How Much Can China Really Diversify Its Reserves?

Could China move out of US Treasuries and into US real economy assets in a big way? In early 2009, China's Premier Wen Jiabao drew attention by announcing an intention to manage foreign-exchange reserves more actively and seek to diversify away from US government holdings. China currently holds more than one trillion of US Treasuries and another $500 billion of US government-backed agencies.

The question of Beijing's ability to diversify its $2.4 trillion foreign exchange holdings is not only relevant for the market demand for Treasuries and alternative securities but also for assessing China's leverage over the United States. This issue will be prominent over the coming weeks, as the United States decides whether to designate China a currency manipulator.

The answer to the diversification question largely depends on whether Beijing can find an alternative store of value for those dollars. China's 2009 experience with one of these alternatives channels-shunting dollars into the real economy via direct investment-illustrates the difficulties and limitations of seeking alternative investment opportunities. After Premier Wen's initial comments in January 2009, China's foreign-exchange manager (SAFE) in February announced a decision to channel foreign exchange to China's corporations to make direct investments abroad, under the rubric of China's "Going Out" strategy. High-ranking officials from the Ministry of Commerce and Sasac-the state-owned enterprise overseer-followed with similar statements, adding that globally depressed assets offered an ideal opportunity for China to buy into natural resources and other sectors cheaply. Businesses abroad listened to this with either fear that a fire sale of valuable assets would enhance China's competitiveness or glee that M&A deal flow would soon boom, while officials in Washington anxiously did the math to see if this could negatively impact demand for US government securities.

Predictions that China would buy up the world and turn into a net exporter of direct investment did not materialize. China's 2009 outbound foreign direct investment fell to about $45 billion, down from $56 billion in 2008. Nonfinancial sector investment grew 6 percent year-on-year to $43 billion-very impressive given that FDI crashed 30-40 percent globally amidst the crisis, but far from the double- and triple-digit growth rates seen in previous years. With $90 billion of direct investment flowing inward in 2009, China remained a net direct investment importer to the tune of nearly $45 billion. China's sovereign wealth fund CIC took a handful of direct stakes abroad, and government vehicles backed some resource investments in Africa and elsewhere, but the amounts were small beside Beijing's $400 billion in foreign-exchange holdings growth.

The limits to ramping up direct investment outflows are largely commercial in nature. If challenges including OECD regulatory barriers, South Korean and European labor union assertiveness, and US consumer protection and legal compliance were not sobering enough, several Chinese firms that did try to take the plunge-like Tengzhong Automotive-were denied or belittled by politicians and approval authorities for being too bold. Even the largest companies were ill prepared for international takeovers, as a Chinese government report attested this week with regard to Chinalco's gambit for a stake in Rio Tinto. China is discovering that neither running an automobile manufacturing facility in Mishawaka, Indiana, nor acquiring companies in the natural-resources space is a ready substitute for phoning in a purchase order for US Treasury bills and notes. Beijing cannot simply press a button and switch from easy government debt holdings to complicated direct investment overseas.

In the years ahead, China will inevitably see its wealth managers (sovereign and private) expand from US Treasuries to a more diverse portfolio, in pursuit of positive returns, a trend that will definitely include more direct investment. Chinese manufacturers will slowly creep closer to their OECD consumers because that is where all the margins for their products lie, but they can do so only slowly. The challenges of making real direct investments will put a significant speed limit on such Chinese diversification for some time to come.

Of course, if Beijing really does want its firms to invest more dollars abroad, there is an easier way to make that happen. It is simple: stop forcing them to trade in the dollars for renminbi in order to manipulate the exchange rate in the first place, leaving the question of how best to manage a dollar portfolio to the firms that earned that foreign exchange to begin with.