Sovereign Funds: How The Communist Party Of China Finances Its Global Ambitions

>> Glenn Tiffert: Welcome, joining us at our first speaker event of 2024 in the project on China's global sharp power. I'm Glenn Tiffert, and along with Larry Diamond here, we co-chair the project here at the Hoover Institution. Our speaker today will be addressing sovereign funds, how the Chinese Communist Party finances its global ambitions, her latest book.

Zoe Liu is the Morris Greenberg Fellow for China studies at the Council on Foreign Relations. At CFR, Zoe's work focuses on international political economy, global financial markets, and energy transition. Her regional expertise is East Asia and the Middle East, and she's the author of Can BRICS De-dollarize the Global Financial System?, in addition to this book.

Zoe received her PhD in international relations from SAIS at Johns Hopkins. Discussing Zoe's book and her talk today will be Eyck Freymann, a Hoover Fellow at Stanford University where he studies the geopolitics of climate change and strategic deterrence in the Taiwan Strait. He's trained as an economic historian and a China specialist, and he's also Indo Pacific director at Green Mantle, a New York based advisory firm.

We encourage our online audience to file questions using the Q&A feature built into Zoom, which we'll take towards the end of the talk. But over to you, Zoe, thank you for joining us.

>> Zongyuan Zoe Liu: Thank you very much, Billy, for having me. And thank you very much, Professor Diamond, for having me, and as well for all your help.

And I am Zoe Liu and it's truly a great honor and pleasure to be here. So I'm going to share my research about sovereign funds, how the Communist Party of China finances its global ambitions. And so this is how Harvard University Press designed the cover. They told me that this is the official slice that we want you to use.

So I figured, okay, it looks nice, and I'm going to sort of spend about 20 to 30 minutes, share with you why I did this book. And then do a little bit of detailed discussion about, when I talk about the Chinese sovereign funds, why I do not name it China's sovereign wealth fund.

Actually, I call it a sovereign leveraged fund, and there is a reason for that. So I'll explain why, what are the motivations, what the government uses for, and why should we care about it? Then I will conclude in the following Q and A. So as acknowledgement, this is half of my doctoral dissertation, but it was not the dissertation that I hoped I would want to do.

Initially, when I went into graduate school, I wanted to study cross border pipelines. I was very interested in energy, and I was curious why this form of energy, natural gas, under certain circumstances, you build pipelines and why under certain circumstances you build tankers. So I was very curious, the politics of natural gas and the natural gas market.

So that's my energy background. And one year into my PhD program, I went to other people's PhD dissertation prospectus defense. So, to understand what it looks like and what should I be looking for. Then I realized that folk was doing exactly the similar topic I wanted to do.

So I had to pivot, and I asked myself, without departing too much away from energy, what are the topics that I can look at? Then I stumbled upon sovereign wealth fund. I realized that if you just look at this map, the interesting fact is that the world leading sovereign wealth fund, including the oldest one, the Kuwaiti's Sovereign Wealth Fund, established back in 1950s.

Or currently the largest one, the Norwegian Sovereign Wealth Fund, they are all established in commodity exporting economies. In other words, the source of money comes from God-given unincumbent natural resources. Then I become curious in the sense that, first of all, how this country manages this money, because you have this institution called a sovereign wealth fund.

Okay then, how this Sovereign Wealth Fund work? As I look into the literature, I realized actually China also has sovereign wealth fund. And at that time, people mostly referenced to the China Investment Corporation or CIC. Then I realized, well, it does not make any sense at all, because starting from 1994, China became a net crude oil importing economy.

And then in the 2000s, China become the largest commodity importing country in the world. So if the majority of the Sovereign Wealth Fund were established by commodity revenue, how could China, as the largest commodity importing economy, have a sovereign wealth fund to begin with? And then existing literature talked a lot about, well, you know, China has a lot of foreign exchange reserves.

Hence it makes sense for China to use foreign exchange reserves to establish sovereign wealth fund, hence CIC. The counterargument to that is that, well, Japan being the world's second largest foreign exchange reserve holder. Specifically the minister of finance of Japan, specifically rejected the idea of using Japanese foreign exchange reserves to establish sovereign wealth funds.

So this was really the empirical puzzle that drives this research. So if you read my dissertation, it talks a lot about foreign trade reserve management and the comparison between China and Japan. But the book itself focuses on China. And this is the way that I contrast sovereign wealth fund with the Chinese Sovereign Funds.

I take a balance sheet perspective to show that a lot of existing sovereign wealth funds, the revenue comes from natural resources. The monetization of natural resources, the transformation of natural resource revenue to financial asset. This is not how China established the Sovereign Wealth Fund and I call it sovereign leverage fund in the process of establishing not just the CIC.

But a series of government owned investment institutions affiliated with SAFE, the so called State Administration of Foreign Exchange is the foreign exchange management arm of the People's Bank of China. So through a series of explicit and implicit leverage that China was able to establish a collection of sovereign leverage fund, and if we can just go to explicit leverage.

I'll explain what is explicit leverage, so explicit leverage by name it involves the expansion of balance sheet, basically the government will issue debt. And in the case of China Investment Corporation back in 2007 it was ministry of finance issue special purpose bond and use this bond proceed to purchase foreign exchange reserves from PBOC, People's Bank of China.

And use the bond proceed to capitalize sovereign funds, by definition, this process involves the issuance of bond, involves the higher leverage. Involve the expansion of government balance sheet, hence it's explicit leverage. In other words, you can trace how the capital is raised or how the foreign exchange reserves were removed from the accounting of official foreign exchange reserve statistics into foreign sovereign funds, at that time called China Investment Corporation.

And this is important because official statistics, by IMF definition, in terms of foreign exchange reserves, it does not include foreign exchange assets managed outside of the monetary authority. And in addition to that, yes.

>> Audience: Do you have time for questions today or are you just?

>> Zongyuan Zoe Liu: Yes, I have questions.

Yes, if you have questions now, I'm happy to take.

>> Glenn Tiffert: Yeah, could we wait until after the discussion, or are you short on time?

>> Audience: Wanna make sure what the format is, I'll wait till later.

>> Zongyuan Zoe Liu: Thank you. And the conventional method of foreign exchange reserve management is that it has to be invested in liquid and safe, low-risk asset.

Whereas the moment you remove foreign exchange reserves to invest in higher risk or risk bearing assets, such as real estate or infrastructure, is no longer counted as foreign exchange reserves, right? And then that's explicit leverage. Implicit leverage is slightly different, because explicit leverage, you can trace it through the accounting, whereas implicit is different.

Implicit leverage, if you go to the next slide, you realize that it basically involved a re-characterization of the risk profile of a certain portion of your foreign exchange reserves. In other words, without the mutual finance issue any debt. The Foreign Exchange Reserve Management Agency, in the context of China, SAFE, State Administration of Foreign Exchange, can basically use foreign exchange reserves.

Either through the format of entrusted loans to help Chinese companies invest or purchase asset overseas, or it can use these foreign exchange reserves before they were used to invest. They use this money to capitalize a series of other investment vehicles. And the moment this money is removed from the SAFE and liquid asset, used for other type of investment, they are no longer foreign exchange reserves.

This is why there is this huge debate, why China's current account surplus keep to a certain extent, whereas the official foreign exchange reserves did not increase, but stabilized around $3.3 trillion. Part of the reason could be that SAFE has been using foreign exchange reserves instead of deposit into the official accounting, but put it into a lot of these SAFE-affiliated investment vehicles.

