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Sovereign Wealth and Sovereign Power

Speaker: Brad W. Setser, Fellow For Geoeconomics, Council On Foreign Relations
Presider: Richard Medley, Chairman, Medley Capital
September 9, 2008
Council on Foreign Relations

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New York, NY

RICHARD MEDLEY:  Morning and welcome to this -- the roll-out of the -- of the public part, at least, of the sovereign wealth draft that Brad has been working on for at least a year now, if not more.  We've been pretending to help, as we can.

This meeting couldn't come on a more auspicious day, after having a GSE rescue -- the largest, you know, takeover, as everyone knows -- dictated largely out of concern for how foreign bond-holders were reacting to the -- to the auctions of Fannie and Freddie bonds.  It has had some -- at least, it looks like -- instant side effects inside the U.S. in the housing market, if you believe the reports this morning on the bank demand overnight.  But the real driving reason, of course, was concern over being able to sell agency bonds and getting the interest rates down between 75 and 150 basis points because of that, for home mortgages.  And that was largely in the hands and in control of the sovereign powers.

Brad has been working this and I don't think even you foresaw this, although you've foreseen much.  But we do come at a time where after 30 years of people talking about the American deficit and how much -- how much we are owned by other countries, it's coming into the public consciousness.  You even see it on late-night talk shows now, jokes about China and their control over the United States.  So it's beginning to put itself into the consciousness of the United States.

And Brad's taken a new look and a fresh look at this much-discussed problem.  And I think it's really important, the new things that he's come up with and the historic context he's been able to put this into.

Brad?

BRAD SETSER:  It's a great pleasure to be here.  There -- particularly great pleasure to -- because Sebastian, who's sitting next to me, strongly encouraged me to do this; Richard, chair of the advisory committee; Peter and Jennifer Harris participated in the advisory committee, so it's -- I'm not sure if they're here to criticize the resulting work, but it's great that they are here.  And I also want to recognize the work that my research assistant Arfan Apandi (sp) did, both in the preparation of the report and in organizing this meeting.

We live in a rather unique world, in some sense.  It's a world where the poor, by and large, finance the rich.  It's a world where fast-growing economies, by and large, finance slow-growing economies.  And it's a world where, at least if you look over a five-year period, a little less through this year, where countries with high returns on their financial markets finance countries with low returns on their financial markets.

Now, that unusual global flow of capital, I think, would be only possible in a context where governments -- and particularly governments in the emerging world -- have added truly unprecedented sums to their foreign assets. 

And that leads to the fourth perhaps unique aspect of the current global financial order, and it's one that we like not to talk about too much, which is that we live in a world where authoritarian or more authoritarian governments finance more democratic governments, and that an enormous share of the growth in the foreign assets of the emerging world comes from countries that are not democratic or in many cases are not allied with the United States. 

And I've left out a little bit of nuance in order to present a clean picture, but I think it is certainly true that all of this is happening and all of this is happening on a scale that is truly unprecedented.

Before I look at the way I think you can debate and think about the strategic and diplomatic consequences of these shifts, I just wanted to try to briefly illustrate the magnitude.  (Pause.)

So this is a graph illustrating, the best I can judge, the increase in the official assets, central bank assets -- I've also included an estimate of sovereign fund assets -- of the world.  The little -- the light blue line is the increase that comes from the traditional economic powers, the G-10, and the dark blue is from emerging market reserves.  And then I've added in an estimate for sovereign wealth funds and the increase in the foreign assets of the Chinese state banking system. 

And one characteristic of this shift, in addition to it being a shift towards the emerging world, is that it has been a shift towards countries that don't report much data about what they are doing with their foreign assets.  That's because many big central banks, like the People's Bank of China, don't participate in some of the IMF's data reporting/gathering exercises fully, and it's because many sovereign funds are quite secretive.

Finally, I just wanted to illustrate the gap between the increase in the foreign assets of democratic, or more democratic, countries relative to the increase of foreign assets of authoritarian or somewhat more authoritarian countries.  I think that's probably somewhat correlated, or the correlation with the increasing opacity and lack of transparency between these two graphs is probably not accidental. 

