Sovereign Funds: How the Communist Party of China Finances Its Global Ambitions

By Zongyuan Zoe Liu

The first in-depth account of the sudden growth of China’s sovereign wealth funds and their transformative impact on global markets, domestic and multinational businesses, and international politics.

One of the keys to China’s global rise has been its strategy of deploying sovereign wealth on behalf of state power. Since President Xi Jinping took office in 2013, China has doubled down on financial statecraft, making shrewd investments with the sovereign funds it has built up by leveraging its foreign exchange reserves. Sovereign Funds tells the story of how the Communist Party of China (CPC) became a global financier of surpassing ambition.

Zongyuan Zoe Liu offers a comprehensive and up-to-date analysis of the evolution of China’s sovereign funds, including the China Investment Corporation, the State Administration of Foreign Exchange, and Central Huijin Investment. Liu shows how these institutions have become mechanisms not only for transforming low-reward foreign exchange reserves into investment capital but also for power projection. Sovereign funds are essential drivers of the national interest, shaping global markets, advancing the historic Belt and Road Initiative, and funneling state assets into strategic industries such as semiconductors, fintech, and artificial intelligence. In the era of President Xi, state-owned financial institutions have become gatekeepers of the Chinese economy. Political and personal relationships with prestigious sovereign funds have enabled Blackstone to flourish in China and have fueled the ascendance of private tech giants such as Alibaba, Ant Finance, and Didi.

As Liu makes clear, sovereign funds are not just for oil exporters. The CPC is a leader in both foreign exchange reserves investment and economic statecraft, using state capital to encourage domestic economic activity and create spheres of influence worldwide.

• Language: English
• Publisher: Harvard University Press
• Release date: Jun 20, 2023
• ISBN: 9780674293403

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Cover: Sovereign Funds, How the Communist Party of China Finances Its Global Ambitions by Zongyuan Zoe Liu

SOVEREIGN FUNDS

How the Communist Party of China Finances Its Global Ambitions

ZONGYUAN ZOE LIU

THE BELKNAP PRESS OF HARVARD UNIVERSITY PRESS

Cambridge, Massachusetts

London, England

2023

Copyright © 2023 by the President and Fellows of Harvard College

All rights reserved

Cover design: Graciela Galup

Cover art: Getty Images

978-0-674-27191-3 (hardcover)

978-0-674-29340-3 (EPUB)

978-0-674-29339-7 (PDF)

The Library of Congress has cataloged the printed edition as follows:

Names: Liu, Zongyuan Zoe, author.

Title: Sovereign funds : how the Communist Party of China finances its global ambitions / Zongyuan Zoe Liu.

Description: Cambridge, Massachusetts : The Belknap Press of Harvard University Press, 2023. | Includes bibliographical references and index.

Identifiers: LCCN 2022042096

Subjects: LCSH: Zhongguo gong chan dang—Finance. | Sovereign wealth funds—China. | Foreign exchange—China. | International finance. | Globalization—China.