One of which later I will discuss would be Silk Road fund. And if we can go back to the other slide, the previous slide. So either way, this implicit or explicit leverage, it really matters, the politics, and it also really matters where the source of money. In this whole process, the Chinese government was able to do this, specifically because this is the pot of money that is sort of outside of the purview of the Chinese people.

And then the creation of all these investment vehicles, it actually involved a lot of political battle between different agencies, such as mutual finance and People's Bank of China. And once these institutions are established, it also matters who gets to influence their investment decision, right? So these are the two key studies discussed in my book.

The first one, China Investment Corporation, this is the process I discussed before. Basically ministry of finance issue bond, and then raise capital to purchase foreign exchange reserves from the People's Bank of China, and use the bond proceed to capitalize China Investment Corporation. Now, you understand this process, this is leveraged.

But what is more interesting is that when I talk with the CIC managers, especially when I was doing my field research around 2016, 2017. Every single person that I talked to, they tried to explain to me that our investment strategy is to maximize our return on investment. In other words, they seek to behave like a normal market participant.

But I find it's hard to justify, part of the reason is that if you benchmark CIC's global portfolio versus S&P 500 annual performance, it turned out that most of the time they underperform. And in the years that it slightly up, they perform better than S&P 500, such as last year, part of the reason is because they are way much more diversified than equity market, right?

So what are the reasons to explain why they, especially the global portfolio, underperform than if you just invest in a passive index fund? I think if you are a pure market participant, at least you should track it. At least you should try to track it closely. Then I also compare CIC with its peers, I choose basically the largest one.

And if you just compare CIC with the third one on the table, this might be a little bit difficult to read, so I put a chart here. The red dot shows you where CIC lies, and the darker green line is the average, and the little gray circles shows the other funds performance.

At most, the CIC is below par, and this is a different way to show how CIC performs. So again, it's puzzling that when people I interview, they tell me that CIC tried to maximize their return, whereas you actually do not necessarily maximize your return. So what could potentially explain it?

When looking into both official statistics as well as CIC's annual report and doing my interview, I realized that they're probably speaking CIC's three types of functions. The first one is network function, they are very proud of establishing and maintaining the network with key points of contact. This is particularly important when CIC was first established back in 2007.

At that time, CIC was officially established around June, July 2007, and that was in the running up of a global financial crisis. And the very first time CIC made the investment, or for that matter, the very first time that the China's foreign exchange reserves were used to invest in overseas market directly, was the deal with Blackstone.

And people talk about that deal very fondly through all my conversations. And if you look at SEC filings filed by Blackstone, it turned out that they also have very good, or read Steven Schwarzman's memoir, or his own memoir, people talk about it fondly. And in SEC filing, the investment is not recorded as a CIC, but recorded as Beijing Wonderful Investment.

I find that the name is very interesting. And people later explained that actually, Stephen Schwarzman, yes, relationship with CIC for him is tremendous. It basically opened the door for him to China's vast market. But then for CIC, they explained to me by saying that, well, with $200 billion initial capital injection, the stress of reducing cash drag.

Meaning you want to invest money as soon as possible so that you reduce, you minimize the opportunity cost of not investing. So that pressure was very high. Therefore, as a little team, less than 12 people, less than 1,000 people when CIC was first established, they were very keen to have access to the best talent out there, hence the deal moved forward.

And later, in times when US-China relationship deteriorated, especially during the Trump administration. Chinese policy making circle consider Mr Schwartzman as one of the few people who can deliver the message to the White House. And then the second function is more important from my research is that it actually plays the role of capital mobilization.

It's sort of capital mobilizer in the 21st century. The idea is that they invest in strategic assets to help China diversify its foreign exchange reserves. And you read this in CIC annual report, and you even read this occasionally in some of SAFE's annual report. In particular 2018's State Administration for Foreign Exchange have a box show that this is our goal.

Our goal is to diversify foreign exchange reserves. And at the same time we want to invest in strategic assets overseas. And what are the overseas assets being invested in? Oil and gas, obviously, mining and minerals, Belt and Road Initiative. And we also supported the China's technological edge. A good example would be Alibaba.

Many people think that Ma is very successful. He is, I do believe he is a tremendously successful entrepreneur. However, he would not have been able to secure the money to launch his IPO back in 2014 if there were no CIC lend money inject to help him. So that's one such example.

And then the other one, a good example would be Didi, the Chinese Uber. Uber ventured into China, but eventually they had to quit. Part of the reason is because Didi received a lot of financial support directly from CIC, China Investment Corporation, so that they were able to out compete, right?

And then finally, in terms of semiconductors, CIC lead the investment into China's very first semiconductor investment fund back in 2013. So if you think about a lot of the conversations that we have now, like how come China become the dominant player in global critical minerals market? And to why China have access to a lot of these western technologies, especially advanced startup companies here in the United States.

Or for that matter when France or Germany, actually Germany in particular, when they were fully embracing Chinese investment. A lot of this did not just happen overnight, it did not happen after Belt and Road initiative. A lot of this foreign exchange diversification conversation happened back in the early 2000s.

And then finally legitimization function. This specifically speaks to why CIC wanted to be part of the IMF Global Sovereign Funds forum. So it is a voluntary member, is one of the lead, one of the initial member joining the IMF International Sovereign Funds Forum. And it's a voluntary signatory of the so-called Santiago Principle.

It's a principle that sovereign funds sign to say that we are not going to invest with strategic purposes. We oblige to, and we promise to invest only to seek for financial returns. But in reality, you do see that reality is more complex than that. And a few details in terms of where CIC invest from overseas oil and gas companies in Canada, in the United States, and investing money on mineral companies.

Again, both in the United States and elsewhere as well. Then finally, in terms of joint cooperation funds, the reason I mentioned joint corporation funds is more relevant in the current context, especially since the United States strengthened investment screening. The CFIUS, in particular in terms of the yen bond investment screening.

The idea is we do not want, for national security purposes, reasons, we do not want undesired foreign entities to have a hold of our strategic asset. So, one way that CIC has been trying to go around the CPSC investigation is to set up a joint cooperation fund, or joint investment fund.

The idea is that by setting up this joint investment fund, the money is yours. But you can argue from a regulatory perspective, the entity is not a foreign alien, but a domestic person. And a good example would be the China-US Industrial Corporation Partnership. This was a product after President Trump visited China, and it was a partnership between CIC and Goldman Sachs.

The source of money comes from CIC, but Goldman Sachs managed the money. And around 2019, they started to make investment. And when CFIUS started to ask questions, Goldman Sachs successfully argued, saying that this is a domestic person from a regulatory perspective. Therefore, when they were trying to buy a California-based company called Boyd, the deal was able to go through.

And there are also several other cooperation funds in addition to China-US, like China-Ireland, Japan-China, China-Russia, China-France, and a series of others. And a lot of these cooperation fund also happened since President Xi Jinping took office. And he has been personally sort of liaison or okayed to some of the funds, including France-China, China-US, and China-Russia.

And then, in terms of investment in companies along semiconductor supply chains, there are three companies here in the United States. But what I wanted to mention is China's Semiconductor Manufacturing International Corporation, as well as the Semiconductor Investment Fund. And then the other part, knowing that previously I emphasized the CIC's global portfolio, and it's globally, it's sort of underperformed.

But the other part of the story is CIC's domestic portfolio, and the domestic portfolio is the so called Central Huijin model. And if you read CIC's latest annual report, which is the latest one, would be 2022. The 2023 annual report has not come out yet, but the 2022 model.

The 2022 annual report, they specifically articulated how much they want to advance this Central Huijin model. Central Huijin was actually the very first time when the Chinese government attempted to use foreign exchange reserves to solve a domestic banking crisis. And this is the key point that I wanted to address here, which is, although I talked a lot about CIC's global behavior, and starting from President Xi Jinping, a lot of these funds are used for strategic purposes.