And then finally, just because I'm sure it's something that's going to be on everybody's mind, here's a graph that shows my best estimate of how many Treasury and agency bonds one government, the government of China, has likely bought over the last year.  And I think a fairly conservative estimate would put that total at above $300 billion.  And so in some sense the question this report asks is, do purchases on that scale come -- carry with them influence?

I think there are four broad views that have been put forward about the political and strategic consequences of these shifts.  One view, what you might call the liberal view -- and here I'm using the sense of "liberal" in which Sebastian Mallaby is a liberal, namely that of European liberalism -- would argue that any increase in economic interdependence creates common interests and common ties, and the increase in flows from the emerging world and trade and investment flows coming in the G-7 countries of the emerging world is no different.

Now, that view has certainly a great deal of truth to it, but I think it perhaps leaves out two critical caveats.  One is that the interest of a debtor and the interest of its creditors, while they are interdependent, are not congruent.  And I would certainly argue that a history of the U.S. relationship of Latin America, one marked by significant amounts of financial interdependence, hasn't been marked entirely by political harmony.

And the second nuance or caveat would be that much of the increased interdependence in this recent period has in some sense come not because of a reduction in government actions at the border which facilitated an expansion of trade and financial exchange, but because of an increase in government intervention at the border -- i.e., many countries intervene very heavily in the foreign exchange market to give an advantage to their exports, and as a result, building up large foreign assets.  I think that that particular character of the integration might give rise to conflicts that might not be present if the integration arose from a reduction in government intervention at the border.

The second general argument that has been put forward is that a country's ability to sell debt, particular debt denominated in its own currency and at a low interest rate, to anyone, but including foreigners, is an important strategic asset.  It allows a country to finance key goals at low costs.

This isn't a view that was developed just in response to the rise in U.S. external debt.  Neall (sp) Ferguson's analysis of Britain's rise relative to other European great powers put a great deal of emphasis on the institutions in the United Kingdom that allowed Britain to place government bonds at a much lower -- at a much higher price, at a lower interest rate, than other comparable European powers, and that that in turn facilitated and increased its relative position.  And I think that view too has some merit. 

Although if you compare Britain in the 19th century to the U.S. today, the institutions that Britain developed, that allowed it to borrow at low cost -- the Bank of England, Parliament -- were domestic British institutions.  And Britain was borrowing predominantly from domestic British savers.  So its advantage was that it was able to mobilize its own savings at a lower cost than other great powers. 

I think if you are honest about how the U.S. is able to borrow so much right now, you would say that it hinges much more on the confidence of many Chinese savers and the Chinese state banking system and the Chinese state bank's willingness to lend at a very low rate, to the People's Bank of China, rather than on confidence in domestic American institutions which, I think, is an important caveat to that argument. 

The other of course is that while the world's appetite for U.S. debt is clearly large, perhaps much larger than many would have though, it perhaps is not unlimited.  In which case, the more you borrow, the more you're depleting that asset. 

Third broad view looks more at the literature -- (inaudible) -- how economic interdependence can give rise to relationships and asymmetries that create the potential for political leverage. 

The traditional view is that most countries need reserves, to guard their own financial integrity, far more than the U.S. needs financing from the increase in other countries' reserves, which creates an asymmetry, which would be viewed as favorable to the United States. 

One of the arguments I try to put forward is that that comforting argument may be a little bit outdated.  And we may now live in a world where the United States needs other countries to add to their reserves, for the United States' own financial stability, more than other countries who already have -- (inaudible) -- reserves actually need to hold additional reserves. 

Now, countries adding to their reserves are not doing so solely to protect and guard their financial independence.  They're also doing so to support their exports.  And that creates certain countervailing interest.  But I think it might be a mistake to not recognize that many countries are adding more reserves, have more reserves than they need.  They're adding even more and they're doing so at some financial cost to themselves which may change, a little bit, the potential power dynamics. 

The final view that has been put forward, about how the relationship between global power and financial power, emphasizes the ability of a leading power, one like the United States, to provide global public goods like financial stability.  And I think the recent events raise questions about whether a country like the United States, which seems to have outsourced just to a degree the maintenance of its financial stability to other countries, can continue to play the global role of a stabilizer in the international system. 

