An Inside View of How China Finances Its Global Ambitions

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• Sovereign wealth funds (SWFs) are state-owned investment funds that use a nation’s cash reserves to boost its economy. The portfolios often include multi-trillion dollar holdings of foreign assets.
• While most of these funds’ capital comes from the monetization of a country’s natural resources, China’s is remarkably different. Although the Chinese government claims its SWFs tap into foreign exchange reserves, the real story is much more complicated.
• Political economist Zongyuan Zoe Liu writes about the evolution of China’s sovereign funds — and the convoluted mechanics behind them — in her new book, “How The Communist Party of China Finances Its Global Ambitions.”

Imagine an exclusive, shadowy, no-holds-barred poker game. But it’s not Texas Hold’em or seven-card stud. The players are powerful nations and the chips are entire industries. 

Welcome to the world of sovereign wealth funds.

Sovereign wealth funds (SWFs) are state-owned investment funds that tap into a nation’s cash reserves to boost its economy. The investments are financial assets like stocks, bonds, real estate and commodities like precious metals — and sometimes private equity or hedge funds. Often, they involve multi-trillion dollar holdings of foreign assets. 

Most of these funds’ capital comes from the monetization of a country’s natural resources, which explains why some of the biggest SWFs are in Norway, Qatar and the UAE. 

But why does China — the largest commodity importer in the world — have a sovereign wealth fund? 

That’s the question political economist Zongyuan Zoe Liu (who goes by Zoe) asked when she was a Ph.D. student in economics studying how countries manage and monetize their natural resources.

Zoe, who was born and raised in China, was curious about China’s approach. She stumbled upon the China Investment Corporation (CIC), the third-biggest SWF worldwide. China claims the CIC’s funds come from foreign exchange reserves, but that was an “unsatisfying” explanation to Zoe, who is now the Maurice Greenberg Fellow for China Studies at the Council on Foreign Relations and a professor at John Hopkins University. 

She spent years researching financial reports and conducting in-person interviews with Chinese policymakers to get to the truth: The CIC is an outlier among international SWFs because it relies on leverage instead of revenue. 

Zoe dives into the financial mechanics behind China’s multiple SWFs in her new book, “Sovereign Funds: How the Communist Party of China Finances Its Global Ambitions.” It’s a labyrinthine journey and a bit like the Chinese government itself — bureaucratic to the extreme, obscured by propaganda and unobtrusively powerful on the world stage.

To help untangle it all, Zoe dropped in for an Ideas Lab installment of Top Traders Unplugged with host Kevin Coldiron. Here’s a recap of her insights on two of the most influential Chinese SWFs — Central Huijin and CIC — including their origin, their seed capital and the politics behind them.

The promise of foreign exchange reserves in the ‘open-up era’

In most countries (historically, at least), foreign exchange reserves are like a rainy day fund, kept in super-safe securities like treasury bonds in case the government needs to access foreign currency.

But China hasn’t always had massive foreign exchange reserves. 

When the People’s Republic of China (PRC) was established in 1949, it was one of the poorest economies in the world. It wasn’t until the “reform and open-up era” (the late 1970s to the early 1990s), that China seemed to realize it could accumulate foreign exchange reserves by exporting more and importing less, says Zoe. 

At first, “China’s reserve accumulation was not necessarily rapid,” she says. But in 1997, during the Asian financial crisis, Chinese policymakers “witnessed how the lack of reserves to defend their currency in the neighboring countries … ended up having a devastating effect on their economy.”

‘Not just economic strength, but also political strength’

China began to accumulate reserves in earnest after joining the WTO at the end of 2001. 

At the time, Chinese economists asked whether it meant they could “stop accumulating now,” Zoe notes. “Because by IMF or World Bank measure … the so-called optimal level of foreign exchange reserves is somewhere [in the range of] three months of trade payments.” 

She remembers reading former premier Zhu Rongji’s memoir, which she quotes now: “Foreign exchange reserves are important for economics … but trade balance is not the correct measure for foreign exchange reserves — because the reserves are not just economic strength but also political strength.”

That idea stuck with Zoe through the early 2000s, when double-digit economic growth propelled China to accumulate more reserves. In recent years, China’s reserve “has been maintaining or stabilizing at about $3 trillion,” she says. But at its peak (around 2013), the reserve topped $4 trillion. 

“If my numbers are correct, that’s a very meaningful part of all the world’s foreign exchange reserves,” Kevin remarks. “I don’t know if it was quite 50%, but it was in that ballpark.”

Enter: Central Huijin 

Eventually, economists started asking why China’s foreign exchange reserves had grown so much in such a short time — and why the government was investing so much of that money in the ways it did.

That was the political backdrop when China founded the investment company Central Huijin in 2003. It was the first time the government “leveraged its foreign exchange reserves to solve a domestic crisis,” Zoe says. “So that’s why the bottom line of my book is that yes, China has the world’s largest sovereign funds, but they were not, originally at least, designed for global power projection.”

In the 1990s, “the accumulated non-performing loans had almost crippled the state-owned banks,” she adds. 

