Moves by China to Improve How It Manages
Its Foreign Exchange Reserves
Eiichi Sekine
Senior Analyst,
Nomura Institute of Capital Markets Research

I.

China Investment Corporation's planned capital increase

1. China Investment Corporation
China Investment Corporation (CIC) was established in September 2007 using
some of China's foreign exchange reserves as capital. After overtaking Japan as theworld's largest holder of foreign exchange reserves in February 2006, China saw its
foreign exchange reserves break the $3 trillion barrier and grow to $3,044.7 billion by
end-March 2011. Some 70% of these reserves are reported to be denominated in US
dollars, with most of this amount managed by the State Administration of Foreign
Exchange (SAFE), an arm of the People's Bank of China, in the form of US Treasury
securities. The choice of US Treasuries can be attributed to China's need to make trade
payments in US dollars and to the liquidity of the US Treasury market. However, CIC
has been assigned the task of reducing the downside risk and improving the return on
the assets it manages.
CIC is a wholly state-owned company under the direct control of the State Council
and has the task of maximizing long-term risk-adjusted returns in accordance with theprinciples of (1) separating business and politics, (2) allowing companies to operate
independently of the state, and (3) pursuing commercial goals. More than 50% of its
initial capital of $200 billion, which was set aside from China's foreign exchange
reserves, is invested overseas. In 2009 it achieved a return of 11.7% on its overseas
investments (compared with –2.1% in 2008) and an overall return on equity of 12.9%
on its overseas and domestic investments (the latter consisting of investments indomestic financial institutions) combined (compared with 6.8% in 2008)1. Although
the corresponding figure for 2010 has not yet been officially announced, it is reported
to be more than 11%2.

1

2

1

For more on CIC's performance in 2009, see Sekine, Eiichi, "The Governance of China
Investment Corporation/China Investment Corporation on Its Way to Becoming a
Sophisticated Institutional Investor," Nomura Journal of Capital Markets, Winter 2011,
Vol.2, No.3.
See Caijing, 12 May 2011.

Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

2. Moves to increase CIC's capital
As of end-2009, CIC's total assets stood at $332.4 billion, meaning it has used up
all of its initial capital of $200 billion, and it was first reported at the time of the 3rd
Plenary Session of the 11th National People's Congress in March 2010 that CIC had
applied to the State Council for a capital increase. Although nothing came of this in
2010, it has been reported that CIC reshuffled its portfolio that year by switching out
of developed markets and into emerging markets in order to improve the return on its
portfolio.
Wang Jianxi, Executive Vice President and Chief Risk Officer of CIC, was also
reported to have said during the 4th Plenary Session of the 11th National People's
Congress in March 2011 that CIC had used up all of its initial capital and had applied
to the State Council for more but had not yet received a reply. Then, in April 2011, theFinancial Times 3 reported that China's Ministry of Finance was set to grant CIC$100–200 billion of new capital. Jin Liqun, Chairman of CIC's Board of Supervisors,confirmed at a meeting of the International Forum of Sovereign Wealth Funds(IFSWF) in Beijing on 12 May 2011 that the Chinese government was indeed
considering increasing CIC's capital but said that no final decision had been made on
the amount and timing of the increase4.

3. Three options for CIC to increase its capital
We understand that three options are under consideration to increase CIC's capital(Figure 1)5.

1) First option: issue of special government bonds by China's Ministry of
Finance (MOF) to purchase foreign exchange reserves and inject capital intoCIC
The option chosen when CIC was established in September 2007 was for MOF toissue special government bonds. One of the reasons for establishing CIC was toreduce China's foreign exchange reserves and generate a higher return on them.
However, simply investing China's foreign exchange reserves overseas would nothave reduced surplus domestic liquidity (by a corresponding amount). It was therefore
decided to issue renminbi-denominated bonds on the domestic market to mop up
some of this surplus liquidity, then to inject a corresponding amount of foreignexchange reserves into CIC as its initial capital 6 . The choice of this scheme also

3
4
5
6

See "CIC set for up to $200bn in fresh funds," Financial Times, 25 April 2011.
See Caijing, 12 May 2011.
See Caijing, 14 March 2011 and First Financial Daily, 25 March 2011.
For further details of the events leading up to CIC's establishment, see Sekine, Eiichi,"Chuugoku no Gaika Junbi Un'yougaisha no Setsuritsu ni Muketa Ugoki" (Moves towards
Setting Up a Company to Manage China's Foreign Exchange Reserves), Kikan Chuugoku
Shihon Shijou Kenkyuu, 2007 Autumn edition, Tokyo Club Foundation for Global Studies(in Japanese).

