Zongyuan Zoe Liu - Ideas Lab Series - September 20th, 2023

[00:00:00] Zoe

At that time, the Deputy Governor of the PBOC, it was Yi Gang who then later became the central banker. So Yi Gang, he endorsed this plan the next day after President Xi Jinping’s announcement. He literally said this is quite necessary and timely to expand Silk Road Fund Capital. So I just feel like you’re absolutely right. The first time when China leveraged it’s foreign exchange reserve was to capitalize Central Huijin to solve a crisis and now even the central bankers themselves are more aligned with President Xi Jinping and the strategic aspect of it.

[00:00:46] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:41] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely, Kevin Coldiron to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor. In this series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. With that, please welcome Kevin Coldiron.

[00:02:18] Kevin

Okay, thanks Niels and welcome everyone. So today, we’re going to roll up our sleeves and get into the weeds a little bit to understand how China manages its vast wealth. We’ve all heard the term sovereign wealth funds, pools of money accumulated by countries and invested in global markets.

Our guest today is going to introduce you to a new term, sovereign leveraged funds. These are also pools of capital, but they’re leveraged either directly or indirectly. They’re not just used as passive investment vehicles, they’re used to further the goals of the government that controls them. That’s important for anyone who wants to understand how global markets are working now, but it’s also a window into the future because it’s a structure and a philosophy that more countries are likely to adopt.

So here to tell us about all of this is Zoe Liu, author of a new book, How the Communist Party of China Finances its Global Ambitions. Zoe, thanks so much for joining us, and welcome to the show.

[00:03:22] Zoe

Thank you, Kevin, for having me. I listen to the Ideas Lab myself and it’s exciting that you invited me. It’s an honor. Thank you.

[00:03:31] Kevin

Well, the pleasure is all ours. So can you just tell us a little bit about your personal background, where you grew up, where you studied, and what you’re currently doing for a day job?

[00:03:42] Zoe

Sure. I grew up in a seashore city in China called Yantai. My hometown makes perhaps arguably the best beer and best wine you can find in China.

[00:03:57] Kevin

Oh, okay. I’m going to note that down.

[00:03:59] Zoe

Yes. Right now, I am the Maurice Greenberg fellow for China studies at the Council on Foreign Relations and I also teach graduate-level classes at the John Hopkins University.

[00:04:13] Kevin

Okay. So your day-to-day job is kind of research and analysis on China’s global economic policy, political policy, the intersection of those?

[00:04:27] Zoe

I am a political economist focusing on East Asia and the Arabian Gulf countries, in particular, the Gulf Cooperation Council members. In that arena, I do energy and finance. So a lot of the stuff that I do situates at the intersection of energy, from hydrocarbon to now everybody’s talking about renewables and clean energy or the energy transition. Actually, this is very much related to finance because financial markets and major institutional investors are at the frontier of this, from ESG transformation in terms of the investment framework or climate financing now.

[00:05:16] Kevin

Okay. So what got you interested in writing this particular book and digging into the details of how China manages its money

[00:05:33] Zoe

This book is a half of my doctoral dissertation. The actual dissertation itself probably is more technical than the book and I think I have become a better writer since when I was in school. I try. When I came to my graduate program, what I really wanted to do was to study cross-border pipelines. I was very interested in at which point natural gas (you know, natural gas, you can ship it in terms of liquefied natural gas or piped gas), I was very interested in the broader context of the energy transition; why countries choose to build pipelines versus tankers.

From there, I started to stumble upon how countries recycle their energy resource money, and part of this stumble was also related to that some people did exactly the topic that I wanted to do. So I pivoted, I tried to think about how these countries manage their natural resources. From there, I realized, oh, okay, it’s very interesting that these countries have this vehicle called a sovereign wealth fund.

Obviously, growing up in China, I always tried to see if China has something similar, and I stumbled upon China Investment Corporation. The literature was particularly rich that talked about the role of China’s sovereign funds or CIC, China Investment Cooperation, during the global financial crisis. It becomes a puzzle to me given that most of the so-called sovereign wealth funds are funded and capitalized by natural resources using basically the monetization of natural resource revenue. The hosting countries are mostly in countries like Norway, Qatar, UAE, these kinds of natural resource exporting countries. It becomes a puzzle.

