China's Trillion-Dollar Game: Sovereign Wealth Funds || El Podcast EP51

Not all sovereign wealth fund investments are strategically oriented; many funds pursue financial returns and care about their international image, as evidenced by the International Monetary Fund's International Sovereign Wealth Fund Forum and the voluntary Santiago Principles agreement where major sovereign funds committed to investing based on market principles rather than strategic orientation.

“not all Sovereign wealth fund investment are strategically oriented you know they pursue they do care about their image and they do care about financial return and more specifically the IMF has this International summer Wells fund forum and amid the global financial crisis the concerns about strategically motivated investment actually uh triggered uh the US uh government to lead a conversation about how are we supposed to discipline this group of a state uh LED or state owned institutional investors”

The front line of great power competition has shifted from military battlefields to novel non-traditional security domains including financial markets, cyberspace, critical infrastructure, and corporate governance, where sovereign funds operate strategically.

“since the end of the Cold War the front line of great power competition has shifted from the military Battlefield to novel non-traditional security domains like financial markets cyers space critical infrastructure and corporate governance”

The Chinese government builds infrastructure projects (bridges) that may not have clear economic utility because counting construction as GDP contribution creates the appearance of economic growth even if the assets don't generate productive returns, exemplifying how GDP can be manipulated through what is technically counted as economic activity.

“I was reading a book I forget the name of it I think it might have been called the Chinese Playbook where he was talking about how they would build like just Bridges to nowhere because if you build a bridge it counts as part as the part of the GDP so it's like well you might have a high GDP but is it actually benefiting anyone”

China is already the world's largest exporting economy, which means the room for expansion in exports is limited unless China begins trading with Mars or Venus, so export-driven growth has structural constraints.

“part of the demand also comes from X and again China is already the world largest exporting economy unless China started to trade with Mars or Venus I you know the room for expansion is limited”

High aggregate GDP does not indicate a healthy economy; the United States has the leading global economy but still has structural problems including income inequality and other challenges, suggesting GDP metrics alone are insufficient for assessing economic health.

“you know aggregate the GDP number does not mean the economy is good even in the United States despite that we are the leading economy in the world we are still having a lot of structural problems here we have you know income inequality we have all sorts of things”

If Chinese per capita GDP were to reach the level of countries like Latvia or Greece (approximately $17,000-18,000), Chinese aggregate GDP would exceed that of the United States in total value, demonstrating the logarithmic potential of reaching US-level per capita prosperity.

“if the Chinese GDP were to reach the of lva or Greece meaning from $112,000 to 17 18 $119,000 the Chinese GDP is going to be bigger than that of the United States as of last year”

Debt itself is not inherently problematic in national economies; leverage is a basic finance principle and can magnify returns when debt growth can be serviced. The problem for China is not debt per se but that the cost of servicing debt and the growth of assets has become slower than debt growth, making the situation unsustainable.

“I don't think debt itself is a problem because the issuance of debt the use of Leverage that's Finance 101 you leverage the hell out of your balance sheet as long as you can service it and that is how you get money so taking on Leverage can sometimes magnify your return and for personal finance for in institutional investors for for for National growth so but but the problem is if the cost of servicing your debt and the growth of your asset becomes slower than Deb growth that becomes not sustainable right”

China Investment Corporation's first investment in a Western financial market was a pre-IPO subscription in Blackstone in 2007, before Blackstone's IPO, motivated by gaining access to financial expertise, talent to manage money, and to avoid cash drag, but the investment also gave CIC exposure to Steven Schwarzman's influence in US policy-making circles.