Moves by China to Improve How It Manages Its Foreign Exchange Reserves2

Figure 1: Three options for CIC to increase its capitalMoneymarket(1) Purchase of
specialgovernment bonds(1) Use of renminbi topurchase foreign exchange
reserves

MOF(1) Capital injection
by MOFCIC(2) Direct capital
injection by PBOC
(SAFE)PBOC(3) Delegation by PBOC
(SAFE) to CIC of
responsibility for managing
forex reserves

SAFE

Source:Nomura Institute of Capital Markets Research, from various media reports

reflected the recognition that simply issuing T-bills would not be enough to absorb
this surplus liquidity.
The capital increase could be financed in the same way as CIC's initial capital:
namely, by issuing special government bonds. However, this could be problematic.
The first problem is that any issuance of special government bonds would, under
China's Budget Law, have to be approved by the Standing Committee of the National
People's Congress. That would take time. The second problem is the need to takeaccount of the impact on the market of a large issue of special government bonds.
When CIC was established in 2007, MOF issued a total of RMB1,550 billion in
special government bonds in eight tranches. The third problem is the fact that thePeople's Bank of China is prohibited from directly underwriting government bonds. In
order to circumvent this when CIC was established in 2007, the special government
bonds issued by MOF were first underwritten by Agricultural Bank of China before
being purchased by the People's Bank of China. As Agricultural Bank of China is now
a listed joint stock company, however, the first option could involve policy banks suchas China Development Bank or China Exim Bank in order to circumvent theprohibition.

2) Second option: direct stake by SAFE in CIC
The second option would be for SAFE to take a direct stake in CIC. As a result,
MOF would become a joint shareholder (along with the People's Bank of China) in
CIC instead of, as at present, the sole shareholder. This would probably affect themembership of CIC's board of directors, currently controlled by MOF (Figure 2). We

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Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

Figure 2: CIC's board of directors (as of June 2011)
Position

Name

Other positions

Chairman & Chief Executive Officer

Lou Jiwei

Previously Deputy Secretary General of the State

Vice Chairman, President &Gao Xiqing

Previously Vice-Chairman of the National Council for theCouncil (formerly Deputy Minister of Finance)
Chief Investment Officer

Social Security Fund (formerly Vice-Chairman of the
China Securities Regulatory Commission)

Vice President & Chief Operating Officer

Zhang Hongli

Formerly Deputy Minister of FinanceNon-executive Director

Zhang Xiaoqiang

Deputy Chairman of the National Development andNon-executive Director

Li Yong

Deputy Minister of Finance, Director of the National

Non-executive Director

Chen Jian

Deputy Minister of Commerce

Reform Commission
Council for the Social Security FundNon-executive Director

Hu Xiaolian

Deputy Governor of the People's Bank of China

Non-executive Director

Fang Shangpu

Deputy Administrator of the State Administration of

Independent Director

Liu Zhongli

Director of the National Council for the Social Security

Foreign Exchange
Fund, formerly Deputy Secretary General of the StateCouncil and Minister of FinanceIndependent Director

Wang Chunzheng

Formerly Deputy Chairman of the National Development

Employee Director

Li XinHead of CIC's Human Resources Department,

and Reform Commission
ex-Ministry of Finance

Note:
Source:Shading indicates association with or former position with Ministry of Finance.
Nomura Institute of Capital Markets Research, from CIC's website

can therefore imagine that MOF might not be happy about the changes to CIC's
governance that a direct stake by SAFE in CIC would probably entail.

3) Third option: delegation by SAFE to CIC of responsibility for managing
foreign exchange reserves
The third option would be for SAFE to delegate to CIC the responsibility for
managing China's foreign exchange reserves. Although this option would not affect
CIC's governance in the way that the second option would, the fact that SAFE has
been seeking to diversify the way it itself manages the reserves (see below) raises anumber of possible complications (e.g., the need to agree an expected rate of returnwith CIC and the size of the mandate CIC could expect from SAFE).
However, whichever of these three options is chosen, an increase in CIC's capital islikely to result in CIC increasing its overseas investments. We understand that thevarious options have been presented to the government, that a decision is expected by
the end of this year, and that fresh capital will be injected at a rate of several tens ofbillions of dollars a year rather than at one go7.

