June 24,2008

CIC and SAFE: Coordination or Bureaucratic Conflict?

By Logan Wright
In assessing the seemingly conflicting or duplicative behavior of Chinese government institutions, it may be tempting to infer a coordinated government strategy, but bureaucratic turf wars often provide more compelling explanations. A case in point is the recent foray into equity investments by the State Administration of Foreign Exchange (SAFE), the official manager of China’s $1.757 trillion pile of foreign exchange reserves. Last year, China’s central government set up a new sovereign wealth fund, the China Investment Corporation (CIC), in order to seek higher returns on a $200 billion portion of China’s foreign exchange holdings. The move was widely viewed as a coordinated central government effort to diversify away from China’s large holdings of low-yielding dollar-denominated fixed income securities. However, underlying the creation of the CIC was a long-running bureaucratic dispute between the Ministry of Finance (MOF) and the People's Bank of China (PBOC), China’s central bank. SAFE's attempts to expand its own equity investments, clearly encroaching onto the CIC's turf, is likely more reflective of these bureaucratic conflicts than a coordinated government strategy for investing China’s foreign exchange reserves.
An Expansion in SAFE's Equity Investments
SAFE has been more active in overseas equity investments in recent months. An April 28 story in Caijing magazine quoted an anonymous Chinese official claiming that the State Council had authorized SAFE to invest 5% of China’s foreign exchange reserves in non-fixed-income investments. While the claim is impossible to verify in China’s highly opaque political system, SAFE's behavior in recent months has been consistent with a broader mandate for overseas investment. As of the end of April, 5% of China's foreign exchange reserves would form a potential equity investment pool of $87.8 billion, which would be larger than the portion of CIC's original $200 billion capital injection that is likely to be invested abroad (one third, or about $67 billion).
As the CIC begins to expand its own outbound investments, SAFE is demonstrating its own intentions to occupy the same space. SAFE recently sank $2.5 billion in a $17 billion fund managed by TPG for private-equity investments. In addition, the foreign exchange manager has bought around $2 billion in shares of British Petroleum and around $2.5 billion in shares of France’s Total. Late last year, SAFE made several smaller purchases in shares of a few Australian banks. In reality, as many of these equity purchases are likely below the ownership thresholds requiring disclosure, and given the Chinese central bank's penchant for secrecy, SAFE has likely been far more active in overseas equity purchases than is currently known. Rumors around the capital point to SAFE actively soliciting investment proposals, in many cases from the same pool of managers courting the CIC.
The CIC: Born Amidst Bureaucratic Conflict
In discussing the seemingly duplicative behavior of the SAFE and the CIC, it is useful to consider the origins of China’s sovereign wealth fund, which arose largely out of bureaucratic conflicts between the Ministry of Finance and the PBOC. In the spring and summer of 2006, economists affiliated with the Ministry of Finance, the National Development and Reform Commission, and the State Council's Development Research Center began to criticize the relatively low rates of return that China was receiving on its foreign exchange reserves, which at that point were still less than $1 trillion. Proposals circulated to invest China’s reserves in natural resources and commodities, or to support state-owned companies in their overseas investments. The central bank countered with arguments that these economists did not understand that foreign exchange reserves were not a piggybank to be raided at will, and were a balance sheet item of the central bank that backed the country's money supply. Nonetheless, with China’s foreign exchange reserves growing rapidly, Chinese leaders began to agree that reserves had grown beyond the level sufficient to combat an attack on China’s currency, and arguments for increasing China’s returns on investments of "excess reserves" gained credibility.
Both the Ministry of Finance and the PBOC argued that they were the most suitable institutions to control China’s new sovereign wealth fund. The Ministry of Finance attacked the PBOC and SAFE's management of China’s existing foreign exchange reserves. The central bank countered that they were the only institution with experience in managing overseas investments. Eventually, the CIC was created under the control of the State Council, and out of the bureaucratic reach of either ministry, but was staffed primarily with personnel tied to the Ministry of Finance and the NDRC. In addition, the PBOC's holdings of shares of China’s state-owned banks under Central Huijin were sold to the newly created CIC at below-market prices. The bank holdings and the relative shares of costs borne by the PBOC and MOF in recapitalizing the banks had been a point of contention between the two ministries.
In the aftermath of the CIC's creation, the new sovereign wealth fund controlled all of the PBOC's shares in China’s state-owned banks and other investment companies organized under Jianyin Investment Corporation. The CIC's initial capital injection of around $200 billion was financed by the issuance of 1.55 trillion yuan in special MOF bonds, of which 1.35 trillion yuan ended up on the central bank's balance sheet. Yet the CIC was viewed within the bureaucracy largely as a creation of the Ministry of Finance, and its early publicized investments, such as the $3 billion stake in Blackstone, created some political space for the central bank to criticize the CIC's investment strategy. In many ways, the creation of the CIC did not resolve the bureaucratic conflict between the PBOC and the MOF. The central bank continued to argue that they were the most experienced institution in managing foreign assets, and the Ministry of Finance continued to criticize the central bank's low rates of return on these reserves.
What is SAFE's Motivation In Expanding Its Equity Portfolio?