“cic's very first investment in Western fincial Market uh Black Stone that was in the running up of global financial crisis in 2007 and that was also before blackstone's IPO so cic invested y blackstone's pre-ipo subscription and the motivation from my conversation with um for Mercy as employees as well as um people who are familiar with the transaction um basically the Chinese investors motivation was that on the one hand when cic was first established it had too much money uh to be managed by a very small team the the initial uh injection by the government was about two was $200 billion and when CI was the first established that they had less than a dozen people so from that perspective is it was a lot of money to be managed by a small team so if the money did not get to be invested very soon it created something called Cash drag the idea that you it create opportunity cost right”

The Chinese government employed explicit leverage in creating sovereign funds by having the Ministry of Finance issue special purpose bonds, having designated state-owned commercial banks purchase those bonds, then using bond proceeds to purchase foreign exchange reserves from the People's Bank of China, thereby moving reserves outside the monetary authority's balance sheet so they would no longer count as official foreign exchange reserves.

“the explicit part specifically involves the government or more specifically the Ministry of Finance issue special purpose Bond and then have designated Chinese commercial Banks which are state owned and have those designated Banks to purchase the special purpose Bond and then Minister of Finance use the bond proceed to purchase foreign exchange reserves from the uh People's Bank of China and the moment when Foreign Exchange Reserve assets move the pocket or the account uh of the PB The People's Bank of China or the Central Bank of of China the moment when the reserve moved outside of the monitary authority they are no longer counted towards foreign exchange reserves”

The Sovereign Wealth Fund Institute's $2.5 trillion estimate for Chinese sovereign funds may be conservative because it likely focuses on officially disclosed funds like CIC and subsets of SAFE-affiliated investment institutions, while SAFE does not publish complete asset management numbers for less transparent subsidiaries, making any robust methodology estimate equally valid.

“it is I think you know anybody's estimate would be sort of equally good specifically because China there is a difference between the official foreign exchange reserves versus all these foreign exchange asset managed by China's Sovereign funds and the The Sovereign wealth fund Institute as made probably focus on China Investment corporation as well as some subset of investment institutions Affiliated or established by safe State administration of Foreign Exchange which is the Foreign Exchange Reserve management arm of China's the Chinese central bank right and because safe does not necessarily publish the specific numbers or asset under management managed um by its sort of less uh transparent subsidiaries”

Some Chinese policymakers view Steven Schwarzman as one of very few people who can 'whisper messages into US top officials,' making his influence in US policy-making circles valuable to China beyond financial returns.

“some Chinese interlocutors even explained to me saying that for for many inside Chinese policy making Circle people view Mr Steven schorman as one of the very few people who can whisper messages into US top officials”

China's initial motivation for establishing sovereign leveraged funds was not global power projection but solving a domestic crisis: the Chinese banking system and state-owned commercial banks were crippled by non-performing loans in the early 2000s, requiring recapitalization.

“the very first time that China leveraged this for Sovereign weals leveraged his foreign exchange reserves was not for Global power projection or anything like that but it was to solve a domestic crisis that was in the early 2000 the Chinese banking system or specifically the state-owned commercial Banks were crippled by non-performing loans and then at that time again this sort of like goes back to the question of follow the money find the politics at that time Ministry of Finance did not have the capacity to recapitalize the banks”

If Western countries were to sanction China, the cost of sanctions would be much higher than Russia sanctions because China's economy is deeply integrated into global supply chains and the world depends on Chinese exports across multiple sectors, whereas Russia's exports are primarily oil and gas.

“if the West were to sanction China perhaps or Chinese entities perhaps the cost of sanction against China is going for the sanctions is going to be way much higher than sanctioning Russia because Russia's primary export um is is oil and gas and sanctioning Russia on the one hand accelerating the global renewable or clean energy Revolution and then on the other hand the United States does not a necessary or the world that does not necessarily depend so much on Russian oil or gas because you have new producers coming out of Elsewhere in the world and the United States as well as Saudi Arabia are very much a swing producer”

They value things more than just financial returns from their Blackstone investment, seeking strategic advantage through connections to powerful individuals, though Dr. Lou does not explicitly state whether this has resulted in actual policy influence.