Classification: LCC HG3978 .L658 2023 | DDC 332.450951—dc23/eng/20221207

LC record available at https://lccn.loc.gov/2022042096

To my parents, LI LIU and XINGKAI LIU,

who made innumerable sacrifices to send me to America for education

to my mentor, DR. KENT CALDER,

who has always firmly believed in me and inspired me as a scholar

and to my husband, DANIEL STEMP,

who is the light of my life

Contents

Introduction

1. China’s Evolving Perspectives on Foreign Exchange Reserves

2. Central Huijin

3. China Investment Corporation

4. State Administration of Foreign Exchange

5. Sovereign Funds in a Changing Global Geoeconomic Landscape

NOTES

ACKNOWLEDGMENTS

INDEX

Introduction

The January 19, 2008, edition of The Economist had on its cover an image of three large tandem-rotor military helicopters, each hauling a pallet full of gold bars and emblazoned with the flags of China, Singapore, and Kuwait. Above the fleet of helicopters, the headline announced the impending invasion of the sovereign wealth funds. This hyperbolic declaration was a reference to several sovereign wealth funds (SWFs) from Asia and the oil-rich Arabian Gulf that had in the week prior pumped $69 billion into troubled Western financial institutions, some of which were among the world’s largest banks and investment managers.¹ At that time the collapse of Lehman Brothers and the advent of the 2008 global financial crisis were still more than nine months away. The prevailing attitude of Western policymakers was still mostly averse to the notion of wide-scale market intervention, which some economists half-mockingly described as drops of helicopter money. Later that same year, when global financial market turmoil forced major central banks to inject hundreds of billions of dollars into the international banking system, such helicopter money was rebranded with the sufficiently technocratic polite euphemism large-scale asset-purchase programs. Although the cash injections from the SWFs were ultimately not enough to rescue the companies in which they invested, SWFs had proven themselves to be the crisis’s first responders.

As state-owned investment funds, SWFs were the first institutions to deploy sovereign capital in a bid to steady markets while it was still possible to prevent the spread of financial contagion and avoid the financial sector dragging down the real economy. SWFs were able to beat other government institutions onto the scene of the crisis precisely because they were proactive participants inside financial markets rather than regulators operating outside of markets. The ability of SWFs to act promptly makes them a potentially invaluable tool for governments, but one that can be effectively wielded only if governments are willing to redefine the boundaries of the state–market dichotomy. One reason Western governments are understandably hesitant to redefine the relationship between state and market is that the existing relationship had been functioning seemingly well up until the last decade. In 2019, when many leaders in the West were congratulating themselves for having recovered from the 2008 financial crisis, global financial markets were again cast into chaos, this time by the COVID-19 pandemic.

The cost of the COVID-19 crisis was more than double that of the preceding crisis. MIT professor Deborah Lucas estimated the total direct cost of US government bailouts in the 2008 crisis to have been 3.5 percent of GDP ($500 billion), whereas the International Monetary Fund (IMF) estimated that in the first year of the COVID-19 pandemic, the US government had spent 8.8 percent of GDP ($1.8 trillion) on economic stabilization.² This double-dip into crisis is undermining public confidence in government and the economy. The high cost of the most recent bailout has contributed to higher inflation rates while simultaneously fueling doubts that governments will have the fiscal capacity to adequately respond to the next economic crisis. Google web search trends showed that the term stagflation, an economic condition in which both inflation and unemployment are high, was more popular in the public discourse in June 2022 than at any time since the eve of the last crisis in February 2008. During the last decade, financial instability has exacerbated social inequality and driven the deterioration in social cohesion.³ Consequently, the vulnerabilities of the Western capitalist system and the boundaries of state–market relations are arguably more subject to debate today than at any other time since the 1970s.

Against a backdrop of heightened socioeconomic angst, it is not surprising that many publications that shape Western political debate deliberately blend the imagery of finance and war when discussing SWFs. This editorial choice reflects the perceived national security impact of capital flows. It implies that countries with abundant state-owned capital could weaponize their financial power and pose a security threat to countries that receive capital inflows. Mounting concerns over SWFs are symptoms of the profound anxiety that capital flows from SWFs are a sign of the West’s waning influence and that SWFs’ geopolitical motivations could harm the future of the liberal democratic capitalist system. Such concerns partly stem from the fact that SWFs represent a state-led approach to capital allocation that did not originate in the West and remains somewhat unfamiliar despite the expanding footprint of SWFs in the global financial system. Between 2008 and 2021, global assets under management at SWFs more than doubled from about $4 trillion to exceeding $10 trillion.⁴

The apparent socioeconomic consequences of SWFs’ investments in Western firms add to distrust in capital-recipient countries. SWFs’ investments inevitably dilute the existing shareholders in a target company, tantamount to the replacement of domestic elites by foreign interests in the ownership class. This change in ownership composition can trigger political conflict at the local level unless the SWF remains a silent partner, as the domestic managerial class is much more responsive to the concerns of foreign ownership than to those of the labor force and the surrounding community. This tension is the theme of the 2019 documentary film American Factory produced by former president Barack Obama. The dilution of existing domestic shareholders’ rights by foreign state-owned capital and the displacement of domestic elites by foreign national interests represented by SWFs feeds into national security concerns, especially when the target company is in a strategic industry. The concern is that SWFs use their capital to buy more than just equity shares in target companies; they are also buying influence in Western corporate boardrooms that can translate into strategic advantages for foreign governments by virtue of the extensive rights granted to shareholders in many Western legal systems.

