The new (financial) world order

In 2007:

China’s government added $430b to its foreign exchange reserves.

Russia’s government added $150b to its foreign exchange reserves.

China’s state banks likely – this is the only point here where there is some real doubt – added around $150b to their foreign portfolio, or would have, had China not made it harder to borrow from abroad and thus forced them to pay down some of their external debt. The state banks' dollar purchases reduced the central bank’s need to intervene in the market (apparently the exchange rate risk remains with the government). The central bank basically told the state banks to hold more of their required reserves in dollars.

Brazil’s government added a bit over $90b to its reserves. Brazil’s Treasury holdings are up close to $70b for through November, in another kind of reverse bailout.

India's government added a bit under $90b to its reserves, almost none of which seems to have been invested in US Treasuries.

The China Investment Corporation likely had about $17b to invest abroad – as the majority of the funds it raised in 2007 were used to buy the central banks’ stake in the state banks and to recapitalize China Development Bank. It will get something like $105b early in 2008. Maybe $45b to $50b of that is already committed to the recapitalize the domestic banking system, leaving up to $60b more to invest abroad. But the CIC is still the smallest official investor among the BRICs.

Sum it up and the BRICs added just a bit under $800b ($760b) to their formal foreign exchange reserves (the total would top $800b if I counted China, Russia and India’s valuation gains) even without counting the Chinese banks. Counting the state banks and the CIC, the total is more like $900b. I was conservative back in July.

Goldman started dreaming of the BRICs well before energy traders started dreaming about $100 a barrel oil. The Gulf can hardly be left out of the discussion today.

The Saudi Monetary Agency’s foreign assets likely increased by $75b in 2007 -- they were up over $60b through November (Table 8a, in Saudi riyal).  Saudi pension funds added another $5b.

The Gulf's other central banks likely added close to $50b to their reserves – though we are still waiting for data from the Emirates for the second half of the year.

The big existing Gulf investment funds – the Abu Dhabi Investment Authority (which, incidentally is likely to be bit smaller than the $875b to $1 trillion total that is commonly cited; see Mohsin Khan’s statements in the FT), the Kuwait Investment Authority, the Qatar Investment Authority and the confusing jumble of Dubai investment funds (some belonging to Dubai, run by Sheik Mohamed, and some belong to Sheik Mohamed, ruler of Dubai) – likely added around $100b to their assets. The $100b total doesn’t count any additional funds that they borrowed to finance some of their more aggressive strategies, or the capital gains on their existing holdings. $100b is what the funds got from their countries surplus oil revenues and the interest on their existing holdings.

Gulf central banks and sovereign funds collectively added about $225b to their foreign assets, and maybe $150b to their dollar assets. The rapid growth in central bank reserves (still mostly in dollars) likely offset the diversification done by various wealth funds.*

It is likely that the world’s central banks added close to $1,200b to their assets in 2007, China’s state banks chipped in another $150b or so, and various sovereign funds – including Norway’s funds – combined for about $150b.

Those sums are so large that they are almost impossible to fathom, let alone believe. That is why I tried to spell out precisely who accounts for the increase.

And for all the attention that sovereign funds have received – their recent contributions to the recapitalization of Merrill and Citi, after earlier investments in UBS and Morgan Stanley merited an Economist cover – the overwhelming majority of the increase in sovereign assets still came from central banks. They – together with the Chinese banks, who have generally been fairly conservative – likely accounted for between 85% and 90% of the total increase in sovereign assets.

The attention catching deals generally have come from the long-established funds, who -- for various reasons – are willing to be much bolder than they have been in the past. ADIA, KIA, the GIC and Temasek account for the lion’s share of recent recapitalizations.

And that isn’t because China, Russia, Saudi Arabia, Brazil and India lack the money. Even the laggards in this group – Saudi Arabia, Brazil and India – added roughly as much to their foreign assets as the Gulf city-states combined.

The over whelming majority of Chinese, Russian and Saudi foreign assets are still managed fairly conservatively. China (counting the state banks as part of China, Inc) spent far, far more buying Agencies and (yes) Treasuries (though in ways that don’t yet show up in the US data) than buying Blackstone, Morgan Stanley, Barclays and South Africa’s Standard bank.