But the very first time when they tried to use foreign exchange reserves was not for strategic purposes. They used the foreign exchange reserve to solve a crisis. Back in late 1900s and early 2000s, the Chinese banking system was crippled by non performing loans. And depending upon the that you read and the way you calculate non performing loans, it could be as high as about 20%.

That basically means the banks were insolvent. So, in order to make sure that these four big banks can become solvent again, basically, the way that the Chinese government resolved the crisis was that People's Bank of China used foreign exchange reserves to capitalize this special purpose vehicle called Central Huijin, which is here Chinese domestic market, the yellow highlight.

And create a Central Huijin as a special purpose vehicle with the goal to recapitalize these debts to save them. In other words, it was a bailout, it's just that they don't call it that way. But Central Huijin did such a wonderful job over the years. It has become the largest shareholder of basically the most important financial institutions in China.

One such example would be all these four major banks. And in times of stock market tank, Central Huijin would be deployed to buy the shares of the banks, to stabilize the stock market and prop up the banks. This happened in 2015, this also happened recently, right? Yes, and when people are talking about, well, the Chinese government is establishing another equity market destabilization fund, there is nothing special about it because they've already done this before.

And in addition to the banks, Central Huijin also owns shares of one of the world's largest development bank. Perhaps now you probably read it in the context of BRI a lot, which is China Development Bank. But actually Central Huijin played a crucial role in recapitalized China Development Bank.

And then obviously there is another institution called China Export Credit Insurance Company. This is played a very important role in transforming the non bankable project along BRI into bankable project because they underwrite risk, right? Now, obviously they also own a lot of Chinese insurance companies and all that.

Therefore, as the Central Huijin model, the way that using Chinese financial institutions, there is a centralized financial institution that can become the sort of the custodian of all these critical financial institutions as perceived important by the government. This is the model that President Xi Jinping actually emphasized a lot.

If you think about his strategies back in 2013, he has his own opinions of how China's reform and open up should be deepened. And in his article or his speech delivered in the National People's Congress, he said two things. One is to strengthen the role of the state, the second is to strengthen the role of the party.

And then the next year, he wanted to implement the government and the party's oversight over the financial and economic sector. And he wanted the state owned enterprises, the SOEs, state owned enterprises, to pivot, to manage capital, manage capital. And guess who is the person in charge of implementing the reform of the SASAC?

It was Lou Jiwei who was the previous CIC chairman. And Lou Jiwei in his whole discussion, he said, well, now we are going to reform all the SOEs and reform the SASAC. The idea is to make SOEs focus less about personnel management, but they should really care about how to manage money.

They wanted to make China a financial superpower. The model they are thinking about is Central Huijin, the Huijin model, and they talk about this so many times. And if you read President Xi Jinping's latest comment on strengthening China's financial power, he actually also talked about strengthening how the state owned enterprises and the party's role in governing, in managing capital.

And perhaps there is a reason for that, and I think Eyck would be the better person to explain why there is a reason. And then the other part that I wanted to talk about in terms of implicit leverage is SAFE. And SAFE is very interesting because when I was looking into the literature, most of the conversations about China's sovereign funds was focusing on China Investment Corporation, CIC, less so about SAFE.

And there is a reason for that, the reason is because, well, SAFE, basically, if you go through its annual report, they do not report anything on their annual report. In other words, many of these are off balance sheet. But you can read this in official press releases, and if somebody buys stuff on Shanghai Stock Exchange, there is paper trail that you can trace.

So, interestingly enough, it follows a very similar model as CIC. CIC has domestic arm and international arm, so it's SAFE. SAFE established this institution called Buttonwood Investment Holding. And when it was established back in 2015, the whole purpose was to capitalize the Belt and Road Initiative. One important institution related to the Belt and Road Initiative, which is the Silk Road Fund down at the bottom.

So, that was the initial purpose of why SAFE wanted to create the Silk Road Fund. And that was also part of the President Xi Jinping's signature initiative. And when Silk Road Fund was created, one of those Belt and Road International Cooperation Forum, President Xi Jinping said, well, we are going to give Silk Road fund another 100 billion, but this time it's Renminbi.

And then when I talk with some PBOC people, they realize the idea back then was to say, well, we want to use the Silk Road Fund as well as the Belt and Road Initiative to be a vehicle to advance Renminbi internationalization, but at our own term. We wanted to have a gradual and controlled format of Renminbi internationalization.

But not necessarily internationalization, in a way, it actually just regionalization, right? So, broader use of Renminbi through financial institutions, through infrastructure investment, through currency swaps, in the context of Belt and Road Initiative. But since the Silk Road Fund is not the only thing that Belt and Road investment holding capitalized, they also capitalized other Belt and Road initiative related funds.

And in addition to that, they capitalized a series of other policy-related banks, such as China Development Bank and Import-Export Bank of China, all related to the BRI. And then what is also important in the context of developing China's financial infrastructure? Part of that is the NetsUnion Clearing, it's very important in terms of developing China's cross border clearance system, and this is part of the Renminbi infrastructure.

Then domestically, those are the four institutions created onshore, and in times around 2015. Before 2015, they played a very important role, propping up China's stock market. And then when the circuit breaker triggered during the stock market crisis, we became the so called the three REC tiers, including Buttonwood and its first two domestic institutions, the so-called three REC tiers, to sort of help stabilize the Chinese domestic stock market.

So, in other words, a lot of the behaviors that we are seeing today that the government is doing is nothing special, is nothing innovative, they have this playbook ready to go. And this is ultimately why I do not necessarily think that China's property market crisis is going to translate into a banking crisis, because we've dealt with that before, and they have the mechanism to deal with that.

And more importantly, if you look at the property market crisis, a lot of those are third and fourth. They are major developers in third and fourth tiered market and they deal with smaller and medium sized banks. So there is a reason for the banks to be consolidated and is very much in the interest of the bigger banks.

As long as the banking crisis does not involve the big banks. They are happy to have more consolidation going. And I envision that more banking consolidation is going to happen this year. So if you take a look at some specifics about so called project financing, it's quite interesting.

The format they do is classic equity plus debt. But the thing that it'll be investing, they not only invest in places like Pakistan or Russia, they also invest in places like UAE. And the other sort of cooperation fund with foreign institutional investors. This is also something that CIC also has done and the Silk Road Fund also did.

But Silk Road Fund did it as a much bigger, did this corporation fund with more institutions, not just westerns, but also Middle Easterns, very interestingly, Saudi Arabia. And the reason I mentioned Middle Eastern is because somehow I feel like there is an inherent interdependencies between China and the Middle Eastern, not just about hydrocarbon, but also about energy transition.

And if you look at the latest development between Saudi Arabia and China, you realize that they are actually pushing forward for financial cooperation, financial collaboration. The Shanghai Stock Exchange also signed a cooperation agreement with the Saudi Stock Exchange. The idea is to explore ways to do cross listing.

Then we are also trying to figure out the ways for financial fintech corporations and standard setting. So a lot of these, I think, are happening in the context of Silk Road Fund. And in the context of the Silk Road Fund under the arm or whose primary shareholder is State Administration of Foreign Exchange, which is the subsidiary of the PBOC, is very interesting, right?

Then basically, the other part that I said, China's foreign exchange reserves can be used to finance Chinese companies overseas mergers and acquisitions. This is through the mechanism of the so called safe co financing. The office was officially established in late 2011, 2012, but it did not show up on the annual report until after 2013.

