Enter the hungry dragon

China is ready to be a key player on the world investment stage, and Australian companies are firmly in its sights, writes Elisabeth Sexton.

This week's flying visit by the urbane, unflappable Xiao Yaqing delivered an unmistakable message: Chinese money is changing Australian business.
A $15 billion surprise raid on the share register of the miner Rio Tinto by the company Xiao runs, the state-owned aluminium producer Chinalco, was a dramatic means of confirming that the second wave of China's economic influence is under way.
It remains to be seen how Chinalco's abrupt interruption of BHP Billiton's drawn-out stalking of Rio plays out. Whichever way it ends, it is now suddenly clear to all local investors and companies that the Chinese have the funds and the guts to be big players in the stockmarket. And while the resources sector is attracting most attention, Chinese companies are also bobbing up on the registers of Australian industrial companies.
The purchase of 12 per cent of Rio's UK arm (via a joint venture vehicle to which US aluminium company Alcoa contributed $US1.2 billion) was the largest single foreign investment by a Chinese company.
It outranked Industrial & Commercial Bank of China's $US5.5 billion ($6.2 billion) purchase of 20 per cent of Standard Bank Group of South Africa in October and China Investment Corp's injection of $US5 billion into the Wall Street investment firm Morgan Stanley in December. Both involved the issue of new capital.
Unlike those moves, the investment in Rio shares, which equates to 9 cent of the dual-listed company, was not welcomed.
Standard Bank's chief executive, Jacko Maree, described his new 20 per cent shareholder as bringing "numerous complementary benefits to the relationship".
Morgan Stanley's chairman, John Mack, announcing the Chinese investment along with $US9 billion in write-downs related to the US mortgage market, said it would "enhance growth opportunities globally, while also building on Morgan Stanley's deep historic ties and market leadership in China".
In contrast, Rio's chairman, Paul Skinner, issued a brief statement. "This unsolicited development, of which we had no prior notice, reinforces our view of the long-term value of Rio Tinto," he said.
China's rapid industrial growth has already been credited with shielding Australia from much of the financial gloom enveloping the United States and Europe. Chinese demand for Australian commodities was a major factor in the Reserve Bank of Australia's decision on Tuesday to raise interest rates, while its US and European counterparts are cutting them.

In phase two, China will be more active.
With foreign reserves of $US1.5 trillion in December - almost double the $US819 billion recorded just two years earlier - and a generation of business leaders already familiar with transactions and joint ventures with Western companies, Chinese firms are ready to call the shots.
They are well placed to take advantage of what the Reserve Bank governor, Glenn Stevens, on Tuesday called "fragile" sentiment in international capital and equity markets.
The chairman of the Australia China Business Council, Kevin Hobgood-Brown, a Sydney lawyer, says China's new role in world markets is a natural progression as its economy develops.
"People have been predicting it for a number of years now, and it's only going to be particularly noticeable in the first years as that [investment] flow commences," Hobgood-Brown says.
"I think it's a healthy development because it means that China, like all developed economies, has a more multi-faceted stake in the success and strength of the global economy."
There is a difference between Chinese firms and their first-world counterparts that invest in global markets. The Chinese companies with the most clout are all owned by the Government. While this gives them privileged access to funds, often via government financiers such as the China Development Bank, it also brings a political dimension to their investments that is not always welcome in target countries.
Around the globe the rise in Chinese direct foreign investment is raising concerns that it is not being driven by commercial rationale but aimed at boosting Chinese development and employment, or other policy or strategic goals, at the expense of other countries.
Attracting particular attention is last year's establishment of the China Investment Corporation, a so-called sovereign wealth fund.
In a paper published in December, two Australian Treasury officials, Will Devlin and Bill Brummitt, defined these bodies as "any government-controlled fund that manages and invests government savings, regardless of the revenue source". The Future Fund set up by the Howard government with the proceeds of the last part of the Telstra privatisation is another example.
The China Investment Corporation was formally set up in September, although by then it had already made a big splash by injecting $US3 billion into the US investment firm Blackstone. The Chinese Government gave the corporation a starting kitty of $US200 billion and, according to its announcement of the Blackstone purchase, a mandate to be "an investment vehicle with respect to the foreign exchange reserve of the People's Republic of China".