Now, it is certainly true that the key decisions that have allowed -- that have been made, about the management of the financial crisis, over the past year have been made by American policymakers -- the decision, to intervene to backstop Bear or to facilitate JPMorgan's takeover of Bear, by the Fed; the creation of various lending facilities to allow the Fed's balance sheet and its treasuries to be lent out, to institutions in need of liquidity, and most recently the Treasury's actions to stabilize the agency market. 

But the backdrop that allowed many of these actions was one where other countries' governments were adding very large sums to their Treasury portfolio and in some sense providing much of the financing, external financing that the U.S. needed and allowing the Fed and the Treasury to try to direct some of that flow to cash-starved institutions.

I think it is certainly the case that if you compare the current situation to past ones that the current global order -- much more so than the post-war order -- has developed outside of the institutions, at least the formal institutions, of international economic cooperation.  The key creditors in the system are not members of the G-7 and many view the IMF with a significant degree of hostility.  There is no obvious means for formal coordination amongst them, let alone between the debtor and the creditor.

Now, so far, that hasn't posed a problem, but if you believe such institutions are critical to the ability to provide global public goods, it is perhaps at least somewhat disconcerting that there are not just no institutions, but there's certainly no tested institutions that could be used.

The core question is whether or not this situation gives rise to vulnerabilities that should be of political and strategic concern as well as of economic concern.  When I went back and looked at the history of the Suez Crisis, the famous incident when the United States refused to provide additional financing to the United Kingdom after the U.K. intervened in the Suez, a couple of things jumped out at me. 

One was that historians, looking back, concluded that much of the U.K.'s vulnerability stemmed from the fact that it had failed to anticipate or even conceive of the possibility that its long-standing political ally the United States might not provide it with the financing it needed in an hour of need and that by not thinking about the possibility and not preparing for it, it was left in a much worse position than a country like France, which had preemptively gone to the IMF and borrowed money to build up its reserves.

But the other point that came out that resonated was that one historian said that the U.S. didn't need to actively pull money out of the U.K., as the U.K. was arguing, in order to have a great deal of influence.  All it needed to do was not to increase its loans.  And in some sense, I think that is why there are reasons to worry or to be at least somewhat concerned about the United States' current position.  It's not that the U.S. needs everyone with current exposure to keep their exposure, but it needs everyone with current exposure or at least someone or others to increase their exposure and to increase their exposure in times of need.

The -- former Secretary Larry Summers has drawn an analogy between the current financial situation and the balance of nuclear terror that prevailed during the Cold War, noting that any disruption to that balance was exceptionally costly, and that gave the system some degree of stability.

And the analogy is that any disruption to this system is also costly, in the sense that the creditors rely on the U.S. as an export market, and the U.S. relies on its creditors for financing to sustain its financial stability. 

When I thought about that analogy a little bit, I concluded that it is maybe less comforting than it seems, because the stability of the balance of nuclear terror hinge on both parties accepting constraints on their freedom of action, constraints that extended to the United States as well as to the Soviet Union.  And I think when most Americans think of the balance of financial power, they're not -- the emphasis is on the constraints that the other guy faces because they need the U.S. as a market.  And I would argue there's at least some possibility that the U.S. may discover it too has to accept some constraints or limits on its political and economic freedom of action.

I think there's particularly three ways in which the shift in the composition globally of financial assets potentially could damage America's strategic influence.  The first is that it lifts constraints that might have previously inhibited actions by other powers.  I think the obvious example there is Russia and in Georgia.  A Russia that had to borrow heavily from the international financial market to meet its budget, to cover its budget, or that needed the IMF to preserve its financial stability wouldn't have had the same capacity to act.

The second is that large pools of foreign assets give some countries the capacity to displace the U.S. from some of the roles that it has traditionally performed in the international financial system, whether that is providing development financing in Africa or potentially acting as a dollar lender of last resort in a financial crisis.  I would be surprised, if a financial crisis came up in Asia, if the IMF played the same role that it played in 1997 and 1998, and I would be surprised if any troubled country does not first explore whether Japanese, Chinese, a coalition of ASEAN countries might provide financing on more generous terms or different terms.

