Thursday, January 24, 2008

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Summers on sovereign wealth funds

Like the rest of the known universe, I've been reading up on sovereign wealth funds as of late. And, to be blunt, I have yet to find much to get exercised about in terms of economic vulnerability to the United States or the west more generally. Basically, in order for a sovereign wealth fund to play politics, they have to shoot themselves in the foot financially.

Reporting from Davos, however, Daniel Gross relays Larry Summers' areas of concern. Summers is pretty smart, so let's review his objections:

1. Corporate governance. SWFs may protect the management of poorly run companies: "SWFs are some people's model investors, and other people's version of 1-800-ENTRENCH. What could be better for not entirely secure management than a long-term, nonvoting shareholder?"

2. Multiple-motive issues. "It's the premise of capitalism that people own shares to maximize value. But if you think of an investment made by a state fund, there could be multiple motives. Perhaps we want the airline to fly to our country, perhaps we want the bank to do extensive business in the country, suppose we want suppliers in our country to be sourced, perhaps we want some disablement of a competitor for our country's national champion. When there's no assurance that value maximization is not being pursued, there is a potential question."

3. General politicization. He provided two examples. "First, suppose that a country ran an active trading operation, and say it was a very inspired one, and found itself in an investment much like George Soros' short position in the pound. Would we be comfortable with the concept that the nation of X had decided that nation of Y's currency was overvalued and launched an attack? There should be some kind of understanding that that won't happen. Also, the SWF of country A makes an investment in a major bank in country B. The bank gets in big trouble. Is there any control in the world that can assert, that with billions of dollars on the line, their head of state and foreign minister are not going to get involved in the negotiations?"

Concern #1 is interesting, but strikes me as ephemeral. If a sovereign wealth fund is interested in maximizing its value, then it's not going to want to keep around incompetent management.

Concern #2 is a possibility, but the more pernicious possibilities seem like straight anti-trust issues rather than problems unique to sovereign wealth funds.

Concern #3 is a massive rationalization. It boils down to, "we're not saying sovereign wealth funds are evil, but other, less cosmopolitan folks are saying that, and they have pitchforks."

There are some foreign policy reasons to be concerned about some sovereign wealth funds -- but I don't see any economic motivation to get all riled up about them. This holds with particular force at the present moment. As the head of Norway's fund put it at the panel: "It seems you don't like us, but you need our money."

Question to readers -- can anyone add an additional reason to believe sovereign wealth funds are bad for the U.S. economy?

UPDATE: For those curious about the official U.S.position on sovereign wealth funds, go read Deputy Treasury Secretary Robert Kimmitt's Foreign Affairs essay:

posted by Dan on 01.24.08 at 03:10 PM


I agree with you on this. I've been studying SWF for awhile now and yet, I can't see any huge problems with them. I would have problems if I was a citizen of the country with SWF with the notable exception of Norway. That being said I agree somewhat with the corporate governance argument but we are talking about only a few investments where this would apply, so its effects are rather limited.

Just wondering what your FP concerns are?

posted by: Patrick Flaherty on 01.24.08 at 03:10 PM [permalink]

An idea:

They can be used to expand or create cartel or monopoly situations. If Russia and Iran got together and bought I ran it might be obvious.

But many of these funds are extremely non-transparent, and some items of national interest are not nearly as obvious as oil.

I realize that the reality may be more difficult to pull then the conspiracy theory. But many things that are difficult to accomplish may still be worth doing with sufficient time and resources.

posted by: russell120 on 01.24.08 at 03:10 PM [permalink]

Isn't it the case that by definition because they are *sovereign* wealth funds they will necessarily respond to non-economic priorities? I suppose one could build a bureaucratic argument that suggested the actors actually running the thing would likely be fairly independent (and have wealth-maximizing preferences), but then whether to worry about these funds or not would depend on their particular institutional make-up. And given the opacity of some of them, that seems problematic.

It's true that these sorts of funds would "shoot themselves in the foot" but sometimes state actors are willing to trade off economic gains for other ends, right? Why wouldn't these funds do the same?

posted by: Michael Simpson on 01.24.08 at 03:10 PM [permalink]

At the end of the day the directors of these funds must report their performance and investments to finance ministers and the like. However much independence they have in their investment decisions, the politicians are the ones at the top of the food chain. Just something to consider.

posted by: Chris Canell on 01.24.08 at 03:10 PM [permalink]

Dan --- I strongly disagree with your characterization of 3) as a rationalization.

