Prior to investments in several large US financial institutions last year, the popular press had largely ignored outbound investment from China. Given that China has become a favorite destination for foreign investment (attracting over $61 billion by December 2007), it is hardly surprising that outbound investments have been largely ignored.
Nonetheless, China's foreign reserves reached almost $1.6 trillion in January and the central government has encouraged enterprises through its “going out” strategy to begin investing those reserves internationally. The effect of this strategy will likely to be profound and long-lasting.
Beginning in 2005, outbound investment from China jumped by over 120 percent, as the Government encouraged local enterprises to expand abroad. According to Xinhua news agency, outbound investment reached over $20 billion. Further, as part of the Ministry's 11th five-year plan (2006-2010), aggregate direct overseas investment by Chinese companies will top $60 billion by 2010 (some market commentators place this figure even higher) as the Government continues to offer PRC firms preferential diplomatic, forex, tax, customs, credit and insurance policies to invest in strategically important sectors.
Overseas acquisitions by Chinese firms can be grouped into three broad categories according to their strategic goals – resources, technology and market access. A global hunt for natural resources (oil, gas, minerals and timber) is a significant driver of overseas investments. In fact, non-resource deals such as infrastructure plays are often coupled with the resource acquisition objectives to insure project acceptance. This trend is particularly apparent in resource-rich developing countries. For example, PRC firms have undertaken projects in Iran, Argentina and across the African continent.
As mentioned above, resources, high-tech and branded manufacturing industries will remain favorite investment targets. Investments in research and development in acknowledged science and technology intensive regions and countries will also be encouraged to improve China's innovative capabilities. Service companies are also being encouraged to invest overseas and to establish more international alliances in engineering, labour service, telecommunication and, transportation.
Based on a quantitative and qualitative analysis of multiple factors including industry profit margins, market saturation, barriers to domestic expansion and access to foreign exchange, we believe that energy, banking and insurance, non-ferrous metals and automobiles have the greatest potential for outbound direct investment: (see chart p. 38)
China is investing its wealth through three major channels including the previously mentioned PRC enterprises; the Qualified Domestic Institutional Investor (QDII) scheme that allows some institutions to invest offshore; and the China Investment Corp (CIC), which was created to invest a portion of China's enormous foreign reserves.
In April 2006, China established the QDII program to provide PRC citizens with the opportunity to invest in global investment funds. China subsequently approved a number of QDII, including but not limited to the Bank of Communications Schroder, China AMC, China International, China Southern Fund, Fortis Haitong, Fortune SGAM, Harvest Fund and Yinhua. Last year, Beijing reduced investment restrictions for the QDII and has expanded the number of firms allowed to participate. Consequently, China's banks, securities houses and insurance companies have developed a wide range of product offerings (often in conjunction with international partners). By the end of September 2007, around $11 billion had been invested in QDIIs and JP Morgan has estimated that roughly $80 billion will be invested by the end of 2008.
CIC was officially launched in September 2007, with an initial approved capitalisation of $200 billion, which immediately made it one of the largest sovereign wealth funds in the world (the sovereign wealth funds of the United Arab Emirates, Singapore and Norway are larger).
However, even before it was launched, CIC was controversial both internationally and domestically. In May 2007 and at the direction of CIC, a wholly owned subsidiary of Central Huijian Investment Company (CHIC), China Jianyin Investment Company, executed an agreement to purchase slightly less than 10 percent of The Blackstone Group (nonvoting shares) for $3 billion. In November, it was reported that CIC acquired the assets and liabilities of CHIC from the People's Bank of China for roughly $67 billion.