And then finally, that it creates some limits on the United States.  I think it is likely that democratic political change in some countries which are now very large creditors of the United States could give rise to financial stability inside the United States, as it is unclear if there's a democratic majority in certain Gulf countries that would maintain current high levels of dollar exposure, or if a democratic majority in a country like China would be willing to subsidize the United States on the current scale. 

And there's at least a high enough possibility that it warrants consideration that in a future crisis where the interests of the United States and its creditors aren't fully aligned, that the market might at least anticipate some reduction in financing, and that anticipation would generate financial instability.  And the traditional world where the United States could in some sense act abroad without worrying that a political and strategic crisis might echo and reverberate and give rise to an internal financial crisis may have disappeared.

So, what to do?  Well, I didn't really come up with any brilliant new ideas.  The same basic message that anyone who has been concerned about the issues around the global imbalances apply; less savings abroad, more savings in the U.S., various steps to reduce the United States' demand for energy or to increase its supply, to help reduce global market prices, and ongoing efforts to encourage exchange rate adjustment and redistribution, rebalancing of the composition of growth in key parts of the world, but no more so than China. 

The more -- slightly more innovative recommendations would emphasize that perhaps the U.S. should build up some liquidity buffers or speak to its allies about how they might want to respond in the small but no longer, in my view, totally inconceivable event that there was a major reallocation of the portfolio of a major creditor, since the way other countries respond in the event of a sharp fall in the dollar could have some implications for how damaging or disruptive that event is.

MEDLEY:  Thanks very much, Brad.

I want to remind everyone that this meeting is on the record as we move to the question part.

Sebastian, did you want to say anything, or --

SEBASTIAN MALLABY (director, Maurice R. Greenberg Center for Geoeconomic Studies):   Well, may I just say thanks to Richard for chairing the meetings that we had when we were discussing Brad's drafts, and also that this report is has been produced as part of the Center for Geoeconomic Studies, and really is a model of what we think of geoeconomics as being.  Geoeconomics is supposed to be the crossover area between international relations, international economics.  The idea is to break down the stovepipes and bring people together from both the foreign policy and sort of military strategic side and the international economic side.  And Brad has really brought both of those perspectives together in one paper, looking at global capital flows but asking the question:  Is there a foreign policy or strategic vulnerability embedded in these flows? 

And I think, in the discussions we've had, it was very interesting to see how a different mind-set from the two sides of the house could lead people to discover things about the same subject which they wouldn't have discovered without those sort of interdisciplinary conversations.

And one example of this was the way that if you think about interdependence that comes about because of capital flows, you know, probabilistically the Chinese, as Brad was saying, do need the U.S. market.  They don't want their currency to appreciate dramatically.  They don't want the value of their portfolio to go down suddenly.  They don't want to be bad players in an international system in which they do have a very large stake.  So probabilistically, are they going to cause trouble by suddenly adjusting their portfolio of U.S. assets in order to inflict harm on the U.S.?  They'd be hurting themselves.  They probably wouldn't shoot themselves in the foot.

But if you go to somebody in the Pentagon and say, "Do you sometimes build scenarios around bad things that could happen which are not sort of 50 percent, 60 percent likely to happen, but 20 percent, 25 percent likely to happen," the answer is, sure they do, all the time.  They're all the time building scenarios around the bad but not necessarily probable event.

So I think by bringing it together, these two ways of looking at the world -- the sort of securocrat, on the one hand, the economic, bright, optimistic -- you know, things will probably go okay -- kind of perspective on the other.

Brad did really come out with something really innovative.  So I'm very proud to have been involved in it. 

MEDLEY:  Thanks, Sebastian.

I think that the two things that emerged for me, just briefly -- then we'll move on to questions -- is -- one is, we do have almost a Ricardian situation here, where our comparative advantage is consumption -- (chuckles) -- and there rest of the world's comparative advantage is production and savings.  And that has created and maintained a balance, I think, longer than any externally driven analysis would have predicted it could. 

The second thing is the frustration, I think, that we all felt is, this is a little bit like, you know, Hurricane Ike, in the sense that we can all talk about it, but it's very hard to figure out, as Brad just said, something new and innovative to do, some way to really get at this beside the -- what have become almost cliches about reducing our spending -- increasing -- reducing the value of the currency, et cetera, et cetera.

