China's Cash Offensive
The country’s $200 billion sovereign fund stumbled with its investment in Blackstone Group. Foreign banks are clamoring for a chance to help.
When lou jiwei visited Switzerland one spring weekend in 1993, the Chinese government economist was so eager to see the inside of a Swiss bank that Credit Suisse Group opened its Zurich head office on a Sunday to show him around. “He asked all kinds of questions,” says William Wirth, the Credit Suisse director who gave Lou a tour that included the strong room. “And he wasn’t just interested in financial matters. He wanted to get a real helicopter view of the economy.”
Lou also stopped at the homes of farmers in the village of Weesen, an Alpine commu- nity with a population of 1,500 people and 3,000 cows. “He even looked inside the fridges and cupboards,” says Dean LeBaron, a Boston-based fund manager who owns a vacation home in Weesen and hosted Lou’s visit. “He was very inquisitive.”
Today, investors, regulators and politicians are asking questions about Lou, now chairman of China Investment Corp., a sovereign wealth fund set up last year. Lou, 57, who’s never been a fund manager before, has about $200 billion in his care, $70 billion of which he will invest outside China.
His first investments for CIC have had mixed results so far. He spent $3 billion in May for a 9 percent stake in Blackstone Group LP, the world’s biggest buyout fund, which has since lost 40 percent of its value. In December, he bet $5 billion for as much as 9.9 percent of Morgan Stan- ley, the second-biggest U.S. securities firm. As of Feb. 11, a 9.9 percent stake would have been worth $5.25 billion. In Decem- ber, CIC invited Western fund managers to apply to help Lou manage the remaining $62 billion he plans to invest abroad. He has made trips to London and New York to meet potential managers. In a speech in Washington in February, Lou explained why CIC had bought the Morgan Stanley stake after the Wall Street bank approached it seeking funds. “If there is a big fat rabbit, we will shoot it,” he said. “Some people will say we were shot by Morgan Stanley, but who knows.”
Lou’s war chest makes CIC the fifth biggest of the sovereign funds, investment pools that are playing a growing— and controversial—role in global financial markets. The largest fund, the Abu Dhabi Investment Authority, manages as much as $875 billion, more than four times the amount held by CIC, according to data compiled by Bloomberg. These state- managed funds control $2.5 trillion in assets worldwide, a figure that will climb to $12 trillion by 2015, according to Mor- gan Stanley’s global currency economist, Stephen Jen. Since late last year, sovereign funds have spent $59 billion invest- ing in Wall Street and Asian banks, according to Bloomberg data.
The downside of all this money is that sovereign funds can lack transparency, follow political rather than commercial agendas and destabilize markets with the sheer weight of their investments, says Edwin Truman, a former assistant U.S. Treasury secretary who testified in November before the Senate Committee on Banking, Housing and Urban Affairs about sovereign wealth funds. “They involve a dramatic increase in the role of governments in the ownership and management of international assets,” he testified. “This characteristic is unnerving and disquieting. It calls into question our most basic assumptions about the structure and functioning of our economies and the international financial system.”
Thanks to booming export industries and trade surpluses, China has accumulated the world’s biggest mountain of potentially investable foreign exchange reserves. On Dec. 31, the funds stood at $1.53 trillion, about 50 percent more than Japan’s and 30 times the U.S. assets of $46.8 billion, according to Bloomberg data.
How much of that $1.53 trillion will eventually be under Lou’s command is an unanswered question. Until now, most of China’s reserves have been invested almost exclusively in U.S. Treasury bills and other low-yielding dollar-denominated bonds, says Brad Setzer, a fellow at the New York– based Council of Foreign Relations. In March 2007, China’s then finance minister, Jin Renqing, announced that the government would create CIC to seek to increase returns by diversifying into equities. The fund, which was only formally created in September, reports directly to the Cabinet.
