Divisive Economic Device? Understanding China's Choice to Create a Sovereign Wealth Fund
This essay seeks to elucidate the puzzle of China's policy decision to create a Sovereign Wealth Fund (SWF). Much literature has been put forth on the topic to predict the strategic benefits China may be pursuing through its investments in American firms using its SWF, China Investment Corporation (CIC). Such speculation on these ambitions continues to present inconclusive theories, and with the available data, further articulations on this matter are unproductive.
Three explanations for why China created CIC, however, can be elaborated with much more evidence. This essay will show that both rational-actor, profit seeking models and bureaucratic politics provide strong explanations for CIC's creation. A third explanation — that China is seeking international power — is much more difficult to prove. This section is of value however, because it permits an opportunity to discern the causes for CIC's creation from the implications of its creation, which have been harped on in previous literature. This paper finds that there could be an explanation for CIC at the international level, but contrary to alarmist literature, there is no evidence to support the claim that CIC was created for use as a strategic tool to threaten the United States.
The ultimate conclusions on the CIC is that the development of the Chinese sovereign wealth fund reflects China's growing power as well as a shift in the international order, in which the interaction between the state and others has changed. In fact, it appears China is using CIC as a way to engage further within the international financial system as it comes to recognize that it's power stems from domestic economic growth. This seems to mirror the global trend towards a politicized economy or political capitalism1.
While this paper shows that CIC is a representation of this trend within China, and that CIC serves an end for international relations for China, it cannot be discerned that this was an explicit goal of China's at the creation of CIC. It is therefore important to underline that CIC is not a tool of foreign policy, but rather a method of international engagement. By outlining the three reasons why China created the CIC, the mechanisms of China's engagement in the international system will be explained. To accomplish this, the essay will be organized in to five sections: the first section will provide a brief overview of CIC, the following three sections will discuss reasons for creating CIC and the final section will be a contribution to the existing literature on the intentions of the CIC in relation to American security, that draws from the conclusions made in the three preceding sections.
Part I: The Guts of CIC
The creation China Investment Corporation was announced in March of 2007. The China Jianyin Investment Company, a government agency, initially bought a $3 billion non-voting stake in Blackstone Group, before officially setting-up operations in September, when the investment group transferred the shares over to CIC2. With a starting capital fund of $200 billion, CIC's addition to the collection of SWFs worldwide is noteworthy. It is marked as the 4th largest in the world, but also the most recently created.
In the CRS Congressional report for January 2008, it was predicted that if China made more of reserves available, the fund could be worth over $1 trillion3. The report cites Brad Setser, who argues an organization "with a working capital for $1 trillion dollars would have the ability to push the US economy into recession."
The financing of CIC was convoluted. Understanding the power and capital flows within the system can be difficult (for reference, see omitted flow chart with indications by Cognato, Aizenman and Glick, and Shih).4 The CIC is headed by Lou Jiwei, who holds the title of Chairman within CIC and doubles as CCP party Secretary. More public within the organization is Gao Xiqing, the CEO who chairs the fourteen members of the executive board council for CIC. The majority of the council members have a background in finance; Gao and another executive, Wang Janxi, worked on Wall Street for several years prior to their CIC careers5.
Two executives are also involved with the National Development and Reform Commission, considered one of the most formidable commissions within the Chinese bureaucratic system6. NDRC makes most of the pertinent policies today, and under the Mao era it was in charge of managing the planned economy7.
The CIC website posts little information about its holdings, despite many complaints about CIC's lack of transparency, and the promises by Gao Xiqing that the institution would boast levels of transparency comparable to Norway's Global Pension Fund8. The most current tally of CIC's holdings can be found in the Security and Exchange Commission's annual report (see SEC report, ending quarter December, 2009).9
According to the report, CIC's largest holdings are in Blackrock, Morgan Stanley, and Teck Industries; however, the Chinese portfolio has never been highly diversified; it mainly contains stocks in financial institutions, technology and research corporations, and energy-production industries10. Prior to the 2008 financial crisis, CIC held almost singularly equities stock. Jiwei reported after loosing 2.1% of its initial investments in the U.S. in 2009 that the CIC would broaden its holdings — leading to an expanded portfolio11. Evidence shows that interests have been directed towards primary consumer goods, particularly in American agricultural production companies12.
Part II: CIC has some Guts
Explanation 1: acting rationally
On October 14th, 2010 China reported that it held $2.65 trillion in US foreign exchange, the highest citing ever13. Holding vast forex is a sophisticated problem for China: while the influx of American dollars represents a transfer of productivity to the Asian continent, it comes at an opportunity cost; with each increase of forex holdings, China's dollar holdings diminish in value14. It has been cited that holding these forex reserves costs China $100 billion a year15. In his interview on 60 minutes, Gao Xiqing, CEO of CIC, explained that the decision to create CIC was essentially a way to reduce opportunity costs of owning so many US dollars and to reduce the risk that forex holdings would depreciate in value as the dollar weakened16.
