February 15,2008

China Overseas Investments Shifting to Real Assets

By Ma Wenluo

The Chinese aluminum giant, Aluminum Corporation of China Limited (Chinalco), has bought a 9% stake in Rio Tinto for $14.05 billion, indicating that industrial investment has again become popular as part of China’s overseas investment strategy.

China’s investment into overseas financial assets is causing concern, mainly prompted by the subprime crisis. Nevertheless, over the next few years, Chinese capital will play an increasingly important role in global purchases and investments, and will possibly change the pattern of international capital flow.

How China Underestimated the SubPrime Crisis

After the outbreak of the subprime crisis in 2007, prices for international financial assets slumped, forcing financial giants to turn to investors from developing countries, including China. The China Investment Corporation (CIC), China’s sovereign wealth fund, and China’s state-owned banks, reached a consensus that this was a good opportunity to purchase US financial assets at a low price. 

The Federal Reserve and US government, who virtually ignored the subprime crisis, have largely influenced the decision makers of Chinese financial institutions in this regard. In the middle of August, Ben S. Bernanke, Chair of the Federal Reserve said that the effect of subprime problems on the US economy was limited and would not spread to the whole financial system or other economic sectors.  

China’s sovereign wealth fund, supported by a huge amount of trade surplus, and China’s state-owned financial institutes benefiting from recapitalization and IPO, made attempts to purchase such overseas financial assets because of their lowered price. "As some sovereign wealth funds have successively invested in large financial institutions suffering losses in order to stabilize international financial markets, CIC will do the same," said Lou Jiwei, Chairman of CIC. CIC then announced it would allocate 1/3 of its funds for financial assets and set about recruiting overseas investment managers globally. Since then, rumors about CIC’s intentions have arisen almost daily causing confusion in the international markets. 

In December, CIC announced an investment of $5 billion in Morgan Stanley for up to a 9.9% stake. As Morgan Stanley urgently needed capital infusion from outside sources to make up for its annual financial statement and to restore investor confidence, CIC was able to gain far more favorable conditions than its predecessor, the State Investment Company (SIC), did when it bought into Blackstone six months ago. Chinese commercial banks, unwilling to be left behind, also showed a keen interest in investment opportunities in the US subprime market. In August, Bank of China said it has bought several billion dollars of real estate mortgage-backed securities.  Industrial And Commercial Bank Of China and China Merchants Bank have also invested in the US subprime mortgage market. Meanwhile, China Development Bank (CDB) declared its intention to purchase a 3.1% stake in Barclays, which owns a large amount of US subprime bonds. A report from China Business News details how after China was urged to loosen capital control and allow capital outflow during the Sino-US Strategic Economic Dialogue (SED) in December, 50 Chinese financial institutes were identified as Qualified Domestic Institutional Investors (QDII) and granted a quota of $64.5 billion of investment, of which $35.3 billion has been invested overseas.

Subprime Crisis Deepened

However, the situation changed rapidly. At the end of 2007 and the beginning of 2008, Morgan Stanley and UBS AG reported, respectively, a $9.4 billion and a $14 billion write-down.  Citigroup and Merrill Lynch also declared losses of nearly $10 billion. The share price for Blackstone, in which CIC has invested, has dropped by 40% and Barclays, with CDB investments, also declined by 1/3. Overseas media predict the Bank of China may suffer losses as a consequence of holding 7.451 billion subprime bonds. The Bank of China has denied these reports, however, and has refused to comment on the amount of any possible losses. Moody’s Investment Service estimates the potential loss of Bank of China could be $2 billion. In a bid to avoid economic recession, the Federal Reserve cut the interest rate twice by 125 basis points within 8 days at the end of January 2008 and declared in a statement that "Financial markets remain under considerable stress" and that " Downside risks to growth remain."