As Jonathan Kirshner argued, the 2008 financial collapse eroded US dominance in global politics, and the United States has since found itself increasingly unable to enforce its political and economic priorities in an increasingly recalcitrant post-crisis world.⁵ China’s sovereign funds debuted in global financial markets in 2007 and have since expanded in scale and scope, contributing to a narrative of Western decline and the twilight of American hegemony.⁶ By deploying sovereign capital to acquire strategic overseas assets and exploit the exalted rights granted to shareholders in capitalist economies, China has the potential to outmaneuver the United States as each looks to assemble regional economic blocs to the detriment of the other. By using China’s state-owned capital to fill the cash coffers of Western firms while advancing national interests, China’s sovereign funds could quietly use the US-led global economic system to put an end to American hegemony. If US policymakers fail to understand the political-economic model of China’s sovereign funds and how they advance the global ambitions of the Communist Party of China (CPC), then the United States risks surrendering its leadership in financial markets earlier than anticipated and in unexpected parts of the world.

As the power of nations ebbs and flows over time, the only constant is the evolving nature of their competition. Since the end of the Cold War, the front line of great power competition has shifted from the military battlefield to novel nontraditional security domains like financial markets, cyberspace, critical infrastructure, and corporate governance. A state lacking the ability to project power in the traditional sense may invent new means to outcompete rivals that are more powerful economically or militarily. China’s sovereign funds are such an innovation. They employ leverage to transform China’s comparative advantage in international trade derived from manufacturing into a long-term strategic advantage in global financial markets and other areas prioritized by the Communist Party of China and the Chinese state (the Party-State).

Political Economy of China’s Sovereign Leveraged Funds

The Chinese sovereign funds complex comprises two leading funds with dozens of affiliated investment funds that collectively managed more than $2 trillion in assets at the end of 2019. No similar fund exists in the United States. Although several other countries have established funds using the same model, none can compare to the Chinese sovereign funds in scale. Among China’s sovereign funds, China Investment Corporation (CIC) has received the most scholarly interest and media attention. Besides CIC, China has several other, more obscure investment funds affiliated with the State Administration of Foreign Exchange (SAFE), the foreign exchange management arm of the People’s Bank of China (PBoC). Although these SAFE-affiliated investment funds are not as well known as CIC, they have established a global network that collectively managed at least $1 trillion in assets as of 2019. Over the past decade, China’s sovereign funds have injected capital into several state-owned policy-oriented investment institutions, such as the China Development Bank, Export-Import Bank of China, and the Silk Road Fund. These policy-financing institutions have played an instrumental role in directly financing the Belt and Road Initiative (BRI), the centerpiece of President Xi Jinping’s foreign policy that aims to construct a new global trade network aligned with China’s vision for the world.

China’s sovereign funds are outliers among the world’s SWFs, which are primarily commodity-based funds established in oil-rich states, including Norway and countries throughout the Middle East and Africa. As the world’s largest importer of commodities, China has relatively little in common with the countries traditionally associated with SWFs. It is perplexing that China should have such massive sovereign funds in the first place. Researchers have pointed to China’s excess foreign exchange reserves as the impetus for China’s sovereign funds, but this is an insufficient explanation. A new framework is required to properly understand the origins of China’s sovereign funds and their political-economic functions. This book analyzes China’s sovereign funds by following a simple research principle: follow the money, find the politics. This approach is operationalized by using financial statement analysis to investigate the capital structures and asset allocations of China’s sovereign funds, including the sources of their capital, the conditions for capital transfer into the funds, their balance sheet strength and risk exposures, and the individuals involved in the funds’ most consequential investments. By closely following the money, one is able to uncover the politics that steered the flow of capital into China’s sovereign funds and the geopolitical motivations that drive the funds’ asset allocation.

