Everyone agrees that China’s economy must be rebalanced, but few have bothered to delve into the costs. Japan’s experience has shown that even well-meant changes could sow the seeds for a bubble.

China cannot stay with its current economic model forever. But as the economy has become extremely unbalanced, to some extent even more so than Japan’s in the 1980s, rocking the boat too much risks tipping it over. Instead of rushing into changes, it would be better to make reforms gradually.

Most observers believe an extremely loose monetary policy was the root cause of Japan’s bubble. But Tomo Kinoshita, an economist at Nomura, reckons that efforts to liberalise the economy, such as sharply revaluing the yen, developing a deeper bond market and deregulating interest rates were among the fundamental reasons behind the bubble.

The challenges facing China’s economy are similar to those seen in Japan in the 1980s. Foreigners are calling for a currency revaluation because the undervalued yuan gives China’s exports an extra boost. Capital markets need to play a bigger role because investment has been directed mostly by state-owned banks.

True, property price increases appear to be milder than in the Japan of the 1980s. Household loans only account for 30 percent of disposable incomes in China, versus about 90 percent in Japan in 1989, according to Nomura. But there are warning signs. New mortgages recently hit a record. And ratings agency Fitch has cited China’s property market as a cause for concern.

The Chinese stock market also looks less overvalued than Japan’s did. The ratio of Chinese stock prices to earnings is only a third of the peak levels reached in Japan. Stock market capitalization as a percentage of GDP is 62 percent, much lower than Japan’s 150 percent at end of 1989. But China is catching up fast, and the ChiNext market, China’s long-awaited Nasdaq-style market, debuted last week with a speculative surge.

Moreover, China has been more aggressive in terms of monetary easing as it tries to prop up the economy while waiting for exports to return. The broad money supply in China has been rising at almost 30 percent this year, twice as much as in Japan back in the 1980s. So if there is a bubble, it could grow bigger than the one in Japan.

Even much-needed efforts to liberalise and rebalance the economy may lead to asset price inflation. Similar to China, Japan’s banks were too big and small companies had trouble getting financing. So developing a corporate bond market and encouraging banks to lend more to small firms was seen as a healthy change.

But policymakers underestimated the negative impact on banks. After Japan developed a liquid corporate bond market, large corporations issued cheap equity-linked bonds to repay bank loans. Because Japanese financial institutions lacked other revenue sources, they targeted smaller corporations and consumers. Total bank loans made to small- and medium-sized companies and individuals rose to 71 percent of total loans in the late 1990s from 47 percent in the late 1980s.

Due to a lack of information on their new clients, the banks’ bad loans started to rise. Their lending standards deteriorated as they scrambled to make up for lost business. This could very well happen in China as the country encourages consumers to take on more debt to stimulate domestic demand.

Moreover, Kinoshita argues that in Japan interest rate deregulation “put a cat amongst the banking pigeons” because banks were forced to lend out more when their margins became compressed due to more competition. Pressure from the United States played a role, and the Japanese authorities were eager to internationalize the yen anyway. Letting banks set deposit and lending rates was one of the requirements for the yen’s internationalization.

The policy lesson for China is that when Beijing takes business away from banks, it needs to balance things out by allowing them to take on new business, such as securities underwriting and broking.

But that leads to the question of how to compensate securities firms for their lost business and prevent them from engaging in reckless behavior. This just underscores the complexity of China’s problems.

Most of the world believes that China risks moving too slowly, not too fast. President Barack Obama might give Chinese leaders another ear bashing during his upcoming trip to China. But without the right systems in place, big bang reforms could be disastrous. It is important that China, as well as the rest of the world, learns from Japan’s mistakes.

When it comes to protecting intellectual property in China, the United States often feels that its pleas are falling on deaf ears. Its best hope is that China recognizes that copyright protection is in its own interests. To achieve that, Washington needs to push for changes from within.

After a fruitless decade of lobbying China on intellectual property, Washington has reached for the microphone. This week, the U.S. Chamber of Commerce launched a high-profile international forum on intellectual property in Guangzhou, capital of Guangdong Province and best known as both China’s manufacturing hub and the global centre for intellectual property theft.

Guangdong understands it cannot hold on to both titles forever. Its reforming leader Wang Yang has vowed to build an innovative Guangdong, but he and his deputies understandably do not want to be criticized in public. The U.S. delegation included high-ranking officials such as Commerce Secretary Gary Locke, but the very man they hoped to engage with didn’t show up.

