A momentous step on China's road to reform
For too long China's need to recycle its export earnings has meant a free ride for the debt-strapped United States government. That's because the mainland's conservative foreign exchange managers have spent most of the surplus buying US government debt, allowing US interest rates to stay far lower than they would otherwise be. That's about to start changing, much to China's benefit.
The announcement that more mainland financial institutions will be able to make foreign investments is an important step towards diversifying Beijing's foreign exchange holdings. By allowing approved institutions to invest their foreign currency holdings in overseas securities and bank deposits, Beijing has made a small but significant step in easing capital controls. It should improve returns and make the mainland's financial institutions more market-savvy.
The limited scale of the qualified domestic institutional investor (QDII) scheme will not satisfy those who feel that Beijing should make further moves to trim its current and capital account surpluses, such as by allowing direct personal investment overseas. Nor will it ease international pressure to allow the value of the yuan to rise faster and permit freer capital movements in and out of the country. But while such calls have merits, Beijing should not rush to make those moves. After decades of capital controls, any attempts to loosen or abolish them must not be implemented with haste. South Korea's 1997 financial meltdown stands as an object lesson in the dangers of hasty financial market liberalisation.
Certainly, the mainland's over-reliance on US treasury bonds has reached absurd proportions. China's foreign currency reserves had reached US$875.1 billion, the world's largest, by last month. The state's policy of encouraging mainland enterprises to invest overseas has had only minimal success. While the state oil and mining companies have made major acquisitions, their investments are dwarfed by much larger amounts that flow into the mainland every year.
The QDII scheme allows banks, insurance companies and state pension funds to invest prescribed proportions of their funds outside the mainland. It provides a new channel for repatriating the mainland's bulging foreign currency holdings overseas. Initially, its effect on reducing imbalances in capital flows will be small, but that should grow over time.
For clients of QDII-approved institutions, the diversification that comes from investing overseas will be welcome. For pension funds, overseas investment is particularly important. The country's immature stock and bond markets mean there's not much for institutional investors to put their money into. The need for higher returns is growing more urgent as the mainland's population ages rapidly.
The scheme also has a less tangible, but no less important, effect. It will enable mainland financial institutions to acquire first-hand knowledge of the operations of overseas financial markets. Such knowledge - now in short supply - will be handy as they strive to lift their game and prepare for the integration of the mainland's financial markets with the outside world.
Indeed, as mainland financial institutions savour the freedom to invest overseas, Beijing must press on with the difficult task of reforming its financial markets.
Ultimately, the problem of the mainland's sizeable current and capital account surpluses can only be solved when the nation has a bigger appetite for imports. Before that day arrives, Beijing will continue to face the daunting task of preventing the surpluses distorting its economy and being used as a stick by its trade rivals.
China has had great success in its step-by-step approach to reform. The QDII programme, though derided as timid by some, is a momentous step on the road of reform - one that, some day, will see Chinese institutions emerge as significant players in global financial markets.