The cover of the January 19, 2008, edition of The Economist showed three large tandem-rotor military helicopters, each hauling a pallet full of gold bars and emblazoned with the flags of China, Singapore and Kuwait. 

Above the fleet of helicopters, the headline announced the impending “invasion of the sovereign wealth funds.” This hyperbolic declaration was a reference to several sovereign wealth funds

(SWFs) from Asia and the oil-rich Arabian Gulf that had, in the week prior, pumped $69 billion into troubled Western financial institutions, some of which were among the world’s largest banks and investment managers.

At that time, the collapse of Lehman Brothers and the advent of the 2008 global financial crisis were still more than nine months away. The prevailing attitude of Western policymakers was still mostly averse to the notion of wide-scale market intervention, which some economists half-mockingly described as drops of “helicopter money.”

But, later that same year, when global financial market turmoil forced major central banks to inject hundreds of billions of dollars into the international banking system, such “helicopter money” was rebranded with the sufficiently technocratic euphemism “large-scale asset-purchase programs.” Although the cash injections from the SWFs were ultimately not enough to rescue the companies in which they invested, SWFs had proven themselves to be the crisis’s first responders. 

When people meet with China’s SWFs, they don’t see a Party apparatchik, but a sophisticated, market-oriented investor. But China’s SFWs are serving the Party. 

SWFs were able to beat other government institutions onto the scene precisely because they were proactive participants inside financial markets rather than regulators operating outside of markets. Indeed, the ability of SWFs to act promptly makes them a potentially invaluable tool for governments, but one that can be effectively wielded only if governments are willing to redefine the boundaries of the state–market dichotomy.

China, of course, has been so willing. 

While several countries have established SWFs — generally understood as any government-owned investment institution — none can compare to the Chinese sovereign funds in scale or scope. Collectively, China’s SWFs managed more than $2 trillion in assets at the end of 2019. China Investment Corporation (CIC) has received the most scholarly interest and media attention: As of last year, CIC had already become the largest sovereign fund in the world, managing more than $1.35 trillion in assets — that’s larger than Mexico’s GDP, and Mexico is the world’s 15th largest economy. 

But China has several other, more obscure investment funds affiliated with the State Administration of Foreign Exchange (SAFE), the foreign exchange management arm of the People’s Bank of China (PBoC). Although these SAFE-affiliated investment funds are not as well known as CIC, they have established a global network that collectively managed at least $1 trillion in assets as of 2019.

Crucially, while these SWFs are state-owned, they are market facing. When people meet with China’s SWFs, they don’t see a Party apparatchik, but a sophisticated, market-oriented investor. 

But China’s SFWs are serving the Party. 

Since the end of the Cold War, the front line of great power competition has shifted from the military battlefield to novel nontraditional security domains like financial markets, cyberspace, critical infrastructure and corporate governance. China’s sovereign funds should be understood in this context, because they have helped the Chinese government to indirectly expand its influence overseas.

They work by deploying sovereign capital to acquire strategic overseas assets and exploit the exalted rights granted to shareholders in capitalist economies. And because China’s state-owned capital is filling the cash coffers of Western firms while advancing its national interest, it is quietly using the U.S.-led global economic system to put an end to American hegemony. 

Indeed, China’s SWFs allow the Chinese Communist Party (CCP) to project power and to outcompete rivals that are more powerful economically or militarily. They could also help China outmaneuver the U.S., especially as each country tries to assemble regional economic blocs to the detriment of the other. 

If U.S. policymakers fail to understand the political-economic model of China’s sovereign funds and how they advance the global ambitions of the CCP, then the U.S. risks surrendering its leadership in financial markets earlier than anticipated and in unexpected parts of the world.

NOT YOUR TYPICAL SWF

It is perplexing that China should have such massive sovereign funds in the first place. As the world’s largest importer of commodities, China has relatively little in common with the countries traditionally associated with SWFs (such as oil-rich states, including Norway and countries throughout the Middle East and Africa). 

The term “sovereign wealth fund” was first used in 2005 by Andrew Rozanov in his article “Who Holds the Wealth of Nations?” Rozanov defined SWFs as “sovereign-owned asset pools, which are neither traditional public pension funds nor reserve assets supporting national currencies.” According to this definition, commodity-based SWFs have existed for more than six decades. The first government-owned investment fund that would later be labeled a SWF was the Kuwait Investment Authority, established in 1953 and capitalized by the monetization of oil wealth found in the state. 

