China's Rich Bet on the Yuan

Burgeoning foreign reserves signal that the country's citizens are optimistic and bringing their money back home.

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China's stockpile of foreign exchange reserves has now reached $3.44 trillion, which was a $128 billion increase in the three months to March and swells the nation's overseas currency coffers to about the size of Germany's economy.

But while many analysts simply view China's hoard of overseas assets such as U.S. Treasury bonds as a signal that it basically owns America, these numbers are also a fascinating snapshot into what Chinese business people think of their own economy and its future prospects.

Why? Because there is a strong relationship between forex reserve increases and Chinese exporters choosing to bring the foreign currencies they have earned abroad back home to swap them for yuan, instead of keeping this money from their overseas sales in bank accounts outside China.

When these companies bring money back into China, that threatens to increase the value of the yuan. China needs to keep its exports cheap, so its central bank tries to suppress the currency when it threatens to rise too much. Part of this process entails the central bank buying foreign assets .

According to Qinwei Wang of London consultancy Capital Economics, around $100 billion of capital flowed into China in the first three months of this year.

"And the majority of this net inflow can be explained by Chinese firms bringing money home and swapping it for renminbi," he tells Quartz. "That suggests they are more confident in the economy after China did not experience the hard economic landing that many predicted in 2012."

The estimated $100 billion inflow also marks a massive change in sentiment. During the second half of last year, money cascaded out of China as analysts predicted the nation's credit fueled economy would crash and the change in the Communist Party's leadership made the wealthy extremely nervous about their assets being seized. Instead of investing their riches at home last year, China's 1 percent were buying condos in the Cayman Islands and spending big on their kids' tuition fees abroad.

Wang also says the net $100 billion inflow is the largest China has experienced since the last three months of 2010. No wonder, as this chart courtesy of Nomura shows, the central bank has been purchasing loads and loads of financial assets denominated in foreign currencies. That is a big change from last year, when China's forex purchases were rather muted.

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Wang came up with his $100 billion net inflow figure by first estimating that the Chinese central bank purchased $150 billion of foreign exchange assets in the first quarter of this year. He then calculated capital inflows by subtracting from the $150 billion around $74 billion, for foreign direct investments ($30 billion) and China's trade surplus ($44 billion) during the first three months. He added back another $25 billion that Chinese firms invested overseas during the period.

The changed mood within China about the country's prospects does not entirely make sense. Earlier this week, credit ratings agency Fitch downgraded China's creditworthiness based on undisclosed risks building up in its financial system. China's debt has probably reached almost 200 percent of GDP and the nation is gripped by a credit bubble.

That said, the credit bubble has also caused the price of assets such as real estate to rise sharply. So China's businesspeople are probably happily profiting from that trend.

It is also worth noting that the Chinese investment outlook tends to be volatile. There is also no guarantee China's wealthy will stay confident.

"Chinese investors are often short-term and incident driven," Fraser Howie, the co-author of Red Capitalism, a book on China's financial system, tells Quartz. "There isn't a lot of buying on the idea of long-term economic fundamentals. So foreign investors also need to take a very short term view. Think months, not years."

International investors also should not expect the yuan to rise significantly because money is flowing back into China. As the central bank has proven so far this year, it is willing to spend big to stop that from happening. Multinationals have for awhile been leaving China for cheaper manufacturing bases in South East Asia. Beijing cannot afford the extra job losses allowing the currency to appreciate further would entail.

And now that China's central bank is stockpiling forex, it may return to facing an old dilemma about how to invest the money. Returns on government debt such as US Treasurys are meager, so China will likely lend its trove to state entities and companies to invest abroad. People with foreign companies to sell are rubbing their hands together in glee. "I am expecting to see more M&A involving Chinese buyers paying silly prices," a Hong Kong-based manager of a European private equity fund tells Quartz.