Download An Empirical Study on the Management of China's Sovereign Wealth Funds

M & D FORUM
An Empirical Study on the Management of China's Sovereign Wealth
Funds
SU Liping1, JIANG Sihui2
1. School of Economics, Xiamen University, Xiamen, China, 361005
2. China Resources Bank of Zhuhai, 519000
[email protected]
Abstract: In September 2007, China's sovereign wealth funds – China Investment Company (CIC) was
established. As a member of the Foreign Exchange Reserve Management System, the CIC can reduce
official foreign exchange reserve assets, and also can enlarge asset returns, It is one of the effective ways
to drive our country away from economic imbalances. This paper will use empirical method to research
the size and structure management of CIC, and propose some improved ideas to our sovereign wealth
funds.
Keywords: Foreign exchange reserves, Sovereign wealth funds, Optimal size, Asset allocation
1 Introduction
In the recent years, with the rapid expansion and the passive holding of foreign exchange reserves lead
to a substantial increase to the monetary base, and increase the inflationary pressure of our country. In
September 2007, China's sovereign wealth funds – China Investment Company (CIC) was established.
As a member of the Foreign Exchange Reserve Management System, the CIC can reduce official
foreign exchange reserve assets, and also can enlarge asset returns. It is one of the effective ways to
drive our country away from economic imbalances. So we will focus on the scale management and the
structure management of our sovereign wealth funds.
2 Empirical Study on CIC’s Size Management
Normally, according to demand of different motive, foreign exchange reserves can be divided into three
parts: liquidity demand, security demand and profitable demand [1]. Liquidity demand is the first level of
foreign exchange reserves management; it mainly includes trade demand, external debt payments, FDI
profit backflow, etc. After fully meeting in the liquidity demand, we will get into the second level of
demand, namely security demand. Security demand is mainly used in the foreign exchange market when
the foreign exchange rate fluctuates beyond the normal range, or used to prevent the financial crisis. The
liquidity and safety demand are fully guaranteed, and then we can consider the profitable demand. So
the scale of foreign exchange reserve’s profitable demand, which is sovereign wealth funds’ optimal
scale, can be also considered as the remaining sum of the total reserves remove the liquidity demand and
the safety demand. Therefore, we will use ratio analysis and Jeanne - Ranciere model (J-R model) to
measure the liquidity and safety demand of Chinese foreign exchange reserve, then calculate the optimal
scale our sovereign wealth fund.
2.1 The size of liquidity demand
As stated above, liquidity demand mainly includes trade demand, external debt payments and FDI profit
backflow. We use the international ratio analysis to calculate the liquidity demand of our foreign
exchange reserves.
In the 1960s, American economists R. Triffin considered that a country's reserve should be keeping a
certain proportion with import [2]. The percentage of the ratio is with 40% and not less than 30% for
moderate.
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Reserves of external debt ratio are divided into short-term debt ratio and long-term debt ratio. According
to Greenspan Guidotti law, short-term debt ratio in general should not less than 100%, and long term
debt ratio should not less than 25% [3].
If foreign investment’ profit are not invested in China, it will increase the demand for foreign exchange
reserves. The FDI profit ratio is normally considered in the range of 10%-15% [4].
In recent years, the developing of the opening up and the appreciation of Renminbi lead increasing
import tendency to a higher level. So we select the upper limit of the above ratio to calculate the
liquidity demand. To sum up, in recent years, liquidity demands of China’s foreign exchange reserve are
shown in Table 1.
Year
2005
2006
2007
2008
2009
2010
Import
6725.199
8116.191
10032.66
11635.87
10056.9
13948
Table 1 The Size of Liquidity Demand
Short-term debt
Long-term debt
FDI
1561.43
1249.02
638.05
1836.28
1393.6
670.76
2200.84
1535.34
783.39
2107.85
1638.76
952.53
2592.59
1693.88
933.13
2957.02
1828.73
1057
liquidity demand
4659.472
5531.77
6715.248
7314.768
7178.79
9151.96
2.2 The size of safty demand
J - R model [5] argues that for an open economy, the motivation of holding foreign exchange reserves is
to prevent financial crises. The monetary authorities hold enough foreign exchange reserves can relieve
the pressure of reversal of capital inflows in international payments, in order to maintain the domestic
consumption level and avoid causing serious impact on the domestic economy.
J - R model hypothesizes in an open economy, there only exists a commodity, this product can either in
domestic consumption or exports. The development of economy in accordance with certain ways, but
might also disturbed by the liquidity impact, the only uncertain factors in this model is liquidity risk.