From a rational-actor stand point we can understand the decision of China to move its US dollar holdings out of US bonds and into the equities market as profit maximization. The move also provided China the opportunity to increase rates of return by taking on more short-term, higher risk rather than maintaining longterm, lower yield investments in bonds.
Further support that CIC was created for profit maximization comes from the SWF's dependency on fast payouts. Due to its structure (briefly recounted above) CIC is responsible for paying out on billions in bonds. This set-up differs somewhat from common SWF construction, but is due to the fact that CIC's capital flows from foreign exchange reserves that sit under the State Affairs Foreign Exchange17. To finance CIC's creation, bonds were purchased from the Peoples Bank of China, and therefore CIC is responsible for paying-out on these bonds annually, which amounts to RMB 1.55 trillion18.
This translates to a cost of $40 million per day to run the CIC, or $14.6 billion per year19. Because CIC is not deferential to any other bank within the system, only to the State Council, CIC is completely dependent on the quick and fast payouts from it's investments to make the payments on the bonds. It is in the great interest of CIC Chairman Lou to find high yielding investments therefore, which commonly take the form of equities investments.
CIC is also very unique in that the forex that finance the fund came not from sales of natural resources — like the petrol financed SWFs of many middle-eastern states, but rather from mass exports. This varies the importance of the SWF somewhat, because the high demand for Chinese products is premised upon the strength of the USD against the RMB. The very existence of the Chinese SWF affects Chinese export strength and China's continued ability to accumulate massive forex, therefore the situation of financing and payout is much more interdependent than is found in natural resource-based SWFs.
If the Chinese government did not address the problem of the massive forex, then the USD would continue to loose its value against the RMB and the Chinese advantage of low-cost exports would be diminished. The establishment of the CIC is pivotal in maintaining the low valuation of the RMB because if China continued to accumulate USD then the RMB would naturally inflate in value to equalize import/export margins. As Chinese growth necessitates a devalued currency, China had to find way to circumvent currency inflation. The creation of CIC disposed of some of the USD influx. This explains why CIC is not particularly risk averse and why the top leadership continues to invest despite the enormity of losses it faced in 2008. This also provides a very rational explanation for CIC's creation — a mechanism to allow China to continue growing.
The issue of unequal USD flow into China because of the pegged value of the RMB parallels China's continued investment in American corporations to prevent equalized trade margins. Both mechanisms simultaneously unravel the possibility for a greater quantity of exports from the U.S. and a recalibration of U.S. reserves across the international system20. The political effects of this are detailed by Herman Schwartz in his book Subprime Nation where he explains: "As SWFs come to hold more and more of U.S. overseas debt, their expectations about a higher return will force an end to the pattern of US Arbitrage,"21 which he pinpoints as the source of U.S. growth and power. He continues, "If Asian countries and oil exporters shift out of the U.S. Treasury debt into equities via sovereign wealth funds (SWFs), they pose an immediate threat to US power," by jeopardizing the potential for growth based on foreign investment in the Treasury.22 SWFs move investments out of the U.S. government and make it practically impossible for the USD to recover its value.
This, in turn, threatens the dollar as the international reserve currency and debases America as the leading economic power — to which US political power is tied23. In this way the development of the CIC has strong political implications, and it is not simply, as Gao articulates, an investment cooperation. Yet, while it is clear that CIC was created to improve returns on US currency, it is not clear whether shifting the economic and consequentially political system was also a goal of the Chinese government. It is more likely that the fears of the changing power differentials outlined by Schwartz are in fact reflections of trends and not decisive actions.
Explanation 2: dictated by Chinese bureaucratic politics
Leading up to the creation of the CIC, there was considerable debate within China among scholarly critics about the accumulation of vast foreign exchange reserves and what to do with them24. Two opinions were vocalized most loudly. One was to employ private financial groups to handle the funds with the single goal of increasing returns on China's foreign exchange reserves25. The other was to create a sovereign wealth fund to back state-owned Chinese companies. It was even proposed to create a super-sovereign reserve of currency26. The top leadership tried to create an entity that satisfied both camps and to create an institution that would act in both capacities concurrently.
Even before the creation of the CIC, however, there were arguments at the bureaucratic level over control of the future institution. The Ministry of Finance and the People's Bank of China, which operates under the State Association on Foreign Exchange (SAFE), both rivaled for control. Eaton and Ming, in their essay China's Sovereign Wealth System, describe the development of CIC as an idea that was born out of the bickering between the SAFE and the MoF for greater control over forex. A SWF was initially decided upon as an option that would allow both institutions to exercise influence over the reserves. In the end, however, neither party gained direction over CIC; instead it was decided that the organization would report directly to the State Council and that it's ties would be more strongly allied to the MoF because traditionally ministries of finance control SWFs27. This proposes the idea that the structure of CIC was determined by bureaucratic politics.
