Brad Setser testified at the recent hearings on "Implications of Sovereign Wealth Fund Investments for National Security" held by the U.S. China Economic and Security Review Commission. Here is his testimony: The Implications of Sovereign Wealth Fund Investments for National Security.
I enjoyed his discussion of interagency competition among the Chinese agencies looking for a role in investing abroad:
The CIC [Chinese Investment Corporation - Ben] itself is under incredible pressure. Its first high-profile international investment – Blackstone -- lost money. It faces tremendous pressure not to make a similar mistake, yet it also faces pressure to invest quickly and generate strong returns. However, it could easily fail to produce sufficient dollar and euro returns to offset RMB appreciation (dollar/ euro depreciation). While the investments of SAFE ["China’s existing foreign exchange manager – the State Administration of Foreign Exchange"] are veiled in obscurity, every CIC move is closely scrutinized at home and abroad. Its autonomy is constrained: large investments likely need the approval of the top level of China’s government. Press reports – and the decision to block the China Development Bank’s investment in Citibank – suggests that China’s top leadership is worried that the CIC’s portfolio is too concentrated in the financial sector.
The rest of China’s government is not necessarily vested in the CIC’s success. The bureaucratic rivalry between China’s finance ministry and central bank has spilled over into rivalry between the CIC – linked to the Finance Ministry – and China’s existing foreign exchange manager – the State Administration of Foreign Exchange (SAFE). SAFE is keen to prove that it can deliver better returns than the CIC at a lower cost if it is given more freedom to take risks. Coordination is likely to be an ongoing challenge. The parts of China’s government with links to the state firms want the CIC to do more to support their outward expansion, including the outward expansion of China’s mining companies. Overtly supporting Chinese state firms would contradict the assurances the CIC has given to the US and Europe that it is motivated solely commercial considerations of risk and return. Not supporting Chinese state firms though risks the creation of a new bureaucratic rival.
He didn't have specific suggestions for revision of the Treasury's regulations on foreign investment security reviews. He clearly thinks there is a short-term problem. There are strong sources of Chinese and U.S. opposition to directing China's investments into index funds. The only solutions that he suggests are longer term, and not connected to security reviews: increases in U.S. savings and Chinese domestic demand, or Chinese policy changes that would leave more foreign assets in private hands (see James Fallows Atlantic article The $1.4 Trillion Question (Jan/Feb 2008 - free on-line) for a great explanation of why all those assets are in public rather than private hands - see the extract below - and a nice discussion of the operations of the Chinese Investment Corporation - CIC):
So long as China confined its investment to bonds, though, the US did not have to worry about China’s potential to exert direct control over US assets...
However, China’s government has made a strategic decision to encourage outward investment by Chinese firms, and to reorient the composition of the portfolio of China’s central government toward equities....
China’s desire to diversify the composition of its portfolio though runs squarely into the United States historic aversion to government ownership of private firms. The most obvious ways of minimizing the associated friction – for example, Chinese investment in index funds rather than individual companies – run directly into China’s strong desire, also rooted it its historical experience, not to compromise its sovereignty. It also runs against the self-interest of cash-strapped US firms – whether capital-short broker -dealers or US metals companies -- who are increasingly seeking looking to do deals with China’s government. China is, so to speak, where the money is. So long as the US saves far less than it invests, China saves more than it invests and China’s government accounts for the lion’s share of the increase in China’s foreign assets, some part of the US economy will either be borrowing from China’s government or selling equity to China’s government.
In the long-term, the US and China would both benefit if their current financial interdependence fell. The United States ability to draw on financing from other governments – financing that has increased as private demand for US financial assets, relative to private US demand for asset abroad – has broadly speaking been stabilizing. But it also implies a rising level of government participation in US financial markets and, as governments shift from a bond heavy portfolio to a more balanced portfolio – rising government ownership of US companies. And the investment of so much of China’s savings – Chinese claims on the US are probably equal to about a third of China’s GDP – raises equally profound questions, not the least because such investment is unlikely to generate strong financial returns in the RMB terms. A world with a smaller US deficit financed by private flows would generate less tension. In the short-run, though, the challenges associated with United States financial interdependence on a country with a very different political and economic system – despite ongoing reforms – look set to rise.
Here's the Fallows extract:
Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.
When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.
This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.
With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.
The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.
Good find, Ben. Will have to ask the good Dr. Setser why he hasn't shared this yet on his own blog. Maybe it's forthcoming...
Posted by: Emmanuel | February 14, 2008 at 10:40 AM