Cao Huining and Liu Jin
It has been reported that China Investment Co, the long-awaited
State forex investment company that is expected to make better use
of the country's huge foreign exchange reserves, will be
inaugurated on September 28.
After three decades of robust and continuous economic growth,
the country has accumulated $1.3 trillion of foreign exchange
reserves. This is about half of China's annual gross domestic
product (GDP), which means every two percentage points of revenue
from the foreign exchange reserves equals one percentage point of
growth in GDP.
Information about the reserve's investment portfolio is not
available to the public, though research indicates a big proportion
of its funds are in the global bond market, especially in US bonds.
Before 2004, the reserve's assets were primarily invested in US
treasury and mortgage bonds. Corporate bonds gained more attention
after 2004.
Compared with other financial assets, especially shares, bonds
are less risky - and less rewarding. Putting the country's forex
reserves into the bond market was fine when the reserves were
small. The wisdom of this stance becomes questionable once the
forex reserves exceed the amount needed for trade settlements.
Past experience proves that a stock-centered investment
portfolio is much more rewarding than a bond-centered one. In the
last century, the annual difference in returns between the two
portfolios was between 5 and 8 percent in the US and around 3
percent in Europe and Japan.
Given the gigantic size of China's forex reserves, the country
could expect to see its returns increase by the equivalent of about
1.5 percent of GDP if the investment portfolio became more
stock-centered.
Switching the portfolio's focus would be worth a try despite the
higher risks involved with stock investments. The newly established
forex investment firm is obviously a pilot step in this
direction.
During the transitional period, the key issue will be what kind
of financial assets are worth investing in.
All non-bond financial assets fall into categories of shares of
listed companies and equities of private firms. The stock of listed
companies is more liquid and transparent, so it is relatively more
expensive. The equities of private firms are less costly, less
liquid and less transparent, but more rewarding in the long
run.
An institutional investor will generally include both of them in
its portfolio, with different proportions of each. So which one
should the investors of China's forex funds favor - shares on the
stock exchange or the equities of private firms? In other words,
the investors will have to choose between acting like a mutual fund
manager and a venture capital runner hunting for private
equity.
Judging from several recent developments, the authorities seem
to prefer private equities. This is understandable because China is
a green hand when it comes to investing funds from the foreign
exchange reserves. Moreover, there is a successful example to learn
from: Temasek Holdings in Singapore.
Set up in 1974, Temasek Holdings oversees the investments of the
Singapore government. Its average annual rate of return in the last
three decades has been 18 percent, much higher than the annual
growth of the stock market. By the end of last year, the company
was managing $100 billion worth of assets, about 83 percent of
Singapore's GDP for the year.
Temasek Holdings operates like a venture capital firm. It makes
its investment decisions only after extensive research. As of last
month, Temasek Holdings was the majority shareholder in more than
20 companies in the banking and telecommunications sectors, among
others, in countries in East Asia and Southeast Asia.
However, while Temasek Holdings' successes are remarkable, its
experiences are not suitable for China to copy at this moment.
As is typical for venture capitalists, Temasek Holdings' huge
rewards came after facing big risks.
Temasek Holdings succeeded in most of its investment projects
because of its unique access to information. About 40 percent of
its investments were made within Singapore, and the rest were
mostly in neighboring countries. It is not hard for Temasek
Holdings to acquire the information it needs to make investment
decisions.
Singapore's economy has been closely integrated into the global
economy ever since the country was founded. The people at Temasek
have been able to draw on their country's rich trade
experiences.
When China uses funds from its forex reserves to invest, it will
have to venture out into global financial markets. However, the
Chinese are far from experienced in the global market.
It is important to maintain a certain level of liquidity in the
forex reserves. If the funds are put into private firms, it will be
hard to convert them back to cash when needed without suffering big
losses. So it is improper for the forex investment body to copy
Temasek Holdings.
Therefore, the stock of listed companies is a better choice for
China as it goes in search of bigger rewards by investing funds
from its foreign exchange reserves.
To manage the risks involved in trading on the stock market, the
forex investment body could choose a global stock market index
mutual fund as their primary investment target.
An index fund would be a good target for the forex investment
body because investing in them does not require experience, talent
or access to information to make an investment decision. By
tracking a package of shares, such funds dilute the risks as much
as possible. And index funds are also the most liquid and least
costly of all mutual funds, raising the long-term returns of the
forex investment.
Simply put, targeting index funds is the best strategy for China
at this moment, as it faces the many possible ways to construct its
investment portfolio.
Cao Huining is a professor with the Cheung Kong
Graduate School of Business, and Liu Jin is a professor with the
University of California
(China Daily September 26, 2007)
