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Today’s Financial Times has an important article by Geoff Dyer and Sundeep Tucker examining the overseas expansion of Chinese companies in general, and Chinese state companies in particular.
It is an important topic. One of my main conclusions my recent trip to Beijing was that the Chinese Investment Corporation (China's sovereign wealth fund) is going to a somewhat smaller force in global markets than many expect and Chinese state firms and banks a somewhat bigger force.
Dyer and Tucker offer two key insights:
First, Chinese state enterprises compete among themselves.
The best example: the different Chinese banks have all apparently expressed interest in buying Temasek’s stake in Standard chartered:
“Three Chinese banks – China Construction Bank, Industrial and Commercial Bank of China and Bank of China – have approached Temasek of Singapore in recent months to discuss buying its stake in Standard Chartered.”
The deep irony here is that all three are share the same large shareholder: the China investment corporation bought Central Huijin’s stake in these three banks (Huijin received equity in return for the reserves the PBoC provided the banks back in 2003 and 2005). If all three compete against each other to bid up the price of Temasek’s stake, Temasek wins and the CIC loses –
Second, the interest of China’s state and the interest of China’s state-owned firms are often not identical. The evidence: Chinese state oil companies often prefer to sell their offshore oil in the global market at the world market price, not domestically at the controlled China price:“About two-thirds of the oil from China’s overseas assets is sold into the global market at the spot price rather than shipped back to China, where the companies would have to sell it at heavily subsidised rates. Even in Sudan, Chinese companies have at times sold much more of their oil production to Japan than they have sent home.”
I would bet that there is a bit of gamesmanship going on here. By selling their oil globally, Chinese state-oil companies put a bit of a pressure on China’s government to push up the administrative price of oil. This may also reflect competition among China’s state oil companies. China ultimately does have to import oil, so if one part of China, Inc sells some of its oil to Japan at the market price, another part of China, Inc has to pay the market price to import oil. One hand wins, the other hand loses. But the state oil company selling to Japan may not be the same state oil company that has to import more. Or the foreign division of a single company may get to book the profits while the domestic division has to take the losses.
If taken to its extreme, the conclusion of Dyer and Tucker’s analysis – particularly in conjunction with comments from Stephen Green (the first to predict China would add $500b to its reserves this year) indicating that “The coming wave of deals is less national strategy, more chaos theory in action” – is that competition among Chinese state-owned firms will more or less replicate competition among private firms.
This is part of a broader intellectual trend (even among investment bankers) to view state ownership of companies in a much more positive light than before.
I am not fully convinced.
Let me provide two examples why.
The first concerns Chinese state ownership of offshore oil fields.
Dyer and Tucker argue that the interest of state firms – especially state firms that have listed on the stock exchange and that care about their profit margins – are not the same as the interest of the state. That is clearly the case. Chinese state oil companies would like to sell all their oil, whether produced domestically or abroad, at the world market price. China’s government has resisted allowing domestic petrol prices to rise by that much. That helps China's gasoline consumers, but hurts the oil companies -- unless they create supply shortages by refusing to import oil, they have to feed the domestic distribution network that supplies gasoline at the domestic price.
The core tension here is real. It applies to domestic oil production China, but it applies with even more force to offshore oil production. I would still argue though that Chinese “state” ownership of resources abroad provides the government with more financial options that it would have if it had to buy all its imported oil on the world market.
Suppose a Chinese state oil company has secured access to oil in Africa – with the help of cheap loans from China’s Exim bank – at a per barrel cost of around $40 a barrel. Oil now sells globally for about $90 a barrel. To simplify the analysis, let’s assume the oil company with the potential $50 a barrel profit is fully owned by China’s government.
The gains – if China’s government actually got dividends from its state companies – from selling oil on the global market could then be redistributed to Chinese consumers of gasoline. Or to avoid favoring those with cars, the gains could be distributed more broadly. Alternatively, the government could insist that the oil company sell its African oil domestically at a $70 a barrel price even though the global price is $90 a barrel. The company wouldn’t like it – its profits are reduced. But the state oil company is still making money. And China Inc wouldn’t need to show any loss; the subsidy to domestic consumption just comes from a lower profit than otherwise would be the case on state investment abroad rather than from high profits and a rebate to Chinese consumers.
Conversely, if China, Inc doesn’t own any overseas assets it will have to pay the current market price (or whatever long-term price it has negotiated) for its imported oil. The subsidy is much more obvious.
China's government may not always opt to force its state oil companies to take lower profits in order to achieve its domestic goals (stable prices, limited political turmoil). The state companies would no doubt argue this reduces their incentive to go forth. But so long as Chinese state firms own resources abroad and are sitting on potential windfall profits from a rise in the global market price China's government at least has the option of cutting the profit margin of its oil companies rather than raising prices or providing an on-budget subsidy.
Now you might say that China never could coordinate policy to force state firms to take lower profits. Different institutions have different interests. Policy coordination is hard.
That is no doubt true. But policy coordination doesn't seem to be impossible -- even when the issue is how to distribute losses.
That brings me to my second example: China’s banks. And specifically the banks' role financing the China Investment Corporation. The issues involved in the sale of sterilization bills by the People's Bank are similar, but the financing of the CIC is a more current issue: China just announced that its Finance Ministry will sell about RMB 750 of bonds (roughly $100b) to a large state bank -- the Agricultural Bank of China (ABC) -- to "fund' the China Investment Corporation.