Before introducing this book’s framework for analyzing China’s sovereign funds, some explanation of SWFs in general is necessary. The term sovereign wealth fund was first used in 2005 by Andrew Rozanov in his article Who Holds the Wealth of Nations? Rozanov defined SWFs as sovereign-owned asset pools, which are neither traditional public pension funds nor reserve assets supporting national currencies.⁷ According to this definition, commodity-based SWFs have existed for more than six decades. The first government-owned investment fund that would later be labeled a SWF was the Kuwait Investment Authority, established in 1953 and capitalized by the monetization of oil wealth found in the state. The 1970s saw the launch of a few more resource-based funds, but most present-day SWFs emerged after 1990. These commodity-based SWFs were capitalized by natural resource revenues and act as a national savings account; their investment revenues help smooth out the effects of commodity price fluctuations and stabilize national fiscal budgets. Such fiscal buffers are crucial to insulating these economies from the vagaries of global commodities markets. By 2007, SWFs had already achieved an impressive scale, managing more than $3.1 trillion in assets—about the same size as the entire US money market fund industry.⁸ Despite their size, SWFs have historically maintained a relatively low public profile.⁹

China’s sovereign funds are unlike commodity-based SWFs and represent an entirely new class, which I term sovereign leveraged funds (SLFs). A distinctive feature of SLFs is their funding scheme, which relies upon a series of complicated transactions, including debt issuances and other forms of implicit financial leverage. SLFs are a political-economic innovation because they are the product of the state leveraging its financial and political resources to make it possible to capitalize a fund without relying upon a high-profit revenue stream like the export of commodities. To fully understand the political economy of SLFs, one must also understand how the state takes on financial leverage. The state can assume either explicit leverage, by issuing debts, or implicit leverage, by recharacterizing the risk profile of existing low-risk assets. A stylized balance sheet of the state can most clearly illustrate the difference between these two approaches. The key point is that explicit leverage and the issuance of new debt leads the state to expand its balance sheet. In contrast, implicit leverage increases the state’s overall risk profile without expanding its balance sheet. Unlike traditional commodity-based SWFs, neither of these approaches to leverage relies in any way upon natural resource revenues. A state without significant natural resource revenues can take on explicit or implicit leverage to source the seed capital for the founding of a sovereign leveraged fund.

The most straightforward way for the state to raise capital for its sovereign leveraged fund is to issue new government bonds or some other form of government debt. This allows the government to raise new capital from private markets, add it to the existing stock of available capital, and deploy the combined lot via a SLF as investments in risky assets. From an accounting perspective, the state has expanded its balance sheet and increased its use of financial leverage. The result of such financial engineering is that the state becomes explicitly leveraged because the newly issued debt remains on its balance sheet. The decisions about how the newly issued debt will be underwritten and who will ultimately control the resultant SLF are the product of intensive political negotiation and aggressive bureaucratic competition. Chapter 3 discusses China Investment Corporation as a case of the state taking on explicit leverage to establish a sovereign leveraged fund.

An alternative approach for the state to obtain investment capital is to convert existing pools of low-risk capital, or state-owned assets like foreign exchange reserves, into high-risk-bearing capital that is subsequently transferred to the management of the SLF. How this process constitutes an increase in the state’s financial leverage can be understood by considering the typical investment made by a SLF. In general, the fund uses its capital to make an equity investment in a target company that is itself internally leveraged—that is, carrying debt on its own balance sheet. The sovereign fund’s equity interest is subordinate to the debt of the target company. The state is implicitly leveraged because the debt of the company stays off the balance sheet of the state, but the state still bears the risk of losing its entire equity stake if the company’s debt cannot be repaid. In other words, the leverage is external to the state’s balance sheet. In this way, the state itself does not issue any new debt or expand its balance sheet, but it still increases its financial leverage. Economically, there is no difference between explicit (internal) and implicit (external) leverage: the only distinction is the accounting treatment and awareness among the general public of its existence.

Regardless of which type of leverage the state chooses when raising capital, the outcome is the same: it will inevitably precipitate a political conflict among those that aspire to control the resultant capital. Implicit leverage is usually the more politically expedient choice because the associated liabilities are usually not recorded in official accounts. Both Central Huijin and SAFE-affiliated investment companies serve as examples of how the state takes on implicit leverage and then political conflict ensues. These two cases are discussed in Chapter 2 and Chapter 4, respectively.

