Zoe Liu on sovereign funds and how the Chinese government makes strategic investments

“Follow the money, find the politics” is how Zongyuan Zoe Liu describes the focus of her new book Sovereign Funds: How the Communist Party of China Finances Its Global Ambitions, published by Harvard University Press in 2023. Zoe is the Maurice R. Greenberg Fellow for China Studies at the Council on Foreign Relations.

China’s sovereign funds, including the State Administration of Foreign Exchange (SAFE) and China Investment Corporation (CIC), control trillions of U.S. dollars that can be invested overseas in projects to advance China’s global strategies. In this installment of China Book Chats, I chatted to Zoe about the specific investment projects of each.

CIC aims for financial returns on investments in tech and natural resources, and its subsidiary Central Huijin, itself a sovereign fund, is focused on rescuing financial institutions. SAFE participates in infrastructure and other strategic projects in the Belt and Road initiative and other investments.

Zoe also explained how she investigated the movement of money between bureaucracies and these entities and how that often leads to power struggles and political influence over these institutions. In this era of geopolitical uncertainty, we also discussed how personal ties between influential American and Chinese business and financial leaders can lead to cooperation between the two countries and the climate of international skepticism about Chinese investments.

Below is an edited transcript of our discussion.

— Christopher Marquis

Christopher Marquis: The first question is a basic and simple one: It’d be great to hear in a few sentences about the goals and approach of your book. One of the phrases I really liked that summarized a theme of your book was “follow the money, find the politics.” Can you say a little bit about what that means, and about the goals of your book?

Zoe Liu: This book is half of my doctoral dissertation. The book is written with the goal of making it accessible to a broad audience rather than solely engaging with scholarly debate. Therefore, I try to use a more intuitively easy way to describe the research methodology. The research and analytical approach of the book is to “follow the money, find the politics.” I started by asking myself the question: where does the money come from? This approach combines balance sheet examination using accounting and financial analysis methods with classic political economy research methodology, such as semi-structured interviews, comparative case studies, and data analysis. I take a balance sheet approach to analyze how the Chinese government has capitalized its sovereign funds. To risk oversimplifying it, the process involved moving money out of one government agency and putting it into the other agency. At the same time, it also involved high-ranking officials with different incentives. When a new institution was created in this process, different government agencies would fight for control and influence over the new agency. In other words, the creation of sovereign funds is not just an economic process or economic phenomenon, but also a political process and political phenomenon. Hence, “follow the money, find the politics.”

Christopher Marquis: Great. You make a distinction between sovereign wealth funds and sovereign leveraged funds, the latter of which is China’s approach.

I think one of the reasons I found your book to be important is that there’s a lot of in the press about China having all these foreign exchange reserves, but actually not much on connecting the dots of what they’re doing with those assets. People just say, “they have like X trillion.” But is it sitting in the bank? Or being deployed in a variety of strategic ways?

I would love to hear a little bit about that distinction you make between these types of funds and why it is important and how it relates to foreign exchange assets?

Zoe Liu: I’m so happy that you see the difference in what I describe as “sovereign leverage funds” compared with SWFs. Some may think the name does not matter. But I think it does. In this particular case, knowing how the funds are capitalized does matter because China’s sovereign funds are different from traditional sovereign wealth funds that are established in commodity-based economies. The difference matters for how the Party and the government use them to exercise financial influence for geo-economic and strategic goals.

Recognizing such differences also matters for international financial norms and the rules and the level of transparency in international finance. I term China’s sovereign funds as “sovereign leveraged funds” for two reasons. First, the process of China’s party-State creating these funds involved the government taking on either explicit or implicit leverage. Using explicit leverage means the government — in China’s case it was the Ministry of Finance — issues special purpose bonds and uses the bond proceeds to purchase foreign exchange reserves to capitalize a new agency, a process that necessitates the expansion of the government’s balance sheet. In contrast, using implicit leverage means without the expansion of the government balance sheet due to the issuance of bonds, but rather recharacterizing the risk profile of existing assets — such as low-risk-bearing bearing foreign exchange reserve assets — and allowing for higher risk taking or less liquid investment. This kind of asset management actually increases portfolio risk and the leverage does not show up on the government’s balance sheet but rather through its external investment. In other words, implicit leverage transforms low risk assets such as foreign exchange reserves invested or could have been invested in U.S. Treasuries into risk-bearing assets.

