When the oil firm Sinopec agreed to acquire Swiss firm Addax Petroleum for US$7.2 billion in late June, it was heralded as one of the largest outbound investments by a Chinese company to date. But the deal – and the general trend of Chinese outbound investment – may be more than just a record setter. It could be a viable long-term solution that China is looking for to end its reliance on its investment in US Treasuries and the US dollar.
There’s only one problem: While US$7.2 billion is a big number, it is less than the amount of foreign exchange China accumulates in a single month, based on patterns of the last few years.
"It helps at the margin but it doesn’t substantially change the need for US Treasuries,"said Ben Simpfendorfer, chief China economist for Royal Bank of Scotland.
Other observers agree. "You have in the neighborhood US$80-90 billion inbound foreign direct investment (FDI) per year so you’d have to match that going out,"said Logan Wright, an analyst with Medley Global Advisors. "The most we’ve seen in Chinese outbound FDI is US$50 billion and that was last year."
Wright said that China’s outflows will increase, but it could take years.
Treasury bond dilemma
Since the global financial crisis hit last year, Beijing has expressed its displeasure with the US government’s policy of issuing new debt to help keep the country’s economy running, concerned that it is eroding the value of China’s US Treasury holdings. According to Wang Tao, senior China economist at UBS, about 65% of the country’s US$2.13 trillion in foreign exchange reserves are invested in US assets. Beijing is the biggest single buyer of US Treasuries, with holdings of approximately US$763.4 billion.
The idea of diversifying China’s foreign exchange holdings has been floated, but the consequences of selling US Treasuries might prove hard to swallow.
"Given the size of its portfolio, a meaningful diversification into many currencies is difficult,"said Brad Setser, a fellow at the Council on Foreign Relations. "It would drive the market against it. And there’s another constraint: By pushing up the value of what it wants to buy, it pushes down the value of its own currency, which may not suit the PBoC’s monetary policy goals."
Increasing FDI outflows isn’t the only option Beijing is considering. According to Wright, the State Administration of Foreign Exchange (SAFE) is selling off some of the new reserves that it receives to buy non-dollar assets. Though it is unknown what SAFE is buying, the fact that new reserves are being used means the amount is rather small. Wright stressed that Beijing would not want to be appear to be abandoning the dollar, as this would lower the value of its remaining holdings.
"If they were perceived as getting out of the dollar in general it’s one of those things that just shoots themselves in the foot,"he said. "How much can you sell before the market starts to notice when the market is looking for it all the time?"
Finding a replacement for the dollar also poses a problem. Neither Europe nor Japan issues sufficient quantities of debt, said Dong Tao, chief regional economist for Asia ex-Japan at Credit Suisse.
Then there are the political implications of diversification. China’s buying of more euro assets than dollar assets would boost the euro while weakening the dollar-linked renmibi, lowering the prices of Chinese goods in Europe and raising the prices of European exports to China.
This would win Beijing few fans in Brussels where policymakers have long claimed that an undervalued renminbi is hurting Europe’s trade prospects.
Commodities are less of a political landmine. China has eyed gold, iron ore, copper and other metals, with gold emerging as the prime candidate. Beijing increased its gold assets in April for the first time in a number of years.
There are issues here as well, though. Most importantly, no single commodities market is large enough to absorb the kind of investment that would equate to a sizeable reallocation of China’s foreign exchange reserves. And even if Beijing made a relatively small move for a particular commodity, it may get swamped by the waves this movement creates. As soon as the market saw China pursuing a commodity, prices would skyrocket, leading to volatility.
"You take a big financial risk – in effect you overpay for gold and then the price of gold falls when you stop buying,"said Setser of the Council on Foreign Relations. "You pay US$2,000 an ounce and then gold falls back to US$300."
Economists believe the best policy would be to relieve the mandarins in Beijing of much of this decision-making responsibility and transfer it to corporate or quasi-corporate bodies. But a lot of work still needs to be done if outbound investment by Chinese companies is to become a viable option.
