Globalaffairs

Issue 8/April-May 2008
By Javier Guerra

On the 15th of January 2008, the governments of Singapore, Kuwait and South Korea invested more than 21 billion dollars in Citigroup and Merrill Lynch, two of the banks that were most affected by the “Subprime” mortgage crisis. In the following weeks, the Singapore and Chinese governments invested more capital in banks such as UBS and Morgan Stanley. These investments were made using sovereign funds, which are investment funds managed by governments. In the last few years, these funds have played a fundamental role in the world financial markets, having brought 69 billion dollars in total to the recapitalisation of some of the largest global investment banks.

Countries that manage these funds are countries that have benefited from high petrol prices (like the United Arab Emirates) or the increase in exportations from Asian countries (like in China’s case.) The reason for creating funds of this type is the professionalisation of investments and an attempt to obtain better profitability from their investments, in place of investing in activities with very low profitability, as they can be the bonus for the American Treasury. However, these investments generate a series of worries in the countries that receive these massive entries of capital, the main problem being the reactions that these provoke on the level of protection and nationalism. For the directors of these businesses that are being invested in, this can be a blessing due to the long time that they have been looking for these investments, fleeing from the short-termness of some investors.

The main sovereign funds of Asia and the Persian Gulf are:

China Investment Corporation (China)
Size: $200 billion

Citic (China)
Size: $130 billion (in December 2006)
Biggest investments: $1 billion in Bear Stearns investment bank

China Development Bank (China)
Size: $300 billion (in December 2006)
Biggest investment: 3.1% of Barclays bank for $3.2 billion

Temasek (Singapore)
Size: $110 billion.
Biggest investments: $4 billion in Barclays and $8.5 billion in Standard Chartered

GIC (Singapore)
Size: Between $100 and $300 billion.
Biggest investments: $9 billion in UBS.

Abu Dhabi Investment Authority
Size: $875 billion
Biggest investments: Citigroup $7.5 billion

Dubai International Capital
Size: $9 billion
Biggest investments: Strong participation in HSBC

Istithmar (UAE)
Size: $8 billion (approx.)
Biggest investments: $1 billion in Standard Chartered

The case of China

It is thought that in 1996 China had already amassed its first 100 billion dollars in capital (the majority in US dollars). By 2001 this figure had become 200 billion and since then, this has multiplied by six, helped by the rise in exportations, making it the country with most foreign money reserves in the world. At the end of 2007, China accumulated around $1.53 trillion in reserves in foreign currency, mostly American Treasury bonds and similar capitals, with a savings rate of around 50%, additional reserves are adding to themselves with increasing speed.

The majority of China’s investments up to now have been in American State bonds, considered as a secure investment as the American government guarantees them, and return 4-5% interest. This has not covered the 5-6% fall of the American dollar against the Yuan, hence the poor investment in terms of profitability.

To increase the profitability of these reserves, mitigate the international pressure on China to appreciate its currency and diversify risks (above all the risk of having a large part of its reserves in only one currency, the US dollar), China has officially started to put together its capitals using a sovereign fund called China Investment Corporation (CIC), formed on the 29th of September 2007. CIC has $200 billion at its disposal, even though it is believed it will be given almost 1 trillion USD to manage. For the formation of the CIC, international legal and financial assessors were contracted as well as a few more prestigious world strategic consultants. Based on the form of other sovereign funds, the Chinese fund has some of its own particular characteristics that reflect the political structure of China and its recent history of financial reform. The fund belongs 100% to the Chinese government and its cabinet of directors is formed by high leaders of public Chinese financial institutions, hence its close relations with the Chinese way of acting, with a strong political implication. This is something that is not as evident in other funds such as that of Singapore.

For the moment, the CIC is focused on constructing its own team of investment assessors. Meanwhile the CIC is trusting well-esteemed international investment assessors, that will take part in a competitive selection process for the lucrative business of advising China on its investments.

The 200 billion dollars that the CIC has is divided into three different segments. The first, with 67 billion dollars, the Chinese government acquired at book value (not the value quoted on the stock exchange). Its participation in the public banks at stock market value (ICBC, Bank of China and China Construction Bank), this investment will mean that this segment of 67 billion dollars is already worth substantially more. The second segment of the fund, also 67 billion dollars, will be dedicated to recapitalising the other two main Chinese banks, the China Development Bank (CDB) and the Agricultural Bank of China (ABC). They are aiming to take the CDB public but the timeframe has not yet been defined. The other third (another 67 billion dollars) of the CIC will be invested abroad.

