Saturday, November 17, 2007

Outsourcing the Nation-State

They're called "sovereign wealth funds". They're not really a new concept in that kings and lords and then nations have, since the dawn of such organizations, consolidated and maintained whatever power they may have amassed with finance, sometimes stripped, often borrowed, from others of their kind.

Back in the days when J.P. Morgan and other robber barons of his century secured their roles in the heart of American finance, most of the US capital used privately and publically came from overseas, principally from London, Brussels and a bit from other European sources, some of it from the foreign governments, but mostly private, or at least channeled through private entities in such manner as to make JP Morgan a very wealthy man, whose legacy has turned into a very wealthy institution. In those times the money for the capital came in the form of debt and the US was a big borrower of such debt.

For a short while after WWI the US found itself to be in the position of having changed from a net borrower to the world's creditor. By the end of the 20th century, the US was back in the debtor side, with some concern being expressed in some places that it was not a good policy for the US to owe so many foreigners so much money. There was a great debate, not settled, to the effect that US sovereignty might somehow be compromised by, for instance, the Chinese holding such a large chunk of America's debt.

But we have been led to believe that the whole world's economy is beholden to keeping the US consumer fat, if not happy, and so this debtor situation wasn't a high priority issue. Debt is good when borrowing is required to keep the cows fat.

Besides, we're told, we only owe the foreigners money; our great industrial wealth is still our own. Much of the debt, we're told, is only a book entry caused because we own so much production and other assets overseas that the "debt" on the books is just returns we owe ourselves. No worries.

But what happens when those damn foreigners begin to buy up our economic base? Well, then, things begin to get a bit more edgy. At least for the politicians and citizenry, but not for the types of the Dutch bankers and JP Morgan's heirs and successors, who live in the nether lands of borderless finance.

In Australia and elsewhere, simple things like buying a house and land are denied to foreign money, or at least regulated. In America, things like having an Arabian company buy into private ports or having a Chinese company buy into a distressed oil company get Congressional scrutiny. In China, having practically anyone from outside buy into practically anything inside is rife with scrutiny, regulation, corruption and risk. Business and trade is one thing, just don't step on the sovereign toes of the host country.

And this is one of the current intersections of world history where government is taking on the shape of hedge funds and private banks while simultaneously "multinational" business is taking on the size and power of governments. (See, Unrepresentative swill, Part 3.)

With foreign countries taking on so much US debt and accumulating so many US dollars, some of these countries are shifting tactics from being a lender to being an owner. So far, they are behaving something akin to private equity, but when does a hedge fund begin to look like a Trojan horse?

Things will be very interesting in the time upcoming as the US tries to maintain its sovereign powers in the face of these sovereign funds. It gets particularly entertaining to see the titans of US capital, who hide themselves in "off-balance-sheet" enterprises, "off-shore" accounts, off-handed relationships and other devices intended to put off scrutiny of their doings, and their political masters or puppets or what have you demand "transparency" of these sovereign funds.

This from capitalism's fount, Forbes:
Treasury calls on IMF, World Bank to lead on sovereign wealth funds UPDATE

The [US] Treasury Department today renewed its call on the International Monetary Fund and World Bank to develop a list of best practices for sovereign wealth funds (SWFs), which he said would help ensure investments controlled by foreign governments are transparent and made for economic rather than political reasons.

Paulson said last month that there are some fears that countries like China that want to pour their vast foreign exchange reserves into overseas investment might base their investment decisions on political aims. McCormick reiterated today that if these countries use their reserves to further broad strategic goals, 'sovereign wealth funds could potentially distort markets.'
Guambat would like a little transparency from the American government to determine if the invasion of Iraq, for instance, was based on investment decisions of, say, Halliburton, or political aims, such as ensuring a re-election? But that is a digression.

