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Chris Carr*

Outbound Chinese Investment and Emerging SWF Trends

With abundant financial resources and favorable investment opportunities presented by the global economic slowdown, private companies and state-owned entities in China have been increasing overseas investment in recent years. In 2011, total outbound investment by Chinese entities amounted to USD74.65 billion, representing an 8.5% increase from the previous year.[1]

China Investment Corporation (CIC), the country’s main sovereign wealth fund (SWF), has a growing overseas investment portfolio, comprising mainly strategic minority positions. The amount of CIC’s total assets increased substantially from USD297,540 million in 2008 to USD482,167 million in 2011,[2] indicating a propensity and means to invest. By way of comparison, the total assets of the leading SWF in Singapore, Temasek Holdings (Private) Limited, only increased from USD147,974 million in 2004 to USD247,660 million in 2012,[3] while the Australian Future Fund’s assets reached a mere USD78,250 million in 2012.[4]

CIC and other SWFs are becoming major participants in the international financial system. To reflect this, the International Working Group of Sovereign Wealth Funds established the Santiago Principles in 2008, which outline generally accepted corporate governance and investment principles and practices for SWFs. The Santiago Principles state that investment decisions of SWFs should be made on the basis of financial risk and return-related considerations; and that SWFs should maintain a sound governance structure, which separates the functions of the owner, governing bodies and management, such that their investment decisions are free of political influence.[5] The Santiago Principles, together with guidance for recipient countries from the Organization for Economic Co-operation and Development (OECD),[6] aim to create an open and transparent investment environment.[7]

CIC, as one of the drafters of the Santiago Principles, has seemingly implemented those principles in good faith and has supported efforts to promote free capital flows and cross-border investments. CIC itself has a comprehensive corporate governance system and its investment decisions are driven by commercial objectives and the aim to maximize long-term financial returns.[8] It also discloses material information in a timely manner, which should be appreciated by recipient countries.

Chinese outbound investments aborted under the cover of national interest or national security tests, but more ostensibly on political grounds, have prompted concerns that Chinese outbound investment might be deterred by protectionist measures in some recipient countries. Governments and regulators should provide more clarity on foreign investment regulations and ensure the transparency of the review process, so as to not deter investments from large SWFs, like CIC, when such investments are needed most.

“National Interest” Protectionism and Implications for Chinese Investment

Although protecting national interests is the imperative of any national government, the United States and Australia, two leading destinations for Chinese outbound investments, have done little to aid investment by having vague laws and regulations protecting their “national interest”. During a media conference held at the recent 18^th National Congress of the Communist Party of China, CIC Chairman Lou Jiwei expressed that a rising tide of global protectionism in western countries is inhibiting SWFs, like CIC, from further integrating into the global economy.[9]

The Regulatory Regimes of the US and Australia

The US and Australia are major destinations for Chinese outbound investment. In the US, foreign investments are reviewed by the Committee on Foreign Investment in the United States (CFIUS). CFIUS has the authority to review any transaction that could result in control of a US business by a foreign person, in order to address any national security risk that might arise from the transaction.[10] National security risks include effects on national defense, energy resources, and critical technologies and infrastructure.[11] Where CFIUS recommends a transaction should be prohibited, it can request the President to make such a determination.[12]

Similarly, in Australia, foreign investment is overseen by the Foreign Investment Review Board (FIRB), which advises the Treasurer on any potential transactions. In respect of each proposed transaction, the Treasurer may approve it, state it has no objection if certain conditions are complied with,[13] or prohibit it if the control of a particular business or corporation by a foreign person is not in the national interest.[14] In determining the effect on national interest, Australia’s Foreign Investment Policy provides that factors such as national security, impact of the investment on the economy and the character of the investor will be specifically considered.[15] In particular, all direct and indirect investments by foreign governments or their related entities, which generally include SWFs or state-owned enterprises (SOEs), are subject to scrutiny under the Foreign Investment Policy, irrespective of the size of the investment, or the level of control sought.[16]

Criticism of the Approval Process in the US and Australia

The interpretation of national security or national interest tests in the US and Australia is uncertain and ambiguous, which makes it difficult for SWFs to predict whether or not their proposed investment will be approved. The legislation in Australia does not provide detailed criteria against which national interest can be measured. Factors stated in the Foreign Investment Policy, such as “community concerns” over foreign ownership of Australian assets, add further uncertainty and political risk to the application of the test. In the US, control is defined as the ability to exercise certain powers over important matters affecting an entity,[17] which is ambiguous. Thus, it may be difficult for potential investors to distinguish between “control” and “influence falling short of the definition of control”.[18]

