Chinese investment in US: $2 trln and counting

If most members of Congress were asked how much China has invested in the U.S., they would respond with about $900 billion. This is a notable sum. Yet it’s too low by $1 trillion and possibly more. If many participants in financial markets were asked about Chinese investment in the U.S., they would fret over the possibility of disinvestment. This seems perfectly reasonable. At present, though, it’s essentially impossible.

The Department of the Treasury just issued its preliminary report of foreign holdings of American securities. It puts Chinese investment in the U.S. at $1.61 trillion, including $1.1 trillion in Treasury bonds, as of June 30, 2010. These are not entirely accurate, but are far more accurate figures than given in the unrevised monthly Treasury report of foreign holdings used by Congress and the media alike. To illustrate: the total for Chinese Treasury holdings was previously $844 billion. Upon revision, it is now $1.11 trillion.

There are two obvious problems. First, the large amount of U.S. dollar assets held by the PRC is obscured by poor numbers. Second, there is widespread misunderstanding of why China holds dollars. It does so due to its own balance of payments system. Until the PRC changes its own rules – which it so far has declined under intense foreign pressure – it has no choice but to buy. Disinvestment cannot occur.

Flawed American Numbers


Congress and the public rely on Treasury’s monthly series on major foreign holders of its bonds, which previously put China’s total at $892 billion at the end of 2010. This was misleading in at least four ways:

1) It obscured over $250 billion in Chinese purchases made via Britain, Hong Kong and offshore sources such as the Cayman Islands.

2) It excluded at least $300 billion in agency bonds purchased from Fannie Mae and Freddie Mac held through the end of 2010.

3) It excluded over $125 billion in purchases stocks and short-term debt.

4) It excluded dollars held outside securities, such as in Chinese and other banks.

Treasury’s annual report addresses the first three problems. It includes agency debt. In the annual report, Treasury uses a more complete survey than the monthly report. It traces some of the indirect buying of Treasuries the PRC does, through Britain especially. The annual report also includes estimates of other Chinese holdings, as in the U.S. stock market. The headline figure of $1.61 trillion is a much more accurate number than the $892 billion.


Unfortunately, the annual survey is not frequent enough. It is eight months out of date upon release and 20 months out of date before being revised. Just as with the inaccurate monthly series, the annual report cannot be used to ascertain whether China is currently buying or selling American bonds. Other limitations of the annual survey include failure to attribute all indirect buying – for example, the Caymans were said to invest $732 billion. It does not measure simple bank deposits denominated in dollars, even in American banks. These are not as important as investments but may involve large sums.

Flawed Chinese Numbers

Chinese figures contain additional information. They also shed light on the true nature of the PRC’s purchases: these are not choices to be unraveled at any time, they are the unavoidable outcome of China’s balance of payments regime.

China’s official foreign exchange reserves stood at $2.85 trillion last year. Remarkably, total Chinese foreign currency holdings are even larger than that. The domestic banking system appears to have held almost $400 billion more in foreign exchange at the end of 2010, though no such figure can be confirmed. A low figure for the PRC’s total foreign exchange holdings is therefore better estimated at $3.25 trillion.

A higher estimate, also using official data, puts total foreign exchange in the banking system at over $3.4 trillion. Sovereign wealth fund China Investment Corp. was originally granted $200 billion in foreign exchange, though the present distribution of its assets is unclear. Finally, deposits held overseas by Chinese entities outside the central government are excluded. It is possible total Chinese holdings exceed $3.6 trillion.

There is no official Chinese figure for total holdings, nor for the dollar’s share in those holdings. The lowest estimate of the dollar share is about 58%. The highest is an official figure on the dollar share of the PRC’s debt, 72%. Chinese dollar holdings therefore most likely ranged from $1.9 trillion to $2.6 trillion by the end of 2010. A recent estimate by Federal Reserve Chairman Bernanke of $2 trillion, which seems to have surprised the Congress as high, may in fact be too low.