So in this discussion today, I would hope that, you know, people like Peter Cannon and Ernie Stern and others who had such experiences, if there's anything that comes up that you would suggest for the task force of other ways to think about this or approach this problem, we'd be most appreciative of that.

So with that, let's move to questions.

Yes, Emily?

(Question, answer and follow-up questions off the record.)

Thanks a lot, Emily. 

Josh. 

QUESTIONER:  I guess I'd like to put a slightly different spin on this and, you know, ask and then ask a question.  Which is, it's very strange to me that the U.S. has borrowed too much on its credit cards.  And the position, the sort of tone that's batted around, you know, in many cases, you know, by the U.S. policymakers, I think, is somewhat dangerous in the sense that, you know, really there's a hostility toward, you know, the creditors that have actually allowed the U.S. to overleverage itself. 

And I think really we need to look no further than ourselves to sort of figure out why we're in this position.  Clearly, you know, someone who has no debt can kind of go out and do what they want to do.  And someone who owes a lot of money, to a bunch of creditors, can't.  And so therefore yes, we've lost leverage in the world. 

You know, our interaction, my interaction with the sovereign wealth funds has been, you know, incredibly constructive, you know, in terms of their really wanting to take a bunch of the dollars they now hold and invest them at the highest risk-adjusted, you know, rate of return.  And so I think having said that and I agree, you know, having said that, I guess, I ultimately -- yes. 

When you owe someone a lot of money, does that ultimately give them some political, you know, political leverage and geopolitical leverage?  It certainly does. 

But I think heretofore, you know, kind of whether, you know, it be some of these sovereign wealth systems in the gulf or even China who might, you know, be slightly less aligned with the U.S. but still have a vested interest in the financial system, given how much dollars they hold, I have, you know, we have yet to see any sort of, you know, kind of geopolitical leverage employed. 

And so I guess, you know, I think it's kind of dangerous when we as the largest debtor start to try to impose, you know, things on the sovereign wealth funds. 

By and large, you know, the, you know, kind of sovereign wealth funds in the gulf, China, they don't really have to invest.  They don't have to do this.  They have plenty of other alternative usage for their capital. 

I think that engaging them constructively, I think, that the dialogue around disclosure was a constructive approach that the U.S. Treasury was taking, to engage them, to try to sort of head off, you know, what I, you know, sort of a populist tone here in the U.S., which is really ringing in this room.  So I guess that would sort of be my statement, and I think it's important that we engage our largest creditors constructively.  It's not their fault that we owe them a lot of money.

I think -- I guess my question to you would be, relative to the disclosure that has been discussed and now, I guess, agreed to conceptually, it sounds like -- can you just talk about, you know, kind of whether that's -- and it sounds like your answer would be no -- whether that's moved the ball relative to -- has there been anything that's come out of that that enhances disclosure, or has it been -- and enhances comfort, if you will, or has it simply at this point been somewhat window dressing?

SETSER:  Well, all that has been disclosed is that there is an agreement. 

QUESTIONER:  Okay.

SETSER:  So the content of the agreement hasn't been disclosed, so it's rather hard to figure out whether it has had an impact.

The -- there have been some sovereign funds that up until now haven't had websites that now have websites.  And I invite anyone who wants to, to Google the Abu Dhabi Investment Authority and draw your judgment about whether that website is exceptionally helpful or exceptionally informative.

I don't, though, want this debate to be focused on sovereign funds, because I think in a lot of ways sovereign funds are, at least in the current global flow, relatively speaking, small.  If you go and look at the increase in the custodial holdings at the New York Fed, you'll see that the average increase in holdings of treasuries and agencies on a(n) average month this year is in the order of $40 billion, which is more than sovereign funds have invested in U.S. financial institutions. 

If I look back on the last three months of data, which is the second quarter, there were no net foreign purchases of U.S. equities, whether by private or by official actors, and there were about $200 billion in net foreign purchases of treasuries and agencies.  So by and large, this official flow -- the very large official flow is that that is going into the treasury and agency market, not the flow into U.S. financial institutions.

