Learn Mandarin: Chinese School - China's financial clout

WORLD / Wall Street Journal Exclusive

China's financial clout

By ANDREW BROWNE (WSJ)
Updated: 2006-10-17 11:53

http://online.wsj.com/public/article/SB116104977336494710-zBVM_zV0Jesbbj4X8
Gky0Axd468_20061023.html?mod=regionallinks

BEIJING -- Sometime in the next few days, China's holdings of foreign
currencies and securities will top $1 trillion -- a sum greater than the
annual economic output of all but nine countries. The rapid growth in
these so-called foreign-exchange reserves has made Beijing a colossus in
the financial world, cushioned against shocks at home, but potentially
able to trigger them abroad.

How China manages its growing pool of wealth has major repercussions for
the global economy. Beijing's reserves totaled $987.9 billion as of Sept.
30 and are growing by roughly $20 billion a month. That total compares
with the about $1.2 trillion in assets under management at U.S.
mutual-fund giant Fidelity Investments.

As the pot grows, the secretive and sophisticated portfolio managers at
China's central bank are trying gradually to boost their country's
returns on its foreign-exchange holdings, at least in part by making
somewhat riskier but higher-yielding investments. Last spring, an
unsuccessful effort to divine their intentions sparked a steep run-up in
the price of gold.

For the U.S., how China deploys its reserves is a question of some
consequence. Most of China's currency reserves are invested in
U.S.-dollar-denominated debt, such as U.S. Treasurys, which are
considered the world's safest investment. That has kept demand for U.S.
Treasury notes high -- and interest rates low. A change in that pattern
could affect how much Americans pay for mortgage loans and other
borrowings.

Some in Washington and in world markets fear that China might one day
dump its holdings of dollar-based assets, setting off a tidal wave of
sales that might swamp the U.S. economy. Despite such fears, there's no
sign that China is making a major move out of dollars and into euros or
other foreign currencies, even though Chinese economists have
occasionally warned that the weak dollar holds down the value of China's
holdings.

China discloses almost nothing about its reserves, beyond their awesome
size. Roughly 70% of the Chinese reserves are believed to be in U.S.
dollar assets, 20% in euros and 10% in other currencies, including the
Japanese yen and Korean won, according to Brad Setser, an economist at
Roubini Global Economics.

China's enormous nest egg adds to its ability to project its influence
around the world. The prospect that the Chinese central bank's State
Administration of Foreign Exchange could spread its investments more
widely hangs over global markets, says Richard Yetsenga, Hong Kong-based
currency strategist at HSBC. "People think about diversification all the
time," he says. The only other investors that rival SAFE in size, Mr.
Yetsenga says, are Russia and the oil-producing countries of the Middle
East.

As China's reserves balloon, markets and many U.S. officials believe it
to be buying less U.S. Treasury debt, which is explicitly guaranteed by
the U.S. government, and more debt issued by U.S. mortgage lenders Fannie
Mae and Freddie Mac, which carries an implicit government guarantee.

China's shopping list also is said to include somewhat riskier but
higher-yielding mortgage-backed securities and U.S. corporate bonds.
Financial-market traders and analysts also believe China has begun to
dabble in even riskier dollar-denominated emerging-market debt, operating
through private money managers around the world.

The country's massive foreign-exchange reserves are a direct result of
China's effort to manage the exchange rate of its currency. To prevent
the value of the yuan from strengthening too rapidly and hurting China's
exports, the country's central bank buys dollars from foreign investors
and China's own exporters, issuing yuan in exchange.

The abundance of yuan created in this way holds down the Chinese
currency's value. But the resulting mountain of foreign-exchange holdings
opens China to accusations from the U.S. and others that it manipulates
its exchange rate to make its products unfairly cheap on world markets.

Chinese central bankers also worry that the plentiful supply of yuan is
overheating China's economy and causing unwelcome inflation. Asked by
reporters last month about the size of the reserves, central-bank
governor Zhou Xiaochuan said: "We think we've got enough."