Beijing’s True Options

This may be apocalyptic for some. In other words, if $900 billion in Chinese purchases was a sign of Chinese influence, $2 trillion is far worse. In fact, the huge figure indicates the opposite: the PRC holds all those dollars because it has no choice.

China cannot spend foreign currency at home. Because the state controls the entire financial system and foreign currency cannot be invested overseas by citizens, any attempt to spend foreign currency at home – for instance to build hospitals — returns the funds to the state. When pushed, senior Chinese officials acknowledge this.


Foreign currency in banks, either to finance commercial activities or simple deposits, accounts for some holdings outside official reserves. However, that leaves perhaps $3 trillion invested overseas. The number is soaring; the balance of payments surplus has averaged almost $400 billion annually the past four years. This is after the PRC buys all its oil, iron, gold, and so on. Outside bonds, China’s outward investment is $55-60 billion annually — sizable but only 15% of the required outlay. This includes all purchases of stocks and other assets foreign countries have allowed.

There is no European bond market and most national euro-denominated bond markets are underdeveloped. The PRC’s holdings of Japanese government bonds are comparatively minor and may be shrinking. Almost all other bond markets are too small. Only one market is large enough to absorb all that money.

If China were running $150 billion annual surpluses, say, it could avoid investing in the U.S. If it changed its balance of payments rules to greatly loosen state control, as Washington wants, it could avoid investing in the U.S. At $400 billion annually and unable to use the money at home, the PRC must allocate huge amounts to American bonds. The amount is so large because there’s nothing else for China to do.

Conclusion: Better Data Make Better Policy

There is far more Chinese money in the U.S. than widely understood. Yet no disaster has occurred. This is because of the depth of American financial markets but also because the PRC cannot disinvest under conditions it clings tightly to – huge external surpluses and rigid balance of payments rules. The actual lesson of $1.6 trillion in June 2010, and counting, is no Chinese financial influence over America.

Mistaken impressions are caused in part by the incomplete picture. Further, when conditions finally change, Chinese funds will need to be monitored better than is done now. Most important, the PRC is not just pegged to the dollar, it is dependent. Addressing that dependence will yield a more open China.

1) The annual Treasury survey is a weighty undertaking but perhaps could be made semi-annual. If not, a more limited quarterly or monthly survey superior to the monthly foreign holders series should be created. Congress needs better information and Treasury should provide it.

2) The U.S. should encourage the PRC to address dollar dependence in mutually beneficial fashion. Led by Treasury and including the Department of State and the White House, the U.S. should offer technical assistance and extensive financial cooperation in the face of any instability. This could be coupled with reciprocal Chinese cooperation in other areas.

Chinese investment is far more extensive than commonly thought, because the PRC has no choice but to pour hundreds of billions in excess foreign exchange into the U.S.

V V: Between God and Mammon

Tom Wolfe in his 1980s best-seller, The Bonfire of the Vanities, described investment bankers as “the masters of the universe”. That description was soon outdated in the 1990s because hedge fund managers assumed the mantle. Just consider two simple facts. In 1990, hedge managers managed assets worth $39 billion. At the peak of 2007, the figure had grown to a staggering $3 trillion. Equally staggering is the amount of money successful hedge fund managers earned in 2008, the top 10 more than $10 billion between them. Quite clearly, the returns hedge funds make can be substantial, given the high fees they charge for services rendered. But there was a downside — the losses can be substantial too — as some discovered in the credit crunch market upheaval that started in 2007. But in the swings and roundabouts, hedge funds became the “In” thing if you were looking for a “gravy train” as Sebastian Mallaby tells us in his definitive work drawn from insights into higher mathematics, economics and psychology in More Money than God: Hedge Funds and the Making of a New Elite (Bloomsbury/Penguin India, Special Indian Price, Rs 599).