Deal uncertainty plays havoc with decision makers of financial investors, who have to weigh the cost of completing a deal against prospective return, often under the constraint of finite internal resources. A signed deal that is ultimately not given regulatory approval results in a significant amount of time and resources being wasted.  SWFs, such as CIC, would be keen to avoid even the perception that it is wasteful in utilizing its resources. There is also the consequential opportunity cost of CIC not having been able to pursue another deal. The existence of deal uncertainty leads decision makers to become more conservative and results in some investments, which would have been made, to be no longer feasible or seen to be too risky, based on a political risk rather than an economic risk.

Another concern for SWFs is that US regulations allow for aggregation of interests in examining questions of control, where more than one foreign person has an ownership interest in an entity. This means the interests of CIC and other Chinese SWFs or SOEs in a particular US entity are likely to be aggregated for determining control, even if they have completely different interests and objectives.[19] Aggregation also occurs under the Australian regime in the context of a potential order restricting the shareholding or voting power held collectively by an investor and its associates to 15%, including “any corporation whose directors are accustomed or under an obligation to act in accordance with the directions of the directors of the investor”.[20] Thus, it is possible that CIC’s interests in an Australian entity may be aggregated with other Chinese SOEs, even though CIC is not subject to the same approval regime, and its financial objectives and interests often differ significantly from other Chinese SOEs. This shows a lack of understanding of the very different role that CIC plays in the Chinese economy compared to traditional SOEs.

There is also a lack of transparency in the review process in the US and Australia. Presidential decisions are not reviewable in the US and an aggrieved investor’s only option will be to challenge the constitutionality of the legislation itself and/or the CFIUS review,[21] as shown by the Sany case (discussed below).  This is compounded by the fact that on the issue of national security, the executive branch generally enjoys substantial deference from other branches of the government.[22] In Australia, the FIRB and the Treasurer are not obliged to provide detailed reasons or justifications for their decisions, such that there may be “arbitrary political influence over investment”,[23] and the national interest test could be used as a discriminatory screening requirement.

Recent Case Studies: Differing Approaches to Chinese Foreign Investment

Rejection of Two Recent Chinese Deals

The recent rejection of Chinese investments in the US, Australia and other similar jurisdictions, demonstrate that the concerns expressed by CIC and other Chinese SOEs have some modicum of truth.

One striking example involves two Chinese telecommunications giants, Huawei Technologies Co. Ltd (Huawei) and ZTE Corporation (ZTE), which a US congressional investigation found to have posed a national security threat. The investigative report issued by the House Permanent Select Committee (the “House Report”) expressed concerns about the companies’ alleged ties to the Chinese government and military, lack of openness and failure to assist with the congressional investigation; and alleged that their networks and equipment might be used as vehicles for spying on the US government.[24] Therefore, it was recommended that CFIUS block acquisitions or mergers involving the two companies and that the US government and private companies should avoid using equipment and services from Huawei and ZTE.[25]

In response, Huawei rejected the allegations as “baseless” and “little more than an exercise in China bashing and misguided protectionism”.[26] The Report did not include any evidence showing either company’s equipment had been used for spying, but simply based its findings on the companies’ failure to provide sufficient information to allay their concerns.[27]

Australia has also blocked Huawei from supplying equipment for the construction of a national broadband network,[28] and the Canadian government has indicated that they are inclined to exclude Huawei from participating in the construction of a secure government communications system.[29]

Sany Group (Sany) is another Chinese company that has run into political and regulatory obstacles in its attempt to acquire a wind farm in the US. The company’s investment was blocked by the President on national security concerns following recommendations from CFIUS. As a result, a US company owned by Sany, filed a lawsuit against CFIUS, accusing it of rejecting its investment in an arbitrary manner and without revealing what the national security concerns were or how they could be addressed.[30] Apart from suing CFIUS, an action was also brought against President Obama, arguing that the president had exceeded his statutory authority by blocking the investment and that the company was deprived of due process in the review process.[31]

Such examples have led the likes of Jin Liqun, Chairman of Board of Supervisors, CIC, to warn that “over-regulation and inappropriate intervention are the major risks to the global recovery and threaten the efficient operation of the financial system”.[32] If Huawei, ZTE and Sany can have their investments blocked, it is even less likely that CIC, a functionary of the Chinese Government, can enjoy a politically free investment environment. If CIC is deterred by the uncertainty and reduces the amount or scope of its investments in certain recipient countries, this may ultimately harm the economy and the national interest of these countries.

