from Follow the Money

Property without power?

January 24, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Diplomatic sovereign wealth funds argue, more or less, that they have no desire for power - so there should be no restrictions on their ability to accumulate property. Those hoping for a cut of the SWF lucre - and those worried about creeping investment protectionism - tend to agree.

Others argue that those who accumulate large amounts of property usually end up with a measure of power. Felix Rohatyn in the New York Times on Tuesday:

"You don’t need to appoint two directors to a board to have influence when you own 10% of the company."

Andrew Ross Sorkin goes further:

"Let’s be honest. The idea that foreign investors have no influence because they don’t have a seat at the board is laughable."

Rohatyn (paraphrased by Sorkin) believes that the countries with sovereign funds "want influence on the world stage, despite their insistence otherwise." He says "there has to be a political objective, above the rate of return." Otherwise, per Sorkin, it makes little sense for "people with little history investing in such large assets" to make "big ticket ... investments ... in a matter of weeks" when they have "virtually no way to value them."

Michael Klein of Citi also doesn’t mince words. He though doesn’t share Rohatyn’s concerns. Hasty, big ticket investments from sovereign wealth funds have helped to stabilize the global financial system:

""The greatest single benefit to the longevity of the U.S. financial structure and the U.K. financial structure is the investments recently made by foreign wealth funds into the banking system."

Sovereign funds clearly have helped out the existing management of troubled banks and broker-dealers. In return they no doubt hope for Alwaleed-like returns.

But, like Rohatyn, I suspect that their home countries also hope to get (political) credit for riding to the rescue of the US financial system as a time when the US financial system needs capital to weather what may be a sharp downturn.The US, in some sense, outsourced the maintenance of US financial stability to the wealth funds of other governments.

It is hard to see how the ability to deploy large sums of money quickly doesn’t provide the institutions controlling that money some measure of power. The ability to inject funds into some institutions and turn others down is a form of power. The United States ability to shape who got financing from the IMF, and on what terms, certainly was a source of US power back in the 1990s.

 

There is another reason why sovereign funds might start to throw their weight around a bit more: self-preservation. If Morgan Stanley starts to go south, threatening the loss of China’s money, could the CIC really afford to stand by and do nothing?

Peter Thal Larsen of the FT thinks not:

"Don’t expect them [sovereign funds] to keep quiet indefinitely if their investment underperforms."

Conversely, should a US bank with a major sovereign investor go bust, could the US government really stand by and do nothing? Former Treasury Secretary Summers, in the FT:

"It is one thing to invest in a passive index but what is going to happen if a bank which has sold preferred stock to a foreign government gets into trouble?"

Summers’ answer -- as related by Slate’s Daniel Gross -- is that the banks fate necessarily will then be decided by finance ministers and foreign ministers.

To my mind, the argument that sovereign wealth funds are can be "financial players" not "political players" -- and the idea that sovereign funds can accumulate property without accumulating power -- has four limits:

1. No commercial financial firm is set up to earn negative real returns. Some sovereign wealth funds, by contrast, are very likely to produce negative real returns, largely because their primary mission it to help stabilize the exchange rate.

The China Investment Corporation is the most obvious example. Borrowing in RMB at 4.5% to buy dollars that are expected to depreciate (at least right now) by 8-9% a year at a time when risk-free US assets yield 3.5% is a very good way to lose money. Taking additional risks to get better returns carries with it the risk of producing even bigger losses (see Blackstone).

The CIC is borrowing in RMB and investing in dollars and euros not because that makes good commercial sense, but because its overarching objective is to support China’s currency policy. The CIC exists, above all, to support a policy that China’s leaders believe is necessary to preserve jobs in China’s export sector, or perhaps to preserve profits in China’s export sector (the great irony of this policy is that about the only thing that hasn’t grown impressively during China’s recent boom is employment). The logic that led to its need to take on currency risk also suggests it won’t be investing in firms that compete with Chinese products and Chinese firms.

China’s sovereign wealth fund’s primary mission is to help China avoid more rapid currency adjustment. It consequently contributes to the world’s imbalances rather than helping to reduce them. That no doubt shapes my view of China’s fund; by channeling Chinese funds abroad (at a loss) rather than investing them at home it helps to sustain the world’s imbalances.

2. Centralizing financial management in the hands of the state almost invariably increases the power of the state.

Compare a world where the oil windfall is distributed broadly among all the residents of an oil-exporting country (by, for example, paying dividend payments) to a world where the oil windfall is saved centrally. The world where the windfall is saved centrally clearly enhances the power of the state in question. Those running the government, rather than the country’s residents, will have a lot of lucre to spread around.* And those benefiting from its lucre aren’t going to want much to change.