Foreign pressure can help, but changes rarely happen in public. First, both parties need to agree on what they are trying to achieve. As a manufacturer for the rest of the world, China has historically seen little upside in protecting copyright. The United States needs to convince Beijing that, if it wants to develop its own products, then protecting copyright is important.

Huawei Technologies, the telecom equipment maker based in Guangdong, could be a good partner in this. In 2003, Cisco sued Huawei for copyright violations, but dropped the suit after Huawei agreed to stop selling some products. Now, Huawei has emerged as a strong protector of copyright. Last year the company filed the largest number of patents in the world.

Song Liuping, Huawei’s chief legal officer, advocates increasing the penalty for IP theft, a view shared by Americans. But he thinks the problem is not the lack of an adequate legal system or even lax enforcement, but the absence of a culture in China that values designs, patents, and copyrights.

China is likely to act when it feels others are trampling on its rights. A Chinese group recently complained that Google’s planned online library of digitised books might violate Chinese authors’ copyrights. The more China feels that its own interests are at stake, the more serious it will get. When every new movie or software program can be copied for nothing, it is impossible to develop a film business or software industry.

It is better to back Chinese movie stars and technology entrepreneurs rather than American politicians to drive this message home in China.

— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

It is hard to be very optimistic about China’s proposed stock market for start-up companies. After all, similar attempts in other countries have a decidedly mixed track record. Why would China, where small private companies face an uphill battle against state-owned firms, be any exception?

Nevertheless, there are reasons to believe that the start-up market, set to debut in October, offers better potential than previous efforts in Singapore, Germany and Hong Kong.

The country has a big reservoir of fast-growing small companies with real profits. In the past, they have opted for listing on foreign exchanges such as the Nasdaq. Though they were attracted by the prestige of a foreign listing, they also faced a home market that favors size over quality.

Indeed, China, home of internet stars such as Baidu and Sina, is the second-largest foreign supplier of companies to the Nasdaq.

But the exodus has almost ground to a halt. Beijing has tightened its grip on foreign listings because it wants to keep the best growth companies at home. Only companies which already have overseas structures can list their shares abroad, but even then they have to jump through a lot of regulatory hoops.

Obtaining a domestic listing will become much easier, as Beijing has ambitious plans to float hundreds of companies on the new market each year. Maintenance fees are lower and disclosure requirements are less stringent when listing at home.

And companies will not necessarily need to compromise on valuations, since Chinese equities routinely trade at a premium to their foreign counterparts because there is a lot of liquidity chasing a limited pool of stocks.

Although institutional participation is likely to be limited because the small size of most start-up companies, the new market is expected to draw in a large amount of retail investors who favor more volatile small-caps.

No wonder that about 150 companies have already lined up to list on the new market. With a potential universe of 50,000 private companies nationwide, there will be no shortage of new supply in the next few years.

Chinese stock market regulators are wary of the lack of success by Western countries in creating markets capable of funding early-stage companies. Easdaq, Europe’s answer to the Nasdaq, rumbled along for years before finally disappearing. Germany’s Neuer Markt, launched during the dot-com boom, soared and then collapsed along with the rest of the stock market bubble.

In an effort to make a good start, the regulator has picked companies with the best track record of sales and profit growth for the first batch of listings. Most of them already qualify to list on the market for small-and medium-size companies, which is also part of the Shenzhen Stock Exchange.

The first 13 companies to go public almost look a bit too old-fashioned, with leading positions in markets such as railway transport electricity systems, lithium batteries, and medical devices. However, being boring is actually better than being too adventurous at this stage.

China has set the standards for listing on the new market much higher than Hong Kong’s growth enterprise market to avoid overly speculative companies. Like the Nasdaq, China requires companies to have a three-year operating record and a history of profitability.

Yet while it is good to set the bar high, it is even more important to keep it there by de-listing companies promptly if they fail to comply with listing rules.

One of the major reasons that the mainland market has a lot of moribund companies is because the regulator does not force de-listing. American exchanges de-list hundreds of companies a year.

Beijing has finally given the green light to the market for start-up companies after 10 years in preparation because it understands that small private companies, the most vibrant sector of the economy, will be the drivers of China’s next stage of growth. It also does not want to wait until the market gets too hot as then will be more speculative behavior.