So, why did China, being the largest commodity importer in the world, end up having sovereign wealth fund? It just simply does not make any sense to me. So I looked into it and the prevailing explanation seems to be interesting, but for me as the intellectual, unsatisfying because our scholars say, well, the reason why China has a sovereign wealth fund is because it has a lot of foreign exchange reserves. But then the question becomes, well, Japan also has a lot of foreign exchange reserves but the Minister of Finance of Japan specifically rejected this idea. So that’s where I got started.

[00:08:31] Kevin

Let’s take a step back, actually. Let’s talk about those foreign exchange reserves since that really became, if you will, the seed capital for a lot of these what you call sovereign leveraged funds. So I’m going to try to do a little summary that anyone who’s got an advanced degree in economics and finance might wince a little bit because I’m going to leave out some of the details. Broadly speaking, let’s say just simplify to China and the US, the US has a big deficit with China; current account deficit. So it’s shipping more dollars to China than it’s getting in return.

Over time, as these deficits accumulate, China ends up with accumulating dollars, and those dollars ultimately end up with the central bank. The central bank, those are called foreign exchange reserves and they’re called reserves for a reason. They’re historically, anyway, used as kind of like a rainy day fund if the country needed to access foreign currency. Because of that, they, again, historically, were kept in very safe securities like treasury bonds, treasury bills.

So your book is really a story about how that old model has changed. So let’s talk about the buildup of China’s reserves, initially, and then let’s talk about how they kind of shifted from the old model to the new model. When did China first start to accumulate meaningful holdings of foreign exchange reserves? When did it peak? Can you give us a sort of rough sense of the scale?

[00:10:08] Zoe

First of all, China as a country has not always had a massive amount of foreign exchange reserves. When China was first established in 1949, or the People’s Republic of China (PRC), the country was actually one of the poorest economies in the world. It was not until the reform and open-up era, starting from 1978, that China started to realize okay, so countries can accumulate foreign exchange reserves by exporting more and importing less. The early years of reform and open-up I would say, from the 1980s to the early 1990s, China’s reserve accumulation was not necessarily rapid.

The idea of the need to accumulate foreign exchange reserves was in the mind of the Chinese economic planners like Chen Yun and others. The critical moment that made Chinese policymakers realize that it is very critical to accumulate reserves and accumulate fast was the Asian financial crisis in 1997 because they witnessed how the lack of reserves to defend their currency, in the neighboring countries starting from Thailand, ended up having a devastating effect on their economy.

So at that time the Chinese Premier (also a very important economic figure), Zhu Rongji, he was the person not just coming out defending the position, in terms of China, if the renminbi wouldn’t depreciate, but also emphasized the need to accumulate foreign exchange reserves. Even in later years, after China joined the WTO in December 2001, Chinese leaders, including the People’s Bank of China governors at that time, from Dai Xianglong to Zhou Xiaochuan and Premier Zhu Rongji, they realized that China actually started to accumulate reserves at a faster speed because of joining the WTO and trading more.

At that time, people asked the question, when China started to accumulate more reserves, does that mean we can stop accumulating now? Because, by IMF or World Bank measure or international standard, a sufficient amount of reserves, or the so-called optimal level of foreign exchange reserves, is somewhere about three months of trade payments. I remember reading Zhu Rongji’s memoir, and he said, and I quote him, he said, “Well, yes, foreign exchange reserves, they are important for economics and they are economic measures, 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 sort of like stuck with me for a while. China’s reserve just kept accumulating in the early 2000s, especially during the double-digit growth years. Right now, China’s reserve has been maintaining or stabilizing at about $3 trillion, but at its peak, is was more than $4 trillion. I think this was around 2013, if I remember correctly.

[00:13:56] Kevin

So they basically grew from essentially nothing, slowly for a while, and then starting the Asian financial crisis quite rapidly to the point where they had accumulated $4 trillion. If my numbers are correct, that’s a very meaningful part of all the world’s foreign exchange reserves. I don’t know if it was quite 50%, but kind of in that ballpark. So at some point, this is the story in your book. At some point, people started asking questions. Not just why do we have so many foreign exchange reserves, but why are we investing so much of them in such a conservative way?

I think initially it was, can’t we get higher returns, but can’t we use those in other ways? So you’ve organized your book in, I think you call them case studies; chapters on each of the key organizations that developed to manage those foreign exchange reserves. So I thought maybe we could kind of work our way through, talk about how those institutions evolved initially, and then how they operate now, because in a lot of cases, it has changed a lot.

So the first one is, I’m going to try to get this pronunciation correct, Central Huijin. Tell us what that organization is. What’s its origin story, and then talk about how its role evolved over time. How did that get started?

