China, whose foreign exchange reserves are the biggest in the world, wants to invest a portion of its money in higher-return assets to avoid losses caused by a weaker US dollar. Analysts say the [investment] corporation might also lift the global profile of Chinese companies, emulating ventures such as the Government of Singapore Investment Corporation. SCMP, June 28 When they first decided in Beijing two years ago to abandon a rigidly fixed exchange rate and allow the yuan to creep up against the US dollar, the emphasis was very much on making it a slow appreciation. I can't speak for the thinking directly, of course, but it is apparent that the authorities were worried they might encourage currency speculators to jump in if they let the yuan rise quickly rather than creep against the dollar. This did not satisfy US politicians, however. They were not prepared to tolerate a creep (except in the White House). They want a much bigger revaluation of the yuan and they want it now. Their influence has also been felt, as the first chart shows. Over the past year, the yuan's rate of appreciation against the dollar has risen from an annualised 1.5 per cent to 5 per cent. That is definitely in the speculator danger zone and must now be contributing to the overheating of the economy. But while the People's Bank of China undoubtedly regards this with concern, it has a more immediate problem, to wit, that it has a bare 22 billion yuan in capital to support total assets of 14.2 trillion yuan in its balance sheet. This is a problem because 70 per cent of the assets are foreign, that is, those huge foreign reserves standing at about US$1.25 trillion in value. My guess is that at least 80 per cent of these reserves are effectively denominated in US dollars. You can now see the scale of the problem. If the US dollar falls by 5 per cent against the yuan and 80 per cent of China's reserves are in US dollar instruments, then the value of those reserves falls by more than US$50 billion in yuan terms or almost 400 billion yuan. This represents many multiples of the bank's capital. How can the central bank absorb this hit without going bust? There is a way. The bank must ensure that it pays a much lower interest rate on the yuan it borrows to buy dollars than it gets from these dollar assets. Thus if it pays 3 per cent on yuan bonds and gets 6 per cent on US bonds it can let the yuan rise by 3 per cent a year and the interest rate gain will offset the currency translation loss. Simple. Easy. Or maybe not. The second chart is a simplistic way of showing how it has all gone wrong by comparing yields on yuan and US dollar 10-year government bonds. In the middle of last year, the US instrument yielded about 1.5 per cent more than the Chinese one and this was the rate by which the yuan appreciated against the dollar. Everything was in balance. More recently, however, yuan interest rates have risen and the yield difference with US dollar long-term rates is considerably less than 1 per cent. This certainly does not compensate for the damage that a 5 per cent appreciation of the yuan against the US dollar would inflict on the central bank's balance sheet. Oh what to do? Oh what to do? Simple again. The People's Bank must make more money on its foreign investments. The way to do this is to emulate Singapore and invest in foreign equities and fixed income instruments. However, leaving aside how odd it is to see the elephant emulate the mouse, how does the elephant come to think that the mouse has a good investment record abroad? The central bank needs go no further than Singapore's ventures in Suzhou to raise a few questions for itself on that score. And while no one really worries about the damage a mouse may do, people are more reluctant to invite an elephant into their homes. The People's Bank of China may find welcome mats pulled quickly from under its feet if it goes equity hunting abroad. Foreign governments will ask what the mainland's intentions are and quickly rule out bids for sizeable equity stakes in key industries. The People's Bank of China may find it very difficult to get that money invested as it would like to do. Beijing has a headache here that will not go away soon.