How to spend a trillion dollars

China has moved a step closer to diversifying its US$1.07 trillion in foreign reserves, with the yet-unofficial appointment of two senior officials to head new vehicles that will seek to invest a portion of China's reserves, which are the largest in the world.

According to The Standard:

Guo Shuqing, chairman of the third- largest lender, China Construction Bank, is tipped to become head of a new state-owned investment company that will adopt Singapore's Temasek model, China Business Post reported Saturday.

Vice Minister of Finance Lou Jiwei will head a separate investment company - the State Foreign Exchange Investment Co, modeled on the Government of Singapore Investment Corporation (GIC) - that will handle one fifth of the foreign reserves.

Both men would operate under the State Council (China's cabinet) and report to Premier Wen Jiabao.

Under the plan, China seeks to move approximately $200 billion of its foreign reserve holdings out of low-yield investments such as US Treasuries and cash and into higher yield, more strategic assets such as stocks, corporate acquisitions, bonds, natural resources, or even real estate. Chief among China's concerns is that as the yuan is allowed to float more freely, the dollar will inevitably decline and is expected to do so to the tune of 5% this year. Consequently, all dollar denominated assets will decline in yuan terms, and the central bank would incur a net loss on these assets.

In seeking to diversify it's foreign reserve holdings and managing them for growth rather than loss-prevention, China follows a growing trend among central banks such as those in Singapore, South Korea, and Norway. Currently, it is estimated that dollar-based assets comprise about 60% of China's foreign reserves, Euros 30%, and most of the remaining 10% is denominated in British Pounds and Japanese Yen.

According to the Wall Street Journal,

[In recent years], China has added to its foreign reserves at a rate of $20 billion a month -- largely because China's successful exporters are bringing in huge amounts of dollars, which the central bank then buys to keep the yuan's exchange rate with the dollar steady.

The most obvious affect is a likely rise in US interest rates, which would be detrimental to the highly indebted US consumer and flagging US housing industry, which is heavily dependent upon cheap money from China. Further on, the Wall Street Journal writes:

Even a slight shift of this type could have a significant impact in U.S. markets. China has long been one of the biggest buyers of Treasury notes, making it in effect a major lender to the U.S. government. China's buying has helped keep interest rates low in the U.S.: The greater the demand for a country's bonds, the lower the interest rates the country needs to offer.

China hasn't publicly discussed its strategy yet. In late January, Premier Wen Jiabao said only that China will "strengthen the management of foreign-exchange reserves and actively explore and expand the channels and methods of using the reserves."

The International Herald Tribune adds that the

Ministry of Finance (MOF) is planning to issue yuan-denominated bonds to raise funds that will be used to "buy out" as much as $200 billion from the country's foreign reserve pool...both the establishment of the investment arm (National Foreign Exchange Investment Company) and the issuance of bonds are expected to be on the agenda of the NPC's annual session, which begins next month.