CIC was finally endowed and began functioning as an investment agency when the CIC bought RMB $200 billion worth of bonds from the PBoC28. Two thirds of this amount was invested into domestic institutions, namely Central Huijin, which controls three of largest recapitalized banks in China: the Industrial and Commercial Bank of China (ICBC), the Construction Bank of China (CBC) and the Bank of China (BoC); and to aid two other ailing banks: the China Development Bank (CDB) and the Agricultural Bank of China (ABC)29. Shih has argued that the CIC will act essentially as a lobbying group for these banks and not particularly as a tool for Chinese diplomacy because the majority of CIC investment is concentrated in domestic institutions.
Therefore, the majority of the CIC's capital will flow from dividends paid by these banks, and thus the bulk of CIC's attention will go towards persuading the government to limit competition within the banking sector, slow down foreign entry, set interest rates to give banks a healthy spread, and bail-out bans if non-performing loan ratios rise30. Senior policy analyst for the US Senate, Eric Anderson, noticed that through these domestic investments, China may be attempting to correct some issues with nonperforming loans. These issues developed out of some faulty economic policies enacted in 2006 to ensure that certain state owned enterprises would not crumble.
The issue of these loans barred China's full accession into the WTO back in 200131. China was given a five-year grace period to restructure these loans — a task that she continually stalls on32. The creation of CIC and the subsumption of these failing banks into CIC could represent an effort on China's part to fix these failings of its domestic financial structure at a superficial level to permit China to fully integrate into the WTO.
From this perspective, it is interesting to consider CIC as an emblem of movement towards greater Chinese participation in the international monetary system and increased acknowledgement of her own political power, stemming from her own economic growth. It seems China feels she has reached a certain economic capacity and that she is legitimated to participate in the international political system. This explains the heavy concentration of CIC's capital in domestic SOEs rather than a dispersal of the capital abroad: if China believes that her political legitimacy in the international realm stemmed from heady economic policy at home, she would be more interested in strengthening this structure than venturing abroad. Interest abroad is still evidentially part of the creation of CIC, but perhaps understanding this perception of her own economic power we can shift our understanding of CIC as a mechanism to consolidate Chinese economic power. Such consolidation will legitimatize great economic growth in China as a way to assume more clout on the international political scene.
"The decision to create CIC was essentially a way to reduce opportunity costs of owning so many US dollars."
Explanation 3: striving for international control
Distinct evidence to support the claim that the CIC was established as a mechanism for international control does not exist. Indeed it is from this puzzle that most of the literature on the CIC stems. The best way to understand if foreign policy explains CIC's creation is to imagine the structures that would appear within the institution if this were its purpose and to discern if CIC does indeed have such structuring. If CIC were to be a tool for foreign policy, it would work in two ways: at a macro-level from the Chinese state herself to affect the American financial system in a systemic way, or from within the businesses in which CIC holds stakes.
Both Kirschner and Drezner have put forth convincing arguments debasing the possibility that the CIC could work as a macro-level foreign policy tool. Kirchner asserts in his article Sovereign Wealth Funds and National Security: The Dog that Will Refuse to Bark that if China were interested in financial coercion, direct action through forex would be much more effective33. Drezner, too, expounds on the limits of financial statecraft, particularly against great powers34. From these arguments it is clear that using SWFs as a tool of foreign policy at the macro-level would be almost impossible footwork and that the CIC displays little of the necessary structure to carry-out such financial jockeying.
If CIC were hoping to act from the inside, we could predict that China would set up CIC in certain ways: lack of accountability and transparency within the investment apparatus, strategic investments, adopting controlling or voting stakes within these companies, and using financial relationships to lobby domestically within debtor countries. The first three of these we can discard as a goal of CIC, while the last proves more difficult due to lack of evidence.
At the conception of CIC, many complained that the institution was less transparent than the Singapore SWF35. To date, CIC has little information available on it's website about its holdings, intentions, investment strategy or long term aims. In his 2008 60 minutes interview, Gao Xinqin explained that China's SWF would be as transparent as Norway's and that there was no need to implement international regulations over transparency of SWFs36. That same year, the IMF, at the request of the G-7, developed a policy of greater regulation, this incited great backlash, particularly on the part of China37.
One of the huge points of contention for China was the "teeth" underlining in the IMF policy38. Bodies receiving investments could punish the foreign states for not upholding the IMF code by mandating investigations or even freezing further investments39. China, however, came to accept the policy. One might argue that China had little choice but to accept if she wanted to continue investing, particularly since the U.S. at this time had also begun implementing its own, more stringent, policy towards SWFs. But further action by China shows that skirting transparency and incorrect investor behavior were not priorities.
One might predict that during the temporary lapse of American power during the financial crash China would use the opportunity to act less-than-transparently. But, in the face of great disdain for the transparency impositions, China continued to act accountably. This shows that given the opportunity, China did not use CIC as a foreign policy tool to accumulate politically sensitive holdings within the US economy. Additionally, it is not profitable to reason that CIC was too new in 2008 to circumvent such regulations. At this point, CIC was able to take on the $1.8 million dollar stake in Morgan Stanley. It was likely of more interest to China to follow these international protocols to ensure future investment opportunities and also to gain legitimacy in the international realm for complying with the IMF's standards40.Continued on Next Page »