To summarize, SLFs are created by the state taking on financial leverage in either of two ways: one is to take on explicit leverage by issuing new debts; the other is to take on implicit leverage by raising the risk exposure of existing low-risk-bearing capital. Whether a SLF is capitalized from the proceeds of debt issuance (explicit leverage) or by reallocating idle reserve capital (implicit leverage), the positive gearing effects are the same, with the practical difference being the degree of transparency. Both approaches require the state to leverage its capital resources, financial assets, and political power. In other words, SLFs are the product of the state’s financial engineering and political engineering. Before a county’s leaders can establish such a fund, a political negotiation must occur between the state bureaucracies to determine where to source the fund’s seed capital and who will ultimately exercise control over the investment decisions. This process of negotiation firmly embeds SLFs in the politics of the state. SLFs use financial leverage to gather the capital necessary to implement the state’s strategic priorities without relying upon politically unpopular conventional means of raising money like tax policy or trimming budgets.

The experience of China’s SLFs demonstrates that although the state cannot always impose its will on markets, it can create new institutions that reshape the incentives that guide markets. SLFs are state-capitalist instruments for market governance. They are powerful tools that allow states to engage with markets and represent a new middle path between the prevailing dichotomy of the liberalist proposal to remove state intervention and the market institutionalist proposition to bring the state back in.

SLFs reconcile the seemingly opposite perspectives of liberalists and market institutionalists. The state’s control over the market cannot extend beyond its own borders, even in the extreme case of a centrally planned economy. Sovereign funds do not administer or regulate their portfolio companies. SLFs reduce the state’s reliance on nonmarket measures when engaging with the market. These funds can use equity participation to become direct participants in the market and provide capital to companies in the industries prioritized by the state. Well-known funds can also influence the market via their pure brand effect. Other institutional investors perceive investments made alongside prestigious sovereign funds to be inherently safer, imparting a higher risk–reward ratio compared to other investments. This effect is sometimes called the Buffet Effect because it was first observed in reference to investor Warren Buffet and his company Berkshire Hathaway, but it can also be seen with increasing frequency in the investments made by the Government Pension Fund of Norway, Abu Dhabi Investment Authority, Temasek, and China Investment Corporation. This is to say that SLFs empower the state to move and even shake the market by making selective equity investments that promote its industrial policies and geoeconomic interests. This is a fundamentally different approach to the traditional model of the state guiding markets by administrative directives.

SLFs are agents of the state in the exercise of noncoercive economic and financial statecraft. The creation of these state agents is firmly embedded in domestic politics, but their global activities are grounded in international geopolitics. How these agents interact with global markets is a function of the state’s own geopolitical aspirations and structural constraints in global markets. SLFs act as a noncoercive means for the state to advance its strategic interests in the global marketplace. They do so by establishing connections to influential foreign actors and gaining access to global networks of sophisticated investors and political elites. SLFs form partnerships and establish joint ventures with other prestigious investment institutions to mobilize global capital for the state’s prioritized goals. They also participate in multilateral institutions that set standards for global financial governance, effectuating the state’s sway over global finance. SLFs offer companies and other capital-seekers compelling financial incentives to comply with the state’s direction, allowing the state to forgo the more blunt tools of economic statecraft like tariffs and sanctions.

SLFs also allow the state to practice coercion by exercising their equity voting rights in firms across strategic sectors or at critical junctures in globalized supply chains. Armed with abundant capital, SLFs can choose to either finance the founding of a new firm that may eventually grow into a monopoly or acquire a controlling stake in mature companies that already have monopolistic power. SLFs influence their portfolio companies through the exercise of equity voting rights and can gain cooperation from even reluctant stakeholders by threatening to withdraw their capital support and sink the company’s valuation. As the first line of discipline, a SLF may cast its proxy vote against the management team as punishment for not keeping the company’s corporate behavior aligned with the state’s national interests. Later, if management refuses to adhere to the SLF’s guidance, it can divest its position and reinvest in a more pliable competitor. The equity capital of SLFs buys more than just a stream of dividends and a seat on the board; it acquires for the state the strategic option of responding to geopolitical conflict with geoeconomic reprisals. This was demonstrated during the early days of the COVID-19 pandemic when many governments cajoled private companies into limiting exports or redirecting shipments of medical personal protective equipment (PPE) to domestic hospitals.¹⁰ By investing in companies at critical junctures in global supply chains, a SLF can ensure that the state’s interests will be given first consideration in all decisions over supplies while its rivals will only receive short shrift.