Why would SAFE begin actively investing in overseas equity positions, when the central government appears to have designated the CIC for this task? Largely, this is a bureaucratic game, in which SAFE still holds several advantages. First, the CIC's early investments lost money and so were heavily criticized domestically, strengthening the central bank's argument that SAFE was the more experienced institution in investment management. By expanding its own equity investments, the central bank may be attempting to reduce the eventual size of the CIC, arguing that if the State Council wants to offset dollar depreciation risks and diversify China’s reserve holdings, these goals can be accomplished more safely and profitably via SAFE rather than using CIC.
Secondly, there is a different level of scrutiny of the two funds, both internationally and domestically. The CIC has been subject to a flurry of speculative media coverage since its creation, with international markets following the fund's every move. In response, the CIC has made promises internationally to provide some transparency regarding its investment strategy, although the degree of this transparency is still very unclear. In contrast, SAFE has been active in international markets for several years, and its holdings remain almost completely opaque, even within the Chinese bureaucracy. The returns on CIC's holdings will be scrutinized by a variety of observers both inside and outside the Chinese government, but the returns on SAFE's holdings are known only to a few key individuals within the State Council and China 's central bank. In addition, the CIC's management structure -- in which SAFE has oversight ability on CIC activities -- provides SAFE with some oversight over the CIC's investments, while no one at CIC is aware of SAFE's activities. For a government with a penchant for secrecy, this gives SAFE bureaucratic advantages over the CIC in convincing China’s leaders that they are the preferred vehicle for overseas investment.
Thirdly, SAFE starts with a personnel advantage relative to CIC, as they have a greater pool of experienced investment managers active in international markets, and have been expanding consistent with China’s accumulation of foreign exchange reserves. CIC, in contrast, is only beginning its operations and is currently recruiting aggressively; creating a system of investment oversight will require time (and perhaps some high-profile mistakes). This may bolster SAFE's self-representation as the superior investment management institution.
It is far more likely that SAFE's foray into equity investments is a result of bureaucratic fighting over turf than the result of a coordinated strategy to divide investment responsibilities between these two entities. If the same investment managers are pitching both funds, as has been rumored, these bureaucratic battles may spill out more clearly into public view. The bureaucratic conflict between the Ministry of Finance and the PBOC has lasted for several years, and while the MOF may have won a temporary victory in the creation of the CIC, the SAFE's activities suggest the PBOC is not abandoning its claim as the more experienced and effective institution to manage China’s reserves.
What Next for CIC and SAFE?
This bureaucratic conflict between the CIC and SAFE dramatically increases the degree of difficulty in forecasting the future of China’s outbound investments. Bureaucratic conflict in a political system with the degree of opacity of the Chinese government produces surprises with alarming frequency. However, the implications of this battle are wide-ranging. This bureaucratic conflict could eventually influence the size and the future of China’s sovereign wealth fund. If the State Council accepts the PBOC's argument that SAFE could invest around 5% of China’s reserves in a more profitable equity portfolio, the next round of funding for the CIC could be relatively small or canceled altogether.
However, the PBOC has its own political difficulties. Recently, the central bank's attempts to expand the medium-term commercial paper market were quashed by the NDRC (presumably with the backing of the State Council). The central bank had attempted to allow companies to issue commercial paper of up to five years in duration on the Chinese interbank market, circumventing the NDRC and CSRC approval processes for enterprise bonds (issued by state-owned companies) and corporate bonds (issued by listed companies), respectively. However, new issuance of this medium-term commercial paper has now been canceled, suggesting the PBOC had overstepped its authority. In addition, the central bank continues to face political pressure because of its advocacy of faster yuan appreciation; following the first quarter, the PBOC was forced to slow down the pace of appreciation after facing pressure from several other institutions. While the central bank had pushed for faster appreciation as an anti-inflationary measure, headline inflation levels remained elevated, and hot money inflows continued accumulating.
Therefore, there is no reason to believe that the SAFE will win this bureaucratic dispute with the CIC; by many accounts, the CIC's relationships within the State Council are stronger than those of the central bank. One possible outcome is that the State Council instructs the SAFE to sell its equity holdings to the CIC in exchange for additional bonds, should China’s government conclude that SAFE has overstepped its own authority. At the same time, if SAFE proves itself as an effective investment manager in the eyes of the State Council, CIC may turn into a different entity closer to a state development fund, holding the stakes of China’s state-owned banks and securities companies and assisting state-owned enterprises with funding for overseas investments. Another alternative is that the CIC becomes much larger, as many analysts expected when it was created, receiving a significant proportion of China’s new foreign exchange reserves. However, based on some of our sources, the next round of funding for the CIC is not even under discussion yet. We would not be surprised to see the CIC and SAFE undertake similar equity investments in the near future. Predicting the behavior of China’s sovereign wealth funds is likely to become considerably more difficult, given the apparent bureaucratic infighting between SAFE and CIC.




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