People's Investment Company
January 29, 2007; Page A16, WSJ

For Wall Street, the big news out of China this month is that the country will "actively explore and expand the channels and methods for using foreign-exchange reserves." The Communist Party might hive off a big chunk of its $1 trillion stash and invest abroad on behalf of its citizens, a la Singapore's Government Investment Corporation. That may be a boon for bankers, but it's not necessarily a smart idea for China.

This is yet another scene in the Party's balancing act between economic liberalization and state control. China's exchange-rate policy -- the catalyst for its huge foreign-exchange reserves -- is at the heart of the debate. By more or less pegging the renminbi to the dollar, Beijing accumulates foreign-exchange reserves when it mops up the incoming greenbacks. The policy has spurred an enormous boom, giving Chinese and foreigners the confidence to invest without worrying about price volatility.

This has also bought time for China to reform its broken financial sector -- a task that's far from finished. At the same financial conference at which the government investment idea was floated, Premier Wen Jiabao kicked off the reform of the Agricultural Bank of China, more than half of whose loan portfolio is rumored to be non-performing; it will take perhaps $100 billion or more to bail it out.

So why hive off foreign-exchange reserves into a Singapore-style fund? For one, China's policymakers may be frustrated that their efforts to encourage money to flow abroad aren't working quickly enough to offset the tide of incoming capital. The so-called Qualified Domestic Investor Initiative scheme, which lets Chinese investors buy bonds abroad, has attracted only a few billion dollars so far.

But there are good reasons for that. Today, Chinese investors see better prospects at home. The Shanghai stock market is up more than 110% over the past 12 months, and property prices are still healthy. Chinese investors probably aren't turned on by buying U.S Treasury bonds. If the Party were serious about opening their capital markets, they'd let investors buy General Electric on the New York Stock Exchange, or a vacation home in Thailand.

It's more likely that Beijing likes the GIC-like setup because it would keep the Party's hands on the money. Singapore's fund hasn't released public accounts since its founding in 1981; its stated total under management, at $100 billion, hasn't changed in years. But at least Singapore has a reputation for clean governance; the same can't be said of China's bureaucracy.

Beijing's policymakers could also make political hay domestically by telling citizens that they will get more return for their renminbi -- which could then be invested in, say, education or health care. This is the "negative carry" argument -- the idea that foreign investors are receiving double-digit returns on their dollars, while China's central bank receives single-digit returns when it invests renminbi in U.S. T-bills.

But that's not the way it really works. Foreign-exchange reserves are liabilities on a central bank's balance sheet, not found money. Up to a certain point, reserves assure foreign investors that a country has ammunition to fight an attack on its currency, such as during the 1997-98 financial crisis. Once reserves accumulate beyond that point, more fundamental questions about government policy have to be raised. Instead of creating an opaque government institution to manage reserves, China would do better to tackle the root problem: the need for more capital freedom.