China Buys Wall Street

Donald Straszheim
12.27.07, 6:00 AM ET

The subprime mortgage problem has now yielded a full-blown credit squeeze on Wall Street with securities firms' stock prices at fire-sale levels. The new fire-sale buyers are the so-called sovereign wealth funds, and China's are the most prominent.

With the world's largest trade surplus, China is accumulating foreign exchange reserves of about $1 billion per day. Rather than holding these reserves in low-paying Treasury securities, China recently created a new sovereign wealth fund--China Investment Company (CIC)--to invest these funds more profitably. Market participants, pay attention.

The West worries about whether these sovereign wealth fund investors will act like conventional rate-of-return focused investors or will have a different agenda in mind. Two points: First, if the sovereign wealth fund investors are rate-of-return motivated, they might have a much longer time horizon than the typical short-term-focused U.S. institutional investor. I am an optimist on this--increasingly disgusted during my many years in the investment world at the ever shorter term focus on stock prices. To me, anything that extends investors' time horizons would be positive, allowing companies to plan and act for the long run.

But second, if the sovereign wealth fund's agenda even borders on the geo-political, or may set up a sequence of events that is uncomfortable to the host country, then such funds' investments are going to be rejected in many parts of the world. China says it wants " ... to be treated as a common investor in financial markets and will follow international practice regarding disclosure." Fine. But China is a non-market economy that is dominated by the state sector. It is understandable that foreign governments are guarded, given that explicitly stated policy in Beijing is to develop centrally owned state enterprises into positions of global dominance. It is hard for many to accept that CIC would have a less-expansive or less-strategic view.

Beijing's CIC has agreed to invest $5 billion in Morgan Stanley (nyse: MS - news - people ), which is troubled by the credit mess. CIC's investment can be converted into a 9.9% stake to Morgan Stanley in a few years. Morgan Stanley's stock had fallen from $73 to about $49, a fire-sale price in CIC's eyes, though it has rebounded to $54 since the announcement of the Chinese investment. CIC gets a bargain, but no board seat and no say in Morgan Stanley's management--a passive investment. I think this is a win-win deal.

Morgan Stanley, a player in China's financial sector since 1994, gets a sizable cash infusion from the best buyer imaginable. An investment in any foreign company by CIC is like a "Good Housekeeping" seal of approval in China. Morgan Stanley's people now can travel China with business cards saying they are partly owned by the prestigious CIC. The way business and government are intertwined in China, few would dare to refuse talking to a Morgan Stanley representative at the door.

CIC, in turn, gets a seat at the table of one of America's premier investment banking firms--admittedly after it has just stubbed its toe. But it is easy to see Morgan Stanley's stock price recovering all it had lost in the subprime debacle-- a return that likely would make CIC or most any other investor happy. Most valuable to CIC (and to all of China) is head-table acceptance in the global securities industry, the chance to understand modern financial practices and technology in the west and to meet talented financiers who would otherwise be out of reach. Despite China's stunning economic growth record, its financial sector remains weak and primitive. Every step, like this one, that modernizes China's financial sector is a plus for China and for the global economy.

Remember also that CIC invested $3 billion in the June 2007 IPO of Blackstone (nyse: BX - news - people ), a top New York-based private equity firm. This also was a passive investment-- no board seats, no management input. CIC is not happy that the stock is down about 30% from its IPO price, but not to worry. Beijing knows that private equity is going to be very important in China during the coming years. To me, far more significant than any anticipated investment returns is the chance to learn private equity from the best. And Blackstone, with the CIC imprimatur, has a great advantage in China over their competitors.

Just two months ago, Bear Stearns (nyse: BSC - news - people ), another respected securities firm weighed down by subprime missteps, sold a stake in CITIC Securities, a predominantly state-owned Chinese firm. CITIC bought into Bear at a big discount. Bear got the cash, but now enjoys bragging rights in China that are pale compared to those that would have accompanied a CIC investment.

One last historical point. In 2005, CNOOC (nyse: CEO - news - people ) of China (a big state-owned oil and gas firm) attempted to buy Unocal but met considerable resistance in Washington, on geo-political grounds, and soon pulled its bid. China would have gained controlling interest in Unocal, a no-no to many in Washington and in many countries in the world depending on the size of the acquisition and the sensitivity of the sector.

So now CIC has a new strategy--to buy passive stakes, usually with no board seat and no control. This Chinese investment vehicle, therefore, represents no threat to the status quo, but it's learning how a modern economy operates and hopefully will earn top equity market returns.

Donald H. Straszheim is vice chairman of Roth Capital Partners in Los Angeles, former global chief economist at Merrill Lynch (nyse: MER - news - people ), a visiting scholar at the University of California-Los Angeles Anderson School of Management and a longtime China specialist. He previously served as president of the Milken Institute and joined Roth in 2006 to spearhead the firm's China initiatives.