from Follow the Money

Does the China investment corporation (CIC) have a coherent investment strategy?

December 30, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I personally would say no.  And I am not alone.  Tan Wei of mergermarket.com reports (in the FT)

“a source familiar with the Chinese government’s thinking … who has direct access to the Chinese government officials”  …  says that until now CIC has lacked a clear strategy and will in future focus its investments in the natural resources sector.”

That jibes with Jamil Anderlini’s reporting in late December:

“Such a concentration of the country’s wealth in one entity has inevitably drawn intense interest, not just from every fund manager on the planet but also from powerful forces within the state bureaucracy.  Each of these groups has its own ideas on how the money can best be spent.”

It now seems likely – despite protests to the contrary (“The deal was struck over a matter of months rather than a few weeks”) – that the CIC’s decision to invest in Morgan Stanley wasn’t entirely the product of a careful deliberative process.   Tan Wei reports that the CIC jumped on the Morgan Stanley deal after the China Development Bank (itself soon to be recapitalized by the CIC) missed out on a big stake in Citi because it wasn’t ready to move quickly enough.  

“An insider at Citigroup revealed that the US investment bank had first approached the China Development Bank (CDB) to see if it was interested in acquiring a stake in the bank. CDB had shown strong interests in doing so, the insider said, but told Citigroup that it would need three days to make a decision because it needed, as a state-owned bank, to get government approval. At that same time, Abu Dhabi was also offered the opportunity to invest and was able to move forward with the purchase right away. The insider added that it was for this reason that CIC didn’t hesitate when approached by Morgan Stanley about acquiring a stake, having learnt from CDB’s experience that it needed to act quickly.”

Wei’s account jibes with Keith Bradsher’s story that the Morgan Stanley stake came as a surprise to the CIC’s staff.  If Wei and Bradsher are right, the decision to take a punt on Morgan Stanley sounds rather like the decision of jump at the chance to get in on Blackstone’s IPO even before China had formally set up an investment agency.  The CIC almost certainly lacks the staff needed to do much due diligence on its investments in large US financial institutions.   The balance sheet of a big US broker-dealer presumably doesn’t look all that much like the balance sheet of a big Chinese state commercial bank.

The CIC was set up in part to make sure that investment bankers pitched their best deals to Beijing.  And it sure sounds like all troubled US banks and broker-dealers are basically flying from Beijing to Singapore to the Gulf playing sovereign wealth fund against sovereign wealth fund (and in some case royal wealth funds) to try to get the best deal. Wei – citing CNBC – reports that the CIC also passed on Merrill in December.   It may get another chance in January.

But the CIC now seems a bit worried that the investment bankers whispering sweet nothings into its ear -- or at least extolling the new “sophistication” of sovereign investors -- are pushing deals that make more sense for the banks than for the CIC. Wei, citing a source familiar with the Chinese government's thinking:

“Outside investors lack the investment acumen to have spotted a bottom in the credit crunch but also that, in the case of China’s CIC, further investments in the US financial sector will be limited. … The source said that CIC is currently being advised on a new investment strategy which would involve diversifying away from its current focus on the US financial sector.”

For what it is worth, I picked up something similar in Beijing, pre-Morgan Stanley.    I didn’t talk to anyone at the CIC – only to people who were talking to the CIC.   And the general sense back in early in November was that the CIC wouldn’t want to risk another Blackstone, and would instead focus on portfolio investment and supporting Chinese state firms.   That was why I was surprised by the Morgan Stanley deal.  Oh well.

There clearly isn’t a consensus inside China on what the CIC should be doing.

Now though the CIC really seems tired of being pitched investment banks rather than oil wells and mines.   Or petroleum and mining companies.   Wei reports it will be investing in Sinopec's parent company to support Sinopec's expansion abroad.    

