from Follow the Money

The shift toward sovereign wealth funds: the policy debate

July 30, 2007

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Both the Financial Times and the Wall Street Journal have done a great job reporting on the rise of sovereign wealth funds.   Joanna Chung and Tony Tassel’s nuanced analysis of the impact of sovereign wealth funds on assets markets stands out (also check out Joanna Chung's contribution to today's special report), as does Henny Sender’s reporting on QIA and ADIA

For the outlines of the emerging policy debate, though, no one has matched the FT.

I liked Larry Summers' note of caution better than John Gapper’s more ethusiastic line.  

The FT leader and Lex’s analysis of sovereign wealth funds also stood out.

Why?  Lex and the FT leader displayed a healthy outrage at China’s insistence on pegging to the dollar -- a policy that has required that China adopt a series of other policies that have pushed its savings rate up to spectacularly high levels.   The editorials of the major US papers on China rarely strike a similar tone: they often seem to worry more about the risk that RMB appreciation might push up import prices than about the consequences of relying on China’s government to finance an awful lot of US investment.  

The FT and Lex also recognize that the US cannot realistically expect China to finance the US current account deficit by building up an undiversified portfolio that contains only the lowest-yielding of US assets forever.  Lex:

“In the short-term, it was all too tempting.   The savings of Asian and oil-exporting countries have helped to fuel the current boom.   Their purchases of Western government bonds have funded the external deficits created by profligate consumers and lower real interest rates, boosting asset prices.    But now the long-term consequences of the bargain are becoming clear.  … . Governments are moving from lending to the West to owning chunks of it.” 

Nicely put.  But purchasing companies raises a lot more concerns than purchasing bonds.  There clearly is a policy debate brewing over how the US and Europe should respond to the rise of sovereign wealth funds. 

Lex– rather surprisingly -- chastises the UK Treasury for not showing a bit more concern about the consequences of the rise of state capitalism. 

“At the other end of the spectrum is the UK government, which appeared to welcome such deals yesterday.    This seems behind the curve.  If it is, as a matter of economic policy, fundamentally undesirable for the UK state to own UK businesses, it is unclear why the opposite should hold for foreign governments?”

Lex recommends encouraging sovereign funds to limit themselves to minority stakes in companies.  

“If sovereign funds simply behave as institutional investors that own minority stakes in companies, there is no basis for objection ….  Protectionism is not the solution but neither is widespread direct control of companies by governments, with the resulting potential for capital misallocation and inefficiency.”

However, Lex doesn’t quite specify what policy makers should do if governments decide that they want to own companies, not just take small minority stakes – or if they decide they want to be private equity firms, not just invest in private equity.

It is still early, but the China Investment Corporation seems to be modeled more on Singapore’s Temasek (which takes strategic stakes in companies) than Singapore’s Government investment company (GIC).  It seems to be acting more like Dubai International Capital (the private equity firm that invests the personal money of Dubai’s sheik) and Qatar’s Investment Authority (QIA, as Henny Sender reports, aspires to be a private equity firm, not just invest along side private equity firms) than the far larger and in some ways more conservative Abu Dhabi Investment Authority. 

But there is one obvious difference between China’s investment fund and the investment funds of Singapore and the smaller Gulf states: scale.  The CIC will be bigger than DIC, QIA, and Temasek by the end of the year.   Nothing like $200b in seed money.  The CIC will soon by about as big as Kuwait’s investment authority (around $200b in reported assets) and Singapore’s GIC (at least $100b, and rumored to be much bigger).

And if the CIC gets all of the $500b or so in foreign assets the Chinese state is currently accumulating every year going forward, well, it will surpass ADIA.    By the end of 2010, it could potentially have close to $1.7 trillion, even in the absence of any capital gains.  That worries the FT:

[It] is the potential scale of Chinese buying that causes concern. The vast foreign exchange reserves that China has accumulated defending its undervalued currency, the renminbi, are currently invested in US Treasury bonds. Buying shares such as Barclays could boost returns and reduce exposure to the dollar and US interest rates, but huge investments would be needed to make a difference.

