Recent data from the State Administration of Foreign Exchange shows that in 2013, China's outbound investment income deficit was $59.9 billion, an increase of 70% over the previous year.

This set of data has once again sparked discussions among industry insiders about the structure of China's external assets and liabilities. "It is clear that the problem lies in the asset-liability structure, but it cannot be reversed overnight, and there is no need for excessive hype. The diversification of foreign exchange reserve investments is currently underway," said a person close to the foreign exchange management department.

The so-called asset-liability structure mainly refers to the fact that China's external assets are dominated by foreign exchange reserve assets, while external liabilities are dominated by equity-type (FDI, equity warrants) liabilities, i.e., mainly attracting foreign investment through equity-type liabilities and conducting debt-type investments abroad through foreign exchange reserves. The investment return gap between the two is nearly 20%, which is the fundamental reason for China's persistent outbound investment income deficit.

To adjust the asset-liability structure, the current consensus is to increase the amount of corporate outbound direct investment (ODI) and improve capital returns; however, there is still some disagreement in academia regarding capital account liberalization.

$59.9 Billion Foreign Exchange Reserve Income Deficit

Recently, the balance of payments statement for 2013 released by the State Administration of Foreign Exchange shows that the net difference between China's income from capital outflows (covering foreign exchange reserve outbound investment and outbound direct investment) and the profits earned by foreign direct investment (FDI) in China in 2013 was -$59.9 billion, the second highest in 30 years, second only to -$85.3 billion in 2011, and an increase of 70% over 2012.

China is recognized as the world's largest creditor. As of the end of December 2013, the reserve assets held by the People's Bank of China [Weibo] were $3.88 trillion, and net external assets were $1.97 trillion. However, the $1.97 trillion in net assets resulted in an investment income deficit of $59.9 billion, with an investment return rate of -3%.

In its 2013 balance of payments report, the State Administration of Foreign Exchange attributed the $59.9 billion investment income deficit to China's external asset-liability structure: "It mainly reflects the structural problems of China's external assets and liabilities. The income from foreign investment in China during the period increased by 23% over the previous year."

According to calculations by Guan Tao, Director of the Balance of Payments Department of the State Administration of Foreign Exchange, from 2005 to 2012, China's average outbound investment return was 3.3%; according to calculations by the National Balance Sheet Research Group of the Chinese Academy of Social Sciences, the average return spread earned by overseas FDI in China was 22%, and even higher in the United States.

Calculated this way, China's total foreign exchange reserves are $3.88 trillion, with annual asset returns of approximately $128.04 billion, while the annual returns on China's $1.5 trillion FDI are $330 billion.

Adjusting the Asset-Liability Structure through Multiple Measures

A person close to the regulatory authorities said that China's long-term negative investment income is structural and historically阶段性, related to the distribution of China's external financial assets in the central bank and liabilities in the private sector, and directly related to China's stage of economic development and economic policies. Even if it is not hopelessly entrenched, it cannot be reversed overnight.

Analyzing China's asset-liability structure, China's external assets are overly concentrated in reserve assets, and the investment return is far lower than the return on China's outbound direct investment; while the liability side is mainly FDI liabilities. If the huge foreign exchange reserve assets are not considered, China's private sector shows net external liabilities, mainly FDI net liabilities.

As of the end of 2013, China's net external assets were $1.97 trillion, of which foreign exchange reserve assets were close to $3.9 trillion. Excluding foreign exchange reserve assets, China's net external liabilities were $1.91 trillion, mainly reflecting the external liabilities of the private sector.

Based on research on the national balance sheet, the Chinese Academy of Social Sciences has suggested that to improve the current balance sheet structure, it is necessary to promote the holding of foreign exchange by the people, reduce the concentration of foreign exchange assets in official hands, and at the same time promote outbound direct investment by Chinese enterprises, especially private enterprises, thereby reducing the excessively high proportion of FDI net liabilities.

