Cash Is King

rmbIf cash is king, then China is the king of kings. With more than US$1.33 trillion of foreign currency reserves, the country has the largest, unleveraged equity pool in the world, and its impact on global capital markets is now being felt.

For the past several years, global stock prices have been underpinned and driven upwards by unprecedented merger and acquisition activity. By far, the biggest players in the M&A market have been private equity firms and their cousins, the hedge funds. Attracted by the high returns which they have been able to achieve investing in leveraged buyouts, pension funds, endowments and other financial institutions have poured money into the coffers of these modern day JP Morgans. Given the outsized fees which they can earn putting the capital to work, the private equity funds have been only too happy to oblige.

While private equity firms will argue that they can earn such high rates of return because they are better stewards of corporate assets than the boards of public companies, the vast amount of credit that they have had at their disposal has been a key to their success. The willingness of banks and the capital markets to provide large amounts of cheap credit to finance acquisitions has not only expanded the amount of capital that they have to spend, but it has also enabled them to earn highly leveraged returns. They have been able to buy multibillion dollar companies the way an ordinary individual buys a house on mortgage.

The reason debt has been so cheap and available is that there have been plenty of buyers for U.S. Treasury bills and bonds, which has kept rates on these benchmark securities low. Few realize, though, that the largest buyer of U.S. Treasuries over the last several years has been the Chinese government. A steady stream of foreign direct investment, combined with China’s growing trade surpluses, has caused a massive buildup of China’s foreign currency reserves. To date, China has been content to park the majority of these reserves in low yielding U.S. Government securities.

In other words, the huge amount of liquidity that has been transferred to China over the past five years is one of the reasons why private equity firms have been able to obtain large amounts of cheap financing; which in turn has fueled widespread M&A activity; which in turn has led to high stock market valuations. Another reason for the strong performance of global equity and bond markets is low inflation, which again comes courtesy of China. By flooding the markets with ever cheaper products, China has been a deflationary force in the global economy.

But all good things must come to an end, and the U.S. stock market sell-offs over the past few weeks indicate that markets sense that the game is changing. Cracks in the armor began appearing several months ago as a result of widespread problems in the U.S. sub-prime mortgage market. Lenders have become more cautious, and rising inflation is causing central banks to raise interest rates. The impact on debt financings for acquisitions has been sudden and dramatic. Bankers seeking to raise $20 billion of loans for Chrysler have postponed a sale of $12 billion of debt for the company due to poor market conditions. Debt financings for virtually all pending acquisitions are now unmarketable on terms which were readily available only weeks ago. The leveraged buyout market has come to a dead stop.

Some of the events leading up to the recent stock market reverses may be temporary, but China’s changing investment strategy represents a more permanent shift. No longer content with low rates of interest on U.S. Treasury securities, China is now committing more capital to key strategic sectors and higher return investments.

Two months ago, China committed $3 billion to take an approximately 10 percent stake in Blackstone, the world’s large private equity firm. More recently, the China Development Bank announced that it would invest up to $13.5 billion in the equity of Barclays to help fund the bank’s proposed buyout of ABN Amro. This would give the China Development Bank 8 percent ownership in the combined bank. Expect more deals to follow, including ones in resources and technology, two areas which China is targeting.

While everyone has been focused over the past five years on China’s trade practices, a massive shift in global liquidity has occurred. As if out of nowhere, China has emerged with the largest amount of foreign currency reserves that has ever been accumulated by one country. As long as China kept these reserves invested in low profile, risk-free securities, their impact on global capital markets went unnoticed. As China now switches its investment strategy to more equity-like investments, the full impact of the country’s rise as an economic superpower will become increasingly visible.

One Response to “Cash Is King”

  1. I think it is common but wholly mistaken to refer to China’s reserves as the largest, unlevered equity pool in the world. Reserves are not wealth, they are simply the asset side of the central bank’s balance sheet, against which the PBoC has appreciating liabilities. The PBoC is forced to buy dollars because the currency regime requires it to act as the residual buyer or seller of dollars (or else it simply cannot set the level of the RMB). It wishes it could stop, but it cannot, and of course in order to buy those dollars, the PBoC has either to sell RMB-denominated bills and notes, or to create currency. Of course I agree with you that they will manage these assets very differently in the future and should spend a larger portion in buying riskier (and higher-yielding) assets around the world. This will have an important impact on global risk appetite.