Christopher Marquis: great. And can you say something about what those higher risk investments typically are. It’s very complex — there’s trillions of dollars here. And there are three different sovereign funds you analyze. There’s Central Huijin, CIC and SAFE, all of which have seemingly different investment strategies. Can you say both generally what the investment strategies are of the different funds, and then maybe how this advances China’s geopolitical strategy as well.

Zoe Liu: Sure. Here it is probably relevant to take a step back and clarify what are and aren’t foreign exchange reserves according to the IMF definition. They are simply those assets that are managed by the monetary authority used for balance of payment settlement, and these reserve assets should be invested in low risk and liquid assets, usually U.S. Treasuries. The moment when the People’s Bank of China uses foreign exchange reserves for other purposes, such as recapitalizing Chinese banks or supporting Chinese companies to go abroad and conducting overseas merger and acquisitions, those reserves are no longer foreign exchange reserves. But these assets are still foreign exchange assets because the source of the money is from foreign exchange reserves and the investments are often denominated in U.S. dollars or other foreign currencies. Typically the investment is less liquid and has a higher risk than U.S. Treasuries, such as investment in real estate, infrastructure, public or private equities, etc.

China’s party-State has used its foreign exchange reserves and its reserve-capitalized sovereign leveraged funds for different purposes. The bottom line is that the first time that China created such a fund was not for geopolitical or geo-economic power projection. Many of China’s sovereign funds were not created with the goal for exercising economic statecraft or achieving a particular geopolitical goal. However, since President Xí Jìnpíng 习近平 came to power, he has been more actively using China’s sovereign funds as tools of economic statecraft, especially financing the Belt and Road initiatives.

The first time that China leveraged its foreign exchange reserves to solve an urgent crisis led to the creation of Central Huijin, which was created in 2003 to recapitalize Chinese banks. At that time, major state-owned commercial banks in China had a high level of non-performing loans and were considered as insolvent. The Ministry of Finance did not have the capacity to recapitalize these banks. After a domestic debate, Chinese officials reached a solution, which was to use foreign exchange reserves to capitalize Central Huijin as a company and use this market-faced company to recapitalize Chinese banks. The capitalization was so successful that Central Huijin later restructured China’s non-banking financial institutions, such as policy financing institutions and brokerage firms. Today, Central Huijin is the “shareholder in chief”of major Chinese financial institutions.

When it comes to CIC (China Investment Corporation), it makes both direct and indirect investments in overseas markets. During the 2007-2008 global financial crisis, CIC invested in U.S. financial institutions. Later it also invested in overseas oil and gas companies, food supply chains, and promising tech startups. It also invested in Chinese companies, such as Alibaba and Didi.

Christopher Marquis: Regarding the investments of CIC, you also have a number of pages talking about their work with Steven Schwartzman and Blackstone, which is really interesting because he is also seen as having a close relationship with China. Can you say more about this case and Schwartzman?

And as I thought about this investment, I also considered how you mentioned later in the book about countries having some FDI restrictions around these entities including core financial services or other companies. Do you think that the investment you examine in the book could happen now?

Zoe Liu: The Blackstone case was special not just because the timing was bad, in retrospect, as it was in the running up to the 2007-2008 global financial crisis, investment was CIC’s debut to global financial market and it was the very first time thatChina’s foreign exchange reserves were used to invest in a western company. Individuals such as Stephen Schwartzman and Liang Jinson have played an important role in this investment as well. In the book I paid a lot of attention to people-to-people connections. This also reflects where I came from — I believe that states and countries do not shake hands, it is people who shake hands with other people. This concept applies in the context of cross-border transactions as well. It’s not the state that makes cross-border investments; it is people that make investment decisions and make deals happen.

Therefore, this kind of people-to-people connection matters even more in times of unabated geopolitical tensions. Because of people-to-people connections, there is still room for China’s government-owned investment institutions.

It’s actually a very good example, because Goldman Sachs and CIC established the China-U.S. Industrial Cooperation Partnership, which was announced during Trump’s visit to China in 2017. Starting from 2018 the U.S.-China tension and the trade war escalated. Despite the tension has been largely unabated, the joint fund has been able to make several investments, including California based engineered material company called Boyd Corp, and a Chicago based supply chain tech firm called Project 44, which has become a very successful unicorn investment.