[00:15:36] Zoe

Central Huijin is the first time that the Chinese government leveraged its foreign exchange reserves to solve a domestic crisis. So that’s why the bottom line of my book is that yes, China has the world’s largest sovereign funds, but they are not, originally at least, they are not designed for global power projection. This can all be traced to Central Huijin’s idea.

Perhaps many of our listeners will remember, China’s banking system, yes, it’s large but it’s very much a state-owned banking system. In the 1990s, the accumulated non-performing loans had almost crippled the state-owned banks. By certain measures, the non-performing loan ratio, on the balance sheet of all these banks, reached more than 20% in the early 2000s.

[00:16:46] Kevin

This is a situation where you’ve basically got state-owned banks that historically were really just vehicles to channel money to state-owned enterprises which were typically not that profitable. So you’ve got basically loans being made on an economic basis to companies that are also not entirely run for profit and so a lot of those loans go bad, and that starts building up, building up, building up to a point where the numbers in the book are quite astonishing. A huge portion of these loans are non-performing, worthless. So there’s a need to fix that problem.

[00:17:23] Zoe

Absolutely. I remember Deng Xiaoping once talked about the Chinese banks. He said Chinese banks are not really doing the job of banks, but they are cashiers. So the idea is that the banks are really not doing the job of identifying the best investment or capital management opportunities but really just did what the government led them to do in terms of giving out loans and all that. So you’re absolutely right, that was the primary reason that caused the non-performing loans.

Now, given the importance of the Chinese banks, state-owned banks, in China’s not just the financial system but also the entire industrial organization, the Ministry of Finance and the People’s Bank of China needed to solve the problem. But at that time, despite Ministry of Finance was the default owner or it owns all the banks, but it did not really have the capacity or the money to recapitalize the bank.

Now, Chinese policymakers realized oh, okay, so now we accumulated a little bit of foreign exchange reserves, why don’t we just use the foreign exchange reserves to capitalize the banks, because that’s an easy pot of money for them to use. So that was the background of the establishment of a Central Huijin. In 2003, Central Huijin was established. At that time, it was a special policy vehicle for the purpose of capitalizing Chinese banks. So basically, what ended up happening was PBOC basically transferred or allocated a part of foreign exchange reserves and transferred that into this special policy vehicle to recapitalize the bank.

Now, by IMF definition, the moment when the reserves are no longer in the hands of the manager authority, it is not reserves. So by default, this capitalization of Chinese banks through Central Huijin actually used implicit leverage because you decreased the risk of the foreign exchange reserves, that are supposed to be invested in safe and liquid assets, and have now been transferred them out to recapitalize Chinese banks.

[00:19:42] Kevin

I know I’m going to jump ahead here, but that turned out actually to be really successful, didn’t it? Because it allowed these banks to shore up their capital. Then you talk about, in the book, once that happened, they were able to sell equity to foreign investors, and then following that, they were able to 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.

[00:20:17] Zoe

Absolutely. I do think Central Huijin’s track record of crisis management has been pretty good. As a government-owned vehicle, it has become this, I would say, Shareholder in Chief of China’s financial institutions. Throughout the years, I’ve been closely following the debate about Central Huijin and there have been some conversations to say, well, given that Central Huijin has become so important, why don’t we basically have Huijin become the financial sector, or the financial analogy, of the SASAC?

SASAC is the institution that owns major state-owned enterprises, those who would be considered as the real economy. Why don’t we have Central Huijin as the financial representative of that given it’s already become so important as Shareholder in Chief owning major financial institutions. Reforming Chinese banks was one achievement or the first achievement of Central Huijin, and then in later years, when China’s stock brokerage firms had a problem, it stepped in. It also participated in the restructuring of China’s policy banks. So from there on.

I think right now, there is relevancy of Central Huijin, as China is experiencing another financial storm. I would not be surprised one day to read the news headline, China’s some of the bad debt managers, or the so-called asset management companies owned by the government, would one day be transferred or reformed under Central Huijin.

[00:22:05] Kevin

You talk about in the book first the first the bank recapitalization and then they rescued brokerage firms. That was important because with the stake in the brokerage firms and the connections there, that gave them a vehicle if they wanted to help support the equity market, they could do that. Do you think they might be operating now in helping to deal with the problems at the wealth management firms? Would they be already in action and that’s something we’ll hear about down the road? Is there a way for you to even kind of figure out what they’re doing in a semi-real-time basis?

