from Follow the Money

Wall Street, the new development frontier …

January 12, 2008

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The children of China’s revolution have turned into capitalists. The China Development Bank now apparently aspires to be a commercial bank, not a policy bank limited to helping finance investment in China’s infrastructure.

But it is still rather ironic that a development bank from a developing country looks set to ride to the rescue of Citi. Past troubles at Citi have often come from lending to the governments of developing countries. This time Citi is turning to the governments of developing countries for help.

The symmetry goes even deeper.

Back in the 1990s, at least prior to the expansion of the IMF’s balance sheet in 1998, the G-7 countries would often join together in a consortium to supplement the IMF’s loan. And right now, it sure seems like a consortium of state banks, sovereign wealth funds and Gulf princes is being assembled to recapitalize Citi. The consortium is presumably being organized so that no single investor has too much exposure - or owns enough of Citi (more than 5%) to trigger regulatory hurdles.

The FT reports that Citi is looking to raise $14 billion and $9 billion from China alone. The New York Times reports that the CDB is in for at least $2b if it can get regulatory approval. The Wall Street Journal reports that Prince Alwaleed is chipping in. Kuwait and Singapore’s investment funds are also involved. Abu Dhabi already did round 1.

And once again, it is a consortium composed almost entirely of government investors, and specifically investment funds from governments that do not subject themselves to a democratic vote and thus have a bit more freedom to take big risks with their money.

Indeed, Citi and Merrill are looking to raise funds from the least transparent of all sovereign wealth funds, not the most. And these funds have shown a lot more interest in increasing their exposure to the US banking system than in increasing their transparency.

I suspect that the United States lost the ability to press for a major increase in sovereign wealth fund transparency when it made a de facto decision to rely on sovereign wealth funds to recapitalize Citi, Merrill and Morgan Stanley in an effort to stem off a credit crunch. Relying on other governments to achieve a policy goal usually has a price.


One other irony. A few years ago, Citi didn’t take a big stake in a large Chinese state bank, unlike say Bank of America, HSBC, RBS and Goldman. Citi wanted to try to have a go on its own in China rather than take a small stake in a big and hard to change Chinese state bank. Oops. The outsized profits from investment in Chinese state banks have helped other banks handle the subprime crisis. And now Citi has to turn to the Chinese state banks it passed on for help.

The US could soon have to decide whether the big Chinese state banks are really separate from the China Investment Corporation - and thus whether say the CDB and the CIC can combine to hold more than 5% of a US institution without triggering any regulatory review. Round two of the sovereign recapitalization may not breach the 5% threshold, but some -- like Meredith Whitney of CIBC capital markets -- worry that the banks will need round three or round four.

The FT notes that line between Chinese government money and Chinese quasi-private money is rather thin: "the distinction between government and quasi-private money is often blurred in China." That is very diplomatic.

The CDB’s debts are fully guaranteed by China’s government. The CDB was set up as a policy bank, not a commercial bank. Its website says that it promotes China’s national development strategy. It just got recapitalized by the CIC. The CDB may be trying to change into a commercial bank, but when the CDB invests in Citi it is effectively investing Chinese government money.

The CIC also owns - as a result of past recapitalizations through Central Huijin - three of the four large state commercial banks, and soon will own the fourth (it plans to recapitalize ABC this spring). One of the most insightful short papers of the CIC - from Andrew Ferris of BNP Paribas in their December 14 Emerging market weekly, presumably with input from Isaac Meng in Beijing; link here for RGE subscribers (it also behind the BNP firewall) - argued that the CIC is already far larger than is commonly thought. It owns the big state banks and thus indirectly already controls a portfolio of up to $450 billion. Or perhaps it is better to think that the CIC has farmed out a good share of its assets to the state banks to manage.

There is no sign that underlying need to sell US assets to the Chinese government to finance the US current account deficit is about to go away. China’s government isn’t buying US assets to help finance a period of adjustment that will ultimately reduce the United States dependence on Chinese flows. It is buying US assets as a byproduct of a policy of trying to defer adjustment.

China’s government added about $500b in foreign portfolio (if not more) in 2007. Details are forthcoming in my next post. It is set to add at least as much in 2008.

It can certainly afford a bit stake in Cit. I personally suspect that China’s foreign assets are growing by about $50b a month. $9b isn’t that much. Talk about financial power.

If China’s government - in all of its forms - isn’t buying US banks, it will need to buy something else. It won’t all be in bonds either. That is a big change.

Optimists think it will create new economic linkages that help to tie the two countries together despite their different economic and political systems.

But there is also a risk that China’s growing external investment will create far more tension than goodwill. The US historically has been leery of government ownership of commercial firm (see Truman, p.4). And even if China’s investments do relatively well in dollar terms, China’s citizens could still end up loosing money on their investments in the US. 

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