Norway's fund got in a bit of hot water shorting Iceland's banks. And its shorts didn't really work out -- Iceland avoided a crisis. Imagine what might have happened had Norway's strategy worked ... the argument that it was a commercial bet wouldn't have flown, in my view.

And Norway isn't necessarily the most aggressive funds. a number of sovereign wealth funds (with an investment style that resembles mutual funds) are slowing morphing into sovereign hedge funds and sovereign private equity funds (leveraging up to buy companies). Funds from countries with appreciating currencies face pressure to take more risks to offset currency losses. As their trading strategies evolve, they will inevitably impact markets, sometimes negatively.

on 2)I think there is growing probability that some funds -- notably China's funds -- will be used very heavily for "development" goals and specifically to promote the "development" of chinese SOEs into global multinationals. the existing funds generally haven't done this b/c they are from countries that are already rich, and in singapore's case, temasek already owned a bunch of singapore multinationals and wanted to diversify. but nearly every fund has domestic development as part of its mandate -- which in most cases was interpreted as promoting the domestic fund management business. those kinds of pressures are multiplied by several factors in the case of cHina.

Finally, four additional potential concerns:

a) sovereigns historically tend to be loss adverse. the desire to avoid disclosed losses could push them to act in ways that destablize markets; selling into a down market for example to avoid having to tell their parliament that they have subprime exposure. this is manageable, but it goes against the notion that sov. funds are always stabilizing forces. a concrete example: the Chinese state banks (who effecitvely manage fx on behalf of the government) seem to have stopped buying us corporate debt after starting to lose money in the summer.

b) it is not at all clear that the residents of the countries with big SWFs would vote to have the funds invest the way they currently do. of course, most sov. funds come from places where there is no vote -- plus, so long as the size and performance of the fund is not disclosed, there is no way to know how its proceeds are being used or for what. good governance types should worry ...

c) the estimated scale of SWFs -- if SWFs get a large share of the $1 trillion plus now being added to global reserves -- suggests to me that it will be impossible for them not to impact a host of markets in ways that we have hardly begun to contemplate. an increase in central bank demand for bonds from $100b a year to $500b a year helped set in motion the housing bubble (imho). the i-banks forecasts imply that SWF flows will go from $120b a year (up until recently invested fairly conservatively, with norway accounting for about $40b of the total and putting a large share of that flow into bonds) to over $1 trillion a year. that is a huge shift -- one that i think can safely be assumed to have a major, unpredictable impact on a host of markets.

d) Many sovereign funds are effectively mechanisms for avoiding necessary adjustments in the global economy, and in the US economy. SWFs are effectively keeping key markets away from equilibrium. Rather than trying to get a higher return on their reserves (or foreign assets bought by governments, including by the SWF, as part of an effort to limit pressure for their currency to appreciate) some countries should be adding less to their reserves.

Why is China's state investing $500b plus abroad? why a CIC for foreign investment (especially given that every $ or euro china buys represents a bigger likely loss b/c of the exchange rate) rather than investing in say schools and health care? More domestic spending wouldn't produce inflation with a stronger rmb. Those are questions that I think warrant a bit more attention.

I agree with your follow-up post -- the US and Europe have leverage because there are few places big enough to absorb big inflows. The last thing india wants is for china to put pressure on the rupee to appreciate v the rmb ...

posted by: bsetser on 01.24.08 at 03:10 PM [permalink]

I'm not certain that "shooting oneself in the foot" is always a problem. Countries spend billions on weapon system's whose only purpose it to damage others.

I don't have a lot of trouble imaging some portion of an SWF used as essentially a "weapon system". Even better, if not used, it's likely that such investment would not be wasted (even if it failed to grow much), unlike regular military spending, which is more or less completely wasted if not used within 10-20 years.

Not that I see any evidence of that happening - but presumably SWFs serve *all* of a country's interests, not just their economic ones. One reason why SWFs should at least be scrutinized more closely than general investors.

posted by: Tom west on 01.24.08 at 03:10 PM [permalink]

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