China Flexes Its Muscles on Wall Street Redux

While China and the United States are increasingly deepening their economic, trade and financial interdependence, Beijing’s experiment on the global stage is being closely monitored by Washington for its national security implications. Such is the case concerning China’s newly established sovereign wealth funds (SWFs) under the government-controlled China Investment Corporation (CIC) back in September 2007. Ever since China, in haste, paid $3 billion to buy a 10 percent stake in the U.S. private equity firm Blackstone Group LP, setting off alarm bells that have been ringing from Wall Street to Capitol Hill and raising the specter of China’s ambiguous intentions behind its muscle-flexing in the world finance market (China Brief, November 14). The Group of Seven (G-7) finance ministers meeting in Washington, D.C. in October expressed serious concern over the nature of expanding SWFs’ profile around the world—pointing to its growing significance in the global political economy.

China Riding in the New Wave of Sovereign Wealth Funds

Sovereign Wealth Funds, large amounts of foreign reserves accumulated from commodity—exporting countries and high-saving states, are not a totally new phenomenon. As early as 1953, Sheikh Abdullah Al-Salem Al-Sabah, then ruler of Kuwait, established the Kuwait Investment Authority to diversify surplus capital from oil revenue for returns that could be used for building Kuwait’s infrastructure. The largest SWF to date, the United Arab Emirates’ Abu Dhabi Investment Authority (AIDA), was set up in 1976. In recent years, however, a new wave of SWFs has emerged on the global financial scene due to the concentration of foreign trade surplus in economies such as China, South Korea, Singapore and Taiwan. At the same time, petro-dollars have flown into the wallets of the Middle Eastern oil-producing states, as well as Russia and Norway thanks to high oil prices in recent years.

As a result of these developments, six of the world’s largest SWFs are—not surprisingly—located in the following economies: Abu Dhabi ($625 billion), Singapore ($325 billion), Norway ($322 billion), Kuwait ($213 billion), China ($200 billion) and Russia ($148 billion) (Zhongguo Jingji Wan, November 19; New York Times, November 24) [1]. SWFs now control more than $2 trillion in assets in the world. Although still a very small portion of the net global financial assets, SWFs are expected to triple in the next four years to $7.9 trillion, and grow to $13.5 trillion in assets in 10 years, rapidly becoming a heavyweight player in world finance with significant political implications. Although China is a late-comer to the SWF frontier, its share of SWF pie is projected to increase from the current $200 billion to $600 billion in two years (Reuters, November 6; Reuters, November 14).

Western powers initially poured massive commodities and capital into poor countries around the world back since the 18th to most of the 20th centuries. The British owned much of Asia’s assets in the colonial era—but with the onset of globalization, the terrain has significantly changed. The rapid rise of oil-rich countries and newly industrialized nations in Asia in the past few decades have created opulent wealth that is often concentrated in the hands of the governments. The world has seen advanced industrialized countries and some powerful rising economies “trading places” when it comes to financial investment: reversing the historical pattern of the former investing in the latter. In this process, there are legitimate questions addressing whether the rules governing current world finance will be changed, either to confront or to accommodate the rise of new sovereign wealth funds.

Mixed Reactions From Around the World

While the underlying economic logic for Beijing to set up SWFs may be similar to other economies that have large endowments for SWFs, China’s entry into the SWF arena has attracted quite a high level of attention. The Chinese government argues that the CIC was launched to mitigate the risks in China’s huge foreign exchange reserve. There remain, however, intense speculations about Chinese motives and strategic intentions—much due to the Chinese propensity for secrecy. Just like the Chinese Ministry of Education’s attempt to set up Confucius Institutes around the world, which are modeled after Germany’s Goethe Institute and the Japan Foundation, was subjected to suspicion of Beijing’s political purposes. China’s new CIC may not be perceived the same as Singapore’s Temasek Holdings or Norway’s Norges Bank Investment Management whose model it tries to adopt. While there is little problem for education institutions around the world to receive funding from Germany and Japan as both are democracies, China’s Confucius Institute initiative was met with some resistance in its earlier stages. Both SWFs out of Singapore and Norway are seen not so much threatening because Singapore is perceived to be a city-state that will not have geopolitical or geostrategic ambitions, while Norway’s SWFs, despite their large size, are seen as primarily at generating returns to sustain the country’s welfare system. In contrast, China’s coming to the SWF sector will likely be met with extra caution because of a perceived incompatibility in regulatory frameworks and Beijing’s potential use of SWFs for political leverage

As in the highly politicized bid efforts by China National Offshore Oil Corp. (CNOOC) to buy U.S. energy firm Unocal in 2005, U.S. policy makers are now again on high alert. The U.S. Stock and Exchange Commission Chairman Christopher Cox expressed concern that trillions of dollars in the hands of authoritarian governments may have strategic implications, which calls “into question the adequacy of our enforcement and regulatory regime” (Associated Press, October 24; BusinessWeek, November 12). U.S. Treasury Secretary Henry Paulson urged for setting up a code of governance for the SWFs at the IMF-World Bank meeting in October (Australian Financial Review, November 8).

