ChinaÆs sovereign wealth fund takes shape

China Investment Corporation should clarify its goals, investment strategy, relationship to government bodies, ownership and management structure.
China has accumulated a vast wealth of foreign reserves from exports and over 20 years of successful foreign investment policies. By the end of 2007, China held about $1.53 trillion in foreign exchange reserves, mostly in US Treasuries and similar securities, with a domestic savings rate of around 50%. Additional reserves are also accumulating at an escalating rate. To increase investment yield and diversify currency risks, China has officially begun to reallocate her surplus reserves, from the traditional highly liquid and low-risk investments, to a sovereign wealth fund (SWF) known as the China Investment Corporation (CIC), formed on 29 September 2007. It is expected that the funds available to CIC for investment might amount to $1 trillion in just a few yearsÆ time.

The set-up of the CIC

CIC was formed after long-time consultation by China with international financial and legal advisors and management consultants, drawing the experience from SWF models of other countries. The final shape of CIC has, typical of all Chinese models, certain ôChinese characteristicsö that reflect ChinaÆs political structure, and specifically her recent history of financial reform.

CIC was established as a limited liability company under the PRC Companies Law, and is owned entirely by the Chinese government. To date, the articles of association of CIC remain unrevealed. Hence, the specific objectives, structure and constitution of CIC is still a mystery to the public.

CIC is presently managed by a distinguished ægroup of sevenÆ drawn from the State Council, the Ministry of Finance, the PeopleÆs Bank of China (PBoC), the National Development and Reform Commission (NDRC) and Central Huijin Investments Company. This implies that CIC would need blessing from, amongst others, the NDRC in respect of its overseas investment, but whether this would equate an approval from the NDRC remains to be seen. Interestingly, the State-owned Assets Supervision and Administration Commission (Sasac), which is the state organ that holds over 100 large state-owned enterprises (SOEs), is not represented on the board of CIC. This suggests that those in government who wish that CIC uses its economic clout directly to support the activities of Chinese state-owned businesses have lost out to those who see such activities as a potentially damaging confusion of roles, between CIC as a commercial investor without political influence, and CIC as state banker for national champions.

At the moment, CIC is focused on building its own investment advisory team. Before the team is formed, CIC will rely on international reputable fund management companies and advisors for expert investment advice, likely to be selected through a competitive tender process.

It is well known that CIC is initially funded in three tranches, totalling $200 billion. The first tranche of approximately $67 billion in funding has already acquired, for CIC at book value, the holdings of the Chinese government in several recapitalised and publicly listed state-controlled commercial banks, including ICBC, Bank of China and China Construction Bank. Given the high share price of their publicly traded shares (as a result of which ICBC had become the biggest bank in the world in terms of market cap), the potential market value of these government holdings is likely to have substantially exceeded the stated $67 billion. These banks and a number of securities firms now appear as subsidiaries of CIC, most of which are held through Huijin Investments.

The second tranche of the funding, which amounts roughly to another $67 billion, is dedicated to recapitalising two other important state-owned banks, China Development Bank (CDB) and Agricultural Bank of China (ABC), both of which are also likely to offer shares to the public at some point.

Accordingly, around two-thirds of the $200 billion funding made available to CIC initially will be devoted to domestic investments in the Chinese financial sector. When British prime minister Gordon Brown visited China in mid-January 2008, premier Wen Jiabao assured the world that CIC only plans to invest a modest sum of around $60-70 million abroad, which is the remaining one-third of CICÆs initial investment. While this message implies that CIC remains conservative in investing overseas, it does not dismiss the potential that additional funding growing from ChinaÆs surplus foreign exchange reserves may be applied towards overseas investment through CIC in the future.

The world is keen to know what CICÆs investment strategies would be. As a reference, even before CIC was incorporated, China applied $3 billion of its foreign exchange that was committed to CIC to purchase just under 10% of Blackstone Group, the US-based private equity firm. In late November 2007, CIC invested less than a 1% stake in the Hong Kong H-shares issue of the China Rail Corporation, a Chinese state-controlled company. Just before Christmas of 2007, CIC entered into an agreement with Morgan Stanley in which it will invest roughly $5 billion through convertible equity units. Upon mandatory conversion of the equity units into common stocks after a specified period of time, it is estimated that CIC would in aggregate hold no more than a 9.9% stake in Morgan StanleyÆs total outstanding shares. Since CIC will remain a passive financial investor, it will not have any special owership right or representation on the board.

Very recently, CIC has, through Huijin Investments, invested $20 billion in CDB, by far its largest known investment. Some latest rumours indicate that CIC would, also through Huijin Investments, invest $45-50 billion into ABC, as early as April 2008. All these transactions, together, indicate that CIC is capable of investing in a broad range of investment targets both domestically and overseas, whether indirectly through foreign private equity firms or directly in Chinese companies listed outside China.

There is the possibility that the United States and Europe may now consider erecting barriers to capital investment from abroad solely on the grounds that such investment funds are ultimately controlled by foreign governments. Another equally important issue relates to SWFsÆ state ownership. It is questionable whether governments as shareholders of SWFs will seek to maximise economic value in the companies they have invested, and whether objectives such as to extract technology or exercise political influence may take precedence.

How CIC is likely to behave

The rising importance of SWFs in the international financial system has been officially acknowledged in the latest G7 officials meeting. A positive remark was made at the meeting to identify best practices for SWFs in such areas as institutional structure, risk management, transparency and accountability, while recipients of government-controlled investments that formulate corresponding policies should do so on the basis of principles such as non-discrimination, transparency and predictability.

Considering the political concerns in western democracies as well as the issues raised by respected financial policymakers in those countries, it is unlikely that CIC will initially invest in a way that will arouse suspicion and hostility in important trading partners of China. This is supported by the recent statement of Premier Wen, as well as that of the chairman of CIC, that its operations would be ôcommercially driven, not politically motivatedö. The senior official in charge of risk management at CIC has also been quoted in the financial press to the effect that the bulk of CICÆs money will be invested through outsourcing to fund managers instead of direct investment.

Thus, in the near term, CIC is expected to focus on the slow and careful assembly of an outside team of financial advisors and fund managers. When cross-border investments by CIC begin to take shape, it is expected that most if not all early investments will be indirectly made through financial intermediaries, and most if not all will result in relatively small percentage stakes in the invested companies. What is not yet clear though is whether CIC will assist Chinese SOEs in offshore investments, for instance as co-investors in the acquisition of major stakes. Although the chairman of Sasac has indicated that there is such a possibility, CIC has not endorsed the strategy yet, and as previously discussed, Sasac is not represented on the CIC board.

It would be prudent for CIC to disclose its articles of association, which should clarify what its goals, investment strategy, relationship to government bodies, ownership and management structure are. This would greatly help eliminate market fears about its intentions.

This article appeared as a client briefing by Clifford Chance in January 2008. This version has been edited by AsianInvestor.
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