And the way how this works is that basically SAFE will designate certain banks that are qualified to take these entrusted loans. These are policy banks and state owned commercial banks. And these banks can then give loans to qualified Chinese enterprises. From my research so far, the data that I have, all these companies that were able to get these entrusted loans, they were primarily engaged in overseas minerals and resource acquisition.

So this is how they were able to do this, to have access state backed financing to acquire overseas strategic asset. But then the way they did, again, if you think about how they started the conversation about diversifying foreign exchange reserves, it goes all the way back in the early 2000s.

The moment they realized we can use foreign exchange reserve to successfully prevent a banking crisis and make our banks the biggest bank in the world, they started Chinese domestic interest groups, from SOEs, from local government officials, from SASAC people. They started to question how can we use foreign exchange reserves to advance China's interest in global market.

Specifically at the time when China became the largest commodity importer in the world. Because companies need financing to buy stuff overseas. And then obviously, in this whole context, it played a very important role in the whole going out strategy, right? And then, basically, this is just to summarize all their functions in terms of network, in terms of capital mobilization, in terms of legitimization.

And then the conclusion here I wanted to say is this becomes such an important model of development, not just for China overseas, but also for China in domestically. This is just an inconclusive list of other funds that China has established in the countries following the same model. And China is not the only country that seeks to use leverage, either implicit or explicit leverage, to establish sovereign funds.

This become a sort of a considered model even by countries in Europe, like France, Italy and even the European Union were thinking about doing something like this. During COVID the Netherlands were thinking about raising debt to capitalize sovereign funds. When interest rate was low, that's a reasonable strategy, but now interest rate is high.

I'm not exactly sure how viable this is a strategy, but if there is implicit government guarantee and somehow the government can pivot this into a public private partnership, things can be done. And not just China does this, but also not just advanced economies or China, but also countries like Saudi Arabia is doing it like the PIF issue bond.

I would not have imagined that countries like Saudi Arabia would raise debt to finance something. But PIF, the Public Investment Fund, did raise green bonds specifically for the purpose of financing their green transition. In other words, sovereign leveraged funds become a way that countries, sovereign entities can raise capital to finance some specific goals that they want to achieve.

It doesn't matter whether you have natural resources or not. And actually China showed that you can do it. So this is my presentation, I hope that is at least entertaining.

>> Glenn Tiffert: So we've asked Eyck Freyman to make some reflections and comments and then after he's done, we'll open it up to the audience for questions.

And those of you online, can I encourage you to file your questions using the Q&A function online, thank you.

>> Eyck Freymann: I believe after I go, Zoe's going to get a response, because I have-

>> Glenn Tiffert: Yeah, that's right.

>> Eyck Freymann: I have some questions.

>> Glenn Tiffert: Okay.

>> Eyck Freymann: Zoe, thank you for joining us.

You've, I think, done an amazing job with this book, doing the hard work of forensically piecing together what we can know about how the balance sheets and institutions function. And pairing it with some, I think, exceptionally deep field research, which includes interviews in Beijing that you could not get anymore.

You've shown light on how two of the most significant financial institutions in China function, I'm talking about CIC and SAFE. And you've, based on that analysis, shed light on a whole range of different literatures relating to Chinese political economy, Chinese finance. I think we could have a whole conversation about the implications of this for RMB internationalization.

What I would like to do is highlight two contributions of your book to the literature that I think are particularly salient for this group. In the process, I want to try to translate some of these more complex slides into simplified, hopefully not too oversimplified, stylized points, and give you the opportunity to tell me if I've butchered them.

And then I want to conclude by asking you to reflect on how these institutions might behave if things go in a very dark way between the US and China. So I think the first big contribution is how this book highlights the role of the sovereign leverage funds, the SLFs, in the backstory to the Belt and Road.

So the traditional conventional wisdom is that the Belt and Road was launched in 2013 as a vehicle to help China export industrial overcapacity in heavy industry. And much of the literature, for example, has talked about competition between SOEs to get money from the state. That's how in my own work, that's in my own work, how I thought about it.

Xi Jinping hijacking a system that already sort of existed and harnessing it to address his personal goals, which included creating a cult of personality. But also centralizing his personal control over China's domestic political economy by saying, I am the one via these institutions who can decide who gets allocated capital.

So I think you agree with this argument, but in the history that you present in the first two chapters, you say that this process begins much further back. It actually begins in the mid 2000s, right when the going out strategy is taking shape and the original goal is something quite different.

It has to do with using this excess of foreign exchange to go and get a better return than putting it in cash, or cash equivalent treasury bonds that didn't yield much. And I think you show very persuasively that around the time of 2013, when Xi Jinping is elevated, there is a profound shift in the model.

And the new decision is coming out of the 18th National Party Congress, that the purpose of CIC is not just going to be to get returns. It's actually going to be to align the state-backed capital in favor of a handful of industries and regions of the world that Xi Jinping thinks are strategic.

And in my reading of your book, tell me if you disagree, is that the transition from Lou Jiwei to Ding Xuedong in the leadership of CIC in 2013 marks this transition in which Xi Jinping himself effectively takes over these institutions. And therefore, this is almost a higher level of gain beyond this question that we have thought about SOEs competing with one another.

And we can almost think about the story of leadership transition around 2012 to 2013 being Xi Jinping becoming the guy who can direct the SLFs to do what he wants. So if you accept that framing of your story, I wonder how you explain why China's outbound FDI flows then reversed after 2017.

There's a couple of possible explanations. One is that, China found that, as you say, it couldn't get the returns and geopolitical benefits that it wanted, and it was actually throwing money into bad places. But I find that explanation not very convincing, because as you show us, they could have just bought a bunch of Vanguard ETFs and made a killing.

So what are the other explanations? Maybe around this time, there was another institutional turf war that led Xi Jinping to have a change of heart about the direction of Belt and Road. Maybe Trump's trade war, which began in early 2018, began to raise awareness in China about the risk of a potential financial war with the United States, and that called for more cautious deployment of FX.

And maybe Chinese authorities learned something, remember, this was the time that they were beginning to speak about de-risking, if not deleveraging, the domestic financial system. And decreasing awareness of the fragility of the domestic financial system might have led to a more cautious approach to managing FX. But from a historian's perspective, I think this has to be explained, because so much political work was done to talk about how Belt and Road was awesome, and we have to go out and invest abroad between 2013 and 2017.

And then speeches made by Li Keqiang eventually slammed on the brakes after that point, and Chinese outbound FDI has continued to fall since then. So I think that's a puzzle that has to be explained. This leads me to your book's second big contribution, which is that you illuminate in a way that no one else has satisfactorily done, the hidden interconnectedness between the Belt and Road, and more broadly, China's overseas asset accumulation, China's domestic banking system.

So if you look at the balance sheets of the big Chinese state banks, you will see a picture of a financial system that has a lot of debt, but is very sheltered from big external shocks. China's financial markets are sheltered by capital controls, and they're almost entirely financed by domestically held debt and equity.

And the exchange rate is very carefully managed because it's backed by SAFE's $3.4 trillion of declared reserves. Which means that the market doesn't want to fight the PBOC, if the PBOC decides it wants the currency to trade within a certain band. And China, as we know, has one of the least volatile currencies in Asia.

And then if you look back at the highlight reel of China's responses to banking shocks over the last two decades, and you tell us about this. The cleanup of the non performing loans in the early 2000s, the successful response to the global financial crisis 2015, and then the more recent bank failures in the past few years.

It seems that China has a solid playbook for containing financial risks before they become systemic. And the backstop of this whole system is the quote, unquote, national team of state organized funds, many of which, as you've shown us, are actually avatars or subsidiaries of Central Huijin. So it's an amazing toolkit.

