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January 28, 2008

Who’s Afraid of Sovereign Funds?

David Beim
Professor of Finance and Economics and Bernstein Faculty Leader
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During the past ten years, Americans have become uncharacteristically fearful — fearful of terrorists, fearful of immigrants, fearful of foreign trade. The latest subject to provoke shivers of anxiety is the rise of sovereign wealth funds, notably the investment by a number of them during the past two months of nearly $20 billion in some leading U.S. financial institutions.

In particular, Singapore’s fund bought a 9.4% stake in Merrill Lynch for $4.4 billion; China’s fund bought $5.6 billion of securities convertible into 9.9% of Morgan Stanley; Abu Dhabi’s fund put $7.5 billion into a 4.9% stake in Citigroup; and another Chinese fund invested $1 billion in Bear Stearns.

The worried commentators point out that government funds are inescapably political, not just passive investors but surely seeking to extend their influence over world events. America must certainly be at risk, they say — what will these investors do, what do they want and will they ever go away? Financial institutions provoke special anxiety because of their central role in the economy.

I find it hard to share these anxieties. To me they are just another aspect of globalization. Our largest financial institutions are no longer exclusively “ours” but have become part of the global economy. The opening of borders to flows of goods, services and investment capital brought many benefits and has internationalized most large business organizations. They have learned how to balance needs and challenges from all sides. America has long extended its investment capital into other countries, and we need to get used to other countries doing the same.

What are the sovereign wealth funds and how did they get so large so quickly? The answer is not difficult to see: America has been importing dramatically more than it has been exporting in recent years. Since governments run the foreign exchange markets in countries such as China, Abu Dhabi and Singapore, governments tend to collect the dollars that Americans pay for the excess imports. As our trade deficits have continued unabated, the sovereign funds have rapidly grown. In the past these dollars were put into passive investments such as government bonds and bank deposits. But the managers of the funds are diversifying, and in particular seeking returns higher than those available on bonds and deposits. Equity investments are as attractive to them as they are to us.

The recent transactions were a benefit to both sides. The financial institutions got large capital infusions which were badly needed after the recent wave of credit losses left them somewhat depleted. If they had sold stock to U.S. investors in public offerings, the stock prices would have been brutalized. Similarly, the sovereign funds had a golden opportunity to acquire some major blocks of stock in leading institutions without disturbing the public market.

The funds are acting carefully, limiting their future actions. The transactions involve stand-still agreements which limit the funds’ ability to expand their positions in these companies. To be sure, large shareholders can exert some influence over management, but their voice will be only one among many. Modern companies have learned how to handle their many stakeholders.

I do have some concerns, but mine are more at the macro-economic level. I see little to fear in the recent transactions taken on their own, but the broader pattern of trading assets for goods is unsustainable in the long run. We have a finite number of investment assets to sell, but an apparently infinite appetite for cheap foreign goods. America used to be a fountain of capital to the rest of the world. Now it has become the world’s largest debtor.

I believe we need to moderate our appetites. If we do not, the foreign exchange markets are likely to drive the dollar ever lower, making our imports ever more expensive until balance is restored in that way. Our huge deficits are enriching the developing world with an efficiency that foreign aid could never have accomplished, and punishing our currency.

There is much we can do to mitigate the global financial imbalance. We can start with oil. If we could double the efficiency of our automobiles, the effect on oil imports would be dramatic. We also need to rein in our foreign military adventures. Apart from their negative impact on America’s reputation in the world, they are terribly expensive. In fact, if the U.S. government could get its fiscal budget under control, that too would make some contribution to correcting the external imbalance — not one-for-one, but measurable.

So I suggest we get over our fears of sovereign wealth funds and concentrate our minds on issues that truly will make a difference to America’s future.

Comments

by Madhavi, India | March 01, 2008 at 3:23 AM

I totally agree that America needs to focus more on issues which are of prime concern to its economic development rather than trying to worry about sovereign funds. Moreover, if sovereign funds are aiding countries in developing economically and globally, what is wrong about that? I am glad that developing countries such as China and India have found a way to survive in this competitive world, create niches which unfortunately are threatening U.S today. Ambition to be a world leader is good. But extreme ambition could only lead to sub-optimal results as we can witness in the case of America. America, in my opinion, lost farsightedness in the course of trying to fulfill its ambition of conquering the World, with its so called "Economic Power". Unfortunately, whether or not U.S likes it , Economic Power lies only with the Economically wise, and if the rest of the world is using its wisdom in exploiting its resources to the best possible in order to gain economic power, there is absolutely no harm in it.

by Adam Crocker | March 06, 2008 at 3:11 PM

Sounds like Warren Buffett would agree with this line of thinking. He touched on this issue directly in the recent BRK annual letter: "There?s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?" I agree that our current path is unsustainable, and we will have to change our policies before market forces change them for us. Thanks for the post.

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