Most of these markets suffer because they cannot attract a sufficient number of long-term institutional investors, so they end up as either illiquid or relying on much more speculative retail investors. This will be an even bigger problem in the retail-driven Chinese market.

Although the start-up market is necessary to provide some much-needed funding for small enterprises, Beijing should avoid getting too ambitious. There were initial talks about bringing as many as 500 companies public a year. But at that speed, disclosure and approval standards will inevitably be compromised.

The low success rate of markets for start-up companies has underscored the importance of not getting carried away. Early investors will walk away at the first sign of disappointment, and the markets are rarely granted a second chance. China should concentrate on getting off to a good start and build it up its new market slowly.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

(Editing by David Evans)

The U.S.-China tire dispute threatens to spill into other sectors and squeeze Chinese exporters’ already razor-thin margins further. It might seem mind-boggling to many that Chinese manufacturers are still hanging on to weak overseas markets even though the domestic economy looks much healthier and surely offers more potential.

But there are structural reasons why the grass is greener outside China. The risk of not getting paid, or getting paid late, is significantly lower when dealing with foreign buyers. The cost of international shipping has dropped so much that it can be cheaper to send goods over the Pacific Ocean than across the country.

In addition, selling to large buyers such as Wal-Mart creates volumes large enough to compensate for weak margins. Moreover, Chinese exporters get all sorts of export rebates and local government incentives which help to lower their costs.

But as the tire spat has illustrated, Washington can slap punitive duties on Chinese imports simply by pointing to a significant increase in imports from China. By imposing penalties in this case, President Obama has opened the door for a slew of similar complaints against Chinese goods. It will only be a matter of time before other countries, worried about where those displaced Chinese exports might end up, start to follow suit.

That’s why Chinese policy makers need to get more serious about stimulating domestic spending. It is time for Beijing to revamp a system built over the past three decades that explicitly and implicitly favours exports and to encourage manufacturers to prioritise selling to the domestic market.

A good first step would be to reduce some of the export incentives China offers to certain industries. These effectively subsidise foreign consumers at the expense of domestic customers. For example, Chinese tyre-makers get a tax rebate of about 9 percent on the value of the products they sell abroad. That’s why tyre makers can afford to price exported tyres more cheaply than ones sold at home, according to Xu Qiyuan, a researcher at China’s Social Science Academy.

To date, however, China’s response to the credit crunch has been to boost incentives to prop up export markets. Beijing raised export rebates on 3,802 items from April 1. Textile exporters also got an increase in their rebate to 16 percent from 15 percent. This activity is not illegitimate and many countries subsidise exports. But the U.S. enforcement action shows that this policy may have practical limits.

China needs more than just a change of heart on subsidies. Longer term, Beijing needs to foster the development of a healthy credit culture for suppliers so they can get paid on time, and to improve China’s transportation infrastructure in order to reduce the cost of moving goods around the country, and most importantly, to break down local protectionism that discriminates against suppliers from other provinces. It may seem odd but China needs to create a single internal market.

Despite all the talk about Chinese consumers being unwilling to spend due to a lack of a social safety net, one important reason that they don’t buy much at home is because prices are often too high . When “frugal” Chinese consumers go to Hong Kong or London, they immediately become big spenders, splashing out thousands of dollars on clothing, cosmetics, bags and watches. The irony is that a lot of the things they buy are actually made in China, but are simply not available there, or cost much more.

Moreover, the lack of a single market hampers foreign companies seeking to sell to China. Although foreign executives might fancy China as a giant market with 1.3 billion customers, the reality is that it is extremely fragmented, so economies of scale are hard to achieve. Transporting goods from one province to another can incur hefty tolls levied by local governments keen to raise local revenue and make it harder for companies to break into their local markets.

The credit problem also needs to be addressed. Big Chinese retailers only pay for goods on delivery. An exporter, by contrast, gets a letter of credit when the order is placed, and this can be cashed in to finance production.

China’s rebalancing away from export dependence has barely begun, and it will take a long time to change attitudes. But now would be a good time to make a start. The recent trade disputes over Chinese tyres and toys should serve as warning shots. China’s leaders must start to make the domestic market more friendly to suppliers and consumers.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

The Chinese leaders have a dream. The banks pump trillions of yuan into the market, which props up asset prices, creates new demand, and gets the economic engine roaring again. Then, just before inflation starts to surge, the money is drained out of the system.