[00:22:48] Zoe

Central Huijin has been one part of the so-called national team in terms of supporting China’s domestic stock market. There is another vehicle established under SAFE, or the State Administration of Foreign Exchange, that actually have historically participated in saving China’s stock market back in 2015 when the stock market crashed. Given their track record, they have done this before. That basically established the precedent. Therefore, they would perhaps do it again if there is a stock market crash.

But now if we are talking about the wealth management or the trust industry, I think that is a slightly different situation because the wealth management and the trust industry, they belong to the so-called shadow banking system. They are not necessarily in the same playing field with the state-owned commercial banks, but that does not stop, say, Central Huijin potentially stepping in because many of the important players in the trust industry as well as in wealth management industry are actually subsidiaries of state-owned banks either after the central government level or at the local government level.

A few years ago, there was this regional bank, Baoshang, in Mongolia province, in the news headline in those days. People were saying that, well, the People’s Bank of China is going to step in, but actually, it was not the PBOC, it was Central Huijin. So from that perspective, I would not be surprised if they decided to step in given that the shadow banking system, in particular at this moment, when people are worried whether the property… (as we are recording now, I think the Evergrande filed for Chapter 15 in housing court).

So if that going to trigger China’s Lehman moment, or even the fear of that. I would say Central Huijin would step in. It has the assets to do that.

[00:25:11] Kevin

So Central Huijin started off as, really, a vehicle (as you say) to kind of solve problems and still serves that function today. It seemed like, based on that success, there was a notion that, hey, well, instead of just having a vehicle that can solve problems, maybe we can have something that’s more proactive? That, ultimately, I think led to the establishment of CIC, China Investment Corporation, which became another vehicle for China to manage its foreign exchange reserves in a more aggressive way. It also had a very interesting founding structure which ties into your notion of sovereign leveraged funds. So can you just maybe tell us a little bit about the origin story of CIC, the history there?

[00:26:08] Zoe

Yeah. Thank you, Kevin. I really appreciate that you picked up on the founding, the structure of CIC, because I think that’s ultimately what makes China’s sovereign funds different from others. CIC, as we’re talking right now, CIC’s assets under management exceeded almost $1.3 trillion. That’s larger than the Mexican GDP, so it’s massive. When CIC was first established, obviously, it’s not from natural resource revenues, but the structure was that the Ministry of Finance issued a special purpose bond and used the bond proceeds to purchase foreign exchange reserves from the People’s Bank of China.

Obviously, it involved several designated state-owned commercial banks to buy this special purpose bond and all that, but the ultimate net effect is that the PBOC’s foreign exchange reserves decreased and those reserves are being transferred into this new institution called China Investment Corporation. Obviously, the investment asset allocation is going to be different because most of the foreign exchange reserves are invested in low-risk liquid assets such as US Treasuries, whereas CIC’s investment portfolio ranges from public equities to real estate and even infrastructure or startups, and so on.

So in this whole process, what we observe is that basically, we can think that the state has a balance sheet. You have a balance sheet expansion by the Ministry of Finance issuing a bond, and 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 US Treasuries, and that is leverage.

[00:28:03] Kevin

This is kind of jumping around a little bit. There’s also an interesting power dynamic there too, Because you’re transferring control of those assets from the central bank, which is (I started off my life working for the central bank), they’re conservative people, to the Ministry of Finance that obviously had a different agenda which is much more closely aligned with the central government. So can we talk a little bit about the evolution of CIC’s investment strategy? Because it seemed to me that there was a couple of learning curves there.

There was a financial learning curve, but there was also kind of like a political learning curve in terms of how do we structure investments to not only minimize political problems with foreign governments but to more closely align their goals with what the Chinese central government wanted to do. So when CIC started, how did it get started in terms of the type of investments it made?

[00:29:09] Zoe

When CIC was started, first of all, the domestic policy debate. in terms of foreign exchange reserve management, was how we are going to increase returns? Obviously, having most of the reserves invested in US Treasuries would incur unmeasurable and potentially large opportunity costs. You’re absolutely right, there is the power dynamics there because at that time, in 2006 and 2007, when CIC was established, the central bankers were not aligned with the Ministry of Finance in terms of riskier investments or, for that matter, reserve diversification.

