from Follow the Money

Are sovereign wealth funds an inevitable consequence of globalization?

February 7, 2008

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Stephen Jen -- Morgan Stanley’s sovereign fund guru -- say so.

I am not convinced.

Sovereign wealth funds are arguably an inevitable consequence of very rapid reserve growth. Thus, they could be an inevitable consequence of targeting an undervalued exchange rate -- or a government decision to save a large share of the surge in government revenue from a surge in commodity prices .

But not of globalization.

Globalization need not imply current account surpluses in the emerging world, and a flow of capital from poor to rich. Eastern Europe is globalizing, or at least Europeanizing. Yet inside Europe capital flows, generally speaking, from rich to poor. The same was true globally in the mid-1990s -- and, I think, the 1870s - as well.

For that matter, today’s flow of capital from poor to rich isn’t a by product of private capital flows either. Private funds are available to support a current account deficit in most of emerging Asia -- and in more than a few big Latin economies as well.

A sudden sharp rise in commodity prices certainly would be expected to produce current account surpluses in commodity exporting economies, as domestic spending and investment adjusts with a lag. But it is hard to see how rising commodity prices explain, for example, the roughly $300b increase in China’s current account surplus over the past three years. Today’s global economy looks very different than the global economy of the 1970s: then, large surpluses in the oil-exporting economies financed deficits in oil-importing emerging economies, not just deficits in the US and Europe. Asia in particular ran a deficit then.

I also would argue that there is nothing intrinsic about globalization that requires an "official" capital outflow from the emerging world to the advanced conomies.

Some reserve build-up, sure -- no one should want a repeat of the financial turbulence and sharp falls in output the emerging world experienced in the 1990s. But not reserve build-up on its currrent scale. Almost everyone would agree that the more reserves you have, the less need to have to add to your stockpile. The $1.2 trillion or so - the final data isn’t yet available -- emerging markets added to their reserves in 2007 certainly looks excessive.

But nothing about globalization required that China and the Gulf maintain (more or less) dollar pegs as the dollar tumbled against the euro. That was a policy choice. And that policy choice large explains why private capital -- on net -- is flowing into much of the emerging world.

Back in 1998 and 1999, lots of people in China were convinced that China would have to allow the RMB to depreciate against the dollar. They -- not surprisingly -- found ways to move money out of China. Now they think that the RMB will appreciate against the dollar. Not surprisingly, ways have been found to move money into China. Hong Liang’s charts showing the fall in domestic dollar deposits as a share of total dollar deposits are indicative of a broader shift. If emerging market currencies were allowed to appreciate toward an equilibrium level, (net) private outflows would materialize. That would create a world -- still a globalized world - that would not be marked by the build up of central bank reserves and SWFs.

I suspect the recent growth of sovereign wealth funds is not an inevitable consequence of globalization so much as an inevitable consequence of a set of specific policy choices. If those policy choices changed, there is no reason why the growth of sovereign wealth funds wouldn’t slow. That no doubt shapes my view of SWFs generally: to me, they stem from policy decisions that have blocked the natural emergence of a more balanced global economy, one that would bring deficits and surpluses globally better in line with private capital flows.

I certainly would argue that the need of many US and European financial institutions to seek capital from SWFS is not an inevitable product of globalization, but rather a product of a set of policy decisions by those firms that left them without enough capital to support the risks they were taking. I think many of the firms that recently have raised capital from SWFs were buying back their stock not all that long ago -- and paying out significant dividends. That was their choice, not an inevitable dictak of a more globalized world economy.

Incidentally, Gillian Tett reports that sovereign funds are no longer quite as eager to invest in troubled financial institutions as they were in December and January. Apparently, they are starting to worry that Dr. Roubini might be half-right and that they put money into troubled banks before the banks had recognized all their losses.

"But having stepped into the breach so visibly late last year, some funds are now getting jitters. In China, for example, there are rising complaints that funds are foolish to shovel cash directly into risk-laden US banks when they could be using it in better ways, such as purchasing western commodity or manufacturing groups.

"The Chinese are worried they are turning into [the source of] dumb money," says one well-placed Asian financier, who partly blames the trend on the Blackstone saga, which produced significant paper losses for the Chinese investors.

Meanwhile, in the Middle East, the latest round of Federal Reserve interest rate cuts has created unease. .... the dramatic scale of Fed cuts has prompted concern that Wall Street is still sitting on a putrid mess - contrary to what the US banks told the sovereign wealth funds late last year. Unsurprisingly, this leaves Gulf investors cynical about promises from Wall Street banks.

Fair enough. Banks lauding sovereign funds for their sophistication and long-term view were (literally) talking their own book, at least in some cases.

That said, China doesn’t appetite for high risk/ high return investment in the financial sector doesn’t seem to be exhausted.

I am a bit surprised that China seems so gung ho to shift from a very safe portfolio -- one dominated by Treasuries and Agencies -- to a quite risky portfolio, one dominated by potentially risky investments in financial institutions. Adding a few commodities to mix would effectively double down on China’s own investment in its own banks -- and both are indirectly bets on continued strong Chinese growth. It probably wouldn’t dramatically reduce the risk profile of China’s fund.

Starting out with a few more old fashioned index finds that provide general equity market exposure would have struck me as a more sensible first step. Call me (financially) conservative.

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