Others, from U.S. Federal Reserve Chairman Ben Bernanke to Bank of England Governor Mervyn King, share the dream but the Chinese economy, still largely driven by the state, should make it easier to realise. Unfortunately, investors in Shanghai’s stock market have their own ideas — the mere suggestion of credit tightening caused the index to plunge 20 percent in just two weeks to Wednesday’s close before bouncing slightly.

The Chinese policymakers are left between a rock and hard place. At some stage, they must stop pumping money into the system, and prepare to mop it up instead, but timing this to avoid another stock market slump looks close to impossible.

Investors can remember what happened the last time. The central bank’s resumption of sales of one-year bills in July looks similar to the tightening action which began in May 2003. That prompted a six-month fall in stock prices.

That time, Beijing was slow to show it meant business. A couple of reserve rate hikes were largely symbolic, and it was not until late 2004 that interest rates were raised, 18 months after the first move. The market had lost half its value about a year later.

Beijing might not be very effective at controlling wild swings in the market, but it is effective at jump-starting the economy. While Japan had to pump free liquidity into the system for seven years before economic growth returned, it’s taken just half a year for China’s astonishing GDP growth to resume.

This increased economic activity has done little to improve corporate earnings. Take banks as an example, they are the biggest beneficiaries of the loans surge, as new lending tripled the amount on the first six months of last year. But net interest income at China’s largest bank ICBC fell 12 percent during the first half, because lending was less profitable — the interest spread was almost a third less than last year.

The authorities’ hope that rising property prices and investment would increase domestic demand, and hence corporate sales and earnings, has not been realised so far. Urban dwellers feel less well off than at any point since 1999, according to a survey by the central bank conducted in late May.

Chinese policymakers hoped the stimulus would buy China some time before demand from developed markets recovered, but the process of unwinding the West’s huge consumer debt total built up in the past two decades will be slow. Net exports, which contributed about 10 percent to China’s economy, have kept falling, and only recovered slightly in July.

Perhaps the latest market sell-off might prompt the Chinese authorities to maintain loose money policy a little longer, to encourage the buyers back in to share and property markets.

Unfortunately, even if the ploy works, it just sets them up for more difficult times next year.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

Chinese banks are like enthusiastic runners on an accelerating treadmill. The weakening economy means poor lending decisions are threatening to catch up with them, but the banks are sprinting ahead by expanding their loan books ever faster. They cannot keep this up for ever.

For now things still look fine. China Banking Regulatory Commission (CBRC) this week claimed that Chinese banks were managing credit risk sagely, pointing to record low non-performing loan ratios. Given the massive increase in the number of loans outstanding — up 24 percent since the start of the year — it’s not surprising that the proportion of them that are non-performing at large commercial banks, which accounts for 60 percent of the lending, has declined from 2.4 percent to 1.8 percent in the past six months.

Chinese banks appear to be focusing their lending on regions which have suffered the most in the crisis. The five regions that have shown the largest increase in new loans are the ones that were hit hardest by the downturn, namely coastal cities such as Guangdong, Jiangsu, Zhejiang, and Shandong, plus Beijing. These are also the regions that have experienced among the slowest growth this year. This suggests that loan growth is being driven by official policy rather than the product of bankers seeking the most attractive investment opportunities.

Chinese banks had double-digit NPL ratios before Beijing cleaned them up in preparation for their listing on foreign exchanges. Foreign banks with risk management expertise were brought in, and offered cheap stakes in Chinese institutions to encourage them to share their knowledge. This led to an improvement in lending standards as Chinese banks installed expensive computer databases and formed central credit offices.

It is not clear however how deeply these reforms have been entrenched. The banks remain very decentralized and lending standards are generally lower than their foreign counterparts.

In the past few years, Chinese bankers were restrained by the regulator from going on lending sprees. Banks were given lending quotas to prevent the economy from overheating. This year, with growth the main concern, there were no ceilings.

Chinese banks have clearly now opened the flood gates and are taking on more credit risk. The chief banking regulator Liu Mingkang said at a closed-door meeting in Tianjiin this April that the maximum Chinese banks should lend out a year is 6 trillion yuan ($878 billion), anything above that would be deemed as risky. During the first half alone, they lent out a whopping 7.37 trillion yuan ($1.08 trillion).

