The Yale Endowment
永远走在趋势前面
Conclusion: In the past five years, while Chinese products have taken over world consumer markets, the return of China’s trade surplus into world financial markets has re-priced all financial assets by flattening the yield curve, in my view. Growing risk appetite in China’s mounting multi-trillion-dollar foreign exchange reserve will spawn the world’s single-largest risky-assets investor in 2007. In my view, this will eventually raise the cost of money both inside and outside China and de-price all world assets. The “China surplus effect” on world asset prices will reverse.
What's New: Following the first proposal at China’s Third Annual Finance Working Conference in January, PBoC officials confirmed in March 2007 that a national forex investment company (for now, we’ll call it CFIC, or China Forex Investment Company, until the Chinese government gives it an official name) is in preparation and should be established in 2007. Initial seed capital should be around US$200 billion. We estimate that the initial net inflow of capital into this company will be around US$100 billion per annum, although the long-term inflow could go well beyond US$200 billion.
Implications: CFIC will change the cost of capital both inside and outside China, I believe. Through its most likely means of raising funds – i.e., issuing renminbi bonds and purchasing forex assets from the PBoC – CFIC will lock up excess onshore liquidity at the same time. Outside the country, by redirecting China’s current large appetite for US TBs into other asset classes, CFIC will steepen the yield curve in the US market. Thus, asset de-pricing in both onshore and offshore markets should follow. However, I believe CFIC is pricingpositive for risky asset classes (mainly equities) in the following industries, where China needs a long-term stake to serve its strategic goal to hedge domestic growth risks and secure the country’s long-term growth potential: 1) energy and materials; 2) financial services and 3) practical technology. “Financial protectionism” is likely to rise to build new barriers around China.
It’s a capitalists’ world, and China will take the game to the next level. The scale of the world’s largest risky-assets investor-in-the making is simply too significant be evaluated in the conventional way. CFIC is pricing-negative to all assets priced against the cost of capital, in my view.
Through its most likely means of raising funds – i.e., by issuing renminbi bonds and purchasing forex assets from the Peoples Bank of China (PBoC) – CFIC will lockup excess onshore liquidity at the same time. Outside the country, by redirecting China’s current large appetite for US treasury bills into other asset classes, CFIC is likely to steepen the yield curve in the US market. In other words, China’s foreign exchange (forex) investment company, expanding its asset size to a trillion dollars within the next five years (my estimate), is so significant in size that it will raise the Chinese risk-free rate by increasing the government treasury supply. It will, at the same time, raise the international market’s risk-free rate by decreasing new demand for treasury bills. The risk-free rate moves the cost of capital. A rising cost of capital means asset de-pricing.
This is exactly the reverse of the liquidity development driven by China’s quickly mounting trade surplus in the past five years. On the one hand, under the current forex management system, the central bank had to keep issuing Rmb in the domestic market to settle large trade surplus forex. On the other hand, it kept buying up offshore treasury bills for “reserve” purposes. The onshore money flood and the hunger for offshore treasury bills have depressed risk-free rates and inflated asset prices, in my view.
Diversification of China’s forex holdings should start with asset classes, not currency. I do not foresee China’s diversifying away from the US dollar, even in the mid-to-long term. Neither do I foresee CFIC’s buying offshore-listed Chinese companies, as the government already owns 48% of this market and there is no need to set up CFIC for that purpose alone.
Although it is hard to forecast what assets the CFIC will invest in and when it will start buying (Chinese officials have been extra discreet on this topic, given its potential impact on world financial markets), it is possible to analyze what China needs. In the long term, I believe, to serve its strategic goals to hedge domestic growth risks and to secure China’s long-term growth potential, the forex investment company should take major stakes in world class companies in the following industries: 1) energy and material; 2) financial services and 3) IT and capital goods with leading technology.
Why CFIC?
In my view, China has at least four good reasons to set up a foreign exchange investment company now. 1) It has enough forex assets for “reserve” purposes already. 2) It needs to diversify it forex assets as it is becoming “the market” for US treasury bills. 3) There is not enough private demand to hold forex assets in China as the renminbi appreciates. 4) China can, at the same time, recycle excessive domestic liquidity caused by its current forex settlement scheme.
Two Sides of the “China Surplus Effect”
I think China’s skyrocketing trade surplus has made a significant impact on the world’s financial pricing mechanism, which I call the “China surplus effect.”