Assuming the government's goal is to maximize total welfare of the private sector, and the private
sector’s welfare is depend on its consumption, so government's total utility function is:
(1)
Ut =
(1 + r )− s u (C )
∑
t +s
s = 0,1,...+∞
u (C ) =
C1−σ − 1
1 − σ ; σ is risk aversion
In the above function, the form of the utility function is
coefficient.
Assuming probability of the financial crisis is π . The duty of the government is choose an optimal
reserve level Rt to maximize the utility before the crisis. But Rt is only related with the expected utility
in the t+1 period. So the government chose the optimal reserve Rt meet the following equations:
(2)
R = arg max(1 − π )U (C b ) + π U (C d )
t +1
t
t +1
According to J - R model derived, assumed that the optimal reserves to the next period GDP is a
constant proportion ρ , we can get the Solution of the above equation, and the constant proportion
ρ
should meet:
ρt =
Rt
=
Yt +1b
λ + γ − [1 −
1
( r − g )λ
](1 − pt σ )
1+ g
1
1 − (π + δ )(1 − pt σ )
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pt =
In Equation (4),
u'(C t+1d ) (1 − π )(δ + π )
δ
=
= 1+
b
u'(C t+1 ) π (1 − δ − π )
π (1 − δ − π ) , g is the economic growth rate,
λ
is short-term external debt and GDP ratio, r is reserve risk-free return rate, δ is the differences
γ
between long-term bonds and short-term interest rates, is output loss ratio when crisis happened.
According to the actual situation in our country, we can get that the economic growth rate of recent ten
years is 9.44%. Using the Jeanne and Ranciere method, probability of the financial crisis is 0.066, the
output loss ratio is 7%. However, because of China's opening-up is deepening, the construction of the
financial system is not perfect and the ability to resist risk is weak, we assume risk aversion coefficient
σ =4. Beside these, the other coefficients of J-R model are calculated in Table 2.
Year
Short-term debt
2005
2006
2007
2008
2009
2010
1561
1836
2200
21075
2592
2957
Table 2 Coefficients in J-R Model
Interest rate of
GDP
λ
long-term bond
23027
0.0678
4.44
27799
0.0661
2.86
34583
0.0636
4.35
44161
0.0477
3.76
49821
0.052
3.29
60400
0.049
3.43
δ
r
4.37
5.09
3.49
0.36
0.45
0.27
0.07
-2.23
0.86
3.4
2.84
3.16
After getting all values in J-R model, we can calculate the safety demand of our country since 2005. The
demand are shown in Table 3.
Table 3 The Size of Safety Demand
ρt
Year
2005
2006
2007
2008
2009
2010
GDP
0.0942
0.091509
0.090313
0.074663
0.079584
0.076148
Safety Demand
23027
27799
34583
44161
49821
60400
2618.666
3164.651
3988.305
3719.807
4806.865
5575.9551
Therefore according to the estimate of liquidity demand and safety demand, we can get the recent
optimal size of our sovereign wealth funds which are shown in Table 4.
Table 4 The Optimal Size of Sovereign Wealth Funds
Year
Liquidity Demand
Safety Demand
Reserves
Optimal
CIC
Size
2005
4659.472
2618.666
8188.7
910.562
2006
2007
2008
2009
2010
5531.77
6715.248
7314.768
7178.79
9151.96
3164.651
3988.305
3719.807
4806.865
5575.955
10663.4
15282.5
19460.3
23991.52
28473
1966.979
4578.947
8425.725
12005.87
13745.09
1 We use the earlier 5 year’ average GDP growth rate to forecast the 2011 GDP.
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September 2007, the Ministry of Finance issued special Treasury bonds of 200 million US dollars which
is as the initial capital to the CIC. But from the Table 4, we can see that, by the end of 2007, there are
457.8 billion dollars in the actual foreign exchange reserves can be used in commercial operation.
Besides, at the year of 2009, global portfolio returns of China is about 11.7%, but the yields on the
10-year United States Treasury note is only 3.85%. So to minimize the opportunity cost of foreign
exchange reserves, CIC's capital size is not enough.
3 Empirical Study on CIC’s Structure Management
According to the asset allocation practice of sovereign wealth funds, we can see that the sovereign
wealth funds investment tools can be divided into three groups, the first type is fixed-income products;
the second is rights and interests kind products; the third is alternative assets which includes foreign real
estate, private equity and derivative products, etc. However, on one hand, from long-term perspective,
equity investments are more profitable than the long-term bonds investment, so in portfolio, we should
give more configuration to equity products[6]; on the other hand, oil, steel and agricultural and other
primary products have dramatic price fluctuations, so it is better to hold the equity of these companies
than to purchase the primary products themselves[7]. Because of these, we only consider the equity
investment of the sovereign wealth funds of our country.