The current NPL statistics are irrelevant. The test for Chinese banks will come in the next 2 to 5 years, as the latest wave of lending shows its worth. True, many infrastructure loans seem to have implicit government backing, but less come with strong underlying cashflows. Instead of celebrating the record-low NPLs, the regulator should take it as a worrying sign that Chinese banks are now running hard to stand still.

— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

Chairman Mao believed the economy needs to run on two legs, but when it comes to corporate financing, China is advancing in a series of giant hops. Its banks are flooding the market with credit, while equity markets actually supply less capital as a proportion of the whole.

Chinese banks lent out a whopping 7 trillion yuan ($1 trillion) during the first half of this year, tripling the amount during the same period last year. In comparison, new capital raised through the stock market was merely 10 million yuan ($1.46 million), down 50 percent from last year.

This is worrying. Excess bank liquidity has arguably severely overheated the equity market. Companies traded in China command a hefty 40 percent premium to the price of the same shares traded in Hong Kong as cheap loans have lowered the required cost of return and propped up stock prices.

Meanwhile, the uneconomic allocation of credit has squeezed out equity as a method of financing. This debt-dependent system advantages state-controlled firms over a vibrant private sector.

The key to the problem lies in Beijing’s hands. By giving the market more freedom to grow, Beijing will help reduce the debt level of the economy and more importantly, give private companies a channel to raise money needed for growth.

As things stand, tradable equities account for only a little more than a third of gross domestic product, tiny when compared to U.S. market capitalization which is 107 percent of GDP. Meanwhile China’s banking sector looks bloated — total loans outstanding are close to the risky level of 120 percent of GDP. In most countries, the ratio is below 100 percent.

Admittedly, Germany and Japan also feature similar banking-dominant financing models, whose merit is that by consolidating power and resources they can achieve faster economic growth. But the risk is the government and banks become too powerful, and neither of the two are successful allocators of capital in China.

State-owned banks favour large state-owned firms, which use 84 percent of total bank loans, even though they only contribute 45 percent of GDP and employ merely 25 percent of the labour force. By funding more overcapacity, banks are throwing good money after bad — large industrial enterprises in China already have an average debt ratio of as much as 60 percent.

Large firms are so flush with credit that they have started punting on stocks and properties, while China’s small enterprises are so short of credit that they pay double the legal lending rate for unofficial loans.

In a sign that small firms are being starved of credit, 108 companies applied on the first day that applications were accepted to be admitted to a new start-up stock market which is scheduled to be launched in October. In the past two years, more than 300 companies filed for initial public offering approvals with the main board.

All stock market listings need to be approved by the China Securities Regulatory Commission. At the current approval rate, it will take three years for all 300 of them to come to market.

China is one of the few countries in the world where regulators decide when is the best time for companies to raise money. The argument is that because China’s stock market is retail-driven, regulators should protect shareholders by making decisions for them.

Moreover, authorities fret that an enlarged share base could lead to falling stock prices which could in turn lead to social instability. There is even a school of thought that some bubbles are healthy because the wealth effect will help stimulate domestic consumption. But the wealth effect from stocks will do very little because it mainly enriches the well-off who are unlikely to drive big increases in spending.

Another downside of the bank-dominant financing model is that that China is a lot less efficient in terms of using capital than countries where the stock market plays a larger role. After growing at twice the U.S. rate for at least a decade, China’s broad money supply M2 is poised to pass that of the United States for the first time this year, yet this huge flood of liquidity only supports a GDP one third of the size of America’s.

The need for China to move towards a more balanced financing model has never been this urgent. The lending spree, despite a weak real economy, has put banks at a greater risk of mounting bad debt in a few years’ time. To rebalance China’s economic structure, the country needs to start walking on two feet, not just hopping on one.

— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

While China has been outspoken in expressing concern about the United States printing too much money, those worries might be better focused at home. No country beats China when it comes to effective monetary easing.

Beijing has scrapped lending quotas, adopted a loose monetary policy and kept interest rates at a four-year low to boost liquidity and promote growth. The policy has worked. China has lent out more money in the first four months of this year than the whole of 2008. Money growth in China is up more than 25 percent this year, versus about 10 percent in the United States.  Click here for a related graph.

Beijing’s “monetary emissions” will have major consequences, and China might suffer from inflation before other countries in the world. The flood of liquidity that has been injected will almost certainly overwhelm the country’s seemingly indestructible overcapacity. History has shown that China can have inflation even during times of severe overcapacity, such as in 2008.

