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January 2007

People’s Investment Company
January 29, 2007; Page A16, WSJ

For Wall Street, the big news out of China this month is that the country will “actively explore and expand the channels and methods for using foreign-exchange reserves.” The Communist Party might hive off a big chunk of its $1 trillion stash and invest abroad on behalf of its citizens, a la Singapore’s Government Investment Corporation. That may be a boon for bankers, but it’s not necessarily a smart idea for China.

This is yet another scene in the Party’s balancing act between economic liberalization and state control. China’s exchange-rate policy — the catalyst for its huge foreign-exchange reserves — is at the heart of the debate. By more or less pegging the renminbi to the dollar, Beijing accumulates foreign-exchange reserves when it mops up the incoming greenbacks. The policy has spurred an enormous boom, giving Chinese and foreigners the confidence to invest without worrying about price volatility.

This has also bought time for China to reform its broken financial sector — a task that’s far from finished. At the same financial conference at which the government investment idea was floated, Premier Wen Jiabao kicked off the reform of the Agricultural Bank of China, more than half of whose loan portfolio is rumored to be non-performing; it will take perhaps $100 billion or more to bail it out.

So why hive off foreign-exchange reserves into a Singapore-style fund? For one, China’s policymakers may be frustrated that their efforts to encourage money to flow abroad aren’t working quickly enough to offset the tide of incoming capital. The so-called Qualified Domestic Investor Initiative scheme, which lets Chinese investors buy bonds abroad, has attracted only a few billion dollars so far.

But there are good reasons for that. Today, Chinese investors see better prospects at home. The Shanghai stock market is up more than 110% over the past 12 months, and property prices are still healthy. Chinese investors probably aren’t turned on by buying U.S Treasury bonds. If the Party were serious about opening their capital markets, they’d let investors buy General Electric on the New York Stock Exchange, or a vacation home in Thailand.

It’s more likely that Beijing likes the GIC-like setup because it would keep the Party’s hands on the money. Singapore’s fund hasn’t released public accounts since its founding in 1981; its stated total under management, at $100 billion, hasn’t changed in years. But at least Singapore has a reputation for clean governance; the same can’t be said of China’s bureaucracy.

Beijing’s policymakers could also make political hay domestically by telling citizens that they will get more return for their renminbi — which could then be invested in, say, education or health care. This is the “negative carry” argument — the idea that foreign investors are receiving double-digit returns on their dollars, while China’s central bank receives single-digit returns when it invests renminbi in U.S. T-bills.

But that’s not the way it really works. Foreign-exchange reserves are liabilities on a central bank’s balance sheet, not found money. Up to a certain point, reserves assure foreign investors that a country has ammunition to fight an attack on its currency, such as during the 1997-98 financial crisis. Once reserves accumulate beyond that point, more fundamental questions about government policy have to be raised. Instead of creating an opaque government institution to manage reserves, China would do better to tackle the root problem: the need for more capital freedom.

A Revisit of Chinese Stock Market: Was I Wrong?


In early 2005, I predicted bearish Chinese stock market in the medium term. Back then, the Shanghai Composite Index was only around 1000. Nobody quite understood how this could happen with the economy soaring every year at double-digit rate. Now, the index stands high at 2650, a 165% jump from 1000. If just count from October to December last year, the index jumped 800 from 1800, almost 45% increase. One word: unbelievable!!!

The bear market I predicted was out of two reasons. For one, there will be huge piles of state-controlled non-circulating stocks waiting be to put into the market, creating an oversupply. Two, China is working toward floating her capital account (sooner or later), domestic investors will want to invest overseas seeking better return instead of earning pity banking interest. This will create a shortfall of demand. Both forces drive down the market in the medium term. Supply and demand work like magic. Is it that simple?

It turns out the supply side of the story was right. But the privatization of state controlled non-circulating stocks completed sooner than expected. The demand side’s just totally opposite. Instead of a shortfall, we had a huge surge.

Several events contributed to the flip of the demand.

First, Chinese government announced appreciation of the yuan in the first half of 2005. And with continuing pressure from the U.S., yuan is expected to appreciate further. This contributed a huge inflow of speculative capital, part of it flowing into the stock market. This is the most important factor in this round of stock rally.

Second, with IPOs of monster big Chinese state banks, and with backings of the prestigious Investment banks such as Goldman Sachs and RBS (in return for favorable access to Chinese banking business), the market psychology turned to Chinese stock holders’ favor.

Third, Chinese government took a gradual approach on freeing its control on capital account. Although the state, in replacing individuals, begins to invest abroad, the process is too slow. The expected outflow of capital did not happen.

Is the huge outflow of domestic capital ever gonna happen? I don’t think so. Here is why? 1) Chinese investors are relatively poor informed about the foreign markets. They do not have experience investing abroad. Simply too much uncertainties out there. 2) The financial institutions in China are still backward. Institutional investors, like mutual fund and pension fund, are inexperienced either.

Now here is the tough question: With Renmingbi expected to rise further, will China suffer similar boom-and-bust in Japan since early 90s? At least, this is what economists like R. McKinnon are worrying about.

Read on, next time…