Back to the matter of these new-ish sovereign wealth funds, there is this from the International Monetary Fund magazine:
The Rise of Sovereign Wealth Funds
Sovereign funds have existed at least since the 1950s, but their total size worldwide has increased dramatically over the past 10–15 years. In 1990, sovereign funds probably held, at most, $500 billion; the current total is an estimated $2–3 trillion and, based on the likely trajectory of current accounts, could reach $10 trillion by 2012.

Currently, more than 20 countries have these funds, and half a dozen more have expressed an interest in establishing one. Still, the holdings remain quite concentrated, with the top five funds accounting for about 70 percent of total assets. Over half of these assets are in the hands of countries that export significant amounts of oil and gas. Norway has a large sovereign fund, as do places as disparate as Alaska, Canada, Russia, and Trinidad and Tobago. About one-third of total assets are held by Asian and Pacific countries, including Australia, China, and Singapore.

As has become apparent in today's fast-paced financial markets, the impact of a particular pool of money on financial stability depends not only on assets under management but also on the potential leverage (that is, debt) used in investment strategies.

For example, many hedge funds and (their cousins) private equity funds are reported to use leverage ratios of 10:1. That means they borrow 10 times their own capital for particular transactions. In some cases, leverage is even higher, probably significantly higher. Hedge funds almost certainly improve the allocation of capital around the world, but recent developments indicate that, in some forms, they also pose a danger to the global financial system. The consensus so far is that while hedge funds deserve considerably greater scrutiny, there are advantages for the allocation of global capital flows if this sector continues to have a relatively light direct regulatory burden.

Now take note of that. Hedge funds are good, even though they and the products they deal in are unregulated, little is known about them, and many of them are hidden away in opaque jurisdictions like the Bahamas. Until now, anyway, most hedge funds have been owned or operated by democratised Westerners, with, of course, proper schooling in the proprieties of gentlemanly responsibility and discretion, tempered by the corporate form of democracy, one dollar, one vote. Now, continuing with the IMF story:
Unfortunately, there's a lot we don't know about sovereign funds. Very few of them publish information about their assets, liabilities, or investment strategies. It's thought that they've traditionally been "long only": that is, they pursue buy-and-hold strategies, with no short positions and perhaps no borrowing or direct lending of any kind. They probably have long horizons and, like other long-term investors, are willing to step in when asset prices fall. This likely exerts a stabilizing influence on the world's financial system. But there is also anecdotal evidence that some sovereign funds have placed investments with other leveraged funds.

At least one central bank is reported to have had investments with Long-Term Capital Management when that hedge fund went bankrupt in 1998. Another central bank has invested recently with a major private equity fund. The Norwegian sovereign wealth fund reports that it has shifted somewhat from bonds to equities, and we think the same movement may be under way more broadly. It seems clear that some part of the hedge funds' assets and private equity assets under management now comes from sovereign wealth funds (care must be taken not to double count when the assets of these related entities are added), but there are no numbers.

Rogue traders, a serious issue for all types of investment funds, are also a potential problem for sovereign funds. Although the problem isn't likely to be widespread, there are specific instances in which traders employed to invest central bank reserves have taken large speculative positions and lost heavily. At least some of these traders acted without the approval of the appropriate credit risk managers. It wouldn't take many such transactions to awaken calls for regulation of cross-border capital flows when decisions by sovereigns are involved.

The emergent approach to "regulating" hedge funds is not to regulate them, but rather to watch carefully over the regulated intermediaries that lend to them (that is, commercial and investment banks). The idea is that this protects the core of the financial system while allowing innovation and risk taking. But as sovereign funds grow in importance, they effectively become a significant unregulated set of intermediaries that may or may not invest with hedge funds in the future.

The real danger is that sovereign wealth funds (and other forms of government-backed investment vehicles) may encourage capital account protectionism, through which countries pick and choose who can invest in what. Of course, there are always some national security limitations on what foreigners can own. But recent developments in the world suggest there may be a perception that certain foreign governments shouldn't be allowed to own what are regarded as an economy's "commanding heights." This is a slippery slope, which leads quickly and painfully to other forms of protectionism. It's important to preempt such pressures.

