China's $1.2 trillion cash hoard

(Fortune Magazine) -- China, Long recognized as the world's factory, is earning a new distinction: America's banker. As it continues to suck in foreign investment and crank out exports, the world's fastest-growing economy is piling up foreign currency, mostly dollars, at an astonishing rate.

In April, China's central bank stunned economists with the disclosure that, in the first three months of the year, China had added $136 billion to its official foreign-currency reserves, more than double the increase in the previous quarter. The influx boosted China's foreign reserves to $1.2 trillion - an Everest of money that towers over reserves held by any other nation.

U.S. Treasury Secretary Henry Paulson and Chinese Vice Premier Wu Yi.

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Beijing's burgeoning foreign-cash pile is a consequence of its effort to boost exports by fixing the value of its currency, the yuan, to the U.S. dollar. To keep the yuan from appreciating too quickly, the central bank buys up dollars brought to China by foreign investors and Chinese exporters. Then the bank issues bonds to mop up the yuan it has paid for those dollars, thus warding off inflation.

It's a complicated arrangement, made more so as the sums in question soar. By any sensible measure, Beijing's stash is excessive. James McCormack, an analyst at Fitch Ratings, the credit agency, calculates that at the end of 2006, China held reserves worth nearly nine times its short-term debt, or 14 months of imports. China's reserves exceed even the most dire estimates of bad loans held by the nation's banks.

But managing this hoard is a growing headache. In Internet chatrooms, Chinese have begun asking why Beijing can't use the money to build schools and hospitals rather than to prop up the U.S. dollar. Policymakers, meanwhile, fret that the reserves are earning poor returns.

In March, Finance Minister Jin Renqing announced plans to launch a new investment fund charged with managing the reserves in a more profitable and efficient manner. The fund is to be led by Lou Jiwei, a respected former finance vice minister. But nearly everything else about it - including how much money it will control and where it will invest - remains a mystery.

Word of the fund provoked consternation in financial markets. "There's a new fin in the water, and no one knows whether it's a great white, a [harmless] basking, or [some other] species of shark," wrote Standard Chartered Bank economist Stephen Green in a note to clients. China's new fund "will be huge, and it could move markets, blowing up well-thought-out trades with the touch of a bureaucrat's button."

Chinese press reports suggest that the fund will be modeled on Temasek, the Singaporean government's investment arm, and entrusted with as much as $300 billion. That's three times the size of Temasek and ten times larger than the world's largest hedge fund. With that much under management, the fund could buy up Wal-Mart (Charts, Fortune 500) and have enough left over to pick up General Motors (Charts, Fortune 500) and Ford (Charts, Fortune 500).

Many analysts expect that the new fund will look for ways to lighten China's holdings of dollar-denominated assets, particularly low-yielding U.S. Treasury bonds. At the end of 2006, China held $350 billion worth of T-bills. Fitch estimates that China holds another $230 billion in bonds from government-backed agencies such as Freddie Mac (Charts, Fortune 500) and Fannie Mae (Charts).

Others predict the fund will bankroll efforts of state-owned resource giants like Sinopec or CNOOC to secure oil, gas, coal and other raw materials abroad. But Arthur Kroeber, editor of the China Economic Quarterly, argues that Beijing will find it difficult to achieve either goal. Few assets offer the depth and liquidity of T-bills. And any effort to finance acquisitions by Chinese companies risks igniting the sort of controversy that scuttled CNOOC's bid for Unocal. "As a practical matter," warns Kroeber, "a state-controlled fund of this size will face problems nearly every way it turns."

Some U.S. lawmakers have expressed concern that China might exploit its status as a major buyer of U.S. Treasury bonds to gain leverage in trade or foreign-policy disputes. But China itself would suffer from any redeployment of reserves that might undercut growth in the U.S., its No. 1 consumer. At his annual press conference in March, Chinese Premier Wen Jiabao acknowledged the immense foreign reserves as a "new problem for us." But he went out of his way to assert that the new fund's first principle would be to do no harm. "China's formation of an investment company for its foreign-exchange reserves will not affect U.S.-dollar assets," he said.

In a recent letter to Senator Richard Shelby (R-Alabama), U.S. Fed chairman Ben Bernanke said much the same thing, arguing that Beijing couldn't damage the U.S. economy by selling bonds or boycotting Treasury auctions because "foreign holdings of U.S. Treasury securities represent only a small part of total U.S. credit-market debt outstanding." Bernanke also said that the Fed could adjust interest rates.

Even so, China's dollar mountain seems sure to grow if exports maintain their recent pace. China's global trade surplus jumped $46 billion in the first quarter; its surplus with the U.S. topped $232 billion in 2006.

The fuss about China's reserves could blow over if, as UBS economist Jonathan Anderson predicts, higher wages, rising inflation and gradual appreciation of the yuan curb export growth. But that's a minority view. Standard Chartered's Green sees continued trade surpluses and expects China's foreign-currency holdings to grow at a rate of about $20 billion a month. Credit Suisse economist Dong Tao says China's foreign reserves could top $2 trillion by the end of next year.

Treasury Secretary Henry Paulson will have a chance to ask how much longer Chinese leaders think this wad of dollars can keep growing when he welcomes a delegation led by Vice Premier Wu Yi to Washington, D.C., in May. For now, however, perhaps the sign on his desk should bear a modern alternative to Harry Truman's favorite motto: The buck stops ... in Beijing.