According to a China Business News article today, the new sovereign investment fund, which is rumored to be set up in October but which has already made a $3 billion investment in Blackstone, may invest in 16 state-owned companies, including PetroChina, China Mobile, Sinopec and China Life. The rationale for the investment is "to help them compete abroad".
In my opinion this does not make sense except from the point of view of domestic political maneuvering, in which different groups are trying to get as much influence as possible on local levers of power. It does little to help China.
First of all, I assume that if they are going to "help" these companies compete abroad, that means that they will be buying newly issued strategic states in the companies, rather than purchase their shares in secondary markets. If they do, they are defeating one of the purposes of the exercise, which is to help minimize the monetary expansion associated with bringing dollars into the country. Their domestic purchases will simply increase net capital inflows into China and so force the PBoC to buy the inflows and expand the domestic money base.
But there is a bigger objection. One of the most useful roles a sovereign wealth fund can perform is to act as a stabilizer for government revenues. This increases government creditworthiness and reduces financial distress costs, which never seems like an important thing when conditions are optimal, but becomes extremely useful when the good times reverse themselves.
In that sense, the fund should be invested in a way that its assets do well when the economy is doing badly, and vice versa. If it purchased oil, for example, that would be stabilizing. The Chinese economy is hurt by high oil prices and helped by low oil prices (i.e. it is naturally "short" oil), so by taking the opposite position it can stabilize government revenues, which are presumable correlated with the health of the economy.
Buying the largest Chinese companies may seem like a great idea when the economy is racing forward and profits are rising, but in fact that is the time when the government least needs the help of a profitable investment strategy. It needs profits most when things are going badly on the revenue side, and only someone who is extrmemly certain that things will never go badly should recommend that the government effectively "double up" on the bet that it is already implicitly making on the economy.
There is a more general point here. Developing countries are cursed by excess volatility. There are many reasons for this excess volatility, but in every case it has a significant effect on the cost of financing, especially debt financing. Lenders hate volatility, and charge a premium for it. Anything that can systematically reduce volatility automatically increases value by lowering the cost of capital. If China uses the new sovereign investment fund in part as a hedge, i.e. it reduces expected volatility, this will have an almost immediate impact on investors' risk perceptions, and the benefit will feed through the economy in the form of a lower cost of capital. No big thing now, perhaps, but a great little remedy to help relieve hangovers when the party is over.
The booming Chinese stock market was responsible for up to half the earnings growth of companies listed in Shanghai and Shenzhen duirng the first six months of 2007 - a worrying trend that analysts say will exacerbate any market downturn.
Profits increased on average 71 per cent in the first half for the more than two thirds of listed Chinese companies that have published results. But profits from core operations increased at about 35 per cent, reckons Jerry Lou, equity strategist at Morgan Stanley: “I don’t think the market fully appreciates that half of the current earnings growth is a one-off thing . . . ”
Non-operational income at listed Chinese companies accounted for only 13 per cent of total profits in 2006. That rose to 31 per cent in the first half for the 900 or so companies that have reported earnings so far, according to Morgan Stanley. The proportion is much higher than most developed markets where non-core income usually accounts for less than 10 per cent of total profits.
From the more-reminders-of-Japan drawer, during the middle and late 1980s, if I remember well, earnings from zaitechu, the catchy name for the speculative profits earned by corporate Treasury Diivisions, accounted for a growing share of corporate earnings until in some cases they represented over 100% of net earnings. Needless to say if stock prices are affected by earnings (as they are through PE valuations), in China stock prices and corporate earnings are likely to be self-reinfoicing -- on the way up as well as, of course, on the way down.
An interesting quote from today's Financial Times discusses the time it took for Japanese capital outflows to become significant.
Chinese investors, excluding the central bank, currently hold foreign securities worth 5 per cent of annual economic output. [Capital Economics' China analyst] Mark Williams said China would generate $1,300bn of additional overseas investment if the country raised its level of foreign portfolio investment to the average for member countries of the Organisation for Economic Co-operation and Development.
"Of course, this will not happen immediately,” Williams says. “It took Japan 20 years from the opening of its capital account in the 1980s for its foreign portfolio holdings to rise from five per cent to 40 per cent of gross domestic product.”
More interesting information in today's Financial Times lists the amount of incoming remittances for a variety of countries, according to the World Bank.
The biggest receiver of remittances are, not surprisingly, India and Mexico, with approximately $25 billion in 2006 (equal to 2.9% and 3.0% of GDP, respectively), China, with $22 billion (0.9% of GDP), and the Philippines, with $15 billion (14.6% of GDP).
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.
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January, 2008
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