7

See Century Weekly, 16 May 2011.

Moves by China to Improve How It Manages Its Foreign Exchange Reserves

4II. SAFE intent on diversifying the way it manages China's
foreign exchange reserves
As well as its Guidelines the CBRC has published a press release and a Q&A
document on the New Standards. We conclude from these that the CBRC's response to
Basel III is to try to impose the following regulatory standards on Chinese banks andthen improve those standards.

1. SAFE's moves to diversify the way it manages China's foreign exchange
reserves an extension of existing policy
On 1 December 2009 SAFE published its Overview of Foreign Exchange
Administration. This was followed, in July 2010, by its publication of FAQs on
Foreign Exchange Management Policies. In both documents SAFE makes it clear thatits management of China's foreign exchange reserves is governed by three criteria:
safety, liquidity, and return. The documents also reveal that SAFE invests in assets
such as government bonds, agency bonds, supranational bonds, corporate bonds, andinvestment funds, while it not only invests in major international currencies such as
the US dollar, the euro, and the yen but is also seeking to diversify into emerging
market currencies as part of its policy of international diversification.
SAFE began to invest in individual companies such as European resource stocks
and financials before the collapse of Lehman Brothers in September 2008 but put thison hold for a time when the global financial crisis deepened. However, it seems to us
that SAFE may now be looking to improve the return on the assets it itself manages—
perhaps with one eye on CIC's performance since 2009.

2. China diversifies its bond investments
Since 2010, China has begun to diversify how it invests its foreign exchange
reserves, especially in bonds.

1) US Treasury securities
The first change is a decline in China's holdings of US Treasury securities.
According to the figures through 2009, these peaked (on a stock basis) at $939.9
billion in July of that year and then began to decline (Figure 3). A monthly (net)decline of $32.5 billion in May 2010 was particularly noticeable.
According to figures released by the US Treasury Department on 28 February 2011and back-adjusted to June 2010, China's holdings of US Treasuries peaked at $1,175.3
billion at end-October 2010 and then began to decline. As of end-March 2011, theystood at $1,144.9 billion, a decline of $30 billion over five months. This decline inChina's holdings of US Treasuries over a period when China's foreign exchange
reserves increased by $283.8 billion from $2, 760.9 billion to $3,044.7 billion gives

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Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

Figure 3: China's holdings of US Treasury securities andmonth-on-month change thereof（$ mn）
1,200,000（$ mn）
300,000
250,000

1,000,000

200,000

800,000

150,000
600,000
100,000
400,000

50,000200,0000-50,000

0
2000

2001

2002

2003

2004

Month-on-month change (rhs)Note:
Source:

2005

2006

2007

2008

2009

2010

2011

China's holdings of US Treasury securities (lhs)

Data for 2011 through March. US Treasury Department has revised data back to June2010 (as released on 28 February 2011).
Nomura Institute of Capital Markets Research, from CEIC datasome indication of the extent to which it has diversified how it invests those reserves
into assets other than US Treasuries in reaction to dollar depreciation and thedowngrading of US Treasuries.

2) Japanese bonds
The second change is in China's sales and purchases of Japanese (government)
bonds. Since 2010, Chinese sales and purchases of Japanese bonds have increased
significantly. In the first seven months of 2010, for example, China purchased a net¥2,315.8 billion of Japanese bonds (Figure 4). Of this amount, ¥2,361.3 billion
consisted of net purchases of short-term bonds with a maturity of less than 12 months,
while ¥45.5 billion consisted of net sales of medium- and long-term bonds. We cantherefore say that China was typically a net purchaser of short-term bonds during thisperiod. However, in August 2010, China sold a net ¥2,018.2 billion of Japanese bonds,
offsetting most of its net purchases during the preceding seven months.
China has remained a net seller of Japanese bonds in general since September 2010and has been seen as seeking to gain from the strength of the yen. However, it hasremained a net purchaser of medium- and long-term Japanese bonds since October2010. In particular, it purchased a net ¥165.2 billion in February 2011 and a net

