Thursday, April 05, 2007

A friend of mine commented that some inflation problem may be on the horizon.  I don't quite agree,
but I do agree that the new FX fund may cause a huge problem down the road. My position, which
I outline below, is that the FX fund does not need to be so huge (projected 200 billion USD). This huge
fund would be a giant moving target for corruption, would concentrate risks, and would hold the government
hostage. I just can't think of any sound reason why the fund needs to be so big. Below is my email.

As always, I love the bearish analysis, though I would not call Xia Bin a "senior official." He is
mainly a scholar who likes the media a bit too much. I suspect that is one reason why he was not
chosen for the monetary policy committee. In any event, investment is a bit higher than what the
authorities would like, but they can keep M2 under control through sterilization. There may be one
or two more rate hikes this year, if it comes to that. Also, let's not forget that at the end of
the day, the State Council can still coordinate another investment crackdown, although its
effectiveness is increasingly short-lived. I still don't see a huge inflation problem on the horizon.

On bonds issued by the new fx entity, I suspect they will raise the money over a year or more and
coordinate it with PBOC sterilization to minimize disruption to the money supply. They don't
want an expectation of sudden monetary contraction, which may put the stock market on a tailspin.

I completely agree with you about the rates of return of the new entity though. It would be hard for
the new entity to earn returns that match the sum of its own bond yield and RMB appreciation.
Also, by putting all their eggs in one basket, the new entity will be a huge moving target for
all kinds of corruption and insider trading schemes. In my opinion, they probably should have
formed multiple investment funds under MOF and Huijin supervision. The funds could have then
competed with one another for the best performance. With one fund, the central government is
held hostage by it, and would have to do whatever it takes to bail out the fund in order to
maintain international confidence in China. In any event, I don't even think I have seen a
good justification for setting up such a large fund.

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