One of CIC’s first actions in June was to buy Central Huijin Investment Co., the government investment arm that holds controlling stakes in China’s three biggest banks, for $67 billion. CIC also paid $20 billion to recapitalize China Development Bank, a fourth Chinese lender.
In turn, the Chinese banks have been acquiring stakes in some of the world’s biggest financial institutions. In July, China Development invested $3.04 billion for 3.1 percent of Barclays Plc, the U.K.’s third-largest bank. And in October, Industrial & Commercial Bank of China, the world’s biggest by market value, agreed to pay 36.7 billion rand ($5.5 billion) for 20 percent of Johannesburg- based Standard Bank, Africa’s biggest lender. CIC and the Ministry of Finance together control 70 percent of ICBC. “There’s a very significant pool of foreign exchange in the hands of various state bodies in China, most of which are owned by CIC,” Setzer, 37, says.
Other Chinese state-controlled financial institutions have also been buying foreign bank shares. In November, Ping An Insurance (Group) Co., the country’s second-biggest insurer, bought a 4.2 per- cent stake in Fortis Group, Belgium’s biggest financial company, for 1.81 billion euros ($2.7 billion).
And the State Administration of Foreign Exchange, or SAFE, a unit of the central bank, has bought less than 1 percent of Australia & New Zealand Banking Corp., the country’s third-biggest lender.
Chinese investors could upset U.S. mar- kets if they tried to sell some of the $387 billion of U.S. Treasury bills they own, Truman says in an interview. “They could cause havoc if they decided to dump those Treasuries,” he says. China is unlikely to do that, he says, since such a move would hurt the value of its other U.S. dollar assets. He says he’s more worried about the risk of a U.S. backlash against such foreign investments and recommends that Treasury Secretary Hank Paulson should be in contact with his Chinese counterparts. “They don’t just need a red telephone between the defense departments, they need one into Mr. Paulson’s office,” Truman says.
The u.s. has shown signs of finan- cial protectionism in the recent past. In 2005, U.S. legislators blocked an $18.5 billion bid for
U.S. oil company Unocal Corp. by China’s third-biggest oil company, state-controlled Cnooc Ltd., on national security grounds. The following year, Dubai’s DP World was forced to sell six terminals at U.S. ports it had acquired for the same reason.
President Nicolas Sarkozy of France, Chancellor Angela Merkel of Germany and U.S. Democratic Party presidential candidate Hillary Clinton have all voiced concerns about the activities of sovereign funds. “They’ve got to be more transparent,” Clinton said on Jan. 15 during a debate in Las Vegas. The International Monetary Fund said in October that it’s drafting a voluntary code of conduct it hopes will regulate sovereign funds.
Lou and his senior executives declined to be interviewed for this article.
In speeches and news conferences, Lou and China’s leaders, including Premier Wen Jiabao, have said that CIC will be independent of its government masters, deciding which shares to buy based on their profit potential. “I need to make money,” Lou said in Washington at a World Bank meeting in February. “If I don’t I cannot survive. So how can I have political motives?”
CIC will also be a passive investor. CEO John Mack is better at running Morgan Stanley than CIC would be, Lou said. “So why not let him do the job?”
When it bought into Blackstone, CIC declined the buyout firm’s offer of voting shares and didn’t ask for a seat on the board, said Stephen Schwarzman, the buyout fund’s chief executive officer. “They’re not trying purposely to influence our activities,” he said during a panel dis- cussion at the World Economic Forum in Davos, Switzerland, in January. “Our experience with the sovereign wealth funds is that they are smart, they are long- term, they are highly professional. All they’re looking for is the highest rate of return with safety that they can. In that sense, they are really a model type of investors.” CIC’s Morgan Stanley stake is also nonvoting.
CIC’s stakes in Blackstone and Morgan Stanley have multiple benefits for Lou, says LeBaron, 75. The American fund manager first met Lou in Shanghai in 1991, where LeBaron was trying to set up one of the first China equity funds. “He’s buying into companies that will be sources of information for him rather than just because banking stocks are cheap,” says LeBaron, who founded Batterymarch Financial Management Inc. and later sold the fund manager to Baltimore-based Legg Mason Inc. “He will be able to learn from Blackstone and Morgan Stanley.”
