Academic

This is the FIFTH of a multi-part series exploring the rise of a new form of integrated sovereign investing. The focus will be on the regulatory framework that is being developed in the West and the reality of innovative sovereign investing being implemented in China. A complete version of these materials will be published in the University of Iowa College of Law Journal, Transnational Law and Contemporary Problems. The manuscript of which may be accessed HERE.

Part I. Introduction

Part II. Projections of Public Economic Power in Private Form: Contextualizing Sovereign Wealth Funds--Form, Function and Policy.
A. Form in SWF Definition and Operation.
B. Function in Sovereign Investing.
C. Form and Function in the Policy Context on the Eve of Financial Crisis.

Part III. Complexity and Coordination in Sovereign Investing: The State Owned Enterprise as Sovereign Investment Vehicle.

Part IV. The Expression of Dissonance in Regulatory Responses.
A. National Approaches to Regulatory Reform.
1. The United States, Canada, Australia
2. Europe
B. Proposed Non-National Approaches to Regulatory Reform.
1. The European Union
2. American Bi-Lateralism
3. Santiago Principles.
4. OECD Soft Standard Setting

Part V. Coordination, Development, Opposition and the Challenges of Sovereign Investing in the Context of Global Economic Crisis: The Case of China.
A. ?Go Global? Strategy and the Consolidation of Sovereign Investment
B. The Organization and Operation of Chinese Sovereign Investing.
C. Sovereign Investment as Cooperative Public-Private Networks: CIC and Its Subsidiaries.
D. Conformity to Current Regulatory Models and Policy Ramifications.

Part VI. Conclusion.

Sovereign Investing in Times of Crisis: Global Regulation of Sovereign Wealth Funds, State Owned Enterprises and the Chinese Experience

Abstract: The financial crisis of 2007 has brought into sharper focus a set of rising global financial actor?the sovereign investor. In the form of sovereign wealth funds (SWFs), sovereigns have become an important player in global financial markets and its stability. Over the last decade they have become more visible and more aggressive in the scope and form of their interventions in global finance. In the form of state owned enterprises, sovereigns have begun to operate indirectly through subordinate legal persons that operate like privately held multinational corporations. In that form, sovereigns are becoming a more significant presence in global markets as owners as well as investors. More importantly, sovereign owners have begun to coordinate their economic activities for economic and sovereign goals. Consequentially, crisis has produced a dynamic element in the evolution of the global economic system. These evolutionary elements now brought into sharper focus issues of law and policy that stretch current systemic conceptions into new and unchartered territory. If sovereign investors are understood as private actors participating in markets, then this might suggest the best case for the equal treatment of states with private entities, because it stands in the same shoes as a private investor. On the other hand, if sovereign investors, and their instrumentalities, are understood as an instrumentality of the state, then these entities can be understood as instruments projecting state power into the territory of other states, and a political solution becomes more likely. Yet, while governmental responses were at first wary?criticizing these funds as potentially dangerous to the sovereignty and independence of national markets, the increasing needs of national economic sectors quickly altered attitudes. Responses have focused on law and policy to protect the integrity and workings of the markets themselves?both domestically and internationally?by decentering the sovereign element of sovereign investment, but without much of a plausible conceptual center. This essay examines these fundamental issues of sovereign investing. Section I contextualizes the problem as a function of the character and control of large aggregations of wealth, Section II focuses on sovereign wealth funds as projections of public economic power in private form. It focuses on issues of the conceptual dissonance in the definition and operation of sovereign wealth funds. The section ends by connecting those issues to policy debates about sovereign investing, especially in the form of sovereign wealth fund activity. Section III then considers the expression of the conceptual dissonance of sovereign investment regulation. It considers national and supra national approaches to regulation and regulatory reform. Section IV considers state owned enterprises as another vehicle for sovereign investment abroad. It considers state owned enterprises (SOEs) as a fundamental component of innovative multi-vehicle deployments of sovereign wealth outside the national territory as part of the implementation of coordinated national development goals. Section V critically examines these issues in context. It considers the approach of China in the use of its state wealth through SWFs and SOEs. The Chinese efforts to coordinate sovereign investing directly by the China Investment Corporation and its principal subsidiaries, and indirectly through its subsidiaries and supported SOEs investing abroad, suggest a more complex organization of sovereign investing in which profit maximization is blended with a pronounced set of political objectives, grounded in development goals. This presents a potentially substantial advance in the integration of programs of sovereign investing, public policy and private markets. A responsive regulatory framework has not followed. The rise of sovereign market participatory entities, operating as both sovereign and private actors, will require a responsive regulatory framework substantially different from those currently in gestation. The Chinese experience suggests that while there is fundamentally little to fear from well operating public-private constructs, that model requires a different regulatory approach, and one that recognizes and rethinks the relationship of public and private sectors and the limitations of the state?s role in both in the context of protecting the integrity of global markets and the free movement of capital and economic activity.

In the context of sovereign investing, whether by SWFs or SOEs, commentators have also sought ways to force sovereigns to benchmark sovereign conduct--and to that extent severely limit what is essentially ungovernable--their motivations or investing and for shareholder activism.389 The problem with these proposals is that they are at war with themselves. Mirroring the American approach, these tend to hunger for the investment, but wish to treat the sovereign investor differently from others. Prior consultations with affected states (whatever that means in a private market for shares of publicly traded companies), severe control of investment strategies and trade volume and the like all suggest that the sovereign is not a private investor. But all the same, such a sovereign would be treated as private with respect to the funds invested and public with respect to the investment decision.

But that tends to distort markets, and impede the very investment that has been made necessary by the aggregate wealth transfers at the heart of the current global financial imbalances. Still, sovereigns do wear two hats. But as long as all shareholders are required, under national legal systems, to avoid activity that breaches their duties--for example to loot the company or to defraud the company--and as long as national legal systems liberally permit shareholders and others to sue the sovereign like any other private party, then everyone should be content. If not, then it seems that more than the character of sovereign wealth funds are at issue. And we should be talking about reforming shareholder rights and obligations vis a vis the corporation for all security holders (but principally equity holders).

