New year, new investment: CIC makes a head start | Global Investing

China?s sovereign wealth fund?s move last week to invest in London water supplier Thames Water puts focus on potential overseas investment in the year of Dragon from China?s central bank PBOC, which plans to create a $300 billion vehicle to invest in Europe and the United States.

After Reuters reported on the plan in December, the PBOC and State Administration of Foreign Exchange (SAFE), which manages reserves, have been mum. A tiny?drop in the country?s reserves, still standing at $3.18 trillion, brings only a small comfort to the world?s largest reserve holder as it struggles with low returns on its sovereign debt portfolios in U.S. Treasuries?(earning almost nothing) and euro zone sovereign debt (under growing risk of further ratings downgrades).

China, which regularly intervenes in the FX market to keep a lid on the yuan exchange rate to keep its exports competitive, is suffering??negative carry? ? the difference between the cost of intervention and its overseas investment.

This is how the negative carry arises: The People?s Bank of China buys U.S. dollars in the FX market. When it intervenes, it pumps yuan into the domestic banking system. This extra liquidity, if left, can cause inflation. The PBOC therefore needs to mop this up by issuing ?sterilisation bonds?.

The sterilisation is not cheap.?As ?foreign reserves keep accumulating, the PBC has to issue more debt for sterilisation purposes, which may drive up the interest rates on the PBOC bills.

So far, Chenying Zhang of the Wharton School at the University of Pennsylvania, argues that?the PBOC?s income from foreign reserves investment has exceeded its sterilization cost consistently from 2003 to 2010.

Zhang, in her paper, estimated the PBOC?s cost of sterilization and compared it with its income from the foreign reserves investment from the period 2003 to2010. She finds that?China?s FX reserves have to drop around 36% (or to put it in another way, the RMB has to appreciate by more than 50% against the US dollar) before it fails to cover the sterilization cost of the PBOC.

But the yield on U.S. and euro zone government bonds are falling further.?Given the yield on one-year U.S. Treasuries stands at a?paltry?0.1025 percent, the cost of carry right now could be as much as 200 basis points. The pressure to find higher-yielding assets must be great.

?If foreign interest rates keep dropping, China will suffer a more drastic decrease in its income from foreign reserves, especially if its investment is of a shorter term than that was estimated,? Zhang writes.

Also worth remembering is the point that Beijing?is using this implicit tournament between the CIC and State Administration of Foreign Exchange as a carrot and stick mechanism with which to discipline sovereign wealth managers. So SAFE must be feeling peer pressure from CIC which seems to have made a head start in 2012.

Source: http://blogs.reuters.com/globalinvesting/2012/01/23/new-year-new-investment-cic-makes-a-head-start/

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