October 17, 2007

China flexes global investment muscles

With the official launch of the Chinese Investment Corp, China's new financial juggernaut will be both a formidable opportunity and challenge for the west.

By Nicola Casarini for ISN Security Watch (16/10/07)

The Chinese Investment Corp. (CIC) has been officially launched, and with an initial endowment of US$200 billion the new state-controlled company is tasked to invest abroad China's huge foreign reserves.

In the shopping bag there will be natural resources from developing countries as well as foreign technologies, research and development (R&D) establishments and brand names from developed economies. For the west, China's new financial juggernaut will be a formidable opportunity, and a formidable challenge.

After various announcements, on 27 September, the Chinese authorities officially unveiled the CIC. Under the direct supervision of the State Council, the nation's cabinet, the CIC is mandated to invest abroad the huge reserves accumulated by Beijing over the last years.

China's forex topped US$1.33 trillion at the end of June and are expected to reach US$1.5 trillion by the end of the year, the largest in the world.

Lou Jiwei, a deputy-secretary general of the State Council and former finance minister, will be the director of the new company.

China's investment corporation has been under preparation for some time. At the conclusion of the annual session of the National People's Congress in March, the Chinese government announced that it would set up a State Foreign Exchange Investment Company (SFEIC) aimed at improving the yield of the country's foreign exchange reserves and generating the largest returns possible.

In May, the new company, while still in preparation, invested US$3 billion of its reserves in non-voting shares of the Blackstone Group, the New York-based private equity firm that recently went public. With the establishment of the CIC at the end of September, the contours of China's investment strategy have become clearer.

The CIC strategy
The CIC is modeled on the Singapore investment company, Temasek Holdings. Temasek is an investment firm incorporated in 1974 and headquartered in Singapore. Its portfolio spans various industries including telecommunications and media, financial services, real estate, transportation and logistics, energy and resources, infrastructure, engineering and technology as well as bioscience and healthcare. The Chinese sovereign wealth fund will also be a private equity vehicle, operating on a flexible investment horizon with the option of taking concentrated risks.

Lou Jiwey, the CIC's director, declared that the new company would "invest, manage and add value to the Chinese portfolio" as an owner of its assets and investments.

Beijing currently holds its reserves in US treasury bonds and other safe but low-yielding, instruments. According to Chinese sources, the CIC will likely be "equity-heavy."

Analysts at Morgan Stanley also expect the Chinese company to hold a substantial share of its assets in equities, not sovereign bonds. "The company's principal purpose is to make profits," Li Yang, director of the finance research institute at the Chinese Academy of Social Sciences (CASS), told ISN Security Watch.

The CIC has an initial capital of US$ 200 billion, but presumably the amount will be increased according to the investments that the company will support. In practice, the CIC will issue RMB-denominated bonds and sell these bonds on the market to buy foreign exchange funds from the central bank. It will then use the foreign exchange funds for investment. In June, China's legislature approved a special issuance of RMB 1.55 trillion (US$200 million) in treasury bonds for the new investment company.

The CIC will operate in both the domestic and global markets. Internally, the investment channels of the new vehicle will include another Chinese state-owned company founded in 2003, the Central Huijin Investment Corp., which has been merged into the CIC as a wholly owned subsidiary company.

Central Huijin holds shares in China's four leading commercial banks and in 2005 injected US$60 billion into three of them. While Central Huijin will be one of the financial vehicles adopted as the central bank's investment arm to improve the balance sheets of Chinese state-owned banks, the CIC will be more of a strategic investment fund focused on industry and private equity.

Internationally, the CIC will be Beijing's investment arm in a range of sectors and countries. Its initial endowment and future prospects make it one of the biggest in the world.

According to a report by Chatham House published in September, the CIC soon will be the number two in the world, behind the Adia, the sovereign wealth fund of the United Arab Emirates, but ahead of both the Gic, the Singaporean fund, and the Norwegian Government Pension Fund.

The central question is therefore where and in which sectors the CIC will invest its capital.