Moves by China to Improve How It Manages Its Foreign Exchange Reserves

6Figure 4: Chinese purchases of Japanese (government) bonds【 Annual basis】（\ 100mn)

Source:【 Monthly basis】（\ 100mn)

Nomura Institute of Capital Markets Research, from Japanese Ministry of Financedata¥234.5 billion the following month, while in April it purchased no less than a net¥1,330.0 billion. (Including short-term bonds, however, it sold a net ¥138.7 billion in
April.) Whether or not China continues to buy more medium- and long-term Japanesebonds is likely to have a significant impact on Japanese fiscal policy and Japan's bondmarkets.

3) Korean bonds
The third change is in China's purchases of Korean bonds. China's holdings ofKorean bonds have risen sharply from KRW79.6 billion at the end of 2008 to
KRW1,872.6 billion at the end of 2009 and KRW6,569.5 billion at the end of 2010. In
2010 as a whole China was the second-largest net investor in Korean bonds(excluding refinancing as a result of redemptions) at KRW4,697.0 billion after the US
at KRW6,224.1 billion.
When investing China's foreign exchange reserves in bonds, SAFE has take theinflation rates of the countries whose bonds it has bought as a benchmark in order tomaintain the purchasing power of its foreign exchange reserves and be able to maketrade payments8. According to SAFE, the average annual inflation rates of the US,
Europe and Japan in 2000–2010 were 2.4%, 2.1% and –0.2%, respectively, while thereturns on its investments in those countries' bonds were higher in each case.

8

See http://www.safe.gov.cn/model_safe/news/new_detail.jsp?ID=90000000000000000,90
2&id=3&type=1,2.

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Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

3. Moves towards setting up a second fund
China's foreign exchange reserves have continued to increase even since $200
billion of those reserves were used to capitalize CIC when it was established in
September 2007 and stood at more than $3 trillion at the end of March 2011 (seeabove). In this connection, it is perhaps worth mentioning that at a financial seminar
at Tsinghua University on 8 April 2011 People's Bank of China Governor Zhou
Xiaochuan indicated that he thought that China already had more foreign exchange
reserves than it needed and that it should do more to encourage imports and diversify
the way it invested its reserves. There have therefore been reports, albeit in the
Chinese media, that the Chinese government is considering setting up a second fundto invest some of China's foreign exchange reserves in other assets such as precious
metals and sources of energy9.
In this regard, some in China appear to think that, since CIC is already invested in
the energy sector, it would be better if a sovereign wealth fund were to be responsiblefor investing some of China's foreign exchange reserves in sources of energy10.

III. Investment in Japanese equities by China's QDIIs
1. What are QDIIs?
As well as establishing CIC and seeking to diversify the way China invests its
foreign exchange reserves (see above), the Chinese authorities are hoping to gradually
generate more capital outflows in order to soak up some of the surplus liquidity thathas been fueling inflation and a possible asset bubble. There are two types of capitaloutflows: outward direct investment, which seeks to gain control of the companies
invested in, and outward portfolio investment, which seeks to earn a return from thecompanies invested in. In April 2006 the Chinese authorities instituted a system of
Qualified Domestic Institutional Investors (QDIIs, pronounced "Cuedees") to allow
authorized institutions to engage in outward portfolio investment. Under this system,
financial institutions first need to obtain a license from the regulator; then they need toapply to SAFE for an investment quota; and then they can invest in overseas securities
up to the amount of their quota. According to product data from those QDIIs that are
required to file disclosure documents every quarter (i.e., companies managing mutual
funds specializing in overseas equities), RMB52.3 billion (roughly ¥664.2 billion) of
the RMB74.3 billion (roughly ¥943.6 billion11) in assets they were managing as ofend-March 2011 consisted of equities. However, RMB31.9 billion (roughly ¥405.1
billion, i.e., 61%) of these equity holdings consisted of "Hong Kong stocks" (Figure
9

10
11

See Century Weekly, 25 April 2011. The article also says that China's monetary
authorities have been considering setting up an equalization fund to enable them tointervene in the foreign exchange market and to reduce the need to rely on the People's
Bank of China's monetary policy.
See Shihua Caixun, 16 May 2011.
We have converted amounts in renminbi as of end-March 2011 to yen using the mid-rate
on 31 March 2011 (RMB1 = ¥12.7).