The whole idea at that time, I remember talking with some central bankers, and at that time their whole idea was still very much that reserves in the central bank today might go away tomorrow. The whole experience of Argentina and the whole experience of the Asian financial crisis was still haunting them. But in the run-up to the global financial crisis, in retrospect, the timing was not necessarily ideal when CIC was established. But nonetheless, this would be a win for Ministry of Finance being able to, well, just to give us 200 billion and see what we can do with it.

[00:30:36] Kevin

I’d like to be able to say that.

[00:30:38] Zoe

I know, right? So the fact that the Ministry of Finance was able to make this happen is tremendous because there is this historical power struggle between the Ministry of Finance and the People’s Bank of China because during the Cultural Revolution, People’s Bank of China was reduced to a subsidiary of the Ministry of Finance. It was not until in the early 1990s, especially with the issue of the PBOC law, that the People’s Bank of China became sort of liberated from the Ministry of Finance.

So personally, in some of my conversations with Chinese policymakers as well as some retired central bankers, I felt that there are some feelings that revenge is kind of the sweet, in that kind of dynamic. But anyway, when CIC was first established, they had a very, very small team. One of my conversations with a former CIC employee, this person told me that at the initial funding time, they only had less than a dozen people managing this massive asset.

So the urge to reduce cash drag or the idea you have to quickly invest your money so that you can generate returns faster rather than holding cash; so the idea of reducing cash drag or the pressure to reduce cash drag was tremendous. That’s why even before CIC was called CIC, three months before the official plaque was put on the door, they decided to buy Blackstone.

At that time it seemed to be a good investment, especially knowing that China really did not have the financial expertise or the talent, and that was also the very first time that Chinese foreign exchange (what was reserves now is not reserves), the first time that this kind of money was going to be invested in Western market. So the stakes were high. I would say perhaps there was no better partners than Blackstone at that time.

[00:33:09] Kevin

What year are we? This is 2007? So they make a direct investment in Blackstone’s equity?

[00:33:18] Zoe

Yeah, it was a pre-IPO purchase. I believe, at that time, it was a few months right before the global financial crisis. They made the investment and then once the global financial crisis happened, obviously the share depreciated by more than 80%, so that was bad. But what is more interesting to me is that once CIC did this pre-IPO subscription of Blackstone, then Blackstone’s founders, the true founders Mr. Schwartzman and Mr. Peterson, they both sold their shares.

So I thought that’s kind of interesting because if I believe my shares are still going to go up or are not overvalued or undervalued, I’m going to hold on to it. But this kind of dynamic is interesting.

[00:34:16] Kevin

So they made several of these investments in US financial institutions that initially anyway not only struggled financially, but also didn’t look so great maybe politically. So there was a pivot or I guess maybe not a pivot, an evolution in their investment strategy and they moved on to doing more almost like limited partnership investments. They would invest in a fund, but they wouldn’t really control the investments. They would be a shareholder in a private equity fund, and then the private equity manager would go ahead and make the investments. Is that accurate? Is that the next stage in their evolution?

[00:35:03] Zoe

I think Kevin, you are right. Part of this evolution, as far as I am informed by my research, broadly speaking, there are two factors that influenced the CIC’s investment strategy and how this has evolved. Part of that was the domestic backlash against CIC’s investment loss, especially during the global financial crisis. The second aspect, and more relevant to today, is related to the backlash against China’s state-led and strategically oriented investment in Western territory.

The domestic backlash was that people became concerned about CIC’s investment loss and was quite obvious and (to a certain extent, to me) was dramatic. I thought, (especially when I went while I was in China doing my initial round of interviews and field research between 2016 and 2017), at that time, I thought this sovereign wealth fund, this subject should be a sort of niche topic. where regular Chinese people on the street wouldn’t have an interest in talking to you.

But I remember a cab, when I was on my way to Beidajie’s CIC headquarter in Beijing, I was in my cab and chatting with my cab driver. My cab driver asked me, “Why are you going to Beidajie? Why are you going there?” I said, I have a meeting with people there, with people working in CIC. He said, oh, CIC, I know, and he started lashing out. This person even called CIC’s money losing investment a traitor because they lost the Chinese people’s hard earning foreign exchange reserves.

Now, I think perhaps that was a little bit of an overstretch because perhaps he did not recognize there is difference between realized actual loss versus paper loss. From what he read, CIC lost a lot of money during the global financial crisis. The degree of public knowledge of the CIC’s overseas investment debacle was surprising to me.