Certain parties in Washington and Wall Street immediately raised concerns over CIC in general and on its investments in US firms in particular. These concerns can essentially be distilled into four major categories:
Both the central government as well as the management of CIC has stated that CIC's objective is purely investment return-driven and that its capital would be used to pursue three broad objectives. First, to acquire CHIC for approximately $67 billion, which held major stakes in the China Construction Bank as well as the Industrial and Commercial Bank of China. Second, to invest approximately one-third of its funds in the Agricultural Bank of China and the China Development Bank to assist in their respective recapitalisations. And, finally, the remaining funds were to be invested in global financial markets. China has also repeatedly stated its belief that CIC will have a stabilising effect on international financial markets because it is a long-term, strategic investor. Some of CIC's current major investments are depicted on p 39:
It is also worth noting that CIC faces a number of challenges domestically. A good example of this is CIC's investment in The Blackstone Group. In May, CIC purportedly made a $3 billion investment at a 4.5 percent discount to Blackstone's $31 IPO price. By early August, the stock price for Blackstone was down around 15 percent and, consequently, CIC was showing a loss of over $400 million (it has been as high as more than $500 million). Given the performance of the PRC stock markets, the timing and wisdom of the investment was criticised by unnamed Government sources in the popular press.
Some have suggested that these “unnamed Government sources” are likely to be political rivals in the Government. Further, it is worth noting that CIC seemed to learn from the experience of the Blackstone investment and structured its $5 billion investment in Morgan Stanley with an eye towards protecting its downside. The deal was structured as convertible securities, which also has the added benefit of making paper losses harder to discern.
It is also worth noting that the nature of CIC capitalisation could put pressure on CIC with respect to achieving the higher returns it is seeking. The Ministry of Finance was to issue up to RMB1.55 trillion ($200 billion) in special treasury bonds. These bonds have tenors of between 10 and 15 years with coupons ranging from 4.3 percent to 4.5 percent. The Chairman of CIC, Lou Jiwei, has stated publicly that the cost of capital is approximately RMB40 million ($5.16 million) per day. If one expects that the renminbi will appreciate at, conservatively, 5 percent per annum, this means that the hurdle rate for CIC is approaching 9.5 percent for the fund to break even. To put this in perspective, the Government of Singapore Investment Corporation generated an annualised nominal rate of return of roughly 9.5 percent over the last 25 years.
Reasons for China's increasing outbound investment can been seen at both the policy and individual enterprise levels. Simply stated, the Government wants to ensure that natural resources are available to support China's frenetic growth, to increase the competitiveness of PRC industries and, perhaps most importantly, to channel increasing amounts of foreign exchange offshore to ease pressure on the yuan exchange rate.
At the enterprise level, many of China's largest firms are extremely liquid due to rights offerings and internally generated cash flows and are eager to venture into foreign markets. Moreover, many of these same firms are seeing their margins eroded as a result of fierce domestic competition. It also makes sense for them to secure long-term raw material supplies, acquire global distribution channels, obtain advanced technologies and, although not often stated, gain internationally experienced management savvy.
As previously discussed, China needs to secure natural resources vital to its continued economic growth, to open new markets for its goods, and to buy new technologies to improve its standards, competitiveness and efficiency. China also needs to invest its vast savings more broadly, reduce the growing gap between rich and poor, and fund the cost of reclaiming its natural environment and supporting its aging population.
But China's global ambitions have coincided with a rising groundswell of protectionism and restrictions on cross-border investing. Ironically, China's desire to invest internationally coincides with a time when the US needs foreign investment to offset its current account deficit but is becoming increasingly resistant to such investment. Moreover, the protectionist sentiment is not limited to the US – from Russia to India and even the EU, barriers are being erected to much-needed foreign investment.
Opposition to foreign investments in the US emerges from essentially two domestic concerns. The first is that of national security, notably the threat of terrorism. The second is globalisation and the loss of white-collar and service sector jobs to other nations. Thus, a PRC company looking to invest in the US needs to consider how its investment will appear when viewed from these two perspectives.
Chinese companies often think the rest of the world operates by the same clear, open-market principles urged on them by Western investors. Most don't take a proactive approach, therefore, to legal and government affairs abroad and so fall victim to national prejudices and politics. Moreover, the problem is often exacerbated by the fact that PRC firms generally lack internationally experienced managers who are familiar with international business rules, cultural backgrounds, legal frameworks and the challenges of internal management systems.
How to master both the business and non-business factors associated with international investing by Chinese firms was the main topic of law firm Akin Gump Strauss Hauer & Feld's conference held in Beijing last year. The conference brought together more than 150 participants, including lawyers, academics, executives and Government officials representing a wide range of industries from aerospace and finance to resources and telecommunications. The panelists and guests offered a number of worthwhile suggestions to the Chinese Government and businesses alike. These included:
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