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October 10th, 2007
The imbalanced global economy of recent years, where the US ran huge current accounts deficits of USD 800 billion or so and emerging markets built up huge surpluses of foreign exchange, is passing from a benign period to one that could bring the openness of investment markets into question and engender a lapse back into financial protectionism.
Ten years ago Asia, Russia, Latin America were broke and In crisis having to obey the dictates of the International Monetary Fund to pull themselves out of the hole the markets had dug for them. With the oil price hovering in the teens, OPEC had no spare funds either. In the midst of the tech boom the US was top dog and ruled the roost.
Talk about the boot being on the other foot! The Asian governments were humiliated by the experience and resolved never to let it recur. They built up an impregnable total of forex reserves more than sufficient for any conceivable contingency. Global forex reserves now amount to over USD 5.3 trillion. China holds the largest pool of reserves at USD 1.3 trillion, followed by Japan with USD 911 billion and Russia with USD 400 billion.
Until now forex reserves have been largely invested in government paper (US and Europe mainly).owning more than half all US Government paper. This was great for the US and other debtor country consumers but hardly sound investment management for the emerging economies since this policy is guaranteed to lose real value over time. The benign period in which the US and others could just parcel out their paper willy-nilly to the emerging economies is over. The pigeons are wising up!
As reserves are projected to keep expanding, a growing number of countries have established stand alone sovereign wealth funds (SWFs) in which their excess reserves can be invested more aggressively into equities, public and private, property and commodities. It is these funds that are likely to make a huge splash in the markets in coming years.
Whilst SWFs have been around in some relatively minor form since the 1950s with Kuwait's fund, they have mushroomed in the last two years. They already manage an estimated USD 2.5 trillion in assets - greater than the total assets controlled by hedge funds - and their assets are expected by Morgan Stanley and others to grow 5 or 6 times in the next few years.
As they will become important players, potentially controlling politically sensitive assets, their investment policies are likely to become hot political issues with the potential to generate a momentum towards financial protectionism. There are straws in the wind in this direction in countries such as the United States and Germany already.
SWFs funds fall into one of two major categories: commodity funds (such as the OPEC or Russian oil funds) or non-commodity funds funded from current account surpluses. Market estimates currently attribute approximately two-thirds of SWFs assets to commodity funds and the remaining one-third to non-commodity funds.
Earlier this year China stated that USD 1 trillion foreign exchange reserves managed the traditional way in government securities were sufficient and an investment holding company (probably modelled on Singapore's Temasek Holdings) would be funded with an initial USD 300 billion of excess reserves. Its first investment was a USD 3 billion investment in Blackstone's IPO, a deal which could assist the fund get introductions to future investments. Korea also announced the start of a Korean Investment Corporation in 2006. In addition, it has been investing actively in natural resources in the Middle East, Africa, Latin America and Canada.
Size of main Sovereign Wealth Funds
The total assets of SWFs are estimated at approximately USD 2.5 trillion, compared with global foreign exchange reserves of USD 5.3 billion and approximately US 2 trillion for all hedge funds. SWFs assets are invested in private and public equity, stocks, bonds and property.
The largest SWFs are shown below:
Estimates of their future growth vary but continued rapid growth is expected and total assets by 2015 are estimated at about USD 12 trillion about the same as the current USD GDP. Even with a very diversified investment policy it is obvious that SWFs are set to have an important impact upon world markets, where the market cap of global stock markets is approximately USD 60 trillion.
Policy issues raised by the growth of SWFs
SWFs are already making occasional waves in capital markets with their investments. China ran into a hailstorm from nativist politicians a couple of years ago when it tried to buy a small US oil company UNOCAL even though it had virtually no reserves in the US. The politicians raised frankly racist arguments against allowing some of its natural resources go to a potential rival for global power. The Chinese backed down.
Similar nativist reactions were seen from American politicians when Abu Dhabi interests tried to buy some US container terminals that had been owned by the British shipping company P&O Lines that it was buying on the London Stock Exchange. The Arab investors had to restructure the deal to exclude the container terminals that were sold to US investors. There are similar murmurs about the Dubai exchanges minority share investment in NASDAQ even though they would just be one voice on the board and exchanges throughout the world are developing linkages for today's 24/7 markets. In addition, the SEC would remain the ultimate regulator in the unlikely circumstance their powers were needed.
EU politicians have also raised questions about allowing their companies to fall into the hands of entities controlled by foreign governments. Security concerns are frequently raised, sometimes legitimately but often spuriously. Europeans have a concern about major companies being controlled by Russian state companies, given that Russia has placed energy politics at the centre of its policy to re-establish itself as a global geopolitical force.
Present concerns in OECD countries are mainly centred on SWFs, from non traditional investors (i.e., China, Russia and OPEC) making controlling investments based on political rather than financial considerations in areas that could be deemed to have security implications.
By way of contrast, the investment of up to 10 percent in Barclays Bank by the Chinese and Singaporean SWFs ticks all the right boxes, is clearly synergistic from an investment standpoint, and has been welcomed by the UK authorities. Similarly, a proposed controlling investment by the Qatari's in the supermarket chain Sainsbury has raised no political concerns, although the founding family is in two minds about selling. The UK says that it remains open for business although, there are probably limits even there.
The Chinese decision to invest in Blackstone to obtain future co-investment opportunities are also seen as sensible, non-threatening and uncontroversial and a way forward.
Other concerns revolve around the secrecy and lack of transparency of many of the new funds particularly when compared with older funds from OECD countries such as the Norwegian Pension Fund of the Alaskan Fund.
From a policy standpoint there is also a dichotomy in countries privatising their state operations on the one hand but then having their companies bought by agents of a foreign power. This has happened in the UK where its utilities have been privatised - only for French government owned state entities to take control through the stock market. Even in the generally open UK the thought of Russian state entities controlling gas distribution raises concerns amongst the population if not amongst the fellow-travelling New Labour government.
SWFs are becoming a growing power in the capital markets and their size should make them some of the largest global investors in the next decade. This asset growth will almost certainly be accompanied by an increased level of controversy in their investment policies which, unless handled creatively, could lead to a backlash against openness in investment regimes; and, in effect, financial protectionism.
The solution should be one of increased transparency in their holdings and policies. International financial institutions, such as the International Monetary Fund and the Asian Development Bank, should have a role to play as honest information brokers and financial intermediaries, if we are to avoid slipping back to a more protectionist environment and a reversal of globalisation that has brought such great benefits, albeit not optimally distributed, to the world. This will be just a further challenge for faith in globalisation viewed from the prospects of a US recession and Democrat control of both the Congress and the White House in 2009.
ABOUT THE AUTHOR
Disclaimer: Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
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