It means that any time the system gets rickety, the national team can just marshal a seemingly unlimited amount of capital to stabilize things. And if you're a market participant, you don't dare bet against Central Huijin ultimately getting what it wants. But by contrast, I think Belt and Road is conventionally seen as this totally separate phenomenon.

Because it's funded through dedicated funds and policy banks, the China Export Import Bank, the China Development Bank, the Silk Road Fund, and so forth. And it's tempting to assume that these entities are separately capitalized and that if the debtor countries can't repay, the national team would just bail them out like they would bail out any other Chinese bank.

But if I read your work correctly, that's not quite right. Because the Belt and Road, and broadly, all of China's overseas asset position, directly or indirectly, and China's domestic banking system are actually two sides of the same coin, which is Central Huijin. Central Huijin is the shareholder in chief of all of the big four banks.

It's also the national team that bails out the big four banks if they come close to insolvency. And it's also the key bankroller of the Belt and Road, with perhaps a trillion dollars or more of highly speculative, illiquid investments overseas. That sounds like potentially a great big macro stability risk, if Central Huijin were overleveraged, overloaded with bad assets and extending and pretending the bad loans so it didn't have to mark them to market.

Well, it wouldn't tell us, as you've shown, that might explain some of the opacity. It would also explain why China's outbound lending reversed after 2017, and why China's authorities continue to make it so hard to piece together what CIC's balance sheet actually looks like. Speaking of data dishonesty, your colleague Brad Setser has done some fascinating work lately, arguing that China is also cooking its balance of payments and investment income data.

And his methodology is a bit complex. But he concludes that China's current account surplus is actually about twice what it declares. It's not 2% of GDP, it's 4% of GDP, which means hundreds of billions of dollars of undeclared FX flowing into China every year and being squirreled away somewhere in the system because SAFE doesn't declare them as reserves.

So I assume because you and Brad collaborate, you are familiar with his work. And so my question is, if you agree with his analysis, where are these dollars going? And if they're going into the SLFs, what is the purpose of recapitalizing the SLFs in this way? The scale of this is huge, by the way, because if China hasn't even doctored the data, and they've been doing it for years, things have accumulated.

So China reports a net foreign asset position of about $3 trillion. And if Setser is right, it's about 4 trillion. So the question is, how do you interpret Setser's findings of what China's doing and its attempts to hide what it's doing? Does it suggest in your analysis that the SFLs are financially unhealthy and that Beijing is trying to recapitalize them?

And what, if anything, can we infer about the risk they may pose to the domestic banking system or about the future of China's overseas lending activity? So these are, I think, the two big contributions, the Belt and Road question, and then the relationship between the external and the internal.

Just to conclude, I want to invite you to speculate a bit on the role that the SLFs might play and the challenges that they might face in a potential geopolitical crisis with the United States. So feel free to ignore this part of the response. Feel free also to engage with it.

I put it out there also for the Q&A. Suppose, hypothetically, that there's a crisis over Taiwan. Suppose that Washington responds by throwing the book at China, including sanctions and asset seizures. I can see one world in which China's domestic banking system faces the risk of bankruptcy, and the national team has called on again to intervene in the market and stabilize the system as it's done before.

However, in this scenario, I can see a world where the SLFs are short on liquidity because their foreign assets are frozen, or because they're tied up in investments that can't easily be liquidated. In that world, this model is a big problem for China's financial stability. It makes China more vulnerable to US financial warfare.

And I can imagine a world in which China has an even bigger problem because of the SAFE entrusted loan story that you've told us about but haven't been able to quantify. That might mean that SAFE doesn't have the capital to recapitalize the SLFs, since it's already lost money on these entrusted loans, and it has to spend also to defend the exchange rate.

So that's the nightmare situation for China. The vulnerability of having the domestic and the external interconnected. On the other hand, I can imagine a world in which this system works as designed, so in which the SLF national team rides to the rescue and stabilizes China's banks on day one of a geopolitical crisis.

And then I can imagine that starting on day two, the SLFs are weaponized because they can borrow against their foreign assets, and they can maybe get more capital from SAFE. And they can go into US capital markets and start buying and selling stuff to wreak havoc. Final thought is, in light of the conversation that's happening in Washington right now about confiscating frozen Russian assets, I can also imagine a story in which, on day T minus 30, before a big blow up over Taiwan or something else, the SLFs try to liquidate all their dollar assets and flee to safety in other currencies where their assets can't be frozen.

So, to the extent that you're willing, I'd like to invite you to join me in this speculative game. What role are the SLFs designed to play in the context of a financial war with the United States? What might they do in advance of a potential conflict that might give us advanced warning?

And God forbid, if a financial war came to pass, do you think they would work as designed? Thanks very much.

>> Zongyuan Zoe Liu: First of all, I thank you so much for your careful read of my book. I can't afford for your thoughtful comment, please write a review of my book.

You would be a great reviewer.

>> Zongyuan Zoe Liu: You would be a great reviewer. And this is excellent. So I'll just start with the first question, just to jump right into it. The first question, why FDI reversed after 2017? I think all the scenarios that all the reasons that you listed are valid.

And I wanted to just add two additional potential explanations. The first one would be heightened international environment, or less friendly, although 2017 was not a necessarily a trade war. But if you look into the literature or just trade, just look at China's financial flows and who invest in what, and who started to be grumpy about China's government led investment.

Actually, I consider 2015 as a watershed moment, because 2015, there was this. It was not about the United States or Canada, it was actually about Germany. A leading country that fully embraced China up until 2015. That company has nothing to do with China's sovereign funds, to be honest.

That company was China's appliance maker, called Midea. It makes TVs or refrigerators or washing machines. But that company has a very clear goal. It wanted to be a smart appliance maker in China and wanted to be smart. So it made a very successful investment in a leading German robotic company called Kuka.

And I get the opportunity to talk with some German people, including later, who was the lead author of Germans investments-bringing regime, which eventually become Germany was a lead country in the entire European Union, together with Italy. I got the chance to talk to him, and he was very angry about that purchase.

But the unfortunate scenario about 2015 of the Midea's purchase of Kuka. Kuka was the leading, one of the premier, like one of the crown jewels of the robotic company in Germany. And when that deal happened, when the bid went forward, when the board approved it, the German government went forward and said, no, this cannot happen.

We cannot let this happen. Can we have other German companies, please? You guys, put some money, beat it. So sort of like, back it around, and nobody in Germany would be happy to take the risk. And then obviously, the robotic company Kuka at that time had some balance sheet problem, and people did not want to bear the rest.

And then they moved around to other European countries, and nobody wanted to take the risk. So, eventually, the Chinese went forward, took it, and then triggered a massive, massive, massive kind of backlash in Germany. Hence, that's the backstory of how Germany suddenly becomes so worried about China's strategically oriented investment.

So, knowing that, and obviously with the European, the China-EU investment agreement framework did not go forward, is sort of permanently shelved. We do not know when it would be resumed. And that basically means Chinese investment flowing into one of the most friendly market becomes not as favorable as before.

So that's the change in external environment. And then, another important thing would be domestically, I would say, around, if I remember it correctly, it was around 2017, Chinese government, President Xi Jinping. The government issued an updated version of outward investment, Chinese version of outbound investment screening. So, it's called regulation and restrictions, the list what are the areas that you can't or you cannot invest.

And that also put a little bit of a hot, the source of financial flows. And then obviously, the stories about the ANA, Asiana, Hainan airline and a lot of these buying sprees, they have to be forced to sell. Again, sort of a confluence of all these factors perhaps contributed to the FDI reverse.

