The Real Deal on China's New Mega Fund

Standard Chartered economist Stephen Green separates fact from fiction regarding China's new state fund to manage foreign currency reserves

China is buying oil! China is buying Korean equities! China is buying corn! China is buying Ford (F)! China is buying Angola! Expect to hear a lot of this kind of thing in the coming months. And expect global currency, commodity, and debt markets to get a little bit crazier as a result. China is allocating some $200 billion worth of its massive foreign currency reserves to a new fund that may well start investing in sexier things than U.S. Treasuries. The problem is that while we know that this is probably a huge event, we do not have even the most basic idea as to how the fund will operate.

Here is what we do know. Over the past five years, China's FX reserves have grown enormously. By the end of 2006, they had hit $1.1 trillion (and according to our calculations they should have been $50 billion more, but more on that another day). And we think they will continue to rise at over $20 billion a month during 2007-08. Based on our assumption that China's trade surplus will continue to grow, we expect $2 trillion in reserves to be reached sometime in late 2009. (That assumes that China somehow muddles through till then avoiding a serious bout of domestic inflation and serious trade protectionism out of Washington.)

As this pile of money has grown, dissatisfaction over its management has been heard in Beijing. Some have complained that the returns (only 4% to 5% a year on U.S. treasuries and other safe U.S. securities, probably accounting for 70% to 80% of the reserves) are too low. Others argued that given the pressing need for more social spending it made no sense to send all this money offshore. And some wondered about nurturing vast piles of metal ores and oil instead, strategic resources which China lacks and has to pay top price for. These voices added up to an ill-defined feeling that "something had to be done."

Changing the Channels

At the same time, the Ministry of Finance (MoF) has been competing with the People's Bank of China (PBoC) over influence. Over the past three years, the MoF has gradually ceded control of the financial sector to the PBoC. First, there were the state banks, particularly Bank of China and China Construction Bank, both of which were recapitalized with funds allocated from the FX reserves at the end of 2003.

The People's Bank, thanks to its management of the State Administration of Foreign Exchange (SAFE), has nominal ownership of the FX reserves. So when the $45 billion was taken out of the reserves, it was channeled through a PBoC-controlled entity called SAFE Huijin, which then took ownership of the banks. All the banks under the previous disposition were nominally owned by the MoF.

Learning its lesson, the MoF resisted a similar restructuring of the Industrial and Commercial Bank of China (ICBC), which resulted in it retaining some control after a much smaller recapitalization (a mere $15 billion) from the reserves, again via SAFE Huijin. It looks as if Agricultural Bank of China (ABC) will follow in the ICBC's footsteps, despite its huge bad debt problem.

New Reserve Fund

Rivalry between the finance ministry and the central bank spreads over other areas, too. But to keep a long story short, in the lead-up to the government's big Financial Work Meeting earlier this year, various working groups were established to consider the big issues. The one most in dispute, reportedly, was the panel looking at the FX reserves.

MoF folk argued that China had best look to Japan, where the FX reserves are managed by the MoF. That, plus the ill-defined sense that the FX reserves could be used differently, resulted in the creation of a new entity. The new fund will not be operated under PBoC/SAFE nor the MoF. But Lou Jiwei, a deputy minister of the MoF, has been appointed to run it.

As to scale, we understand that an initial framework document prepared by MoF and PBoC stated that $200 billion would be a reasonable size (apparently because leaving some $900 billion in the reserves sounded just about right).

And that is pretty much all we know, and where unconfirmed reports, second-guessing, and rumors begin.

Getting the Straight Story

A recent trip to New York made clear that the rumor mill is already in full grind. To be fair, you can't blame the hedge funds—they now have a huge and scarcely transparent player to deal with, one that can blow up a well-thought-through trading strategy with nothing more than a carefully leaked news story.

