Wednesday, 31 August 2011

Should China invest its forex reserves in Asian (including Indian) Bonds?

Bin Zhang of China Academy of Social Sciences writes this nice paper on the topic.

We calculate the return on the major Asian currency denominated long-term government bonds in terms of a basket of the People’s Republic of China’s (PRC) imports of goods and services, namely the real return on those assets from the PRC’s perspective. In the sample period of January 2002 to December 2009, the real return on United States (US) treasury bills is lower than that of Japan, India, the Republic of Korea, Singapore, or Thailand’s government bonds, and a little higher than that of Malaysia’s government bonds. This result shows that it is desirable for the PRC to substitute Asian currency denominated government bonds for US Treasury bills to maintain the purchasing power of its foreign exchange reserves. To some extent, this research supports the proposal by Fan, Wang, and Huang (2010) on the cross holding of regional currencies in foreign exchange reserves.

Hmm. The differences amidst real returns compared to US Treasuries are large:

over the period of January 2002 to December 2009, the average real return on longterm government bills of India, the Republic of Korea, Malaysia, Singapore, Thailand, and Japan. was 1.55%, 0.31%, -0.58%, 1.26%, 3.44%, and 0.45%, respectively. The average real return on long-term US Treasury bills over the same period is -0.06%. The average real return on long term Australian government bonds in the same period is 5.65%.

This is well-known that China gets very low returns from its forex reserves and is actually a flow of capital from Poor China to rich US. Hence, the oft-repeated suggestion is China should balance its growth and move from export-driven to internal demand economy. And limit investing in US bonds and instead invest in its own assets.

But this suggestion from Zhang to invest in Asian bonds is something I have read for the first time. However this is unlikely to work as well. First, the problem is Chinese forex reserves are huge and supply of Asian bonds unlikely to satisfy the demand. Second, none of the Asian markets are as deep and liquid as US. Third, not sure how many Asian economies allow active foreign investment in their bond markets. The lessons of East Asian crisis have been to not open debt markets so freely to foreign investment and they have been cautious on that front.

So yes financial return basis, investing in Asian bonds makes sense. Not sure how it will work out when we look at other parameters. The title of the post should actually be Can China invest in Asian Bonds?

by: Amol Agrawal


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