Then there was the international backlash against China’s strategically oriented investment. I would have assumed real calm after President Xi Jinping came to power and more specifically with the rolling out of the Belt and Road Initiative and the whole idea of China’s state-owned investments not being, necessarily, for pure financial return concerns but also for strategic orientation.

That has made CIC’s overseas direct investments more difficult because, if you remember around 2013 (the year when China launched the Belt and Road Initiative), around that time, CIC also had its own organizational change. They elevated a direct equity office into an overseas direct investment subsidiary. There is a CIC domestic arm called Central Huijin, there is the CIC International, and the CIC Capital. So CIC Capital was supposed to make direct investment, but with the international backlash against China’s direct strategically oriented investment, as of last year, actually, CIC Capital not only lost their people, their talent, but as a branch, they no longer exist.

[00:39:00] Kevin

That’s interesting. So they’ve moved away from this direct investing, how are they executing indirect investments? You talk about a couple of different ways. There’s cooperation funds. There are also, I guess, just investment vehicles that are set up in financial centers that make investments into other funds. So what’s the primary way in which CIC makes these strategic investments and avoids or mitigates the foreign screening or the concerns of foreign government?

[00:39:40] Zoe

The primary way or mechanism that CIC has learned to do is to rather than making direct investment, they set up partnership funds or joint investment funds. You’re correct that there has been so many of them like China-Europe, China-Russia, and even China-America, US-China Industrial Corporation Fund led by CIC and Goldman Sachs. So this transformation happened around 2016.

At that time, the General Manager, Mr. Tu Guangshao, decided that that’s the way forward because of, on the one hand global backlash, on the other hand we started to experience the US-China relationship deterioration and a more stringent CPS screening. The idea is to use partnership funds, having more influential local partners, so that we can assist the way that CIC invests. The whole idea is to reduce foreign political backlash.

If we think about it in terms of investment managers, the idea is there is pure economic risk premium, and then there is a geopolitical or political risk premium. By partnering with a local partner, the idea is to reduce the negative political risk premium, if you will.

[00:41:12] Kevin

You gave a good example in the book of how that actually worked in the US with the China-US investment partnership. Can you tell us that story about Boyd when that fund wanted to buy a California company and then Congress raised a red flag and they were able to get it through?

[00:41:31] Zoe

Yes. So the fund that we are talking about, first of all, thank you for your careful read of my writing. This means a lot coming from somebody like you, The Rise of Carry. Certainly, you also talked about sovereign funds and their role in carry trade. Thank you.

So, that particular story really relates to CIC’s partnership with Goldman Sachs. The fund, a joint investment fund was announced when President Trump visited Beijing. During that time, the US and Chinese policymakers and US policymakers and non-leaders announced that there is going to be this US-China joint investment; US-China Industrial Cooperation Fund sponsored by CIC and Goldman Sachs. Since 2018, with the rise of the US-China trade war and tensions, the broader relationship, economic financial relationship between the two countries has deteriorated.

But even with this relationship deterioration and when CPS basically knocked down a couple of other Chinese investments in the United States for a variety of concerns, especially privacy data issues, Goldman Sachs was able to successfully convince CPS to say this is basically representing this investment, this transaction, this investment in Boyd, an advanced material engineering company, was able to convince that this investment does not involve a foreign alien, but rather this is a US person transacting with another US person, so from a regulatory perspective.

So that was the nature of the deal. So I think the lesson learned from that is that regardless of the actual source of the money of the joint investment fund, as long as the investment can be structured in a way that it is perceived, at least from a regulatory perspective, it is not a foreign alien, then it has nothing to do with CPS concerns.

[00:43:53] Kevin

Right. Fascinating. Yeah, we talked about the power dynamic shift from the PBOC to the Ministry of Finance. This is also part of the power dynamic because it puts a lot of power in the hands of the partner that CIC chooses in whatever country it operates.

We’ve got Central Huijin, we’ve got CIC, and then there’s a third organization that’s probably the least visible of the three, which is the SAFE, State Administration of Foreign Exchange. They also manage a huge amount of money, you say maybe as much as 1.5 trillion and they do it through, again, a complicated structure. But a lot of those organizations that SAFE uses are not even listed in the PBOC’s balance sheet. They’re kind of off-balance sheet, very difficult to figure out.

So you talk about two tools that SAFE uses. One is these investment funds, I think you call them the golden flowers or maybe that’s their nickname. Then there’s a second type of instrument called foreign exchange entrusted loans. Both of those are quite important for, again, diversifying how China manages its wealth. So can you just give us an overview of the first one of the various investment funds that SAFE uses to invest the foreign currency and how that operates, maybe how that differs from CIC?

