World Marketplace
Home Improvement
Charles W. Thurston
12/01/2007

If it were so inclined, China could infuse the global economy with $250 billion to $300 billion from its new sovereign wealth fund (SWF)—one of the largest funds of its kind—by investing in other nations, at a time when the world needs such liquidity. As the Asian press has recently suggested, however, a more likely scenario is that the fund, named China Investment Corp. (CIC), will instead be using much of its capital to help the country’s own big blue chips acquire foreign companies.

Sovereign wealth funds are government-run investment pools largely financed by a nation’s foreign exchange reserves. These reserves, often built up to multibillion-dollar levels, are primarily acquired through oil or other exports. The global reserves fueling these funds are worth roughly $5 trillion, up last year alone by $1 trillion. And they are growing by $2.5 billion a day, according to Stephen Jen, a Morgan Stanley SWF specialist in London. A third of this growth takes place in China, he notes.

Many nations invest their sovereign wealth fund reserves to great global benefit, says Lou Gerken, founder and CEO of the San Francisco–based hedge fund group Gerken Capital Associates. He sees the past year’s boom in investing by sovereign wealth funds as a good thing, at least for some markets. "New investment by the SWFs in the emerging markets accelerates the diversity of financial products available there and leads to greater overall market transparency," says Gerken, who spent three decades entreating others to invest in the emerging markets and who has built a portfolio now worth $1.4 billion, mostly through such investments. "So for the high-net-worth investor contemplating whether to be more aggressive in investing in the emerging markets, very large sovereign capital inflows are a very positive thing."

Market Manipulator

Unlike much of the rest of the world, China’s economy is suffering from excess liquidity with no outlet.

Yet the rush of sovereign capital inflows is also sparking fears around the world about foreign ownership of strategic assets. Another challenge is the market momentum that a fund can produce by making a large capital infusion. It seems logical that SWF investment in a given sector or country will drive up market values. For example, the U.S. subprime mortgage market grew with debt obligations held by Asian investors who, to be sure, eventually got burned. A long-term SWF investment could be the onset of a self-fulfilling prophecy for economic growth by the investment target. Yet because SWFs will invest in good measure for strategic reasons, price may not weigh too heavily in their investment calculations, and thus could readily contribute to rapid volatility. Global investors should watch for new pockets of seemingly inexplicable market and/or economic activity.

"If the sovereign funds chase one particular sector, a bubble could occur; and then they might sell their overvalued positions, so there could be a recycling of assets on a global basis," says Richard Stone, the founder and CEO of Salient Wealth Management in San Rafael, Calif. Stone has been watching sovereign funds for 20 years, after being involved in a purchase, by Singapore, of U.S. real estate. Secrecy notwithstanding, the money trail will be there. "If you see sudden outperformance of some large-cap companies in the global arena, that might be some indication of sovereign fund money going in," Stone says.

TOP VIEW
China could infuse as much as $300 billion into the global economy through its new sovereign wealth fund. However, experts predict that the country will continue to support its own blue-chip companies rather than invest in other nations. That’s not all bad: Some countries fear that such outside investment, especially in key industrial areas, could severely damage their security.

But if a bubble fueled by China’s fund is on the immediate horizon, it might be in China’s blue-chip companies, which already tend to rise and fall with market frenzy. At the current rate of yuan appreciation, CIC would need to get 5 percent returns on its foreign investments to achieve adequate growth—returns that are not going to be easy to achieve with the global economic slowdown. Instead, the fund reportedly plans to take equity stakes in 16 large state-owned companies, including oil giants Sinopec and China National Petroleum, the big four state-owned banks, China Mobile and China Life Insurance. The goal is not necessarily quick returns, but rather the establishment of an indirect route to the rest of the world through corporate mergers and acquisitions activity.

CIC does not appear to have any desire to lead the kind of market reforms that would bring diverse investment products and liquidity into China, except inasmuch as there is a general cry, from inside and outside China, to let its own individual investors put their money into foreign markets. The government has begun to experiment with that sort of reform; in August the country’s currency regulator, the State Administration of Foreign Exchange, announced a pilot plan to let Chinese citizens who have a Bank of China account in Tianjin (a city the government wants to turn into a financial hub) invest in Hong Kong–listed shares.

Unlike much of the rest of the world, China’s economy is suffering from excess liquidity with no outlet. Household savings total about $2.2 trillion, partly because savings are the only option ordinary people have aside from the domestic stock markets. "The correct solution is to permit individuals to export capital," Charles Dumas, a director at Lombard Street Research in London, told The Banker magazine in September. Calling SWFs in general "deeply suboptimal," he went on to say that for the Chinese, "channeling their savings through state-owned banks, via the People’s Bank of China, into a sovereign wealth fund will create understandable suspicions abroad, and lesser welfare for China." Outflow from millions of Chinese investors, on the other hand, could pump life into markets in other parts of the world.

Charles W. Thurston writes about emerging markets finance and serves as a project consultant to multilateral banks and nongovernmental agencies.

Forbidden Fruit
Some countries are wary of sovereign fund investment in strategic assets.

Much of the world fears sovereign funds because of their ability to acquire certain strategic foreign assets. Though the International Monetary Fund (IMF) calls the funds "black boxes," a reference to their secretive nature, it is believed that Russia has considered investing its $100 million stabilization fund into civil aviation and high-precision machine toolmakers. There is also global concern that China, certain Middle Eastern countries and others with dubious motivations will invest in strategic technologies. Even Iran has an $8 billion sovereign wealth fund.

Consequently, nations are greeting foreign suitors with a mood of suspicion. The United Kingdom has been an exception, selling shares in its ports, utilities and even the London Stock Exchange to foreign investors. Yet nearly every other country that expects to be a recipient of SWF capital is considering regulations about disclosure and foreign ownership in strategic industries, hoping to prevent cross-border intrigue and accusations.

France, Spain and now Germany are among the EU nations considering outlawing ownership of certain national industries by foreign investors. U.S. authorities are pressuring the IMF to require transparency of investments by members’ funds. Perhaps in reaction, China unveiled in August a new plan to screen foreign investment for national-security concerns. And China is expected to restrict Singapore’s ability to invest in its third-largest airline, the debt-plagued China Eastern Airlines. Singapore Airlines and Singapore’s SWF Temasek announced recently that they intend to buy a 24 percent stake; China has strict rules preventing foreign investors from owning more than 50 percent of any airline.