China Forming Fund to Invest Reserves
Friday March 9, 2:24 pm ET
By Joe Mcdonald, AP Business Writer

Here’s an excerpt

The growth in China’s reserves is driven by the rapid growth of its exports, which brings in dollars, euros and other foreign currency, and by the billions of investment dollars being poured into the country.

The surge in money flooding in from abroad forces the central bank to drain billions of dollars from the economy every month by selling bonds in order to reduce inflationary pressures.

The precise composition of China’s foreign currency reserves is a secret. But economists believe that as much as 75 percent is believed to be in U.S. dollar-denominated instruments, mostly Treasuries, with the rest in euros and a small amount in yen.

Stephen Green, chief economist at Standard Chartered Bank in Shanghai, calculated that last year the central bank made a $29 billion profit on its Treasury holdings after paying interest on its own bonds and other expenses.

But even that represents a return of less than 3 percent on the $1 trillion in holdings.

By contrast, Singapore’s Temasek says it has averaged an 18 percent annual return since it was created in 1974.

When a country sells more than it buys, and when other people make investment (gives the country a loan), the excess money ends up parked somewhere, in this case, at the central bank. According to this article, the central bank takes this money and invests it in US Treasury Bonds, but is looking for other investments. But it also mentions, as a separate matter, the central bank sells its own bonds (denominated in RMB, presumably) to absorb excess RMB. But the selling of bonds is not much different from offering a time deposit account, so all that the central bank does is to encourage more savings in it. The intention to remove excess money means the government has determined that the economy can’t bear any more production/investments so that investments should be made to external projects. But it’s strange that the central bank can pay its bonds and still get 3% additional return on behalf of the depositors (which it keeps). Why wouldn’t people just invest in US Treasury Bonds or whatever other external investments themselves? Is it due to the non-convertibility of the RMB? Or is it something else?

In fact, why does any country end up with a huge reserve, even ones with convertible currencies? Some reserve for safety is understandable, but a huge reserve must mean that its people just like to save save save. But why do they like to save? It must be because they have low risk tolerance as individuals — that makes them seek out the government as an investment fund? If so, then it only makes sense for the central bank to leverage its large funds to make risky but diversified investments to give its depositors a high return at a still tolerable risk. In that case, it makes sense that China is making adjustments to its reserves investment policy away from the completely safe US Treasuries, ahead of any further loosening of RMB convertibility. That way, when convertibility arrives, the reserves will be competitive enough to remain large enough for the government to still have its monetary levers on the economy.

In contrast, the US sells less than it buys. But the US Federal Reserve is still awash in money. It gets money from the rest of the world well in excess of what would be the usual investments in the US economy, due to the status of the dollar as the world’s preferred reserve currency. So even with large deficits and lack of savings, the Federal Reserve still can do what it needs to do — and this includes handing out cheap loans to the US government and banks (and indirectly, consumers). Nice.