China as an international investor
Increasing the flexibility of the exchange rate regime is the major priority in setting a course towards the full integration of China into the international financial system.
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China's international balance sheet is highly skewed.1 On the liability side, FDI looms large, with relatively little investment by foreigners in the Chinese stock or bond markets. According to the State Administration of Foreign Exchange (SAFE), FDI accounts for over half of Chinese external liabilities of $965 billion, with portfolio equity and debt liabilities taking just 11% and 1.5% respectively. On the asset side, the pre-dominant category is official reserves, with non-reserve portfolio assets and FDI very low. SAFE reports that China had official reserves of $1073 billion at the end of 2006 (representing 65% of the total asset holdings of $1627 billion) but portfolio equity assets stood at a measly $1.5 billion, with FDI assets also low at only $82.4 billion. (Non-reserve debt assets accounted for a further $471 billion).
It is clear that China's external position is set for a major re-configuration. While progress in developing the domestic securities markets and improving the health of the banking sector will over time allow the Chinese government to relax restrictions on non-FDI capital inflows, much of the world's attention in recent months has focused on the asset side. This reflects the fact that China is currently a net capital exporter, with a positive net foreign asset position of 25% of GDP at the end of 2006 and the current account surplus expected to hit 10% of GDP this year. Moreover, the opportunity cost of China's rapidly-growing official reserves holdings has made it abundantly clear that it is in China's own interests to develop a more diversified foreign asset position.
While non-reserve foreign assets have grown quickly since 2004, it has been from a very low base. However, recent months have seen a number of high-profile moves that suggest an acceleration in the pace of outward investment. The $30 billion purchase of a 10% stake in the private equity group Blackstone in May 2007 has highlighted the gear shift in the investment strategy of the Chinese government, quickly followed by the July 2007 acquisition of a stake in Barclays Bank by the state-owned China Development Bank. Moreover, $200 billion in reserves is to be transferred to the China Investment Corp.(CIC) that has the mandate to invest in quoted securities, private equity and other alternative investments. FDI outflows have also picked up and there have been some moves to relax restrictions on outward portfolios flows from the private sector, although these remain quite circumscribed for now.
The move to a broader investment strategy has several ramifications. First, the switch away from the accumulation of dollar-denominated debt securities removes a subsidy from the suppliers of such reserve assets - primarily the US Treasury, but also the agencies (Fannie Mae, Freddie Mac) and corporations whose bonds have been in high demand. The estimates by Frank and Veronica Warnock suggest that a decline in official purchases of US bonds will lead to positive pressure on US interest rates: they estimate that the 10-year Treasury yield would be 90 basis points higher had there been no foreign official flows into US government bonds during the recent period.2
In contrast, the new strategy will raise demand for other asset classes. In relation to the portfolio component, this expands the market share for issuers of securities. In particular, the `financial gravity' literature suggests that markets that are close to China in terms of geographical, cultural and trade linkages will be primary beneficiaries. However, it will be those countries that do most to ensure high standards of governance and transparency that will be best positioned to attract inflows from Chinese investors. Since the evidence suggests that bilateral currency stability promotes portfolio investment, there may also be an incentive for emerging Asian countries to stabilise bilateral exchange rates vis-a-vis the RMB and/or to issue RMB-denominated securities.
In relation to non-portfolio investments, the prospect of Chinese firms acquiring control of foreign entities has triggered a political backlash in the United States and some European countries. Although Lenovo's acquisition of IBM's PC business has proceeded smoothly, the bigger concern is in relation to state-directed Chinese firms, especially in so-called strategic sectors. However, although high-profile firms in the advanced economies (plus the commodities and energy sectors around the world) are sure to be a target for Chinese multinationals, the gravity literature suggests that the bulk of FDI outflows from China will be directed towards other Asian economies.
The conditions under which China is likely to adopt a liberal capital account regime are also the conditions under which the Chinese current account surplus may be expected to shrink or even turn negative. After all, the baseline neoclassical model would predict that China should be a net importer of capital since anticipations of higher future income should lead to an increase in current consumption and a high marginal product of capital should draw in extra investment from overseas. If social insurance systems are put in place and distortions in the domestic financial system are resolved - which is a precondition for prudent liberalisation of the capital account - this prediction may start to come true. Indeed, David Dollar and Aart Kraay of the World Bank have run simulations in which China may run average current account deficits of 2-5% of GDP over the next 20 years.3 Since high growth and a trend of real appreciation mean that China's share in global GDP is set to increase rapidly, deficits on that scale would be a major drain on the global financial system, even if not quite reaching the scale of today's US deficit. Moreover, if there are no willing counterparties that are prepared to run the counter-balancing current account surpluses, the adjustment will occur through an increase in global real interest rates. This will be good news for net savers but costly for other countries that would like to import capital, either due to a high marginal product of capital or a high preference for current consumption.
The factors discussed above indicate that China's role as an outward investor is sure to grow over the medium term. However, it faces difficult tactical decisions in mapping the transition between the current system and a fully-open capital account. In particular, there is widespread agreement that the pre-conditions for successful liberalisation include a flexible exchange rate, a robust banking system that can handle fluctuations in interest rates and properly-functioning currency and derivatives markets to allow firms to hedge exchange rate risk. If these conditions are not fulfilled, there is a greater risk of a post-liberalisation financial and currency crisis. However, preserving the status quo is not a sensible option, since the current dollar-tracking regime is itself contributing to imbalances, both in terms of the composition of the external balance sheet and domestically through the impact of reserve accumulation on the domestic banking system. Accordingly, increasing the flexibility of the exchange rate regime is the major priority in setting a course towards the full integration of China into the international financial system.
1 This article draws on some of the analysis reported in "The Evolving Role of China and India in the International Financial System" by Philip R. Lane and Sergio Schmukler, Open Economies Review 18(4), 499-520, September.
2 See "International capital flows and U.S. interest rates" by Frank Warnock and Veronica Warnock, NBER Working Paper No. 12560.
3 David Dollar and Aart Kraay (2006), "Neither a Borrower Nor a Lender: Does China's Zero Net Foreign Asset Position Make Sense?," Journal of Monetary Economics 53(5), 943-971.