But this may miss the mark. While the global community moves to a piecemeal encounter with the instruments of sovereign investing, sovereigns have begun coordinating and using their sovereign investment vehicles in new and innovative ways that may make much of the thrust of current regulatory approaches less relevant. Even as the developed world was engaged in its own self directed conversation about the nature of sovereign investing, its taxonomy, and the character of the regulatory frameworks appropriate for each piece of what to them appeared to be the universe of separable components of sovereign investing, one of the principal global sovereign investor, the People?s Republic of China, began of forge a distinct model of sovereign investing that appears to have the potential of making the regulatory framework so carefully constructed around it substantially irrelevant. ?China is also becoming increasingly important as a source of outbound FDI. The ?go global? campaign launched in the late 1990s encourages both state-owned enterprises and smaller private and collective enterprises to invest abroad.?390 This section first focuses on the ?go global? campaign as the template through which a new basis for strategic coordination of sovereign investment?grounded in an aggregation of commercial and political welfare maximization objectives?was forged. It then examines the organization and operation of Chinese sovereign investing in light of the ?go global? strategy. It then examines the operation of the model of sovereign investing suggested by the Chinese organizational framework of coordination among investment vehicles and financial objectives that advance state interests. It then contextualizes this approach in the emerging global regulatory matrix and suggests reasons why the emerging ?idealized private investor standard? of SWF regulation may serve little purpose in the regulation of Chinese SWF-SOE activity.

A. ?Go Global? Strategy and the Consolidation of Sovereign Investment.

On July 20, 2009, China?s Premier Wen Jiabao addressed ambassadors in a conference and discussed China?s current policy and Strategy. He pointed out that the relation between China and the world was currently undergoing a historical transformation that affected diplomacy. Crucially, Wen emphasized that China ought to accelerate the ?Go Global? Strategy, to consolidate the utilization of China?s foreign reserves with Chinese enterprises? implementation of the ?Go Global? Strategy, to consolidate outbound investment with export of products.391 ?Chinese Premier Wen Jiabao said: "speed up the implementation of 'going out' strategy, the use of foreign exchange reserves and business' go to 'combine up to foreign investment and merchandise exports combined. "??.392 China?s foreign reserves is exactly the source of capital that was used to build the Chinese sovereign wealth fund; Wen?s speech explicitly connected China?s ?Go Global? Strategy to its sovereign wealth fund, as well as other sovereign investment vehicles.

Wen?s speech suggested the self-consciousness of a new approach to sovereign investing in which all formally distinct components of sovereign participatory vehicles?from sovereign wealth funds, to state owned enterprises, to traditional reserves are deployed in a coordinated manner to maximize the benefits to the domestic and foreign affairs policies of the state.393 The Chinese development of coordinated sovereign investing suggests both the dynamic nature of developments in sovereign investment, and the disjunctions between regulatory approaches coming out of host states and the reality on the ground in home states. The notion of neutralizing the sovereign element in sovereign investing in return for free movement of capital by sovereigns participating in the market is, at least in China?s case, giving way to a different model?one grounded in the projection of state power through direct economic activity in which commercial and sovereign objectives are blended.394

Three days after Wen?s speech, the China government indicated that China will actively utilize its two hundred billion US dollars of foreign reserves to advance the ?Go Global? Strategy. Economists pointed out that the new policy was meant to diversify China? foreign reserves. The Chief Economist at HSBC, Qu Hongbin, commented at an interview with British news organization Financial Times that this was the first time the government declared where it stood with regard to Chinese companies? overseas acquisition. Qu also believed this policy was meant to diversify China?s foreign reserves.395 At the same time, the president of China Development Bank emphasized the bank?s target is not ?Wall Street,? but the international natural resources and energy sectors.396

While the efforts to consciously combine the ?Go Global? Strategy with China?s foreign reserves is the Chinese government?s new policy, the ?Go Global? Strategy itself is not new at all. The ?Go Global? Strategy, which is also referred to as the ?Go Out? Policy, was an effort initiated in 1999 by the Chinese government to promote Chinese investments abroad.397 ?The ?go global? strategy was highlighted in work reports at the 2003 National People?s Congress and promoted at Chinese business conferences in 2004.?398 The ?Go Global? strategy is itself a component of a two prong economic strategy, which combines a ?Bring In? and ?Go Out? policy.399 The Government, together with the China Council for the Promotion of International Trade, has introduced several schemes to assist domestic companies in developing a global Strategy to exploit opportunities in the expanding local and international markets.400

Since 1979, the Chinese government has opened its economy to foreign investment and international competition and reduced the state?s role in the economy as foreign, private, and collectively owned firms account for an increasing share of production.401 ?Beijing?s economic reforms (and broader foreign policy) reflect ? a relatively coherent grand strategy for building China into a wealthy and powerful state??402 Over the last 30 years, ?economic reforms have transformed China?s economy from a backward and isolated economy run by inefficient central planning mechanisms into a large and rapidly growing economy driven primarily by market forces and increasingly integrated into a globalized world.?403 China has welcomed trade and investment from overseas economies, yet at the same time become dependent on exports to overseas markets.404 After entering the WTO in November 2001, the Chinese government refocused its economic policy on the tasks of securing access to energy and other resources, building competitive international companies, and opening developing country markets with Chinese products and investment. This policy has led to a substantial increase in Chinese resources devoted to Africa, Latin America, and the Middle East.405 At the same time, the Chinese government foresaw that world class competitors would compete for business in the Chinese market, and so China has been seeking to equip the domestic firms and their management with international experience so that they can take the competition to the home markets of the foreign nations and so that they also can compete better at mainland China's own domestic market. Chinese leaders emphasized the integrative nature of economic activity, especially in its ?Going Out? or ?Go Global? aspects.406 As such, the notion of separation of function and character, a notion inherent in the regulatory framework developed for SOEs, SWFs and the like, was missing, virtually from the inception of Chinese strategic thinking about sovereign investment.