Its 10 per cent stake in Blackstone is in non-voting shares. Similarly, Morgan Stanley said in December that the corporation would "have no special rights of ownership and no role in the management of Morgan Stanley, including no right to designate a member of the firm's board of directors".
On Thursday a US congressional committee called financial and market regulators to a hearing to debate whether the benefits of Chinese capital during the subprime crisis were outweighed by concerns about currency manipulation and the difficulty of supervising market activities by government bodies.
In Australia, "direct investments by foreign governments and their agencies" trigger the interest of the Foreign Investment Review Board irrespective of the size of the investment. (For non-government investors, the usual threshold is a 15 per cent stake.)
Any proposals for such investments "should be notified to the Government for approval", according to a summary of Australia's policy published by the Federal Treasury.
During a convoluted exchange with reporters after a meeting with China's Foreign Minister, Yang Jiechi, the Prime Minister, Kevin Rudd, said the policy of reviewing direct investments by foreign government agencies was "as relevant to the national interest considerations as anything else".
Rudd would not be drawn on whether Chinalco fell under the description of "foreign government agency".
"I presume this will be the subject of deliberations between the staff of the Foreign Investment Review Board and those seeking clarification of the facts from the Chinese investor," he said.
According to Chinalco's website, it is "one of the key state enterprises managed by the central government directly".
Ian McCubbin, a Melbourne lawyer, says all Chinese state-owned enterprises apply to the Foreign Investment Review Board as a matter of course. "The Australian Government's position is that all those well-known Chinese enterprises that are now investing in these major projects in Australia are all regarded by FIRB and other agencies as government enterprises for the purposes of that policy," says McCubbin, who heads the China practice at the law firm Deacons.
For 20 years the state-owned enterprises have been notifying the board about their proposals, and throughout that time "FIRB hasn't raised any national interest issues and the applications have simply been approved without much fanfare," McCubbin says. The regulator has been more concerned about the development of Australian assets than the ownership of the foreign investor, he says.

"The sort of issues that have been put to us might be whether a major resource in Australia might not be developed in an optimum way, or whether a timetable reflects Australia's best interests [where] an applicant company might have other projects of a similar nature around the world that might take priority."
Longstanding investments by Chinese state-owned enterprises include the stake in Victoria's Portland aluminium smelter, now 22 per cent, held by the investment conglomerate CITIC since 1985, and Rio's 1987 Channar iron ore joint venture with what is now Sinosteel, China's largest raw materials supplier and sales agent for steel mills.
But McCubbin says the applications to the Foreign Investment Review Board are coming much faster now, and are more commonly involving proposals to buy shares rather than joint venture stakes.
He cites three recent policy changes by a newly outward-focused Chinese Government driving the change, starting with the China Investment Corporation. His second factor is Beijing's recent change to the rules governing investments by its banks, particularly the China Development Bank. They are now encouraged to finance projects outside China.
The third factor is the Government's recent blessing for state-owned enterprises to invest directly in foreign stockmarkets.
"Over the last 12 months approvals from the National Development and Reform Commission and the other authorities in Beijing seem to have been freed up to all the state enterprises to participate in equity markets more easily," he says. "Now we are starting to look at the prospects of takeovers by Chinese companies."
In the past few months several companies listed on the Australian Securities Exchange have reported investment by Chinese companies.
A focus has been the mid-west region of Western Australia, where iron ore projects have caught the attention of steel companies, although others include the chemical manufacturer Nufarm and the China-focused dairy company Montec. In some cases the target companies are in the market for development finance and are happy to strike a deal with their future customers.
State premiers have been vocal supporters of development funding. The West Australian Premier, Alan Carpenter, whose state has benefited most from Chinese money, spoke up after Chinalco's move attracted criticism.
"I welcome Chinese investment in Western Australia," Carpenter said. "China has become our most important, our biggest, trade partner and much of the economic vitality and strength we are enjoying here is due to our relationship with China."