Lou, who spent eight years as a deputy finance minister before joining CIC, cur- rently relies for investment advice on two lieutenants. Chief Investment Officer Gao Xiqing, 54, is a graduate of Durham, North Carolina–based Duke University Law School who once worked on Wall Street for Richard Nixon’s old law firm, Mudge, Rose, Guthrie, Alexander & Ferdon. Gao most recently was vice chairman of Chi- na’s fledgling $26 billion national pension fund and also worked in Hong Kong at the investment banking arm of Bank of China, the country’s third-biggest lender. He also served as deputy chairman of the China
LSecurities Regulatory Commission.
Lou’s other senior aide is Vice President and Chief Risk Officer Jesse Wang, 57, also chairman of China International Capital Corp.,
the first Chinese-foreign investment bank, which is 34 percent owned by Morgan Stanley.
The three men have to deliver the profits their political masters demand. CIC is modeled after Singapore’s Temasek Holdings Pte., which invests its $110 billion portfolio in companies ranging from banks to port operators, to defense equipment, then Finance Minister Jin said when announcing CIC’s cre- ation in March 2007. Temasek’s total shareholder returns averaged 17 percent a year during the five years ended in March 2007, the Singapore company said in August. That compares with an average annual return of 4.12 percent on U.S. Treasuries during the five years ended on Dec. 31. “We will try to maximize the profits and returns on our management of foreign exchange,” Jin told a press conference at the time.
‘he’s not goIng to be an arm of chInese foreIgn polIcy,’a sChOLar says Of LOu.
That won’t be easy, Setzer says. CIC’s profits have to pay the interest, ranging from 4.45 to 4.66 percent, on local currency bonds that were sold by the government to the central bank to raise CIC’s investment funds. And the fund’s foreign currency returns will be weaker when they are converted into yuan, which the government has been allowing to appreciate against the dollar. In Washington, Lou disputed this analysis, saying that CIC wouldn’t be investing domestically, so its returns in yuan would be irrelevant. “Our annual rate of return target is 5 percent,” he said. “Our long-term return target is a little bit higher than this.”
“Lou and Gao are in a pretty impossible situation,” says Nicholas Lardy, a China scholar at the Peter G. Peterson Institute for International Economics, an independent Washington-based research group. With global stock markets in turmoil after the drop in the Blackstone investment, he says, “The timing couldn’t be worse.” Still, Lardy says, Gao proved his independence during his stint at the China Securities Regulatory Commission. “He was abrasive, impatient—he thought they were underperforming, moving too slowly,” says Lardy. “He’s not going to be an arm of Chinese foreign policy.”
Lou and Gao face criticism at home, especially after the Blackstone investment. “Now we know what Lou Jiwei, Gao Xiqing and other officials are up to— squandering taxpayers’ money like it’s dirt,” wrote one blogger who used the nom de plume He Bi, Chinese for Why?, on Sina.com, the country’s biggest portal, in August.
CIC should stick to investing in China, says Liu Yang, who helps manage $4.2 billion in Hong Kong for Atlantis Investment Management. “Why are they running overseas?” Liu says. “The yuan is appreciating, and investors worldwide are divert- ing their funds to China, seeking a haven for their investments. China has so many enterprises which are flourishing.”
Outside China, Lou is being wooed— partly because he’ll likely have a free hand in choosing outside fund managers, says Victor Shih, Seattle-based author of Factions and Finance in China (Cambridge University Press, 2008). “For the fund managers, he will be a very powerful figure because he will determine their bonus paychecks,” says Shih, a political economist at Northwestern University in Evanston, Illinois.
In December, the City of London threw a banquet in Lou’s honor at the Mansion House, the Lord Mayor’s official residence. Among the 60 guests: Stephen Green, chairman of HSBC Holdings Plc, Europe’s biggest bank; Barclays Chairman Marcus Agius; Mark Tucker, group CEO of Prudential Plc, Britain’s second- largest insurer; and John Fraser, chair- man of global asset management at UBS AG, Switzerland’s biggest bank. Spokes- men for the banks declined to comment on whether their firms are seeking to help CIC manage its funds. Prudential has applied, says Hong Kong–based spokesman Chad Tendler. CIC was due to announce which fund managers it has chosen in March.
At the London dinner, Lord Mayor David Lewis proposed to Lou that CIC open an office in London. Lewis says Lou told him that such a move was under consideration. “We would like to learn from you,” Lou told the London bankers. In Washington, Lou said some other European countries had made him feel unwelcome and that he wouldn’t invest in those places. In Japan, which Gao visited in February, financial services minister Yoshimi Watanabe told reporters that CIC investments would be welcomed.
Lou, a native of Yiwu, 200 kilometers (124 miles) southwest of Shanghai, is used to learning on the run. Born in 1950, the year after Mao Zedong’s com- munists seized power, Lou was forced to stop his schooling at age 16 when the chaos of the Cultural Revolution enveloped China. University entrance exams were suspended for 12 years, and most youths of Lou’s age were sent to the countryside to work.
Lou chose another option. In 1968, he joined the People’s Liberation Army. He was assigned to the navy and sent to Hainan, a tropical island off China’s southern coast, where he served with the southern patrol fleet number 4009, according to a biography supplied by Chi- na’s state information center. “We talked frankly about his time during the Cultural Revolution,” LeBaron recalls. “For him and other Chinese I know, it was about trying to find a line between being a fanatic and still surviving.”
In 1973, Lou joined the Communist Party and moved to Beijing, where he was a worker in the Shougang iron and steel Aworks, according to the official biography.
After the Cultural Revolution ended, China resumed univer- sity entrance exams. The 1977 exam was one of the most
competitive ever held, says China-born Lawrence Lau, 64, emeritus professor of economics at Stanford University and dean of Hong Kong’s Chinese University. Almost 6 million students from 13 to 37 years old sat for places, according to Education Ministry statistics. Fewer than 5 percent gained entry compared with 56 percent in 2007. “People who took it had to have strong initiative, a strong will to succeed, as well as an ability to teach themselves—a great combination,” says Lau. “It was a remarkable class.”
Lou, then 27, won a spot at Tsinghua University, China’s equivalent of Massachusetts Institute of Technology, to study computer engineering, according to the state information center. On graduation in 1982, he switched to the China Academy of Social Sciences, where he studied econometrics.
By then, China’s paramount leader was Deng Xiaoping, who had assumed power intent on transforming China into a booming market economy. Since then, China has recorded an average 10 percent annual growth. In 1984, Lou joined the State Council Research Center, which helps China’s cabinet shape policy. Four years later, he moved to Shanghai to become deputy director of the local state reform commission, which put into prac- tice new economic rules that would trans- form the city into China’s commercial and financial capital.
‘Ideally, I would have loved to have only $2 bIllIon at the begInnIng,’ LOu says Of CiC’s funds.
Shanghai’s mayor at the time was Zhu Rongji, later to become governor of the central bank and, from 1998 to 2003, premier of China. Lou became a Zhu proté- gé, LeBaron says. “Working in the Shanghai reform commission in those days was a license to be liberal,” he says.
LeBaron says he was introduced to Lou, who became his government point man. “He was very helpful, allowing us to buy securities in China at a time when securities laws had not been properly implemented,” LeBaron says. “Stock exchanges were open but more for show than actual practice. Could we have done it without him? Probably the answer is no.”
LeBaron’s Equity Fund of China raised $30 million from investors such as AT&T Inc. and General Motors Corp., according to Mao, Marx & the Market (John Wiley & Sons, 2002), the book LeBaron wrote about his adventures investing in China and Russia. By 1995, his Batterymarch managed $5.7 billion. Legg Mason, which paid $120 million for the company, merged the China fund into an emerging-markets fund in 1999.