The Chinese government has 5 goals so far in launching the strategy: (1) to increase Chinese Direct Foreign Investment (FDI); (2) to pursue product diversification; (3) to improve the level and quality of the projects; (4) to expand financial channels with respect to the national market; (5) promote brand recognition of Chinese companies in EU and US markets.407 For that purpose, all sectors of the Chinese economy were to be directed. Little distinction was made between the direction of sovereign investment vehicles and private entities. There would be conformity the forms of economic organization through which global economic activity functioned. But embracing the form of that activity did not require adoption of all of the policy postulates on which they were based in the West. The ?Go Global? strategy effectively implements a well conceived Chinese model of engagement, which, ?provides a blueprint for how nations that choose a more collectivist approach to state organization can engage the emerging economic community on its own terms--using the language of private economic collectives as the primary vehicle for the development of the means of production of the state and reserving to states a secondary role as regulator and shareholder.?408

Since the launching of the ?Go Global? Strategy, Chinese companies? interest in overseas investing has increased substantially, especially among state-owned enterprises. Statistics indicate that Chinese direct foreign investments rose from US$3 billion in 1991 to US$35 billion in 2003.409 Under the context of the 2008 financial crisis, Chinese companies significantly accelerate their outbound investment. To guide and assist these companies? investment activities, the Chinese government has been actively providing regulatory, cultural and diplomatic support. The Chinese Ministry of Commerce implements this strategy by issuing, among others, a regulation named Procedures for the Administration of Overseas Investment, in which it delicately defines the relation between the government and companies seeking outbound investment.410

The Chinese government also has been developing internal strategies to encourage and support outbound investment. China will lower the investment threshold in the entertainment and cultural industry and allow more private and foreign interests to invest in state-owned media groups, according to a State Council statement prepared for a meeting held on July 22, 2009.411 The statement said that multimedia broadcasting, digital media, web and mobile TV service should be ?actively promoted.?412 In addition, other elements of the state apparatus haves begun to educate Chinese children on the value of outbound investment and entrepreneurship.413

Stabilization has been a key part of China?s diplomatic policy. In addition to stabilizing, the Chinese government has also been making increased efforts to strengthen and promote relations with countries where Chinese companies may invest. In 2001-2002, China established strategic partnerships with major European countries and began to repair ties with India. The government also deepened economic and political ties within East Asia via its relationship with ASEAN and the ASEAN+3 grouping.414

It is only within this conceptual context that the organization of Chinese sovereign investing can be understood. Its critical foundation is to bend economic activity to the maximization of the interests of the state. Within that context commercial and financial welfare maximization models may be appropriate. Indeed, since Deng Xio Ping it is hard to suggest that macro or micro economic strategies that do not improve the material welfare of the people of China serve the interests of the state. Yet the form of that activity, in the long and short term, the ways in which investing strategies are formulated, the places where economic power is projected, the factors that weigh on determinations of relations with foreign assets are meant to be understood as manifestations of state policy. Moreover the form of that investment?whether as SWF, SOE, bank or industrial concern?is essentially instrumental. All are meant to prosper, and to prosper in conventional terms. But that is a baseline goal in the attainment of the greater goal of benefitting the state and advancing state interests internally and abroad. I have suggested how the Norwegian SWF has sought similar goals through a very narrow and directed program of investing. I have also suggested that these objectives in more limited form serve private investment as well. The Chinese have created a far more elaborate and sophisticated instrument, and a model that appears to blend financial and political welfare maximization within a private-public system of economic organization. It is only in this context that Chinese sovereign investing, and the inaptness of emerging global regulatory frameworks in light of this new form of holistic and integrated public-private investment can be understood.

B. The Organization and Operation of Chinese Sovereign Investing.

China founded its Sovereign Wealth Fund in 2007 by incorporating China Investment Corporation, in order to manage China's massive foreign exchange reserves.415 China Investment Corporation (?CIC?), duly incorporated under the Company Law of the People's Republic of China , is a wholly state-owned company engaging in foreign exchange investment management businesses.416 ?CIC was established on September 29th 2007 with the issuance of special bonds worth RMB 1.55 trillion by the Ministry of Finance. These were, in turn, used to acquire approximately USD 200 billion of China?s foreign exchange reserves and formed the foundation of its registered capital.?417 The issuance of 1.55 trillion RMB special bonds was voted by the Standing Committee of the National People's Congress in June, 2007. At the same time, Central Huijin Investment Company, the former state investment vehicle, was merged into CIC as a wholly-owned subsidiary.418

CIC conducts its internal management and builds its legal structure under the Company Law of the People?s Republic of China. CIC?s governing boards are comprised of the Board of Directors and Board of Supervisors. The CIC Board of Directors is mandated and authorized to oversee the company's operation and overall performance. Based on objectives and broad policy set by the State Council,419 the Board sets investment strategy and operational guidelines. Its mandate also includes: (i) deciding how to implement such strategies; (ii) identifying major issues that need to be reported to the State Council; (iii) appointing, and if required, authorizing the removal of management; and (iv) delegating responsibilities and establishing committees as necessary. The Board also has the authority to carry out other functions according to the Law of the People's Republic of China, the company's Articles of Association, and other constitutive documents. The Board of Directors has eleven seats and is composed of executive, non-executive, independent, and employee directors.420

The Board of Supervisors has the authority and responsibilities to oversee the company's accounting and financial activities. The Board also has the mandate to monitor the ethical conduct of the members of the Board of Directors and senior executives. In situations where members of the Board of Directors or senior management have broken laws, regulations, ethical rules, or committed other breaches in conduct, the Board of Supervisors is empowered to call for disciplinary action or the removal of those directors or executives. The Board of Supervisors is also empowered to amend the supervisory procedures to ensure appropriate levels of supervision. The Board of Supervisors has five seats and is composed of a chairman, three supervisors, and an employee supervisor.421

Under the Board of Directors and Board of Supervisors, there exists an Executive Committee, which is responsible for CIC's daily operations. As mandated by the Board of Directors, the Executive Committee has full operational independence, and the authority to make individual investment decisions and operational decisions. It assumes full accountability to the Board of Directors and to the State Council. The Executive Committee is composed of eight members,422 and has been heavily promoted within the Chinese media, where they are described as an ?all-star team? by Chinese media.423