The ABC will, in turn, buy foreign exchange from the PBoC which it will then sell to the Finance Ministry. And the central bank will use the cash it raised from the sale of foreign exchange to buy the bonds the Finance Ministry sold to the ABC. The net result, of course, is that the PBoC ends up the Finance Ministry’s bonds and the Finance Ministry ends up with the PBoC’s dollars. The ABC is involved solely to avoid a legal prohibition on direct PBoC financing of the government.
Forbes – drawing on Market News International -- reports that these 15 year bonds will carry a coupon of 4.45%.
That seems like a rather low coupon for a country with 6.5% or so CPI inflation, particularly given widespread expectations that the PBoC will need to raise short-term rates to contain inflation -- though right now the PBoC seems to be relying (once again) on administrative controls, perhaps because of concerns that higher rates would bring in more hot money).
4.45% for 15 years is less than the 5.6% coupon the Railway Ministry paid for a far smaller ten year issue, or the 6.34% coupon the Finance Ministry recently paid on a five-year bond issue directed at retail investors. Data on interest rates comes from Michael Pettis’s blog.
Now it is possible that inflation expectations are so well contained that 4.45% is the right price for 15 year money. But I rather doubt it.
Remember, these bonds were supposed to be a sterilization instrument for the central bank, so it wants something that it can sell into the market (read sell to the state banks) at close to the price it paid for the bond (The PBoC doesn’t particularly want to take losses … ). And I would be willing to bet a lot of money that no bank would prefer to buy – at par -- the Finance Ministry’s 15 year/ 4.45% coupon bond rather than the Finance Ministry’s 5 year/ 6.34% bond.
The PBoC looks to be buying a bond at par that it cannot sell in the market at par.
So what will happen? Well, The PBoC could hold the low-yielding bond as an assets on its books for a long time (it initially replaces a bunch of fx) and sell still more short-term sterilization bills to offset ongoing reserve growth. But avoiding losses -- given the low-yield on the PBoC's long-term bond -- likely means forcing the banks to buy yet more low-yielding sterilization bills.
Or the PBoC will ultimately end up forcing the banks to buy the 15 year/ 4.45% bond from it (avoiding the need for new bill issuance) at par.
The banks won’t be required to mark this to market. I kind of doubt their owner (the China Investment Corporation) will insist. But they are, in effect, being asked to cut into their profits – they could make more lending or buying other bonds on the open market at a market price – in order to help the Chinese state achieve its policy objectives.
Kind of like what China might ask the state oil companies to do in some circumstances.
No doubt this big bond issue has raised plenty of friction inside China – the People’s Bank and the Finance Ministry seem to have a relationship not unlike the US state and defense department under Powell and Rumsfeld. But at the end of the day, the government still seems able to use the state owned banks to achieve its policy objectives -- in this case, low-cost sterilization – at the expense of their profits margins.
I may have some the details here wrong. All this isn’t exactly transparent. I share my friend Dan Rosen’s view that a lack of transparency adds to the concerns associated with China’s outward expansion. Rosen, in the FT:
“The problem with China is not its size or growth but the lack of transparency,” says Mr Rosen at China Strategic Advisory. “The world can handle its magnitude but what it cannot handle is the uncertainty all the time about motives and about how the system actually works.”
I am though a bit – more than a bit actually – more concerned that Mr. Rosen about the “magnitude” of China’s outward flows given that all, more or less, come from different parts of the Chinese state.
$500b a year – and $500b a year for the foreseeable future – of foreign asset growth by one single state is unprecedented. Splitting the flows up so they are not all coming from a single institutions (SAFE) helps, but it also raises the very real possibility that one part of the state (the CIC, the state banks) will subsidize outward flows from another part of the state.
Indeed that seems almost certain to happen.
The CIC is already helping state firms (China rail) raise money abroad. Through fx swaps with the banks, the central bank can also increase the foreign exchange the state banks have available to lend out even as domestic dollar deposits shrink.
And I suspect that China has encouraged the state banks and state firms to hold on to more foreign exchange – unhedged -- to reduce pressure on the central bank. It recently lifted a legal requirement that Chinese firms sell the foreign exchange from their export earnings to the government (a so called surrender requirement). It now is probably doing a bit more than allowing firms to hold on to their foreign exchange earnings.
The net result is pressure to go out (see Michael Pettis). Dollars that cannot be converted to RMB need to be put to work. Otherwise they will depreciate in value.
The government doesn’t even really need to tell Chinese firms what to buy – by forcing firms to hold more foreign exchange, the government can change their incentives. They in effect have no choice but to overpay for foreign exchange, and then have to make the best of a bad situation.
Or course, they would far rather sell their foreign exchange to the state and hold RMB -- especially if they can then borrow dollars from another part of the state (say the state banks, which in turn can borrow dollars through the swaps market with limited foreign exchange rate risk) if a juicy target comes along. No one in China really wants to take foreign exchange rate risk right now if they can avoid it.
UPDATE: RGE's Rachel Ziemba provides more detailed analysis of the coupon and maturity structure of the CIC's various bond issues. My bet is that a lot of the smaller bond issues sold to the public (as opposed to the large bond issues sold to the PBoC) were in fact bought by the state banks.