In the mid-west region near Geraldton a consortium of five Chinese companies, including Sinosteel and Ansteel, is backing a $3 billion port and rail project via an investment in the unlisted Yilgarn Infrastructure.
The Foreign Investment Review Board approved the Chinese involvement last month, and it is understood the application was considered within the standard 40-day process with no serious hiccups.
The Queensland Premier, Anna Bligh, in her previous role as infrastructure minister, met Chinalco's Xiao in September, when she granted a mining development licence for a $3 billion bauxite project in Cape York to Chinalco's subsidiary Chalco. At the time Bligh hailed the prospect of the largest single foreign investment in Queensland history, saying it would create thousands of jobs.
Many Foreign Investment Review Board applications contain supportive submissions from Australian partners or target companies. That is not always the case, if the investment involves a transfer of an existing shareholding rather than an injection of development funding.
A recent purchase of shares in Mount Gibson Iron by a Chinese state-owned enterprise, the Shougang group, has received a prickly response from the company.
Mount Gibson is expected to raise concerns with both the Takeovers Panel and the Foreign Investment Review Board.
On January 31 Shougang filed a notice with the Australian Securities Exchange disclosing an agreement to buy 9.7 per cent of Mount Gibson from the Russian Gazmetall group with an option to buy a further 10 per cent. It will pay the Russian company $408 million for the combined 19.7 per cent.
Mount Gibson has responded by pointing out that Shougang also has an interest in another Mount Gibson shareholder, APAC Resources, which has 20 per cent. Shougang's 18 per cent stake in APAC appears low enough to prevent Shougang being considered in control of both the Gazmetall and the APAC stakes, which could trigger a Corporations Act requirement for a full bid.
But Mount Gibson is gathering information about the history of the relationship between Shougang and APAC, both in terms of current links via third parties and the reasons for Shougang's decision last year to reduce its holding in APAC. Should such issues about the application of the Takeovers Code, which could crop up in transactions involving Australian investors, be raised with the Foreign Investment Review Board?
There is certainly nothing to stop Mount Gibson urging the board to consider the manner in which the investment was made, as well as the outcome. But more to the point will be Mount Gibson's arguments that unlike other emerging West Australian iron ore companies it is already a producer and is not in the market for development capital. It is likely to ask the board to consider whether Shougang, as a prospective customer for Mount Gibson's iron ore, might end up controlling the output.

In such cases the argument normally goes that this could be to the detriment of other customers and could depress the value Australia extracts from its natural resources.
This issue also cropped up this week after Chinalco bought its stake in Rio. Was it acting as a member of China Inc, in the interests of Chinese steelmaker customers of BHP and Rio?
Carpenter warned against a repeat of the unjustified "frenzy of fear" that greeted Japanese investment in the resources sector in the 1960s.
The Australia China Business Council's Hopgood-Brown is optimistic about the national response. Born in the United States, he moved to Australia 11 years ago after a long stint in Asia. "One of the great things about the society and the economy in Australia is that people have been able to take a much more dispassionate, objective view than in the United States and Europe of what it means to have an economy that's intertwined with the global economy," he says.
"Frequently in other countries there's a very politicised and not very objective debate."
This week the US presidential candidate Barack Obama said: "I am concerned if these … sovereign wealth funds are motivated by more than just market considerations, and that's obviously a possibility."
Last month the US Senate ordered an inquiry by the Government Accountability Office into government investment vehicles from Asia and the Middle East that have also taken large stakes in the US banks and finance houses Citigroup, Merrill Lynch and Bear Stearns.
Three weeks ago the German Economics Ministry confirmed it was considering a law that would allow Berlin to intervene in investments by funds controlled by foreign governments, and the European Commission has begun an inquiry into whether market stability is threatened by the increasing role of such funds. The issue of a co-ordinated regulatory approach is expected to be raised at a meeting of Group of Seven finance ministers in Tokyo today.
Meanwhile, it appears inevitable that Rudd and the Treasurer, Wayne Swan, who administers the foreign investment regime, have not received their last challenging application from a Chinese investor.Five challenges