These foreign investments even started before the CIC was officially created, and in July it acquired just under 10% of the Blackstone investment fund (one of the biggest in the world), and that was floated last summer for 3 billion dollars, an investment which for the time being has made a loss of 1 billion dollars. Another investment has been the purchase of 9.9% of the Morgan Stanley investment bank for around 5 billion dollars. The operation amounts to a relief for the bank, as it was hit by the credit crisis especially in the last quarter. Between September and December, it lost 3.588 billion dollars and its takings fell 57% in the 2007 financial year.

Despite the crisis, Morgan Stanley is one of the large American banks in Wall Street, and has “a long agreement with China and has made its position as leader clear in this region,” explained its president and delegate advisor, John J. Mack. Another of the investments that stand out has been that of 4 billion dollars in the JC Flowers & Co investment fund. It should be highlighted that the CIC will limit itself to a passive role, given that it will not have any representation on the board of Morgan Stanley or Blackstone; therefore its participation is without the right to vote.

Japan is another of the countries where the CIC is investing in an active way, with the intention of investing around 10 billion dollars in businesses mainly in the energy sector, particularly oil and gas companies, particularly Inpex. This is a strategic investment for China, given that it is hoped that this Japanese company to become one of the Japanese national leaders, therefore it will benefit from Japan’s activity in the search for natural resources in the sea to the east of China. This is something that has caused diplomatic conflict between China and Japan, getting round to work out how to define the sea frontier, given the potential natural resources that they could find, something that the coming visit of Hu Jintao to Japan at the end of this year could resolve. However, Japan is saying that the only intention of the Chinese president is to smooth the way for investments from the CIC in Japan and China’s hep in the creation of a Japanese sovereign fund, a project that has officially already begun.

On a domestic level, one of the main investments in non-financial institutions has been the purchase of 1% of China Rail Corporation, a company controlled by the Chinese government, and whose flotation on the stock exchange was extremely successful.

The vice minister of finances, Li Yong, revealed that the investment strategy of the CIC will be a gradual one and with precaution, and that they will not invest in airlines, telecommunications companies or foreign oil companies (something that did not succeed with Inpex.)

Due to the great power and political influence of sovereign funds, in particular of the CIC, the possibility exists that now both the United States and the EU are considering putting up barriers to foreign investment controlled by foreign countries, using the excuse of questioning the purely economical interest of these investments, but they also bring with them the problem of taking technological knowledge or political influence from the control of the companies subject to the purchase. This is something that from my point of view is hypocritical given that countries within the EU are allowing the entry of private companies controlled mainly by governments, for example the case of the electrical companies in Spain with the possible takeover bid by EDF (controlled mainly by the French government) against Iberdrola.

The growing importance of sovereign funds was a subject of discussions at the last G7 summit, where they urged said funds to follow guidelines in areas such as institutional structure, risk control or transparency, while the countries receiving these investments would apply some principles of non-discrimination and transparency. Given the concerns of Western democracies (USA, Switzerland and Germany have declared themselves in agreement) it is not very likely that the CIC will start investing in a way considered hostile in a business associate country like the USA and Germany. This is why two of the CIC’s largest investments up until now (JC Flower and Blackstone) have been investment funds as these will invest its money without the country receiving the investment having the concern of China being the direct investor.

What is not clear so far is if the CIC will help businesses controlled by the Chinese government in its investments outside of China as co-investors, something that the CIC has not confirmed nor denied until now. Being such could mean certain political conflicts (remember the example of the failed takeover bid by the American oil company Unical in 2006 or the recent failed purchase of the 3M company by Huawei with the help of the Bain Capital investment fund.)

It is thought that in a reasonable amount of time the CIC will clarify its investment strategies, its relationship with the government, among other aspects in order to eliminate fears that could exist in the markets and give the fund the necessary transparency to freely invest in international markets.

In short, we find ourselves facing a new actor in the international finance panorama, which comes to show the growing influence of China in the global political and financial panorama.

Javier Guerra
Investment Executive for the investment fund GSF Capita

Global Affairs is not liable for author’s opinion