And in some sense, I would argue that the risks are more on the side of that, just because that is a much bigger flow.  And if -- and I'm not convinced that if there were to be an interruption in that flow, that the market reaction would be benign, in the sense that everybody else would buy what a large creditor wants to sell, at a very -- a price that is largely unchanged, or whether it might be somewhat less benign, in the sense that the prospect of large sales by a large creditor might induce additional selling, and the price would have to adjust much more.

I will, though, take issue with the argument that it is all our fault -- "our" being the United States' fault.  I think if that were the case, I would have found the writing of the recommendations list far easier, because then I would be able to say in good conscience that if we just changed our own behavior, then everything would get better.

But I honestly don't think that's fully the case.  I don't think that you can divorce our deficit from the policies in, say, China, that have led to a meaningful depreciation in China's currency over the past five years on a broad or real weighted basis, and have led China's current account surplus to go from $50 (billion) to about $400 billion.

Now, part of that is a reflection of stimulus here in the U.S. that induced an expansion of China's exports, but it's also a function of the very large depreciation of the renminbi against the euro and the enormous expansion in China's trade surplus with Europe.  It's also a function of policy choices that China has made to restrain domestic lending and build up an actually quite significant fiscal surplus in order to try to offset some of the overheating that was induced by the weak exchange rate.

All these are policy choices.  And in a global equilibrium, if China's running a very large surplus -- $400 billion -- at a point in time when the oil exporters are running a very large surplus through largely -- perhaps you can put a little bit more blame on the United States for not having a more appropriate energy policy, but if you combine those two facts, you have a $1 trillion surplus between one oil importers and a bunch of oil exporters, and there has to be very large offsetting deficits, I think Peter Kennon (sp) would argue, in a global equilibrium.

And so, yes, some of that is the byproduct of our behavior.  I think some of it is a byproduct of policy choices that other countries have made -- China.  But also, you know, if the Gulf adopted the Sarah Palin policy of giving the oil surplus back and writing dividend checks, my guess is there'd be a smaller oil surplus.  So I think there are policy choices globally that have some impact.

MEDLEY:  Robert.

QUESTIONER:  Well, I have a couple of observations.

First of all, to look at sovereign wealth funds in terms of their potential for pretty aggressive influence, you need look no further than CalPERS, which has used its power to pursue all kinds of political agendas.  I'm aware of people who have gotten pressure to support the abolition of closed ballot for union elections, for example, a whole bunch of other political agendas.  So we don't have to look very far to see how this kind of power can be used in an intrusive way.  And perhaps it would serve us well in the long run if we would not exemplars of the abuse of sovereign wealth powers ourselves.

The second observation I'd make is a little bit encouraging us to look at the situation from the other end of the telescope.  We're looking at it very much from the U.S. as a deficit and borrower country, but you could also look at it as that we're satisfying a global demand for saving services.  I mean, the focus in these countries, for whatever reason -- in China, et cetera, in the Gulf -- have a huge propensity to save, and we offer very liquid capital markets, very innovative capital markets, lots of transparency, et cetera, et cetera, which is -- which is what they need in order to invest these savings.  And I'm just looking at it a little bit from that end of the telescope.

And then the third observation I'd make is that we are very fortunate that we are dealing with autocracies, at least in the Middle East, in the oil exporting countries, because the consequence of that is that it's a relatively small handful of people who are controlling this wealth, and who have a very symbiotic relationship with our system.

They really want the West and the developed countries to succeed in the broader sense.  If that power ever got into the hands of people who want us to fail, that's the real threat, it seems to me, in this scenario.

SETSER:  I guess I would agree with your last observation, although there's a large part of me which finds a portfolio -- which worries a little bit when there's a very large and growing portfolio that is likely being managed in a way that a democratic majority of -- you know, obviously a real relevant concept for countries which aren't democracies -- but a majority of that country's residents wouldn't find politically acceptable.  And so I find that is a -- while it is true that the existing Gulf monarchies are very closely aligned financially with the U.S. and with Europe, I think the gap between their investment pattern and an investment pattern that would command poplar support in their own country is a long-term risk.