Risk management
Decisions on how much risk to take in a fund and the management of that risk are critical to long-term value creation in a superannuation fund. Taking risk effectively requires good governance, to set strategy and monitor and control progress. Given that the investment world is dynamic and competitive, those governance resources need to be able to adapt to change in order to secure a competitive advantage.

Focus on appropriate time horizon
The differences between short-term and long-term investing are significant. Most institutional funds have a long-term investment mission. The governance challenge is generally to manage to the long-term plan but be resilient to the short-term pressures that build up from time to time. Best-practice funds had built up a balance around these issues.
Innovation capability
The concept of "early mover advantage" in the corporate world is well-known. In the context of investment markets, it relates to successfully identifying and accessing markets and asset classes early in the cycle, ahead of the crowd. Funds investing in newer, less popular asset classes, newer strategies, or newer managers face many challenges. This places significant demands on governance, not least from the challenge of peer pressure.
Alignment with a clear mission
Institutional funds have difficulty with their mission. A particular complication for superannuation funds is their shared purpose. The role of a superannuation fund is to produce value propositions for both members and sponsors, but sometimes it will be difficult to satisfy both needs. A clear statement of goals is an important step to building alignment between the parties, so that the appropriate investment risk profile and strategy can be identified. Best-practice funds tend to have not only a clear primary objective, but a number of defined secondary objectives which enable all parties to match operational goals with the mission.
Managing agents
In general, superannuation funds are not resourced to manage all of their activities in-house, and consequently employ agents in both advice and delegated roles. This exposes them to the risk that the goals of the agents do not align with those of the superannuation fund. Governance is critical to monitor and control these misalignments, particularly with a large line-up of managers. Best-practice funds are experts in managing these agents and building good alignment.
Source: Watson Wyatt/Oxford University.