The 1970s saw the launch of a few more resource-based funds, but most present-day SWFs emerged after 1990. These commodity-based SWFs were capitalized by natural resource revenues and act as a national savings account; their investment revenues help smooth out the effects of commodity price fluctuations and stabilize national fiscal budgets. Such fiscal buffers are crucial to insulating these economies from the vagaries of global commodities markets. 

By 2007, SWFs had already achieved an impressive scale, managing more than $3.1 trillion in assets — about the same size as the entire U.S. money market fund industry. But despite their size, SWFs have historically maintained a relatively low public profile.

China’s sovereign funds, however, are unlike commodity-based SWFs and represent an entirely new political-economic innovation, which I term sovereign leveraged funds (SLFs). China’s SLFs have two distinctive features: first, the funds were seeded with capital raised from the Chinese state taking on “leverage” in the form of either explicit or implicit liabilities; second, the funds were generally founded without an explicitly defined geoeconomic mandate but have tended to adopt an underlying geoeconomic agenda as they have expanded in global markets, advancing the strategic interests of the Party-State beyond China’s territorial borders.

In 2007, for instance, CIC was founded by a complicated funding scheme, including issuing new government bonds that would free China’s foreign exchange reserves from low-yield U.S. Treasuries bonds. 

At the time, China’s foreign exchange account surplus combined with a desire to fix the value of China’s currency required the People’s Bank of China (PBoC) to conduct large-scale sterilization operations, soaking up domestic currency to keep a lid on inflation. Maintaining these operations began to place pressure on the balance sheet of the PBoC when two trends started to emerge: the falling value of the U.S. dollar and declining rates on U.S. Treasury bonds. Conversely, the hot economy in China was driving up domestic real interest rates, increasing the interest-payment burden on the PBoC’s liabilities denominated in renminbi. 

In short, the opportunity cost of investing foreign exchange reserves in U.S. Treasuries was rising. 

The plan for CIC was to free China’s foreign exchange reserves and use them to serve China’s development needs. Accomplishing this required a series of convoluted transactions, but essentially the Ministry of Finance (MoF) was allowed to issue RMB 1.55 trillion ($226.9 billion) worth of special treasury bonds and use the proceeds to purchase the equivalent value of foreign exchange reserves from the PBoC. Eventually, it used these foreign exchange reserves to capitalize CIC. 

The net accounting effect of this transaction was to increase the government’s outstanding debt and decrease the country’s foreign exchange reserves. By definition, increasing the debt-to-assets ratio increases the leverage ratio; the establishment of CIC has thus been the product of the state taking on explicit leverage. 

…CIC’s fundamental purpose is to achieve the political and economic objectives of the Party-State by leveraging foreign exchange reserves that would otherwise be dormant sovereign capital. 

The peculiar funding scheme highlights the most salient difference between SLFs and sovereign wealth funds (SWFs). Unlike conventional SWFs funded by free cash flow from natural resources revenues, CIC’s seed capital was not from the state’s natural resource wealth but instead from debt proceeds raised in the domestic markets and ultimately recycled by the central bank. 

Embedded in this financial structure is also a currency risk since CIC’s assets are denominated in U.S. dollars, while its liabilities are denominated in renminbi. This asset-liability currency mismatch means that CIC’s net profitability is a function of not only its investment prowess but also the USD-RMB exchange rate — an unusual constraint for a sovereign fund that is supposed to have a long-term investment horizon but at the same time is faced with annual distribution pressure.

But CIC is unique because its main goal is not limited to economic factors, such as earning a higher yield on foreign exchange reserves. Instead, the goal was to transform China’s foreign exchange reserves into strategic overseas assets. Like the other SLFs in China, CIC’s fundamental purpose is to achieve the political and economic objectives of the Party-State by leveraging foreign exchange reserves that would otherwise be dormant sovereign capital. 

SAFETY IN NUMBERS

Between 2007 and 2021, CIC’s global asset allocation reflected China’s quest for natural resources and President Xi Jinping’s Belt and Road Initiative (BRI). In 2014, CIC contributed $1.5 billion of the total $10 billion in initial capital for the Silk Road Fund, an infrastructure financing fund. And in January 2015 CIC launched a new subsidiary, CIC Capital, to focus on overseas direct investment in long-term assets, especially infrastructure and agriculture.

Just months later, CIC Capital teamed up with China’s two largest port operators, COSCO Pacific and China Merchants Holdings International (CMHI), to acquire a 65 percent stake in Kumport Terminal, Turkey’s third-largest container terminal, for $940 million. 