“from that perspective they do value things more than just the financial returns”

China's sovereign funds are anomalies among world sovereign wealth funds because China is the world's largest importer of commodities rather than a commodity exporter, making the existence of massive Chinese sovereign funds perplexing when compared to the traditional commodity-export model.

“China actually also has the so-called Sovereign Wells fund and many scholars have done research on China's Sovereign WS fund including more specifically China Investment corporation but I would argue that China is a sovereign wealth fund as people would claim summer Wells fund is actually very much different from what you would anticipate because China has become one of the world's leading commodity importing economies when you think about a Sumer WS fund most of them are in you know Arabian Gulf economies how could China have uh s walls fund where where does the money come from”

There is a critical distinction between renminbi internationalization (attempting to dethrone the dollar as global reserve currency) and cross-border use of renminbi for trade settlement, which are fundamentally different objectives.

“I think there is a difference between what the Chinese wanted to do in terms of REM internationalization and the crossborder use of Remi to support trade settlement and trade flow is very much different from the dollarization or thring the King Dollar”

As top Chinese leadership changed and the Communist Party's vision evolved after 2013, the functions of government agencies and policy-oriented financial institutions like sovereign funds changed dramatically, including taking on the function of supporting the Belt and Road Initiative.

“as the top leadership change as the party's Vision change uh a lot of the functions of the government agencies as well as policy oriented financial institutions would change right and in the case of a China summer leverage fund whether it is a cic or safe Affiliated various investment institutions before 2013 they they didn't necessarily have the function to support the Bel and Ro Initiative for example but after 2013 with the launch of the Bon Road initiative by President xinping various Sovereign funds as well as policy Banks all have taken that kind of function to support project Under the Umbrella of the Bon Road in initiative”

The Costa Rica investment case demonstrated to Chinese policymakers that outright, high-profile use of financial influence to change a foreign government's behavior, especially on highly sensitive issues like Taiwan that touch on China's national sovereignty, generates international backlash and is 'not necessarily the best practice' compared to more subtle approaches.

“from a Chinese Sovereign funds perspective is a lesson learned because outright use of financial influence to change the behavior of a foreign government specifically on a highly sensitive issue is to the core of China's Sovereign sovereignty uh or national security and it is also a core issue in uh China's relationship with many countries in the world or for that matter us China relations so it's a lesson learned for the China's s funds more specifically from the perspective of well you know perhaps this kind of high-profile use of money is not necessarily the best practice and it generate more backlash than some other more subtle ways”

No Chinese leader, not even President Xi Jinping, has stated that China intends to dethrone or dedollarize the global financial system; even President Putin of Russia said that Russia's development of alternative payment systems was not because Russia wanted to dedollarize but because sanctions forced defensive measures.

“no Chinese leader leaders has have ever said that China has the intention to dollarize or Dethrone the US dollar never said that even President Putin he himself said that um it's not that Russia wanted to dollarize it's just that if they were under sanctions you know this is he said that after 2014 when uh when several European leaders proposed the idea of kicking Russian financial institutions off Swift in that particular context that was a trigger sort of accelerated Russia's development of its own uh payment system”

China has accumulated foreign exchange reserves that peaked at over $4 trillion and have stabilized at slightly above $3 trillion in recent years, creating the financial base for sovereign funds, though this alone is a necessary but insufficient explanation for their creation.

“China has a lot of Foreign Exchange reserves and at its height China has more than $4 trillion dollar of Foreign Exchange reserves and today it has stabilized over the past a few years at slightly above $3 trillion”

BlackRock alone manages around $10 trillion, which is approximately equal to the total of every sovereign wealth fund in the world combined, demonstrating the scale difference between private asset managers and sovereign funds.

“Black Rock alone manages around $10 trillion which is essentially the total of every Sovereign wealth Fund in the world combined”

China does face structural problems that Lou has analyzed using a framework of the 'Four Ds': Debt, Demographics, Demand, and Decoupling/De-risking, which represent interconnected economic challenges requiring attention.