I'm not, though, I have to say, convinced that money is flowing to the U.S. because we offer the world's most liquid and most transparent markets.  You know, there are certainly vast parts of the U.S. market that right now wouldn't be characterized as either liquid or transparent.  But setting that aside, I think there's an important difference between a world where private capital is flowing out of the emerging world and seeking safety in the United States -- which, you know, certainly has been the case at some points in the past -- and the world we see today, where, to take the example that I know best, China, Chinese dollar deposits have been migrating into Chinese renminbi deposits, China's offshore dollar holdings have been migrating from offshore dollar holdings into onshore renminbi accounts as Chinese savers take advantage of what is expected to be an appreciation of the renminbi against the dollar. 

And in that context, it isn't the attractiveness of U.S. markets that is generating the inflow from China, it is the absence of private Chinese demand for U.S. financial assets that leaves money to come back into China and leads to an even greater accumulation of reserves in the China central bank, which then has to be sent to the U.S. market because of an exchange rate policy decision.  And that exchange rate policy decision requires China to invest, frankly, on terms that imply large financial losses for China.  And I think that's the part which I think introduces an element  of instability into the system.

Now, it is true that, as Sebastian says, that any Chinese move would be shooting itself in its foot, but I think you've actually got to be careful; it's actually shooting China's exporters in its foot.  It's China's ongoing policy of exchange rate intervention is shooting China's taxpayers in the foot every day as they overpay for U.S. dollar assets.  And so far, that's been a trade that China's been willing to make, but I, at least, wouldn't characterize it as a flow that is driven by a desire on the part of private Chinese investors for the safety and liquidity of the U.S. capital market.

QUESTIONER:  Hi.  I'm Priva Premovic (ph) from -- (affiliation inaudible).  Concerning these dollar holdings, Mr. Medley, what I was wondering is if you thought that as the dollar -- it seems like it's rebounding or turning around a little bit against the Euro, against the renminbi, against -- well, not against, but the renminbi is appreciating.  And what I'm wondering is if you think this talk of sovereign wealth funds and other foreign banks, of them switching from dollar into other holdings, whether we could see this talk subsiding or whether you think that maybe dollar holdings might increase again at central banks and sovereign wealth funds.

MEDLEY:  Well, I think that the -- this is just a recurring thing.  I mean, it comes and it goes in waves and as the dollar is strengthening, you know, in the current moment, we obviously will get a subsidence of that talk.  But pressures, everything Brad has outlined and we all know, in terms of the current context, it will continue to weigh down on that.  The dollar turn has been important and decisive in the past four months, but it's a relatively short time and it hasn't changed any historical currents as far as I can see.

QUESTIONER:  And going forward, would you characterize yourself as a dollar bull or dollar bear?

MEDLEY:  I only go forward in very short increments.  (Laughs, laughter.)  Over the next few weeks, yes, but I have no comment about the future.

Jeffrey?

QUESTIONER:  Several observations, and then I guess a question.  First, in response to the description of Governor Palin's example in Alaska of giving checks back, it should still be recognized that the Alaska sovereign wealth fund, although not quite as large as CALPERS, is still very significant in its own right.  So it's not like they're giving all the money out to everyone in Alaska.

Second, I think there's a real danger in this discussion of applying some of the concerns too broadly.  And I know you've mentioned that, but a couple things come to mind -- you know, for example, the concept of transparency and the concept of who these sovereign wealth funds report to, the sovereign wealth fund community is a broad-based community, including everyone from China, who we've talked about significantly, to Norway to, you know, even the example of Kuwait. 

Kuwait responds to a democratically elected parliament; it makes full transparency of its holdings to its parliament.  Now, that may be a different type of transparency than you're talking about, but which transparency is the more relevant?  I think that's -- that's another question to raise.

And I guess ultimately, if you look at sort of the types of damage that can occur in world markets when people take positions that can be strategically harmful, probably the most recent example of that or certainly the most public example of that is attacks on the U.S. -- or on the British pound back in the early '90s, attacks on the Asian currencies in the late '90s.  And there the actors that were involved, at least if you believe the press reports, were not the sovereign funds but were hedge funds and private equity funds and other sources of capital that are even larger than the sovereign wealth funds. 