Countries that rely on oil revenue - a very volatile revenue stream - do need some kind of fiscal buffer. Budgeting for $60 a barrel oil is far less of a risk if you have a bit of spare cash around. But those oil-exporting economies now adding to their assets most rapidly are generally those that already have plenty of spare cash. They have the capacity to consider more innovative strategies for decentralizing the management of oil wealth. Maintaining the oil fund under the central management of the state tends to increase the state’s power, both at home and abroad.

The lack of transparency of the big funds in the Gulf is also a political choice. It gives those running the funds more flexibility. It also gives those running the funds the capacity to invest in ways that their populations might not support.

*Norway is a special case. Its was already rich before oil and its oil is likely to run out far more quickly than the Gulf’s oil, so there is a stronger case for spreading the oil windfall across several generations. The decision to save rather than spend was democratically decided, and the broad portfolio choices of its fund have been democratically ratified.

3. The line between commercial and political investment is never completely clear.

The CIC’s investment in China Railways (a Chinese SOE) has done better than its investment Blackstone. Central Huijin’s (now part of the CIC) investment in China’s state banks will likely generate larger returns than the CIC’s investment in Morgan Stanley. China expects to get political credit for its commercial aircraft purchases. It is fairly widely thought among the Beijing Press corps that China was disappointed that it didn’t get more political credit for its investment in Blackstone.

4. Sovereign commercial decisions with negative economic consequences will almost inevitably be considered political.

Suppose the CIC’s investment in emerging equities add to pressure on other emerging Asian currencies - causing problems for other Asian central banks. Suppose their government sends an emissary to China asking China to invest less. Suppose China says, sorry, the CIC is making a purely commercial decision - and we don’t interfere in commercial decisions. Would China’s neighbors be pleased?

Suppose the CIC decides, on commercial grounds, to sell dollars and buy euros, adding to the pressures on both the US and Europe. Would Europe believe that such a decision is simply commercial? Remember, Europe supposedly asked China not to add to its euro holdings a while back.

Suppose the CIC gets worried about its exposure to the US financial sector, and were to decide its financial interests would be best served if took large short positions against several large US banks?

We already know that Iceland didn’t look kindly on Norway’s decision to short its banks. The Economist:

IN REYKJAVIK almost two years ago the Norwegians were throwing their weight around and the locals were furious ... a government-owned fund from Oslo ... had found an easy way to make money in a market it knew well. It began to sell short the bonds of Iceland’s over-stretched banks. Only common sense, you might argue.

Halldor Asgrimsson, then Iceland’s prime minister, did not see things quite like that. Why was the Norwegian state investing hundreds of millions of dollars to undermine Iceland’s economy? ... "We must protest against this action," he told Morgunbladid, a newspaper.

Asia didn’t exactly look kindly on American resistance to reining in American hedge funds that were shorting their markets back in 1997 and 1998 - even though it was quite clear that these hedge funds weren’t investing US government money. And, as Summers notes at Davos (do read the entire piece), it is hard to think that any country would view another country’s sovereign fund taking a commercial decision to short its currency favorably.

To sum up, I don’t quite see how an aggressive sovereign wealth fund can avoid politics.

Large sovereign funds will end up having an impact on market in other countries - positive and negative. Sovereign funds are accountable -- in some cases literally -- to a sovereign, not to shareholders. Complaints about their actions will be directed to the sovereign too.

There are ways to minimize the associated risks while still giving sovereign investors exposure to equities: using intermediaries, buying index funds and the like. But they require that sovereign investors accept some limits on their sovereignty now to avoid the risk of problems later. I don’t yet see much evidence that those with large fund are open to such limits either.

Today we have a global economy, with large global flows of funds across borders.

Much of that flow currently is organized by governments, often governments seeking to resist market pressures for adjustment.

But there is no global consensus on the right role of the government in the economy. So long as governments investing abroad generally limited themselves to bonds, the absence of such a consensus didn’t matter much. Now that governments want to invest in equities, though, a host of issues are a lot harder to avoid.

Nouriel thinks sovereign funds are a passing phase; I am not so sure. So long as governments are resisting more rapid balance of payments adjustment, they will have a lot of funds to invest. Overall sovereign asset accumulation is still trending up -- both in the oil-exporting world and in oil-importing Asia.

UPDATE: I didn’t exactly find Ken Rogoff’s comment at the end of his interview with Katrin Bennhold that the Gulf sovereign funds think that they are doing the US a favor by investing in US banks reassuring. Favors are expected to be returned. And I am fully convinced that the leverage works only one way -- true, the US needs inflows to sustain a large deficit, but large surplus countries also need places to invest, and there aren’t all that many big enough to absorb the kind of flows now being discussed. The euro and pound can only be pushed up so far ...

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