So far, China remains in a honeymoon period. Cheap money is sloshing about but thus far it has only generated asset price inflation — the sort of inflation that investors like. Meanwhile consumer prices are still falling — by 1.4 percent in June versus the same period last year. Factory gate prices were down 7.2 percent.

These price declines must be seen in context. They reflect a high base of comparison last year, showing China needs to worry more about inflation than deflation. Chinese policy makers might have misread the symptoms — the big drop in manufacturing activity late last year has been exaggerated by a sharp destocking process, which means end demand did not fall as much as the authorities thought.

Beijing has prescribed a strong remedy in flooding the market with liquidity. And businesses, banks and local governments are only too happy to swallow it, for commercial as well as political reasons. Banks make money when they lend, businesses like cheap money, and local government officials get promoted when local economies perform well.

As one might imagine, equity prices have been the first to respond to this liquidity injection. Chinese stocks  have been a top performer this year, up some 63 percent, while the Dow is down 3 percent over the same period.

Next in line is the property market. House prices in America are still falling, but in Chinese cities such as Shenzhen and Shanghai, they have risen by up 20 percent since April. Long queues increasingly form when new apartments go on sale, and the government is talking about increasing the supply to help cool the market.

BLAME THE PIG

It will not be long before asset price inflation starts to infect the real economy. People buy televisions and refrigerators to go with their new apartments and a buoyant stock market prompts investors to order shark fins and hairy crabs for lunch.

In China, the first signs of real economy inflation will almost certainly be seen in pork prices. Over the past decade, pork prices have acted like a coal mine canary in predicting inflation. In 2004 and 2007, inflationary bursts were preceded by spikes in pork prices.

A jump in pork prices in 2007 and 2008 prompted the authorities to introduce new incentives to promote pig farming, which increased supply. As a result, pork prices have dropped by 39 percent from the high seen in early 2008. Pig farming has become unprofitable and farmers have cut hog numbers as a result. This simply paves the way for another round of pork price increases. Click here for a related graph.

It will only be a matter of time before inflation is transmitted to the country’s factories. After sharp de-stocking during the last quarter of 2008, Chinese companies have started restocking in anticipation of higher commodity prices later this year, which in turn has helped drive global commodities higher.

The price of some manufactured goods such as clothing and toys has already risen as the export slump forced thousands of factories to close, causing supply to drop more than demand.

When inflation reaches consumers and factories, policy makers will start to raise interest rates again. Asset prices might then experience a last round of euphoria as a wider spread between domestic and international interest rates attracts foreign inflows. But higher interest rates will reduce corporate earnings and home buyers’ spending power, and asset prices might start to fall.

Inflation is always and everywhere a monetary phenomenon, as monetarists like to say. China is on a money-go-round ride that can only end with higher prices. Watch out for the next export from China — inflation.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –

America may have fallen out of love with Wall Street, but China hasn’t. That’s one way to read CIC’s just-announced $1.2 billion investment in Morgan Stanley — funds that allow the investment bank to repay Tarp money to the U.S. Treasury.

This looks to be an aggressive vote of confidence in the beating heart of U.S. financial capitalism.

Up to a point, but it is also a defensive move.

The truth is that CIC is kicking itself after turning up a chance last autumn to become Morgan’s main shareholder at a rock bottom price, letting in Japan’s Mitsubishi UFJ which bought a big stake at prices which now look sensible.

CIC is not in such a happy position. It bought $5.6 billion of Morgan Stanley convertible securities with a conversion price of $48 to $57 in 2007. When Morgan Stanley’s shares slumped to only a quarter of that price last September, the then beaten-down bank asked CIC to plough in more money.

Facing a big backlash at home for big paper losses on its investment in private equity firm Blackstone and also the Morgan Stanley stake, CIC demurred.

Acting as a sort of rainmaker, former U.S. Treasury Secretary Henry Paulson called up a top Chinese official, promising that Morgan Stanley would not be allowed to fail, according to people who are familiar with the matter.

By asking the Chinese to raise its stake beyond 10 percent, he essentially offered to waive the rule that would have required the Chinese group to be regulated in the U.S. were it to own more than 10 percent of a financial firm.

While that was tempting for CIC, fear still won out over greed and the Chinese resisted Paulson’s entreaties.

That left the field clear for Mitsubishi UFJ, to step in. It paid $9 billion for a 21 percent stake through a mixture of common stock (purchased at $25.35 a share) and convertible preferred shares, with a conversion price of just over $30 per share, roughly half what CIC paid a year ago.