The Kumport Terminal fits neatly into the BRI plan for developing new sea routes to carry China’s international trade. There were also potential synergies between the Kumport Terminal and COSCO’s previous investment in the Piraeus Terminal, the largest port in Greece. Together, the ports were capable of serving as China’s gateway into Europe and parts of the Middle East, and the investments demonstrated China was committed to securing its presence and long-term interests in territories beyond its borders.

A year after investing in Turkey’s Kumport Terminal, CIC Capital made another significant infrastructure investment. In September 2016 CIC paid $900 million for a 20 percent stake in a consortium that leased for 50 years the Port of Melbourne, Australia’s principal container and cargo port. CIC was joined in the consortium by Queensland Investment Corporation, Australia’s Future Fund, Canada’s Ontario Municipal Employees Retirement System, and Global Infrastructure Partners (GIP).

But CIC’s stake was even larger than meets the eye, since CIC is the primary investor in GIP, owning about half of the fund’s shares. (Before this deal, GIP and CIC were part of the investor team that acquired Asciano, one of Australia’s largest freight logistics businesses.) 

CIC Capital’s involvement in the Port of Melbourne lease attracted some attention, but it was considerably less attention than the Landbridge Group, another Chinese company, garnered when it purchased a 99-year lease on the Port of Darwin. In 2015 the Landbridge Group paid $361 million for 100 percent of the lease on the Port of Darwin. 

The deal drew the U.S. government’s interest: U.S. and Australian naval vessels sometimes visit the port, and the Landbridge Group has close ties to CCP and the Chinese military through its founder Ye Cheng. The U.S. State Department concluded in an internal document leaked to the Australian press that the Chinese presence could facilitate intelligence collection on the U.S. and Australian military forces stationed nearby. 

Following this deal, the Australian government strengthened its rules for selling critical infrastructure to private foreign investors. Before proceeding, such sales require a formal review by the Australian Foreign Investment Review Board (FIRB). In 2016 the Australian FIRB vetoed the sale of 50.4 percent of Ausgrid, an electrical grid operator that supplies Sydney, to China’s State Grid and Hong Kong–based Cheung Kong Infrastructure. The veto sparked protest from China’s Ministry of Commerce, which said the decision to block the sale was “protectionist and seriously impacts the willingness of Chinese companies to invest in Australia.” 

About three months after the scuttling of the Ausgrid transaction, the deal to lease the Port of Melbourne to a consortium of companies, including CIC Capital, successfully closed.

Increasingly stringent foreign direct investment (FDI) screenings have forced CIC to be innovative in structuring deals, and the success of the consortium in the Port of Melbourne deal provided a model. Starting in 2017, CIC entered into more partnerships with leading institutional investors in Western countries and launched several bilateral cooperation investment funds. 

One such example is the China-U.S. Industrial Cooperation Partnership, a joint venture between CIC and Goldman Sachs and one of several deals announced during President Trump’s visit to Beijing in November 2017. 

The fund, which has a target size of $5 billion, has a broad mandate to invest in the manufacturing, industrial, consumer, and healthcare sectors in the United States and in specific companies that have the potential to develop material business connections to China. With Goldman Sachs as the sponsor for the Cooperation Fund and CIC as its anchor investor, the fund aims to “enhance commercial linkages and promote market access for U.S. firms in China and will seek to improve the balance of the U.S.-China trade relationship.” 

As an investor, CIC is not supposed to provide investment advice to Goldman Sachs but instead support the fund by identifying potential value-added opportunities in China. According to Goldman Sachs, “CIC is not involved in the investment management of the fund nor the operation of the fund’s portfolio companies . . . ​CIC’s role is to help Goldman Sachs, as the investment manager, identify and pursue opportunities for portfolio companies to do more business in China.” 

By partnering up with one of the most illustrious names on Wall Street, CIC hoped to avoid U.S. government scrutiny on its investments in American companies. It worked: The CIC–Goldman Sachs partnership demonstrated its political efficacy several times in the following years. 

In September 2019, for instance, the Collaboration Fund invested $3 billion in California-based Boyd Corp., a leading maker of engineered materials and thermal management technologies. The Committee on Foreign Investment in the United States (CFIUS), the U.S. government panel that scrutinizes corporate acquisitions for national security risks, asked CIC to divest from the deal, citing data privacy concerns. But Goldman Sachs successfully convinced CFIUS to allow the purchase to proceed with CIC remaining as a minority investor through the Cooperation Fund. 

