Xinxin Li, of the G7 Group recently sent me a report on China’s newly created sovereign wealth fund. G7 Group is a New-York-based research and consulting group partially owned by Xinhua that gives especially good information of the activities of various major governments and their impacts on financial markets. He has allowed me to quote the following:
1) The Ministry of Finance has issued RMB 600bn STBs, the first batch of the approved RMB1.55 tn (equivalent to $200 bn), to finance the new CIC. It is expected to receive another RMB100 bn by the end of September and the balance before year-end.
2) A seven-person executive team has been formed, representing all the interested parties. The Chairman of the Board is the vice secretary general of the State Council (China's Cabinet) Lou Jiwei, who invited the current deputy head of the National Social Security Fund (China's national pension fund) Gao Xiqing to be the CEO of the CIC. The team also includes vice finance minister Zhang Hongli, the head of Central Huijin, Xie Ping, and a representative from the NDRC. The PBoC is supposed to send a deputy governor to join the team, but the appointment is still pending. A possible candidate is the current deputy governor Su Ning.
3) This structure reflects the inter-ministerial nature of the CIC: it is not only a SWF seeking high investment returns, but a coordinator among different government agencies on China's overseas investment.
4) The CIC will have three major departments in terms of investment functions. Central Huijin, the former investment arm of the PBoC, will be integrated into the CIC and continue to capitalize domestic financial firms. Another existing institution, China Jianyin Investment, will mainly operate in the area of managing domestic assets and disposing of non-performing loans. In addition, the CIC will establish a new department for overseas investment. The takeover of Central Huijin and Jianyin will make the CIC a big agency with about 1000 employees.
However, the CIC is quite different from what the global market was expecting, in terms of investment strategy and the pace at which it will operate overseas. At the initial stage, it will focus on domestic issues rather than picking where it left off, so to speak, seeking overseas ventures similar to its Blackstone investment. Why? - Seemingly, its investment strategy is very flexible with only two criteria: its foreign currency investments cannot be exchanged back into RMB; and it must be profitable. However, this ambiguity gives other government agencies excuses to tap into the CIC's foreign reserves, and lobbyists already are lined up at the door of Lou Jiwei's office. - Very likely, the CIC will cooperate with the State Assets Supervision and Administration Commission (SASAC) and invest in 16 state-owned enterprises to fund their overseas expansion plans. - The CIC has domestic policy responsibilities, e.g., pushing forward restructuring and capitalization of domestic financial firms. As expected, it will inject up to $60 bn to two state-owned banks: the Agricultural Bank of China and China Development Bank. Consequently, its available funds for foreign investment will be sharply reduced. - At the same time, the CIC has to compensate the PBoC for its previous capitalization of domestic financial firms though the Central Huijing. The PBoC is asking a "reasonable" price -- RMB500 bn ($67 bn). This means, the CIC will limit its overseas investment further to roughly $70 bn. - But the CIC is unlikely to use even this limited capital for overseas direct investment (ODI). The State Council made it very clear that, "given its initial stage and the sensitive timing of the international financial market", the CIC will mainly outsource its foreign reserve management to the State Administration of Foreign Exchange (SAFE) and specialized financial institutions, at least in the short-term. - Its portfolio will include non-dollar currencies, foreign stocks and high yield bonds, but strategic investment in commodities is not a priority yet.
All of a sudden, the CIC appears to be embracing a very conservative and gradualist investment strategy, in contrast to its audacious investment in Blackstone. The unstated reasons behind this shift are both external political pressure and domestic criticism on the Blackstone deal. - During German Chancellor Merkel's visit to China at the end of August, Chinese officials promised her that the CIC had no intention of buying a strategic stake in a big western company in the near future. Clearly, that was a response to the growing worries from European countries about potential takeovers by foreign SWFs. Many US officials also expressed the same concerns in their visits to China. - Furthermore, Blackstone's share price has dropped below $24, or 20% below the CIC's purchase price. This has aroused public criticism and political backlash. Some critics accuse the CIC of recklessness, poor execution and bad-timing. Others wonder why the investment was approved before the CIC had either a basic investment strategy or a risk management framework.