India expressed concerns about the capital inflow of SWFs, especially from China. The Indian government is looking into setting up a special investment framework to regulate the SWFs, partly prompted by the establishment of CIC (The Economic Times, November 23).

Britain, however, appears to welcome Chinese investment in the forms of sovereign wealth funds. UK Trade Minister Digby Jones assured that Chinese SWFs would not face barriers to invest in UK companies as long as they abide by the country’s standard regulations. Facing calls to curb Chinese investments in Europe, Jones said Britain would resist any attempts in the European Union level to restrict SWF investment. Responding to questions of foreign investment in UK’s potentially strategic industries, Jones stated that “I don’t believe I know where the limit on (sovereign wealth fund investment) is, because for us there isn’t one” (Dow Jones International News, November 20).

Poor Investment Results

Even if Chinese SWFs face no restrictions around the world, moving from relatively safe investment in U.S. government bonds with guaranteed returns to a range of private sector investment portfolios with potentially higher but uncertain profits is not a simple drive. In a matter of months, the CIC lost a quarter of its $3 billion investment in Blackstone since it went public in June, triggering a major debate in China on how the public money has been handled and the high risk model it adopted.

While some have complained about Western prejudice in singling out Chinese SWFs for scrutiny, others have questioned why the decision-making process for China to put $3 billion into Blackstone only took two weeks before the CIC was even officially launched (Reuters, November 23).

There is a widespread perception that CIC is simply another arm of the PRC government, with top officials at the National Development and Reform Commission or the Ministry of Finance calling the shots. The Blackstone investment debacle also demonstrates that the Chinese bureaucrats are no master calculators with Sun Tzu- style strategic vision when it comes to maneuvering in the complex global financial market place. Rather than depending on highly trained professionals, the CIC is staffed with government officials who have little international financial investment expertise. Despite its massive capital accumulation, China has much to learn in this area and will remain a new player in the foreseeable future. It will take time to establish a professional management team; it will take time to gain a handle on the complex global finance; it will take time to measure where the good returns may come from; and it takes time to persuade others that China is indeed a new financial player that will play by the rules.

Mixed prospects

Despite Chinese SWFs’ uncertain status and risky performance, a common criticism is that Beijing has manipulated the market to keep its currency low in value. Yet, many outside of the political circles both inside and outside China have not taken such an argument as the major cause of China’s massive foreign reserve buildup. Ironically, it was the United States and other Western countries that have moved much of their production base to China in the past two decades, which has enabled the latter to accumulate even more trade surplus dollars. Most of that money has in fact flown back to the U.S. economy via Beijing’s purchase of U.S. treasury bonds but now are also ending up in sovereign funds to mitigate the risks of a potential recession in the United States. That trend is likely to continue with more trade deficit with China from the United States and Europe.

At the same time, the Renminbi’s (RMB) appreciation to a higher value under increased pressure from the outside will likely drive China to accelerate diversifying its investment away from U.S. treasury bonds in order to seek higher and quicker returns. If Washington is comfortable having Beijing buy up $400 billion of its treasury bonds to subsidize President Bush’s deficit spending economic policy, it needs to answer the question of why it should be so alarmed about Chinese investments in the form of SWFs—both are in nature to seek interest returns for the money.

There are also strong incentives around the world for capital infusion from large investors such as China. When Nikkei prematurely reported that CIC was about to buy Japanese assets with its $200 billion treasure chest, both the Japanese yen and stock market went up (Reuters, November 27). If managed well, SWFs may inject new blood into the world economy and maintain global finance equilibrium; otherwise, SWFs may trigger a new wave of protectionism and lead to world financial instability.

Back in the 1980s when Japanese companies were seen by U.S. lawmakers as “buy[ing] up America” —even though it never really happened, there was much resentment against Japan. Maybe it’s more appropriate this time around for the United States to be more judicious in assessing the actual potential of a “Chinese financial threat.” Beijing, on the other hand, has much to gain if it proceeds to assure the rest of the world how it intends to use its newly gained and expanding foreign reserve to diminish suspicion and enhance mutual trust with other economies, to reform its financial institutions with much-needed transparency, and to make its global investment more wisely and less aggressively. In that regard, it is a bit insuring when China’s Vice Minister of Finance Li Yong stated that “[t]he CIC will make things more transparent, and learn best practices from other sovereign wealth funds” (Xinhua, November 8).

Notes

1. Other experts estimate the numbers of SWF allocation slightly differently. See Florence Chong, “Risks and rewards in sovereign funds,” The Australian, October 30, 2007.