from Follow the Money

Sovereign wealth funds

September 23, 2007

Blog Post

michael pettis

One of my tricks when I want to look smart on the topic of global financial flows and monetary conditions is to check out the latest entries in Brad’s blog, which is the only blog I read nearly every day.  Now that I am guest blogger, of course, this trick isn’t going to work nearly as well, although some of the comments from some of Brad’s regular readers should help somewhat. My background is in emerging markets, which until 2002 generally meant Latin America but since then, when I moved to Beijing, has largely meant China.  I will try as much as possible to discuss global conditions, like Brad does, but I suspect I will be spending far more time on China and emerging markets in general than he normally does. 

So with that caveat, let me post my first blog on – what else? – China, and more specifically what we know or think we know about the soon-to-be-established but already operational sovereign wealth fund.  I will use as my crib sheet a very interesting report prepared by Xinxin Li, chief China analyst for the G7 Group, a New-York-based consulting and research firm. I have been spending a lot of time thinking about the impact of these funds. 

In early August, just as the sub-prime crisis was really getting going, I wrote an op ed piece for the Wall Street Journal that argued that, in spite of the problems we were facing, not only was this not going to be the end of the world – I expected spreads to be back by October – but that the crazy party we have been living through would go on at least a few years longer.  A lot of my friends on Wall Street (I am a former emerging markets bond trader) wrote me very patient emails explaining that I had finally lost all my market sense – it was obvious that this time around the crisis was so severe that it was going to derail the whole liquidity boom.  This, according to them, really was going to be the big one.  I still disagree. An important part of the reason for my believing this has to do with the reserve management strategies of China, Japan, the OPEC countries, and other, mostly Asian, central banks. 

It is a basic assumption on my part that globalization cycles, of which by my count there have been six in the past two hundred years, are driven largely by new developments or structural changes in the financial system that cause a significant increase in global liquidity and a concomitant increase in risk appetite.   Because of rising risk appetite this newly-abundant capital flows into a variety of risky countries or ventures – financing canals in the 1820s, railroads in the 1860, long-distance communication media in the 1920, the internet in the 1990s – and sets off the growth in international trade, capital flows, technological development (and, for some reason, the rebirth of liberal economic theory) that we associate with globalization. 

I write about this history extensively in my book, The Volatility Machine, which Brad was nice enough to plug, and in articles in various journals. These liquidity cycles were never smooth sailing but were often interrupted by sometimes shockingly severe crises in the form of temporary liquidity panics which, after scaring the hell out of everyone, eventually reverted to benign conditions.  Some well-known examples might be the Overend Gurney Crisis in 1866, the Panic of 1907, or the 1976 Peso Crisis and, I am willing to bet, the sub-prime mortgage crisis of 2007.  Each of these crises was severe and frightening, and each resulted in significant subsequent changes in regulations and banks, but each also ended with minimal damage to the economy and a quick reversion of the earlier optimal liquidity conditions.  The jury is still out, of course, but I expect the same will occur over the next few weeks and months as the impact of the sub-prime mortgage crisis fades away. 
These liquidity cycles do eventually end, of course.  Typically when they do end they end badly.  The 1873-80 depression, the Great Depression, and the Latin American Lost Decade are all examples of a real close to the liquidity cycle, but these real endings are very different from the liquidity panics that interrupt them.

We are pretty certainly living through a major liquidity expansion cycle, and in my opinion there have been two important causes of the current expansion.  The first was the beginning of the massive securitization of illiquid assets, especially of mortgages, in the 1980s, which had the effect of turning a huge amount of illiquid assets into extremely liquid and widely-traded securities.  I believe that Robert Mundell would argue that increasing the “money-ness” of an asset is analogous to increasing the money supply, and this massive securitization process had that very impact.   More important than securitization, especially in recent years, has been the Asian recycling of the massive and growing US trade deficit.  To me this recycling process is a machine that converts a big chunk of US consumer spending into Asian savings, leading to what Bernanke has called the global savings glut, and may have had some similarities with the petro-dollar recycling that fueled the LDC lending boom of the 1970s. 

If you agree with this model of globalization, the trick to projecting financial markets is then to predict the evolution of the US trade deficit and to follow the way in which it is being recycled.  I am not smart enough to tell you what is going to happen to the US trade deficit, but whatever happens it is likely to change fairly slowly.  Unlike most commentators, I think, I do not believe the US trade deficit is very serious problem for the US and I do think that there are very strong structural reasons that will cause it to reverse significantly over the next few decades, so as far as I know this could continue for a few more years. 

I can however make some higher quality guesses about the recycling process, and here I think China, because it has the largest hoard of reserves, is in the front line of the global change in central bank reserve investment strategy. As we all know, China is accumulating reserves at a furious pace, and I would argue that the whole process has gone so far out of control that there is nothing the financial authorities can do to stop it.  It will take a fairly nasty “adjustment” of some sort or other to reverse conditions, and until we do get this shock, the reserve accumulation process will continue and even speed up.  It has become pretty clear, however, that whatever the appropriate amount China needs to keep in liquid, safe, and therefore low-yielding assets, it is far less than what they actually have at China’s central bank, the People’s Bank of China (PBoC).  That has prompted the authorities to move part of their reserves into some kind of sovereign wealth fund where it can be more actively managed (and to manage more actively, according to rumors, the portion that has remained at the PBoC).  Active management, of course, is another way of saying that it will be deployed to buy a much wider range of riskier assets. 

As China and the rest of the high-reserve countries increasingly recycle the US trade deficit into riskier assets, the sheer size of funds under management will appreciably drive global risk appetite up.  This, as I wrote in my WSJ piece, will keep this crazy party (which has already gone on long enough) going for at least a few more years.  This is also why I think it is extremely important to keep an eye on what these sovereign wealth funds are doing.  

Because this posting is already long enough, tomorrow I will discuss the Chinese SWF and what Xinxin Li and others are suggesting about its evolution.