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

by Stephen Green

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).