Born from Crisis: China’s Sovereign Leveraged Funds

The evolution of China’s SLFs has unfolded against the backdrop of China’s domestic financial reform and the globalization of Chinese capital. Once a backward country, China has caught up with Western powers on gross economic terms by relying upon its ability to mobilize capital. No other country in history has so rapidly transformed its economy from being among the world’s poorest and most isolated to one of the world’s largest economies, at the heart of the global supply chain, and a leading source of international investment capital. For the last two decades, SLFs have played a significant role in China’s economy, mitigating financial crises and tempering exogenous shocks. SLFs have supported China’s industrial policies by financing the state’s procurement of strategic overseas assets, bankrolling Chinese enterprises’ mergers and acquisitions abroad, and sponsoring the development of indigenous Chinese technology startups. As China’s state-owned capital has gone global, the scope of China’s geoeconomic influence has duly expanded.

Although SLFs have become essential tools of China’s economic statecraft, their creation did not arise from some grand strategy of the CPC. Like most innovations, China’s SLFs were born out of necessity amid a state of crisis. Two exogenous shocks formed critical junctures in the evolution of China’s SLFs. The first was the Asian financial crisis in 1997; the second was the global financial crisis in 2008. At each of these critical junctures, the Chinese economy was at a starkly different level of integration and embeddedness within global markets. The CPC leadership responded to these shocks by reexamining the boundaries of state–market relations in China and reinterpreting the Party’s commitment to reform and opening up. Among the results of this process, the CPC changed its approach to managing state-owned capital, especially China’s foreign exchange reserves.

The 1997 Asian financial crisis was the precursor for the CPC leveraging its political and financial resources in 2003 to create Central Huijin, the first of China’s sovereign leveraged funds. The Asian financial crisis had major consequences for China’s state–market relations and foreign exchange reserve management. Chinese policymakers witnessed how quickly the Asian financial crisis derailed the economies of China’s neighbors, primarily South Korea, Indonesia, and Thailand. More specifically, the CPC leadership was keenly aware of the devastating economic consequences of a lack of sufficient foreign exchange reserves. Capital flight from the countries at the center of the Asian financial crisis had exacerbated their already weak foreign exchange reserve position. In light of this, the Chinese state moved to tighten its control over foreign exchange and capital flows, part of a suite of policies scholars refer to as financial repression. Violation of these foreign exchange regulations was made punishable in the criminal code.¹¹ These regulations drove a 52 percent increase in China’s foreign exchange reserves during the four years following the crisis (1997–2001). This trend sharply accelerated when China ascended to the World Trade Organization (WTO) in December 2001 and Made in China goods were exported to newly opened-up foreign markets. Between 2001 and 2005, China’s foreign exchange reserves increased 386 percent to $820 billion. This trajectory convinced the CPC leadership that foreign exchange reserves would continue growing and would be sufficient to deter capital flight for the foreseeable future. Subsequently, the attitudes of the CPC leadership toward foreign capital and foreign exchange reserves began to shift. Rather than intently focusing on attracting foreign capital, the CPC leadership began to consider how China’s foreign exchange reserves could be deployed to secure the state’s strategic interests at home and abroad.

Protecting China’s economy from the fallout of the Asian financial crisis led the CPC leadership for the first time to consider financial security a core element of China’s national security. For the CPC, financial security had become too important to be subject to market vagaries, and the task of improving the supervision of China’s financial system had become more urgent. By the early 2000s the rise of nonperforming loans (NPLs) in the financial system was causing China’s largest banks to drift toward insolvency. Given that the level of foreign exchange reserves was already more than enough to cover the needs of China’s real economy, the CPC leadership began to contemplate using excess reserves to finance the restructuring of the domestic banking system. In 2003 the Party broke with the practice of putting state ministries at the head of reform by establishing Central Huijin, a special purpose vehicle incorporated as a