China’s forex cache: too much of a good thing

May 2, 2011, 10:10 p.m. EDT

China’s forex cache: too much of a good thing

By Wang Ziwu, Zhang Yuze, Huo Kan and Tian Lin

BEIJING ( Caixin Online ) — The People’s Bank of China is mulling a new strategy for managing — through diversified investment — its enormous cache of foreign currency and bonds, whose total value exceeded an all-time record $3 trillion in late March.

The amount of U.S. Treasury bonds, dollars, euros and other currency held by the Chinese government is “really too much,” said the bank’s governor, Zhou Xiaochuan, at an April 18 financial forum at Tsinghua University.

Zhou’s comments at least in part reflected international market pressure on the U.S. dollar, which analysts say may comprise 70% of China’s foreign holdings. Euros, pounds and yen are also mixed into the reserves, details of which have never been publicized by Beijing.

The same day Zhou spoke, the ratings agency Standard & Poor’s frowned on the U.S. government’s debt position, raising the possibility of a lower debt rating in the future. China this year has maintained its position as the world’s largest holder of U.S. government bonds, with $1.15 trillion in U.S. Treasurys as of February.

And for months, international prices for dollar-based commodities, including gold, have steadily risen. Global crude-oil prices recently neared three-year highs.

Zhou suggested the central bank might react to these tumultuous conditions by changing its approach to strategic investments that rely on foreign currency held in reserves.

More specifically, Caixin learned through official sources, the bank has talked about setting up categorized forex investment funds in areas such as energy and precious metals. It’s also studying the feasibility of a foreign-exchange stabilization fund.

These “specialized foreign-exchange reserve investment funds” could operate similarly to Norway’s model for forex investment. A central bank source revealed that “China’s central bank and the Norwegian central bank communicate a lot” and that “Gov. Zhou has also visited Norway.”

Another tactic under study, sources say, would open the door to central bank purchases of foreign currency directly or through the international forex market. A source close to the bank said, under one proposal, an exchange balance fund through the State Administration of Foreign Exchange could be formed to intervene in foreign-exchange markets.

Xu Nuojin, deputy governor of the central bank’s Guangzhou branch, wrote in an internal newspaper of the central bank earlier this year that the central bank should consider using an exchange stabilization fund to buy and sell foreign currency on the forex markets. He said the fund could help regulate supply and demand, so that exchange rates fluctuate within a given range.

Xu said the proposed market intervention fund would serve to cut current ties between China’s monetary base and its foreign reserves, helping the central bank strengthen its control over monetary policy.
CIC’s role

The government’s sovereign-wealth fund manager China Investment Corp. (CIC) could play a role in the diversification process, given its successful overseas investment track record.

CIC’s “rate of return over the past two years has been in the double digits,” said a source close to the agency.

In his speech, Zhou said he favored “relying on CIC and channels like it” for reserves investment management. He noted the central bank in 2003 had mapped out — but then was forced to reject — a plan to invest in oil after failing to find a professional investment group to assist.

Most of CIC’s assets are managed by professional institutions, said CIC Chairman Lou Jiwei.

Caixin has learned that, under current proposals, CIC would not be given sole responsibility for managing forex investments. And based on CIC’s development and the forex management system, officials have not said when or how CIC might get a hold of forex cash for investments.

A source close to CIC said the agency was initially founded to help the government separate forex reserves held as a long-term security hedge from another cash cache: money available for use in reaching short-term liquidity goals through appropriate high-risk investments.

Experts say base reserves of $500 billion to $600 billion would be sufficient to meet China’s debt obligations and other spending requirements. The rest of the nation’s reserves could be managed for investments by CIC and similar agencies.

Meanwhile, some CIC officials have raised doubts about following the Norwegian model. For one thing, one official said, the Chinese government agency may have trouble finding international investment professionals to join the team.

Staffing has long been a problem for CIC, although over the past four years it has “reached a relatively mature position,” said an executive at Central Huijin Investment Ltd., an arm of CIC.

Yet questions remain. The executive asked: “How much time do other organizations need, and what costs will be involved for them to reach maturity?”

“Is there adequate talent?” was a question posed by a CIC official. “Where do we find these professionals? Can an incentive mechanism be created to match the task?”

Norway’s foreign-exchange reserves have been divided into liquidity and foreign-investment portfolios. An independent agency that manages Norway’s pension fund under the central bank — Norges Bank Investment Management (NBIM) — is responsible for managing the outgoing investment portfolio, while the Norges Bank Monetary Policy Committee manages the liquidity portfolio.

The Norges Bank Executive Committee establishes guidelines for forex management. And, through open tenders, NBIM hires well-known asset management companies to invest its money.
More hurdles

Another potential hurdle for policy makers trying to design a new forex strategy has been the central bank’s practice of buying foreign currency from commercial banks with yuan to keep the value of the yuan stable.

Industry insiders say these monetary operations, which have overwhelmed the bank as foreign currency from trade floods China, have affected central bank monetary policy making.

One way that policy makers have reacted to their currency operations has been by repeatedly increasing bank deposit reserve ratio requirements. These ratio hikes have perplexed the industry, prompting bankers to wonder whether the tighter requirements are a component of monetary policy or a means to sterilize foreign-exchange funds.

More than half of the money raised by issuing central bank notes every year are used to pay interest and principal due on maturing notes. This suggests that the central bank’s ability to sterilize forex funds is weakening.

About 4 trillion yuan ($615 billion) in central bank notes are currently outstanding which, based on last year’s median rate of return of 2.54% for central bank bills, will require interest payments of more than 102 billion yuan — an amount nearly equal to the central bank’s interest payments to banks for deposit reserves.

The bank has paid nearly 1 trillion yuan in interest since the first notes were issued in April 2003.

Policy makers are also grappling with expectations of yuan appreciation and capital inflows, which one source said are unlikely to change in the near term.

The central bank will likely have to issue more notes to sterilize funds for foreign exchange, while interest-rate pressure continues to rise along with the monetary base, at least partially offsetting the effectiveness of any program designed to reduce forex holdings, the source said. See this report and accompanying chart at Caixin Online.

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