Wall St. and Business Wednesdays: China's Trillion-Dollar Reserves Start Search For A Home by Marcus Gee

In 1900, for sanitary reasons, civil engineers reversed the Chicago River so that it would flow away from Lake Michigan and toward the Mississippi River basin instead. In today's China, financial engineers are attempting a similar feat with a different liquid: money. Their aim is to reverse the flow of capital in the world's most populous country.

For years, foreign money has been pouring into China as investors seek to profit from the great China boom.

Now it is starting to flow out.

In May, the government of China signalled its intentions when it invested $3-billion (U.S.) for a stake of nearly 10 per cent in private equity giant Blackstone Group.

Then, on July 23, Barclays, the British bank, surprised the investment community when it announced that state-owned China Development Bank would invest $3-billion in Barclays - a stake that could grow to $13-billion if Barclays wins its bid for the Dutch firm ABN Amro. That would make it the biggest investment abroad by any mainland Chinese company ever.

Coming one after another, the Blackstone and Barclays deals have created a stir - and a bit of trembling - in the money world as investors anticipate a flood of Chinese billions into world capital markets.

Until now, China's impact on the global economy has come mainly through its exports, valued at $960-billion-plus last year.

That export boom has attracted hordes of investors keen to take advantage of cheap Chinese labour to make their computers, toys and T-shirts. They pour about $70-billion a year into China. China, by contrast, invested just $16-billion abroad last year.

But China's success has presented it with a problem of sorts. It is simply swimming in money. Banking the profits from all those exports, it has accumulated an incredible $1.3-trillion in foreign exchange reserves. That is five times the amount it had just five years ago. China's reserves grew by $267-billion in the first half of this year alone. They are now almost one-and-half times as big as much wealthier Japan's.

"This pace of reserve accumulation," Lehman Brothers said last month, "appears unprecedented and is one of the world's most compelling macro developments."

For years now, China has parked its hoarded loot in U.S. Treasury bonds, which are secure and easy to liquidate if it needs to use the money to back up its currency in the event of a currency crisis.

But China has more than enough money to back up its currency, and the massive reserves have become a bit of a burden. Like water behind a dam, they are building up, and Beijing is looking to divert the flow to more rewarding locations than safe old Treasuries.

The Blackstone and Barclays moves are just the beginning. China is in the midst of setting up a so-called sovereign wealth fund that will have a pool of up to $300-billion to invest offshore. It is transforming China Development Bank, which used to be content with financing infrastructure projects at home, into a real commercial bank with hopes of becoming a player on the world stage.

It is also loosening capital controls on Chinese companies that have money on their hands, like insurance companies, so that they can invest abroad. Chinese commercial banks and securities companies already have that power and they may send up to $50-billion abroad in the next two years, by one estimate. If things keep going this way, one analyst at JPMorgan predicted recently, capital outflows from China could reach $1.5-trillion a year by 2020.

What will that mean for the world financial system?

Lots of scare stories are going around. Will Beijing pull out of Treasuries and undermine American finances? Will Chinese companies gobble up strategic Western companies and compromise Western security?

Such fears are overblown. Beijing has been typically cautious in its investments so far. It was careful to take only a minority stake in Barclays. It shows no sign of getting out of safe and convenient Treasuries. Its decision to venture out into the world of global investment is good for everyone. Good for China, which gets to diversify its assets and draw down that dangerously large pool of reserves. Good for the rest of the world, which gets the benefit of Chinese capital to help its companies grow and prosper.

China's Great Reversal is to be applauded, not feared.

Marcus Gee can be reached via e-mail at: mgee@globeandmail.com

Editor's Note: This article first appeared in The Globe and Mail.

Wednesday, August 8, 2007