The Maharlika strategic investment fund: Lessons from China’s Sovereign Leveraged Funds
(Part 4) “Follow the money, find the politics.” — Zongyuan Zoe Liu
At a forum on Dec. 6 that was organized by Miriam College, FACTS Asia, the Foundation for National Interest, and Amador Research Services, I was privileged to be a reactor to the book by Dr. Zongyuan Zoe Liu, Sovereign Funds: How the Communist Party of China Finances Its Global Ambitions (Harvard University Press, 2023, 380 pages). The book is a laymanized version of her doctoral dissertation at Johns Hopkins University, and a result of research over eight years with 105 interviews with key participants.
This piece highlights the uniqueness of the Chinese model, how their goals/mandate and business models changed over decades as the Chinese economy gained a more prominent role in the world stage, and lessons for the Philippine sovereign fund.
In creating a new category, the Sovereign Leveraged Fund (SLF), China addressed several key issues.
1. Reduced international reserves = lower money supply = reduced inflationary pressure. Highly liquid financial assets were converted into longer-dated strategic assets. Strategic assets acquired by issuing new debt via domestic bond issues (converting dollar assets into renminbi) and expanding the state’s balance sheet is making use of explicit leverage. Raising the risk exposure of existing low-risk bearing capital without increasing the state’s balance sheet is called implicit leverage.
Because of reduced liquidity and higher risks, such strategic assets were no longer counted as international reserves per IMF definition, thus reducing the Net Foreign Asset (NFA) component of the domestic money supply. Because money supply is typically computed as the sum of net domestic assets and net foreign assets, lower NFA means reduced inflationary pressure.
Hence, the term Sovereign LEVERAGED Fund (SLF). This concept of leverage, where the state issues domestic bonds backed by forex reserves, partly explains the paradox that despite having international reserves of $3.1 trillion as of October 2023, China’s debt to GDP ratio is 265% as of March 2023 (Bloomberg).
2. Avoiding the “Dutch disease.” The sustained surge in foreign exchange reserves from China’s massive export machine has made it increasingly difficult for the People’s Bank of China (PBoC) — the country’s central bank — to “sterilize” its impact on money supply (p. 65) and avoid the so-called “Dutch disease” that plagued other countries with foreign currency surpluses. “Dutch disease” is a term first coined by The Economist in 1977 to describe the decline of the manufacturing sector in the Netherlands following the discovery of the large
Groningen natural gas field in 1959, which lead to the strengthening of its currency that rendered its exports more expensive. The effective reduction of the forex reserves level helped the PBoC relieve this pressure.
3. Opportunity cost. Diversification = higher yields. Keeping the bulk (two-thirds) of the Chinese international reserves in low-yielding US Treasuries meant losing the chance to earn better returns. Song Hongbing, author of Currency Wars, estimated in 2008 that US dollar volatility was costing China “approximately four aircraft carriers a month” (p. 62). The turning point for the impetus toward diversification came when the reserves hit the $3 trillion mark.
4. Resources to recapitalize troubled banks. The book traces the origins of the SLF from the 1997 Asian financial crisis when the Chinese government created Central Huijin (Chapter 2, pp. 74-89) as a bailout fund. Its first mission was to recapitalize state-owned commercial banks (SOCBs) saddled with huge nonperforming loans averaging 20% and as high as 38%. The cost of fixing the banking system was estimated at up to 30% of China’s GDP in 2005 (p. 78).
As the main tool of the party state to mitigate financial risk, implement financial reforms, and improve corporate governance, Central Huijin became “shareholder in chief” (p. 142) of the Chinese financial sector including the so-called Big 4 banks — the Industrial and Commercial Bank of China (ICBC) which is currently the largest bank in the world by assets, the China Construction Bank (CCB), Bank of China (BoC), and the Agricultural Bank of China (ABC).
The banks eventually became healthy enough to be listed in the stock exchanges of Hong Kong and Shanghai (p. 84). Central Huijin also restructured major securities brokerage firms, and later the insurance sector.
LESSONS FOR THE PHILIPPINES
1. China has created a unique SLF model, which evolved into a family of SLFs. The betterknown China Investment Corp. (CIC) was established in 2007 under the Ministry of Finance and focused on external investments while the Central Huijin, under the central bank PBoC, was more focused on the domestic financial sector.