Reporting to the executive committee are three functional committees: the International Advisory Council, the Investment Committee, and the Risk Management Committee. CIC established an International Advisory Council (?the Council?) as its legitimating public face. The Council members are primarily scholars from academic institutions all over the world.424 The Council provides CIC's management with insight, advice, and expertise on issues such as corporate development strategy, overseas investment policies and opportunities, best business practices, global economic and financial developments, and other key issues impacting CIC's investments.425 The Council convenes at least once a year, though it may meet more often. The Public Relations and International Cooperation Department functions as the secretariat of the Council.426

The Investment Committee manages and implements investment strategies, policies, and goals determined by the owner, the Board of Directors, and the Executive Committee. The Committee also defines permissible asset classes, approves the allocation of strategic assets, and changes in the balance of the company's investment portfolios. Mandated by the Executive Committee, it approves individual investments, related applications, reviews investment programs and reports, and approves amendments to investment plans. The Chief Executive Officer, Mr. Lou Jiwei, chairs the Committee and the President of CIC, Mr. Gao Xiqing, is the deputy head of the Committee. The Investment Committee reports directly to the Executive Committee.427

The Risk Management Committee is responsible for setting company-wide strategy, risk management systems and policies, defining exposure thresholds, reviewing and finalizing reports concerning risk management, and establishing risk control evaluation criteria. The review process is governed by the risk requirements set out by the Board of Directors and the Executive Committee. The Committee proactively assesses and measures the company's portfolio risks and, initiates, when necessary, a review of the portfolio's composition to ensure corporate risk exposure is managed appropriately. The Committee includes CIC's Chief Executive Officer, Chief Operating Officer, Chief Risk Officer, and heads of relevant departments. It reports directly to the Executive Committee.428

Beyond these key management committees, the organizational structure of CIC as reported on its web site, looks like this:429

The operational structure of the company produces a substantial amount of incentive toward cooperation and consultation, both within the organization and between CIC and the state apparatus.430 First, the Board of Directors sets CIC?s investment strategy and operational guidelines. Second, the Executive Committee makes individual investment decisions to implement the investment strategy and operational guidelines set by the Board of Directors. The Executive Committee assumes full accountability to the Board of Directors of and to the State Council.431 Both the Executive Committee and the Board of Directors may consult the International Advisory Council. Third, the Investment Committee manages and implements investment strategies, policies, and goals determined by the Board of Directors and the Executive Committee. Mandated by the Executive Committee, the Investment Committee approves individual investments, related applications, reviews investment programs and reports, and approves amendments to investment plans. At the same time, the Risk Management Committee is responsible for setting risk management systems, defining exposure thresholds, reviewing and finalizing reports concerning risk management, and establishing risk control evaluation criteria. The review process is governed by the risk requirements set out by the Board of Directors and the Executive Committee. Under the Investment Committee and Risk Management Committee, there exist several functional departments each responsible for investments in specific markets, law compliance,
finance and accounting, human resources and etc.

1. Role of the State Council and the Party related to CIC and its Subsidiaries. CIC, as positioned at the premium cabinet-level within the Chinese government, is responsible directly to the State Council through the State Owned Assets Supervision and Administration Commission of the State Council (SASAC).432 This is meant to effect the policy of separation of economic and political functions within the state apparatus.433 But that separation is effected only functionally. SOEs, like the political elements of state administration remain subject to the overall direction of the Chinese Communist Party and subject to the direction of state policy. Thus, for example, in 2003 the Chairman of SASAC, Li Rongrong, reemphasized the relationship between SOE oversight and the governing principles applicable generally to the state.434 Other SOEs follow the same path, for example, gearing business analysis to conformity with the current CCP party line of scientific development.435

The State Council through SASAC exercises the authority of appointment and dismissal of the governing board members of the CIC. But the organization of CIC produces a formal separation between state and fund operator. CIC?s Article of Association clarifies that CIC ?shall separate its commercial activities from governmental functions, make its business decisions independently, and operate based on commercial grounds. The Company bears civil liabilities to the extent of the total assets held by it as a legal person.?436 But the relationship is not purely arms length. Like the Norwegian Fund, separation does not mean an insensitivity to state policies and objectives.

?While it operates with independence and its investment decisions are based on the pure economics of each deal, CIC remains accountable to the State Council of the People?s Republic of China and, ultimately, to the citizens of the People?s Republic of China.?437

Integration with the state apparatus is not limited to oversight by the State Council. In line with the Chinese constitutional system that accords the Chinese Communist Party a preeminent place as ?party in power,?438 the Chinese Communist Party is also represented within the organizational structure of CIC. CIC?s Party committee has six seats: the Chairman of the Board of Directors and Chief Executive Officer, Mr. Lou jiwei, serves as the secretary of the Party committee; The Vice Chairman of the Board of Directors, President and Chief Investment Officer, Mr. Gao Xiqing, is one of the two deputy secretaries; another deputy secretary might be the chairman of the Board of Supervisors, Mr. Jin Liqun. Mr. Zhang Hongli, one of the Executive Directors and the Executive Vice President and Chief Operating Officer is also among CIC?s Party Committee members.439 In addition virtually all of the governing officers are members of the Chinese Communist Party. As cadres, they owe an overarching duty to implement the party line in accordance with the important political principle of democratic centralism.440 As a consequence there is a close and necessary connection between state, party and fund that exists beyond the formal limitations of fund objectives and which, in the interests of state and Party, may supersede technically narrow readings of such limitations. It would be difficult to understand the investment strategy of CIC in isolation, or otherwise apart from the activities of other state organs, whether political or economic. In this sense, the connection and coordination suggests a different conceptual basis for the organization of sovereign investing, one that is grounded in specialization and coordination. While the pieces may appear distinct, they do not operate independently of each other in a broader sense. The political and organizational structure thus suggests the operational culture of the fund and its controlled entities. It is to that web of organizational activity that the essay turns to next.

