by US$74.5 billion in the month of April alone, to reach US$1.76 trillion.

As a point of comparison, the world’s second largest foreign reserves are held by Japan, and in March 2008 they increased by one tenth of China’s apparent April gains - just US$7.6 billion. Incidentally, it was only in February that Japan’s foreign reserves surpassed one trillion for the first time, and they have since fallen back below the trillion mark, once again leaving China the lone member of the trillionaire’s club.

China first hit the one trillion mark way back in November 2006 but, unlike Japan, its foreign reserve increases are usually measured in double-digit billions. If later confirmed by SAFE, April’s increase of US$74.5 billion will be the biggest ever increase, anywhere.

If this pace continues, China’s foreign reserves could reach two trillion as early as August this year.

This is perhaps not the message China’s government wants to send to the world during the Beijing Olympics (”All your money are belong to us”), so there is intense discussion at the highest levels of China’s government over two issues: How to reduce the foreign exchange reserve, and how to use the existing foreign reserves more efficiently.

Reducing China’s Foreign Exchange Reserves

At one time, having enough money on hand to pay for imports might have been a prime consideration, but this has not been the case in China for years. Its current amount of reserves may cover monthly imports 15 times over, or more. What about another main reason countries keep a large foreign exchange reserve on hand, to defend the currency from speculative attack?

China does not allow convertibility of the yuan, which curtails the possibility of a run on the currency, but as well, China, together with the ASEAN countries plus Korea and Japan (the so-called ASEAN + 3), recently pushed forward the Chiang Mai Initiative, a US$80 billion foreign reserve pool that could be swapped to any member country experiencing speculative pressure. In theory, from 2009 this could reduce the need of Asian countries to hold such large foreign reserves. Until then, Asian central banks may feel better safe than sorry and decide to keep more reserves on hand, but China really doesn’t need to do this in the first place, so it needs to more aggressively reduce the size of its foreign currency holdings.

One way to reduce the size of the foreign reserve is to encourage foreign currency outflow. At present, the yuan’s continued and still expected appreciation has actually increased inflows, both as FDI and as hot money, to record levels.

In the first four months of 2008, FDI was up almost 60 percent over the same period last year, while the total number of company registrations actually decreased by 23 percent, according to the Ministry of Commerce. One likely explanation for this is that foreign firms inflated their average investment size so as to benefit from the future yuan appreciation. In fact, for hedge funds and other investors, this is one of the only methods they have to skirt Beijing’s capital controls, sneaking money in as legitimate-seeming FDI. The exact amount of hot money is unclear but can be inferred from known inflows (e.g. announced FDI), the estimated trade surplus, and other data.

To lessen the inward flow of hot money, China could either reduce interest rates to make passive funds less profitable in China, or could revalue the yuan exchange rate in a one-off revaluation similar to 2005 when the original dollar peg was removed. The former is likely to exacerbate China’s current inflation problem, while the latter would shock the country’s exporters. On balance, allowing the yuan to appreciate faster seems the lesser of two evils for the government.

An appreciation will cause outflows for several reasons. Some of the hot money will repatriate, while the stronger Chinese currency will encourage more consumption and imports from abroad. If the trade balance can reverse the current trend of annual surpluses, foreign reserves will dwindle rapidly.

Using the Foreign Reserves more Effectively

The second issue on China’s leaders’ minds is how to use existing reserves more efficiently. Some may even wonder why large foreign reserves are a problem at all. A rich country is a strong country, as this argument goes.

But the foreign reserves are, in effect, sitting in the central bank earning meager returns and keeping the yuan under-valued. Each unit of foreign currency that enters China is bought up by SAFE and yuan notes are issued by the central 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 US$466 billion in T-bills alone according to the US Treasury, earning interest in the low single digits, this 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 a common estimate that China’s total foreign reserves are comprised of about 70 percent dollar-denominated securities and cash, and that the depreciation in the US dollar over the last year has been about 10 percent against the yen and 13.5 against the Euro, that is like saying those Chinese reserves in US dollar terms have lost about US$100- 150 billion in spending power.

Of course, China’s Euro and Yen holdings have increased buying power in terms of US dollars, but they only represent about 20 percent and less than 10 percent respectively of China’s foreign reserves. With such low interest returns and the passive depreciation of its US dollar holdings, China is anxious to look for other ways to spend its growing fortune.

In the last six months, SAFE has made a number of portfolio investments abroad in an attempt to diversify and increase returns, while China created the China Investment Corporation, a US$200 billion sovereign wealth fund, in 2007 to place funds in higher-growth areas. [ED: I covered the uses of China's foreign reserves by both SAFE and CIC in an earlier post, The New Gold Mountain.]

At the time of writing, the yuan appreciation has reached 20% against the dollar since that fateful day in 2005 when the peg was finally removed. It has taken three years to get here, and if it takes three more for the next 20%, I worry about the effect this will have on inflation in China as the foreign reserve will continue to surge.

There’s no easy solution to China’s growing problems of inflation and low rate of return on its reserves, but letting the yuan appreciate more quickly is probably the best place to start, for the sake of the Chinese economy, and maybe even the global economy, as a whole.

[UPDATE: June 25 - Two notes which just came to my attention: In regard to how some foreign media have not covered the April 2008 rise of US$75 billion as alarming or even sufficiently surprising, Yves Smith of Naked Capitalism commented yesterday on the apparent nonchalance, and overnight Brad Setser added some data on changes in China's portfolio investments and overall foreign asset growth. On the point of western media attention: I don't think the lack of in-depth coverage on the ramifications is indicative of disinterest. As I pointed out above, the April foreign reserve figure of US$74.5 billion hasn't been officially confirmed and will not be until July, most likely. I held off reporting on this figure in my newspaper column until June 23 expecting a repudiation by SAFE or the PBOC, but their combined silence on this issue has been deafening.]

Categories: Affluencing, Foreign Direct Investment