China will struggle to copy state investment agencies such as those of Dubai and Singapore by taking large stakes abroad. Nobody is scared of those nations; they are afraid of China.  China would be better advised to invest its money quietly in hedge funds, private equity or funds that track an index.

If there are many more deals like the $3bn investment in US private equity group Blackstone by China’s new state investment agency, they will become a political issue of the highest order. China’s trade surplus and exchange rate policy are bad enough, but if it is seen to be buying up the world economy with the proceeds, it can only end in hearings before Congress, public demands for protectionism, and ever louder demands for a higher renminbi. That is the last thing that China needs.

The rise of sovereign wealth funds has drawn attention to five different issues –

1.   Reciprocity.    According to this view, sovereign wealth funds should be free to purchase controlling stakes in US and European companies so long as private US and European investors are free to purchases companies in China, in the Gulf and in any other country with a large fund.   Norway, Singapore and arguably Russia meet this standard. China does not: it is closed to most portfolio inflows.   And the Gulf may not either – its oil and gas firms are firmly controlled by the state.

2. Transparency.   Sovereign wealth funds should be free to invest in US and European markets so long as they disclose their broad portfolio and investment strategy.     Sure, this risks allowing private market players to try to front-run the big funds, but that is the price sovereign wealth funds have to pay for the ability to invest as they please.  They need to accept some restrictions on what they can try to do for the good of the market.   

Norway discloses its debt/ equity mix, the country composition of its portfolio, its returns and its outside managers (though not its derivative book … ).  It would meet this standard.   But Singapore’s GIC and the Gulf funds do not consistently disclose their debt/ equity mix, let alone more details about the country and currency mix of their portfolio.   That raises one obvious question:  are the US and Europe really prepared to tell ADIA and the GIC that they have to sell if they do not disclose more?  

3. Government control.   According to this view – articulated effectively by Willem Buiter -- sovereign wealth funds should not do more than take small minority stakes.  Indeed Buiter would restrict sovereign wealth funds to non-voting shares.

SWFs should only be allowed to invest in equity that does not have control rights attached to it, that is, non-voting stocks and shares

Government control raises a host of concerns beyond the potential fall in economic efficiency.  Say China bought a big drug company.  It suddenly would have a large economic interest in certain US legislation – the Medicare prescription drug benefits, patents, corporate taxation and so on.   Dr. Summers identifies two other scenarios:

Apart from the question of what foreign stakes would mean for companies, there is the additional question of what they might mean for host governments. What about the day when a country joins some “coalition of the willing” and asks the US president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank?

His recommendation: sovereign wealth funds should rely on outside intermediaries.

4. Leverage.  This hasn’t received as much attention, though Treasury assistant secretary Clay Lowery implicitly raised it in his remarks ("the funds' counterparties and any creditors may simply assume a sovereign guarantee and fail to exercise market discipline").  One way to enhance returns is to borrow money.    Some sovereign wealth funds already do.  Dubai international capital isn’t technically a sovereign wealth fund since it manages the sheik’s “private” money, but it clearly is leveraged.   QIA seems to be as well. 

In some ways, sovereigns with strong balance sheets are well positioned to compete with “private” private equity firms in the private equity business.  If their sovereign wealth funds borrowing has a de facto sovereign guarantee, they can gear up cheaply.  That might not make “private” private equity fund managers happy.  They have grown fat managing Gulf money.  But they may not want to compete with Gulf money 

5. Scale.   

According to this view, big sovereign wealth funds need to be held to a different standard than small funds.  Lower articulates a version of this argument to make the case why long-existing funds need to be more transparent.   But the point extends beyond transparency.

Small investments by the government funds of small city states are unlikely to change the character of the overall market.   They won’t change the market ecosystem.  Big investments by big states, by contrast, could change the market.    Henny Sender reported that QIA has $1 billion a week to place.  That seems a bit high – oil and gas flows would suggest an annual inflow of more like $20b a year not $50b a year.   Collectively the Gulf city states (Kuwait, Qatar, Abu Dhabi and Dubai) certainly have at least $1b a week to invest.    