3. CIC?s Investment Strategy. CIC?s investment strategy has been slowly evolving as it has moved from a stand alone and traditional SWF structure to the center of a web of investment that includes direct and indirect investment through SWFs, SOEs, financial and operating enterprises from within and outside China. This evolution was both highlighted and accelerated by the 2008 financial crisis. CIC suggests its overarching investment principle in its Articles of Association: ?[CIC]'s business objectives are to carry out an active and steady operation, endeavor to maximize the shareholder's interests within an acceptable scope of risks, and continuously improve the corporate governance in the state-owned major financial institutions it controls.?441 CIC?s Articles of Association also broadly defines its scope of business:

?The scope of business of [CIC] includes: domestic investments in debt securities denominated in foreign currencies and other financial products denominated in foreign currencies; overseas investments in debt securities, stocks, funds and derivative instruments and other financial products; domestic and overseas equity investments; overseas investments through external fund managers; provision of loans through entrusted financial institutions; management of entrusted foreign exchange assets; establishment of equity investment funds and fund management companies as a promoter; and other businesses approved by the relevant governmental authorities.?442

The Articles of Association further explicitly limits CIC?s direct investment in domestic enterprises,443 but permits indirect oversight of such investment through subsidiaries.444 Lastly, the Articles of Association suggests a comprehensive system in making investment decisions.445

CIC?s specific investment policies were articulated in 2007.446 They reflect conventional understanding of the investment strategies globally appropriate for these enterprise: first, CIC selects investments based on economic and financial objectives, and an assessment of the commercial return; second, CIC allocates capital and assets within the given risk tolerance of the owner to maximize shareholder value; third, CIC usually does not seek an active role in the companies in which it invests nor attempts to influence those companies? operations; CIC seeks long-term, stable, sustainable, and risk-adjusted return.447 CIC?s investment principle also suggests an ethical or political nature.448

CIC allocates its assets among equity, fixed income, and alternative assets. Equity investments include outsourced equity investments, concentrated equity holdings, initial public offerings, and open market investments; fixed income investments include outsourced fixed income investments, limited outsourced fixed income investments, and cash management; alternative asset investments include private equity investments, direct investments, and real estate investments.449

CIC?s risk management framework is also framed in conventional terms. ?Its internal risk management system is based on international best practices, such as the risk management principles established by the Committee of Sponsoring Organizations (COSO), developed to give clear directions and guidance for enterprise risk management.?450 Like other SWFs, its internal risk management apparatus is structured in conventional terms.451 ?The Risk Management Committee is responsible for setting company-wide strategy, risk management systems and policies, defining exposure thresholds, reviewing and finalizing reports concerning risk management, and establishing risk control evaluation criteria.?452 In addition to making investment by itself, ?CIC retains external fund managers to assist with the management of certain aspects of its international investment portfolio.?453

Lou Jiwei, chairman and CEO of CIC, recently published an article named Sovereign Wealth and the Financial Crisis454, in which he summarized CIC?s investment principle as follows:

?CIC?s mission is to diligently seek long-term investments that maximize returns while maintaining a rigorous approach to managing risks for the benefit of shareholders. Thus, through its management style, CIC sticks with a commercial orientation that maximizes financial returns. In terms of risk tolerance, CIC can afford rather high, short-term risk fluctuations to maximize long-term returns. In strategic assets allocation, CIC is more aggressive than traditional central banks in managing forex reserves by investing both traditional equity and fixed-income investments that have rather low liquidity but are forecast for rather high investment returns.

Affected by limited talent and capital, CIC developed an investment strategy based on ?an investment approach that is a mixture of international financial products, with most assets invested in public market products and the rest invested in alternative assets.? Meanwhile, direct investment should not be abandoned. Investments are mainly made through external fund managers with a gradual increasing weight of proprietary investments.?455

Lou Jiwei further claimed that the financial crisis had not affect CIC?s investment
principle:

?During this crisis, sovereign wealth funds have suffered some losses and are going through a very difficult time. They are trying to rebalance and reshuffle their portfolios. Some funds adjusted investment strategies or amended investment solutions by shifting to domestic investments.
As the sole sovereign wealth fund in China, CIC continues to comply with our previously set goals of cautious overseas investments and commercial operations. One important factor is that, despite China?s high level of foreign exchange reserves, CIC has not shifted its investment goals or strategy.?456

Yet, appearances can be deceiving. As numbers of Chinese companies are expanding globally in the financial crisis, especially state-owned companies in natural resources sector, CIC appears to have adjusted its function in order to assist these companies and to accelerate the process. Some Beijing-based bankers and officials described CIC?s preferred role as a financier and facilitator for state-owned companies making offshore acquisitions. ?In spite of its earlier protestations, CIC now seems to have accepted a role as piggy bank for China Inc?s global expansion,? commented Financial Times.457

CIC, together with its two subsidiaries, has manifested change of investment strategies in at least three aspects. First, CIC?s investment in large international companies has expanded from preferred stocks to common stocks. Second, CIC has clearly switched its emphasis from financial sector to natural resources sector. Third, the reallocation of functions between CIC?s two subsidiaries, Central Huijin and Jianyin, will certainly affect the strategy China allocating and managing its sovereign wealth. First, CIC has manifested a tendency of expanding its portfolio from purely preferred stocks to common stocks, which is can be demonstrated by CIC?s investment in Morgan Stanley (MS). In June, 2009, CIC subscribed $1.2 billion common stock in MS. CIC had existing investments in MS before this transaction. On Dec 19th, 2007, CIC purchased $5.6 billion mandatory convertible securities into MS common stock, representing approximately 9.86% equity ownership in MS. After Mitsubishi UFJ Financial Group, inc.?s investment in MS in October 2008, CIC?s equity ownership was diluted to approximately 7.68%. This new purchase will bring CIC?s equity ownership in MS back to approximately 9.86%, effectively reducing CIC?s overall cost basis and increasing the returns potential.458 Similarly, CIC intended to increase its stake in U.S. private equity firm Blackstone to 12.5 percent from the original 9.9 percent via buying shares on the open market after the two sides agreed to raise the ownership limit to that level.459 It was reported that the additional stocks would be common stocks, as opposed to the 9.9% preferred stocks that CIC bought initially in 2007. If that is the case, the additional stocks
would bring CIC voting right in Blackstone.

