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Financing Best Practice

Forget Sovereign Wealth Funds

by Diana Choyleva

Executive Summary

  • Sovereign wealth funds (SWFs) have generated great hype over the past couple of years. But the economic and financial forces that led to the rise in their importance were also responsible for the creation of unsustainable global financial imbalances whose painful and prolonged correction is now underway.

  • SWFs will continue to exist, but they are unlikely to play a dominant role in the global financial system. If the existing global financial status quo is maintained and sovereign wealth funds are still causing the same hype in the next couple of years, economic policy in the SWF countries would be on the wrong track, risking a major global downturn.

Introduction

The hype about sovereign wealth funds began in early 2007, when China announced it was setting up such a fund and planned to invest $3 billion in US private equity group Blackstone. The realization that SWF assets had nearly doubled since the start of the decade, reaching $3.3 trillion by the end of 2007, while China had $1.2 trillion in foreign exchange reserves which could be channelled through its SWF in riskier assets, caused a quick escalation. Analysts tripped over themselves in projecting exponential increases in the wealth of SWFs, claiming that this marked a historic change or a paradigm shift in the global financial system. But although sovereign wealth funds will continue to exist, the hype about them is a transitory phenomenon. The global economic and financial circumstances that led to their rise in importance were also responsible for the creation of unsustainable global financial imbalances whose painful and prolonged correction is now underway. If SWFs still dominate the news headlines in the next couple of years, economic policy across the world will have failed.

SWFs’ History

Sovereign wealth funds are not a new phenomenon. The term has existed since 2005, but the first sovereign wealth fund was created as far back as 1953. SWFs are pools of assets owned and managed directly or indirectly by governments. For decades, sovereign wealth funds were the prerogative of the oil-producing countries. Their domestic nonoil economies tend to be dwarfed by the size of their oil revenues. At the peak of their cycle these countries run current account surpluses on average as high as 20–30% of output. Consequently, the pressure on their currencies to appreciate is massive, undermining the competitiveness of their nonoil domestic economies. A country can always keep its currency from appreciating by printing money, but at the expense of rampant inflation. To avoid the effects of extremely excessive liquidity, oil revenues can be set aside in a fund or funds that invest in foreign assets.

In most oil-producing countries most of the oil is in the hands of the state. Even if it is not, the intervention in the foreign exchange markets needed to keep the currency down siphons money into government hands. But, historically, the oil producers have invested their SWFs in search of high returns. More importantly, they have always used their oil revenues to smooth the global economic cycle. When global demand slumps and the price of oil falls, their current accounts tend to move from a huge surplus to a huge deficit. Oil revenues not only fall, but tend to be used up in an attempt to soften the cyclical blow to the domestic economy. The gigantic surge in oil producers’ SWF assets during this decade was the result of the prolonged global economic cycle, which was also accompanied by a spectacular commodity price boom.

China Changes SWFs and the Global Economy

The crucial global change responsible for this unusual Goldilocks period was the rise of China. China and some of the other tiger economies, with their large structural savings, are the other part of the sovereign wealth funds story. The key driving force in the world since the Asian financial crisis has been the desire to save excessively in a number of countries around the world—not just China, Japan, and the tigers, but also north-central Europe and Russia. The reasons behind the excess saving were different in different regions, but all were deeply ingrained. Moreover, these economies were saving well in excess of what they were investing domestically. They ran large current account surpluses and had to find a home for their huge savings.

More than half of the savings glut was in Asia. China was the linchpin. Its national savings rate is more than a half of income. Savings are high for structural reasons. These include the lack of universal social security and pension provision, together with poor health care and limited financial products to channel savings between the old and the young, or into the private corporate side of the economy. In the first half of this decade China wasted its savings in a huge domestic overinvestment binge. Since 2005 it has exported them abroad, running an expanding current account surplus that reached 11% of output in 2007. China’s mercantilist authorities believed that keeping their exchange rate pegged to the dollar ensured fast, export-led growth, but sheltered the weak financial sector from being exposed to damaging external pressure. Official capital outflows were needed to prevent the currency from appreciating. China accumulated huge foreign exchange reserves, amounting to $1.9 trillion by the autumn of 2008.

The tiger economies had similar structural reasons for their excessive desire to save. In addition, the International Monetary Fund’s harsh treatment during the Asian financial crisis taught them never to be international borrowers again. The tigers, together with Japan, did not want to be hollowed out by China, so they also either pegged their currencies to the dollar or kept them from appreciating. Therefore, they ran current account surpluses as well and had to park their savings in low-yielding, less risky dollar assets. The Asian savings glut was not in search of return, leading to a slump in real yields around the world. But for the global economy to grow, it needed someone else to do the borrowing and spending. The past ten years of illusory prosperity would have never been possible, and the Asians could have never saved and lent, had not Americans and others been willing to borrow and spend.

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Further reading

Book:

  • Dumas, Charles, and Diana Choyleva. The Bill from the China Shop: How Asia’s Savings Glut Threatens the World Economy. London: Profile Books, 2006.

Articles:

  • Bradsher, K. “State fund in China turns focus back home; Overseas investment halted as Beijing tries to help weak banks.” International Herald Tribune (November 29, 2007).
  • Buiter, W. “Taming sovereign wealth funds in two easy steps.” Maverecon—Willem Buiter’s blog (July 22, 2007). Online at: blogs.ft.com/maverecon/2007/07/taming-sovereightml
  • Choyleva, D. “Forget sovereign wealth funds.” Lombard Street Research, Daily Note (September 10, 2007).
  • European Central Bank. “The accumulation of foreign reserves.” ECB Occasional paper no. 43 (February 2006). Online at: www.ecb.int/pub/pdf/scpops/ecbocp43.pdf
  • European Central Bank. “The impact of sovereign wealth funds on global financial markets.” ECB Occasional paper no. 91 (July 2008). Online at: www.ecb.int/pub/pdf/scpops/ecbocp91.pdf
  • International Monetary Fund. “Sovereign wealth funds—A work agenda.” February 2008. Online at: www.imf.org/external/np/pp/eng/2008/022908.pdf
  • Jen, S. “Sovereign wealth funds: What they are and what’s happening.” World Economics 8:4 (2007): 1–7.
  • Jen, S. “How big could sovereign wealth funds be by 2015?” Morgan Stanley Global Economic Forum (May 4, 2007).
  • Rozanov, A. “Who holds the wealth of nations?” Central Banking Journal 15:4 (2005): 52–57.

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