“China does have structural problems and I have written um China's structural problems that need to be addressed and I summarize China's problem from the that's what I my framework of analyzing China is the for D that demand demographics and a decoupling or der risking right”

Countries, particularly China, don't actually want to eliminate or replace the US dollar because China holds more than $3 trillion in foreign exchange reserves with significant portions invested in dollar-denominated assets, meaning China would be a major loser if the dollar were dethroned.

“countries really don't necessarily want to get rid of US dollar I mean in the dollarized world China probably would be the one of the largest losers because you know at least three more than three trillion dollars of Foreign Exchange reserves of the significant portion of that is invested in dollar denominated asset and on top of that you also have all these Sovereign funds invested in uh dollar denominated asset market”

People making predictions about the collapse of major countries like the United States or China are common, but historically both countries have withstood significant global financial turmoil and crises, suggesting predictions of collapse should be treated skeptically.

“people have making the predictions saying that countries would collapse either the United States or China you know I've heard this kind of predictions all the time but it it seems that the United States has withstand a lot of Global Financial turmoil and so has China”

Critical thinking and exchange of ideas are essential in an age of information explosion where algorithmic feeds and search engines can reinforce confirmation bias, and podcasts enable the kind of idea exchange that counters this tendency.

“we are living information explosion here people are not unfamiliar with all sorts of information and sometimes we might find that our cell phone or our search engine our computer might just feed as whatever we we like so that really takes a higher degree of demand for critical thinking and for exchange of ideas so podcast like this actually allows people to have an exchange of ideas so I encourage people to you know listen to your program”

Major institutional investors' large moves inevitably influence markets, and prestigious investors like Warren Buffett create a 'Buffett effect' where their investments signal quality and attract additional capital, while sovereign funds and sovereign leveraged funds create a similar 'brand effect' where companies attract long-term oriented investors and signal state alignment.

“in terms of the size any major institutional investors a big move would uh inevitably influence market right and for prestigious institutional investors such as waren Buffet there is legitimate the so-called Buffet effect the idea that is actually a shield of proof the idea that if I got buffi investment it it it shows that you know it I am a good company or I I I value something or in certain way I value more than whatever Market is currently evaluating me so it helps to attract additional investment and that's where stare wellth fund investment or St leverage fund investment actually sort of have the similar effect the idea that companies wanted to attract long-term oriented investors such as Norwegian Sovereign fund or tasac or China Investment corporation and so on so forth there is this brand effect”

The Santiago Principles, while representing a voluntary international agreement, lack an enforcement mechanism, making them similar to much of international law; without enforcement, countries cannot easily prevent hostile or strategically motivated investments without appearing to violate market principles and free capital flow norms, creating a regulatory headache.

“it is voluntary the San dieago principle is voluntary the idea and it is more like a international agreement but you know it it is like a lot of international law there is not necessarily an enforcement mechanism and given that it is international you know this is international sort of International Space you cross border Capital flows um if Western economies don't NE in particular you know operating on Market principle uh nobody wanted to give the impression that they are influencing they they are practicing either Capital controls or uh close their border so from that perspective it has become a regulatory headache in terms of how countries can defend their own strategic industry from or against against undesired a hostile takeover or you know strategically oriented investment”

Kuwait created the first sovereign wealth fund in 1953 by funding it with surplus oil revenue, establishing the commodity-export model that most global leading sovereign wealth funds have followed, including Saudi Arabia, UAE, Qatar, and Norway.

“Kuwait created the first Sovereign wealth Fund in 1953 funding it with Surplus oil Revenue what exactly are sovereign wealth funds in and how have they evolved since the 1950s”

Peter Zeihan, a geopolitical analyst, predicts that China will collapse economically within the next 10 years, citing factors such as declining and aging population as well as escalating debt levels.

“Peter Zan the fame geopolitical analyst he predicts that China will collapse the next 10 years at least economically and he cites factors such as a declining and aging population as well as escalating debt levels”