So I guess one question is should we be directing concern to the sovereign wealth funds generally?  If so, why not to other regulated pools of capital?  And at the end of the day, isn't this really in some sense a commentary not so much on sovereign wealth funds or on capital accumulations, but on macroeconomic policies adopted by some of the world actors?

SETSER:  Transparency to parliaments is more important than transparency to markets, and I think it would be a great improvement if all sovereign funds, including sovereign funds in the Gulf, disclosed their portfolios to the people whose money they are in principle managing.

I also, though, think that we're in a time when official asset accumulation in many of the cases has come off a little bit because the oil price has come down and pressure on the dollar has gone off a little bit -- the ballpark is running in the $1 trillion a year range -- that sovereign funds in aggregate -- and I don't know why this debate's kind of gotten to sovereign funds, other than, you know, the title Sebastian suggested about sovereign wealth -- because one of the core arguments in the paper is that it's still a central bank world.  It's still the Bank of Russia, SAM (ph), the TBOC (sp) that have the really big bucks.  It just goes into fairly safe investments.  But there's some capacity to change.

And there, I think that, you know, the extent of the aggregate inability of official actors to shape markets has increased so dramatically since the 1990s or since 2000 that I think that there would be some value in having at least the capacity to see on an aggregated basis, like you can see for those central banks that report through the IMF the currency composition of their reserves, some data about how the aggregate portfolios of the official sector is evolving could help us understand how these actors are impacting markets.

Now, you mentioned, you know, the attack on the pound -- probably not uncoincidentally, given some people here -- but if you think of the recent things, it's not called an attack, but it's got some characteristics of it.  I would guess that over the past month and a half, China's central bank stopped buying agencies.  It wasn't an attack; it was just a decision.  They were worried.  Certainly the increase in agency holdings at the Federal Reserve Bank of New York have gone down over the past several weeks.

Now, that didn't lead to an attack on the dollar because those funds shifted from the agency market to the treasury market, but it still created pressures and pressures in the market that the U.S. government had to respond to.  And it's those kinds of more subtle pressures which, you know, could be adopted for purely self -- in a self-interested zone, financial self-protection -- I'm worried about my risk exposure -- could nonetheless have implications for the U.S.  And that's -- and that capacity is growing.

China's government has put more than 10 percent of China's GDP into both the treasury and to the agency market.  If those two pools are effectively the same thing, China's government has put 25 percent of its GDP into the U.S. government-backed treasury market.

Whenever the U.S. government has lent much smaller sums of money to another country's government, the U.S. has generally thought that it should have some influence over that country's economic policies.  And I think it's -- the challenges of managing the exposures that have been built up are likely to get bigger, not smaller.

QUESTIONER:  Can I add one thing?

It seems to me that, you know, there is a key distinction between the sterling episode in '92 or the Asian crisis on the other hand and something that we're talking about potentially in the future with sovereign wealth -- not sovereign wealth funds, sovereign wealth -- in the future.  And that is that we understand that, you know, market actors will attack a currency if they think they can make money.  And if Britain gets itself into a position where its macro policy is basically unsustainable because it's pegged to the deutschmark and the deutschmark is going through a period, because of German reunification, where interest rates are very, very high, the U.K. is totally out of whack -- you know the story -- then, sure, we understand that market actors will go after that profit-making opportunity.

But I think what we're all struggling here with is what happens to the world when the actors in the system are not motivated necessarily by profits?  For most of the time, the custodians of sovereign wealth, whether they are central banks or sovereign wealth funds, especially the fund, are profit-seeking, especially the funds.  But there is a potential in the future for governments, that are political entities, to make decisions about how they allocate assets not as Boris did in '92 because he wanted to make money, but rather for a strategic motivation.  And so it changes the -- it changes what -- it changes the animal that you're looking at, and I think that's what we're -- that's the discussion that we're trying to reach here.

MEDLEY:  All right.  I think on that note we have to end in our accordance with the plan to get people out of here at 9:00.  But this has been -- and I thought that was a good concluding colloquy, and thank you Jeffrey for that.

So thank you all for coming and for attending this breakfast.


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