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By Frederik Balfour (Business Week)
Updated: 2007-01-26 11:41

China's Trillion-Dollar-Plus Quandary

Arguably the most intriguing, though vaguest, decision to emerge from the financial planning in Beijing was the future investment strategy of China's massive stockpile of foreign currency reserves. The official China Daily newspaper said managers of the country's more than $1.1 trillion in foreign reserves will be encouraged to "explore new means and extend channels" for management of the money.

Most economists interpret this to mean that China will diversify away from low-risk assets like U.S. treasury bills (which currently account for about 70% of China's foreign exchange holdings) to riskier assets yielding higher returns. Tao of Credit Suisse reckons China needs no more than $360 billion in official foreign reserves to provide a comfortable cushion to handle import needs.

But the big question is what kind of entity would be created to manage these riskier assets. One possibility is the creation of a State Investment Corporation (SIC) similar to Singapore's state-owned investment arm Temasek to make private equity investments.

However, it remains an open question whether China has the kind of expertise needed to run a fund controlling as much as $200 billion. China would have to pay big bucks to attract the kind of financial talent needed, which is scarce at a time when private equity managing partners are commanding record-high salaries worldwide.

Yuan Appreciation Outlook

Expect at least a 5% appreciation in the Chinese yuan in 2007. During the first part of January, China's financial authorities have tolerated a bout of currency appreciation and recently broke through the psychologically important level of parity with the Hong Kong dollar, which is pegged to the greenback.

Beijing's willingness to allow the yuan to strengthen at a faster pace reflects its confidence that the bulk of bank reforms have been completed and China's financial system can accommodate a stronger currency. It is also clear that the more than 5% appreciation of the currency over the past 18 months has not hurt China's exports. China reported a record $177 billion trade surplus last year.

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