Closer fund scrutiny becomes sovereign idea

PUBLISHED : Monday, 17 December, 2007, 12:00am
UPDATED : Monday, 17 December, 2007, 12:00am

News that the China Investment Corporation - the mainland's new US$200 billion sovereign wealth fund - is looking for outside companies to manage some of its money will help to allay the suspicions of those international sceptics who doubt the fund's purpose and motivation.

Yet as a new research paper from the Asian Development Bank makes clear, the rule book for sovereign wealth funds has been re-written over recent months. In the current environment, the CIC's managers will have to do a lot more than farm out some of their funds if they want to meet the latest international standards of best practice.

The CIC was set up to maximise returns on a portion of the mainland's rapidly growing US$1.5 trillion pool of foreign exchange reserves (see chart), most of which is parked in low-yielding US Treasuries and agency debt.

But the people who run the CIC face two big problems. Firstly, every investment they make is going to be ruthlessly scrutinised at home to see if it generates a decent return.

The fund's bosses have already learnt this lesson. Their first investment, made back in June, was a US$3 billion slice of the initial public offering in US private equity company Blackstone. Alas, Blackstone's shares promptly dived on listing, and have now lost almost 30 per cent of their value in yuan terms, exposing the CIC's managers to withering criticism in China's internet chatrooms.

The fund's chiefs will be anxious to avoid any repeat of the Blackstone fiasco, but they will be equally nervous of international censure. Because the CIC is a state-controlled body, critics around the world will immediately assume that the fund's real objective is not to maximise investment returns, but rather to flex the mainland's financial muscle in support of Beijing's political aims.

For example, last month, US senator Evan Bayh told an influential senate committee on banking that 'a lack of transparency that characterises many sovereign wealth funds undermines the theory of efficient markets at the heart of our economic system.'

At the same time, rumours abound that Washington may block the proposed acquisition of a 16.5 per cent stake in US computer network company 3Com by Huawei Technologies on national security grounds. Meanwhile in Brussels, the European Commission is pondering new rules to govern investments by sovereign wealth funds.

If they are to overcome these doubts, the CIC's managers will have to pay close attention to a stringent set of standards for sovereign wealth funds outlined recently by the Asian Development Bank.

First of all, political objectives should be slung out the window. 'Using a state-owned financial institution to pursue non-economic objectives inevitably muddles purpose,' warned the ADB. Political aims will not only confuse managers with conflicting objectives, they will lower the fund's investment returns.

'A narrow focus on the pursuit of fiscal dividends, served by a commercially-oriented and operationally independent agency has compelling attraction,' argues the ADB. 'Experience and analysis suggests that sovereign wealth funds become more effective investment vehicles when commercial objectives are paramount and reflected in autonomous operational structure.'

According to the ADB's prescription, governments setting up sovereign wealth funds should dictate a simple objective of maximising investment returns within acceptable levels of risk and then back off. And they should ensure maximum transparency.

'The sole criterion for assessing a fund's performance should be the rate of return,' the ADB advises. And day-to-day operations should be completely independent. 'Once the government or central bank interferes with how the fund carries out its business, profits will inevitably suffer for the simple reason that motives other than profit maximisation will enter the picture.'

And although it may go against the grain in Beijing, the sovereign wealth fund operations should be entirely open to public scrutiny. According to the ADB, transparency reassures the public that their money is not being misused, it helps ensure that the interests of the fund's staff are aligned with the objectives of the fund itself, and it is needed to soothe suspicious foreign regulators. 'Lack of transparency is not an option,' the ADB warns.

Employing external managers is a good way for the CIC to make sure it comes up to the ADB's standards. But judging from the fund's efforts to recruit its own money managers, it plans to run at least some of its assets in house.

Here the CIC should tread carefully. As the ADB warns, the fund will simply not be competent to invest successfully in areas like private equity, venture capital and real estate. 'A gradualist approach of learning-by-doing is probably necessary,' the bank advises. 'Moving into risky assets without adequate institutional capacity may lead to big early losses.'

The early signs are that the CIC's managers are heeding this advice and are going to tread carefully in international markets. This is just as well; not only are the eyes of China's own self-proclaimed chatroom experts trained on them, but nervous international observers are watching carefully to make sure the CIC lives up to the demanding standards of best practice outlined by the ADB.

Jake van der Kamp is on holiday