Begin from the beginning. While most people have heard how much hedge fund managers have made, very few are clear what they are or what they do. To get a hang what the game is about, it is best to start with Philip Goggan’s Guide to Hedge Funds: What they are, what they do, their risks, their advantages (Profile Books, Indian reprint 2011, Rs 295). Coggan, who was the economics editor with The Economist and earlier with the Financial Times, has covered the fundamentals in six easy-to-read chapters: Hedge Fund Taxonomy; The Players; Funds-of-funds; Hedge fund regulation; Hedge funds: For or Against; and The Future of Hedge funds. Of course, More Money than God covers the same ground too, but this is an easier read and once you have grasped the rules of the new game, Mallaby’s big tome becomes that much simpler and enjoyable.

Mallaby has written the book for a wide range of readers, from hedge fund managers and finance professors to the intelligent common reader interested in markets, economics and finance.

The story begins with Alfred Winslow Jones, an eccentric who at different times in his life worked on a tramp steamer, studied at the Marxist Workers School in Berlin, a friend of Ernest Hemingway and other outsiders. Like many top hedge fund managers, Mallaby tells us that Jones didn’t learn the ropes at Goldman Sachs or Morgan Stanley, did not go to business school, nor did he have a PhD in quantitative finance. What he did have, however, was an unerring instinct for money like all successful fund managers possessed.

Jones launched the fist “hedged fund” meant to use leverage to enhance equity exposure along side short sales to protect one’s downside, and he first conceived the concept of “performance fee” whereby his fund would keep for itself 20 per cent of the profits. Mallaby tells us with his fund’s returns at 5,000 per cent, investors didn’t mind parting with 20 per cent of the profits. Many commentators today feel that 20 per cent is too high a fee to be paid but Jones quite rightly believed that the anticipation of substantial returns would concentrate the minds of portfolio managers. Besides, Jones argued that “performance fee” was an expense and could be written off against the profits; others like Mallaby think it is a tax dodge. Jones’ performance-fee innovation still forms the basis for the hefty returns of hedge fund managers.

With Jones as the introduction, Mallaby provides a continuous history of investment vehicles which he calls “loners and contrarians”, the very “individualists whose ambitions are too big to fit into established financial institutions”. These individuals can’t be tied down by regulations and red tape. They defy the conventional wisdom about efficient markets and could be described as “edge funds” for their managers offer investors returns uncorrelated with the markets.

Mallaby explains that markets are efficient only if the liquidity is perfect; and when liquidity is not perfect, markets can be highly dicey or fickle. Mallaby takes the case of Steinhardt who offered liquidity where it didn’t exist, especially when it came to a large block of shares. He was able to negotiate discounts in return for liquidity which eventually returned to his original investors 480 times their initial investment. Fund managers can do this but only if they have a large amount of cash to play around with; if they don’t have a fall-back strategy, it is simply not possible to achieve such high returns.

Mallaby’s story of the Hungarian immigrant George Soros is inspiring, considering that he started off in London as a busboy and once told by the head waiter at a restaurant that if he worked hard he would some day be his assistant. Soros made it to the London School of Economics and although he didn’t do well academically, he learnt that markets were anti-efficient and that it was possible to make money by trading on faulty human reasoning.

Hedge funds have sometimes been described as “casino capitalism”, that success depends on the luck of the draw. But it is also a play on the vagaries of the human mind which Mallaby’s story-telling brings out beautifully.

'India handled the crisis extremely well'

Pulitzer Prize winning author Liaquat Ahamed speaks about the “absurdities” committed by governments throughout history in the wake of financial crises
t may seem ironic to hear a hedge fund manager speak freely about the evils of the financial system, butLiaquat Ahamed speaks with such unerring conviction and precise logic that it’s impossible not to be mesmerised by his arguments. The professional investment manager, who won the 2010 Pulitzer Prize for History for his book Lords of Finance: The Bankers Who Broke The World, has also worked at the World Bank in Washington DC apart from serving as a consultant to several top hedge funds. 

Why do you think the Indian economy – for the most part – has remained immune to the worst of the economic crisis?