The central government tried to get the ball rolling in 2007 with the establishment of China Investment Corporation (CIC). However, CIC’s bank account represents just a small slice of the official foreign exchange reserves. It has US$200 billion under management, less than 10% of Beijing’s total holdings.
About US$120 billion of that money is actually tied up in domestic investments and financial institutions, which means the foreign portion of CIC’s playbook is even smaller than it appears.
Beijing has tried to do more by actively encouraging companies to buy assets abroad. SAFE has relaxed some regulations on foreign investment so that, in many cases, companies looking to make overseas acquisitions need only register their plans with the authorities rather than wait for official approval. China has also signed a number of oil-for-loans agreements – notably with Brazil and Russia – that were financed from the country’s foreign exchange reserves.
Nevertheless, total outbound direct investment from China came to US$52.15 billion in 2008, part of an upward trend but barely more than one-tenth of the increase in foreign exchange reserves that year.
Although there has been much talk about Chinese corporate acquisitions, it hasn’t been matched by action. Setser suggests that Bejing itself contributes to the hesitancy. By intervening in the foreign exchange market – soaking up US dollars and replacing them with renminbi – the government keeps the value of the renminbi artificially low. In doing so, however, it makes foreign assets comparatively more expensive than domestic ones.
"You [need to] let the exchange rate adjust so that foreign assets become cheaper,"Setser said.
The path to convertibility
There are, of course, conflicting priorities at work. Renminbi appreciation effectively makes Chinese exports more expensive. Policymakers have halted the currency’s rise in recent months, conscious of the challenges facing the export sector.
The government appears to be encouraging internationalization and convertibility of the renminbi in a limited manner. Under currency swap agreements with China, companies in Argentina, Brazil as well as several Asian countries will be able to use the renminbi as a settlement currency. Hong Kong is even further ahead, with banks on both sides of the border having put in place processes to allow local firms to carry out renminbi-denominated transactions with counterparts in five mainland cities.
It will take time, though, for the full benefits of renminbi business to be felt in Hong Kong. And while swap agreements may in theory facilitate trade, they won’t make the Chinese currency an international standard overnight.
"It remains to be seen how Argentina will have to set up facilities to draw renminbi from the central bank and pay for exports with renminbi,"said Medley Global’s Wright. "They also have to create facilities where Chinese banks will accept those export contracts in renminbi, which is actually a little more complicated than people think because it’s just not set up that way."
Eventually, if Beijing is serious about lessening its reliance on US Treasuries and building global Chinese companies, it will need to embark on economic restructuring.
Government officials have long talked of, among other things, the importance of moving from low-end manufacturing into higher value-added products and encouraging domestic consumer spending. These goals – which might require some belt-tightening and perhaps job losses in certain parts of the industrial sector – are vital to China’s development. In this sense, a slowdown in US debt purchasing would be a byproduct of wider reforms.
RBS’s Simpfendorfer points to the establishment of a national health system as an example: It would encourage manufacturers to produce more for the domestic market and encourage consumers to spend their money rather than hold on to it in case a family member requires medical treatment.
The net result is fewer exports and more imports, meaning slower accumulation of foreign exchange.
A political problem
It is a long-term fix and one that relies on Beijing bringing local governments onside. Given the short-term challenges presented by these reforms, it will be difficult to win over officials who tend to prioritize fast growth and job creation above all else.
"It’s about political will. It’s not about the policy initiative,"said Wright. "The policy path is pretty clear, but there is some definite pain associated with it."
Success, and slower growth in foreign exchange reserves, would allow Beijing to consider diversification in earnest. But even then, China’s interest in the US dollar would not disappear. As long as the dollar remains the world’s dominant reserve currency – and therefore the closest many investors come to a sure bet – Beijing will remain a buyer.
"Selling off the US Treasuries not only harms the US Treasury, it undermines China’s own interests,"said Credit Suisse’s Dong.