Chasing Wealth

The formal launch of China's investment agency may prove to be a milestone in the development of sovereign wealth funds but for now it is largely irrelevant to the conduct of the country's economic and monetary policy.

Besides giving Beijing a way to earn more on part of its $1.4 trillion in reserves, the agency was billed as a way of siphoning off some of the inflows from China's record trade surpluses that are boosting money supply and pumping up asset prices.

But as the China Investment Corp (CIC) prepares to open for business on Saturday, economists say the fund's initial remit is such that it will not make much of a difference to policy makers at the People's Bank of China, the central bank.

Critically, new net currency inflows will be bought not by the CIC, as was once assumed, but by the central bank.

As it issues yuan in exchange, the central bank will keep creating high-powered reserve money -- the building blocks for bank credit and money growth -- that it will have to keep mopping up through open market operations.

This means that the scope of the current monetary policy implementation, as well as the complications, including forex reserve accumulation and sterilization, would remain largely unchanged with the establishment and operation of the CIC, economists at JPMorgan Chase said in a note to clients.

The sums of Chinese money chasing a home overseas are also likely to be underwhelming.

Although the CIC has initial capital of $200 billion, one-third of that will pay for Central Huijin, an investment vehicle that the PBOC used to pump foreign exchange into several big state banks.

Media reports have also said the CIC will be used to recapitalize two other banks and perhaps even to buy shares in big state-owned enterprises.

The external implications are that the impact of the CIC, on the U.S. dollar and U.S. treasuries, at this phase may not be as negative as some market participants may have feared, JPMorgan Chase said.

POLITICISED

Recent market turmoil and domestic criticism of the CIC for its purchase of a $3 billion stake in Blackstone (BX.N: Quote, Profile, Research) mean the fund is likely to start off investing fairly conservatively in liquid foreign securities, said Michal Pettis, a professor at Peking University.

Shares in Blackstone have fallen 20 percent since the U.S. private equity group's initial public offering in June, handing the CIC a big paper loss.

As the CIC grows, I would bet that an increasing amount of its assets is likely to be invested in strategic investments, which I suspect will include the financing of the foreign expansion of state-owned companies.

This may turn out to be the most highly politicized aspect of the CIC's future business, Pettis said.

Beijing is treading cautiously not only with the CIC but also with two other conduits for outflows: the year-old Qualified Domestic Institutional Investor scheme and a proposed program to allow residents to buy Hong Kong-listed securities directly.

A backlash by risk-averse bureaucrats against the Hong Kong stocks through train means the plan is stuck in the sidings more than five weeks after it was greeted by analysts as a momentous opening of China's capital account.

Relevant departments are still carrying out further discussions and coordination, Wang Yungui, a senior official with the currency regulator, said on Friday. The main reason for that is to ensure that risks are controllable.

LET THE YUAN RISE

Given the risk of financial instability if money floods out of the banking system, portfolio outflows to start with will probably be very low, said Dwyfor Evans with State Street Global Markets in Hong Kong.

If the Chinese authorities' track record is anything to go by, they will probably want to avoid doing anything drastic, he said.

With money thus largely bottled up inside China, it is little wonder that household savers and corporations alike are pouring into equities and real estate.

The stock market has risen more than 400 percent in two years; property prices nationwide rose just 8.2 percent in the year to August but at a much faster clip in some big cities.

The authorities' eternal monetary policy bind is thus etched in sharp relief.

To deflate incipient asset bubbles before they burst with unpredictable social consequences, China needs to keep raising interest rates. Yet to do so, at a time when the Federal Reserve is cutting U.S. rates, would be to invite fresh capital inflows that pile up on the PBOC's balance sheet.

The way out, as economists never tire of saying, is for China to defang the speculation and let the yuan rise faster.

Their only monetary response can be to allow the currency to appreciate, Evans said. I think this is the policy dilemma they're in at the moment.