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Getting the most out of forex reserves
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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)


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