But supporting the big Chinese state mining and petroleum firms hardly seems any more coherent than a strategy of balancing the CIC’s holdings of potentially dodgy Chinese banks with potentially dodgy investment banks.   The financial performance of mining companies and Chinese banks are likely to prove to be highly correlated with China’s own growth; an investment slump in China would lead to a rise in bad loans and a fall in commodity prices.  There is a plausible case China’s investment fund should invest in strategies that are not correlated with China’s own growth, though China now has so much spare cash that it really doesn’t have to worry too much about holding some assets whose value will go down when China’s own economy slows.

The big sovereign funds of the Middle East seem to function like the family offices of some of the world’s wealthiest individuals.  They are about making the very rich even richer.  They aren’t quite private investors – the head of the fund also runs a government, and that does make them a bit different – but they also aren’t subject to the political pressure and public scrutiny typical of publicly managed money.

Norway’s government fund acts like a large conservative public pension fund or an aggressive central bank.  It has a large passive portfolio.   It isn’t in the business of doing deals – and isn’t all that keen to pay big fees to investment banks.  It is the only big sovereign fund yet to buy a big stake in a big bank.

Right now, the CIC isn’t a secretive Middle Eastern fund controlled by a single family or a transparent portfolio investor like Norway.    Rather it is a jumbled mix of different strategies.  Lex got this right back in early December:

“CIC’s mandates include promoting China’s overseas expansion and rescuing domestic banks; supporting Chinese companies’ overseas offerings and enhancing returns.”

Those goals will likely come into conflict. 

The CIC’s biggest position is its stake in three large Chinese state commercial banks  (now four -- it just recapitalized China Development Bank) – and it will soon have a large stake in the Agricultural Bank of China as well.   It also has stakes in 13 domestic securities firms.

That makes the CIC a bit like Temasek.  Before Temasek went forth are starting investing abroad, it managed the government of Singapore's stake in Singapore's state firms. China though doesn’t have Singapore’s record nurturing successful national champions, at least not yet.   The CIC's big stakes in big state firms also makes the CIC a bit like SASAC – the body that manages China’s stake in non-financial state companies.    The CIC cannot manage its stakes in domestic financial firms as a purely commercial investor, solely interested in returns – not so long as China relies on the state banks to support China’s economic policy objectives, including exchange rate management.   Ironically, though, the CIC’s non-commercial strategic stakes in China’s domestic financial sector could be among the most profitable of all the CIC’s investments: there is no exchange rate risk, and it bought the state banks at book …

The banks the CIC owns also now manage a very large dollar book.  They likely will own about $300b of US and European debt by the end of the year.   Those funds are the legacy of the funds Huijin injected into the banks as part of their recapitalization, and the $137.5b (as of end-October) in swaps the PBoC seems to have done with the banks.  If the CDB – which the CIC will recapitalize – buys a stake in a large US bank, is it really different than a direct CIC stake?

The CIC also has a mandate to support Chinese firms as they go forth.   It could do so by depositing some of its foreign exchange in the accounts of the state banks it owns, and then letting the banks lend the funds to state firms looking to expand abroad.   But that is a bit too close to what the PBoC already (in effect) does; it won’t produce big returns.   The CIC seems more interested in buying into the offshore equity and bond issues of Chinese firms (though that does raise the question of whether they are really “offshore”), and perhaps co-financing big deals with big-state firms.    

Here too it is serving a strategic purpose, not just a commercial purpose.   Here too it hopes to make money – after all, China would have done far better if it had bought oil rather than dollars five years ago.  And here in particular it risks stepping on the toes of SASAC, as it too will own an equity stake in Chinese state firms if it buys into their offshore IPOs.

It also has large – 9.9% -- stakes in Blackstone and Merrill.   Stakes that it acquired because either someone in the top run of China’s government (Blackstone?) or the top of the CIC (Merrill) thought they were good deals.    These stakes are small relative to the CIC’s $200b portfolio: $3b (now only a bit more than $2b) in blackstone, and $5b in Merrill.   But they are also the most high-profile and controversial part of the CIC’s portfolio.  