The deal also diluted CIC’s stake to about 7.7 percent. Morgan Stanley’s shares have since risen. Mitsubishi has used its stake to carve out commercial ventures with the U.S. bank.

CIC’s fresh investment at least allows it to reverse last autumn’s humiliating dilution, although Mitsubishi has resisted being diluted, maintaining its stake at the 21 percent level.

But it is not clear it does much more for CIC than that. True the deal allows them to average down their in-cost. But it may simply confirm their reputation as a sort of reverse-Buffett, buying only when the market is greedy and sitting things out when it is fearful.

When U.S. Treasury Secretary Timothy Geithner told students at Peking University that China’s holdings of U.S. Treasury bonds were safe, his answer drew loud laughter from the audience.

Even economist and columnist Paul Krugman, who is often critical of U.S. economic policy, found himself defending America when he was repeatedly asked the same questions in China recently: Will you (U.S.) underwrite the value of China’s holdings of U.S. government debt? Will you be prepared to pay a much higher rate of interest against the risk of high inflation and dollar depreciation?

This is a big change from two decades ago, when many Chinese felt the best way to preserve their savings was to convert yuan into dollars on the black market.

Dollars are still affectionately called “mei jin” in Chinese, which literally translates to “American gold”, but they are now also referred to as toxic assets by many in China.

Last week’s decline in U.S. bonds and the dollar after the sale of $100 billion in new U.S. Treasuries have made the Chinese even more concerned about the country’s estimated $1.4 trillion of reserves parked in dollar-denominated assets.

The Chinese government wants to assuage rising domestic fury about the losses China faces on its $2 trillion foreign reserves, so the country’s economists have come up with various options for Washington to “guarantee” the value of China’s dollar holdings.

China craves such a guarantee because it has no choice but to keep buying U.S. debt. Were it to stop doing so, the value of its existing holdings would be imperiled.

LIFTING CAPITAL CONTROLS IS KEY

There is, however, something Beijing can do to rid itself of the shackles of its reliance on U.S. Treasury bills: allow its companies and citizens to invest more freely abroad, and loosen its grip on the capital account.

When the private sector buys dollars from the central bank to invest abroad, the pile of foreign currency the central bank has to manage will decrease over time.

Currently, Beijing enjoys a near-monopoly on investing externally (as well as domestically) as it is virtually the only holder of dollars in the country given the stringent controls on foreign exchange holdings.

Given the huge volume of funds Beijing handles, and the requirement to keep reserves in liquid securities, much of the cash has found its way by default into the U.S. Treasuries market.

The yuan has appreciated about 20 percent against the dollar in the past four years, while returns on U.S. Treasuries at most match that, meaning the reserves have made no money in yuan terms.

Private sector investors would be more likely to be interested in stocks and commodities than in “boring” Treasuries. Buying stakes in the world’s best companies and securing natural resources are also in China’s strategic interest. China’s sovereign wealth fund has progressively been doing that on behalf of its 1.3 billion people, but the fund only accounts for 10 percent of China’s reserves.

China has talked about “cang hui yu min”, meaning dividing some foreign currency holdings among its citizens. So far, it has put some dollars on state-owned banks’ balance sheets, partly in an effort to mask the rapid pile-up of its reserve holdings, and allowed Chinese investors limited access to foreign securities through certain funds.

For ordinary Chinese, there is growing interest in investing beyond Chinese assets. People do want to diversify their yuan holdings, buy property abroad for children studying overseas and invest in foreign bluechips. But under current rules they are not even allowed to buy stocks of Chinese companies traded in Hong Kong.

Beijing has also stressed a “going abroad” strategy in recent years, but Chinese companies with global ambitions still have to go through lengthy approval process. That partly explains why China’s outbound foreign direct investment accounts for about 3 percent of the global total, far below its share of world trade and economic output.

Now is a good time to loosen some control, since China’s economy is healthier than most others, the risk of big capital outflows is relatively lower.

Admittedly, even reform of this sort is fraught with short-term risk because the markets will punish the dollar as soon as it senses the effect of what the Chinese are doing.

But what is clear is that the key to preserving the value of China’s reserves lie in the hands of Beijing, not Washington — pursuing a U.S. guarantee for China’s current investment strategy is barking up the wrong tree.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –