Appreciation of the Role of Sovereign Wealth Funds in the Global Economy

 Studies 

Róbert Csoma Appreciation of the Role of Sovereign Wealth Funds in the Global Economy

Summary: This article is intended to explore the reasons behind the accumulation of massive foreign currency assets in oil exporting and large manufacturing economies in the 2000s, and to explain how the affected countries adjusted their investment policies after the 2008 crisis in respect of their reserves. Based on the statistics and analyses available, the article demonstrates how it was inevitable in these countries to dedicate a substantial portion of the claims – in excess of the optimum central bank reserves – to set up large public funds (“sovereign wealth funds”), and to invest a part of the assets in those funds abroad. This proved to be a wise solution particularly in China, where fiscal reasons render the economy prone to overheating in any case, and the unrestricted exchange of export receivables to the domestic currency would make the money supply balloon, leading to high inflation. Although low-risk but also low-return money market investments had dominated sovereign wealth funds for a long period of time, the countries concerned have changed their investment policies since the crisis, gradually shifting their focus to capital market options promising higher returns. Owing to the tightening of regulations in the wake of the crisis, banks’ previous role in project finance was called into question, especially in the case of infrastructure project financing, which is associated with a long-term return on investment. This provided an additional investment opportunity for the funds. At the same time, through the investment activity of funds, a peculiar nationalisation process is at work in the global economy, allowing funds owned by foreign governments to interfere with the strategic decisions of private corporations.1

Keywords: sovereign wealth fund, nationalisation, China–USA economic relations, long-term financing

JEL codes: F02, F32, F34, F62, F63

Wealth restructuring developed countries and an increase in their in the global economy sovereign debt levels. Meanwhile, the general fall in investment rates and the deterioration of During the Asian meltdown at the end of investment efficiency weighed on global GDP the 1990s, the trade balance of emerging growth. Boasting significant surplus savings, economies was dominated by deficit. In the moderately and lower developed countries, in W2000s, however, the world economy saw a ma- turn, became the most important creditors of jor restructuring of wealth. Most developed developed countries (“perverted capital flow”). countries failed to finance their investment By the time the financial crisis broke out in 2008 activity and consumption from domestic savings and investment activity slowed even further, the alone. Reliance on external financing led to the deficit of internal financing had decreased only deterioration of the balance of payments in many slightly (Farkas, 2011). As an antecedent to – and partly a reason E-mail address: [email protected] for – this restructuring in wealth, world trade

270 Public Finance Quarterly  2015/2  Studies  quadrupled during the 20 years preceding as regards managing the reserves, after 2008 the 2008 crisis, while trade among emerg- the shift to longer-term investments was an in- ing countries multiplied tenfold. China and evitable phenomenon; indeed, with the falter- India opened up their economies, increasing ing of credit-based consumption, international the global workforce by one billion. The in- money markets were increasingly less suited to vestment spree and growth spurred by China’s offer an alternative vehicle for the investment enormous demand for commodities benefited of official reserves both in terms of the volume developing commodity exporters in Africa, and the returns of the investments. the Middle East and Latin America especially, but a number of developed countries, such as Australia or Canada also profited from these The rise of sovereign wealth funds trends. The substantial savings of emerging coun- Funds separated from the reserves of countries tries – in particular, in South East Asia – result- that accumulated reserves in excess of the ed from the fact that GDP growth far exceed- optimal central bank reserves are generally ed the growth rate of domestic consumption. referred to in the literature as sovereign wealth Some of these savings continued to accumu- funds. (As regards what should be considered late as central bank reserves. The ballooning of “optimal”, several approaches are available to reserve holdings commenced as early as 1971 model the “optimal level” of reserves; see for – the elimination of the gold standard system example, Dani – Tőrös, 2011.) There is no –, but the process gained real momentum from consensus on a more detailed definition of 2000. The rise in reserves was especially sharp a sovereign wealth fund. As a starting point, in China, where reserves accounted for 40 per we will rely on Jen’s (2007) definition, which cent of GDP by the end of 2006 (Cree, 2008). considers five factors to be the key features of Another group of countries, oil exporters, had sovereign wealth funds (SWFs): amassed substantial claims vis-à-vis the rest of uthey are state-owned, i.e. sovereign entities; the world primarily as a result of the jump in vthey have high foreign exposure, i.e. for- crude oil and natural gas prices. eign currency assets; The rest of the article attempts to take ac- wthey have no explicit future liabilities count of the factors that – given the current (such as pension); system of global economy – inevitably led xthey have a long-term investment hori- to the accumulation of reserves, especially zon; (and hence), in emerging countries. Thus, the enormous ythey have high risk tolerance. reserves descending upon the international Among public funds, sovereign wealth financial system are stemming, on the one funds are “close cousins” of sovereign pension hand, from the massive revenues of commod- funds and central bank reserves. In the case ity exporting countries where production is of sovereign pension funds (SPFs), however, based on oil as a dominant source of energy. the dominance of foreign currency content On the other hand, in countries with large within the fund’s assets is not a requirement, manufacturing exports – in particular, China while SPFs tend to have some explicit pen- – it was the functioning of the economic sys- sion liabilities attached to them. The main dif- tem that lead to the accumulation of reserves ference that separates sovereign wealth funds by restricting internal consumption. Another from central bank reserves is that official re- objective of the article is to demonstrate that, serves are held, by definition, 100 per cent in

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foreign currencies, while this is not necessarily Development funds are meant to finance so- the case with SWFs. (For instance, in specific cio-economic projects (usually infrastructure) sovereign wealth funds of Singapore, Malaysia (e.g. United Arab Emirates, Iran). and Canada, only a majority but not all of the Pension reserve funds are established to fi- assets are held in foreign currency.) Moreover, nance future pension-related liabilities. For due to their constant need for liquidity and example, Australia, Ireland and New Zealand low tolerance for credit risk, central bank re- hold a large portion of their assets in equities serves are usually held in short-term govern- as a preparation for covering the increased ment securities traded in large and liquid mar- pension costs associated with the ageing of the kets, which is the exact opposite of the long population. (At this point, pension-related li- investment horizon favoured by most sover- abilities appear only implicitly, in the form of eign wealth funds. expected expenditure.) It is also noteworthy that, although the as- Reserve investment funds (corporations) are sets of SWFs predominantly derive from the aimed at earning higher return by high alloca- sale of commodities or the surplus generated tions in equities and alternative instruments, by manufacturing exports, it is not unknown while the surplus assets in the fund are still rec- for countries struggling with external balance ognised as reserves (e.g. China, South Korea, problems to operate sovereign wealth funds as Singapore). well. Among studies aimed at classifying the As an implicit objective, their investment more specific objectives of sovereign wealth policies may also include the goal of circum- funds, Al-Hassan et al. (2013) distinguished venting the “Dutch Disease”, i.e. the phenom- the following types: enon of exchange rate appreciation. When Stabilisation funds are intended to cushion foreign currency flows into the economy, it the economy and the budget from commod- typically lands in the central bank reserves ity price volatility and external shocks in the because allowing the entry of surplus foreign short term (e.g. one of the SWFs in Chile, Iran currency incomes from abroad would raise the and Russia). Similar to official reserves, they money supply in the domestic economy, which have a short investment horizon. For the most may accelerate inflation and/or deteriorate the part, they tend to invest in fixed income in- competitiveness of the given country’s export struments, primarily short-term government industries through the appreciation of the do- securities. (The only difference distinguishing mestic currency during the currency exchange. stabilisation funds from central bank reserves In order to avoid these effects, it might be a is their separate institutional form, and since good course of action to channel the surplus their share in the assets of sovereign wealth assets above the safe level of reserves into sov- funds is less than 10 per cent, this type of SWFs ereign wealth funds and invest them abroad. is disregarded in the rest of this analysis.) The weight of sovereign wealth funds has Savings funds are set up to share wealth increased in recent years as the official foreign across generations. They invest the revenues exchange reserves of newly emerging econo- from the exports of non-renewable commodi- mies – especially China and Russia – surged ties in diversified financial instruments (e.g. as a result of the expansion of exports and high Abu Dhabi, Libya, Russia). In the hope of commodity prices. Today the capital assets of high returns, they are willing to take high risks; sovereign wealth funds surpass the wealth of most of their investments target equities and speculative hedge funds, and even in 2007 their alternative instruments. magnitude was comparable to the combined

272 Public Finance Quarterly  2015/2  Studies  capital markets of Africa, the Middle East and comprised acquisitions by state-owned en- Europe, or the capital market of Latin America terprises or by the state itself, but sovereign (Santiso, 2008). wealth fund investments also rose dynamically This magnitude and growth dynamics are (Megginson, 2013). all the more impressive as the appearance of The global financial crisis and the ensuing the first sovereign wealth funds dates back only government bailouts intensified the acquisi- to the 1950s, while some hedge funds, for in- tion process even further. (The most major stance, were up and running as early as the end state acquisitions in the USA involved as- of the 19th century, yet, the private capital sets acquired under the USD 700 billion managed by them grew far less rapidly than “Troubled Asset Relief Program (TARP)”, in- in present-day SWFs. As private capital funds, cluding General Motors Corporation (60%); hedge funds operated in unregulated interna- American International Group (79.9%); tional capital markets. Their activities and the Citigroup (36%) and Fannie Mae and Freddie allocation of global capital flows they entailed Mac (79.9%). In the United Kingdom, as part contributed to the emergence of long periods of the GBP 500 billion bank rescue package, of boom and productivity surges in the global the government acquired 60 and 40 per cent economy; however, their unregulated nature stakes in two major financial service providers, spawned numerous crises (Johnson, 2007). the Royal Bank of Scotland and HBOS-Lloyds According to data released by the Sovereign TSB, respectively. In Germany, the share of Wealth Fund Institute – an organisation stud- the government rose to 46 per cent in Bayern ying SWFs specifically – the consolidated as- LB, and 25 per cent in Commerzbank and sets of SWFs exceeded USD 6,600 billion in Deutsche Telekom.) July 2014, 60 per cent of which comprised the Even before the acquisition wave of the assets of funds accumulating revenues from 2008–2009 period, in 1998 – during the oil and natural gas sales. Despite their grow- Asian meltdown – government interventions ing share, as yet, they do not have a dominant rose to unprecedented heights compared to the role in global capital markets. In 2012 their previous years. Nonetheless, the fact that near- total assets accounted for around 8 per cent of ly a half of all state purchases between 1981 global capital market capitalisation compared and 2013 took place in the two-year period to the 47 per cent share of pension funds, the between 2008 and 2009 is indicative of the 42 per cent share of global mutual funds, and depth of the recent crisis. the 3 per cent share of hedge funds. As another special feature, average transaction Considering comprehensive global eco- values increased sharply after 2007, especially nomic privatisation and nationalisation de- in Europe (United Kingdom, Netherlands, velopments (including, besides the sovereign Belgium, Ireland, France and Luxembourg), wealth funds, the roles of states and state- Central Asia and North America. Evidently, owned corporations), two distinct periods during the financial crisis governments tended can be distinguished in the years between to support corporations mainly in the finan- 1988 and 2013. Until 2000, governments pri- cial and real estate sectors. These two sectors vatised assets worth around USD 1 trillion, account for 72 per cent of all acquisitions be- roughly triple the value of assets nationalised tween 2008 and 2013, more than quadruple of during the same period. After 2000, these two those seen in the period of 1981–2007. values levelled off at USD 1.6 trillion. Most Oil-rich Gulf countries, in turn, grabbed of the surge in state purchases of private stock major stakes in mammoth corporations

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through their sovereign wealth funds. In 2008, the rapid expansion of SWF assets were exac- Abu Dhabi’s sovereign wealth fund acquired a erbated by the fact that most funds were es- 4.9 per cent stake in Citigroup, while Qatar’s tablished in countries with questionable dem- SWF purchased 15 per cent in Volkswagen ocratic standards. This fuelled apprehension AG in 2009. In the period between 1981 and about sovereign wealth funds regarding their 2013, acquisitions by sovereign wealth funds future attitude to exercising the influence ob- made up 7 per cent of all privatisation transac- tained even though most of their investments tions, but the value of purchased assets reached were passive initially, without any ambition to nearly 15 per cent. Following the declared cri- obtain majority influence (Truman, 2010). sis, SWF activity intensified further: between As opposed to large institutional investors 2008 and 2013, SWFs drove one fifth of all – such as investment or insurance funds –, sov- privatisation deals, investing triple the amount ereign wealth funds generally do not have pay- allocated in the 1981–2007 period. A half of ment obligations toward private shareholders their investments targeted foreign enterpris- or insured parties; therefore, their operations es; thus they played an important role in the and investment strategies are less transparent. recapitalisation of distressed domestic com- With a view to increasing their transparency, panies. The importance of sovereign wealth the Santiago Principles formulated by the funds is expected to increase further; indeed, working group of the IMF advise sovereign the fiscal deficits of numerous economies and wealth funds to consult with the government most developed countries that had launched of the target country before any major invest- massive privatisation programmes in the post- ment, and publish reports on their activities crisis period suggest that privatisation is like- on a continuous basis. That notwithstanding, ly to remain a central issue in years to come adherence to the Santiago Principles is not (Guedhami, 2013). mandatory. As is the case with any other government, governments running sovereign wealth funds are driven by various economic objectives depend- Sovereign wealth funds during ing on their assessment of the economy and the the crisis and after the declared social situation, and these goals vary over time. crisis While they typically do not seek profit maximi- sation, with the policy measures available they Initially, sovereign wealth funds primarily must support economic growth to ensure tax targeted investments in the government bonds revenues and the sustainability of the equilib- of developed countries, in particular, US rium of public finances. Sovereign wealth funds government securities, which had a reputation may also be suitable for serving these purposes of being safe. The volume of US security issues, as, in theory, they have no preferences conflict- however, could not keep pace with the growth ing with those harboured by the owner govern- of the foreign exchange reserves of emerging ments. As long as the risk-weighted real yields countries; in addition, the yields offered by on their investments exceed the level of the real US papers declined continuously amid the ra- interest rate on government debt, it may be pid growth of demand. worth allocating capital to SWFs as their activ- Nevertheless, owing to their ample liquidity ity may boost national wealth. and state investors’ ability to absorb enormous In the period preceding the 2008 crisis, po- amounts of funds, traditional North American litical concerns in Western economies about and European capital markets have remained

274 Public Finance Quarterly  2015/2  Studies  the primary targets of SWF investment to corporate governance (such as approving man- date. However, sovereign wealth funds often agement decisions), in sharp contrast with set specific yield goals today, and accordingly, their previous attitude of a passive financial in- their portfolios began to shift, at least in part, vestor (Biedermann, 2013). Through the activ- toward riskier investments. It is indicative of ity of SWFs, a peculiar nationalisation process the diversification of their investment policies is in progress in the global economy, allowing and simultaneously, their higher risk appe- funds owned by foreign governments to in- tite, that their investments now target private terfere with the strategic decisions of private capital and hedge funds as well. By acquiring corporations. Nationalisation was observed stakes in these investment firms, sovereign in the form of bank and corporation bailouts wealth funds assign external asset managers to in several countries as a crisis management manage a portion of their assets. tool, but mainly with the participation of the In the hope of higher return, they have re- “home” country. In times of crisis, protection- cently eased their risk management policies, ism emerges as a natural phenomenon; the de- although they have not shed their aversion to cisions of state owners are often shaped by a risk entirely: indeed, based on their internal desire to keep a corporation in domestic own- regulations, some funds are not permitted to ership, rather than allowing it to be bought up invest in certain asset classes or apply specu- by a foreign investor. It is a different scenario, lative techniques. Accordingly, investment in however, when another state (fund) invests in OTC markets or the use of leverage may be distressed companies. Obviously, the actual ef- prohibited for some funds, or they may only fect will depend on the extent to which sov- be permitted to apply derivatives for risk ereign wealth funds assume an active role as coverage. shareholders. The financial crisis improved the perception Many sovereign wealth funds miscalculated of sovereign wealth funds in developed econo- the depth of the crisis by thinking that they mies, as a large part of their investments in- had managed to purchase assets at the cheap- volved stabilising capital injections. Attracted est possible price at the deepest trough of the by the good investment opportunity presented crisis. Since, for the most part, they missed the by inexpensive, continuously depreciating moment when the crisis hit its bottom, they bank stocks, at the beginning of the crisis pe- became some of the biggest losers of the burst- riod SWF investments targeted the financial ing of the asset price bubble. In proportion to sector. the assets invested, some funds realised losses During the capital injection, banks’ revenues as high as 30 per cent in 2008. However, even from equity sales corresponded to the losses re- this could not break the steady accumulation alised on their security holdings, raising their of assets by sovereign wealth funds, and ever capital adequacy ratios at least to the approved since 2007, the value of their portfolios has in- level. Foreign investors, in turn, believed that creased each year. The underlying reasons for they had acquired stakes – sometimes in ex- the accumulation of surplus foreign currency cess of 10 per cent – in the largest US banks at assets did not disappear overnight either at a bargain price. In addition, sovereign wealth large manufacturing exporters or commodity funds obtained significant ownership stakes exporters; only the rate of growth has become in numerous industrial corporations. Their more moderate temporarily. shareholdings reached the level at which they They rearranged their investments in re- were “forced” to assume a more active role in sponse to the crisis and, as a result of the losses

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sustained and the high risks, the share of the fi- The research was also aimed at assessing the nancial sector declined. Although the number attractiveness of selected capital markets for of transactions increased, the decline in capital investors. TheU nited Kingdom and Germany value per transaction points to a more cautious proved to be the most attractive targets, while investment policy, especially in 2009–2010 India received the worst score. The United (ESADEgeo, 2013). Kingdom is attractive to investors for its eco- Investment in infrastructure, real estate, nomic stability and openness to foreign invest- and the shares of commodity producers has ment, and the alternative investment opportu- taken preference over investment in the fi- nities it offers. nancial sector. Interestingly, publicly disclosed Respondents expect to increase new alloca- data appear to capture only a small proportion tions to alternative investments across all as- (USD 50–100 billion) of direct investments set classes (real estate, private equity funds, by sovereign wealth funds, the actual level of infrastructure, hedge funds, commodities). which is likely to be a multiple of the numbers Respondents perceive an especially acceler- reported. This assumption is indirectly sup- ating trend toward investments in real estate ported by the dynamic growth in the number and private equity funds. Besides alternative of investment professionals hired by SWFs. In investments, equity markets were also popular many cases, the same professionals had been in 2013, increasing the risks and lengthening laid off during the financial crisis and before the time horizons of investments. Although long, they wound up assisting in the acquisi- the share of domestic market investment was tion of their former companies. Co-investment more than 40 per cent among the respondents has also gained ground: sovereign wealth funds in 2013, home market bias is on a declining open managed accounts at private equity trend, and sovereign investments become in- funds through which they acquire stakes. This creasingly globalised. activity, by nature, is not included in direct investment statistics (Ohrenstein, 2013). An advantage of managed accounts is the shared Economic and monetary policy interest between the account manager and its dilemmas of the Chinese economy clients, i.e. the private equity fund and sovereign wealth funds. The funds of the SWFs are Out of the 11 sovereign wealth funds held on their own accounts, while relying on managing a portfolio of more than USD 100 its special expertise, the account manager pri- billion – more than three fourth of the assets vate equity fund is responsible for trading. accumulated in SWFs – 4 funds are Chinese. According to a recent survey (Invesco, The share of Chinese funds in the total assets 2014) conducted among more than 50 sov- of sovereign wealth funds is more than 25 per ereign investors representing USD 5.7 trillion cent. (Similarly to China, Singapore owns two of assets, emerging markets (including Latin large funds financed from sources other than America, Africa, China, India and emerging oil exports.) countries in Asia) increased their share with- Such a massive accumulation of foreign ex- in the investments of sovereign wealth funds change reserves invested abroad demonstrates in the period of 2012–2014. (However, al- the growing strength of the Chinese economy, locations to Central and Eastern Europe and which propelled China to become the larg- Russia are expected to remain muted due to est economy of the world, boasting the larg- political instability.) est manufacturing output and trade volume

276 Public Finance Quarterly  2015/2  Studies  worldwide. The surplus of its trade balance investment inflows in the global economy, and has been rising practically continuously since the third largest FDI exporter. 1990. With a positive capital balance to boot, Sinde 1979 nearly a half of FDI flows to China has amassed the most enormous foreign China originated from Hong Kong. (However, exchange reserves in the world – nearly USD according to a number of analysts, some of 4 trillion in mid–2014. Since 1979 – the be- the FDI originating from Hong Kong may ginning of the economic reforms – 500 mil- in fact derive from Taiwan. In addition, some lion people are estimated to have been raised Chinese businessmen may take funds out of out of extreme poverty. In terms of per capita the country only to reinvest them in China GDP, China has thus transitioned to a middle where they can take advantage of preferential income economy. Its rapid rise as a major eco- investment policies). The second largest source nomic power is combined with bilateral com- of FDI inflows to China is considered to be the mercial ties with the United States: China is British Virgin Islands (with shares of around currently the second largest trading partner of 8 per cent), and given its reputation as a tax the USA, its third largest export market, and its haven, the original source of the FDI is usu- largest source of imports. The convergence of ally a different country. Statistics are probably China has been in progress since 1979, China’s more reliable in measuring FDI inflows in the opening up to global economy (see Table 1). case of Japan and USA, with respective shares Having said that, the evolution of China’s of 6.5 per cent and around 5 per cent. (Given FDI flows followed a peculiar path. According the uncertainty around the identity of actual to official statistics, after the USA, China is investors and the fact that official statistics the second largest recipient of foreign direct do not include potential outflows, the nearly

Table 1 Selected convergence indicators of China

China USA

Average annual growth Average annual growth rate (%) rate (%) Description Description 1979– 1991– 2001– 1979– 1991– 2001– 2012 2012 2012 2012 2012 2012

GDP 9.8 10.3 10.1 GDP 2.7 2.5 1.8 Gross fixed capital formation n/a 22.4 22.6 Total domestic investment 3.2 3.6 1.0 (100 million yuan) (USD billions) Retail sales of consumer goods 15.5 15.8 15.0 Retail sales of consumer goods n/a 4.4 4.1 (100 million yuan) (USD billions) Total foreign trade turnover (100 16.6 17.3 19.1 Total foreign trade turnover 7.9 7.2 6.2 USD million) (100 USD million) Household deposits 24.9 20.1 16.4 Household deposits 11.5 9.4 11.2 (100 million yuan) (USD billions)

Source: National Bureau of Statistics of China, U.S. Bureau of Economic Analysis, Board of Governors of the Federal Reserve System and own calculations based on the United States Census Bureau

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USD 1,500 billion direct investment figure is more pronounced than vice versa. Numerous likely to overestimate the level of capital ac- American companies continue to use China as tually invested by foreign investors between the final point of assembly (seeTable 2). 1979 and 2013; Morrison, 2014) The Chinese economic policy achieved the It exacerbates the statistical uncertainty convergence successes outlined above through mentioned in relation to FDI inflows even decades of export-driven, high investment further that the ranking of the destinations rates and the high domestic savings rates that of FDI outflows is very similar to that of FDI provided the required resources. The exces- inflows. Besides Hong Kong, several other re- sively investment and export-driven economic puted tax havens are listed among the most growth, however, led to the overheating of the important destinations (British Virgin Islands, economy. From 2005 until the outbreak of the the Cayman Islands, Luxembourg). The USA global economic crisis, China registered GDP and Australia are the only two countries on the growth of over 10 per cent; however, this was list that are less likely to be targeted by Chinese accompanied by an inflation rate of around 8 investors mainly for tax saving purposes. per cent as early as 2008. (Decades of rapid Even in consideration of stakeholder de- economic growth in China has fuelled a spec- cisions strongly influenced by tax implica- tacular demand for energy. As a result, China tions, it can be established that Chinese and became a net oil importer in 1993, recording American investment practices are, for the the second largest oil imports after the USA time being, asymmetrical. When comparing worldwide.) US investment activities in Asia and the Pacific It is a specificity of the financing of China’s region and the capital exports of the same re- economic growth is that it has increasingly regions to the USA, it is evident that US invest- lied on domestic savings in recent periods. By ments targeting these regions and China are far 2009, the savings rate of urban households, for

Table 2 Foreign direct investment flows between the USA and China

Foreign direct investment in the USA 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 (USD millions)

Asia and the Pacific region 204,708 230,231 246,585 269,772 294,976 325,431 323,404 346,605 409,512 427,679 of which: China 284 435 574 785 584 1,105 1,624 3,300 3,729 5,154 Share of Chinese 0.1% 0.2% 0.2% 0.3% 0.2% 0.3% 0.5% 1.0% 0.9% 1.2% investments

FDI investments by the USA (USD 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 millions)

Asia and the Pacific region 270,830 374,754 375,689 403,637 444,101 484,796 502,826 570,111 606,174 651,305 of which: China 11,261 17,616 19,016 26,459 29,710 53,927 54,069 58,996 55,304 51,363 Share of US investments 4% 5% 5% 7% 7% 11% 11% 10% 9% 8%

Source: own calculations based on the U.S. Bureau of Economic Analysis

278 Public Finance Quarterly  2015/2  Studies  instance, soared to 29 per cent compared to to China’s massive US money market invest- 18 per cent in 1995. Corporations – especially ments – remained low both before and during those in state ownership – are major net sav- the crisis, encouraging American households ers, because they do not pay out dividends to to maintain their level of consumption (even shareholders. The high savings rate and conse- by resorting to borrowing), which continued quently, the decline in the ratio of private con- to generate demand for Chinese merchandise. sumption and disposable income to GDP, can (For the same reason, through the dampen- be largely attributed to two factors: China’s ing effect of its money market investments banking policy and the lack of an adequate so- on interest rates and the ensuing growth in cial security system (pension scheme, health- outstanding borrowing, China itself contrib- care system, unemployment benefits). uted – albeit inadvertently – to the real estate Since China restricts households’ capital ex- surge materialising in the USA before the crisis ports, they deposit a substantial part of their which, eventually, led to the events of 2008.) savings in Chinese banks. Deposit rates are set Besides the sheer enormity of accumulated by the government, and occasionally they are foreign currency assets, remunerative invest- lower than the inflation rate. In practice, this ment is also hindered by the less than optimal implies an income transfer from households to composition of the assets: the lack of adequate the corporate sector, as corporations take ad- diversification. As a matter of course, for a vantage of the alignment of the lending rates long time China held its foreign currency as- to low deposit rates. In addition, the lack of a sets in investments denominated in USD social safety net also forces households to save – the key currency –, around 70 per cent of a large portion of their incomes. them in US treasury bills. Even today, China Due to the Chinese economy’s propensity holds more than a third of its portfolio invest- to overheating, the Bank of China needs to ments – around USD 1.3 trillion in 2013 – in adopt restrictive monetary measures from time US government securities; however, it reduced to time. In the 2000s the key policy rate and its low-yielding Treasury bill portfolio to 40 the required reserve ratio were raised several per cent. times in a bid to contain inflation. As the USA stepped on the path to rapid in- In addition, the Chinese government’s deci- debtedness in the 2000s, the portfolio invest- sion in 2006 to allow the yuan to appreciate ments of China began to depreciate parallel to – combined with the rising of real wages since the weakening of the USD. This was accom- the 2000s – contributed to alleviate the over- panied by a sharp fall in the yields on US gov- reliance on exports, decelerated the accumula- ernment securities, primarily because of the tion of trade surpluses and hence, slowed the heightened Chinese demand in the first place. accumulation of foreign reserves somewhat. The yields fell short of even the Chinese infla- Obviously, demand for Chinese exports was tion rate, generating additional financial losses temporarily restrained by the global economic for China. It was for this reason that China crisis itself. began to diversify its foreign investment port- At the same time, the appreciation of the folio gradually (Dani – Tőrös, 2011). yuan raised concerns among Chinese politi- Additional financial losses were sustained cians about the ability of Chinese products to because, for the sake of the public offering, the retain their competitive prices. So far, it ap- interest paid on the sterilisation bonds issued pears that their concerns were unfounded. US in China in order to alleviate inflationary pres- interest rates – to some extent, precisely due sures had to be determined lower than those

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that could be achieved by China, as an inves- developed economies. The yuan is yet to be- tor, on its USD denominated reserves. come convertible, and current and capital The effect of the high interest rate paid on transaction restrictions also hamper the yuan’s sterilisation bonds resembled that of central rapid transformation into an international cur- bank base rate increases in that it attracted ad- rency (Dobbs et al., 2013) ditional foreign investors to this market (even In addition to changes in its monetary pol- illegally), which put an appreciation pressure icy, the Chinese government needed to apply on the yuan. Expectations about an actual ap- fiscal measures as well to stabilise GDP growth preciation of the currency spurred a further in- which, owing to the subdued demand for ex- flow of foreign capital, generating a speculative ports during the crisis, was only conceivable by spiral (Cognato, 2008). Continued speculative expanding domestic demand. Increased public capital inflows in recent years, however, would spending on infrastructure projects became a continue to necessitate large-scale sterilisation, tool for providing fiscal stimulus, primarily by presumably resulting in further financial losses way of railway developments. This policy was a (Gábor, 2010). By 2012, the number of quali- success in the sense that the key economic in- fied foreign institutional investors (those per- dicators did not show a downturn until 2009. mitted to invest in China) rose to more than However, excessively increased public invest- 200 compared to 33 in 2005, pointing to a ment combined with drastically raised budget- further increase in investments. Chinese pol- ary expenditures overheated the economy once icy-makers cannot afford to ignore this upon again (Csanádi, 2013), leading to a surge in formulating the monetary policy. inflation and the mounting indebtedness of In the past, the speculative inflow of foreign local governments. Since new capacities also currency forced the Bank of China to buy up contributed to the dynamic growth of exter- the currency, which increased domestic money nal trade after 2009, China faced the recurring supply and hence, encouraged banks to in- problem of how to invest its ballooning for- crease lending. This led to the formation of eign exchange reserves profitably. spare capacities, for instance, in the steel in- dustry (Selfin et al., 2011), or generated asset bubbles in the real estate market (Martin, Specificities of Chinese sovereign 2008). Contrary to the most developed econo- wealth funds mies which restrained lending during the crisis, outstanding borrowing in China soared to The state-owned China Investment Corporation 132 per cent of GDP during the crisis, surpass- (CIC) was established in 2007 as a sovereign ing even the level observed in developed coun- wealth fund to manage a part of surplus tries. 85 per cent of the loans were granted to central bank reserves and increase the return corporations. The need to contain this expan- on foreign exchange reserves. Although sion often forced China’s government to adopt American investments still account for around administrative restrictions in respect of the a half of the foreign investments of the fund credit conditions applicable to certain sectors. due to its initial investment policy, as a long- Despite the steps taken forward – laden, term investor it is now keenly interested in as they were, with regulatory difficulties –, infrastructural and environmental projects and the depth of financial intermediation (the to- real estate investments as well (Rao, 2013). tal value of China’s financial assets as a share Apart from its foreign investment activity – of GDP) remains only half of the average of for which CIC International was established

280 Public Finance Quarterly  2015/2  Studies  originally –, CIC recapitalised the domestic Since the USA has a protectionist attitude banking sector during the crisis, acquiring in respect of China’s investments aimed at the a stake in excess of 40 per cent in Chinese USA’s energy and telecommunications sec- state banks. Through its investments held in tors, China has shifted its focus to Europe in its investment corporation, Central Huijin, recent years. Among the European countries, CIC directly controls the four large Chinese the United Kingdom is the most welcoming state banks, which represent 65 per cent of the of Chinese investments, especially in its infra- Chinese banking market. The largest owner of structure and industrial projects. This arrange- the investment company is the State Council ment also benefits the activities of European of the People’s Republic of China. While CIC corporations in China because, given the clos- maintains that its foreign investments do not er commercial ties, they have easier access to have a political nature, it openly admits that China’s product and services markets (Wenbo, its domestic investments were political; instead 2013). While China’s investments in Europe of aiming to achieve profitability, they were were largely driven by profit considerations, meant to rescue state banks and resolve their Chinese investments in emerging countries capital position. are also motivated by strategic interests: secur- At the inception of CIC, instead of execut- ing energy and natural resources to power the ing a direct recapitalisation from the foreign Chinese economy over the long term. exchange reserves, the Chinese government is- In terms of the funds managed, China’s sued bonds worth CNY 1.6 billion, and from State Administration of Foreign Exchange the proceeds it purchased USD 200 million (SAFE) is even bigger than CIC. At the same from the Bank of China. This amount was time, the organisation is also responsible for then used as the equity capital of CIC. Initial China’s foreign exchange regulations. As re- yields on the 10–15 year bonds ranged be- gards the investment activity of China’s two tween 4–5 per cent; thus, in order to achieve a major funds, in addition to investments in return, China expected to receive at least cor- the financial sector, both funds increasingly responding yields on the investments by CIC tend to invest in foreign commodity produc- from the start. This is an unusual procedure ers, as well as the sectors of technology and upon the launch of sovereign wealth funds, real estate. In particular, SAFE has a special which typically commence their activities focus on the equity market of the United without any explicit payment obligations. In Kingdom Additional important funds include combination with the weakening of the dol- the sovereign wealth fund of Hong Kong, the lar during this initial phase, these stringent China-Africa Development Fund (established yield requirements translated into even higher in 2007 mainly for financial investments in expectations (Santiso, 2008). The fund failed Africa) and the National Social Security Fund to meet these expectations, and had produced (NSSF), which was set up in 2000. losses even in 2011, before its yields soared to Besides the investments of sovereign wealth 10 per cent after a major portfolio diversifica- funds abroad, Chinese companies themselves tion in 2012. From 2011, the permitted ho- pursue activities in foreign countries, partici- rizon of long-term, higher-return investments pating in projects and making investments. was raised from 5 to 10 years and parallel to While in the developed regions of the global this, the fund increased direct investments in economy the goal of Chinese corporations is private corporate stock, private equity funds, to obtain technology, they move to Africa for hedge funds and real estate investments. as yet unexplored minerals, in consideration

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of the massive commodity and energy de- regions of the global economy after the crisis mand entailed by the rapid economic growth. (despite its dependence, even in relation to In their export markets, large Chinese export OPEC countries), as regards China, its import corporations need services (transportation, in- demand – which deteriorated during the crisis surance) and they also aspire to obtain control – recovered in the period of normalisation; over such service providers. In order to im- thus the deteriorating trend of the USA’s prove their competitiveness and achieve higher balance of payments position was only sales prices, emerging Chinese corporations temporarily slowed by the crisis (see Chart 1). strive to acquire recognised Western brand The previous trend of securing financing names. Sometimes they seek cheaper labour (due to the insufficient level of domestic re- markets (e.g. in Vietnam) than the domestic serves) mainly through Chinese capital inflows market (Artner, 2010). also persisted (see Chart 2). Amid the spectacular economic growth, Since 1969 – the last year that closed with a real wages have been rising dynamically in budget surplus – the USA has typically pursued China for a longer period of time. Rising real a fiscal policy of overspending. However, it was wages and the export competitiveness of the not only the amounts spent on crisis manage- manufacturing sector inevitably led to the ac- ment and bank bailout packages that boosted cumulation of foreign exchange reserves and the budget deficit. Some of the deficit can be the appreciation of the yuan, which forces the attributed to programmes and reforms such as Chinese government to implement an eco- state aid granted to funds for the financing of nomic transformation: China needs to switch healthcare services for the elderly and the poor; from an extensive, excessively export-oriented the extension of the health insurance system growth pattern to a development path that to the 45 million Americans yet uncovered; is rooted in human capital and R&D, and is and the improvement of the general financing more aligned to domestic household demand. conditions of the healthcare system and pub- The capital for this is readily available; moreo- lic education. Owing to regular fiscal deficits, ver, through its sovereign wealth funds, China the other main imbalance of the USA is as- may also become the most important creditor sociated with the continuous and accelerating of emerging countries. growth of public debt seen since the Reagan administration. The insufficiency of domestic savings is also demonstrated by the fact that Expected trends in the near future more government bonds have been purchased and in the longer term by foreigners in the past twenty years than by domestic investors, and today two thirds of In terms of balance, the path followed by US government securities are held by non- the USA in the 2000s was the exact opposite residents (Szilágyi, 2009). of the one taken by China. In contrast with Financing burdens were only escalated by the enormous surpluses of the balance of the unprecedented monetary and fiscal expan- payments and massive foreign exchange sion launched by the American government reserves in China, the USA is struggling with at the outbreak of the financial crisis. Bank a significant balance of payments deficit, bailouts and fiscal stimulus packages con- mainly due to the growing deficit of its trade served America’s equilibrium problems. Since balance vis-à-vis China. While it was able these problems are not expected to improve to improve its external positions in several significantly in the near future, the unique

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Chart 1 Current account balance of the USA USD millions

Europe Asia OPEC Central and South America China Japan

Source: own editing based on the U.S. Bureau of Economic Analysis Chart 2 External financing requirement and main creditors of the USA USD millions

Europe Asia Japan China USA

Source: own editing based on the U.S. Bureau of Economic Analysis

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relationship between the USA as China’s mas- down the rate to this threshold in the first few sive export market and China as a major ex- months of 2014 already. Since in the Fed’s as- porter and creditor is unlikely to change over sessment economic growth is still fragile, it is the short term, and the interdependence of unlikely to increase interest rates at a fast pace these two countries is expected to persist. despite the favourable unemployment figure In a certain sense, China was taken hostage (Questor, 2014). by itself in this mutual reliance: due to the From a strategic perspective, it is of great sheer size of its reserves invested in the USA, it significance that the United States aspires to must do everything in its power to protect the become one of the leading oil producers of value of its investments. A weak dollar would the world in the next two years and, by 2035, hurt China’s interests as it would devalue it it may become self-sufficient in this regard. immense reserves in the USA. Developments Projections regarding the size and extraction in the dollar’s exchange rate – which, in part, capabilities of shale oil and shale gas resources are dependent on China itself – pose one vary widely; however, if the plans come to pass of the greatest challenges for the Chinese as scheduled, the strengthening of the American government. currency may persist over the long term. In view of the Fed’s fiscal tightening, the China is expected to improve its economic continuous tapering of asset purchases, the performance at a slower rate compared to its wave of interest rate increases expected from previous performance and its GDP growth 2015 and the ensuing rise in US capital mar- may dip below 7.5 per cent in 2014. If the ket yields, analysts envisage, for the most part, scenario presaging the medium and long-term the strengthening of the US dollar. In the post- strengthening of the US dollar materialises, crisis period the moderation of household in- it may secure the value of existing Chinese debtedness and the recovery of household con- investments in the USA over the long term. sumption point to the gradual acceleration of China, as an investor, may achieve an even bet- American economic growth. ter position if it gains better access to the non- In December 2013 the Fed decided to taper financial sectors of the US economy. off its asset purchases in the course of 2014. Under its asset purchase programme, the Fed purchased long-term government securities Summary and mortgage bonds in order to ensure low interest rates over the long term and hence, fa- The weight of sovereign wealth funds has cilitate the acceleration of economic growth. increased in recent years in parallel with the The first phases of the asset purchases by the robust accumulation of the official foreign Federal Reserve System (Fed) – the central exchange reserves of China and Russia in banking system of the USA – have largely particular. The sovereign wealth funds owned contributed to the soaring of certain capital by China dispose over nearly a quarter of market segments in recent years, especially as the assets held in SWFs worldwide. The regards the corporate stock prices of developed funds rearranged a part of their investment countries. portfolios in response to the crisis and, owing In its guidance the Fed had indicated that to losses sustained and high risks, the share it would maintain its quantitative easing as of the financial sector declined. At the same long as unemployment is over 6.5 per cent, time, however, they acquired significant stakes but the US economy was close to bringing in numerous industrial corporations.

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The Chinese economy achieved its successes developments securing renewable energy re- through decades of export-driven, high invest- sources in order to manage the deficiencies ment rates and the high domestic savings rates in primary commodities, environmental pol- that provided the required resources. In terms lution and the climate change. In numerous of balance, in the 2000s the USA followed a emerging economies, there is a comparable path directly opposite the one taken by China, need for investment, in particular, infrastruc- facing massive balance of payments deficits. In ture projects, that would ensure that the ur- the context of increasing globalisation, the po- banisation entailed by the rapid increase in sitions of the two nations in financial markets household income is combined with accept- became mirror images of each other; Chinese able living conditions (Aglietta, 2013). All capital inflows became the main source of fi- these development needs require long-term nance for US deficits. Over the medium and financing. Finances need to adjust to these long term, this situation is not expected to trends. change significantly unless the United States, Although the global crisis had demonstrated relying on its new resources, becomes one of that global financial markets are not self-reg- the leading oil producers of the world in the ulatory, in the lack of a common political will next few years, and subsequently becomes on the part of the key countries and groups of self-sufficient. countries, a uniform international regulation European banks had borrowed heavily in of global markets cannot be expected over the US dollar during the pre-crisis period, and short term. Besides banks, large pension funds used the funds for their own lending opera- are not expected to ensure an adequate level tions worldwide. A substantial part of these of long-term financing either; indeed, with loans were used for the long-term financing of the ageing of the population they themselves infrastructure projects in emerging countries. struggle with undercapitalisation, as do large After the outbreak of the crisis, banks gradu- insurance companies because of the solvency ally began to refrain from these activities as requirements. Sovereign wealth funds appear their own sources of credit dried up. As a re- to be the most likely candidates to fill the fi- sult, many emerging countries – which do not nancing gap; since their purpose is to preserve operate sovereign wealth funds – face difficul- the surplus assets of nations – as materialised ties in financing their projects. Consequently, in the foreign exchange reserves – for future the global economy currently lacks the in- generations, they take a long-term approach stitutional system required for long-term fi- by definition. Sovereign wealth funds may nancing, and is not expected to provide ac- partly replace bank credit, channelling capital cess to an adequate volume of credit to satisfy from Asian countries with abundant surplus future needs. This is particularly relevant at savings to fast-growing but desperately under- a time when there is an increased need for financed emerging economies.

Note

1 The author wishes to thank Mária Csanádi and Éva Voszka for their valuable comments on this article.

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