Anxiety about the risks of sovereign wealth funds is bordering on mass hysteria and needs urgent redress, says Arnab Das
At best, sovereign wealth fund (SWF) newcomers in the CIS and emerging Asia don’t offer rules-based behaviour like Norway’s state petroleum fund; or market incentives like Singapore’s GIC/Temasek. A potential political backlash reflects the rising wealth of newly capitalist states that lack the checks and balances of G7-style representative democracy. At worst, up-and-coming SWFs are controlled by potential long-term geopolitical rivals of western powers, particularly the United States.
It’s critical to distinguish the rapid rise in FX reserves from the growth of SWFs. This is no mere semantic detail. Galloping reserve growth owes to three main factors: current account surpluses, capital account surpluses and fear of floating – the managed exchange rates designed to prevent changeable global flows from whipping their currencies around.
There are key messages here for the future growth of SWFs. First, only current account surpluses should go into SWFs. As the excess of domestic savings over investment, they represent genuine national “wealth”. By definition, investment inflows are savings of non-residents who might repatriate dividends and interest, or sell onshore assets. Central banks would want to keep liquid reserves to manage the economic or financial repercussions.
Second, SWFs have grown very fast lately, but their rise may now slow. Domestic demand in natural resource and high-savings export economies is accelerating. Global imbalances, the external surpluses of net exporters, and corresponding deficits of rich countries – particularly the United States – should fall. This in turn should curb SWF growth from recent lofty peaks.
Market forecasts of SWF growth are often based on optimistic extrapolations. The consensus puts the stock of SWFs at $2.5 trillion; forecasts range up to $15 trillion – a sextupling – by 2015. Dresdner Kleinwort projects doubling by 2010, tripling by 2015, based on rising domestic absorption, especially in the major new players, Russia and China. This is still huge, but it doesn’t suggest that SWFs will become the dominant category of investor planet-wide.
SWFs should be able to address G7 political concerns that they might dominate core markets and strategic firms. G7 countries themselves deploy public investment funds, which no one expects to manipulate markets or break the rules because they are run on commercial lines. Calpers, the pension fund of the (sovereign) State of California, is an activist investor in US and foreign firms, but few would argue that it is a danger to private enterprise. The Social Security Trust Fund of the United States holds Treasuries that are not in the free float. Yet few argue that this distorts markets, even though Treasury yields are the benchmark rate against which risky assets are valued.
Convergence
Above all, incentives faced by SWFs should converge on the G7 model over time. As economies and markets become ever more integrated and globalized, pressures for accountability and rational investment decisions should rise. Populations will not sit passively by while SWFs play politics or make bad investment decisions with public resources. And episodes like the recent credit turmoil will likely increase SWFs’ caution about liquidity or credit risk, limiting their contribution to irrational pricing or herd behaviour.
It is critical for the continued, undistorted growth of economies worldwide, that financial markets remain free and open. The challenges can be managed if SWFs are subjected to the same rules, best practices, and critically, the same incentives as their private-sector counterparts. The case for SWFs to be managed at arm’s length from their governments, and to be subject to the normal regulatory oversights when they operate in foreign jurisdictions, is as strong as the case for keeping markets open and playing fields level.
Arnab Das is head of research and strategy for emerging markets and global foreign exchange at Dresdner Kleinwort bank.