Individuals and people definitely matter. A lot of influential people in charge of Chinese financial institutions, both state-owned ones and private equity firms, are princelings and highly politically connected. For example, Jiāng Zémín’s 江泽民 grandson, runs one of the largest Chinese private equity funds.

Christopher Marquis: I really agree, and I’m so glad you brought this up, because this is something that concerns me a bit in in the world is that during COVID all these personal connections were somewhat disrupted and they have not seemed to come back to prior levels, which is concerning. For instance, my industry, educational exchange, there’s still a lack of traction in rebuilding those ties. People-to-people connections have really declined in the last 5 years.

You mentioned the princeling tie. What’s your sense of the overseas hǎiguī海归, maybe with Wall Street experience. Are there Western trained individuals that are senior in these institutions as well as princeling links?

Zoe Liu: That’s an excellent point. In the book I included a table illustrating the changing HR profile of CIC. In this table, I show details such as how many foreign experts and people with overseas education experience. I have to say at least, up until before Xi Jinping came to power, CIC’s senior leadership did have a lot of Wall Street veterans. Having Wall Street experience and Wall Street connections have mattered a lot for CIC’s earlier growth.

Christopher Marquis: I don’t think we’ve talked much about SAFE yet. Central Huijin was designed to help overcome some of the challenges in the financial sector like banking recapitalization. CIC seemed a little bit more focused on making a return, as opposed to rescuing problematic companies, and actually making a financial return on tech companies, natural resource investments, etc. And then SAFE, is it focused on things like Belt and Road and potentially able to advance China’s geopolitical strategy? I’d love to hear a little about SAFE and the work on the Belt and Road, with some of the other investments and how that may differ than CIC.

Zoe Liu: SAFE or the State Administration of Foreign Exchange is a subsidiary of the People’s Bank of China, and specifically in charge of the foreign exchange reserves management. The goal of China’s foreign exchange reserves is to preserving and growing the value, and helping Chinese companies’ overseas expansion. This last point is important because promoting overseas investment is not a conventional reserve management approach.

As China’s reserves accumulation accelerated after China joined the WTO in 2001, Chinese policymakers and scholars became increasingly aware of the opportunity costs of having most of China’s foreign exchange reserves invested in U.S. Treasuries. CIC was established in 2007, which involved the Ministry of Finance issuing special purpose bonds and using the bond proceeds to purchase about 200 billion USD from SAFE. In this context, SAFE started to become more active as it involved the battle over who should manage China’s foreign exchange reserves and how the reserves should be managed. After 2013, since the launch of the Belt and Road initiative, SAFE has used China’s foreign exchange reserves to support the BRI through two primary ways. One is to use the entrusted loans program through designated Chinese state-owned commercial banks and policy banks, which then make the entrusted loans using China’s foreign exchange reserves to support qualified Chinese companies in their overseas mergers and acquisitions. Most of these companies are involved in overseas resource acquisitions, such as mineral resources.

The second way for SAFE to support China’s domestic economy and the BRI is to use foreign exchange reserves to set up funds and directly participate in China’s domestic financial market or invest abroad. One example is the Silk Road Fund, which was created to specifically finance BRI and overseas infrastructure projects.

Christopher Marquis: Great. I only have two more questions. One of which builds off a discussion towards the end of the book in the conclusion. France and Germany started to create their own sovereign funds, and I think underlying that was a skeptical view of Chinese investment. And in Germany, there was a robotics company where taking Chinese investment was controversial. Can you talk a little bit about this skepticism? And the eventual responses?

Zoe Liu: Sure. Europe has embraced Chinese investment with an open arm for a long period of time. And the sudden change happened after a Chinese company called Midea, an appliance maker, acquired a leading German robotic company called Kuka.

The German Robotic company was in financial distress at that time. The Chinese company has a plan to be a leader in smart home appliances. Midea’s acquisition of Kuka triggered a concern from German policymakers and industrial leaders because they viewed Kuka as a strategically important company and Midea’s acquisition of Kuka hurt Germany’s strategic interests. This acquisition led to a backlash against Chinese investment in Germany, which then spread across other major EU economies such as Italy and France and triggered their concern over the strategic nature of Chinese investment. In some of the interviews, people told me that this was the beginning of the EU’s discussion about establishing their own investment screening regime specifically against strategically motivated investment from China or other Middle Eastern or Russian entities. The EU has already launched their own investment screening regime which mirrors the CFIUS but far less sophisticated and is not enforced to the same extent for every EU member.