Moves by China to Improve How It Manages Its Foreign Exchange Reserves8Figure 5: Countries in which 30 QDII stock investment trusts are invested(as of end-March 2011)
Country/region
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

As End-March 2011

Share

(RMB mn)(%)

Hong Kong
US
Korea
Australia
UK
Singapore
TaiwanIndia
Indonesia
Thailand
Malaysia
Japan
CanadaFranceChina

31,873.44
6,188.14
2,979.01
2,873.82
2,112.58
1,309.41
1,209.68
1,095.18
582.49526.56469.48361.09262.77154.31
90.50

60.97
11.84
5.70
5.50
4.04
2.50
2.31
2.09
1.11
1.01
0.90
0.69
0.50
0.30
0.17

Total

52,276.71

100.00Note: 1. Data derived from 30 stock investment trusts, excluding those managed by HuaAn FundManagement Co., Ltd. Only data for top 15 countries/regions shown.
2. The total is slightly erroneous because of differences in the way the data for each fund arecollected.
Source: Nomura Institute of Capital Markets Research, from Shanghai Wind Information Co., Ltd.
data5). In fact, although this may be referred to as "outward portfolio investment," thecompanies whose shares these funds have invested in are Chinese companies listed on
the Hong Kong Stock Exchange.

2. Investment in Japanese equities by China's QDIIs
RMB360 million (roughly ¥4.6 billion, i.e., 0.69%) of these equity holdings
consisted of Japanese equities. This marks an increase from end-2010, when the
figure was RMB290 million (roughly ¥3.6 billion, i.e., 0.53%)12. Since these fundmanagement companies benchmark most of their QDII products to global stock
indices such as the MSCI, their holdings of Japanese equities had never exceeded 1%of their equity holdings. However, it is noteworthy that they increased their exposure
to Japanese equities after the earthquake that struck Japan on 11 March 2011.
As of end-March 2011, seven companies offered exposure to Japanese equities
through a total of eight QDII products. The company with the largest holdings inJapanese equities was China Asset Management Co., Ltd. (ChinaAMC), China's
largest fund management company. Its holdings of Japanese equities increased from
RMB201.37 million as of end-2010 to RMB300.75 million as of end-March 2011, an
12

We have converted amounts in renminbi as of end-2010 to yen using the mid-rate on 31
December 2010 (RMB1 = ¥12.3).

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Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

increase of some RMB100 million. Perhaps not surprisingly, ChinaAMC's parent andChina's largest securities company, CITIC Securities, has had close ties with Japan's
financial sector ever since the introduction of market-oriented reforms in China in
1978. Just as overseas investors have been net purchasers of Japanese equities since
the US Treasury Department announced its second round of quantitative easing (QE2)
in the first week of November 2010, the indications are that China's QDIIs have been
following suit.

3. Lessons for Japan
CIC has also been in the news with regard to investment in Japanese equities inconnection with the earthquake that struck Japan in March 2011. For example, on 23
March 2011, Securities Times Online reported that Wang Jianxi, Executive Vice
President of CIC (see above), had said the day before about a report in the Wall Street
Journal (namely, that CIC had invested ¥35.9 billion in Tokyo Electric Power
Company (TEPCO)) that the investment had actually been considerably less than
¥35.9 billion and that CIC's policy was to invest in a diversified portfolio ofinternational stocks benchmarked to a global index. However, Mr Wang apparently
did not give any exact figures. Similarly, Securities Times Online reported that Mr
Wang had said about another report in the same Wall Street Journal article (namely,that CIC had invested ¥522.2 billion in 10 leading Japanese companies, including
Canon and Sony) that the actual investment was only a fraction of that amount andthat CIC was careful about the timing of its Japanese investments and did not react toevery short-term change of market direction.
In addition to investments in Japanese equities by Chinese QDIIs, moves toincrease CIC's capital or to establish a second fund for investing China's foreignexchange reserves should be seen as possibly giving the Tokyo stock market a boost
and as requiring Japanese companies to foster their relations with Chinese investors.
We shall continue to monitor China's moves to improve how it manages its foreignexchange reserves.

Moves by China to Improve How It Manages Its Foreign Exchange Reserves

10