India has hardly been affected by the recent financial slowdown. Indian banks weren’t exposed to the kind of mortgages American banks were, they were also reasonably well capitalised. India only got hurt when trade got hit – especially in the case of, say, the IT industry.

What worked for India is that it had built up a nice cushion of foreign exchange reserves which, very smarty, it used at the right time. All said and done, India definitely handled the crisis very well. But, of course, that doesn’t mean India will never have a financial crisis 

What can India do to prevent that?

Well, economic crises have two ingredients. The first one is a bubble or a mania. For example, as anyone who comes to Mumbai can vouch for, it’s ludicrous that real estate prices here are higher than they are in New York or London. That is a recipe for disaster. Secondly, at some point, the bubble will burst. That will lead to far too much borrowing which will in turn lead to banks getting heavily exposed.

Basically, to avoid a crisis, banks, which are essentially the plumbing of the economy, need to remain robust. Whether banks or private or state-owned are irrelevant; what matters is if they’re well-run. The answers lie in, quite simply, lots of capital and more stable sources of funding. This, I believe, is something India has gotten right so far.

You’re famously opposed to the gold standard. What are your reasons for that?

The gold standard system requires you to have gold as the foundation for the financial system. That requires you to have that much gold. Now, if you took all the gold in the world and you piled it up, it would end up forming a two-storey office building the size of a tennis court. That’s not nearly enough to fuel the world economy.

That’s the first problem. The second problem is, if you raised the price of gold so that it could generate that much money, you’d have to raise its price by about 10 times. Furthermore, the biggest problem is that discoveries of gold are growing by say 2% a year, while the world economy is growing by 4% a year and the entire global financial system is growing by 6% a year.

What’s your next book all about?

I’m writing about economic history. I’m going further back in history to the 19^th century to the conflict between the government in Washington and Wall Street. My objective is to show that anti-banker sentiment goes back a long way in the United States.

FIIs include hedge funds, pension funds and MF

A foreign institutional investor (FII) is an investor or investment fund that is registered in a country outside of the one in which it is currently investing. FIIs include large hedge funds, insurance companies, pension funds and mutual funds. They are required to register with the Securities and Exchange Board of India (SEBI) to participate in the markets here.

The buoyant markets in 2010 owe much to FII influx. FIIs bought equities in the markets to the tune of around 28.6 billion dollars (Rs 1.30 lakh crores). The first week of 2011 began on a grim note as the Sensex and Nifty dropped contrary to expectations of breaking barriers. The banking stocks pulled the indices down, followed by metals sector that faced selling pressure too. The markets are choppy and are bound to remain so for a few more weeks. Since significant market turnover can be attributed to FIIs, it is essential for investors to chalk their strategy after observing FII movements and investment patterns.

Hedge Fund Capital Raising for 2011

New York (HedgeCo.net) – 2011 will be a very good year for flows into the hedge fund industry despite the recent negative publicity generated from the insider trading scandal, according to hedge fund consulting specialist Don Steinbrugge, Chairman at Agecroft Partners.

“This conclusion is based on several dominant and emerging trends identified through conversations with more than 300 hedge fund organizations and 1,500 institutional investors during 2010.” Stienbrugge said.

These trends include: 1. decreased competition from large prominent hedge funds: 2. improvement of capital flows across most major hedge fund investor segments including endowments, foundations and hedge fund of funds: 3. large increase in hedge fund launches: 4. increased allocations to small and medium sized hedge funds: and 5 increased importance of high quality marketing. These trends are explained below.

Decreased competition from large prominent hedge funds

In 2009 and 2010 there was a significant increase in competition within the hedge fund industry due to many previously closed hedge funds opening their funds to new assets. There were two primary reasons for this competitive increase. First, managers wanted to replace assets which had redeemed after the 4th quarter of 2008. Second, many of these high profile managers were below their high water mark and they needed new assets to generate fees in order to pay and keep their people. After two years of the majority of assets flowing to the largest hedge funds combined with strong performance, many of these big funds have either closed or are near capacity. Of the large hedge funds that aren’t yet closed, many either have issues or are gathering assets dilutive to their returns. The end result is less competition for assets from the largest well known hedge funds as investors shift their focus away from investing in brand names toward managers capable of generating future alpha.