Christopher Marquis: Yeah, got it. And then how about France and Germany establishing their own sovereign funds?

Zoe Liu: . France established its Bpifrance to protect its strategic industries. Germany has had several rounds of debate about whether to establish a German sovereign fund during the financial crisis, after Chinese appliance maker Midea bought the German robotics company Kuka, and since the Covid pandemic. But this growing interest in establishing sovereign funds for strategic purposes is not only restricted to France and Germany. For example, After the global financial crisis, Ireland restructured its National Pension Reserve Fund, which was a savings fund for pensions, into a strategic investment fund called Ireland Strategic Investment fund, specifically to promote domestic economic development. Italy has also established its own sovereign fund called Fondo Strategico Nazionale del Made with the strategic goal of boosting growth and promoting supply chain security Netherland has also been debating about the need for a Dutch sovereign fund.

Such growing interests in sovereign funds among European economies is largely due to their concerns about the lack of domestic alternatives to fend off undesired strategically motivated foreign investors. By establishing their own sovereign funds, these governments hope that the next time they are challenged with a strategically motivated or predatory foreign investor targeting their domestic strategic industries, they would have their own sovereign funds or government-owned investment institutions to guard against undesired foreign investors and protect their core economic security.

This is relevant in the current context as well, especially when everybody is talking about industrial policies. If countries want to achieve all these different varieties of priorities, you literally cannot only count on the private sector. To do this you have to give private sector incentives. You can give a tax credit or incentives. And then you can also utilize government equity investment in order to crowd the private investment. Having a government-only investment institution backed by data capital state assets in Western democracies or Western capitalist economies basically place that kind of role.

Christopher Marquis: What’s your sense about the U.S. appetite for this type of institution? After the 2008 financial crisis, the government invested in banks and I think most of that was paid back really quickly. There’s a lot of discussion, particularly around the CHIPS Act, on industrial policy in general — “we’re the US, we’re about free markets. We don’t want government involved deeply in the private sector.” Given all these trends, do you think the U.S. will ever choose to create such an entity?

Zoe Liu: That’s another excellent question. This speaks to the nature of the messy landscape of Sovereign Wealth Funds. Some people would argue that the United States at the individual state level, some already have their sovereign funds. For example, Alaska has its Alaska Permanent Fund. However, these state-level funds are in a different category compared with China’s sovereign funds. The closest government fund that the U.S. government has to a sovereign fund is the exchange stabilization fund, which has been enactedduring the COVID relief. In other words, depending upon how you view it, the United States already has a sovereign funds although at a much smaller scale and infrequently used. The question then becomes to what extent the U.S. government is comfortable to actively use government finance vehicles to achieve strategic goals in an era of competitive industrial policies and great power competition with China.

And right now, we see the Biden administration certainly is not shy to use industrial policies and offer tax incentives. But a lot of the existing tools aim at crowding in the private sector and make investing at home more attractive. However, if the government actively participates in frontier financing, I think that’s a different story. In times of crises, such as during the 2007-2008 global financial crisis and during the COVID-19 pandemic, we see people actively debate whether the United States should have a Sovereign Wealth Fund at the Federal level or not. I would argue that the United States has a sovereign fund at its disposal already, but its function needs to be augmented if the U.S. government views it as a tool to compete with China regarding development finance. Furthermore, the U.S. government alone cannot achieve the desired outcome or scale. It must mobilize the private sector and work with U.S. allies and partners.

Christopher Marquis: My final question is about your future work. This is part of your dissertation. Do you have any follow up things you’re doing that stem out of this or are moving into an entirely new direction?

Zoe Liu: I appreciate the question. I continue the study of resource wealth management, the cycle of the petrodollar, and the future of the U.S. dollar, as well as the trend of de-dollarization.

My next book project is still about the role of China in the global economic system. But this time instead of focusing on the state, I have decided to focus on the households and provide a bottom-up analysis of China’s rise and challenges to its continued growth.

Christopher Marquis: Thanks so much for the interesting discussion, I look forward to talking to you about that in a few years!