Checking China’s white knight

In the lead-up to President Hu Jintao’s White House visit this coming week, China analyses abound. I will leave the question of whether the United States and China are careening toward a new cold war to Dr. Kissinger and focus instead on the underlying irritant of China’s foreign exchange reserves.

This week brought news that those reserves had grown to $2.85 trillion, up almost 19 percent over the last year. This followed stories about how China was riding to Europe’s rescue with the promise to buy Spanish bonds and asking whether China might serve as Europe’s white knight. Both reports seemed to support a narrative in which China’s mercantilist approach has given it the resources to take a leading role in world affairs. In fact, each illustrates some of the pitfalls to the Chinese way of doing business.

First, is China saving Europe? The story spoke of a rumored $8 billion Chinese purchase of Spanish bonds. According to one Citigroup analysis, Spanish government financing needs through the end of 2012 total 467 billion euros (about $625 billion). The alarming thesis of the Citigroup report was that if doubts about government finances spread from Greece and Ireland through Portugal to Spain, the funds the other European governments have pledged to address the crisis so far would be insufficient. If China is to serve as Europe’s white knight, an $8bn bond purchase would be a very feeble joust.

There’s always the possibility, of course, that a token investment of this sort could send a signal to other investors: if China has confidence in Europe, why shouldn’t we? Unfortunately, China’s track record as a foreign investor has probably left it with a relatively small following. China had invested heavily in the debt of Fannie Mae and Freddie Mac in the years leading up to the U.S. housing crisis. It invested in the Blackstone group just before those shares took a dramatic fall. And though the exact composition of China’s reserve holdings is not public knowledge, its presumed large holdings of U.S. bonds are subject to substantial risk; they drop in value whenever interest rates rise or the Chinese currency appreciates. Following this sort of reasoning, one estimate from last year assessed China’s 2010 loss on foreign reserve holdings as between $177.0 and $211.3 billion.

That’s rather a lot of money. It raises the question whether this was bad luck, or whether it is a problem inherent to China’s large and growing account. I would argue the latter.  So-called "hot money" is flowing into China because China’s undervalued exchange rate makes this look like a one-way bet. If an investor thinks China will be forced — by threat of inflation and burgeoning reserves — to appreciate its currency by 10-20 percent over the next few years, that makes a very appealing expected rate of return, particularly in a time of cheap and easy borrowing in the West. (Oddly enough, China has just decided to facilitate such flows by opening banks offering yuan accounts in the United States. The Wall Street Journal explains how and why this should be part of your portfolio.) The loser in these transactions is China, which is paying high prices now for dollars that will inevitably be cheaper in the near future.

When China tries to get around this problem by entrusting its funds to sovereign wealth funds or state-owned enterprises who will seek out higher rates of return, it faces two problems. First, there is a suspicion of Chinese government motives that stirs opposition to major investments abroad (see CNOOC). Second, there is the problem of the poker novice who walks up to  the table, puts down a big pile of cash and asks, "So how do you play this game?" When the Blackstone Group luminaries are selling, one should think hard about whether to be buying.

Of course, China could give up on the idea of making a return on its money (or even preserving value) and treat it as a giant slush fund used to curry favor abroad. But China remains a developing country, with income per person of $7,400 and substantial problems to address, as Chinese officials will readily explain. Further, past losses have drawn a backlash within China, as the public has objected to having resources squandered. This week Chinese officials publicly expressed their concern about the fate of their dollar assets.

China’s rampant accumulation of reserves cannot continue indefinitely. If reserve growth continued at the rate it did for the last year, Chinese reserves would equal the size of total current reported world foreign exchange reserves in less than 7 years. The sooner China acts to stem this growth, the less painful it will be for them.

Treasury Secretary Timothy Geithner and the administration this week seemed to broaden their demands of China towards concerns other than currency — more market access, less Chinese government intervention in the economy, better intellectual property protection. This seems wise. There is plenty to complain about and there is reason to hope that China may be more responsive on these other issues. U.S. importunings on currency have fluctuated between ineffective and counterproductive. China’s undervalued exchange rate is misguided, but for the Chinese, the quixotic accumulation of foreign exchange reserves serves as a punishment, not a reward.