January 31st, 2008 | The Economic Observer Online Day of Reckoning for China's Sovereign Fund ?
China’s sovereign wealth fund has overly concentrated its investments in financial assets, leaving it little room to take further advantage of the credit crunch and facing difficulty in paying off debt. Though it has significant stakes in Morgan Stanley, Blackstone, the Bank of China, the Construction Bank of China, and ICBC, it may have trouble gathering enough revenue from dividends to make interest payments in February on its debt.
From Cover, issue no. 352, Jan. 28th 2008. Translated by Ren Jie
On one day in mid-January, Gao Xiqing and his team from the China Investment Company, the new body charged with putting China’s foreign exchange reserves to better use, held a closed-door conference with executives from Goldman Sachs. It was the last day for the CIC to settle on which foregin financial institutions would serve as its fund managers.
Those chosen by the CIC will take charge of approximately 70 billion dollars, a significant portion of which has been earmarked by the CIC for overseas investment, and which comes with high standards for returns.
A steep challenge, but one the CIC desperately needs to overcome–it will pay 12.9 billion yuan in interest in February, the first part of interest payments it must make on the 1.55 trillion yuan in special national debt bonds that were floated during its founding.
And although the spreading of the US sub-prime lending crisis has created a window of opportunity for the CIC to make investments abroad, it has already made deep investments in the financial industry and is facing increasing pressure to diversify its investments.
Fund managers from global institutions the world over descended on Beijing en masse since the CIC announced on December 12th that it would be looking for investment managers, all looking for a piece of the 70 billion dollar pie. Aside from this, the CIC has brought on Boston-based firm Cambridge Associates for various strategic consulting services.
In a forum held at the end of last year, the chairman of CIC Lou Jiwei announced that the CIC would begin investing 70 billion dollars overseas step by step. He also said that in 2008, the CIC would increase investments in index products and bond markets, while expanding investment areas in general as well.
Too Concentrated in Finance
One senior financial expert who wishes to remain anonymous says that Cambridge Associates will be less helpful to the CIC now since the latter’s portfolio is already saturated with financial investments.
On November 26th 2007, Yale economist Chen Zhiwu suggested that the CIC take the opportunity of the US sub-prime crisis to buy equity stake in international financial institutions which were struck by the crisis and in demand of capital.
The next day, at the “China Forum” hosted by the Industrial and Commercial Bank of China and HSBC, chairman of CIC Lou Jiwei echoed said that some sovereign wealth funds had successively invested in losing huge financial institutions in order to stabilize international financial markets.
Less than one month later the CIC declared its business deal with Morgan Stanley. The CIC would spend 5 billion US dollars to purchase convertible securities issued by the firm, after full conversion of which the CIC’s share of the company would not exceed more than 9.9%.
One source close to the CIC who wishes to remain anonymous says that besides Morgan Stanley, two other financial giants ailing from the credit crunch had also negotiated with the CIC during that period as well. The source says that the CIC invested in Morgan Stanley because it was about to publish its annual financial report and reveal 7.4 billion US dollars in losses, leaving it little time to bargain.
Ther CIC has made three major investments, two of which involved the purchase of shares in financial institutions–3 and 5 billion dollars in Morgan Stanley and Blackstone respectively. In addition, the CIC spent 100 million dollars on shares in China Railway in Hong Kong. The source close to the CIC says that all things considered, the China Railway investment is not significant and more likely considered for short-term earnings, which will not likely be the future investment style of the CIC.
Thus shares in Blackstone and Morgan Stanley remain the bulk of the CIC’s portfolio. Central Huijin Investment Company (CHIC), which is a wholly-owned subsidiary of the CIC, has invested funds in the Bank of China, China Construction Bank, Bank of Communications, the Industrial and Commercial Bank of China and the China Development Bank. When combined with the funds invested in a securities brokerage firm in 2005, the total is close to 90 billion dollars. If adding a planned 40 billion dollar investment in the Agricultural Bank of China, the CHIC will have spent 130 billion dollars on Chinese financial institutions, and another 8 on US ones.
And it leaves only around 60 billion dollars for other investments. If considering that the company must maintain a degree of liquidity, that amount is even lower.
Chen Zhiwu says that even if the CIC can spend all of 60 billions dollars on other investments, it won’t be enough of a diversification, and that the CIC would still suffer huge losses if the Chinese financial industry went into decline or a global financial crisis emerged.
Pressure to Make Payments
The Ministry of Finance issued 1.55 trillion yuan in special national debt bonds in order to etsablish the CIC. On February 29th 2008 the first interest payment for the first batch bonds is due, with the CIC required to pay 12.9 billion yuan in accordance with the 4.3 percent annual interest rate.
At the end of last year, it had 750 million dollars in losses due to the Blackstone investment. And neither the Morgan Stanley nor China Railway can earn much in the short-term. Only dividends from the CHI’s investments in three state-owned banks can be put towards interest rates.
CHIC has been the biggest winner of China’s wave of state-owned bank listing. With the Chinese market doubling in value last year, three of China’s state-owned banks now rank as the top three among the world’s in market value. The CHIC owns 350 billion dollars worth of their shares, and return on investment up 50 percent.
But Lou has said that the CHIC will continue to operate as the controlling stakeholder of the three state-owned banks. Thus it can gain returns from dividends paid out on those shares, but cannot sell them outright.
A Mixed Deal
After considering the possibility of yuan appreciation, CHIC signed a dollar re-purchasing option agreement with the three banks at the time of investment梚n the end of 2003 in the cases of the Bank of China and the Construction Bank, and in April of 2005 with ICBC.
But by the end of 2006, the value of that option had decreased. The CHIC will lose millions of yuan from the implementation of those option agreements, which all must be subtracted from the 130 billion yuan in dividends.
If using an the average dividend rate of 35% -45%, the CHIC can make anywhere from 43.3 -55 billion yuan from these investments. But the interest of 1.55 trillion yuan in bonds is 66.65 billion yuan per year. And this does not include costs associated with running the CHIC.
A source close to the CHIC says that its managers are mulling over this very problem. Just one week after the New Year, the CIC held a whole-day closed-door meeting to discuss investment strategy and return requirements.