According to sources, China's international investment strategy will take two directions. One the one hand, it will invest in natural resources in developing countries. On the other hand, it will concentrate on the acquisition of foreign technologies, R&D establishments and brand names in advanced economies.

According to Li Rongrong, director of the China State Asset Management Commission (the agency that oversees government assets), the CIC may also help major state-owned companies expand overseas.

Taking the world by investment
Since the mid-1990s, the search for natural resources has continued to gain momentum as a result of China's high economic growth, with increasing emphasis on oil and industrial raw materials.

In its 2006 World Investment Report, the United Nations Conference on Trade and Development (UNCTAD) indicated that China's outward foreign direct investment had more than quintupled in the first half of this decade, to reach US$11.3 billion in 2005. South-East Asia, Latin America and Africa have become the prime targets. For instance, in 2002, the China National Offshore Oil Corporation became the largest foreign oil producer in Indonesia after its takeover (for US$585 million) of Repsol Indonesia.

In Africa, China's investment strategy has been directed mainly at sourcing natural resources, including oil. Moreover, increasing numbers of Chinese companies have recently established production bases to supply local markets with cheap products highly compatible with local demand and purchasing power. As a result, total trade between China and Africa nearly quadrupled in six years, from US$10.8 billion in 2000 to nearly US$40 billion in 2006. China is today Africa's biggest trading partner and the second most important investor. China's new investment company will further boost these trends.

At the same time, China will invest more and more in developed countries, where its presence is often welcomed for the jobs, cash and infrastructure that it brings. In Australia, for example, China has become the biggest foreign investor in the mining sector. The CIC will place more emphasis on the acqui¬sition of advanced technologies, R&D establishments, managerial know-how, distribution networks and brand names.

China's investment strategy will likely take the form of profitable participation in private equity funds as well as strategic participation in foreign investment companies running businesses considered of importance for China.

While normally in the first case, the CIC would hold a minority stake or give up voting rights for the entitlement of a higher return (as in the Blackstone investment fund), in the event of acquisitions of strategic assets, China's investment company would presumably detain the majority of shares or in any case full control of the company. It is in this scenario that questions of corporate governance, transparency and strategic considerations will be unavoidable.

Eye on Europe: challenge and opportunity
While in the US protectionist tendencies may create difficulties for China investing in key strategic sectors, Europe is emerging as the most attractive place for China's technology-seeking shopping spree.

China is eyeing Europe's IT, aerospace and defense sectors as investment opportunities, both in terms of profitable returns on its foreign reserves and in terms of acquisition of advanced technologies needed for China's industrial (and military) modernization.

Chinese investments in European companies would be helped by the fact that EU-China relations are characterized by the conspicuous absence of issues that could provoke a confrontation between the two sides - such as the Taiwan question. Unlike the US and Japan, Europeans look at China almost exclusively in terms of business opportunities and not as a possible military competitor.

Some EU policy makers - such as the Italian minister for the economy, Tommaso Padoa-Schioppa - have openly invited the CIC to invest in Europe. At the same time, French President Nicolas Sarkozy and German Chancellor Angela Merkel have called for a European "golden share" to protect industrial strategic assets from unwanted takeovers from sovereign wealth funds (SWFs).

EU Economy Commissioner Joaquin Almunia added that "the EU might restrict investments by government funds unless they disclose more about what they invest in and why."

The CIC will thus be, on the one hand, a great opportunity for some industrial sectors, as it will offer fresh money into tight markets after the sub-prime mortgage crisis. On the other hand, the Chinese investment vehicle could well succeed in gaining control of western assets and advanced technology that could be turned into military might in a situation where there could be future tensions in US-China relations, especially over Taiwan.

In sum, for the west, the new Chinese investment corporation will be a great economic opportunity, but also a formidable strategic challenge to watch.





Nicola Casarini is Jean Monnet Fellow in the Robert Schuman Centre for Advanced Studies, European University Institute (Florence).

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