CIC: True Identity of the Chinese Governmental Investment Fund

Establishment of the China Investment Corporation (CIC)

In recent years, China’s balance of payments surplus has been rapidly expanding with a growing trade surplus and stable and rich inflow of direct investment. Meanwhile, with the goals of maintaining export competitiveness and protecting financial institutions weak in risk management capabilities, the central bank has been absorbing vast amounts of foreign currency from the market to stabilize the yuan on the exchange market and prepare for financial crises. As a result, China’s foreign reserves ballooned from US$286.4 billion in 2002 to US$1.53 trillion in 2007. China normally deems it necessary to maintain US$700 billion in highly liquid foreign reserves for stability in the exchange market and to be equipped with foreign cash reserves, but its foreign reserves surpassed this amount in the middle of 2005 and have continued to amass. How to manage the foreign reserves “excess” of US$800 billion has become an issue.

The responsibility of managing China’s foreign reserve assets has hitherto been held by the State Administration of Foreign Exchange (SAFE), and the assets have primarily been invested in US government bonds under the premise of stability and liquidity. However, as both the risk of concentrating the vast reserves in a management body or investment target and the currency exchange risk grew, it became necessary to restructure the portfolio and diversify the management bodies for long-term and highly-profitable management. The Chinese government began researching into the management of “excess” foreign reserves in the middle of 2006, and in September 2007 it established the China Investment Corporation (CIC), a 100% state-run government investment fund with registered capital of US$200 billion.

In the past, China established the Central Huijin Investment Company Limited (CHICL, 100% state-run investment company established with direct financing by the central bank, similar to a state-owned financial assets administration commission of the state council), and used US$67 billion of foreign reserves to infuse capital into state-run financial institutions on the brink of bankruptcy. As the establishment process of CHICL was the focus of domestic criticism, the establishment of CIC was carried out with ratification by the National People’s Congress. The CIC purchased US$67 billion in equity from the central bank, and made CHICL its subsidiary.

The roles of CIC have been set as: 1. management of “excess” foreign reserves, and 2. investment into and management of state-run financial institutions. CIC board members recently announced that the US$200 billion investment fund (capital) would be divided into thirds (about US$67 billion) and directed towards funds for the purchase of CHICL, capital infusion into Agricultural Bank of China and the China Development Bank (a US$20 billion capital infusion into the China Development Bank was completed at the end of 2007), and investment into overseas portfolios.

Announced Management Policy of the CIC

Established as a limited company based on corporate law, CIC aims for “separation of state and business”, “self-management” and “commercial purposes”. Governance institutions have been installed with a board of directors, board of auditors and board of supervisors. However, membership is comprised entirely of government officials.

Government-related institutions and various industries are demanding that the investment strategy focus on: 1. portfolio investment in the capital market, 2. strategic investment in overseas energy and raw materials, and 3. support for the overseas M&A strategy of Chinese companies. However, unless the rate of return on investment exceeds the roughly 10% in cost (including interest payments of about 5% for the special government bonds which serve as the funds, and exchange rate loss from about a 5% annual appreciation of the yuan and administrative costs), the fund will go into the red. Therefore, many argue that investment should be exclusively for commercial purposes to maximize profits. In reality, CIC’s investment policy has not been made clear, and there is concern from overseas that the focus will be on “government strategy” rather than “commercial purposes”.

Realities of Management

In fact, foreign investment had begun before CIC was formally established. In May 2007, US$3 billion (10% controlling share) was invested in the Blackstone Group, the largest US private equity fund, under the conditions of non-voting stock and a no-sales period of four years. The investment targeted Blackstone’s growth potential (annual managed asset growth rate of 41.1%) and profitability (return on investment of 25%), as well as the opportunity to buy on the eve of IPO. As a pure financial investment there was no objection from the US, but domestic Chinese criticism has intensified in light of the significant appraisal loss (recent estimates at US$750 million) due to the decline in Blackstone’s stock price. The second round of investment was US$100 million H stock investment (about 1.6% controlling share) in the Hong Kong market IPO of “China Railway Group Ltd.”, a major Chinese state-run engineering company. Public trading was started in the Hong Kong Market on December 7, 2007. The third round of investment was US$5 billion into Morgan Stanley, a major US securities firm that suffered considerable damage from the subprime problem. The method of investment was refined, so that instead of direct investment into equity it was done with equity certificates (9% annual rate) convertible into stock two years and seven months later.

In addition, CIC is globally recruiting 24 investment managers from the three markets of Europe, Northern America and Japan, and emerging markets. It is also working with fund management companies, so it is expected that investment will be pursued indirectly through these funds instead of only direct investment by the CIC itself.

The CIC’s recent investment into the Hong Kong stock exchange to prevent a takeover from overseas (political purposes) and investment into the Japanese stock market have garnered attention, and it has significantly impacted stock markets. The investment movements of this giant governmental fund, expected to add to its foreign reserves management in the future, will be closely watched by governments and markets alike.