There will be much written about sovereign wealth funds in the coming years, and it will pay to pay attention and try to discern the subtle battle between private capital and nation-state capital. We are all (well, mostly all) citizens of some country or other, but none of us are yet citizens of private enterprise. The only way to maintain the franchise of citizenship is to make sure the disenfranchising aggregation of corporate power remains under governmental checks and balances.

The world's most expensive club
The announcement on May 21st that [China] would invest $3 billion of its reserves in Blackstone, a New York-based private-equity firm soon to issue shares, shows that it is prepared to barge into murky private markets as well as liquid public ones.

By choosing a private-equity firm, China will also be able to invest directly in a partner that, notwithstanding its forthcoming share offering, can keep many of its operations out of the public eye. But this is where the ironies of the deal are most apparent. “Crony capitalism? It is a marriage made in heaven—a partnership that does not want investors to ask questions with a country whose firms do not want investors to ask questions. I worry about the serious conflicts of interest this generates. More generally, government entities shouldn't be in the business of investing in private firms,” opines Raghuram Rajan, of the University of Chicago's Graduate School of Business.

Moreover, it is widely believed that by having China as a partner, Blackstone will receive preferential access to China's market (as well as providing China with experience it clearly covets on how to set up its own domestic private-equity industry). This is an advantage for Blackstone, and for its shareholders, China included, particularly so when other private-equity firms complain that the impediments to operating in China are growing.

[China] is not the only inscrutable country to be cosying up to the inscrutable private-equity industry. Around the world, a secretive society is emerging of governments flush with foreign assets, some of them petrodollars, that are increasingly calling the shots in international finance. The Blackstone deal is likely to stir others to invest their money even farther away from prying eyes than they do already.

To the extent governments have traditionally held investment assets, it was to protect domestic currencies and banks from crisis. Since the funds were for emergencies, they were of a type that could be liquidated easily—initially the holdings were in precious metals, lately they have been in dollars. The idea of building up an endowment to replace shrinking natural resources did not exist.

That process may have started inadvertently in 1956 when the British administration of the Gilbert Islands in Micronesia put a levy on the export of phosphates—bird manure—used in fertiliser. The manure has long since been depleted. However, a once-tiny set-aside of money has become the Kiribati Revenue Equalisation Reserve Fund, a $520m investment portfolio that has grown to about nine times the tiny atoll's GDP.

A similar approach is now common among oil-producing countries, which, it is estimated, account for two-thirds of the assets in these sovereign-wealth funds, and are keen to diversify their national revenues, aware that their wealth is being pumped away. They have typically invested along similar lines to central banks, holding bonds, dollars and bank deposits. Temasek, a Singaporean entity created in 1974 to pool state-owned investments, started to change the mindset. It subsequently evolved into an even more complex investment vehicle. The heady combination of state-control, success and secrecy, entranced other governments.

Recently, central bankers have also begun wondering whether they have a fiduciary duty to make higher returns from the public wealth under their supervision, which could mean placing at least some part of foreign-exchange reserves in high-yielding, if less liquid, investments. In Asia this question has become increasingly pertinent in the past two years, as reserves have mushroomed.

The result has been a torrent of money into a finite pool of assets. There is no precedent for such fortunes suddenly to find their way into global financial markets, and they help explain the waterfall of liquidity that has driven up the value of risky (and less risky) assets of all descriptions around the world. The world's entire supply of shares is $55 trillion, and bonds account for a similar amount. Sovereign-wealth funds could soon become the most important buyers of such assets, and many others besides. If so, the world will witness the intriguing spectacle of its largest private companies being owned by governments whose belief in capitalism is often partial.

The last time governments were this involved in sinking money into private assets, the process tended to be called nationalisation. Now the funds are invested both abroad and domestically. A new term will have to be coined: internationalisation, perhaps.

Yes, perhaps so. Globalization is so yesterday.

No doubt Goldman will already be making money from it.

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