China’s Sovereign Wealth Fund

michael pettis

The Chinese sovereign wealth fund (which, following convention I will call the CIC) is expected to be approved later this month or early October, before the October 15 meeting of the 17th National People’s Congress.  Much of its expected structure, however, is known and it has already made one very big and visible investment, the $3 billion it invested in the Blackstone Group IPO, which value began falling almost as soon as the deal was launched.  As of last week the market value of the investment had declined by $600 million, causing a great deal of complaints and criticism in China, not all of it rational.  

The CIC has already been approved to purchase $200 billion from China’s central bank, the People’s Bank of China (PBoC).  The purchase will be funded by a RMB 1.55 trillion bond offering by the Ministry of Finance (MoF) with maturities of ten years or more.  Already about one-third of the money (RMB600 billion) has been raised, with all of the rest expected to come before the end of the year.  Given that China is accumulating reserves at the rate of $100-120 billion a quarter, it is probably safe to assume that if it is perceived as being successful (from the point of view of domestic political considerations, not investment performance) a lot more money will eventually be transferred into the CIC.

One bit of good news is that the PBoC plans to use these MoF bonds as part of its open market operations to control the expansion of the domestic money supply.  This is good news to me because I think the use of central bank bills, which is what the PBoC mainly has used in its ineffective sterilization attempts, has been pretty much a waste of time.  They are too similar to money and way too liquid to have much impact in draining China’s ocean of liquidity.  The less liquid MoF bonds should do a better job.  

Interestingly enough, the loss on the Blackstone IPO and the recent turmoil in the markets seems to have affected the CIC's investment strategy, as has the international outcry against non-transparent SWF's purchasing major strategic assets around the world.  During their meeting with German Chancellor Merkel's during her visit to China at the end of August, Chinese officials promised that the CIC had no intention of buying strategic stakes in big western companies.  In fact it seems that the original goal of the CIC – to maximize investment returns – has been put on hold.  This is probably a good thing because, it seems to me, the most valuable use of excess reserves is as a sort of stabilization fund that minimizes the changes in creditworthiness of the sovereign borrower.  Instead of maximizing returns – which is likely to be pro-cyclical and so will only increase volatility – the funds should be invested in ways that hedge Chinese risk, for example, by buying assets that perform best when conditions in China are likely to be at their worst, and vice versa.  

Unfortunately that doesn't seem to be the alternative strategy.  It looks like the management of the CIC's investments, perhaps not surprisingly given the size of the honey pot, is going to be the result of a hodgepodge of competing ministries and claims.  This is what Xinxin Li has to say about it (see the September 20 entry for my blog at piaohaoreport.sampasite.com for a more complete excerpt):  

A seven-person executive team has been formed, representing all the interested parties.  The Chairman of the Board is the vice secretary general of the State Council (China's Cabinet) Lou Jiwei, who invited the current deputy head of the National Social Security Fund (China's national pension fund) Gao Xiqing to be the CEO of the CIC.   The team also includes vice finance minister Zhang Hongli, the head of Central Huijin, Xie Ping, and a representative from the NDRC.  The PBoC is supposed to send a deputy governor to join the team, but the appointment is still pending.  A possible candidate is the current deputy governor Su Ning…This structure reflects the inter-ministerial nature of the CIC: it is not only a SWF seeking high investment returns, but a coordinator among different government agencies on China's overseas investment.  

This will be a pretty big agency.  It will have 1,000 employees once it completes its expected takeover of a couple of other agencies involved in the management of domestic assets, and it will be supervised by a representatives from the State Council,, the National Social Security Fund, the MoF, Central Huijin, the NDRC and the PBoC.  

Given that these different institutions have very different goals and interpret current conditions in China in very different ways, one can just as easily argue that the executive team is as likely to coordinate interests as to paralyze action. My concerns aren't allayed by the scope of the CIC's mission.   According to Li, “Central Huijin, the former investment arm of the PBoC, will be integrated into the CIC and continue to capitalize domestic financial firms. Another existing institution, China Jianyin Investment, will mainly operate in the area of managing domestic assets and disposing of non-performing loans.  In addition, the CIC will establish a new department for overseas investment.” It is also, apparently, expected to use its assets to fund the overseas expansion of domestic corporations.  It is hard to imagine that domestic political clout will not be at least as important a factor in deciding which domestic entities will be funded and on what terms as economic rationale.  

My guess is that the CIC will start out investing largely in liquid foreign securities, which responsibility will be handed off to SAFE (State Administration of Foreign Exchange, the body that is responsible for most foreign exchange transactions of Chinese state entities).  Given the recent turmoil in the markets and the criticism the CIC has received for the Blackstone investment, I suspect that its first investments will be fairly conservative, although a lot of people from different banks are telling the CIC that the market turmoil is an excellent opportunity for a cash-rich entity to find great bargains.  I don't think the CIC is buying the argument, but who knows?  Lou Jiwei is supposed to be a pretty sharp guy and depending on how damaging the Blackstone criticism has been to his career prospects, he may be eager to score a goal or two as soon as possible.

As the CIC grows, I would bet that an increasing amount of its assets is likely to be invested in strategic investments, which I suspect will include the financing of the foreign expansion of state-owned companies.  This may turn out to be the most highly politicized aspect of the CIC's future business.  

With $30-40 billion a month pouring into China's reserves, it wouldn't be surprising if a steadily increasing amount of money , either held at the PBoC or at the CIC, is invested in riskier assets and strategies than in the past.  It is a little too early to get a bead on exactly how and where this money will get invested, but certainly anything that lifts the fog that surropunds Chinese finances should help clarify the direction of the global balance of payments.  I will try to stay on top of rumors and facts about the CIC and PBoC investment strategies, and of course would appreciate comments from anyone that knows anything.