Beijing could face huge losses on its foreign-currency holdings when the global economy recovers
Sitao Xu 23 February 2009
Is the mainland now facing capital outflows? If so, should Chinese officials be worried? At the end of 2008, foreign-currency reserves stood at US$1.95 trillion. But this enormous figure embodies both good and bad news. On the positive side, foreign reserves rose by almost US$300 billion during the year, hitting another record. The continued reserves build-up was partly a reflection of the mainland’s robust investment environment and currency stability. But, on the negative side, the speed of the accumulation slowed significantly. In fact, the increase in reserves was much less than the current-account surplus. This suggests that the mainland has experienced net capital outflow.
Given the country’s slowing economy, the reversal in the flow of capital - especially speculative “hot money” - makes sense. The mainland’s stock market crashed long before the global financial crisis spread to China, and is still trading at less than half the level of its highs in October 2007. The property market, once viewed as a one-way bet to riches due to long-term structural factors such as urbanisation, has also crumbled. With short-term economic prospects still uncertain, few investors expect a quick rebound in domestic asset prices.
In theory, Beijing should welcome capital outflows. It has said it does not want such a rapid build-up of reserves. So, if hot money is leaving, this should make policymakers’ job of capping the reserves at more manageable levels easier.
Beijing could also make the most of the subsiding upward pressure on the yuan to introduce a more flexible exchange-rate regime and neutralise foreign accusations of currency manipulation to gain unfair trade advantage.
In reality, however, policymakers are not keen to see any sizeable falls in reserves, lest they be viewed as a sign that foreign investors are losing confidence in the economy. So, large drops in reserves may prompt tougher restrictions on capital outflows. In fact, this is happening.
Authorities recently threatened to investigate some foreign companies which have allegedly shut down operations and repatriated their assets while still owing salaries to their mainland workers. This was a thinly veiled warning against anyone hoping to take large amounts of money out of the country.
The official angst about the ebb and flow of the nation’s reserves, however, masks a bigger concern: how to place the nearly US$2 trillion in diverse and safe foreign-currency holdings. The central bank’s cautious approach to reserves management has meant it is sitting on hundreds of billions of dollars of US government securities. Now, the country’s heavy investment in them has become a strategic issue. China has little to worry about as long as the value of the US dollar remains strong, which is the case today thanks to market players’ extreme risk aversion. But such investor sentiment - as well as record low yields and relatively high prices of government securities - could quickly change when the global economy starts to recover. Beijing could then face massive potential losses on its foreign-currency holdings.
Officials are well aware of the risks and have sought to diversify out of US government securities. But this has been easier said than done. As the global financial crisis intensified, state entities encountered well-publicised setbacks in their initial investments in riskier foreign assets. China Investment Corp (a sovereign wealth fund) lost billions of dollars with its equity stakes in the Blackstone Group, a US private-equity fund, and Morgan Stanley. Meanwhile, Ping An Insurance’s 5 per cent holding in Fortis was all but wiped out when the Belgian financial group was nationalised.
Beijing now realises that a few high-profile investments by state-owned enterprises simply will not lead to meaningful diversification of its foreign reserves. But what about empowering individual Chinese? Interestingly, Zhang Weiying, dean of Peking University’s management school, has proposed distributing half of the reserves to Chinese consumers. His suggestion underscores the politically touchy issue of the massive gap between the cash-rich government and penny-pinching private citizens, who are some of the greatest savers in the world.
Policymakers, of course, are unlikely to entertain such unorthodox notions - though they seem tempted to use some of the reserves to fund various domestic projects to stimulate the economy.
The truth is that Beijing does not have to worry about capital flight as long as it continues to generate large current-account surpluses. But how to reinvest efficiently such immense inflows remains a big challenge.
Until policymakers can figure out a satisfactory solution, the country’s reserves will continue to be exposed to the risk of a potentially sharp depreciation of the US dollar, dramatically higher yields and falling prices on US government securities, and misallocation on rushed domestic projects.