Theoretically, preferred stocks should have been more preferable to a risk averse investor, especially in the present economy where even large companies that have been operating over centuries may go out of business. This is because preferred shareholders will receive dividends before the common shareholders receive any dividends, and will also receive a share of the assets in the event of bankruptcy before common shareholders get any, though preferred shareholders do not get a vote in running the company. CIC nevertheless moved from preferred stocks to common stocks, especially in the Blackstone case. Such change of favor may be quite suspicious in that CIC may have departed its investment policy of ?not [seeking] an active role in the companies in which it invests nor [attempting] to influence those companies? operations.?460

On the other hand, CIC?s change of favor can arguably be interpreted to be a legitimate strategy caused by the downturn of economy, or even merely a coincident. First, a responsible investor tends to seek more controlling power over its investment. Such intention becomes more understandable as the economy becomes less predictable. SWFs usually bear pressure and criticism from the domestic. This is especially true CIC, which had lost large amount of book value within one year of its corporation. To establish voting power in a company it invests in may be a ?less evil? choice to CIC, which, even though, may not be a legitimate or appropriate strategy for a SWF, based on it sensitive state-owned character. Second, there could be no intentional expansion from preferred stocks to common stocks on CIC?s part, because it could be merely a coincident that MS and Blackstone both priced public offering of common stocks in the open market while CIC need to increase its stocks in both companies.

More significant has been CIC?s program of direct investment for the purpose of obtaining controlling interests in domestic and foreign enterprises. First, CIC has acquired control of important state sector industries. Prominent among them has been China Reinsurance (Group) Corporation, the only state-owned reinsurance company. Sovereign wealth fund China Investment Co., whose management CIC acquired from the China Insurance Regulatory.461 China Reinsurance has six units covering reinsurance, property insurance, life insurance, asset management, insurance brokerage, and insurance media, according to a statement on CIC's website.462 This may also reflect the need to insure the profitability of these enterprises while adhering to state investment targeting, especially after the large losses suffered by CIC in the course of the
2008 financial crisis. 463

Second, like other state-owned enterprises, since 2008, CIC aggressively began to invest in the natural resources sector.464 CIC?s activities, of course, reflected participation both in the ?Go Global? Strategy and implementation of the State Council?s preference for investment in global resources sector.465 But it also reflected the investment strategy that such state directed investment ought to be commercially advantageous.466 Much of the focus was on acquisition of control of Australian natural resources.467 CIC?s most recent deal in the nature resources sector was with Teck Resources Limited, a transaction that was meant to provide CIC with an indirect stake in the target company.468 The speed and intensity of the transactions, coming from various sectors of the sovereign investing establishment, sometimes presents coordination problems as one sovereign acquisition might jeopardize another. That, effectively, was the fear in the acquisition by Hunan Valin Steel Company and its effects on Chinalco?s469 acquisition of a stake in the Australian enterprise, Rio Tinto.470 And Chinalco actually lost the deal with Rio Tinto in June 2009.471

The Rio Tinto investment itself highlights another point of convergence between state and sovereign investing. China has tended to apply its political and criminal laws to the commercial activities of its SWFs and SOEs. It effectively conflates, at the state level, economic and political activity, whether in or outbound. The recent arrest of the Rio Tinto executives for breach of the Chinese State Secrets law is a case in point.472 Sovereign investment, whatever its form, remains an integrated component of the projection of state power, and to that extent, a sovereign activity foremost and a commercial or financial venture thereafter.

Third, CIC reallocated the functions and operations of its principal investment subsidiaries, Central Huijin and Jianyin, to permit a certain flexibility in indirect investment. Central Huijin became a policy-related financial investment institution controlling majority stakes in the largest state-owned enterprises, effectively it will serve as a state investment agency.473 Jianyin will serve as an industrial investment platform for CIC, in order to assist Chinese companies to expand overseas.474 It might be reasonable to assume that CIC, or the State Council, intended to build a sophisticated state investment mechanism to manage China?s sovereign wealth, which can, at the same time, effectively promote and stabilize China?s economy. It is to this interconnection that the essay now turns.

C. Sovereign Investment as Cooperative Public-Private Networks: CIC and Its Subsidiaries.

Taken in isolation, CIC presents well as a fairly standard, and somewhat transparent SWF. Like the Norwegian Fund, CIC appears to be taking a greater interest in both equity positions and in a more involved shareholder activism. But CIC?s operations cannot be understood in isolation. As the center of a large network of interrelated sovereign wealth, finance, and operating entities, CIC is a pivotal point of an integrated approach to sovereign investing. This section examines that web more closely. It first looks first considers CIC?s principal subsidiaries, and then looks at their aggregate investment operations through controlled SOEs in the financial and operations sectors.

1. CIC?s Subsidiaries: Central Huijin and Jianyin. To understand the investment strategies of CIC, then, it is important to understand the roles of Central Huijin and Kianjin. For that purpose, the legal structures and investment activities of both Central Huijin and Jianjin, respectively, will be explored. These serve as a foundation for the discussion of the institutions that are financially related to Central Huijian or Jianyin, for the purpose of exploring the relationship between the Chinese Sovereign Wealth Fund and other state-owned enterprises, in the subsection following.

CIC?s wholly owned subsidiary, Central Huijin Investment Company (?Central Huijin?), manages the sovereign assets invested in state-owned financial enterprises including five large commercial banks, two securities companies, one financial holding company, one investment company and one reinsurance company. Central Huijin further wholly owns another subsidiary, China Jianyin Investment Limited (?Jianyin?). The two subsidiaries conduct different functions as assigned by the state council.

