The heavy burden of Beijing’s cash pile

China’s bulging foreign exchange reserves have become a headache to manage for the central bank. Poor returns on its US reserves should encourage Beijing to chase higher-yield assets in Australia.

Can you ever have too much money? It's a silly question if you ask your average Joe, but it is a serious question if you pose it to Chinese central bankers, who have a staggering $US4 trillion in foreign exchange reserves at their disposal.

Beijing’s cash pile accounts for about one third of total foreign reserves in the world and it has increased tenfold in the past decade. For many, it is seen as a source of strength for the world’s second-largest economy, but in reality it has become a burden for the country to manage.

Chinese Premier Le Keqiang made it quite clear recently when he was visiting Africa that the large reserves had become a headache for the country. “Frankly speaking, foreign reserves have become a big burden for us, because such reserves translate into the base money, which could affect inflation,” he reportedly said.

Beijing needs to 'sterilise' the large inflow of US dollars -- earned from China’s export industry -- in order to keep the exchange rate within a desirable range, which involves buying the US dollar and indirectly injecting more cash into the Chinese financial system.

In short, the need to sterilise the greenback makes China’s monetary policy less effective. The constant conversion of the US dollar into yuan will simply expand China’s money base at a time when Beijing wants to rein in credit expansion. The build-up of foreign reserves is also making it harder for the central bank to keep inflation in check.

China has parked a large chunk of its holdings in US Treasury notes, which pay low interest rates. We are looking at a strange situation in which a poor developing country is providing the United States with subsidised loans. Common sense dictates that Beijing needs to find better returns for its vast sums of money.

Chinese central bankers understand the need to diversify, but finding enough options in which to invest several trillions of dollars is easier said than done. The deputy governor of China’s central bank Yi Gang, who is in charge of the foreign reserves, said he was open to all suggestions about how to invest China’s vast holdings, which may include farming out the management of reserves to fund managers, private equity and banks.

The simplest solution to resolve China’s build-up of reserves is to reduce the current account surplus, or import more. “The only prescription to achieve a current account balance is to import more, get people to spend more on overseas holidays, buy more services from abroad and invest more overseas,” he said (Cashed up China Inc needs to spend, December 5).

How China manages its large reserves will have a strong impact on Australian economy.

The State Council has just issued a policy document that urges the country to abandon its old mercantilist policy in favour of a more balanced trade policy that encourages both exports and imports. The top recommendation is to encourage the country to import more commodities and consumer goods.

High-quality Australian produce like dairy products, wines and meats are already enjoying significant success in China. Even purple bears stuffed with lavender are selling like hotcakes to Chinese buyers. Chinese tourists are also outspending everyone else here. It is important that Canberra can secure a high-quality free trade agreement with Beijing to encourage greater exports of goods to China.

Another important aspect of managing China’s foreign reserves is to diversify away from investing in low-yield US treasury bonds. Beijing clearly wants to get better returns on its money and is making it easier for Chinese companies to invest abroad.

The National Development and Reform Commission, the country’s lead economic agency, has relaxed its grip on the outbound investment process, allowing Chinese companies to invest less than $1 billion without the need to seek approval (China’s rekindled love affair with AustraliaMay 15).   

The relaxation of the outbound rule in conjunction with the desire to turn part of the country’s vast reserves into higher yield assets is most likely to see a resurgence in China’s appetite for Australian assets. In fact, Chinese global mining acquisition activity increased 63 per cent in the first four months of this year.

China’s $4 trillion in reserves is more than enough to deal with any conceivable emergency under the sun. Beijing recognises it is no longer in the country’s own interest to make it even larger. How it decides to spend that money will have important consequences for Australia -- and we need to get ready for that.