Then, in June 2021, despite U.S.-China relations sinking to their lowest depth in five decades, the Cooperation Fund led a $202 million investment in Project44, a Chicago-based supply-chain visibility technology provider.

…the experience of China’s SLFs shows that there is an effective role to be played by the state as a direct participant in the market to embed the national interests into markets.

These experiences convinced CIC of the importance of partnering with a local institutional investor that can act as a “clean glove,” assuaging the concerns of U.S. authorities and ultimately winning their approval. 

There has been growing pushback in the West, of course. In some ways, the past success of China’s SLFs has made them less effective going forward, as each new investment engenders more scrutiny. 

But the policy response of Western governments so far has been disjointed, tightening their individual respective national screening regimes for foreign direct investment. A more effective response would be based on the risk-management principles of avoidance and hedging and would involve coordination between the U.S. and its allies.

A NEW MODEL?

CIC’s global investment performance has achieved varying degrees of financial success over the years. There have been big wins, such as when it provided critical financial support for Alibaba’s record-setting IPO on the NYSE in September 2014. But a close review of CIC’s annual reports from 2008–2020 reveals that the fund’s global portfolio return has been less than satisfactory. Since CIC was founded, its global portfolio return has consistently been lower than the benchmark S&P 500 Index return.

Even worse, the fund’s return often failed to exceed its cost of capital. CIC’s breakeven rate on investments was estimated to be approximately 10 percent after adjusting for inflation and the negative effect of exchange rates. But the global portfolio’s return surpassed 10 percent only six times between 2008 and 2020. Since its founding, it has fallen short of its breakeven rate about half the time. 

When comparing CIC’s global portfolio returns with other major sovereign funds, CIC has performed below the average return of its peers half of the time. 

China’s SLFs and their overseas assets also do not represent an uncompromised geoeconomic strength. Under some circumstances these funds could become strategic vulnerabilities. The more reserves China invests overseas, the more assets there are for the U.S. government and its allies to seize or otherwise hold hostage in the event a conflict erupts between China and the West, such as a clash over the sovereignty of Taiwan. 

This geoeconomic weakness was demonstrated to China’s leaders when Western governments responded to Russia’s invasion of Ukraine by freezing the assets of Russia’s central bank while also sanctioning Russia’s sovereign wealth fund. There is no straightforward way for China to invest state-owned assets and foreign exchange reserves in the U.S.-led global financial system while also sheltering itself from the coercive geoeconomic power of the U.S. government.

Finally, the establishment of CIC has fueled something of a bureaucratic competition among China’s financial regulators. In several ways, CIC has challenged the role of the PBoC and SAFE, the legal administrator of China’s foreign exchange reserves. Thanks to the peer pressure of CIC, SAFE has changed its traditional conservative approach to managing reserves and has adopted unconventional and aggressive diversification strategies. SAFE and SAFE-affiliated investment funds manage $1-$1.5 trillion in assets, including now risky and illiquid assets that are ill-suited to meeting the country’s balance of payment needs. 

Despite the risks and downsides, however, China’s SLFS have successfully deployed China’s foreign exchange reserves to finance the realization of the Party’s ambitions in global markets. By the end of 2019, CIC’s executive vice president, Zhao Haiying (赵海英), estimated that CIC had invested approximately $28.1 billion in BRI countries. SLFs have transformed the CCP and the Chinese state into a shareholder state, allowing the Party-State to shroud its commanding power over the market behind the veil of a market-oriented investment fund. 

Indeed, the experience of China’s SLFs shows that there is an effective role to be played by the state as a direct participant in the market to embed the national interests into markets. The advent of China’s SLFs speaks to the rise of state-led investment and finance globally, while the lack of a Western alternative to Chinese state-led capital points to the necessity of establishing SLFs in the West that stand at the ready to deploy capital to outcompete foreign investors in the market. Governments in liberal market economies can design and establish their own SLFs that — with supervision — can act as white knight investors to defend strategic industries against undesired foreign takeovers.

SLFs are powerful tools, and they represent a new middle path between the prevailing dichotomy of the liberalist proposal to “remove state intervention” and the market institutionalist proposition to “bring the state back in.”

Excerpted from SOVEREIGN FUNDS: HOW THE COMMUNIST PARTY OF CHINA FINANCES ITS GLOBAL AMBITIONS by Zongyuan Zoe Liu, published by The Belknap Press of Harvard University Press. Copyright © 2023 by the President and Fellows of Harvard College. All rights reserved.

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