Inside China, under the current foreign exchange management mechanism, PBoC has to keep issuing currency to settle large sums of foreign exchange inflow from the trade surplus. Although PBoC has turned much more proactive in open-market operations and has kept raising the required reserve ratio (RRR) to lock up more liquidity, the overall net supply of liquidity in the domestic market has been excessive in the past few years, when China’s exports rose dramatically. The result is a negative real interest rate and asset price inflation.
In the offshore market, under the old policy deeming all foreign exchange as “reserves” for the country, China kept parking its quickly growing dollar pile in offshore-issued treasury bills (TBs), mainly in the US. Unfortunately, while the nation has never disappointed the world in producing as many Chinese-made products as needed, the world cannot supply as many financial assets as China needs at the same time. The net issuance of TBs in the world simply could not catch up with the speed at which China increased its trade surplus. This theory has been well explored by our currency economist. Although Steve did not point this out specifically, China clearly is the most important demand driver of the world’s low-risk financial assets.
The result has been the depression of long-term yields (or the flattening of the yield curve) and asset bubbles. Sovereign debt prices, represented by US TBs – the safest financial asset in the world – have surged, in turn depressing the risk-free rate. At the same time, the price of all risky assets has surged because of the low risk-free rate, on which their prices are built.
Forex Investment vs. Forex Reserve: More Risk Appetite
Although China may not reduce its core dollar asset holdings, mainly US treasury bills, the chance that China will maintain the same large appetite, even in the near term, is quite low, both practically and strategically. Although US TBs are the safest asset class in the world and serve the purpose of capital preservation well, theoretically, no assets are safe if one or two buyers represent the majority of the demand. On the other hand, China is facing unprecedented challenges in its growth model – such as energy safety, material sufficiency and financial stability. In recent years, hedging the country’s long-term growth risks has emerged as a higher priority than simply preserving capital.
Indeed, China’s progress on this subject has been fast. In January 2007, at the country’s Third Finance Working Conference, the proposal was made to set up a national foreign exchange reserve investment company to invest in riskier asset classes. In March 2007, during the annual National People’s Congress season, PBoC officials confirmed that the forex investment company was in preparation and should be established in 2007.
CFIC Can Reshape the Yield Curve
As disclosed by a few reputable domestic financial media, including the official Shanghai Securities News, initial seed capital of the national forex investment company is US$200 billion (approximately China’s annual trade surplus in 2007). I personally expect that this entity will receive some US$100 billion capital inflow in the following few years (i.e., approximately half of China’s annual trade surplus). Our chief currency economist, Stephen Jen, with his extensive expertise in global forex strategies, forecasts that transfers out of China’s forex reserves into this investment fund will eventually be much larger than US$100 billion a year, probably close to US$250 billion a year. Buying more US TBs simply does not help China, we think.
I believe that a large portion of China’s current appetite for US TBs will be redirected to other asset classes with the up-and-running of CFIC. China’s current massive craving for US TBs is unlikely to be maintained. In the mid- to long term, I expect a reversal of what we have seen in the past few years – i.e., the steepening of the US yield curve and the rise of the risk-free rate. The result would be the “de-pricing” of all assets. This may not happen quickly, considering that China itself is a major dollar asset holder, but I believe this has to be the long-term trend.
CFIC Can Lock up Domestic Excessive Liquidity
PBoC cannot simply “transfer” the forex assets on its balance sheet to CFIC. It is unlikely that the Chinese Central Bank will put a significant portion of its assets with a commercial fund management company to invest in risky asset classes. It is also unlikely, in my view, that CFIC will “borrow” US$200 billion forex assets from the PBoC, by such means as issuing dollar bonds to the PBoC, because this would not change the forex asset size on the Central Bank’s balance sheet.
The most likely way of funding CFIC, in my view, is to issue renminbi-denominated government bonds to the public and “swap” forex assets with the PBoC. The Central Bank does not take any risk in this scenario, and its forex assets size is reduced.
It is clear that such a method of funding the CFIC would recycle liquidity in the domestic market – which is probably preferred be the central bankers, who have been busy raising interest rates and required reserve ratio (RRR) since the beginning of 2007, anyway.
If the CFIC were to fund all of its US$200 billion seed capital by issuing Rmb bonds, it would lock up approximately Rmb1.5 trillion of liquidity, equivalent to raising the commercial banks’ RRR by 4.5%! It is impossible for China to lock up so much liquidity in one shot. The CFIC will most likely issue bonds in different batches, in my view.