According to the sovereign wealth funds’ investment characteristics, we use the mean-variance model
and Sharpe’s ratio to study on the structure management of sovereign wealth funds, the asset allocation
model can be written as follows:
Target equation:
(4)
µ −r
W 'µ − r
p
max S p = max
σp
f
2
= max
f
W 'VW
Constraint conditions:
I
∑w
i
i =1
=1
, wi ≥ 0, ∀i ∈ I
Therefore, sovereign wealth funds are faced with the problem that how to construct a portfolio makes
unit risk portfolio yields biggest income.
Due to the long-term characteristic of sovereign wealth funds, we should be in the selection of the
long-term and stable yield rate. So we choose the equity market data of USA, Canada, Japan, developed
countries in Europe DEURO , emerge market in Middle-East, Europe, Africa EMEMEA and Asia
EMASIA from Jan. 1988 to Jun. 2007. And we eliminate the impact of incidental factors like the
2008 financial crisis on global stock markets.
Sovereign wealth funds invest primarily in foreign markets, and the currency fluctuations will affect
investment returns, so the investment returns can be separate into two parts: return on assets and
exchange rate changes. In order to simplify the model, we hypothesis the exchange rate meet the
random-walking process, so the investment yields equal the return on assets. The risk-free rate has no
effects on results, in order to simpler the calculation, we assume the risk-free rate is zero. We use
LINGO 9.0 to calculate the optimal allocation of our sovereign wealth funds. The results are shown in
Table 5.
（
）
Market
（
USA
）
（
Table 5 The Asset Allocation of CIC
DEURO
CANADA
JAPAN
EMASIA
）
EMEMEA
Yields Means
0.830471
0.904185
0.917143
0.201513
0.932323
1.266082
Variance
15.27205
24.40351
24.77257
40.76099
49.25123
78.1333
Allocation
72.15%
14.66%
6.24%
0
0
6.94%
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Based on the consideration of venture and gains, China's sovereign wealth fund should pay more
attention to the developed markets. In recent years, trade barriers emerging endlessly, production factors
flow are blocked, we can only take part in the income distribution in the form of international
investment. Our country is a labour-intensive and developing country, capital-intensive industries are
relatively weak, and therefore CIC invests in developed countries’ telecommunications, financial
services, biotechnology and other high-tech, capital-intensive industries can obtain relatively high
returns.
4 Conclusion
In the size management of China's sovereign wealth funds, we use the hierarchy relationship between
each demand to calculate the optimal size of China's sovereign wealth funds. And we find out the initial
capital of CIC is below the optimal level. Considering the CIC’s overseas investment income is higher,
and to reduce the opportunity cost of holding foreign exchange reserves, we could use Norway’
experience for reference to establish a buffer set which can transfer the excrescent foreign exchange
reserves to CIC.
In the structure management of China's sovereign wealth funds, we think CIC should pay more attention
to the developed markets based on the consideration of venture and gains. But given the limitations of
the data analysis and the defects of the mean variance model, and from the strategic level of our country,
we also can invest in Japan and the other emerging market if the industries are worthy to be invested.
References
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Experience of Norway and Singapore and Their Meaning for China. Economic Theory and
Business Management ,1(2007), p46~53(in Chinese)
[2]. Robert Triffin. Gold and the Dollar Crisis. New Haven: Yale University Press ,1960
[3]. Shi Xianghong. Study on the Scale of Foreign Exchange Reserve Based on the Current Foreign
Exchange Rate System. Studies of International Finance ,7(2008), p75~80(in Chinese)
[4]. Chen Zhanyun. Scale of Foreign Exchange Reserves under the RMB Appreciation Pressure.
Management Science ,5(2006), p143~144(in Chinese)
[5]. Oliver Jeanne, Romain Ranciere. The Optimal Level of International Reserve for Emerging Market
Countries. IMF Working Paper ,2008
[6]. He Fan. The Foreign Exchange Reserve Investment can not Take Too Much Risk. Investor
Journal ,2008(in Chinese)
[7]. Liu Liya. Transformation Research on China's Foreign Exchange Reserves Management Mode.
Shanghai :Shanghai University Of Finance Press,2010(in Chinese)
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