Do you hold too many Shares? read on

In a bear market the toughest task any investor must face is to answer the question: ‘How much should I have in equities in this market?’ There is no answer that covers everyone but I want to use three examples to at least canvass some of the options. And before we start, last night's trading on Wall Street was typical of a tough market. At one stage the Dow index was up 132 points but then shares ran into a wall of pent-up selling and fell back to negative territory before returning to the positive. The US market is brittle and won't stand a volley of bad news. Events in US and China are still unfolding, so in Australia no one can be certain of the final outcome. But when a market turns bad it usually lasts longer than expected, although it is punctuated by big rallies. Of course, bull markets also usually last longer than expected and also experience serious corrections. The fall in share prices over the past two months has caused all investors to look much more closely at their underlying investment strategies and asset allocations. A lot of people have begun to realise that they have selected a mix of assets that might have looked good in previous years but are now throwing up losses that are causing personal anguish. Others take a different view and some are actually excited by possibility of a period of depressed share prices. I would like to illustrate some of the options using the example of three people I know:
A self-managed superannuation fund investor nearing retirement who did well out of the share market but pumped big sums into his fund last year as part of the special $1 million entry concession launched by former Treasurer Peter Costello.
A young sports medicine professional, having paid for his education was beginning to save a house deposit. He believed the way to get there faster was to leverage a leading share portfolio. After procrastinating for a year he dived in last November near the top of the sharemarket.
The manager of a closed "value" investment fund who is now emerging from two of the most difficult years of his life. The SMSF investorOur self-managed fund investor put 60% or more cent of his fund's money in leading local and international shares and about another 20% in listed property trusts, leaving a bit of cash. It was an aggressive strategy that served him well. He believed property trusts would not fall greatly even in a tough market – the old "bricks and mortar" view. The losses he has incurred are much more than he was mentally prepared for and it's affecting his sleep. His wife is not fully aware of what has happened and he has not told he that he may not retire when they planned. There are countless numbers of people in this situation. I will talk about property in a coming edition, but suffice to say that commercial property can fall dramatically in certain circumstances and those circumstances have recently arisen in the US and the UK. We will get some of the backlash. And private homes – despite assertions to the contrary – are not spared if the economy turns down sharply: Around 1990 in Australia, the value of large expensive houses fell 40%. Investing in listed property trusts is investing in shares, so it's classed as equity. As a result, the investor is invested 80–90% in equity in a bear market and facing losses approaching 20%. The advice that many planners would now give is: “Tough it out and keep investing. Wait a year or two and it will all come around." Long-term that's good advice but the timing is impossible to predict: "a year or two" might not be enough time. It could be less. While the person's fund chalked up big profits in past years the avalanche of money close to the top has been a disaster. For what it’s worth, I think that where the losses are affecting an investor’s personal life, it’s time to face them and adjust the portfolio to a level of equity exposure they can live with. Two-year bank deposits offer annual returns of about 7.5% (twice the rate of inflation) but you have to shop around. They could rise further. Some say the best strategy is to accept the 20% loss and sell all the equity, putting the money on short and long-term deposit until the bear market has passed. The trouble with that strategy is that those that adopted it in the late 1980s usually never returned to the sharemarket because, first they had to be certain that the market had really stopped falling; and then, by the time they were satisfied, they felt they had missed the inevitable upswing. But let’s say our friend moved to 50% equity, including property exposure and 50% bank yield-based investments such as interest-bearing deposits. Many would say that a 50/50 ratio too conservative but serious losses in people's late 50s or 60s can be so stressful as to reduce life expectancy. A rival view is that shares are the best savings mechanism and you should have and 80–90% exposure and ride the ups and downs. That's true over the long term but not everyone has the ability to sleep through the loss periods. The young professionalMy second example, the young professional, tells me he simply forgets his disaster, although when I see him he always asks about the market. With the help of parents, he has cobbled together more money so he can hold the loan-financed portfolio. There have been enormous sums made on borrowing to invest in shares, but I have been through several long nasty bear markets and seen hideous losses from margin investing so I have never been tempted. It's a wonderful game in a bull market but it’s better to do other things when the market turns because a much greater skill level is required. And we have seen some very high-risk takers (like Tricom) play in the market, ignoring the safety rules and paying the price. There are two clear rules from the past when it comes to margin investing.
Never use margin lending to acquire a significant stake (more than 10%) in a company because you may not be able to sell it if the price falls.
Never margin borrow to buy illiquid shares (stocks where there is a low turnover). You may make a fortune but it's a huge risk. The only time when those strategies are appropriate is if you have other assets that can be tapped. A lot of the margin lending deals in recent years were sold like life insurance, or encyclopaedias of old. Lottery tickets would have been a lot safer because with them people recognise the risk and don't over-commit funds. On the other hand, my young professional has time on his side and he will get through this. But unless a young person in that situation finds a rich partner he will be renting for a few more years The value investorMy value investor specialises in small companies and has not done well over the past two years after many years of wonderful returns. He could not find the stocks and made a few big mistakes. Now he is seeing institutions beginning to dump small illiquid investments at any price. That's where fortunes can be made. But we are operating in a period where credit is much tougher so it's very important when selecting small companies to make sure they have plenty of funds and/or a strong cash flow. Those that are running out of cash are going to find it very hard to raise it. The trouble with the small-company market is that it requires a lot of research and only a few brokers undertake it. It also requires a long-term time strategy because it can take years for a stock to perform. The message I deliver is that there is no asset allocation formula that suits everyone. You know you have the wrong one if the losses are getting to you. Make sure you have cash breathing space.