Sitao Xu is the Economist Intelligence Unit Corporate Network’s director of advisory services in China
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Ebbs and flows
Beijing could face huge losses on its foreign-currency holdings when the global economy recovers
Sitao Xu
23 February 2009
Is the mainland now facing capital outflows? If so, should Chinese officials be worried? At the end of 2008, foreign-currency reserves stood at US$1.95 trillion. But this enormous figure embodies both good and bad news. On the positive side, foreign reserves rose by almost US$300 billion during the year, hitting another record. The continued reserves build-up was partly a reflection of the mainland’s robust investment environment and currency stability. But, on the negative side, the speed of the accumulation slowed significantly. In fact, the increase in reserves was much less than the current-account surplus. This suggests that the mainland has experienced net capital outflow.
Given the country’s slowing economy, the reversal in the flow of capital - especially speculative “hot money” - makes sense. The mainland’s stock market crashed long before the global financial crisis spread to China, and is still trading at less than half the level of its highs in October 2007. The property market, once viewed as a one-way bet to riches due to long-term structural factors such as urbanisation, has also crumbled. With short-term economic prospects still uncertain, few investors expect a quick rebound in domestic asset prices.
In theory, Beijing should welcome capital outflows. It has said it does not want such a rapid build-up of reserves. So, if hot money is leaving, this should make policymakers’ job of capping the reserves at more manageable levels easier.
Beijing could also make the most of the subsiding upward pressure on the yuan to introduce a more flexible exchange-rate regime and neutralise foreign accusations of currency manipulation to gain unfair trade advantage.
In reality, however, policymakers are not keen to see any sizeable falls in reserves, lest they be viewed as a sign that foreign investors are losing confidence in the economy. So, large drops in reserves may prompt tougher restrictions on capital outflows. In fact, this is happening.
Authorities recently threatened to investigate some foreign companies which have allegedly shut down operations and repatriated their assets while still owing salaries to their mainland workers. This was a thinly veiled warning against anyone hoping to take large amounts of money out of the country.
The official angst about the ebb and flow of the nation’s reserves, however, masks a bigger concern: how to place the nearly US$2 trillion in diverse and safe foreign-currency holdings. The central bank’s cautious approach to reserves management has meant it is sitting on hundreds of billions of dollars of US government securities. Now, the country’s heavy investment in them has become a strategic issue. China has little to worry about as long as the value of the US dollar remains strong, which is the case today thanks to market players’ extreme risk aversion. But such investor sentiment - as well as record low yields and relatively high prices of government securities - could quickly change when the global economy starts to recover. Beijing could then face massive potential losses on its foreign-currency holdings.
Officials are well aware of the risks and have sought to diversify out of US government securities. But this has been easier said than done. As the global financial crisis intensified, state entities encountered well-publicised setbacks in their initial investments in riskier foreign assets. China Investment Corp (a sovereign wealth fund) lost billions of dollars with its equity stakes in the Blackstone Group, a US private-equity fund, and Morgan Stanley. Meanwhile, Ping An Insurance’s 5 per cent holding in Fortis was all but wiped out when the Belgian financial group was nationalised.
Beijing now realises that a few high-profile investments by state-owned enterprises simply will not lead to meaningful diversification of its foreign reserves. But what about empowering individual Chinese? Interestingly, Zhang Weiying, dean of Peking University’s management school, has proposed distributing half of the reserves to Chinese consumers. His suggestion underscores the politically touchy issue of the massive gap between the cash-rich government and penny-pinching private citizens, who are some of the greatest savers in the world.
Policymakers, of course, are unlikely to entertain such unorthodox notions - though they seem tempted to use some of the reserves to fund various domestic projects to stimulate the economy.
The truth is that Beijing does not have to worry about capital flight as long as it continues to generate large current-account surpluses. But how to reinvest efficiently such immense inflows remains a big challenge.
Until policymakers can figure out a satisfactory solution, the country’s reserves will continue to be exposed to the risk of a potentially sharp depreciation of the US dollar, dramatically higher yields and falling prices on US government securities, and misallocation on rushed domestic projects.
Sitao Xu is the Economist Intelligence Unit Corporate Network’s director of advisory services in China
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