Today, Batterymarch’s mainland China investments are worth $724 million, according to Legg Mason spokeswoman Maria Rosati.
In 1992, the government transferred Lou to Beijing to head the state reform commission at the national level, according to his biography.
The following year, together with a group of colleagues, he traveled to Germany to study techniques to battle inflation, LeBaron says. It was during that trip that Lou called LeBaron in Switzerland and asked to visit for the weekend.
In 1995, the Chinese government dis- patched Lou to Guizhou, an impoverished southwestern province that then had only 100 kilometers of paved roads, to become deputy governor. Lou threw himself into that challenge, says LeBaron, who spent a weekend with him during that time. “He built a new airport and roads,” he says. “He was very enthusiastic.”
In 1998, Zhu Rongji, then premier, recalled Lou to Beijing as deputy minister for finance, a position he held for the next eight years. Then in March 2007, the new premier, Wen, promoted Lou to the cabinet as deputy secretary of the State Council. Three days later, the central bank announced he had been appointed to head CIC.
“Getting so much money at the beginning was not because we were ambitious,” Lou said in Washington. “It was meant to absorb excess liquidity. Ideally, I would have loved to have only $2 billion at the beginning.”
Lou and his team set up shop in graypainted, low-ceilinged temporary offices on the fifth floor of the Ping An building in Beijing’s financial district, about a mile west of Tiananmen Square. Even before CIC was officially established in September, they had done their first big deal.
In January 2007, Blackstone appointed as its Asia chairman Antony Leung, 56, a former banker with Citigroup and JPMorgan Chase & Co. who from 2001 to ’03 had served as Hong Kong’s finance secretary. Leung, who’s married to Chi- nese Olympic diving gold medalist Fu Mingxia, declined to be interviewed about his role in the CIC deal.
Blackstone approached the Chinese government about investing in its initial public offering, Jesse Wang, who acted as spokesman for CIC, announced at the time. Instead, Lou and his team decided to buy a stake pre-IPO at a 5 percent discount to the IPO price. “When you have that sort of money, a lot of people want to kiss up to you,” says Andy Xie, former chief econo- mist in Asia for Morgan Stanley and now a Shanghai-based independent economist. “Someone shows up and gives you a dis- count. Blackstone was a hot name.”
Xie, 47, says Lou and CIC have learned to be more cautious. In Novem- ber, CIC announced it would invest 780 million Hong Kong dollars ($100 mil- lion) in the Hong Kong IPO of China Railway Group Ltd., the world’s third- biggest construction company. Since the Dec. 6 share sale, China Railway stock has risen 63 percent compared with an 18 percent decline in the benchmark Hang Seng Index.
Then on Dec. 19, China Investment acquired as much as 9.9 percent of Morgan Stanley for $5 billion, making it the company’s second-largest shareholder after Bos- ton-based State Street Corp. CIC, advised by New York–based investment bank
Lazard & Co., has avoided the danger of the sort of paper losses it incurred with Black- stone by buying securities that convert into Morgan Stanley shares at a 5 percent dis- count. The units pay interest of 9 percent. “The Morgan Stanley deal is reasonably good,” Xie says. “The yield covers the cost of capital.” Since CIC’s purchase, Morgan Stanley stock has fallen 1.5 percent.
This year, CIC is due to move to grand- er premises in the New Beijing Poly Plaza, a 24-story tower designed by Chicago- based architects Skidmore, Owings & Merrill. The building, whose name translates as “Protecting the Profit,” boasts a 90-meter-tall (295-foot-tall) atrium enclosed by what the architects claim to be the world’s largest cable-net-support- ed glass wall. It also houses jade sculptures and a museum exhibiting ancient bronze artifacts.
For Lou, the challenge now is to deliver returns as impressive as his new headquarters.