China's $300 billion fund a wake-up call to U.S.

By Nick Edwards | Reuters – 14 December 2011
BEIJING (Reuters) - China's plan for a new $300 billion sovereign wealth fund is as much a warning to Washington as it is a body blow to Brussels.

It's the clearest sign yet of Beijing's waning faith in bonds issued by Europe and the United States. Europe's festering debt debacle, record low yields on U.S. Treasuries and a depreciating dollar all add weight to the view in China that the time is ripe to change investment tack.

"China has decided that real assets are better than broken debt fix promises and low interest rates," says Paul Markowski, president of MES Advisers and a long-time external adviser to China's monetary policymakers on global financial markets.

Beijing has watched for two years as Europe's crisis has choked growth and demand in China's biggest export market and stoked default risks on the near $800 billion of euro zone government bonds it is estimated to own.

It has been a painful lesson.

After all, China had actively bought euro assets to guard its $3.2 trillion reserve pile against over-exposure to U.S. dollars, which have lost about a third of their value in the last 10 years as U.S. Treasury yields have sunk to record lows.

Reuters reported last week that the People's Bank of China plans to create the new vehicle with two funds, one for Europe and one for the United States, making China in aggregate the world's biggest sovereign wealth fund investor. The plan originated before Europe's debt crisis, sources said.

That gels with comments from investment sources with links to China's monetary authorities and foreign reserve managers who detect a clear desire in Beijing to acquire real assets in return for supplying fresh funds to bridge U.S. deficits and recapitalize European financial institutions and governments.

HAPPIER RETURNS

The $300 billion figure is consistent with the sum that Markowski and others calculate China has in excess reserves -- the amount beyond what Beijing would need to tackle a balance of payments crisis or a domestic funding emergency.

"They want underlying assets. Equities, corporate bonds, real estate -- anything that governments want to flog," said one source involved in foreign exchange trading for official institutions such as central banks.

The source singled out bidding for the Portuguese government's stake in utility firm Energias de Portugal, which would net roughly 2.5 billion euros for Lisbon, as typical of the path indebted countries will have to follow in future to persuade reserve managers to part with additional cash [ID:nL6E7NC0UN].

Granted, Chinese investors won't be warmly received everywhere -- a sovereign wealth fund showing up in Paris or Madrid with an offer to buy up public infrastructure would probably come away disappointed.

"It's easier said than done," said one Hong Kong based investment banker who has advised Chinese clients on overseas acquisitions. "One idea is that China could buy up agricultural land. They've also eyed ports in the past. They just don't want to do anything that's politically unpopular."

There are domestic pressures, too. China Investment Corp (CIC), the country's existing sovereign wealth fund, was sharply criticized within China for money-losing investments in U.S. investment bank Morgan Stanley and private equity firm Blackstone Group in 2007.

But with a European debt crisis and the U.S. triple-A rating no longer a given, China's state investors have good reasons to push into new kinds of assets.

"There is a great deal of discomfort (among reserve managers) over what the concept of a risk-free asset is," said Gary Smith, the London-based global head of official institutions at BNP Paribas Investment Partners.

Doubts about the safety of government bonds in developed markets where fiscal balance sheets are battered and inflation risks are high in the face of exceptional monetary stimulus have seen Smith's clients allocate new cash to inflation-linked bonds this year and even move into higher risk emerging markets.

"Of course your risk goes up if you invest in emerging markets, but if your risk has already gone up in what you previously considered risk-free assets, then the relative disadvantage of emerging markets has gone down."

That analysis speaks volumes to reserve managers and wealth funds, opening up a raft of new investment opportunities that developed economies had not previously had to compete against.

Data shows China's shift into real-world assets is under way.

China's outward foreign direct investment (FDI) hit $68 billion in 2010 after more than doubling in 2008 to $52 billion from $23 billion in 2007, according to Karl Sauvant, executive director of the Vale Columbia Center on Sustainable International Investment at Columbia University and an expert on global FDI.

Sauvant's institute estimates China will strike $1-2 trillion in FDI deals over the coming decade, adding to its existing portfolio of over $300 billion.

ONCE IN A LIFETIME

Whether China's change of focus is all borne of European debt and dollar debasement or a desire to move China's economy up the value chain, a new mood in Beijing is evident to many.

"Many foreign firms have advanced technology and they are having business difficulties and at the brink of bankruptcy. This is the opportunity that occurs only once in a thousand years," Zheng Xinli, an influential government adviser, was quoted as saying last week by Hong Kong's Wen Wei Po newspaper.

It's at least the best time in 15-20 years to buy European listed equity, even adjusting for the tattered price-tags on European financial stock, says JP Morgan analyst Mislav Matejka.

Euro zone shares are trading at a 46 percent price-to-book value discount to the United States, making it the cheapest region in the world for a global equity investor, says Matejka.

Independent China policy expert Andy Xie agrees.

"European stocks are cheap," said Xie. "Many European companies earn profits all over the world. It makes sense for Asian central banks to shift their reserves from overpriced government bonds like US Treasuries into such stocks. It would pump money into the euro zone through a channel that benefits Asian countries over time."