The book devotes an entire chapter to other funds such as the State Authority for Foreign Exchange (SAFE), while additional internationally funds were focused on certain sectors (Buttonwood) and specific countries (the four “Golden Flowers” investment companies established in London, Hong Kong, Singapore, and New York). More recently, the SLFs were involved in financing (directly and indirectly) China’s Belt and Road Initiative (BRI) and the Silk Road Fund (SRF).
2. China’s SLFs recapitalized the state banks. In contrast, the Philippine Maharlika fund seed capital was provided by the state banks Land Bank and Development Bank of the Philippines, with a serious impact on their capital ratios (discussed in this column of Oct. 30). In hindsight, the seed capital of the Maharlika Fund could have just been provided directly by the National Government without involving the state banks and the Bangko Sentral ng Pilipinas, as was done by India and Indonesia.
3. Learning by doing. The CIC lacked a clearly defined mandate in its early years (p. 197), but eventually became more sharply focused, following the evolution in strategic thinking at the political economic leadership. It has evolved from being a passive owner entrusting the management of its funds to third parties, to becoming an active shareholder, and, later, as “capital mobilizers” (Alexander Gerschenkron). Its learning curve was facilitated by being plugged into the international network of prestigious global investors through its initial partnerships.
4. Combining market forces and state power to achieve desired results. Dr. Liu quotes Chen Jinhua (State Commission on Economic System Reform, 1982) about combining the “visible” hand of the state with the “invisible” hand of the market (p. 39). In practice, an equity stake by an SLF buys more than just a stream of dividends and seats on the board. It also acquires the strategic option to influence company direction from shareholder push versus direct administrative fiat or regulatory oversight.
5. Governance, professionalism, transparency. CIC is the most transparent of the Chinese SLFs, while Central Huijin and SAFE in particular do not disclose their portfolio holdings and gains/losses. Soon after its founding, CIC signed up to the 24 Santiago Principles with the International Forum of Sovereign Wealth Funds (IFSWF). CIC also formed an internationally recognized advisory council (p. 199), a key step in establishing credibility with the international investment community.
CIC rated well in the scorecards of sovereign funds by the Petersen Institute of International Economics, with a good score of 74 in 2021, an improvement from 64 in 2012. This compares favorably with Temasek’s 79, Mubadala of the UAE’s 75, BPIFrance’s 74, Texas Permanent School Fund’s 73, Khazanah Nasional of Malaysia’s 71, the HK Exchange Fund’s 70, the Kuwait Investment Authority’s 70, Singapore GIC’s 64, and India’s National Investment and Infrastructure Fund’s 62. Norway is the gold standard with a perfect score of 100.
6. Need for the long, patient view. You will make mistakes. And learn from them. CIC was established in 2007 and suffered major initial financial losses with its $3-billion pre-IPO investment in Blackstone right before the Lehman crisis (pp. 100-109). It took CIC 11 years to exit the investment in 2018, by which time Blackstone shares were trading at 117% higher than IPO price. Despite the initial losses, the partnership yielded mutually beneficial results in later deals.
From 2008 to 2021, CIC performed worse than S&P, failed to exceed its cost of capital, and its global portfolio fell short of breakeven rate half the time (pp. 143, 144).
On a positive node, Chinese SLFs financed notable startups like Alibaba and Didi. A sophisticated approach to investing in technology ventures gave the SLFs access to overseas markets and obtained critical proprietary information on leading edge technologies.
7. Leveling expectations, beyond the hype.
Nicolai Tancen, CEO of the Norges Investment Bank which manages the Norwegian Pension Fund-Global, said it best when clarifying realistic expectations. “Your job is to beat the market. If you beat the market by 1%, you are very good. If you beat the market by 2%, you are a hero! But this means you will still fail 48% of the time.” For the Philippine case, this is a strong argument to have realistic expectations and not be carried away by the hype.
(Parts 1 to 3 of this series can be found here: “The Maharlika Strategic Investment Fund governance issues: Aligning with best practice” (https://tinyurl.com/ylhpyvu4), “The Maharlika strategic investment fund — the ‘pause,’ the fix” (https://tinyurl.com/yuetlvaq), and, The Maharlika strategic investment fund — How to prioritize projects — BusinessWorld Online (bworldonline.com).