One person I spoke to said that he had heard that the allocation of the new China fund would put $100 billion into physical commodities, $60 billion into Asian equities, and $40 billion into debt. Another had heard China was already buying equities in Hong Kong, Singapore, Korea, and Japan. Another could see no evidence of this. Another thought that buying up Asian debt made much more sense in terms of nurturing influence in the region. And yet another serious fund manager believed that the fund could only continue with the SAFE's old investment strategy, given the negative impact on the U.S. dollar if they did anything else.

Which brings us, I think, to the main issue: can money buy happiness? Or in other words, can this fund meet any of the policy goals that various bits of Beijing seem to want? It will certainly be very hard, and Lou's path is strewn with challenges.

Needed: Experienced Fund Managers

Consider those three criticisms of SAFE's "old" investment strategy. None of them is terribly well-considered. First, low returns. This criticism is plain silly. Running FX reserves is not like running an investment or hedge or even pension fund. It should not be about maximizing returns, but first about supporting the chosen exchange rate regime, and then about guaranteeing the capital value and liquidity of the investments.

One might also add that higher returns will only mean more capital inflows into China, something SAFE is trying to avoid at present. And if one were really interested in raising the returns to China's capital, one should start with the exchange rate itself. More appreciation should result in Chinese workers gaining a higher income for their labor.

That said, if the new fund really wants to increase returns, this will entail a new investment ethos and strategy. But this creates its own difficulties. Lou certainly has a head on his shoulders, but his experience is almost entirely on the fiscal side. Even if he brings in folks from the SAFE to help run the fund, many of them have simply spent each day of their working lives buying treasuries. What the new entity needs is some experienced fund managers, and there are reports that a search is under way.

Who Has the Keys?

Second, if health and education are to be funded, the government's coffers has plenty to do that. At year-end 2006, the MoF had $128 billion in its savings account with the central bank, but seems curiously unwilling to spend it. Using FX reserves is not an option—since as soon as you use them, they will need to be converted into yuan and we will be back at square one since the PBoC will have to issue yuan and buy the FX. Social spending should be done on the MoF's account—not off the central bank's balance sheet.

The third criticism is a bit more sensible. It involves purchases of commodities offshore in foreign (not domestic) currency. And strategic reserves of some things, including crude oil, would be useful. But the devil is in how this is all organized. First, if China is really going to go into the oil or copper or grain markets, how on earth can it ensure that prices do not move against it the instant other traders realize what they're up to? Second, how does one defend oneself from every Tom, Dick, and Harry from the central ministries and provinces who is lobbying for purchases of his needed resource? And third, how does one manage and distribute the stuff once it's bought? There is bound to be intense debate over who gets to hold the purse strings and the warehouse keys.

There are other issues which will complicate Beijing's pursuit of happiness. There could be huge political ramifications overseas. First, with the dollar. Premier Wen Jiabao, answering questions at the National People's Congress, went out of his way to make this point, saying the new fund would not have any impact upon the dollar. And for its own part, China is still caught in what former U.S. Treasury Secretary Larry Summers once called "the balance of financial terror", since if they sell their dollar holdings, the value of their residual U.S. holdings will fall.

Can't Buy Happiness

If the markets ever caught wind of China diversifying its holdings, dollar-selling pressure would be immense—and Washington would have something to say, too. But this raises the question why start a new fund if you don't want to do anything differently? That creates incentives to be extremely conservative, diversifying quietly and gradually.

Second, consider the possible impact on the region. How would people react if Beijing bought large quantities of the equities and debt traded in Taipei? Or of those traded in Tokyo? If the fund does indeed turn out to be active in Asian equities, China's relationship with the region will get a lot more complicated. How would other investors feel if China FX Fund owned 5% of their company? Would they be assured that China was only holding a position for financial reasons?

There are also big operational questions. If the new fund went into buying control of ventures overseas—an Indonesian gas field, a failing U.S. corporate, a high-end German engineering venture—how would that entity be operated? Would it be handed over to a Chinese corporate with some experience in that area or would managers and/or directors be sent from the fund?

These are immense challenges, and the potential for generating nothing more than dissatisfaction at home and unease overseas are significant. Money, in short, will likely not buy Beijing happiness, at least not easily.

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