China's reserves already far exceed what the country needs to protect its
economy from global financial shocks: $1 trillion is roughly 1.25 to 1.5
times China's total import bill last year and is equivalent to roughly
45% of the year's economic output. The total could pay off China's total
short-term foreign debt six times over. It dwarfs the world's single
biggest mutual fund, American Funds' Growth Fund of America, with $147
billion in assets, and makes Harvard University's $30 billion endowment
look like pocket change.

The latest data from the U.S. Treasury Department show that, as of June
2005, China's public and private sectors held a total of at least $527.3
billion in U.S. securities, including about $450 billion of long-term
U.S. Treasury or agency debt. The composition of its dollar assets
suggests that China is a more sophisticated portfolio manager than Japan,
which is believed to keep a larger fraction of its $881 billion in
reserves in short-term U.S. securities. But the Treasury's figures may
underestimate China's holdings because the U.S. government can't always
identify the ultimate owner of its debt.

Indeed, the Chinese central bank's State Administration of Foreign
Exchange leaves few tracks as it buys and sells assets through dealers
all over the world, as well as through the largely state-owned Bank of
Communications in Shanghai. The sums are so large that traders and
analysts from Hong Kong to London prize even the slimmest details.

The flimsiest reports from China on the management of its reserves can
cause gyrations in global markets. In May, for instance, China Gold News,
a leading industry publication in China, carried comments from a Chinese
economist who said China should raise its holding of gold to 2,500 metric
tons from 600 tons.

The economist, Liu Shanen, doesn't speak for SAFE: he is a part-time
economist at the Beijing Gold Economy Development Research Center, a
government organization closely affiliated with state-owned mining
groups. Nevertheless, the report helped push gold prices to a 25-year
high.

By spending a large chunk of its national savings to buy U.S. debt, China
is helping keep mortgage rates in the U.S. low at a time when the money
could be put to use in its own huge, developing economy. The Chinese
health system is collapsing; schools are starved of funds; social welfare
systems are in dire need of cash.

In the brewing debate about how the reserves could be better spent,
Premier Wen Jiabao has suggested that some of the funds could be set
aside to buy high technology to transform Chinese businesses. Vice
President Zeng Qinghong advocates using the money to buy raw materials
that China lacks. Meanwhile, former U.S. Treasury Secretary Lawrence
Summers has been barnstorming the globe telling countries like China they
are squandering resources by parking billions in low-yielding U.S. debt
securities.

Some Chinese economists advise caution. Using foreign-exchange reserves
to invest in oil and other commodities is "far too risky," warns Yi
Xianrong, a researcher at the Chinese Academy of Social Sciences, a
leading think tank. He advises buying fewer dollars and larger quantities
of other currencies.

Just this month, comments by an adviser to the central bank that it was
risky for China to hold so many dollars sent the dollar slipping from
multimonth highs against major currencies. But Fan Gang, a member of the
central bank's monetary policy committee, speaking at a financial forum,
was quoted by Reuters news service as saying that China had few
alternatives to dollar investments.

U.S. officials currently worry less about China dumping its dollars than
they do about the prospect that some developing country, unhappy with
conditions on International Monetary Fund loans, might end up borrowing
instead from China, potentially increasing China's influence in emerging
markets.

According to officials involved in the discussions, the U.S. recently
balked at letting China join the Inter-American Development Bank as a
"nonregional member," something China wanted to do to raise its profile
in resource-rich Latin America. Washington insists that countries such as
China that borrow from the World Bank aren't eligible for such status.

Demonstrating the enormous flexibility its vast reserves provide, China
offered a compromise: For every dollar China borrowed from the World
Bank, it would put an equivalent amount from its reserves into the World
Bank through another doorway.

The deal didn't materialize. A spokesman for the Inter-American
Development Bank says he can neither confirm nor deny that such
negotiations took place.

Saturday, March 22, 2008

Chinese School - China's financial clout

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