[00:45:26] Zoe

Sure. The biggest difference between SAFE-affiliated or SAFE-owned investment vehicles versus CIC or China Investment Corporation is that SAFE funds are not transparent. At least CIC’s international arms, international portfolio are fairly transparent compared with other Chinese funds because CIC is a voluntary member of the Santiago Principles that governs sovereign wealth funds, whereas the SAFE is different.

Now, SAFE became more active since 2008 because at that time, it becomes more apparent, at least from Chinese policymakers and investor’s perspective, for them the opportunity cost of investing in not just US Treasury but perhaps dollar assets becomes risky and may not necessarily generate the best return because the global financial crisis originated from the United States. From their perspective, this combined with CIC’s investment loss during that time (paper loss), gives the People’s Bank of China and in particular SAFE (the arm that managed foreign exchange reserves) an opportunity to see what we can do.

At that time, the political environment was also more convenient for reserve diversification or even more active reserve management for two reasons. The first reason is that China’s foreign exchange reserves already surpassed 1 trillion, at that time, and then the voice for reserve diversification simply becomes louder because of obviously the loss in the US market and then China has more foreign exchange reserves and the opportunity lost for those people becomes more obvious.

The state-owned enterprise people, they even made a proposal to say we needed to use this reserve to support state-owned enterprises going abroad, this whole go out, invest abroad, purchasing oil and gas and mineral assets. At that time, those people started to voice their interest. Although there are still some concerns with people like Zhou Xiaochuan with classic central bankers, they are no longer as fully objective as they were before.

Even around the time, I remember the Zhou Xiaochuan gave a speech many years later around 2013. At that time, his perspective had already changed. In one of these speeches in Tsinghua University University, he said, perhaps we need to think about active reserve management such as the model of CIC. Now, I considered that as, coming from a central banker, that is dramatic. At that time, when SAFE became more active, or so-called less safe if you will, there were certain state council members who put out some serious writings and said these are the six areas that we can invest our foreign exchange reserves in, including natural resources as well as other strategic assets.

So now, in the context of clean energy transition, people started to realize how come China owns cobalt or copper mines in Democratic Republic of Congo or in Chile and elsewhere. A lot of these actually happened through what you just mentioned. One vehicle of the so-called SAFE’s entrusted loan program, and then there are also other vehicles that SAFE established such as through this institution called Buttonwood. SAFE was able to recapitalize major Chinese policy banks such as China Development Bank and Import and Export Bank.

We read of this, in the news headlines, a lot these days. But the fact that these two policy banks can become who they are today actually has a lot to do with the SAFE’s capitalization of them. Then there are also several other industrial corporation funds related to that.

[00:49:53] Kevin

It’s a fascinating web. Just to kind of summarize, you’re saying that SAFE was able to kind of a little bit, maybe using the model of Central Huijin, recapitalize the development banks and then once those banks were recapitalized, they were in a position to make loans to Chinese companies to go out and acquire these assets. Then there’s also the foreign exchange entrusted loan program where SAFE is essentially, through a bank, loaning foreign exchange again to state-owned enterprises mostly at really favorable rates, much lower than they would be able to get on the open market. Again, that supports their own ability to acquire foreign assets.

What’s interesting to me, and you do a really good job describing this, is that now all of a sudden… SAFE as part of the Central Bank of China. So all of a sudden, not that long ago, you had a stodgy reserve manager. Now you’ve got this kind of complicated global financing operation that’s lending money and it is lending money in a way that’s really supporting the strategic interests of the state and that’s kind of, in some sense, the broader theme of your book, is that these various vehicles ultimately, over time, become aligned with the state’s goals. They didn’t really start out that way. They’ve just kind of evolved, over time, to be more instruments of projecting power, I guess, or just acquiring assets that the state wants.

[00:51:31] Zoe

I think, Kevin, you are right. You describe the whole process very elegantly. If I can just add one example to justify this agenda and the point that you make. The central bank and the reserve management agency have become more aligned with the party in terms of strategic investment. If I can give one example. I would say it’s the Silk Road Fund. The Silk Road Fund was established specifically to finance President Xi Jinping’s Belt and Road Initiative. The primary capitalizer of the Silk Road Fund was SAFE.