But I think the point that you were talking about, the turf war, perhaps within the bureaucracies. The looming, that the emergence of Donald Trump and the running up to trade war, as well as a lot of the conversation about derisking, perhaps all contributed to it. And then your second question with regard to the national team and to what extent.

No, sorry, the connection between the national team, the BRI, and to what extent this actually relates to the hypothetical question you were talking about, to what extent. No, no, no, the third question with regard to what extent are they financially sound, given that I call them sovereign leverage fund, and trust me, nobody likes me to call them leveraged fund.

Like nobody wants to be called leveraged. But the reality is, if you just do an honest analysis, it is leveraged, right? But yet you are right, they don't like it. And there is a reason to be concerned about their financial soundness. But so far, honestly, I'm not too concerned about their book.

Part of the reason is because if you look at the CIC, it's right now it's about $1.1 trillion. As of last year, it was the largest sovereign funds in the world. But then, the asset depreciated, lost money, now they are at number two. And the total size of CIC's asset under management is bigger than the GDP of Saudi Arabia.

And when they were number one, they were bigger than Mexico's economy. And Mexico is the 15th largest economy in the world. And if you think about CIC in the context of the sovereign, it's actually way much more diversified. Its portfolio is way much more diversified than countries like Saudi Arabia or Mexico.

And in terms of governance structure, perhaps we have American educated Wall Street veterans. But the problem becomes, to what extent they can safely guard their asset, and to what extent they have the financial expertise. But to what extent, when they make investment decision-making, their optimization function is only about pursuing financial return, rather than this intangible stuff, right?

So if President Xi Jinping decided that we wanted to have 100 billion to finance PRI, this is what we want to do, you have to make money for that. And for any investment institutions, you have something called budget constraint. You move money here, you cannot move money there, right?

So it's not necessarily cash, it's not opportunity cost, but actually it is. It's the kind of burden that you have to bear with. And then on top of that, every single senior management of the CIC, of SAFE, of Central Huijin, they have to be approved by the party's HR department.

A party decide who take this position, it's not that the board decides, right? Then finally, so, there is a reason to be concerned. But right now, if I just think from pure financial, from market diversification perspective, I think that they are pretty solid. And then the other part of the solid, why I think their book is solid is actually related to what you were talking about, their asset.

Again, this relates to CIC global portfolio versus domestic. About two thirds of CIC's $1.1 trillion is held domestically. So, despite I was talking about a global portfolio, we are talking about CIC as the second largest sovereign funds in the world. Two thirds of its asset is domestically. If just think about it, if it's a major shareholder of the four largest banks in the world, obviously it got to be big.

But it happens that these four largest banks, as a primary shareholder, their asset are at home. But the other part of Central Huijin is that it does risk debt on its own. They started releasing, Central Huijin was established back in 2002, but they did not do any kind of annual report up until 2015.

So, if you look at their recent financial report, the recent years, you can trace, they actually grow their asset quite significantly. So, the risk that I have here, the bigger concern that I have here, is the deterioration of the talent, and the management team. Because you are absolutely right when you were mentioning the transition from Lou Jiwei to Ding Xuedong, right?

So, this transition was interesting because, when Lou Jiwei was appointed to be finance minister, he got promoted. And then there was about a six month gap, where CIC as one of the leading investment institutions, there were no people. People cannot decide who to lead it. Eventually they decided to have Ding Xuedong.

So, since he came into power, he has a lot of experience managing China's domestic financial system, but less so internationally. So, compared with his predecessor, Lou Jiwei, or for that matter, who is Wall Street veteran, he's like, Wall Street lawyer, do mergers and acquisitions. So, compared with them, he has less international expertise, but he's very loyal.

And that was after Xi Jinping. And one thing I thought, two anecdote very interesting, was that two separate conversations that I interviewed people. When I interviewed them, they were no longer working at CIC. So, we were able to have this conversation. So one person told me that there was, since Ding Xuedong came into power.

There was a major sort of internal anti-corruption going on. And they started to, they went around and asked people, to self discipline. And when you report other people's wrongdoing or you were discovered any wrongdoing, you have to write. Have to write like self correction. You have to write a and you have to sort of, basically publicly express I did this wrong and I should not be doing it.

And that's what that was under Ding Xuedong. And then the other interesting anecdote was that at a bigger level, the China's national audit office. Actually did a conducting an audit about CIC around 2015, actually before 2017. The watershed moment they were talking about. And once you started auditing, it's a process.

And the result of the audit is that they discovered some of these CIC people use company money to play golf, and that becomes something that worth criticizing. Therefore, playing golf is no-no. So it's very interesting what has happened under Ding Xuedong compared with his predecessors. And now from Ding Xuedong moving to now Peng Chun.

Peng Chun is the current head of CIC, he is somebody that has zero international experience. His whole experience is from ICBC is a rise up through China's domestic banking system. Now, you see, based upon who they appoint, it shows that they probably want to put more emphasis on people who are more familiar with Chinese domestic banking system.

And more importantly, he knows that these are the people we trust, right? And then on top of that, mostly way somebody has proven track record to make CIC work, therefore, he's been put in charge of pushing forward this idea of reforming SOEs so that they are better at managing capital.

But this better managing capital is defined by the party, meaning you have to follow this specific way we want to channel money into this specific industries as you laid out. I'm worried that this trajectory is only going to be exacerbated, rather than reversed. Part of the reason is because of China's slow economic recovery, because like when the economy was growing.

The need for the government to spend the money on a variety of issues from healthcare or social benefits expenditure or infrastructure or any type of stimulus, the demand is low. And the SOEs did not have that much demand to ask government. Typically, the guys outside holding money bags, there is less of them because we can't make money.

But when the economic growth slows down or growing international trade headwinds. That basically means the Chinese companies that are heavily reliant on international trade are going to have a more difficult time. This basically put more constraints on the government, rely on the government to support them. Therefore, you really need to make sure that all the SOEs are aligned, rather aligned perfectly, if possible, but as closely as possible with the trajectory that the government wanted to go.

So it is not necessarily optimization of western free market sense, but it's more about where the party want to spend the money. And then finally, like the hypothetical scenario, I really do hope that the dark scenario don't happen. I really do not hope, God forbid, a war would have broke out.

I mean, just think about it. The travesty, 80% of the PLA combat forces, they are the one child generation. They are people like me. I'm the only child in my family, carry down the family line, and there are so many people like me. 80% of the PLA, they are the only children in their family to carry down the family line.

If they die, their grandma, their parents, they are going to be devastated. I'm hoping that this is going to be the constraint that prevent President Xi Jinping, to make a move, because it's going to be a very difficult, a social mobilization movement. But recently, what concerns me about it is that he seems to be mobilizing Chinese women.

And I do believe that moms would not want their sons or daughter to be killed on the battlefield. But recently, perhaps many of you already see this on social media. There is this young 23 or 24 years old Chinese woman. She's the youngest woman captain of a Chinese battleship.

And the journalist asked her, if the country wants you to go to war, are you afraid? She said, I'm afraid, but I'm afraid that the country would not send me to war. Her answer is she's afraid that the country does not send her to war. And this becomes massive popular, and I've never seen anything that tried to mobilize the woman.

And if you are able to mobilize the moms, the same as Americans try to mobilize the moms so that we can get rid of drunk drivers. That's what reading your paper, that made me deeply worried. I'm really hoping that this is not going to happen. But if it were to happen, I do think China at least can survive it.

I do think it has the capacity to survive it, for two reasons. The first, obviously, this depends upon the timeline. I don't think this is going to happen until China feels comfortable enough that its financial system is isolated enough. Because if it were able to extended the time horizon, separate its financial system enough so that sanctioning China, have a currency war against China is at least equally costly for the sanctioners for the war wagers.

