China revealed last week that it is planning to set up an investment agency to manage a substantial portion of its massive foreign currency reserves. The new agency is expected to based on Singapore's Temasek Holdings, the Singapore Government's investment arm. As an investor, Temasek has been an excellent government entity. It has been estimated that Temasek has managed only a 3% annual return in it's 30 year history, making it worse than simply leaving the money on deposit at a bank. Their recent aquisition of Shin Corp in Thailand has managed to become a money losing diplomatic incident, which is pretty good for an investment company but not for its shareholder. Until recently Temasek (in theory, owned by the people of Singapore) didn't even disclose it's results.

But what does it mean for China? In the early stages, probably not much more than some accounting shuffling. Firstly, this is not new money - it already sits in SAFE's accounts. Most likely is this new agency will "buy" stakes in key Chinese companies. But in order to prevent an inflationary boom the money from this purchase will be steralised through the issuing of bonds. Secondly this is a political wheeze. These reserves earn 4 or 5% a year by sitting in US Treasuries. Politicians want better returns on these funds through investment. But do they really? China's problem (politically, at least) is it already generates too many US dollars. It has a quasi-fixed exchange rate and while China saves and makes more than the Americans, the Americans will continue to pay for both with their dollars. While the PBoC wants only a slow appreciation in the yuan and while China's capital account remains largely closed this can only continue. Thirdly, what else can this new agency invest in? They could diversify into other currencies, but again there are problems. The main one is that most of China's trade is denominated in US dollars. Any moves into other currencies will have major market impact and would ruin the PBoC's efforts to contain the rise in the yuan. Also, remember the fuss when a Chinese firm (CNOOC) tried to buy a middle-tier American oil firm (Unocal)? Imagine the response if it was China's official investment agency doing the buying.

So while this all sounds good and exciting, especially for investment bankers, I suspect the reality is going to be rather different to the expectations.