Wall Street seems annoyed that China funnels nearly every dollar it earns into safe but low-yielding foreign securities, particularly U.S. Treasury bonds. Yield-hungry Westerners can't understand why China, with $1.2 trillion in foreign-exchange reserves, hasn't sought out higher returns on its trove. So there was cheering on the Street when China appeared to join the private equity craze, saying on May 20 that it would spend $3 billion for a piece of Blackstone Group. Blackstone co-founder Stephen A. Schwarzman called it "a paradigm shift in global capital flows."
But this paradigm shift might not amount to a pair of dimes. While China appears to be intrigued enough by private equity to invest one-quarter of 1% of its reserves in Blackstone, it's likely to keep salting away most of its foreign-exchange reserves in ultrasafe, liquid securities, primarily those of the U.S. and other Western governments. The reason: China's authoritarian government needs to preserve social stability to stay in power, and a big pile of easily accessible money abroad serves as a nice cushion. China is the world's third-biggest importer after the U.S. and Germany, and in a crisis that disrupts the normal flow of finance and trade, hard foreign currency would ensure that Chinese factories get all the imported raw materials and equipment they need to keep operating--and, not incidentally, to keep millions of workers employed.
Overly cautious? Not necessarily. China was reminded during the Asian financial crisis of the late 1990s that there's no substitute for ready cash. With its ample reserves and trade surplus, China rode out that regional meltdown unscathed while South Korea, Indonesia, and Thailand found their traditional sources of money cut off and had to go hat in hand to the International Monetary Fund. Freedom from IMF dictates is worth infinitely more to China than getting a bigger piece of private equity action.
Conventional wisdom says China needs only enough reserves to prove that it's creditworthy so it can get a loan when it requires one. By that standard, it's overendowed, with reserves of 13 times its short-term foreign debt, far more than hoarders such as Taiwan and Russia. But China may not want to be forced to depend on foreign lenders in a crisis. It's safer for it to have enough money to pay for imports without borrowing. From that perspective its reserves don't look so excessive. At the end of 2006, the reserves covered 15 months of imports--a bit more than Taiwan has, but less than Russia.
China has the wherewithal to withstand any ordinary economic upset. But China is no ordinary country. It's a volatile blend of growth, speculation, and rising expectations on the one hand and corruption and political repression on the other. The world's biggest rainy-day fund isn't meant for ordinary economic upsets--it's for a regime-shaking calamity that the Chinese themselves hardly dare to imagine.
By Peter Coy