My Blog

October 15, 2007

After netting out its existing commitments, the CIC has not $200 billion but closer to $70 billion to play with.  It is paying the PBoC $67 billion to take over Central Huijing’s bank shares and is making further investments of $40 billion in the sickly Agricultural Bank of China and $20 billion in the China Development Bank.  Taking out the $3 billion that was used to invest in the Blackstone IPO leaves a mere $70 billion of the original $200 billion for other investments.  With reserves growing at its current astronomical rate ($400-450 billion in 2007?), it would be a surprise, however, if the CIC’s assets under management weren’t substantially increased at some point.

Most market expectations are that the CIC will be a passive investor, looking to put together a diversified portfolio that emphasizes getting the highest returns possible within some risk parameter.  This is not going to be easy, since the CIC’s funding cost – interest rate plus expected RMB appreciation – exceeds 8% and may well exceed 12-13% if, as many expect, the RMB were to appreciate at a faster pace.

Much of the discussion on reserve management strategy focuses on plans for maximizing returns, stabilizing commodity import prices, or managing the money for strategic purposes.  I would argue that there is another strategy, closer in spirit to the stabilization fund but a little different, that China should consider.

In a very useful May 2007 research piece on sovereign wealth funds, Andrew Rozanov of State Street Global Advisors claims that "defining a liability profile is arguably the most important step in designing and running any fund."  As I see it, a fund needs to figure out what kind of liability structure it has and how much risk it is willing to take, and this risk is often largely a consequence of the relationship between the asset and liability sides of the balance sheet (this applies to funds, companies, countries and even individuals).  Besides the normal economic volatility that developing countries must accept, there is another great source of volatility that arises from the mismatching of assets and liabilities.

One of the great weaknesses developing countries have is what statisticians call “fat tails”.  Whatever the average expected outcome over many years of such measures as GDP growth, the fact is that for a number of structural reasons there is a much wider range of plausible outcomes for developing countries than for developed countries.  While one can argue for example that “expected” GDP growth for China over the next several years may be between 8% and 9%, it is not implausible – in fact it is very likely – that for individual years, and maybe even for the whole period, growth rates can be significantly higher or lower.  Any estimate of future expected growth is incomplete if it doesn’t come with a warning that the range of plausible outcomes is extremely wide – much wider, for example, than a prediction for the equivalent European, Japanese or US figures.

During the boom period we are currently living through it may be very hard to imagine that China might ever experience many years of very low growth, but this just reflects the tendency we have towards simple projections of the recent past.  In my previous developing-country experience, it was very hard during the boom years to convince anyone that Latin American or Asian countries might soon experience sharply slower growth, let alone debt crisis or defaults, and it is now equally difficult to argue that China is also likely to experience some serious turbulence.  However it would be a massive historical anomaly (anomalous even in the context of China’s own economic history) if this were not to be the case.

These fat tails around our average expected outcomes have a real cost.  Not only do they increase political and social instability, but they are one of the main reasons why the cost of capital for developing countries can be so unstable and generally so high.  They also have a tendency to encourage massive simultaneous inflows and outflows as investors chase the tails (or, more correctly, as they chase the swings to either extreme of the range of outcomes).  Anything a developing country can do to smooth out its development path and narrow the range of possible outcomes will, in the medium term create much more growth and political stability.

There are many reasons for fat tails – for example, an excess dependence on commodity exports, or a tendency to major policy changes and reversals caused by unstable political centers – but one of the major reasons the range of expected outcomes for developing countries have such fat tails is that weak financial systems and national balance sheets tend to exacerbate economic conditions, both for good and for bad.  This means that the countries’ balance sheets, which are often seriously mismatched, tend to incorporate structures that are self-reinforcing or pro-cyclical. 

This causes positive shocks to drive a country into a virtuous circle and a better than expected outcome, and vice versa.  In the current case of Brazil, for example, the very high and worrying government deficit, funded mostly by short-term borrowings, has exactly this sort of effect.  When conditions are good, interest rates fall, thereby causing the deficit to drop sharply (interest expense accounts for more than 100% of the deficit), which boosts confidence and so causes further interest rate declines.  Of course the opposite can happen, in which case rising interest rates and rising fears of government deficits reinforce each other until the point of crisis or near crisis, as in 1998 and 2002. 

Countries that borrow in dollars (or any external currency) to fund domestic operations also have this problem.  Mexico in 1994 and Korea in 1997 both suffered from very high levels of dollar debt, which seemed like a good idea during their earlier periods of high confidence and growth, because the value of dollar debt declined in real terms (with the real appreciation of the local currency and of domestic asset prices) just as things were doing so well.  Needless to say, when conditions reversed, both countries found themselves struggling to contain dropping asset prices and rising debt levels (caused by the depreciating local currency) which were mutually reinforcing because corporations with dollar debt were desperate to hedge, and the only way they could hedge was by selling local assets and using the resulting local currency to buy dollars, which caused further declines in the local currency as well as in local asset values. 

In both cases good conditions on one side of the balance sheet begat good conditions on the other, and bad begat bad.  There are other sources of this balance sheet instability.  Rigid or insolvent banking systems, excess commodity dependency, high levels of government contingent liabilities, and weak governance, for example, can all create or exacerbate balance sheet instability.  I discuss other such structures and their impacts in my book, The Volatility Machine.

Comments for "The CIC should not invest in...

No comments posted.