China’s great leap into private equity will revolutionise the world’s markets

23/05/2007

The Chinese will eventually act like Arab states and royal families, taking stakes in blue chip companies

IT IS a shame that Deng Xiaoping, the Chinese leader who reconciled China with capitalism, is no longer with us to savour the moment. You can hardly get more capitalist an institution than Blackstone, the American private equity giant run by Stephen Schwarzman, the bombastic billionaire who has made his name organising massive leverage buy-outs. So the news this week that China would take a major stake in the company, a first step towards creating what amounts to its own activist investment fund, is truly a milestone in the development of socialism with Chinese characteristics.

It is also a hugely significant moment for the world’s financial markets. As a result of China’s decision to start to manage its massive foreign exchange reserves more rationally, hundreds of billions of dollars could ultimately be reallocated from low-yielding government bonds into private equity and hedge funds, giving the international stock markets a huge fillip and potentially fuelling dangerous asset price bubbles.

To see why a seemingly arcane shift in monetary policy on the other side of the world matters so much, consider the following. Because China exports far more goods than it imports, it has been accumulating vast amounts of foreign currency, especially greenbacks. China allows its renminbi to fluctuate only in a narrow band against a basket of foreign currencies and is reluctant to convert much of its foreign exchange holdings into its own currency, as this would push up its value and make Chinese exports less competitive. So, instead of being able to spend its vast treasure trove domestically, the Beijing authorities keep it in foreign currency, recycling it into overseas assets.

The result is that China’s foreign exchange reserves have now hit around $1.2 trillion, up $259bn in the past year alone, an astonishing sum even by the standards of the region. It now easily beats Japan, whose own foreign exchange (called forex for short) reserves stand at a record $915bn, the world’s second-largest stash after China.

About three quarters of Beijing’s forex reserves are thought to be invested in dollar-denominated assets, mainly low yielding US Treasury bills, mortgage backed securities and agency securities, as well as other similarly boring assets. The rates of return on 10-year Treasuries is a paltry 4.8% or so, less than what the Chinese would make sticking the money in many high-yielding British accounts; the declining value of the dollar is also costing Beijing billions.

China could be making far greater returns if it were prepared to be imaginative in its investments, hence its new relationship with Blackstone, its first concrete action after announcing earlier this year that it would be shifting at least some of its holdings into riskier investments.

The Chinese government is setting up a new state foreign exchange investment company, which is expected eventually to be endowed with around $200bn; its first move is to spend around $3bn buying a 9.9% stake in Blackstone ahead of it going public. The shares will be devoid of voting rights in an attempt to neutralise political opposition from protectionists in America; but like all shareholders in Blackstone, which will be floated in June with a value of up to $40bn, Beijing will be entitled to its share of the fees and profits that accrue to the management company.

Similar deals with other private equity companies, investment funds and financial institutions could all easily follow; the Chinese will eventually want to buy direct stakes in regular companies too, as well as snap up property or any other asset they feel like. The days of the passive accumulation of foreign exchange reserves by China are coming to an end, a development which will have a huge impact on the City of London.

From now on, the Chinese will increasingly act like Arab states and royal families, which have for many years now professionally managed their petrodollars, often hiring the best Western investment managers to do so and taking stakes in a growing number of blue chip firms.

It may take several years before the full extent of this shift becomes clear but for a harbinger of things to come, consider that Saudi Arabia’s Maan al-Sanea owns 3.1% of HSBC, Dubai International Capital also owns a stake in the bank and Qatari investors own 17.6% of

J Sainsbury, the supermarket group. The Abu Dhabi Investment Authority’s portfolio is worth between $250bn and $500bn and is made up of a large numbers of investments in a range of securities, funds and property around the world.

Many of the London-based hedge funds and private equity raiders are at least in part (often indirectly) being financed with petro-dollars; as a result of China’s latest move, we can expect a new wall of money to be injected into Western and Eastern markets. As much of this money will end up leveraged many times over, the real impact could be monumental and could easily fuel bubbles in property, stocks, commodities, currencies and a raft of other assets.