Dan Rosen was the first to alert me to the fact that short-term rates in China have soared in recent days.The benchmark rate is the 7-day repo rate, which hit a pre-September high of 4.77% in April.Today, however, it went to 6.69%.The one-year repo rate, which had peaked at 4.45% in April was even more volatile, reaching 7.21% today.
My first thought was that this was a reaction to some recent large IPOs, notably the China Construction Band deal which priced on Monday with $300 billion of demand.Combine this with a 50 basis point increase in the bank reserve ratio last week, and the recent and planned sales of long-term MoF bonds to finance the sovereign wealth fund, and it seemed like the run-up in rates was caused by a normal excess demand for funds in the repo market. This is how it was described last Thursday (September 17) in the South China Morning Post:
Traders dumped mainland bills and bonds on Thursday as a money market squeeze triggered by tighter policy and China Construction Bank’s huge Shanghai initial public offering worsened. “There’s panic selling - people are scrambling to raise funds,” said a trader at a Chinese bank in Nanjing. “Liquidity is much tighter today than yesterday.”
The money market has suffered half a dozen other squeezes this year during big initial public offers of equity, and each time short-term interest rates have quickly pulled back near their previous levels after the IPO has passed. But the current panic appears to be more serious because it is occurring at a time of unprecedented monetary tightening, and after Tuesday’s announcement that last month’s inflation jumped to a 10-year high of 6.5 per cent, several traders said.
Over the past week authorities have announced a reserve ratio increase, a 151 billion yuan issue of special bills and a plan to sell 200 billion yuan of special bonds to the market, while an interest rate rise is expected as soon as this week. That has left the market unsure about how much liquidity the central bank intends to leave in the market after the IPO is completed, and how far short-term rates will eventually come back down. “There are too many uncertainties about policy now. The special bond issue really scared the market,” said a trader at a leading domestic bank in Shanghai.
Trading volume has shrunk dramatically because of the squeeze but some individual bonds were quoted early on Thursday at yields at least several basis points higher than Wednesday’s levels, traders said. “Nobody is buying bills or bonds,” said the trader in Nanjing. The weighted average seven-day repo rate, the key measure of short-term liquidity, jumped to a fresh two-month high of 4.0173 per cent from Wednesday’s close of 3.8437 per cent. Traders think it could hit a multi-year high of 5 per cent in the next couple of days as subscriptions are taken on Friday and Monday for CCB’s IPO, which is expected to attract a record total of more than 2 trillion yuan in subscriptions.
The central bank appeared to be trying to ease the squeeze last Thursday by canceling its regular weekly issue of three-year bills. That means it injected RMB 140 billion into the market, against a net drain of RMB 145 billion last week.But that wasn’t the end of the story.Today, as Dan pointed out, the deals have been put the bed and the unsuccessful bids returned, but instead of coming down, rates have actually increased.
So what is going on?Quite a lot, it seems. Market rumors are that this is all part of a short squeeze engineered by the PBoC because of their worries about inflation and rising stock prices, which may be linked in their minds.Instead of acting to balance short-term changes in the supply of and demand for funds, as they normally do, they are simply walking away from the short-term markets and allowing rates to rise sharply.By causing such volatility in market and letting short term rates rise so sharply, albeit temporarily (money is expected to seep back into the market over the next few weeks), they are hoping to undermine speculative fervor and, by slowing down the stock market, even take wealth-effect pressure from consumption (and thus reduce inflationary pressures).
This squeeze might have a dampening impact on the stock market, but since margin buying is illegal, I am not sure how the transmission will work. At any rate the market has been slow but not panicky in the last three days, and in fact was up 1.40% today. I suspect high repo rates may dampen demand for new issues more than they affect secondary trading levels.
There may also be a very negative and unintended consequence. With the Fed having lowered rates by 50 basis points, this may not be the best time to raise short term RMB rates if the PBoC wants to discourage speculative inflows.After all, if you can get 7% in RMB, plus 5% or more in expected RMB appreciation against the dollar, the resulting 12% return in dollars is high enough to make all but the wildest hedge funds pretty happy.Of course anything that encourages more hot money into the country will simply exacerbate the very process that is at the root of the imbalances the PBoC is so desperate to end.
Will any of my former students or other readers of this blog who are active in the local money markets weigh in? What exactly is going on?
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
Subscribe to this Site
January, 2008
.