Established in December 2003, Central Huijin?s main function was to recapitalize and stabilize China's major state-owned commercial banks. In September 2007, the Ministry of Finance issued special treasury bonds and acquired all the shares of Central Huijin from the People's Bank of China. The acquired shares were injected into China Investment Corporation as part of its initial capital contribution for around US$ 67 billion. However, Central Huijin's principal shareholder rights are exercised by the State Council. It is authorized by the State Council to exercise rights and obligations as an investor in major state-owned financial enterprises on behalf of the Chinese Government.475

Historically, there have been many problems emanating from China?s underdeveloped financial sector, partially reformed banking industry and vulnerable state-owned enterprises. The banking industry is still in the middle of reforms and its problems affect the economy as a whole. It suffers from deep-rooted problems such as a low degree of commercialization, distorted incentives, high ratio of bad loans, government ownership, and inefficient management. The estimated size of bad loans, or non-performing loans, ranges from about 25 to 45 percent of the total loans outstanding for Chinese banks.476 The State Council endeavored to reform and restructure China's major commercial banks, consequentially created the Central Huijin in 2003.477 The official character of Central Huijin can be most accurately described as directed toward purely internal financial investment.478

An important wholly owned subsidiary of Central Huijin is China Jianyin Investment. It was founded in 2004, with a registered capital of RMB20.69225 billion,479 through the restructuring of China Construction Bank, one of the four largest stateowned commercial banks in China.480 ?China Jianyin Investment took over all of the state-run lender's non-banking business, including a 40% stake in China International Capital Corp., which is 34%-owned by Morgan Stanley.?481 In the year before its reorganization, China Construction Bank had been the recipient of substantial financial infusions from Central Huijin.482 Its initial objective after restructuring was to manage bad assets in ailing Chinese state banks and securities firms.483 Its activities eventually expanded to include operation of six securities firms including Huaxia Securities, Nanfang Securities, Xinan Securities and Beijing Securities ? all of which were recapitalized and restructured.484 Jianyin turned Zhejiang International Trust Investment Co. into a subsidiary and has planned to establish fund managers.485

In October 2008, however, the State Council reallocated functional authority between Central Huijin and Jianyin. Central Huijin became a policy-related financial investment institution, controlling majority stakes in the largest state-owned enterprises. Jianyin abandoned its objective to become a financial holding company and instead was redirected to serve as an industrial investment platform for CIC. As such, Jianying would serve as a vehicle for the indirect overseas investment activities of CIC through programs of assistance to Chinese SOE and private companies for expansion overseas.486 This reform was also motivated by a legal restriction, provided in Securities Companies Supervision and Management Regulations,487 which bars any two, closely affiliated firms from engaging in similar businesses without special permission. This restriction, however, will not take full effect for five years. As a consequence, Central Huijin has been increasing its direct stake in China Construction Bank, with the eventual aim of acquiring full control form its wholly owned subsidiary.488 Jianyin transferred its holding of 20.7 billion H-shares of CCB to Huijin in May 2009.489

The reorganization was said to further the aims of the Chinese State Council to encourage state agencies to spin off nine securities firms currently under their wings. These nine firms would be related through shareholders and common parents. Under the new allocation of functions, the State Council expects Central Huijin to efficiently accelerate the restructure of major financial enterprises in compliance with the legal restriction.490 As a result, Central Huijin essentially continues its role as a state investment agency,491 while Jianyin possibly will become a platform or even piggy bank for Chinese companies acquiring overseas assets.

Central Huijin is established as an SOE under Chinese corporate law.492 Central Huijin?s chairman, Mr. Lou Jiwei, is also concurrently the Chairman and Chief Executive Officer of CIC.493 The Articles of Association further requires all directors to be appointed by the State Council.494 Central Huijin also establishes its Board of Supervisors, which shall consist of not less than three supervisors. All supervisors are also appointed by the State Council.495 Central Huijin?s Articles of Association came into effect upon the approval by the State Council. Any amendments to the Articles of Association shall be proposed by the Board of Directors and shall come into effect upon approval by the State Council. The State Council authorizes the Company's Board of Directors to interpret the Articles of Association.496

After the 2008 reorganization, Jianyin began to fulfill its new role as an industrial investment platform. Specifically, Jianyin may become the shareholder of the German Daimler company. Daimler CEO Zetsche (Dieter Zetsche) stated that Daimler and the Chinese investors may have consulted on the Chinese investors to become shareholders of the company which current consultation did not end. It was reported that Chinese investor may be Jianyin.497 Perhaps due to the fact that Jianyin is currently under process of transition, it rarely makes public announcement, nor takes any effort to demonstrate transparency, as opposed to what CIC and Central Huijin have appeared to be. Yet, based on it official role described by the government, it will soon play an important role in assisting Chinese companies acquiring assets overseas.

2. CIC?s Relation to other State-owned Enterprises. The complexity of sovereign investing on the Chinese model is nicely captured in the relationship between CIC and its subsidiaries. CIC indirectly controls a number of Chinese state-owned enterprises through its wholly owned subsidiary Central Huijin, despite the fact that CIC?s Article of Association explicitly restricts CIC?s investment activity in domestic market. These stateowned enterprises have been expanding into overseas markets, including both the resources sector and financial sector, especially after the outbreak of the 2008 financial crisis. Based on the list of companies that Central Huijin holds share in, which is provided on the official website of Central Huijin, together with other sources, it seems necessary to scrutinize companies that financially related to the subsidiaries of CIC, for the purpose of exploring the Chinese SWF?s relation to other state-owned enterprises. The importance of these holdings is a key to the consolidating investment strategy of the state.

Currently, Central Huijin holds shares in a significant part of the Chinese banking sector.498 Indeed, its purchase buy CIC was meant to provide CIC with an indirect control of the outbound investment activities of the Chinese banking sector.499 Based on the list of companies that Central Huijin has disclosed on its official website and related sources,500 it is possible to get a sense of the nature and extent of indirect sovereign holdings in the banking sector. These relationships are important both to understand the ways in which sovereign investing is being consolidated within the Chinese SWF structure, and the relationship, now quite conscious, between the Chinese SWF structure, SOEs and outbound investment. Lastly, that model is useful for understanding the ways in which sovereign welfare maximization is accomplished through an integrated program of political and regulatory, as well as private and participatory, projections of power abroad. Thus, the importance of these holdings is a key to the consolidating investment strategy of the state. This section starts with a description of the most significant financial sector holdings, and then turns to the strategies for integrating the operations of this sector with SOE investment and the SWF activities of CIC. It is meant to suggest the organizational complexity of sovereign investing in the context of a ?Go Out? or ?Go Global? strategy. This complexity is founded on the integration of commonly controlled SWF and SOE enterprises which coordinate their efforts at a macro level to attain the lager state objectives and provide instrumental methods of projecting state economic power abroad in a directed manner, while seeking to maximize commercial or financial objectives.