Political Rhetoric

Both the US and Australia claim openness, while operating ultimately opaque regimes for approving foreign investment, which leave room for political interference. Incidents of blocked Chinese investments in the US inevitably lead to the impression that the US administration discriminates against Chinese investment by manipulating the wide “national security” grounds as the basis for rejection.[33] Statistically minded observers will counter this with increasing investment figures, but blocked foreign investments deny the potential of what could have been. Ill-defined investment barriers are not conducive to foreign investment nor do they automatically enhance national security interests, but they could deter further foreign investment and cross-border trade.

In light of such protectionism, Lou Jiwei emphasized that CIC would not invest in countries that “do not welcome” its investment and that it would mainly target Asia for further expansion.^[34]Whether CIC follows through with that will depend on a number of factors, including access to sufficient deals in Southeast Asia to satisfy its investment needs. The fact they are looking elsewhere is already reason for Washington and Canberra to take note.

As CIC and other SWFs, for example, Temasek, are both proponents of the Santiago Principles and base their investment decisions on financial objectives, they should prima facie be treated the same as other investment entities rather than be subject to a rigid view of state-owned entities of foreign governments. If recipient nation governments intend for investments by SWFs to adhere to stricter regulations than other commercial investors, then this should be made clear.

Governments should focus on the substance of guidelines and regulations published and minimize the areas of potential ambiguity. Clearly defining the risks and being nimble as circumstances change will ensure a more robust investment environment.

Consider Chinese Investment in the UK and Canada

Despite concerns in other countries about Chinese access to their key assets, the UK has been developing closer business ties with China. In January 2012, CIC bought 8.68% of the entity controlling the UK utility group Thames Water.[35] CIC further expanded its investment in the UK in November 2012, by acquiring approximately 10% of the entity that owns London’s Heathrow Airport.[36] We can safely assume there have been other investments in the UK, just not with the same public visibility.

Although the US and UK cooperate closely on security issues, their attitudes towards investment from CIC and other Chinese investors seem to be quite different. Both Huawei and ZTE, which have substantial investments in the UK, commented that investment in Europe is preferred over the US, because the European market is perceived to be “much more open and transparent”.[37] Perhaps the US and Australia, also close allies on matters of security, could consider a similar approach to the UK; or at least improve the sharing of intelligence, if there is something they know that London does not.

On 7 December 2012, the Canadian government approved the US$15.1 billion takeover of Nexen Inc, a Canadian-based oil and gas company, by China National Offshore Oil Company – a Chinese state-owned enterprise. This is a landmark approval, as the transaction represents the largest foreign takeover by a Chinese company.[38] Subject to a number of conditions, the transaction was given the green light as it ultimately satisfied the “net benefit” test. The Canadian government did warn that further foreign state control of oilsands development would no longer be of net benefit to Canada,[39] but minority stakes and joint ventures with Canadian businesses would still be welcomed in the future.[40] Such clarity gives investors a certain picture of what the lay of the land will be.

What Governments and Their Agencies Can Do To Promote Foreign Investment

In order to promote rather than deter foreign investment from China’s significant outbound investors, regulators of recipient countries should create a transparent playing field by introducing a higher level of clarity on the relevant rules and regulations. Although protecting national interests is essential (and China has certainly shown its own intention to do so in the South China Sea recently), any test should have clear and objective criteria, and not be used as a cover for protectionist policies.[41] It is desirable for regulators to increase transparency around the review process, by providing detailed decisions and reasoning, if not publicly at least privately or informally, so that investors fully understand why an investment proposal is accepted or not.

Regulators should continue to engage informally with SWFs, like CIC, in order to facilitate understanding of the proposed investment and their investment objectives. In addition, regulators need to appreciate the Santiago Principles, which although bear no teeth, are a set of international investment standards that large SWFs should adhere to. Regulators should also make a greater effort to distinguish between industry players and financial investors from countries like China, whose political and economic systems may not be as well understood. This may facilitate decisions being made on the facts, rather than perception and rumor.

As a financial investor, CIC’s investments are driven by commercial objectives, which is evident from the domestic criticism and scrutiny of their financial returns.[42] If political pressure at home focuses on financial returns, politicians of receiving countries should be able to see their investments in the same light.

Governments and regulators of recipient countries should eliminate the opaque and unnecessary barriers to foreign investment. Clarifying the interpretation of national interest and national security tests is a significant first step.