All of which will also cause problems for smaller private equity players. As more and more money continues to chase the same number of assets, and valuations continue to rise, less well funded players will increasingly be outbid. If there were another trillion in leveraged investments floating around the world economy, it may well be that someone like Guy Hands would have stood no chance in his quest for EMI. It might even cause problems for the giants of private equity, such as KKR and Goldman Sachs, unless they follow in Blackstone’s steps and sign deals with the Chinese.

At the moment, China’s reserves are biased towards the greenback; but this is unlikely to remain as pronounced over time, as many of the fastest-growing assets are to be found outside the US. A growing share of China’s assets will be injected into other economies, which will gradually put downwards pressure on the greenback. This would be no bad thing: the dollar remains in need of a significant decline to help rebalance the US economy away from the consumption of imported goods and rekindle its exports.

A weaker greenback would also help assuage protectionist concerns in Washington. The US trade deficit with China accounted for almost one-third of the record $765bn US trade deficit in 2006; US companies sold $55bn worth to Chinese consumers, while Chinese firms sold $288 to US consumers. None of this should matter: it makes sense for America to buy cheap goods from China; as the Chinese become wealthier they will purchase more from America. But economic illiteracy remains rife, especially on Capitol Hill, and feeds on the vested interests of those who stand to loose from Chinese competition.

A delegation of Chinese officials, led by Wu Yi, the Vice-Premier, travelled to Washington this week to meet Henry Paulson, the US Treasury Secretary; the Blackstone announcement was carefully timed to come just prior to the visit. The Chinese believe that it will send a strong signal to the US that Beijing wants to recycle its vast funds into the global economy, which would benefit everybody.

But the move could backfire. The Left on both sides of the Atlantic already hates private equity, which it wrongly sees as little more than heartless, debt-fuelled asset-strippers and job-cutters on steroids. Human rights activist are deeply and rightly concerned about the horrendous abuses across China, which remains a deeply authoritarian state. At the same time, many conservatives are worried about China’s increased geopolitical clout, as well as its intentions towards Taiwan.

So the combination of communist China, the trade deficit and private equity could prove an inflammatory cocktail. It could also make Blackstone’s life much harder: each time it attempts to buy a firm or to make a large investment, it could end up being tarred as merely a wing of the Chinese Communist Party. So while the fiercely right-wing Mr Schwartzman is hoping that he has uncovered the key to the Chinese economy, and that his new high-level contacts in Beijing will help and support him when he chooses to make investments in China, he may also found that the deal has actually increased the constraints on his business.

More important to the rest of us, China’s embrace of activist wealth management could also mean that credit becomes more expensive. Thanks to the massive bonds purchases undertaken by the Japanese, Chinese and other Asian central banks, global yields on long-term bonds have been kept artificially low (strong demand for bonds increases their prices, which keeps yields down). The full impact has been to cut the long-term cost of borrowing by between half and a full percentage point.

Despite much higher short-term interest rates set by the Federal Reserve, real yields on US longer-term bonds have fallen from 4.7% at the end of the 1990s to around 2.7% in the first quarter of 2007.

This has been a key factor propping up the international property market, and has made it easier for governments to finance their budget deficits. Anything that helps to unwind this would be a positive development.

As the OECD rightly argues in a report this week, it makes no sense blaming record buy-out activity and financial speculation on private equity funds or the banks that supply them with financing. The real reason why the world is so awash with liquidity is the monetary polices of the Asian economies, especially China; although the mechanics are slightly different, we are living a repeat of the distortions created by the ill-fated Plaza and Louvre Accords of the 1980s.

At the time, the dollar was massively devalued; but while the aim was to boost the US economy and stave off protectionism, the effect was to tip Japan into economic crisis. The Bank of Japan slashed interest rates and turned on the liquidity taps; this soon fuelled an unsustainable stock market and property boom which encouraged Japanese companies to purchase assets at ludicrously over-valued prices over the world. When the party eventually came to an end, Japan was plunged into 15 years of stagnation and deflation from which it has never entirely recovered.

While the cause of today’s liquidity bubble is slightly different, the effects are very similar; the risk is that it will all end just as painfully. China’s move away from bonds will help a little, but ultimately it will merely shift the bubble from one asset class to many others. It will only be when Beijing finally liberalises its currency – and abandons its ridiculous policy of accumulating ever larger reserves – that the world economy will finally return to some sort of equilibrium once again.

From The Business