Milking nation's trillions could be hard

PUBLISHED : Thursday, 12 July, 2007, 12:00am
UPDATED : Thursday, 12 July, 2007, 12:00am

Lou Jiwei has a tough job ahead of him. Right now it does not look too hard. At the moment Mr Lou is one of the most sought-after players in international finance. As the boss of the mainland's proposed US$200 billion sovereign wealth fund, he holds the strings of a very large purse indeed.

Financiers around the world will compete to turn his head with their investment advice, hoping to pick up some of the handsome brokerage commissions or, even better, the lucrative asset management mandates he has in his power to dispense. Ordinary investors will hang on to his every word, aiming to front-run the fund's allocations. In the financial world, it is likely Mr Lou will rapidly attain rock star status.

Satisfying his bosses, however, may prove harder. In essence Mr Lou's job is to earn a better return on a chunk of the mainland's foreign exchange reserves - which the central bank announced yesterday hit US$1.33 trillion at the end of last month.

Chinese officials believe the returns all this money earns are too small. Most of it is held in US dollars and invested in US Treasury or agency bonds earning an annual yield of a little more than 5 per cent. However, given that the yuan is currently appreciating against the US dollar at an annual rate of about 5 per cent, that return is immediately wiped out. And considering that the central bank pays 3 per cent interest on the yuan debt it issues to fund its foreign exchange purchases, the actual return on the mainland's foreign exchange reserves is negative.

This is the situation Mr Lou has been told to address. But earning a positive return on his US$200 billion will not be as easy as it seems at first. If he is to cover the yuan's 5 per cent annual appreciation and funding costs of 3 per cent, Mr Lou will have to earn 8 per cent a year just to break even.

There are not many reputable assets out there yielding 8 per cent. Venezuelan or Argentinian government bonds would do the trick, or even Ford's corporate debt. But given their junk status, Mr Lou may find such investments uncomfortably risky.

The obvious alternative is to buy equities, but they can be risky too. Last month the mainland invested US$3 billion in the initial public offering of private equity company Blackstone Group. On listing, the stock promptly dropped below its offer price.

Mr Lou could parcel the money out to hedge funds. The Greenwich investable hedge fund index has returned an acceptable annualised 8.8 per cent over the last three years. But he will have to select his managers carefully. Over the same time span, those following directional trading strategies have returned just 0.2 per cent annually.

Earning a decent return will be hard, and it is likely to get even harder. Other countries too are setting up similar sovereign wealth funds to invest their reserves more aggressively. According to Morgan Stanley, the assets under management in such funds could reach almost US$12 trillion by 2015. Such a large weight of money entering the market could easily squeeze available yields, making returns even harder to come by.

The only way to succeed will be to take on more risk. But if Mr Lou loses money, what looks like a great job now will suddenly seem a lot less enviable.