The London Times’ take on Chinese equity investment abroad

I found the Times’ article (hat tip, SWF Radar) on the China’s plans to invest abroad to be somewhat confusing.

The article’s headline claimed “Plans are are afoot to diversify its [China’s] holdings of reserves without causing political rows.”

But what are those plans? Well, the CIC “will help [China’s] state-owned companies to expand overseas in a shift of strategy” and specifically will “assist inexperienced Chinese companies in financing, foreign-exchange risk management and handling trade barriers.” Yet it isn’t at all obvious — at least to me — that using a sovereign fund to assist state firms is a strategy for avoiding political rows.

The article jumps between three very different ways China’s government is looking to gain equity market exposure abroad:

1) Supporting Chinese firms — Haier, Baosteel, no doubt others — looking to expand expanding abroad;

2) Handing funds over to private equity funds and other external managers;

3) Buying equities in the public market.

These are conceptually different different activities, and raise different policy issues. The CIC seems to be doing all three. SAFE doing the last two — though the foreign exchange it has placed with the state banks is also available to support Chinese state firms.

Much of the confusion in the Times article comes because it starts by indicating that Beijing has decided to use the CIC/ SAFE to support Chinese state firms and then jumps to a list of the various investments the CIC and SAFE have made without really explaining how these investments relate to this new reported strategy. And best I can tell, there is no connection. China has plenty of funds to commit to all three strategies.

The Times article does include some useful new information though. Caijing apparently has reported that the State Council has authorized SAFE to invest up to 5% of its portfolio in equities.

However, the magazine [Caijing] quoted a former official as saying the state council had authorised spending 5% of the $1.7 trillion reserves on shares in foreign companies.

SAFE likely now has more than $1.7 trillion — the last data point we have is for end-April, and we aren’t far from the end of June. 5% of $2 trillion is $100 billion, enough to make SAFE one of the largest sovereign equity investors in the world even though it technically isn’t a sovereign fund. The distinction between a sovereign fund and the investment portfolios of some over-reserved central banks is often very thin.

The fact that China is looking to encourage its state firms to expand abroad shouldn’t be a huge surprise. After World War 2, the US ran significant current account surpluses, which combined with capital inflows from central banks needing to build up their dollar reserves — that in an economic sense financed foreign direct investment by US companies. China is in a similar position. It now has a large — roughly $400 billion — current account surplus that could be used to finance direct investment abroad. It has successful domestic firms but those firms have a fairly small global footprint.

The outward expansion of private US firms after World War 2 generated plenty of controversy though. I would guess the outward expansion of Chinese firms will generate at least as much.

And there is a critical difference between the US then and China now.

After World War 2, the dollar was strong, which facilitated private investment abroad by US firms. By contrast, China’s currency is weak. A profit maximizing Chinese firm wouldn’t want to finance investment abroad with RMB. The outward expansion of Chinese state firms consequently hinges on the willingness of China’s state to make the dollars it is accumulating to hold its currency down available to Chinese state firms — and then making sure those firms down use the dollars they have received from China’s state to buy RMB.

The state’s large role in the process strikes me as a major additional source of friction — hence my surprise that the Times would indicate that a plan based on supporting Chinese state firms was part of a strategy of avoiding political rows. If China wants to diversify into equities without causing political rows, the obvious strategy is to invest in equity index funds. And to disclose its equity exposure, in much the same way the Swiss do. China clearly hasn’t opted for this strategy.

originally published on CFR and reproduced here with the author’s permission.