The much hyped State investment company set to be launched faces multiple challenges ranging from establishing transparent management under laws as yet to be written to showing solid financial gains.

Zhou Xiaochuan, governor of the People's Bank of China the central bank revealed during the National People's Congress session that policymakers are tapping new channels to expand the investment scope of the country's huge foreign exchange reserve.

Hu Xiaolian, head of the State Administration of Foreign Exchange (SAFE), also said that the State investment company will be established this year, although details are yet to hammered out.

The new company is expected to be under the direction of the State Council, China's Cabinet, while professional managers will handle the reserve fund.

Most of the world's state foreign exchange investment companies, such as Singapore's Temasek Holdings, have had only a limited scale of investment funds.

In contrast, in China, even if the company's initial fund is $200 billion, as the market expects, and it is not increased, it will be the largest investment company in China.

Moreover, the fund is expected to grow.

Such a large scale fund will attract attention from the international market. The managers of the fund must be adept at maneuvers in the international capital market and familiar with global economic growth trends.

The managers will undoubtedly face pressure for proper management. The new company will also face pressure for earnings.

The company is expected to sell bonds in the market to buy foreign exchange funds from the central bank. It will then use the foreign exchange fund for investment. The goal obviously is to have a higher rate of return on investment through professional management.

The cost of its capital, however, could reach 10 percent if taking possible renminbi revaluation into consideration. Given the cost level, it will be a challenge for the company to hire top professionals and establish a transparent information disclosure system to raise investment returns.

International experience shows that the foreign exchange reserve should be diversified to satisfy different policy strategies.

For China, as it manages its reserve fund, it is necessary to divide it into three categories: investment with high liquidity to prevent risks, earnings-targeted long-term assets and assets aimed at long-term value.

Considering the huge scale of the reserve fund, China needs to further clarify the fund's different functions. Meanwhile, a rational fund allocation regime should be established.

The establishment of the State investment company can reduce the hedging pressure on the central bank and will have a positive effect on China's monetary policy.

However, as the company issues bonds to purchase foreign exchange, it actually involves a transfer of policy costs from the central bank to the fiscal departments as the company is a State establishment and the State is the de facto guarantor for the bonds.

The issuance of the bonds will have a positive impact on the domestic bond market, possibly improving its structure.

Meanwhile, many foreign investors, especially US-based ones, will pay close attention to the new company. They will care about whether the reserve fund used for investment will be funded through selling China's US treasury bonds on the US market or by transferring China's newly increased reserve.

Moreover, if the United States does not open some of its markets that have been off-limits, there will not be much investment from the State company flowing into the US market.

Currently, the legal framework for managing the foreign exchange reserve is yet to be updated.

The law governing the People's Bank of China has relevant articles but they are only general principles.

The regulation of foreign exchange management, on the other hand, has no stipulations on management of the foreign exchange reserve fund and needs to be amended.

The lack of legal clarification may stem from the misconception that the reserve is a free lunch and needs no detailed regulation.

Therefore, relevant legislation needs to be in place and a stricter management regime needs to be established to govern the fund's management. China's foreign exchange reserve management regime has been improving in recent years. Starting last April, the central bank has reformed policies on foreign exchange accounts under the current account, service trade settlement and individual purchasing of foreign currency.

As a result, procedures for individuals to purchase foreign currency have been simplified. The limit on corporate foreign exchange accounts under the current account has been eased. And enterprises with real need for foreign exchange have been allowed to make purchases without prior approval.

Regarding capital outflow, the central bank, the banking regulatory commission and SAFE released a regulation last April. It allows domestic institutions and individuals to invest overseas through domestic commercial banks. SAFE later further expanded the scope of investment channels for domestic institutions and individuals to invest overseas.

Such policy changes marked a shift from the past practice of strictly controlling capital outflow to promoting balanced capital flows.

The author is a researcher with the Development Research Center of the State Council

(China Daily 03/23/2007 page10)