Then the risk calculation would be different. If it were to happen tomorrow, there is no chance China can survive, the financial system can survive this. What you described, bank runs, currency depreciation, or just people want to smuggle money or gold or just leave the country. It is going to happen.

But if it were able to expand the delay, kick the can down the road, while sufficiently expand its Renminbi based financial system, you are right. The point of building international financial system based on Renminbi right now at this moment, despite the transaction volume is small, it's not the point.

We do not really care about the transaction volume is slow and there perhaps is no immediate urgency to boost the transaction volume. However, the point is to prove that the system can work and if we need it to work, it will work. So far, based upon the Renminbi based infrastructure, the so called CIPS, China Interbank Payment System, this has been able to process not just Renminbi cross border payment, but also digital Renminbi payment.

And they have been doing this through international commodities market as well. And that's the other part of China-Saudi, China-UAE, all these connections. And on top of that, China has also been actively developing domestic commodities exchanges that trade commodities using Renminbi. So from that perspective, if they were able to delay this sufficiently enough while either simultaneously build their own Renminbi business system.

Not for the purpose of waging a war, but for the purpose of self preserve, I think there is a chance for them to work.

>> Glenn Tiffert: Thank you for an exceptional discussion. I have so many questions, but given who's in the room, I wanna take a list first and maybe I'll chime in a little bit later.

Let's start with Erin and then I'll go to Alvin.

>> Alvin: Could we extend this to 2 o'clock, because there's no way we're gonna get this discussion done in 20 minutes.

>> Glenn Tiffert: Let's be brief.

>> Erin: All right. Thank you for taking the questions first. Thank you. Congratulations on this important book.

Thank you for really fast hitting talk. So my question is very specific. It's about the stock market. So you have this great figure, or a chart rather, of all the holdings that Central Huijin has and all these very important companies that are listed. Of course, there's huge hazard in the market where investors expect these bills, right?

So my question is, have you seen just this steady increase over time in the amount or has sales at certain points? When have those occurred and to who?

>> Zongyuan Zoe Liu: Yeah, yeah, that's a great point. Yes, they have been slowly divesting their shares on open market. So basically, it's purchasing through market stock exchange over open market purchase, and in times of crisis.

And once the crisis goes away, around 2016, they started to slightly decrease the shares, slowly decrease the share. There's no way it won't impact the market. Despite if they try to do it discreetly, but they have slightly decreased. But overall, their share has always been maintained around 30%, 25, 30.

So somehow that's the magic number they try to maintain. But I suspect that if they were able, it probably is politically incorrect for Central Huijin to dump its ownership of their Chinese banks, right? Yeah, we have done that, yeah.

>> Alvin: In five years, when you bring out the new revised edition, I expect the title to be House of Cards, How and Why the Chinese Financial System Crashed.

Now, I've been lucky to see a bunch of bank runs in real time. I saw the Hang Seng Bank run in Hong Kong in 1967. I was actually in the middle of stopping the bank run in 1983 when they had the currency crisis in Hong Kong. And then I was put out to pasture and emeritus here in 2009 because of the financial crisis in the United States.

So, I keep thinking about Bernie Madoff. And the reason I do is this notion that somehow or other you can protect yourself and more or less insulate yourself, even if you're gonna wrap it in domestic market. Suggest to me the experience of people who've been running a western style monetary financial system a couple of decades.

They really don't have the experience and depth of having lived through these things for a century, or a kind of learned experience. And of course, politics takes command, we know that too. And Xi Jinping can change on a dime. So the Hong Kong stock market hit its low of two years.

Money's pouring out, it's crashing, property prices are gone, why? Nobody trusts the damn government there, and they don't trust Xi Jinping. Now, the notion that people in China itself are gonna trust them. Whole blocks at Palo Alto were owned by capital outflow people from China, and there's ways of getting money out of the country through Macau, through.

I don't believe the foreign exchange flow numbers. If you go look at the stock exchange of the Virgin Islands, the British Virgin Islands, that's nothing but Hong Kong companies. In fact, I've been up to the Hong Kong Stock Exchange, it's all British Virgin Island companies. These are not Chinese companies controlling Chinese assets, these are overseas companies controlling China assets overseas.

And so I think in some ways, while your book is fantastic, it's a greatly, I wanna say this, oversimplified treatment of the realities of the whole system. And what I see happening, by the way, is since 80% of the Chinese own their homes, when the crash comes, and they've used home equity to borrow and leverage it.

The banks, so they'll close the capital markets, they'll fix all prices and controls. The whole system will creak and come to a halt, economic growth will grind to a halt, and without growth, you can't cream off any extra money to keep the system afloat. So, as I said, I've got another 20 minutes, I'll stop at this point.

So your last notion about a quasi optimistic they'll survive, they won't. And the reason they won't, and too bad Daryl Duffy had to leave, because he would have told you exactly the same thing in a much more monetary, economic style. But I just don't see that they're cushioned and buffered enough with what I would call inner reserves and hidden reserves that they can go to patch holes on the dike.

And when you pull out one link from the bottom of the Lego structure, you know what happens to the Lego structure, don't you? But great talk. But as I say, I think you could double and triple the size of that book. Too bad they won't let you in to talk to Xi Jinping or whatever.

 

>> Alvin: Anyway, but just a bunch of thoughts off the top of my head.

>> Zongyuan Zoe Liu: No, this is great, thank you so much for the thoughtful comment. I take a note of the title, the House of Card, and I keep House of Card, but I reserve the second part depending upon how it goes in the revised part.

If you allow me to sort of push back a little bit, I do think a lot of the problems that you describe are extremely solid. But fundamentally, I do think the ultimate problem that we perhaps can all agree on is that the system is ultimately financial repression. We build upon financial repression, and people describe Chinese economic growth model as government-led, export-driven.

But I tend to think about the Chinese economic growth model built upon financial repression. Now, people can say that, well, in the financial repression, it's up until 2012. And then after 2012, a lot of things started to change because of the P2P lendings, because of the massive proliferation of wealth management product.

But I would argue that the proliferation of all this stuff, people buying houses, but not just buy one, but buy two, buy three. Not just buy in China, but form housing purchase group in Vancouver, in, I don't know, in Italy, or in New York, or in California. All these behaviors fundamentally is because of financial repression, is because the inherent realization that you can harvest higher return elsewhere.

 

>> Alvin: 28,000 acres in Oregon, which the Oregon government

>> Zongyuan Zoe Liu: Right, and also, there's this private company in Shandong province investing in American farmland. It turned out that is ten minutes drive from American air base. So a lot of this, fundamentally, I think it comes down to the realization of, again, opportunity cost, right?

The system itself is by no means perfect, but I do think there is this tension between this is what the government want and this is what the people want. So this is actually my next book project. So the idea, I'm rebelling against myself rather than studying the government, but I study the people and how people cope with this financial repression system.

My working hypothesis is very much similar to what you were describing. So the idea is that in the early days of reform had open up, people were all motivated that, yeah, okay, great. And now you are basically-

>> Alvin: And population decline, that's really dropping like a lead rock in China.

 

>> Zongyuan Zoe Liu: Yes.

>> Alvin: Biggest ever.

>> Zongyuan Zoe Liu: Right, so the whole idea is that there is this growing incentive mismatch between the people and the private sector, and-

>> Alvin: It's all your women's fault, in China, they're not having kids.

>> Zongyuan Zoe Liu: Very much so. So hopefully I can address some of the questions.

 

>> Alvin: No, no, as I said, I want another half an hour.

