China's financial integration into the world economy progressed rapidly between 2004 and 2010, mostly through accumulation of reserve assets and direct investment. A study of China's international investment position, an important holistic indicator of the extent of its financial integration into the world, sheds light on the strategy and motivation behind China's growing importance in the global financial system.

China's overseas assets and liabilities both grew strongly during 2004-2010. Its net foreign assets increased more than six-fold from $276.4 billion in 2004 to $1.79 trillion in 2010, which translates into 36.5 percent compound annual growth rate (CAGR).

This was primarily driven by the growth of reserve assets, which increased at 29.5 percent CAGR during the same period. China ranks among the world's major creditors in contrast to the United States, which had an external net debtor position of $2.47 trillion in 2010.

By component, reserve assets represent the lion's share of China's total assets, with the share fluctuating between 65 and 70 percent. The second largest component on its assets side is "other investment", which comprises trade credits, loans, currency and deposits and other assets, accounting for 16 percent of the total assets in 2010.

The stock of outward portfolio investment (6 percent of total assets) exceeded that of inward portfolio investment. In the case of direct investment, the opposite was true: the stock of inward foreign direct investment (FDI) far exceeded outward direct investment (ODI), which made up 7.5 percent of the total assets.

The profile of China's international investment position can be characterized as "long debt, short equity". While this phenomenon is not unusual among emerging markets with capital flow restrictions for residents, the return differential between equity and debt carries a cost. Specifically in China's case, its sizeable holdings of foreign governments' debts mean that it pays more on its equity liabilities (that is, inward FDI) than it earns on its debt assets. In addition, China is vulnerable to credit risks such as the downgrade of developed markets' sovereign debt ratings.

The medium-term path of China's foreign reserves depends on how much progress is made with rebalancing the economy and reducing excessive net savings. This requires domestic reforms to increase household disposable income and strengthen the pension system and banking sector in order to boost domestic consumption on a sustainable basis.

Chinese policymakers will surely weigh the trade-offs in foreign reserves accumulation. A global slowdown will not be conducive to slower foreign reserves accumulation, though a further rise in domestic inflation may work in the other direction.

Portfolio investment trends are likely to be more evolutionary than revolutionary in China. The track record of inflows as well as outflows of portfolio investment suggests that China's approach is gradual and one of learning-by-doing. In such a situation, "big bang" liberalization is highly unlikely, because the authorities will carefully weigh the pros and cons of further liberalization against monetary policy objectives and global financial market conditions.

Nevertheless, a more liberal regime is possible in the medium term, given China's ambition to further internationalize the yuan and to make Shanghai an international financial center by 2020.

China's direct investment abroad is poised to increase further. In terms of flows, ODI grew much faster than FDI inflows from 2005 to 2010, but inflows made up 8.5 percent of the world's total while outflows accounted for only 4.5 percent in 2010. The top targets for China's ODI have been the mining, computer and electronics, oil and gas, and financial services sectors during the past 10 years. And inflows and outflows of direct investment both are poised to expand in the medium term on the wings of government support.

Looking toward 2015, the gross size of China's international balance sheet in assets and liabilities is set to grow strongly. The factors that will influence the speed of growth and the composition of the foreign assets will be, first, the strength of the global economy, and second, the orientation of China's growth drivers.

In an ideal scenario whereby the world economy gets back on a sustainable growth path and China's rebalancing effort toward consumption-driven growth makes good progress, its current account surplus will narrow down, leading to less pressure to accumulate foreign reserves.

In such a scenario, the authorities will be more comfortable to proceed with capital account liberalization in view of the benign external environment and the goal to advance the international status of the yuan. And outward portfolio investment will gain pace alongside China's "Going Global" initiative for direct investment.

In a double-dip global recession scenario whereby the world's major economies slip back into recession, possibly a prolonged one, China's rebalancing efforts would proceed more slowly because the priority would shift from controlling inflation to sustaining a reasonable level of growth.

If that happens, China's current account surplus could still narrow down because export growth is expected to slow, while import growth may not slow as much because of the ongoing massive investment in infrastructure in the inland provinces. Progress on capital account liberalization, however, is likely to be slower because of higher risk in global financial markets. And portfolio investment outflows are expected to slow as well owing to higher investors' risk aversion.

In conclusion, China's net foreign asset position is set to grow in the medium term. The question on the speed of growth and the composition of assets will depend on the global environment and progress of China's domestic reforms.

China's financial influence in the world has already increased tremendously in the past decade. If and when its capital account is fully liberalized and portfolio investment flows are free, China's financial integration and its financial influence will reach even greater heights. But the associated costs will be less autonomy in monetary policy and higher vulnerability to global contagion.

The authors are senior economists at Deutsche Bank.

(China Daily 12/15/2011 page9)