That is a lot.  But it pales relative to the sums now available to China, which needs to place $2b every working day.  The Gulf is adding something like $60-80b to its sovereign wealth funds from its oil revenues (and the Saudis are adding another $50b to their reserves); China is on track to add $500b to its reserves/ the CIC this year.  If all of China’s funds were going into an (unleveraged) investment fund, it would need to do a Barclay’s sized deal every two weeks, year in and year out, for the next few years …  

My own view?

It is still a work in progress. 

Sovereign wealth funds and central banks certainly should be far more transparent than they are now.   More transparency would put me out of business – no one would want my estimates of the currency composition of China’s reserves if you could find that information on the PBoC’s web site.    But it would also help the markets function more efficiently.   Less time would be devoted to guessing what the big players are trying to do.

Transparency would also deter the managers of big sovereign funds from taking imprudent risks with the money they manage.   Call me old-fashioned, but I think the citizens of the countries with big funds should be able to know how their money is invested.   

At the same time, I wonder whether it will be possible to convince the big sovereign funds to act more transparently.   Is anyone prepared to kick ADIA out if it doesn’t disclose more.    That seems to me to be a big obstacle to Willem Buiter’s proposals.       

By contrast, I am not impressed by the argument for “reciprocity.”   In a world with large deficits and large surpluses, the flow of capital intrinsically lacks full reciprocity.   Surplus countries like China, Russia and the Gulf by definition are building up claims (in net) on the rest of the world.

Moreover, reciprocity implies liberalizing China’s capital account to portfolio inflows – and that is something that China cannot open up so long as it is intervening massively to hold the RMB down.  Keeping the RMB down doesn’t just make Chinese goods cheap.  It also, as Stephen Jen notes, keeps Chinese assets cheap.    There isn’t a constituency in China that favors selling off China on the cheap.  The nationalists don’t like it – they think foreigners already own enough Chinese assets and Chinese purchases are just redressing an existing imbalance.  And the last thing the PBoC wants is even large capital inflows –

Absent RMB appreciation, more private inflows into China just means faster reserve growth – and ultimately, an even bigger CIC. 

Nor am I convinced that the UK is willing to enforce such a standard.   The CDB’s investment in Barclays is arguably “reciprocal” given RBS’s investment in the Bank of China, but if a British company thinks it can raise money from China -- or a British shareholder thinks it can sell at a higher price to China than to someone else-- will Britain really say no, not unless your capital markets are as open as ours?

Finally, there is the issue of scale.   

China didn’t buy Treasuries in the expectation that it would always just hold Treasuries; US government debt is a fungible asset.   I suspect China could – if it move slowly and avoided taking controlling stakes – manage to put $200-400b of its existing in equities without disrupting the market very much.  But that doesn’t deal with the real issue: China’s portfolio is currently doubling every two years or so.   

$500b in late 2004 (q3 2004) became $1 trillion (a bit more actually) by the end of 2006.   $1 trillion will morph into $2 trillion by 2008.   Even if China takes policy actions to slow the growth of its current account surplus and Chinese foreign asset growth stabilizes at around $500b a year, its portfolio will continue to grow very, very rapidly.  $2 trillion in 2008 will become $4 trillion in 2012 even in the absence of any capital gains.

A credible commitment to bring down China’s current account surplus needs to be part of any deal that accompanies the shift in China’s state portfolio toward equities.  

I am not sure that the US has the leverage to make this happen.   If forced to choose between no Chinese financing and a 7% ten treasury interest rates and Chinese purchase of US equities on China’s terms, would the US tell China to take a hike?    Then again, the US may have a bit more leverage than it seems.  China hasn’t – at least to date – been willing to stop buying dollar assets and direct its enormous monthly flow into euros, pounds, and other currencies.   That would put pressure on the dollar … and so long as China basically pegs to the dollar, on the RMB.   Unless China is willing to drop its peg or it accept an even weaker RMB, it may find that it effectively forced to buy just those dollar assets that the US is wiling to sell.

And then there is the possibility that driving the RMB down v the euro might not do much to convince Europeans to warmly welcome Chinese-style state capitalism.

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