Improvement of capital flows across most major hedge fund investor segments including endowments, foundations and hedge fund of funds

2010 saw the hedge fund industry approach its all time high for assets. This was primarily driven by a gradual yet substantial increase in allocations made by pension funds looking to enhance their risk adjusted returns and decrease their unfunded liability. This trend will continue throughout 2011 as we see an increase in the number of pension funds allocating to hedge funds as well as an increase in the percentage of their portfolio asset allocation to hedge funds. Pension funds will continue their evolution in how they achieve their hedge fund exposure. This process begins with an investment in fund of funds, followed by investing directly in brand name hedge funds, then focusing on alpha  generators and finally changing to the endowment fund model of  “best in breed” hedge fund investing.

Agecroft believes 2011 will see the return of many hedge fund investor segments that have been primarily on the sidelines the past two years. Some of these segments are reviewed below:

1. Endowments and Foundations: The endowment and foundation space is a bifurcated market comprised of organizations with more than $1B AUM and those with less than $1B AUM. Many of the larger endowments and foundations experienced significant liquidity issues within their portfolios as the expected duration of their private equity portfolios lengthened after 4^th quarter 2008.  These liquidity issues greatly reduced hedge fund allocations from this market segment over the past two years. Most of these liquidity issues have now been resolved and as a result we will see a significant increase in hedge fund allocations by large endowments and foundations in 2011. This will especially benefit mid-sized hedge funds as these sophisticated investors tend to have a bias against the largest hedge funds. For endowments and foundations with less than $1B AUM, 2010 provided an opportunity to increase their average portfolio allocations to hedge funds. We expect this trend to continue in 2011 as these mid-sized endowments move closer to the allocations of their larger peers.

2. Hedge Fund of Funds: 2009 and 2010 saw significant contraction in the number of hedge fund of funds as many ceased operations due to 1. Madoff exposure, 2. poor performance 3. strategic decisions by a parent company 4. lack of profitability, or 5. acquisition by larger competitors. In addition, a majority of assets flowed to a small number of the largest hedge fund of funds managers, keeping most hedge fund of funds well below their asset peak. This dynamic significantly affected small and mid-sized hedge funds managers because the largest hedge fund of funds tend to allocate to the biggest hedge funds, due to the large amount of money they need to allocate. The balance of the hedge fund of funds marketplace,which typically prefers the small and mid-sized hedge funds, were not allocating because as their assets declined, instead of replacing under-performing managers with new managers, they simply ran more concentrated portfolios.

Agecroft expects these trends to reverse. Most of the flows into the hedge fund of funds industry have come from large institutional investors who have been more focused on the perceived security provided by the size of a firm and its infrastructure as opposed to pure performance. Many large institutions have invested in a number of hedge fund of funds in an attempt to diversify their exposure. They may not realize that many of these large hedge fund of funds have significant overlap of underlying managers and have underperformed their smaller peers. As large institutional investors continue to increase their knowledge of alternative investments they will begin to utilize a hub and spoke approach to hedge fund of funds investing. This approach involves a hub investment in one of the largest hedge fund of funds as the core hedge fund allocation, and spokes made up of niche hedge fund of funds that either focus on small to mid-sized managers or specific strategies like CTA/Global Macro, Credit or Long Short Equity.These strategy specific hedge fund of funds will also be utilized in other parts of institutional investor’s portfolios in addition to their hedge fund allocation.

This growth of niche hedge fund of funds will increase the number of hedge fund of funds while insuring a smaller percentage of assets flow to the largest hedge fund of funds.  Likewise, as these smaller, niche hedge fund of funds see their assets stabilize and begin to grow, they will reduce the concentration of underlying managers and begin to allocate again to new hedge fund managers. This should result in small and mid-sized hedge fund managers being included in more searches.