By the early 2000s, some metrics suggest that the non-performing loan ratio on Chinese banks’ balance sheets reached more than 20%. Essentially, these state-owned banks were simply vehicles to channel money to state-owned enterprises, which were often unprofitable and not profit-motivated, either. Those companies were given loans they couldn’t pay back, and the inevitable domino effect began.

A ‘special policy vehicle’ for capital infusion 

According to Zoe, Chinese revolutionary and statesman Deng Xiaoping once remarked that Chinese banks functioned more like cashiers than true banking institutions. In his view, these banks didn’t perform fundamental financial stewardship, like identifying optimal investment opportunities or managing capital effectively. They merely issued loans to whatever entities the government endorsed. 

The Communist Party of China (CPC) tasked the Ministry of Finance and the People’s Bank of China with resolving the issue. But although the government owned all the banks, it lacked both the financial resources and the capacity to recapitalize them. So the idea of using foreign exchange reserves to infuse capital into the banks was an attractive one. 

Central Huijin was “a special policy vehicle” designed to do exactly that, Zoe adds.

In this scheme, the People’s Bank of China (PBOC) transferred a portion of foreign exchange reserves into Central Huijin to recapitalize the country’s banking system. But according to the IMF, once reserves are no longer under the control of the managing authority, they cease to be “official” reserves (i.e., public-sector, publicly disclosed funds meant to improve a nation’s resilience to economic shocks).. 

Zoe explains that this capitalization strategy, executed through Central Huijin, used “implicit leverage” because foreign exchange reserves are supposed to be invested in safe and liquid assets.

Central Huijin as ‘Shareholder in Chief’

China’s capitalization strategy worked. It allowed the banks to shore up their capital, so they were able to sell equity to foreign investors. Eventually, Central Huijin made an IPO. 

“So you basically take the FX reserves and you leverage that into, ultimately a few years down the road, a successful public listing of these banks,” Kevin remarks.

“Absolutely,” Zoe says. “I do think Central Huijin’s track record of crisis management has been pretty good. As a government-owned vehicle, it has become this … ‘Shareholder in Chief’ of China’s financial institutions.”

Because reforming Chinese banks was such an achievement for Central Huijin, it has been a key player in bailing out other sectors of the Chinese economy during crises. Zoe says she wouldn’t be surprised to hear that the asset management companies at the apex of China’s current financial crisis would be “reformed” under Central Huijin.

‘Shadow banks’ and China’s ‘Lehman moment’

“Do you think Central Huijin might be helping to deal with the problems at the Chinese wealth management firms?” Kevin asks. 

Zoe explains that Central Huijin has been “one part of the so-called national team in terms of supporting China’s domestic stock market.” Other entities, like a vehicle established under the State Administration of Foreign Exchange (SAFE), participated in saving China’s stock market when it crashed in 2015. 

In the event of another stock market crash, she thinks the government might tap that organization (i.e., SAFE) again. But other parts of the economy, like the wealth management and trust industries, belong to “the so-called shadow banking system,” Zoe says. If those sectors of the economy trigger “China’s Lehman moment,” she thinks Central Huijin has the assets to step in — and would do so.

Enter: China Investment Corporation 

Eventually, the Chinese government wanted to establish something more proactive than a mere problem-solving company like Central Huijin.

Launched in 2007, China Investment Corporation (CIC) became another vehicle for China to manage its foreign exchange reserves, but in a much more aggressive way than its predecessor. According to its 2021 annual report, CIC’s assets under management exceed $1.3 trillion. 

“That’s larger than the Mexican GDP, so it’s massive,” Zoe remarks. 

One of the main points in Zoe’s book: The structure of CIC is what makes China’s sovereign funds different from others in the world. When CIC was first established, the Ministry of Finance issued a special purpose bond, and several designated state-owned commercial banks bought that bond. The Ministry of Finance used the bond proceeds to purchase foreign exchange reserves from the PBOC. 

Then PBOC’s foreign exchange reserves were transferred into the CIC. 

While most foreign exchange reserves are invested in low-risk liquid assets such as U.S. Treasuries, CIC’s investment portfolio ranges from public equities to real estate and even infrastructure and startups, Zoe notes.

“Basically, we can think that the state has a balance sheet,” she explains. “You have a balance sheet expansion by the Ministry of Finance issuing a bond. Then on the other hand, the bond proceeds are used to capitalize a new institution that invests in a different class of asset that is less liquid and less secure compared with U.S. Treasuries, and that is leverage.”

China goes to NYC

In retrospect, 2007 wasn’t a great time to launch an SWF like China Investment Corporation.

Initially, CIC faced pressure to quickly invest its funds and reduce cash drag, leading to its pre-IPO purchase of Blackstone later that year. 

The move marked a historic moment in the financial industry. Not only was it one of the largest cross-border investments by a Chinese entity at that time, but it also symbolized China’s growing economic power.

However, CIC’s investment in Blackstone suffered heavily during the global financial crisis, with share values plummeting. CIC’s losses led to a domestic backlash, but the company still taps foreign entities like Goldman Sachs to reduce regulatory and political hurdles. 

The story of how China manages its vast foreign exchange reserves perhaps is one of the best-kept secrets in finance — until now. And it’s also a reminder that sovereign wealth funds, once enigmatic entities, are now integral players in the global economic arena — with all the complexities faced by nations managing their wealth on a global stage.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.