The sub-prime crisis has diverted attention from rising fears about Sovereign Wealth Funds (SWFs) as the new bogeyman of global finance. But the minute the sub-prime crisis subsides, anxieties about SWFs will return. For the emergence of this vast and growing pool of state-controlled funds may have implications more far-reaching, and certainly more politically sensitive, than the hopefully temporary distress caused by the subprime crisis.

Indeed, if SWFs continue to grow, their investments are bound to permanently alter the relative weight of state- and privately-controlled assets in advanced economies. According to Morgan Stanley, SWFs are expected to manage $12 trillion by 2015, up from about $2.5 trillion today. Both sums dwarf the sums controlled by hedge funds and private equity groups. Thus some of the biggest investors – both passive and strategic – in financial markets in the coming years will be government institutions. That the biggest of these institutions are in China, Vladimir Putin’s Russia and some unstable petro-states adds another worry to the mix.

The growth of SWFs is a direct consequence of the accumulation of more than $5 trillion in foreign reserves by emerging-market economies in Asia and among oil and commodity exporting countries. These economies’ current-account surpluses, together with massive inflows of capital, have led their monetary authorities to try to prevent their national currencies from appreciating in order to maintain the competitiveness of their industries.

Initially, these countries invested their foreign reserves in liquid assets – short-term United States Treasury bills and government securities issued by other reserve currency countries. Then they realised that their holdings in liquid and low-return assets far exceed what is needed to avoid the type of speculative runs that East Asia experienced in 1997, and Russia in 1998. After all, why hold US T-bills with a meagre five per cent return, German Bunds with a four per cent return, or Japanese government bonds with a 0.5 per cent return when you can acquire foreign firms, invest in real assets, stock markets, or higher-yielding corporate bonds?

The answer seemed a no-brainer. So central banks are transferring their excess reserves to existing or newly-created SWFs, which in turn invest in high-return equities.

But the emergence of SWFs is creating a political backlash in the form of “financial protectionism”. Examples include the China National Overseas Oil Company’s failed effort to buy the US energy firm UNOCAL, and Dubai Ports’ failed bid to buy a firm managing major US ports. There is now legislation pending in the US Congress aimed at tightening the approval process for foreign acquisition of US firms, and a similar reaction is occurring in Asia and Europe.

Of course, not all SWFs favour strategic investments, i.e. taking controlling stakes in the acquired firms. Some, like Singapore’s Government Investment Corporation, prefer passive and diversified investments with no controlling stake in companies. And China, when it took a 10 per cent stake in the US private equity group Blackstone, eschewed any voting rights in the company’s management, perhaps as a way of keeping US financial regulators happy.

A third type of SWF takes the form of oil investment funds among oil/energy exporting countries, which are saving their windfalls into foreign assets. Norway, indeed, has been doing this – very quietly – for many years

Views about how to respond to the SWFs vary. The United Kingdom has adopted a laissez-faire approach, while political concerns dominate in the US, France and Germany. Some worry about reciprocity: if Chinese firms are allowed to invest in US and EU firms, shouldn’t US and EU firms be allowed to invest freely in any Chinese firm? Others worry about national security: what would happen if “our” ports and security industries or other “strategic” firms were taken over by China, Russia, or Saudi Arabia?

Still others worry about the fact that SWFs are state-owned: what would happen to corporate governance when investors may have objectives other than maximising risk-adjusted returns? Similarly, there are concerns about transparency: many SWFs do not reveal their investment strategies and how they operate.

What would happen if a small group of huge state-owned SWFs made very large investments in a variety of assets? How might equity prices or bond yields be distorted by $200 billion gorillas that need to invest $4 billion per week?

Dire predictions that the rise of the SWFs means that the global financial system is becoming a form of state capitalism may be exaggerated. But a small group of government players managing a vast amount of foreign assets does create complications. Of course, so long as the US runs annual current-account deficits of almost a trillion dollars, it will need to borrow from strategic rivals such as China, Russia, and unstable Middle East petro-states, which increasingly will lend in the form of high-yield equity investments rather than low-yield T-bills. So unless the US starts to save more, it will find it hard to complain about the form – equity rather than debt – that the financing of its external deficit takes.

It is also true that the massive accumulation of foreign reserves that is now feeding the SWFs’ growth is excessive and driven by misguided exchange-rate policies, with vastly undervalued currencies resulting in current-account surpluses. These countries need to allow greater exchange-rate flexibility and currency appreciation to reduce their external surpluses – and thus the need to accumulate huge foreign reserves in the first place.

Indeed, emerging-market economies should reduce their accumulation of foreign assets rather than hope to weather the political backlash against SWFs in the US and EU. SWFs are, it seems, here to stay and grow, and they do offer significant benefits. But if they grow too large while their activities remain opaque, widespread “financial protectionism” will become all but inevitable.

Nouriel Roubini is chairman of RGEMonitor.com an online information service and professor of economics at New York University Stern School of Business

Copyright: Project Syndicate, 2007

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