from Follow the Money

Why worry about sovereign wealth funds?

October 16, 2007

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Martin Wolf, as usual, is the voice of reason.   I highly recommend his most recent column.

Dr. Wolf notes that a set of countries with a far different conception of the role of the state in the market have emerged as major international investors.   He views

 

“the emergence of these funds as part of the integration [into the global economy and global financial system] of countries that accept a bigger role of the state in markets than western countries do today”

 

For that matter, the rise of the state as an investor can also be viewed as a byproduct of the gap between the size of the US current account deficit that private creditors are willing to finance and the actual US current account deficit.   Official investors have to make up the gap.  The latest IMF WEO data shows that private funds are far more readily available to finance current account deficits in the emerging world than in the US.  But so long as the emerging world resists adjustment and maintains large current account surpluses, central banks and sovereign funds have to recycle the private inflow -- along with the emerging world's current account surplus -- back to the US and Europe. 

 

Until recently, that flow has largely been a bond flow.  But for very understandable reasons, over time, the emerging world is likely to want to buy more equities and fewer bonds.

 

That means that the governments of emerging economies will become large investors in a range of US markets, not just the bond market. 

 

Wolf also notes that sovereign wealth funds are potentially much less of a problem than big state firms.   

The big truth is that contemporary globalisation has brought players into the game that operate by different rules from those espoused by today’s high-income countries: vast state-owned companies, such as Gazprom; billionaires who have gained fortunes by a mixture of force and fraud; and funds owned by governments. Of these, the last may well turn out to pose the smallest problems. 

Very true.  I suspect some big Chinese firms fall in the same category as Gazprom.  They too operate by different rules than those prevalent in the US and Europe.

Martin Wolf notes that the way governments invest matter.   A fund, like Norway, that seeks to maintain a diversified portfolio is bound to cause less concern than a fund that makes concentrated bets on a few companies, even if the concentrated bets are made for commercial rather than strategic purposes.  

I agree.  That is why I am a bit worried that a lot of funds now want to take concentrated bets, not to hold a broad, diversified portfolio.   The CIC is a case in point.  It wants to sit on the boards of the companies it invests in.  Concentrated bets on an individual companies raise issues of control that a bet on the direction of the broad equity market doesn't. 

The potential scale of the sovereign investments in US and European equities also is a source of concern.  China and Russia are both setting up investment funds now -- and the Saudis are likely to start to manage their non-reserve foreign assets more aggressively. 

That matters.   

Right now, there are a group of small and aggressive sovereign funds, and a group of large and fairly passive funds -- but no large and aggressive funds.   If Russia and Saudi Arabia started investing like Dubai and Qatar, the world would notice. 

Norway's government fund only bought $3b or so of US equities in 2006.   China's investment company could buy far, far more in a single month.  

The market will, of course, adapt -- just as the market adapted to central bank demand for US Treasuries and Agencies.    Many in New York are already salivating over the prospect of managing money for a big sovereign wealth fund. 2% of a trillion -- plus a performance fee -- is real money, even in New York’s second gilded age (though I suspect the big SWFs will get a volume discount).  Some equity investors are looking forward to  selling their existing holdings at a very high price to a sovereign fund.  US financial firms – and UK financial firms -- think that selling a share of themselves to the still nominally communist Chinese government will give them an advantage inside China.   History takes strange turns.

And some investors are already trying to use China's fund to their advantage.  Want to drive the price of something up?   Hint that the CIC is buying …

 

But markets do not operate in a political vacuum.   Big cross-border investments require the support of the host government.  And I am not sure that there is a political consensus in the US in favor of allowing big foreign government funds to play an active role on US corporate boards, let alone to let big state firms own big US companies.   Judging from Richard Portes' column, there also may not be a political consensus in Europe for the "renationalization" of European firms.

 

 

 

Up until now, US policy makers have generally downplayed the United States dependence on official inflows.   The US capital flows data is far better than what the UK produces (the UK's BoP data is rather embarrassing).  But even the US data isn’t all that good.  Among other things, it tends to undercount official inflows.   The US government – at least the technical folks at the Treasury and the Fed – know this.  They can see the direction of the survey revisions as well as outside analysts.   But US policy makers generally haven't opted to draw attention to this fact.  

 

Now all of a sudden hidden -- or at least quiet -- official demand for bonds may turn into very visible purchases of large stakes in iconic US firms.    Goldman’s stake in ICBC and Bank of America’s stake in China construction could be matched by the CIC’s stake in Blackstone, the CDB’s stake in Barclay’s and, possible, CITIC's stake in Bear Stearns

 

 

 

Fair is fair, you might say.  If US bank can invest in Chinese state banks, Chinese state banks should be able to invest in the US.  True enough. 

 

But the US concept of globalization was always that the rest of the world would adopt the US model of market capitalism, not that the US might end up importing the rest of the world’s model of state capitalism.   

 

In some sense, the US conception of globalization has been at odds with its current reality for some time.  It is a bit hard to see how the US can export its economic model when it is import huge sums of capital from the rest of the world.   But the US public may not see it that way.   George W. Bush has argued that US consumers benefits from the low prices on goods imported from China, but he hasn't exactly warned that importing more goods than the US exports might eventually imply pressure to import aspects of China's model of corporate governance. 

 

China’s financial integration into the world is coming almost entirely through the investments of China’s government in the rest of the world – not from an outward flow of private Chinese capital.  So long as the RMB is undervalued, this flow almost has to be a government flow – private investors in China don’t want to be underperforming, depreciating assets.  

 

Talk about a recipe for friction. 

 

Right now, though, China doesn’t seem particularly inclined to make the CIC as transparent at Norway’s government fund to try to ward off US -- and European -- concerns.   The battle lines are already being drawn.  China’s response to US calls for more transparency is that private hedge funds are a far larger threat to financial stability than sovereign wealth funds.    

 

It certainly is possible that China is right.   Almost all hedge funds are leveraged.  Only some sovereign wealth funds are leveraged.  Most hedge funds are fairly nimble.  Only a few sovereign funds are.  Some hedge funds are willing to take big risks in the hope of getting big returns.  Sovereign funds – I hope – won’t quite have the same incentives.

 

But China's response also is unlikely to build public support in the US for a larger Chinese state presence in the US equity market.  The CIC probably would be better off -- politically speaking -- if it had started by postings its portfolio composition on its website at the end of the third quarter, setting a new standard for transparency.  That would have put its critics on the defensive.

 

Update: The world has a new investment fund, the Libyan Investment Authority (LIA).  I sort of like the Gaddafi fund better, but, well, that isn't terribly diplomatic.  It seems to have a close relationship with the QIA (Qatar investment authority).  I wonder when Algeria and a few other oil states that still manage their reserves conservatively will get in on the act.   

 

I have highlighted the risks associated with the growth of sovereign wealth funds.  But I should note that in this case, Libya's desire to get a higher return on its swelling cash than it could get while subject to US sanctions likely contributed to its desire to normalize its relationship with the world.   Call it the lure of Blackstone, and Blackstone-like returns ...

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