from Follow the Money

Maybe the CIC isn’t motivated entirely by commercial gain …

June 15, 2008

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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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The CIC claims it wants to be a commercial investor. Gao Xiqing is often quoted to the effect that the CIC "operates on commercial principles" and intends to only take passive stakes.

I have always found that those claims sit uncomfortably with the CIC’s current portfolio, which is dominated by stakes in China’s state commercial banks. Those state banks are used to support the government’s policy objectives. Right now, for example, they are being encouraged to hold dollars to help the central bank manage the unprecedented growth in China’s foreign assets. They also can be asked to lend to strategic sectors.

However, the CIC’s stake in the state banks can be viewed as a legacy of China’s 2003 decision to use foreign exchange reserves to recapitalize the state banking system. If they are in effect grandfathered in; the rest of the CIC’s portfolio could be determined by risk and return.

But it will be very hard for the CIC to make that argument if one of its mandates is to help finance the expansion of Chinese enterprises abroad. And apparently that is part of its mandate. Sender and Guerra of the FT reported, in a story about Haier’s potential bid for GE’s appliance division:

Executives at China Investment Corp say that one of their mandates is to help finance such moves abroad. Banks such as China Development Bank could also be tapped to help finance a bid and even take a slice of equity in any deal.

Supporting national champions is a separate mission from managing an external portfolio that maximizes risk-adjusted return.

For that matter, I suspect it will be hard for the CIC to argue that it is a purely commercial investor if the state banks that it owns aggressively support Chinese state enterprises as they expand abroad.

China isn’t Abu Dhabi. It has a competitive, growing domestic industrial sector – sometimes state-owned, sometimes privately owned -- that wants to expand abroad. A company that wants to expand abroad could borrow RMB to buy dollars – and then use those dollars to expand abroad. But that leaves it exposed to the risk of future RMB appreciation. Far better to borrow some of the state’s dollars. As a result, there is pressure inside China to use the government’s foreign reserves to support Chinese firms. Cheng Siwei for example argues that China should be purchasing companies rather than Treasuries. He isn’t alone:

some national enterprises under State-owned Assets Supervision & Administration Commission have advocated that China’s foreign reserve should be invested in industrial and strategic resources.

But using government resources to finance the outward expansion of Chinese national champions sounds a lot like an extra-territorial industrial policy -- something that that is bound to generate concerns outside China.

Right now, the CIC seems to have five missions:

-- supporting China’s exchange rate regime by raising funds in RMB to buy foreign assets. It may also face limits on the extent it can diversify its external portfolio away from the dollar so long as China manages the RMB against the dollar. Massive dollar sales by the CIC that drove down the dollar might put unwelcome downward pressure on the RMB

-- managing an inhouse portfolio of foreign securities

-- selecting external fund managers to manage a portion of its investment portfolio (a process that assures the CIC will have friends abroad)

-- managing China’s strategic equity stakes in the state commercial banks. It is a holding company for the state’s investment in the domestic financial sector.

-- supporting Chinese state enterprises as they expand abroad, whether directly or through funds placed with the state banks

The first three arguably fit well together, though supporting China’s exchange rate regime could at times conflict with investing in ways that maximize return. But I am not sure that supporting Chinese firms and managing the state’s strategic stakes in the state banks fit well with the CIC’s other objectives.

As importantly, I suspect that the CIC was set up without full consensus inside China on what it should do. As a result, there is a constant battle between those who want the CIC to do more to support state firms, and those who want the CIC to focus on external investments.

Large losses on the CIC’s high profile investments abroad likely provide those who think the CIC should do more to support state firms with ammunition; they can argue that supporting Chinese firms expanding abroad may produce better returns than investing in say the US equity market – or a US investment bank.

The battle over what the CIC should do, in turn, means that its investment process risks being highly politicized. China’s top leadership gets drawn into the debate. It has to decide, for example, if the CIC should bid on Rio Tinto -- or whether the CDB should finance a state firm looking to buy a stake in Rio Tinto. China’s top leadership likely will have to decide if the CIC should help finance Haier.

Back in May, the magazine "Emerging Markets" published an article -- an oped really -- where I laid out my concerns about the CIC’s complex mandate. It is now online as well. I touched on many of the these issues -- and the tension between the CIC and SAFE -- in my lengthy January paper on the growth of China’s foreign assets.

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