Beyond its stake in CCB,501 Central Huijin has acquired stakes in, and has undertaken outbound investment through a number of other banks. Prominent among them is the China Development Bank.502 China Development Bank is a state-owned bank currently in the process of transforming to an international commercial bank.503 It?s mission consciously blends commercial and sovereign macro economic objectives.504 China Development Bank holds stakes in overseas financial entities, such as Barclays PLC, the third largest bank in Britain.505 It also has been assisting Chinese companies in acquiring overseas equities. For instance, it provides finance for CHINALCO in participating in the allotment of shares in Rio Tinto.506 China Development Bank also has been cooperating with Shanghai Zhenhua Heavy Industry Corporation and will provide Zhenhua up to 10billion finance in the next five years.507 Zhenhua Heavy Industry primarily manufactures automatic loading system of container terminal, oil or exploration platform and other marine engineering equipments.

Central Huijin also controls the Industrial and Commercial Bank of China (ICBC), a commercial bank.508 ICBC claims that it is the world?s largest bank by market value and has served as an instrument for the purchase of overseas bank assets. It announced in June 2009 that it would purchase 70 percent of Bank of East Asia?s Canadian unit, as it takes steps to expand overseas. ICBC previously paid about $5.6bn for a 20 percent stake of South Africa?s Standard Bank, the largest bank in Africa.509 In addition, Central Huijin owns controlling stakes in the Bank of China,510 and the Agricultural Bank of China.511 Together these banks represent the largest banking enterprises in China. Consequently. The Chinese SWF, indirectly controls not only its own funds but also that of a large segment of the Chinese banking sector and its investment activities.

In addition, Central Huijin serves as an investment coordinator through its interests in China Everbright Group,512 which was established on November 30, 2007 on the State Council approved restructuring of a large conglomerate of financial and industrial sector businesses ?into the first full-fledged financial holding corporation in China.?513 In furtherance of that purpose, China Everbright Group controls a variety of businesses, including China Everbright Bank, 514 Everbright Securities Ltd.,515 China Everbright Limited,516 Sun Life Everbright Insurance Co., Ltd,517 Everbright Financial Holding Asset Management Company,518 Everbright Pramerica Fund Management Co., Ltd.,519 and Everbright Futures Co., Ltd.520 CEG has also engaged in large transactions with other SOEs in the financial services sector. On 13th May, China Everbright Bank (CEB) and China National Investment & Guaranty Corporation (I&G) another Central Huijin controlled enterprise, held Overall Cooperative Agreement at Everbright Plaza. CEB granted RMB 3 billion credit limit to I&G.521 The two entities has been cooperating in the business sector of steel trade financing, government procurement financing and other SMEs loan guarantee.522 The most interesting thing about Everbright?s activities is the inclusion of a number of businesses in which it or its subsidiaries can serve as a fund manager at one or two levels removed from the fund activities of CIC. The Everbright conglomerate suggests both the complex and multilayered approach to investing being pioneered.

Central Huijin?s other important holdings include indirect holdings in securities companies,523 insurance companies,524 and guarantee institutions, principally the China National Investment & Guarantee Corporation (I&G).525 Each of these enterprises on turn controls in and outbound investment.526 Central Huijin also controls operating companies in the natural resources sector. Among them are the China National Petroleum Corporation (CNPC) and its subsidiaries.527 These have engaged in indirect acquisition activities abroad.528 PetroChina has signed agreements with Industrial and Commercial Bank of China and Agricultural Bank of China, under which, the two stateowned commercial banks will cooperate with PetroChina in a wide range of area, including providing finance to boost PetroChina?s global expansion.529 Commercial Bank of China and Agricultural Bank of China are both controlled by Central Huijin. The cross investments became tiughter in June, 2009, when PetroChina acquired the Commercial Bank of the City of Karamay and announced that it planned to promote the Bank, together with others, to an international financial entity.530 Lastly, Central Huijin controls Sinopec, the China Petroleum and Chemical Corporation.531 It, too has been acquiring significant interests in related foreign entities.532

This description suggests organizational structure and complexity of an integrated approach to sovereign investing. In this case, investment flows in and outbound through operating entities under the overall direction of an instrumentality of the Chinese SWF that itself ultimately implements strategic policies of the State Council in a commercial or financially prudent manner. But this basic structure is mimicked in larger form in the relationship between Central Huijin and its controlled financial enterprises, including the Jianyin conglomerate, and again, in its most global form in the relationship between CIC and Central Huijin.

D. Conformity to Current Regulatory Models and Policy Ramifications.

What is emerging from the description of CIC?s web of activity is a model of coordination and intervention in foreign and domestic markets in the interests of state policy but grounded in commercial and financial welfare maximization. These activities spiral outward from CIC through its subsidiaries and then indirectly through the SOEs that both control. The effect is to coordinate, and to a certain extent, integrate the commercial activities of SOEs, the investment activities of SWFs and the political interests of the state in a way that is grounded on the notion of advancing state interests in a profit maximizing way. Each of these entities thus conform to expectations of both private enterprises and of state owned enterprises and sovereign wealth funds. But the cumulative effect manages to avoid the policy limits of the piecemeal regulation through which these entities are regulated.

Thus, this exploration of the operations of the Chinese SWF evidences the ways in which SWF innovation in investment strategies, and its consequential synergies with SOEs, has produced an aggregate operation that are substantially unrelated to the assumptions underlying SWF regulation. Rather than operate discrete entities with individual programs of investment, the Chinese have begun combining operations in distinct ways. The effect is to leverage CIC?s SWF operations through SOE investment activities. Two principle aggregations are particularly importan

Full post as published by Law at the End of the Day on July 31, 2009 (boomark / email).

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