SAFE provided 65% of equity investment in the fund. At that time, former PBOC Governor Zhou Xiaochuan, he described the Silk Road Fund as a state version of the private equity investor and the investor with a long-term horizon. Throughout the Silk Road Fund process, established throughout it’s life lifespan so far, it actually received a second round of a capital injection. It was at that time when President Xi Jinping in, I think it was 2017, in 2017 there was be a Belt and Road forum for international cooperation and Xi Jinping committed additional renminbi, 100 billion, to the Silk Road Fund.

At that time, the Deputy Governor of the PBOC, it was Yi Gang who then later became the central banker. So Yi Gang, he endorsed this plan the next day, after President Xi Jinping’s announcement. He literally said this is quite necessary and timely to expand Silk Road Fund capital. So, I just feel like you’re absolutely right. The first time when China leveraged it’s foreign exchange reserve was to capitalize Central Huijin to solve a crisis, and now even the central bankers themselves are more aligned with President Xi Jinping and the strategic aspect of it.

[00:53:42] Kevin

We’re kind of running down on time a little bit. I had wanted to ask about other countries imitating this. You seem to think that other countries, even Western countries, are looking at how China’s managed to leverage its foreign exchange reserves. So you think this is a model that we’ll see being deployed not just in China but across the globe?

[00:54:06] Zoe

I do think so. Before the Federal Reserve and the ECB and Western central banks had raised interest rates, and in particular during he time when in Europe when the interest rate was negative, many European countries were considering this whole model, the idea that you can borrow and then borrow at negative rates and then capitalize investment funds to achieve a higher returns. That’s a good model. I think the government of the Netherlands did that. During the global financial crisis, Ireland restructured their fund following a similar model, and so did Italy. I would say this is not unique to China.

It is not only unique to non-natural resource exporting economies either, because if you look around, Saudi Arabia, the PIF, the Public Investment Fund also issued a bond but for a different purpose. So from that perspective, I think leveraging the financial resources, whether it is for exchange reserve or oil assets or for strategic purposes (either for industrial policies or green transition), I would say this is going to happen and happen more often.

[00:55:20] Kevin

I’ve got my eye out for it now and I think all of us should. One last question, more just kind of personal curiosity. Could you write this book now if you started today? Because you go to China, do the field research, do the interviews, have the conversations, if you started doing that today as opposed to six or seven years ago?

[00:55:42] Zoe

If I started from scratch today, I don’t think I could get to the interviews that I got before. Part of the reason is because people may become very reluctant to talk to me, and then they have good reasons. I would also not want to expose my contacts to this kind of scenario. There is also this anti-espionage law, a very broad sort of coverage in terms of just anything potentially could be related to national security, it’s like a no, no. So perhaps in terms of the interviews, no.

But I would say that at least so far, the PBOC still publish their financial statement and the Silk Road Fund and all these funds, we still have numbers of publicly listed companies, or for that matter, Chinese investment in the United States, they still have to file an SEC report. So a lot of my research is based upon digging through SEC filings. I think that’s actually quite relevant. But the short answer is no, probably not.

[00:56:50] Kevin

Right. Well, then I’m really glad that you did the work when you did. It’s a service to all of us to have this out there. I look forward to reading your updates and your future research. So Zoe, thanks so much for taking the time to join us on the show. It was a real pleasure to talk to you and we wish you all the best.

[00:57:12] Zoe

Thank you Kevin for having me. It really means a lot to me to come on your show. Thank you.

[00:57:18] Kevin

Thank you. With that, we’re going to pass it back over to Niels.

[00:57:22] Niels

Thank you so much Zoe and Kevin for an absolutely fascinating look into how China manages their vast foreign exchange reserves, which perhaps is one of the best-kept secrets in finance until now. It was so interesting to hear how China has gone from the old model to essentially now have trillions of dollars managed off balance sheet and allocated not necessarily to get the highest returns and how there, today, seems to be very little difference in what the leadership wants and how the official institutions are allocating the money.

Knowing how the world is heading for the Green Revolution and that China today owns copper and cobalt mines around the world should really raise some questions among those promoting this agenda. Of course, the way they leverage local institutions like Goldman Sachs to reduce regulatory and political hurdles is not to be ignored.

That is it for today. Make sure you go and follow Zoe’s and Kevin’s work, as well as getting a copy of their books because as you can tell from today’s conversation, some of these ideas and topics are not being discussed enough on mainstream media. From Kevin and me, thanks so much for listening. We look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other.

[00:58:47] Ending

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