China creates a massive foreign investment fund.

China is creating a new $200-billion to $300-billion "sovereign wealth fund" to diversify its foreign holdings away from U.S.-dollar denominated debt securities and to make large-scale equity investments in companies overseas. The money will come from the more than $1.2 trillion the country currently holds in reserves, with at least another $400 billion expected to be added to that stockpile this year. China's reserves are said to be growing by about $10 billion per week. By 2010, China could be sitting on $3 trillion in foreign assets. The shift of wealth to China and U.S. indebtedness are growing in unison--and at an accelerating rate.

China has made its first investment from the fund: a $3-billion non-voting investment in the Blackstone Group.

China's decision to diversify its vast holdings through the so-called China Foreign Exchange Investment Co. will provide a fresh supply of cash for the purchase of foreign assets instead of U.S. debt securities, which currently account for 99.9 percent of China's holdings. But diversifying its portfolio, especially if it does so with centralized government control aimed at manipulating industrial markets, would raise political flags throughout the world.

"China no longer needs to hold most of its external assets in safe, liquid securities," says Brad Setser, a research associate at the Global Economic Governance Program at the University College in Oxford. "China is integrating with the world economy before China's internal corporate governance has fully converged with global norms."

Most of what China will do with its sovereign wealth fund will be heavily scrutinized, but it should not be feared, says David Marchick, a partner with Covington & Burling in Washington, D.C. "While important policy questions are triggered by the creation of this fund, particularly given its potential size, the United States should not react negatively to the move by China," Marchick wrote in prepared testimony presented to a May hearing of the U.S.-China Economic and Security Review Commission. "Such sovereign wealth funds have become commonplace in recent years."

Three panelists describing the fund to the U.S.-China Commission agreed with that assessment.

Other countries with similar funds include Norway ($300 billion), Singapore ($300 billion), Kuwait ($200 billion) and Abu Dhabi ($500 billion to $600 billion). Korea, United Arab Emirates, Brunei, Malaysia, Taiwan, Canada and Chile also have sovereign investment funds. Alaska and Wyoming have funds that invest state revenues in private equities. The Ontario Teachers' Pension Fund invests 24 percent of its portfolio abroad. The Alabama state pension fund had a controlling ownership interest in U.S. Airways from 2002 to 2005. The Canadian Pension Plan has heavily invested in foreign firms including Serta, Nielsen and Univision, among others, says Marchick.

"Far from a cause for alarm, sovereign wealth funds such as China's proposed fund are part of a recent and growing trend by central banks and state pension fund managers to add the goal of increasing returns to the longstanding goals of solvency and liquidity," says Marchick. "The manager of China's new fund recently said that they intend to take small stakes in a number of publicly traded entities as opposed to controlling stakes or acquisitions of Chinese and foreign companies."

But the fund could grow to be much, much larger, says Setser. With the addition of $1.5 trillion in foreign holdings between now and 2010, China will have $3 trillion sloshing about. "A world where China creates a $1.5-trillion investment fund rather than adds $1.5 trillion to its reserves over the next few years isn't hard to envision," says Setser. Even a more modest forecast of China adding equal sums to its reserves and investment fund would generate $900 billion for equity investments by 2010, making it the world's largest equity fund. "Relative to a scenario where China invests only in bonds, a scenario where China invests primarily in equities might push U.S. interest rates up by as much as 50 basis points," he says.

With such large amounts of money available for equity investment, "two key policy issues arise," says Marchick: "First, will the fund be professionally run by independent financial and investment experts, or will the investments be made to advance industrial policy, political or foreign policy objectives? More specifically, will investment decisions be made according to financial criteria, or are they being used as instruments to extend state policy? Second, will investments by the fund in the United States raise any national security issues?"

It's hard to answer these questions now, but in all likelihood, the fund will be a good thing for China and the United States, Marchick argues. For China, it could help spur economic reform and integrate it into the global economy. "A U.S. policy that encourages investment by American companies in China while frowning upon Chinese investments in the United States is neither sustainable nor sound from an economic perspective," he says. "Rather, the United States should simultaneously encourage China to allow FDI and make clear that Chinese investment in the United States is not only welcome but encouraged. Greater FDI from China would bring substantial economic benefits to the U.S. economy, just as investment from other countries already does. Chinese investment in the United States will create jobs, promote research and development in the United States and enhance U.S. exports to China, including through intra-company trade."

China's new overseas investment company managers could help the country's leading manufacturing firms gain strategic footholds in foreign markets, says Daniel Rosen from the Peterson Institute for International Economics. "I expect there to be a dramatic increase in offers from Chinese firms to purchase stakes in U.S. firms in the future," he says. "In large part, this is for the same reason there has been and will be a dramatic increase in U.S. purchases of stakes in Chinese firms including in strategic Chinese industries such as finance and mining machinery. Our economies are becoming more integrated and in the process there are only two options for establishing a business platform from which to sell to a new market: build it or buy it. In the case of China, there is a special urgency to buy it."

China has exceptionally good skills in manufacturing, but little in distribution, retail and high-end services. As manufacturing margins shrink, the country's leading exporters "absolutely must expand their businesses downstream from the factory," says Rosen. "And yet, they have little experience operating in a heavily regulated, customer-oriented marketplace such as the U.S. To build retail operations from scratch will require decades; acquisition is the logical and quicker alternative. Typically, the business capabilities global Chinese companies attempt to acquire in this regard will be mundane."

China will have to improve its public relations operations if it decides to move aggressively into the U.S. market for equity stakes in U.S. businesses. "They will need to demonstrate their commitment to creating jobs, complying with U.S. laws and regulations, working collaboratively with organized labor and being good employers," said Marchick. "They will need to become involved in their communities in the same way that the best American and foreign companies do. Indeed, the initial U.S. experiences with Chinese investment have been positive."

The Chinese owners of Lenovo, IBM's former personal computer division, have proven themselves worthy by increasing purchases of American software for sale in China. South Carolina Governor Mark Sanford has spoken favorably about Chinese investments in appliance manufacturer Haier. South Carolina intends to open an economic development office in China seeking investment in the state.

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