ANALYSIS - China's FX reserves, outbound investment and Rio

A woman looks at U.S. one dollars notes on display in Hong Kong in this November 2007 file photo. Overshadowed by a sparkling economic report card for the second quarter, last week's leap in China's official currency reserves is yet one more reason to bank on a transformative surge in its direct investment abroad.

BEIJING (Reuters) - Overshadowed by a sparkling economic report card for the second quarter, last week's leap in China's official currency reserves is yet one more reason to bank on a transformative surge in its direct investment abroad.

But the diplomatic storm whipped up by charges levelled by Beijing against four employees of Anglo-Australian miner Rio Tinto shows just how bumpy the journey overseas may be if it triggers a backlash against Chinese interests.

China has long been scouring the globe for energy and commodities to feed its thrumming economy.

What is new is a determination by the leadership to ramp up outbound foreign direct investment (OFDI) as it weans the economy off low-value, export-orientated manufacturing.

Last month's deal by Sinopec, the country's largest oil refiner, to buy Swiss oil explorer Addax for $7.24 billion was China's largest overseas acquisition yet.

The government is not throwing caution to the winds. Beijing blocked Bank of China's purchase of a stake in French bank Rothschild and has responded tepidly to a bid for GM's Hummer unit by Sichuan Tengzhong, a little-known machinery maker.

But the first half of 2009 may prove to be an inflection point for Chinese OFDI, said Daniel Rosen, a visiting fellow at the Peterson Institute for International Economics in Washington.

"Despite short-term anxieties, Chinese OFDI is poised to grow markedly in the medium and long term, and the importance of these investments to Chinese firms is changing fundamentally as the nation confronts the need to rebalance its growth model," Rosen wrote in a paper co-authored with Thilo Hanemann.

With domestic economies of scale largely exhausted, firms will have a powerful incentive to move abroad to upgrade their manufacturing and to compete for the more valuable parts of the production chain such as distribution, design and branding.

"Made in China" will increasingly give way to "Made by China -- abroad," Rosen and Hanemann argue.

MONETARY HEADACHE

On top of the commercial motives, greater capital outflows would temper the difficulty of conducting monetary policy by reducing China's overall balance of payments surplus.

Because the People's Bank of China buys most of the foreign currency entering China to cap the yuan's exchange rate, every dollar that can be recycled abroad as OFDI is one dollar less that the central bank must buy for yuan and add to its reserves.

Those reserves jumped $177.9 billion in the second quarter to $2.13 trillion, helping to generate record credit and money supply growth that economists fear is creating asset bubbles.

"We don't know what the right amount of domestic monetary creation is but it's pretty safe to say it's much much lower than the increase in central bank reserves," said Michael Pettis, an economics professor at Peking University.

Hence the significance of new rules issued last week by the government that will make it easier for firms to fund OFDI.

"On top of China needing to invest -- they need to secure energy supplies, they need to acquire technology -- there's also the element of recycling dollar revenues," said Qu Hongbin, chief China economist with HSBC in Hong Kong.

China's OFDI has increased steadily this decade and last year's outflow of $52 billion was a record.

Still, the stock of OFDI -- $170 billion -- is puny next to China's foreign exchange reserves and its inward FDI stock of $876 billion.

China's per-capita OFDI was $70 in 2007, bigger than India's $25 but dwarfed by America's $9,300 and Germany's $15,000.

Qu, however, believes outflows could reach $100 billion to $150 billion a year as soon as 2012. Rosen, in an email, said that sum was "entirely conceivable" if there is no political interference from Beijing.

LEVEL PLAYING FIELD

Rosen and Hanemann identify four areas where progress, now blocked by the state's reluctance to take its hands off the economy, are needed to promote OFDI.

The government must completely pull back from firms' investment decisions; it must further liberalise access to foreign exchange and OFDI funding; it must let all firms invest overseas; and it needs an OFDI strategy that serves China's long-term interests: defending pariah states where China has invested hurts the image of the country's firms among consumers.

Similar reputational damage is where the detention by China of Rio's chief negotiator in fractious iron ore pricing talks, Australian Stern Hu, may dim China's ambitions to expand abroad.

The perception that Beijing is exacting revenge on Rio for being outsmarted in the ore talks risks hardening attitudes far beyond Australia.

After all, critics already complain that foreign firms in China cannot trade and invest on a level playing field. So why should the West roll out the welcome mat for Chinese investors?

Pettis said he expected OFDI to keep growing despite "political noise" generated by trophy transactions, but he acknowledged that Chinese attitudes towards overseas investors would hardly endear foreigners to Chinese capital.

"It's too easy if you are opposed to a Chinese acquisition to point out the things that have happened here in China," he said.

The "callousness" with which Beijing has blocked some inward investments raises questions about its seriousness towards cross-border investments both ways, Rosen and Hanemann said.

Yet the implications of the Rio case are not clear-cut.

The charges laid at Rio's door reflected China's immaturity on matters of commercial regulation, Rosen added in his email.

"On the one hand, that immaturity is an impediment to cross-border investment flows both ways. But on the other, and somewhat counter-intuitively, it is one of the reasons China is so attractive as an investor and as a place to invest," he wrote.