The Hindu Business Line : Spectre of sovereign wealth funds

The day will come when surplus funds begin to shift away from functioning as lender to the external world, resulting in pressure on the dollar and on long-term US real interest rates. This is the spectre that haunts the US, says K. SUBRAMANIAN, adding that the way out would be to explore how such funds could be smoothly integrated into global finance.

With apologies to Karl Marx, a spectre is haunting the capitalist West: that of sovereign wealth funds (SWF). The rates at which foreign exchange reserves of emerging economies rise, and the efforts made by them to invest abroad are scary.

In recent years, the International Monetary Fund (IMF), the Bank for International Settlements (BIS) and major banks have been publishing data on the rising reserves of these countries. Until two years ago, they were not troubling.

What set the cat among the pigeons was a study by Morgan Stanley published in May 2007 (“How big could sovereign wealth funds be by 2015?”). It reported that SWFs could turn absolutely massive and rise from the current level of $2.5 trillion to $12 trillion by 2015, with an annual rise of $500 billion. The report went on to suggest how this would affect fundamentally the risky assets trade and give rise to “financial protectionism.”

The Economist described SWFs as a ‘secretive society’ flush with assets and added how, if they continued with their spree, “the world will witness the intriguing spectacle of its largest private companies being owned by governments whose belief in capitalism is often partial.”

Sebastian Mallaby of The Washington Post (“The Next Globalization Backlash,” June 25, 2007) narrated the challenges posed by them to globalisation and how “chunks of corporates could be bought by Beijing’s government — or, for that matter, by the Kremlin.”

It is evident is that the fear of SWFs that has been creeping in recently has degenerated into paranoia. A Cold War-like atmosphere permeates discussions on the subject.

This turnaround is surprising as, till recently, members of the developed world were the advocates of globalisation with capital freedom and foreign investment as its centre-pieces.

Further, economists sympathetic to the concerns of emerging economies were cautioning the latter about the ‘excessive’ build-up of reserves and investing them in low-yielding US Treasuries. Prof Lawrence Summers, former US Treasury Secretary, in a lecture in Mumbai in March 2006, bemoaned the irony of the emerging nations wasting their reserves. He pleaded for a new focus toward the challenge of deploying them effectively.

Separate vehicles

Within the emerging economies, public opinion turned against their central banks and pressed them to adopt bolder investment strategies. With the levels of reserves far exceeding prudential liquidity needs, the central banks themselves realised the need for setting aside a part of the reserves in separate vehicles for investments to get better returns.

Singapore set the precedent by creating Temasek. Oil exporters such as Kuwait, Abu Dhabi and Saudi Arabia had set them up earlier. Russia, with its equalisation fund, is a recent addition to the pantheon.

China setting up a State Foreign Exchange Investment Corporation with a capital of $300 billion was a thriller when it was reported. The formal launch on September 28 of China Investment Corp (GIC) with a capital of $200 billion was a low-key affair, ostensibly in order not to ruffle the feathers of western critics.

On date, the SWF club has 25 members and includes small countries such as Kazakhstan and Botswana. Truly, it is a motley assortment. Many are new to the game and do not have any common strategy. And yet, their emergence has disconcerted the older players.

The chorus voicing concerns over SWFs is from Western governments, academics and journalists. Broadly, they allege that SWFs are state-owned and, ergo, are not commercially driven and thus their motives suspect. Prof Summers would argue that these funds “shake capitalist logic” (Financial Times, July 29, 2007) as they seek non-economic objectives.

More transparency

It is also suggested that SWF operations are clothed in secrecy and lack transparency. Most attacks on SWFs harp on these themes in some form or other.

Mr Clay Lowry, Acting Under-Secretary of the US Treasury, gave his views in a lecture delivered in San Francisco. He felt that the “common objective should be an international financial system where countries do not accumulate more foreign exchange assets than they want or need.” Sadly, he could not elaborate how this utopia could be achieved with the US’ uncontrolled twin deficits.

Indeed, he was pragmatic and added, “SWFs are not going away, and it will be increasingly necessary to work to integrate these funds as smoothly as possible into the international financial system.” His main thrust was on transparency of their operations and adoption of ‘best practices.’ He hoped a joint task force of the IMF and the World Bank could work out the guidelines.

There are reports about Germany drawing up plans to stop strategic assets falling into the hands of “giant locust funds” controlled by Russia, China and West Asian governments. Germany’s fear was over Russia ‘stealing’ its technology, though it does not say it openly. It is said to be drafting new legislation to cover national security and, possibly, energy.

The EU Commissioner for Economic and Monetary Affairs, Mr Joaquin Almunia, explained in an interview on September 27 that unless investments by SWFs are more transparent, they would be restricted. The intention, as he explained, was not to be ‘protectionist’ but to protect the region’s interests without being ‘protectionist.’ Though somewhat ambivalent, the UK holds a similar position.

Southern shift

Fear of SWFs has deep roots. There has been a southern shift in economic balance in recent years. The US has been losing its hegemonic role even in financial markets. In the post-bubble era, its strength was boosted by the passive piling of reserves by emerging economies. In fact, they were subsidising the US financial market and some economists even dubbed it “Bretton Woods II” which would subsist for long.

As Prof Brad Setser of Oxford put it in his blog (of July 10), “the BRIC taxpayers are subsidising the US to the tune of roughly $130 billion a year. That is roughly 1 per cent of US GDP.” It helped Americans buy BRIC goods and services at lower prices. It kept interest rates low and helped banks and brokers make huge capital gains selling debt back to emerging economies in complex packages.

“Private equity firms might not be the kings of Wall Street in the absence of huge surge in central bank for debt, and the resulting easy availability of liquidity.” They would lose their kingdoms if emerging economies withdrew their reserves or diversified into other economies. True, there are limits to which they may do it individually or collectively. However, there are signs that the trend has commenced.

Stephen Roach of Morgan Stanley puts it more trenchantly: “The day will come……. when surplus funds will begin to shift focus away from functioning as lender to the external world….” It would lead to a shifting mix in composition of global savings and tradeoffs associated with the alternative uses of funds. There will be downward pressure on the dollar and upward pressure on long-term US real interest rates. Investment through SWFs is another major and significant trend. All these together would end the party in New York. This is the spectre that haunts the US.

“It cannot be resolved through campaigns against SWF investments or shutting them out totally. A more pragmatic approach is to explore how they could be smoothly integrated into global finance. The Financial Times (September 2) reports that investment banks such as Merrill Lynch, JP Morgan and Morgan Stanley are rushing to form SWF teams to advise and to cash in on the growing investment wave of government companies.

Banks and big retailers are secretly seeking liquidity from SWFs even as private equity groups have retreated. Financial Analyst Mohamed El-Erian has cautioned western politicians to “avoid the temptation of going too far.” As he argues (Financial Times, October 2), if the politicians frustrate the proper functioning of the markets, they run the risk of derailing a comprehensive repair job of re-tooling and re-plumbing the financial system through global capital flows.

It may sound over-optimistic. History has shown how, often, when reason fails, necessity drives. The western markets need the SWFs more than ever and this realisation would lead to a modus vivendi, notwithstanding the anti-SWF rhetoric.”

(The author is a former Finance Ministry official with extensive experience in international, financial and trade issues.)

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