China made headlines by becoming the largest foreign holder of US Treasury bonds at the end of September 2008, and it was already the largest foreign holder of other US public debt. In the last few years, the People's Republic of China (PRC) has invested over USD 100 billion in Africa, the Middle East and elsewhere. The current financial crisis further highlights the role of Chinese bond investment in the US economy and prompts questions about whether Chinese investment in equities or other assets would be helpful as well. Some in the US Congress are concerned that China will stop buying American bonds. At the same time, there is alarm over the extension of Chinese investment beyond bonds in the US and around the globe.
Why China Invests
Too Much Liquidity
A lack of transparency has generated suspicion of Chinese motives overseas. Until recently, Beijing proceeded like any cautious investor, placing the vast majority of its funds in the safe haven of American government bonds. The last four years have seen a much-discussed drive to acquire foreign mineral assets and financial instruments as Chinese government arms and state-owned enterprises drown in cash and search for an investment outlet -- any investment outlet.
The global crisis shows painfully how too much liquidity breeds over-extension. The PRC is spending, and unintentionally wasting, a great deal of money, in part simply because it has accumulated so much money through trade surpluses and purchases of foreign currency to defend the Yuan. There is no conceivable balance of payments use for the massive foreign exchange pile; it is almost twice as large as annual imports and debt accumulation combined. Hypothetical large-scale government purchases of imports to benefit Chinese consumers clash with the core objective of developing local industry. Moreover, the non-convertibility of the Yuan, to which Beijing is just as staunchly committed as to developing local industry, means that reserves cannot be spent on domestic needs, an enormous waste.
This odd set of conditions makes for a very odd implication: Public talk aside, there is little practical value in gaining higher returns from investing reserves. Achieving higher yields would merely earn more foreign currency, which the Chinese government cannot use within the system it has created. Hence, other motives for outward investment are at least as important. These are largely political. One aspect is domestic: US treasuries appeal to Beijing because they cannot suffer visible and gigantic losses or outright defaults the way other bonds and stocks can -- losses that infuriate the "Chinese street" far more than abstract complaints about mere two per cent returns.
Outward investment can also bring foreign goodwill by providing the liquidity sought by policymakers worldwide in response to the financial crisis and from job creation. As Japan did in the 1980s, China can invest overseas in part as a political strategy to protect lucrative trade links. Purchases of American bonds certainly fit in this category. The PRC can also secure outright political gains in small countries. In January 2008, China's State Administration of Foreign Exchange (SAFE) bought USD 150 million in US Dollar bonds from the Costa Rican government as part of a 2007 agreement under which Costa Rica cut ties with Taiwan.
On the commercial side, investment activity begets better investment activity as experience is gained. Acquisition of equity stakes and joint ventures bring managerial learning and exposure to better corporate practice. Majority stakes, of course, bring control of either physical resources or unique corporate assets. This relates to the main objection to Chinese spending: In the US and Europe, it is a means to acquire technology; elsewhere, it is a resource grab of physical assets such as oil fields. There is a non-commercial component to the behaviour of state enterprises: Following national priorities in securing mineral supplies can trump market valuation. Non-commercial investment bids up commodities prices beyond the additional demand naturally introduced by China's growth. In addition, SAFE takes small stakes in strategic sectors like energy to serve national interests without inciting a protectionist reaction.
As shown later, the amount devoted to physical assets is far less than the amount stored in safe securities such as US T-bonds, which merely augments the conclusion that strategic considerations are more important than commercial in most outward investment decisions.
Who Are the Players?
SAFE Dominates, Followed by State Financials
One common error is to view Chinese foreign investment through the prism of the China Investment Corporation (CIC), the explicit sovereign wealth fund. In fact, CIC is a minor player, at least by Chinese standards. The headliner in this drama should be SAFE and its near USD 2 trillion in reserves at the end of 2008. The second act is a group of state financials which have acted as a distributive channel for the overflow of foreign money pouring into SAFE. State-owned non-financial enterprises have also invested heavily overseas in recent years, often funded by the government lender China Development Bank.
SAFE will shortly hold ten times the assets of CIC, is presently adding the equivalent of at least two CICs annually, and is the largest securities investor in the world. It is an arm of the central government and should function as the definition of a sovereign wealth fund. SAFE's holdings of American bonds were at least USD 1 trillion by the end of June 2008. These holdings flow naturally from the fact that China runs a trade surplus with the United States. China must do something with those Dollars.
In an obvious bit of bureaucratic competition, SAFE began to move beyond bonds in 2007 coincident with the creation of the CIC. SAFE is permitted to invest five per cent into assets other than bonds, a number that passed USD 90 billion by the end of September 2008 and grows higher every quarter. Other than American bonds, SAFE's major outlays appear to be in Britain, where, in barely over a year, it invested more than USD 16 billion in firms from banking to utilities. All stakes are less than three per cent and need not be disclosed under British law. This connects to a critical issue: SAFE is secretive; its activities uncovered only by outside investigators after the fact and usually even then denied by SAFE.
he activities of China's state financial institutions have also been poorly documented. They received massive sums of foreign exchange as a means of capitalisation. In the last two years, they have been ordered by the People's Bank to hold larger amounts of foreign currency as part of required reserves. In both cases, the money was transferred from SAFE; otherwise official reserves would be even larger. Brad Setser at the US Council on Foreign Relations calculates the amount of foreign money at Chinese state banks at no less than USD 430 billion at the end of June 2008, on extremely rapid growth over the preceding 18 months.