This has led to criticism concerning the huge losses brought about by Chinese financial institutions that attempted to purchase financial assets at low prices. These institutions effectively failed to control the risks present during this period of market turbulence. CIC and Huijin (its subsidiary) invested nearly $140 billion - i.e. 70% of its total capital - in domestic and overseas financial institutions. Market professionals have expressed doubts about CIC’s decision to invest in overseas financial assets and fear that it has failed to disperse the risks involved. CIC also has to consider short-term financial pressures. The Department of Finance injected funds into CIC by issuing special treasury bonds, which means that CIC has to pay annual interest of 66.6 billion yuan ?a figure that can’t be covered by the dividends of its investment into state-owned commercial banks. "Everyday when I wake up, I can’t help thinking about how I will be able to pay the daily interest of 200 million yuan," said Gao Xiqing, president of CIC.

Critics contest that CIC represents the government and should focus on the improvement of the country’s flawed economic structure as opposed to seeking short-term profit.

When one considers RMB appreciation of 7%, a interest rate differential between China and the US of 2%, and about 2% of overseas management costs, then in order to avoid losses, short-term investment would need to gain at least a 12% return; an achievement that most agree is almost a "mission impossible". The departments concerned have also had their disputes over large-scale overseas investment with dissenters vetoing CDB’s $2 billion investment proposal in Citigroup.

Shifting to Industrial Investment

After China’s entry into the WTO, Chinese companies have become an active force in international purchases. However, because of the political backlash from the US government, Chinese companies repeatedly failed in purchasing or buying into American companies. China’s strong capital forces are now returning to the international markets. China’s overseas investment will focus on natural resources as China’s rapid economic growth requires large amounts of oil, gas, iron ores, etc; resources that China is naturally short of. The Ministry of Commerce will encourage some industries, such as giants in heavy industry and chemical sector, as well as the telecommunication industry, to "go out" and acquire new investment tools such as equity investment and overseas purchases.

On February 1st 2008, Chinalco, China’s Aluminum giant announced plans to buy jointly with Alcoa, a 12% stake in Rio Tinto through Shinning Prospect based in Singapore. The total amount of the deal was about $14.05 billion. Since BHP Billiton, the world’s largest resource company, announced a proposal to merge with Rio Tinto, it’s rumored that CDB, CIC and Baosteel also want to join the bid in order to avoid the merger and thus prevent a negative impact on China’s iron ore supply; 50% of China’s iron ores are imported from overseas. 

Natural resources have become an important focus of Chinese investment and since 2007, China’s state-owned companies have been relatively successful in overseas purchases. China Minmetals Corporation, jointly with the Jiangxi Copper Co Ltd, has purchased the Northern Peru Copper Corp for $1.15 billion, thus acquiring copper mines and gold mines in the north of Peru. China Metallurgical Group Corp successfully purchased a copper mine in Afghanistan for a price of $3.7 billion, while Chinalco won a bid for a bauxite program in Australia with a total investment of about $3 billion AUD. Chinalco has also acquired an exploitation area for bauxite with exploitable reserves of 2 billion tons in Guinea in Africa. And recently, the Shougang Group, China’s sixth largest steel company, bought a 20% stake in an iron ore mine in Australia though a listed company based in Hong Kong. Sinosteel Corporation is also planning to purchase Midwest, based in Australia,in order to acquire iron ore resources.

The government has also supported the overseas purchases. Chinalco gained nearly 100 billion yuan of credit-granting quota from China’s major banks and CDB helped fund Chinalco’s deal with Rio Tinto. Analysts and some government departments believe China’s overseas financial investment should support the overseas operations of Chinese companies. They praised some investment programs such as the Industrial and Commercial Bank of China buying a 20% stake in the Standard Bank of South Africa and a 90% stake in Bank Halim based in Indonesia, as well as the establishment of overseas branches of Chinese banks, which helps the trade settlement of Chinese companies.

Unlike the Japanese, China does not intend spending money on cultural icons such as the Rockefeller Center and Hollywood film studios. Currently Chinese companies are more interested in natural resources and financial assets in their overseas purchases. However, in keeping with the nation’s traditions, Chinese people are more interested in tangible assets, as many of them used to buy land and build houses with their hard-earned wages. So compared with financial assets on Wall Street, industrial investment may be a more desirable option.


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