And by controversial I don’t mean controversial globally – the CIC’s stake in Merrill has generated less opposition, given China’s record of using its state banks for non-commercial objectives, than I expected.  They are incredibly controversial inside China.   Critics worry that China is getting taken to the cleaners by clever bankers intent on selling the CIC tainted goods.  The PBoC largely avoided US subprime; the CIC’s hasn’t avoided the LBO hangover.    And critics ask why China’s funds are being used to bail out the Street rather than support China’s development.

And finally the CIC is expected to award mandates at some point to a few external fund managers to manage an external investment portfolio.   Here it will be acting a bit like ADIA (before ADIA started doing deals with its bankers and fund managers) or the GIC (before the GIC started doing deals with its bankers and fund managers).  If it starts managing a large portfolio in-house – and starts to transparently report its actions – it will even be a bit like Norway’s government fund.

To me, these different functions fit poorly together.    In its role as an external fund manager – including its role managing the strategic stakes that it has taken in US and European financial firms – the CIC claims to be a purely commercial player.   The head of the CIC, Lou Jiwei has indicated that the CIC should be:

“a transparent, apolitical, long-term institutional investor which takes small strategic stakes in offshore institutions and makes portfolio investments through public markets.” (quoted by Anderlini, FT)

Yet in its roles managing China’s stake in China’s state banks and supporting Chinese firms as they go forth, it is supporting China’s own development policy.   And all key decisions are taken at a very high – meaning political – level.  Anderlini:

“final decisions on big deals must still be approved by state leaders, whose primary concern is the strategic interest of the nation.”

At some point, there is a risk that these competing roles could merge – with Merrill and Blackstone facing pressure, for example, to partner up with the domestic financial firms the CIC owns.   Merrill and Blackstone don’t seem all that worried by this – in part because one of the lessons of China’s recent history is that the big money is made by partnering up with the government of China.  Just ask Goldman, the CIC’s partner in ICBC …   

I wish though I knew a bit more about Morgan’s past experience with the CICC – itself now part owned by the CIC, which also is set to acquire a bit of Morgan.   What a tangled web.

The CIC may never push the foreign funds it owns to support China’s domestic financial sector.  Or it may push the foreign funds to do exactly what the foreign firms want to do, and they may get an edge because of their ties to the CIC.  Other firms certainly worry that firms part-owned by the government will have a leg up.   Sundeep Tucker:

… foreign involvement in China’s booming domestic capital markets is tightly restricted, so any deepening of a relationship with an arm of the Chinese government is seen as useful in the long journey to secure licences and approvals for new business ventures. …. Matt Austen, the head of the Asia corporate and institutional banking practice for Oliver Wyman, an industry consultant, … added: “Having such connections to the CIC is unlikely to hinder your business development in China.”

For now, the conflicts of interest intrinsic in the CIC’s owning stakes in foreign firms looking to do business with domestic firms the CIC owns and that other parts of the government regulate are currently considered a positive.  Everyone wants an edge in China.

Nonetheless, housing strategic investments designed to support China’s own development and China’s “commercial” external investment in the same institution seems like a bit of a risk to me – both to China and to the rest of the world.

And perhaps as importantly, there are advocates of each of the CIC’s current roles – supporting Chinese banks/ financial firms; supporting Chinese business as it goes forth, taking strategic stakes (whether in the hope of a home run or in the hope of generating externalities that will help China) in US and European firms and acting as a large portfolio manager – inside the CIC and inside China’s government.   

The end result seems likely to be an ongoing battle over the purpose of the CIC.  

China hasn’t really figured out what it wants to do with all its dollars and euros.  There seems to have been a consensus that it no longer made sense to hold all of its foreign exchange as reserves, but not consensus – at least not real consensus – on what else to do.

The most likely outcome of a lack of any real consensus and pressure to do something?

Some rather surprising decisions …

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