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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. 307 M & D FORUM 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 ) 308 (3) M & D FORUM 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. 309 of M & D FORUM 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% 310 M & D FORUM 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 [1]. Ba Shusong. Multi-level Demand Management Framework of Foreign Exchange Reserves: 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) 311