3. Family Offices: This segment of the market place has experienced significant growth as more and more super high net worth families hire full-time staff to manage their assets. This growth has recently been fueled by fortunes made in the technology, private equity and hedge fund industries. Many of these family offices prefer small and mid-sized managers who they view as more nimble and able to generate higher returns. Family offices will continue to be active allocators to hedge funds.

4. Consultants: The hedge fund consultant market place has seen explosive growth as more institutional investors and large family offices begin to invest directly in hedge funds. These consulting firms have seen their hedge funds asset under advisement balloon in size, which will eventually create difficulties for these firms in adding value to their client’s portfolios. 2011 will see continued growth in this industry with increased competition from new entrants into the marketplace from both traditional institutional consulting firms and hedge fund of funds organizations creating customized,separately managed portfolios for large institutional investors.

Large increase in hedge fund launches

The number of hedge fund launches steadily declined over the past two years as asset flows for start up managers slowed to a trickle. This created pent up demand for mangers wanting to launch a new fund, but waiting for improved market conditions before starting their new venture. With improved asset flows across most major hedge fund investor segments, many of these managers will have the confidence to finally launch their new funds. This will make 2011 the best year for hedge fund launches since 2007. This activity will be further fueled by leading financial institutions shedding their proprietary trading desks resulting in multiple, billion dollar hedge fund launches.

Increased allocations to medium and small hedge funds

2009 and 2010 were devastating for small and medium sized hedge funds. Even though these managers represent 95% of the number of hedge funds, they were only able to attract a small fraction of new hedge fund allocations. This despite the fact a study conducted from 1996 through 2009 by Per Trac showed that small hedge funds outperformed their larger peers 13 of the past 14 years. Unable to attract new assets, these small and mid-sizedhedge fund organizations feared the industry was in a new paradigm making it almost impossible to raise assets going forward. Agecroft believes thata much larger percentage of assets will flow to small and mid-sized managers due to the many strong trends leading into 2011 discussed here. These trends include less competition from the large, well known hedge fund managers, as well as increased allocations from endowments, foundations and hedge fund of funds. These investors tend to focus more on alpha generators than brand name hedge funds. In addition, we will see some of the more sophisticated pension funds allocating to small and medium sized hedge funds.

Continued importance of high quality marketing

Although a larger percent of assets will be allocated to small and medium sized hedge funds, the days of posting performance numbers to hedge fund databases and waiting for the assets to come are over.  The market remains highly competitive with approximately ten thousand hedge fund managers. The typical institutional investor utilizes a process of elimination in selecting hedge funds where they are contacted by thousands of investment firms a year, meet with a couple hundred and ultimately hire half a dozen. Their due diligence process is longer, more focused and deeper than ever before. Institutional investors typically require three to five meetings before making an investment decision. Their process focuses on multiple evaluation factors including: 1. organizational quality, 2. investment team, 3. investment process, 4. risk controls, 5. operational infrastructure, 6. terms and 7. historical performance. A perceived weakness in any of these factors will eliminate a firm from consideration. As a result, hedge fund managers need to not only have a well refined marketing message that effectively articulates their differential advantages over their competition, but also a professional, proactive and knowledgeable sales force able to deeply penetrate the market place and stay involved with investors throughout their lengthy due diligence process. This is very difficult for a single salesperson to achieve. As a result, we will continue to see hedge funds building out their sales teams and leveraging third party marketing firms to expand their distribution efforts.

In conclusion, Agecroft Partners expects 2011 to be a strong year for flows into the hedge fund industry. Although the competition from the largest, well known funds will decline, the market place will remain highly competitive where a majority of assets will be going to a small percentage of managers. The managers that are successful growing their business will be those that rank well across multiple evaluation factors, have a high quality marketing message and strong distribution capabilities. The hedge fund industry is moving toward a period of sustained growth driven by institutional investors that will increasingly adopt a more institutionalized process for evaluating hedge fund managers.