China Encouraging Overseas Investment To Take The Pressure Off Of Its Currency, The Yuan

China, for the first time in 17 months, allowed mutual fund companies to resume purchases of foreign assets through its Qualified Domestic Institutional Investors (QDII) program. The government’s decision to allow funds to invest overseas shows Beijing is confident in the global economy, but concerned about the value of its currency, the yuan.

E Fund Management Co. Ltd., China’s fifth-largest mutual fund company, and the smaller China Merchants Fund Management Co. Ltd. both obtained investment quotas from the State Administration of Foreign Exchange (SAFE). SAFE approved $1 billion in investment for E Fund and $500 million for China Merchants. That means both funds are now free to invest in offshore markets such as stocks and bonds.

While the quotas aren’t particularly large they mark a significant shift in policy within the central government, which hasn’t issued a quota since May 2008. The move provides an outlet for so-called hot money inflows - short-term speculative funds in search of quick profits - as well as the government’s massive trade imbalance.

China’s foreign exchange reserves rose by $141 billion in the third quarter to $2.27 trillion in September. Combined with the trail of hot money that has followed the economy’s recovery, China’s forex holdings are pressuring the yuan to rise - something that would hurt the nation’s export sector.

“In order to keep the nominal exchange rate stable, the government has to allow more capital to flow out,” Wang Tao, chief China economist at UBS Securities told the Financial Times. “But they want to encourage outflows in a controlled way and as long as they have some kind of upper quota they will not be able to fully offset the appreciation pressure from inflows.”

For that reason many analysts believe that this marks a turning point for the QDII program, which could see a spike in activity.

“I won’t call it the opening of the floodgates but an opening of the window,” said Peter Alexander, Shanghai-based principal at Z-Ben Advisors. “This move is very much in line with other recent policy initiatives, which clearly stepped up support for the globalization of Chinese businesses.”

Alexander estimates that as many as 16 other domestic mutual funds are awaiting SAFE’s QDII quota approval.

“This is the outcome of a marked shift in China’s policy,” he said.

As of May 2008, SAFE had approved 56 QDIIs with a total quota of $55.95 billion in investments. However, just $28.71 billion, or roughly half of that amount, was remitted abroad.

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