from Follow the Money

The alliance between China’s (nominally) communist government and Wall Street deepens …

December 19, 2007

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The China investment corporation (the CIC) is investing $5b in Morgan Stanley, taking a 9.9% stake.

That is a bit of a surprise, at least to me.   After the CIC's (mark to market) losses on Blackstone, I expected the CIC to shy away from similar high-profile, visible stakes -- especially ones that risk further losses.    I got that wrong.   Very wrong.

I apparently am not the only one who was surprised. Keith Bradsher reports:

[The investment in Morgan Stanley by] China Investment Corporation ... also marks an abrupt shift in strategy for the $200 billion fund, and underlines the extent to which the government fund appears to be under the direct control of China’s leaders.

Lou Jiwei, the fund’s chairman, said in a speech at a financial forum on Nov. 29 that the fund sought liquidity and would mainly invest in financial instruments like index products. Mr. Li also said that the fund, which has fewer than two dozen employees, would start hiring foreign experts before making more overseas investments.

....The investment fund declined to comment late Wednesday on its acquisition of nearly 10 percent of Morgan Stanley. But a person familiar with the fund’s activities said that the decision had been sudden and little expected by the fund’s staff.

“I am also surprised,” said the person, who insisted on anonymity because of the sensitivity of the deal. [Emphasis added]

I can see why the fund's staff was surprised -- in late November, Lou Jiwei seemed to indicate that the CIC wasn't yet ready to make a large investment in a major financial institution.  This kind of investment wouldn't have been made without the approval of China's State Council -- not after Blackstone.   Indeed, Bradsher's reporting suggests that the impetus for the deal came from the State Council rather than the CIC's staff.

It presumably has been vetted by the Treasury and the US regulators as well.   The FT reports "it had been discussed with the US authorities “at the highest level”

I am much less keen on this kind of investment than the Street -- or my friend Michael Pettis.    Morgan Stanley needs the capital, no doubt.    And if Abu Dhabi's government can hold a large stake in Citi, and Singapore's GIC can hold a large stake in UBS (together with an unnamed investors in the Middle East) and Temasek can own a large stake in Standard Chartered, it is hard to argue that large government stakes in US and European banks are verbotten.   

China would argue that the CIC's minority stake in Morgan Stanley is no different than the minority stake private US and European firms (Goldman, Bank of America, RBS) have taken in the large Chinese state banks.   

Basically, the CIC could argue that it some grand sense, it has swapped a stake in ICBC with one US financial institution for a comparable stake in another US financial institution.   The CIC's stake in Morgan just remedies an existing discrepancy between US investment in China and Chinese investment in the US.

The CIC's big stake still worries me -- in large part because the CIC also owns three of the four large Chinese stake banks, and is expected to own two others (the Agricultural Bank of China and China Development Bank) after the recapitalization.   And there is no doubt that the state banks have been managed in part to achieve non-commercial goals.

China's banks have historically been used to implement China's version of industrial policy -- directing credit to favored sectors of the economy.  That likely still happens, though credit is no longer being allocated to support as many loss-making industrial dinosaurs.

Right now, though, the state banks are being used to achieve another Chinese policy goal: the low cost sterilization of China's huge reserve growth.    The banks are effectively forced to buy sterilization bills, both through various regulations that limit their lending and more informal pressure.   They will likely be forced to buy the Finance Ministry bonds sold to finance the CIC's foreign exchange holdings -- and probably to buy them on non-market terms.   The bonds have a low coupon (well below the current inflation rate) and a long duration , and Chinese rates are expected to rise.   They are not exactly something the banks want to hold right now.   

In various ways, the fact that the government owns the biggest banks has made it far easier for China to sustain its current exchange rate regime by passing some of the costs of maintaining that regime over to the banks.

No doubt, the CIC's investment in China's state banks (or really Huijin's investment, which the CIC bought at book) has been very profitable.   The market value of these banks has soared.    But so long as the state banks are used to achieve policy goals, it is hard to argue that CIC assets are managed for purely commercial goals.

Here, the China Investment Corporation differs from Abu Dhabi's Investment Authority.   Its mandate is much broader -- and includes managing the state's stake in China's own banking system and supporting the outward expansion of Chinese firms. 

The CIC's stake in Morgan Stanley falls short of control, to be clear.   And there is no reason why the CIC's couldn't manage its offshore assets differently from its onshore assets.   I though would be a lot more comfortable if the CIC was buying the S&P index, not significant stakes in large -- indeed iconic -- US firms.

The irony here is immense.  

A few years ago the consensus view in the US financial community was that China's state would have to relinquish control of Chinese banks in order for China's financial sector to develop.   State ownership was generally considered an impediment to a modern financial system.   But rather than selling controlling stakes in China's  state banks to Wall Street firms, China's state is now buying (non-controlling) stakes in Wall Street firms.  

Talk about a change. 

There was a time not-so-long ago when the US was on a push to export its form of government (and its form of capitalism) around the world.   Remember when the US was criticized for using the IMF to foist privatization on the world?  Now both the US government and large Wall Street firms rely heavily on non-democratic governments for financing -- and the US is, in a limited sense, importing other countries form of capitalism.  The US government hasn't historically owned large stakes in US banks and broker-dealers.   

UPDATE:  The FT story suggests this deal has been in the work for months and -- according to Lazard's Gary Parr who advised the CIC:  "The investment is structured in a creative way that protects CIC’s downside.”   It other words, it wasn't rushed like Blackstone -- which was pushed through in a few weeks.  If so, Lou Jiwei plays a good game of poker.  In late November, Lou signalled that large Chinese investments in US and European banks were still a year away:

Lou Jiwei, the head of China Investment Corp, said on Thursday he would like to emulate sovereign wealth funds that have invested in large western financial institutions hurt by the credit crisis, but that such investments were still a year away.

The FT also emphasizes the tie between Morgan Stanley's Wei Christianson and the CIC's Gao Xiqing from their time as securities regulators in Hong Kong and China helped move this deal along.   Regulators turn deal makers ... 

UPDATE 2: A couple of scale metrics.  $5 billion is 1% of the likely foreign asset growth of China's state in 2007, counting central bank reserves, CIC foreign assets and the increase in the foreign assets of the state commercial banks.   And if Logan Wright is right, $5 billion is less than 5% of the $120b in foreign exchange China may have forced the state banks to hold to meet their reserve requirements in q4.   It isn't that much money, relative to the stunning growth in China's foreign assets.

UPDATE 3:  The Wall Street Journal writes that the 9% return on the CIC's convertible bonds far exceeds China's 5% cost of funds.  

"The terms of the Morgan Stanley deal guarantee CIC a 9% annual return, well above the fund's 5% cost of funding until it converts its investment to shares in 2010."

That is true, but only if you ignore the currency risk.   And I don't think it really makes sense to ignore one of many elephants in the room.  Right now the market expects the RMB to appreciate by around 8% a year (the appreciation over the last 12 months was around 6%).    If that expectation is realized in 2008 - and the RMB continues to appreciate by more than 4% a year through 2010 --  the terms seem to me to guarantee that China will lose money if Morgan Stanley's stock doesn't rise in value.  The dollar coupon won't cover the CIC's renminbi interest bill, net of the dollar's depreciation.  

I was also -- incidentally -- pleased that Stephen Green of Standard Chartered was as surprised as I was by this deal.   I don't feel quite as alone.   I really thought  the scars from Blackstone would push the CIC toward adopting a more conservative initial investment policy.

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