Professor Fan Gang, Director of the National Economic Research Institute of China, also said in a public speech recently that the main growth component of China's foreign exchange reserves is the capital and financial account, not the current account. If more capital can "flow" out, China's foreign exchange reserves may not grow as much.

According to a recent introduction by Guan Tao, from 2010 to 2013, the contribution rate of the current account surplus and the capital and financial account to foreign exchange reserves changed from a 70:30 split to a 40:60 split, and in the first quarter of 2014, the contribution rate of the two to foreign exchange reserves changed to 10:90.

"Compared with attracting foreign investment to support domestic economic construction, China should open its domestic capital market to a greater extent and attract financing through the bond market. The financing cost of the bond market is lower than equity financing; this is the law of the market," said a bond underwriter at a European foreign bank in China.

The person added: "This requires further opening of the capital account, but judging from recent actions by regulatory agencies, the bond market is gradually opening up to overseas investors, but the current share is still very low and insufficient to affect the asset-liability structure. A more direct way is to encourage more Chinese enterprises to invest overseas. However, given that Chinese enterprises lack experience in overseas investment and are at a low industrial level, there is still a large gap between the overseas investment returns of Chinese enterprises and those of developed countries."

In addition to encouraging enterprises to go global, the implementation of the Shanghai-Hong Kong Stock Connect is also promoting cross-border investment by individual investors.

In order to gradually diversify foreign exchange assets that are overly concentrated in official reserves, the mandatory foreign exchange settlement and sale system is also being gradually relaxed. Since 2009, the State Administration of Foreign Exchange has allowed enterprises to maintain appropriate foreign exchange balances and allowed overseas profits to be retained for direct overseas investment.

It is also worth noting that a new normal is emerging: two-way fluctuations in cross-border capital flows and the RMB exchange rate, which will also play an adjusting role in improving China's balance sheet in the long run. As China's current account gradually achieves balance and arbitrage and speculative funds decrease, China will gradually bid farewell to the era of rapid accumulation of foreign exchange reserves.

Some scholars believe that the most urgent matter in transforming the management of foreign exchange reserves is to reduce the balance of foreign exchange reserves as soon as possible, thereby reducing the passive situation in which foreign exchange management agencies passively manage foreign exchange and the official foreign exchange management logic is caught between asset safety and return balance.

Earlier this year, Yi Gang, Deputy Governor of the People's Bank of China and Administrator of the State Administration of Foreign Exchange, said that the huge foreign exchange reserves have exceeded the appropriate level, and continued increases are no longer cost-effective, as the marginal cost has exceeded the marginal benefit.

Financial Reform to Correct

In addition to encouraging enterprises to invest overseas, Professor Ding Zhijie of the University of International Business and Economics (Weibo) [Weibo] believes that RMB internationalization, capital account liberalization, and market-based interest and exchange rates are all aimed at correcting past distortions, which are one of the root causes of China's long-term unreasonable asset-liability structure.

Yu Yongding, Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, believes that capital account liberalization may not necessarily solve the current problems. He believes that the most critical thing is for the central bank to fade out of foreign exchange market intervention and solve the problems of arbitrage and speculative foreign exchange, and only then consider capital account liberalization, because at the current stage, capital account liberalization means more fluctuations in short-term capital inflows.

Previously, Professor Huo Deming of the National School of Development at Peking University also said in an interview that the conditions for capital account liberalization are difficult to achieve when interest rate differentials still exist at home and abroad; otherwise, short-term cross-border capital fluctuations will occur, affecting the stability of China's financial system.

Analyzing the policies currently implemented by regulatory agencies, 2014 should be a year of major breakthroughs in exchange rate reform: on the one hand, the depreciation of the RMB since February has provided conditions for expanding the daily trading band of the RMB against the US dollar, and the central bank announced the expansion of the band on March 17; on the other hand, the central bank and relevant agency heads have repeatedly emphasized that they will fade out of normal foreign exchange intervention and let the RMB exchange rate be more determined by the market.