>> Speaker 7: I had a question, did you see any maybe a counterpoint to, at the national level investment at the provincial or the municipal level using similar leverage funding vehicles? Cuz I'm concerned that, they're gonna copy what they're doing at the national level, they're gonna be even more overexposing their leverage.

Taking bonds that are essentially low risk and high risk, and converting them into a high risk investment, such as real estate market, you're talking. And maybe that we're even more overexposed than we think we are. Did you see anything like that? Or if they are like that, how could we determine if that's true?

 

>> Zongyuan Zoe Liu: My goodness, there are two versions of that. They are the good, the bad, the ugly, right? The good version would be the so-called government guidance fund. There are central government level, there are company level, but provincial level, even city level. There are a variety of this provision, the so called government guidance fund.

The whole idea is set up this vehicle, government put some money, and then you find other ways to raise capital. And it could be private, private sector, raise, deposit money in here. And when you raise the money, it's very much like a government, very much like a private equity fund, but got managed and guided by the government, and it has a dedicated purpose.

This is the government guidance fund, established for the purpose of developing pharmaceutical companies, developing semiconductors, or supply chain diversification, supply chains. There are varieties of that. The latest number shows that there is at least 12,000 varieties of those, obviously, the size would be different. And then again, you have to figure out, different sources would give you different estimation in terms of numbers, but they are there.

So this is sort of like the good part, the bad and the ugly, perhaps, would be related to the property market. The local government financing vehicles, those are the classic versions of the local government raising debt. But they do not want the debt to be on the your own buck.

Hence you set up a special purpose vehicle, and this company is going to be managed by, is going to raise debt. Hence the debt is going to be on the company's balance sheet, not on the government. Hence it's the big hidden debt problem for the Chinese economy. And all these local government financing vehicles, the way that they can borrow money is because of land sales.

And it's not the land sales to sell the land, it's the right to use and develop the land. Hence, you can just when this property developer fail, you sell it to the next one. The local government financing vehicles raising debt, that's a huge problem. Now, this is something that challenging the Chinese economy going forward.

 

>> Glenn Tiffert: I wanted to pull on a thread of your response to that last question, because one member of our online audience has actually asked. To what extent do you think that that central Beijing, for example. And CIC actually have control over the investment decisions that are made by government guidance funds and VC funds as well in China.

When they take this vast pool of resources available to them and begin to deploy them in the market?

>> Zongyuan Zoe Liu: That's an interesting question. Let me talk about this from two perspectives. The first one would be before stringent investment screening. That was the time between 2013 and 2018. During this period of time, CIC, as well as SAFE affiliated funds, were very much interested in direct investment overseas, direct equity investment.

That it was in this particular context that CIC elevated its equity investment arm into a independent subsidy, CIC Capital. So the purpose of CIC Capital is to make a direct investment overseas. Now, to what extent CIC Capital itself can make a decision, obviously, to a less degree, they can make specific decisions about whether we can do this project.

As long as this project is in the broader guideline set out by the board, which is mostly officials composed from different government agencies. And then for the money that they previously given to other private investment funds, such as just external asset managers, it doesn't pay a fee and then we sign an agreement.

This is how you manage money, the purpose is to grow the asset, perhaps has less control over how the external money is being managed. But when it comes down to if the question is about to what extent CIC plays a role in financing this local government guidance fund and Chinese VC fund.

So far I haven't seen a direct CIC Capital injection into any VC fund, but there have been joint partnership, joint investment. A good example would be the case of Alibaba. That was the deal when CIC and the whole capital, I think it was by the grandson of Jiang Zemin.

So it's like a bunch princely ran VCs and hedge fund, they become sort of a very enclosed circle. And then if you look at other, Premier China, China's largest hedge fund or private equity fund, they're basically princelings. And if you look at who is holding or like the investment arm of China Construction Bank, a lot of these people are princelings.

So it's a closed circle, and sometimes finance is about, it's less about money, it's actually about connections and the lawyer work.

>> Glenn Tiffert: That's an excellent segue to what I think will be the last question, and I'll exert the host's prerogative to pose it. And that is, you only very briefly alluded to corruption in your remarks, right?

But there was that wonderful slide that you had that said, if the market, if CIC and Central Huijin were really truly participating in the market to maximize returns. Then either they've got really bad asset managers and they should all be fired, or something else is going on, right?

But the explanations that you tended to give were intentional explanations. That there are strategic reasons for them to be making these investments that may not generate the greatest returns or policy decisions. But there's a whole other realm that you could use to explain it too, and part of it is patronage networks, right?

Within the sort of pathologies of the way that Chinese politics works. And then beyond that, corruption, in the last year and a half, it's been very dangerous to have a high level job in the financial system of China. Particularly, I mean, just ten days ago, there was a lurid documentary about how the deputy governor of the People's Bank of China was on the take.

And had just been expelled from the party, senior leadership of China Development Bank. Actually, just in the last few days, the former chairman of China Everbrite, which central Beijing is the principal shareholder of. And if you look, actually, the two most recent chairmen of China Everbrite, going back to 2007, unbroken 15 straight years, have all just been expelled from the party.

Which is setting them up for trial, essentially, this is the way the process works in the PRC. So one of China's largest bank groups, for 15 years, its chairmen, have just been sort of defenestrated. And you see this across the financial system in the last 18 months. So that's potential.

That's more than just playing golf here, right? And eating a little bit extravagantly. So can you say something about the way that the system, which looks brilliant on paper, truly functions with respect to the patronage networks in China and the epic corruption that it's had?

>> Zongyuan Zoe Liu: I think my own self criticism of my book is that I actually do not spend much time talking about corruption in the book.

It mostly focused on the balance sheet analysis of how the funds work and all that. But I have some scattered anecdote about that probably can cast into the idea of how the system, the patronage network, could potentially work. One example, I'll start with China Development Bank. A long time serving head of China Development Bank was Chen Yuan, and he was the son of Chen Yuan, who was China's economic mastermind.

And so this is just one example. And I also shared with you a couple of other examples where the princelings run the financial system. And there was even rumors saying that President Xi Jinping's wife, and not his wife, his sister and her family basically run, support China Construction Bank.

So you basically have the China's financial system becomes, the analogy these days people use is to say, in the Kuomintang time, there was the four-

>> Glenn Tiffert: The four big families.

>> Zongyuan Zoe Liu: Right, the four big families control China's financial system. And you have the families, the big financial mastermind.

 

>> Glenn Tiffert: His papers are here at the Hoover Institution, by the way.

>> Zongyuan Zoe Liu: Really? I have to look into it. Good source to use. Yeah, but then people's analogy these days are saying that basically there is the reason that the party now wanted to strengthen control over the financial system.

And part of the reason is because they wanted to have their trusted allies and their close allies, their friends, installed in this system, rather than the people in the previous administration. But I do not have access to the high level people. I never get the chance to talk with Xi Jinping or his officials.

So I really don't have any more insight into how much corruption is going on. But if you allow me to sort of conclude the answer by using a Chinese saying, I think in Chinese it's called. Means if you rob a jewelry store, you are a criminal, you are going to be punished.

You are a thief, but if you somehow managed to rob the national treasury, you rob the state. Now you are the king.

>> Glenn Tiffert: Thank you, that's a brilliant way to end the session.

>> Glenn Tiffert: I wanna invite you all for our next speaker, who, and it's not like we didn't really plan this, but it was also from the Council on Foreign Relations.

On March 18, we're gonna have Ian Johnson, who's gonna be speaking about his new book, Sparks: China's Underground Historians and their Battle for the Future. Thank you very much. Thank you, Eyck, thank you, Zoe.

>> Zongyuan Zoe Liu: Thank you.