CIC and State Firms Play Smaller Roles
Well down the ladder, then, is CIC. Its high-profile launch and well-trained executive team made it the face of China's foreign investment. CIC's promises to abide by market norms, including those pertaining to transparency, were intended to offer reassurance about its investment. But CIC has been nearly irrelevant from the outset. Two-thirds of its USD 200 billion endowment is allocated to domestic banks as capital. That leaves less than USD 70 billion for "overseas" spending, but even that includes initial public offers by mainland companies in Hong Kong. The last set of players is state firms, with a helping hand from two national-level policy lenders, Export-Import Bank of China and, especially, China Development Bank. These have invested a comparable amount to CIC -- though over a longer period -- in Africa, the Middle East and elsewhere, searching for energy and metal ores. Their acquisitions are transparent, or at least visible, but often made on a non-commercial basis because the firms are instruments of national strategy.
CIC is widely designated as a sovereign fund. SAFE is increasingly, and properly, recognised as a sovereign fund. State-owned banks are tightly connected to CIC in administrative structure and have behaved similarly to SAFE. The major investors among state-owned firms, such as China's oil giants, are tightly held. It is a diverse set of names making China's purchases overseas, but they are all very closely related. As such, Chinese foreign investment is best understood as almost entirely sovereign.
What China Invests In
Government and Other Securities
It is also an error to view China's foreign investment through the lens of a few controversial events, such as China National Offshore Oil Corporation's (CNOOC) failed attempt to buy Union Oil Company of California (UNOCAL). In particular, while equities and direct investment receive most of the attention, the core of China's foreign investment consists of American government securities. Over half of SAFE's holdings appear to be official American debt, both treasuries and agency debt, such as bonds issued by Freddie Mac. As of September 2008, China was the largest holder of US treasuries at approximately six per cent of the total. SAFE began moving into US agency debt in 2003 when China's foreign reserves began to mushroom. For currency balancing, it holds official European and Japanese debt as well. There is corporate debt of many national stripes.
The composition of state banks' holdings has been obscured by SAFE's larger investments. Some banks have disclosed small positions in troubled institutions and companies, such as Fannie Mae or Lehman Brothers, but there is no external public auditing of their true exposure. In the aftermath of the financial crisis, at least, the political relationship between state sector and central government makes it likely that in 2009 state financials will purchase US treasuries almost exclusively. As for CIC, the financial crisis did reveal a multi-billion Dollar placement with an American money market fund that likely reflects much more money placed by all Chinese institutions. Beyond bonds, SAFE now also capitalises foreign investment funds and buys equity stakes in individual foreign entities, such as British Petroleum. CIC does, too, though so far not very adeptly. Acquisitions of both equity stakes and physical assets by state-owned enterprises range widely and geographically and in terms of sectors.
State banks have made a few discrete equities investments and also operate through a government-controlled program for foreign equities investment by commercial entities. Approved Chinese institutions apply to act as mutual funds in the US, as well as in Britain, Hong Kong, Japan, Korea and Singapore. Less than one-third of the USD 42 billion authorised under this program has been invested. But regulators have worked to jump start the program and, when global stocks recover from the current crunch, Chinese institutional investors could quickly become major players. The principal concern with respect to the large investment in bonds is that it may stop or even unwind. The concern over the much smaller investment in equities and physical assets is that it will continue and intensify. This is partly because such investment has been concentrated in the sensitive areas of energy, finance and metals.
Metals, Energy, Logistics and Finance
Metals, not energy, have been the leading target for Chinese investment, with nearly USD 43 billion committed in less than five years, even prior to Aluminum Corporation of China's near USD 20 billion bid for a piece of Australia's Rio Tinto. While aluminium is important, iron and steel are the main focus, as with Minmetals and Xinxing Iron's planned venture with India's Kelachandra and Manasara to produce six million tons of iron pellets annually and build a 2.5 million ton steel mill in Karnataka, India, for USD 2.2 billion. The PRC has committed approximately USD 40 billion to purchase energy assets of various types. It may be surprising that energy is not the principal target, but the number of energy acquisitions peaked in 2006, and then tapered off somewhat as the cost of assets mounted. If pre-2005 transactions were included, energy would be the largest sector for China's foreign investment. And more energy investment emerged in the third quarter of 2008 when crude prices dropped from their peak.
Government arms and state firms have spent the money all over the globe. In May 2006, China Petroleum and Chemical Corporation (Sinopec) paid nearly USD 700 million for control of three Angolan oil blocks. In April 2008, SAFE paid USD 2.8 billion for 1.6 per cent of the French oil and gas company Total. The sum goes higher if agreements to construct power plants and aid for power distribution are included. There has been more than USD 8 billion in awards of these kinds as well as outright power investment in the past four years, highlighted by State Grid Corporation of China's participation in a consortium that won a 25-year, USD 4 billion award to operate the Filipino power grid. The leading sector in drawing contracts, however, is transport and logistics, featuring port management and highway construction. Investment in the sector stands at only USD 1.5 billion, but more than USD 16 billion in large engineering and construction contracts was inked from January 2005 to September 2008.
Most relevant to the global financial crisis, more than USD 25 billion was committed in finance, all from May 2007 through the third quarter of 2008. In addition to the stakes taken in Morgan Stanley and Blackstone by CIC, SAFE contributed USD 2.5 billion to a fund created by Texas Pacific. The largest single transaction was outside the US: Industrial and Commercial Bank's USD 5.5 billion purchase of 20 per cent of the Standard Bank of South Africa, with an eye to financing China's activities on the continent.
Part 2 of this series will discuss how much and where China is investing overseas.
Derek Scissors is a research fellow in Asia economic policy at the Heritage Foundation.
First Appeared in BusinessForum China