Asset Allocation: a Theoretical Study
Despite extensive media speculation, I do not think that CFIC will buy offshore Chinese companies’ stakes as its core asset holdings. First of all, the Chinese government already owns 48% of the Hong Kong listed H-shares and Red Chips. Further increasing the government’s stake is clearly not necessary and probably does not make commercial sense. Second, even if China wants to invest in offshore-listed domestic companies, there is no need to set up a forex investment company for this purpose – the current Huijin Company (the government’s domestic investment company) already has this function (it currently owns about 45% of four Chinese commercial banks listed offshore).
I do not think that China will diversify aggressively away from US dollar assets either. Our chief currency economist, Stephen Jen, concurs with this view. In our opinion, the diversification should be around asset classes, not currency, at least in the near to mid-term. Outbound investments in the US, Europe and emerging markets are the core holdings of the Government of Singapore Investment Corporation (GIC) – one of the most successful forex investment companies. Most of GIC’s investments are in risky assets as well – 50% in equities and 20% in private equities, hedge funds, real estate and commodities.
Considering that CFIC will assume the “investment” function, while the “reserve” function will remain with the PBoC, a likely asset allocation outcome for the CFIC should be around the US dollar and other mainstream currencies, in risky assets, most likely in equities and corporate bonds.
CFIC differs from Singapore GIC in the sense that it is too big to pursue superior returns with the whole world watching carefully its every little move. Although China’s official tone is that the purpose of such a forex investment company is to pursue higher returns by taking more risks, I believe its greater priority is to hedge China’s long-term growth risks. The primary focus of the forex investment company should be “diversification” rather than “return,” at least in the near- to mid-term.
What China Needs
A more interesting part of this study is to forecast where China will invest. Envisioning China’s building a trillion-dollars of extra demand for risky assets in the next five years (assuming that the forex investment fund has US$200 billion seed capital with US$100 billion capital inflow in the next two years and US$200 billion in the three years after) is enough to encourage speculation on China’s next move.
Although I think it is almost impossible to guess what specifically China will buy in the near term – considering the sensitive nature of the subject and the extra prudence of officials on such discussions to prevent front-running, it is possible to analyze what China needs to buy in the long term. I think China has three major risks to its current growth model and that there are three things it needs to buy aggressively to hedge its growth risk.
1) Energy and materials. China’s current “world factory” growth model is energy- and material-intensive. Although many industries in which China engages are “labor intensive,” I have not seen a single, real, labor-intensive plant in China in financial terms, because labor cost rarely goes beyond 30% of a typical Chinese factory’s costs in China, given that labor is so cheap. The real bottleneck in China’s “labor-intensive” growth model is energy and materials, not labor. It makes a lot of sense to me that CFIC takes strategic equity stakes in major multinational corporations (MNCs) in energy and materials industries. Although the Chinese government may not necessarily be able to influence the decision-making of these companies, at least this is a good way to hedge China’s financial downside when it meets an energy and materials bottleneck.
2) Financial services. The domestic financial sector’s volatility has driven three boom-bust cycles in the past 20 years in China. Even today, commercial banks monopolize more than 70% of the country’s corporate loan business, and China does not have a domestic yield curve, due to the irrelevant size of its corporate bond market. In other words, credit officers, not the financial market, price the credit risk in China. China is the world’s fourth-largest economy with an outdated financial system. Although financial reform is speeding up, it is not risk free. CFIC should take strategic stakes in the world’s leading commercial and investment banks to hedge this risk. Large multinational financial institutions can also serve as China’s best proxy to participate in growth opportunities worldwide.
3) Practical technology. “Industrial upgrade” is a term frequently used by Chinese officials these days. The application of practical technology to upgrade China’s current low value-added business model requires capital, and most companies in private sectors cannot afford it. An outside-the-box but practical idea would be for CFIC to take control of companies with such practical technology and reinvest the technology in Chinese companies. This should be quite a profitable business for both parties.
“Financial Protectionism”
At MacroVision 2007, the term “financial protectionism” was first used by our economists and strategists to describe barriers preventing emerging market companies from taking strategic stakes in companies in developed markets, such as the US. CNOOC’s failure to buy Unocal was a classic early example of such rising protectionism.
With the up-and-running of CFIC, financial protectionism will naturally gain an even greater audience among the right wings of the US, Europe and Japan.
However, just as trade protectionism never really reversed globalization, financial protectionism, at best, will serve as a disruption to “financial globalization,” in my view. At the end of the day, China did not reinvent the wheel. It is playing the capitalists’game.
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