Saturday, December 22, 2007

sovereign wealth funds and US sovereignty

The papers are reporting on a new Saudi sovereign wealth fund. I've written about these funds once before. They are established by dollar-rich nations to permit hedge-fund style investing in the world's financial markets. They are important because, until now, these states have relied exclusively on government agencies such as central banks to invest their surplus dollars and these agencies have traditionally made conservative purchases, mostly purchases of US Treasury Securities. This meant that money Americans spend on such things as imported oil is returned to the United States to help pay the interest on our national debt. Without these investments it's safe to say the US would not have been able to keep interest rates low while also increasing national productivity and, in sum, maintaining an economy that grows faster than that of other highly-industrialized nations. These two charts graphically demonstrate US reliance on purchase of Treasury investments by central banks and other foreign sources.

{Click to view full size. Source: Who Do We Owe and How Much?. }

The number and extent of the sovereign wealth funds is large and growing. Their total assets, shown below, are estimated at about $2.5 trillion. They are expected to grow to $12 trillion in the next eight years.

The move from central bank investment in the US national debt toward SWF investments in all kinds of financial instruments destabilizes a precarious balance in global finance. As foreign government shift investments away from US Treasuries, there's a risk that the value of the dollar will plummet. It's dropped already as a result of the housing crisis and foreigners' nervousness about the extent of their holdings of US investments (in addition to other factors of course).

As the International Monetary Fund has repeatedly said, a gradual and orderly decline in the value of the dollar will actually increase global financial stability, since low interest rates in the US have kept the value of the dollar artificially high. So the risk is a dramatic plunge in value. The IMF would like to see a gradual shift from dollar-denominated investments to toward investment in developing nations (coupled, necessarily, with reductions in the US national debt, strengthening of the Euro economies, a shift in China away from internal investment, and in general reform of corrupt regimes in developing countries).

The value of the dollar would plummet, producing a huge international depression, if foreigners made a precipitous decision to move investments to other economies than the US. Since the depression would be global, foreign investors can be expected to do their best to avoid that scenario. They have to balance their risks however.

The risk hangs on a matter not just of rational decision-making in dollar-rich countries but also a matter of faith: faith in the ability of the US to work its way out of the current financial crisis and establish policies that insure -- as much as can be -- orderly and predictable economic growth. So far, the dollar-rich nations have kept this faith. If they were to lose it, one or more of them might pull investments out of the US despite the risk of global depression. Their motivation would be the same as that of investors in an overheated stock market whose fears of recession cause them to do panic selling of their holdings. If a crash is seen as inevitable, those who sell first end up better off, during the ensuing depression, than those who sell only after the value of stocks has gone way down.

The news about SWFs and their investment policies actually has an optimistic aspect in this respect. There's no evidence of a decline in faith in the US economy. Instead what's happening, so far, is SWF investment mainly in the US. They are buying stocks and bonds, but also real estate, and -- I guess it shouldn't come as a surprise -- they are buying up US businesses, particularly within the depressed financial sector.

The Telegraph (UK) explains:
Merrill Lynch set to take $5bn from Singapore, by Angela Monaghan, Dec 22, 2007.


Merrill Lynch is set to become the latest global investment bank to receive a capital injection from an Asian government fund. Temasek's investment in Merrill would make it the fourth bank to receive a foreign state bail-out from cash-rich developing economies to stem their escalating sub-prime problems, a further sign of the shift in power to the Far East and Middle East. China's sovereign wealth fund - China Investment Corp (CIC) - has injected $5bn to shore up Morgan Stanley's capital position in return for equity units that will convert into as much as 9.9pc of Morgan Stanley stock. Abu Dhabi's sovereign wealth fund invested $7.5bn in Citigroup last month while last week GIC, an investment arm of the Singapore government, and an undisclosed Middle Eastern investor injected Sfr13bn (£5.6bn) into Swiss bank UBS.
It seems strange to welcome purchase of US assets by foreign governments. Doesn't it compromise US sovereignty? This has been a major concern, but -- when you think about it: (a) the US doesn't have much choice and (b) the US is already so much dependent on foreign investment that the task for the US government is to regulate these inflows of investment to keep the risk of lost sovereignty to a minimum.

By risk of lost sovereignty I mean such things as the ability of one or more foreign governments to, in effect, blackmail the US into bending its policies to suit the foreign governments. An example might occur if dollar-rich Russia took a huge stake in, say, American Express, and then threatened to sell unless the US aligned with Russia on some issue involving Iran, Iraq, or Afghanistan.

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