The big shift has yet to come. Blackstone and Morgan Stanley represent less than a week of China’s foreign asset accumulation. And, one foreign banker quoted in Henny Sender’s excellent FT article notes,

“"The Chinese government has too much money," declares the head of strategy at one foreign bank in Shanghai. "Everything is government. They are controlling all the investment flows outside China. "

The debate on sovereign funds – at least so far – has focused largely on the question of whether or not these funds will be invested for commercial or strategic purposes.

The precise way sovereign funds manage their growing stakes is a real issue, and poses real dilemmas. But framing the debate as “strategic” v “commercial” still seems a bit too narrow too me.

-- Sovereign funds may be managed commercially, but in ways that do not reflect the wishes of their populations. It isn’t at all clear that China’s residents would rather lose money (remember that the CIC needs a very high dollar return just to break even; see Andrew Rozanov) investing on commercial terms abroad rather than investing more at home on non-commercial terms. As Jim Fallows highlights, the money China’s finance ministry raises for the CIC could be used, for example, to build schools -- and yes, I realize that this would imply a broader adjustment, since the CIC would no longer be a mechanism for moving china’s savings out of the country. It isn’t hard to think of other examples: the population of the Gulf, for example, might well prefer a smaller dollar portfolio than the Gulf states now have.

-- The line between investments driven by policy and commercial investments will never be clear. China so far has done far better trading its foreign exchange reserves for equity stakes in its state banks than on its investment in US and European banks. The CIC has done better financially on its investment in the China railway group than on its investment in Blackstone.

-- Commercially managed funds will sell, not just buy. That will be particularly true if some sovereign wealth funds morph in sovereign hedge funds in their quest for higher returns. Sovereign hedge funds will want to match the strategies of other sophisticated players; that means going short as well as long. And it isn’t at all clear that any country that is being sold heavily by a sovereign fund will believe that the sovereign funds’ decision is purely commercial. Ask Iceland. They didn’t like it when Norway’s fund started shorting their banks. Imagine the outcry is sovereign funds – not private hedge funds and private banks – had shorted the Thai baht (a very good commercial decision) back in 1997, helping to trigger the broader Asian crisis.

And finally, even if sovereign funds are managed commercially, there is an enormous difference between a world where central banks $1200b to their portfolio and sovereign funds add $150b to their portfolio and a world where sovereign funds add $1200b to their portfolio of risk assets and central banks add $150b to their portfolio of Treasuries and Agencies. As recently as 2004, central banks “only” added $600-700b to their assets – and almost all of their reserves were invested in the safest of government bonds. Even if sovereigns invest over $1 trillion on commercial terms outside their borders, the sheer scale of their demand will have an impact on the market.

The positive case is that this shift will end some of the distortions associated with excessive official demand for bonds, distortions that indirectly helped to encourage over-investment in residential real estate, excessive home price appreciation and the subprime crisis. The negative case is that this shift will introduce new distortions to new markets.

And then there is another question: to date, most attention has focused on how sovereign funds manage their money, rather than why sovereign funds have so much money in the first place.

Yet the decision to accumulate so much money in sovereign wealth funds is intrinsically a political decision. And generally, speaking, it reflects a set of policy decisions that have, in my view, impeded a necessary adjustment in the global economy.

This is most obvious for China. Its foreign asset accumulation cannot be attributed to an unexpected rise in commodity prices. The reason why the CIC is selling long-term RMB bonds to buy risky foreign assets is that it is meant to substitute for the PBoC selling short-term RMB bills to buy safe foreign assets. Both are accumulating assets to avoid a faster pace of exchange rate adjustment. Sender:

China's capital controls mean that private sector money, mostly from the country's burgeoning trade surplus, cannot easily leave the country. In the past, ingenious investors found ways to get money offshore, despite the rules and helped offset the trade surpluses.
These days though, there are no longer massive outflows from private hands-which means Beijing has a quasi monopoly on investing offshore.

In an open, less controlled economy, these pressures mean the currency would appreciate or interest rates would rise. But the government is reluctant to let the currency appreciate for fear of hurting smaller exporters and unwilling to let interest rates rise because of the impact on weaker firms.

But it is also true in the oil exporting economies.

Their central banks are also intervening in the market to offset market pressure for their exchange rates to adjust.

And their sovereign funds have so much money because their governments have made a policy decision to save the majority of the countries oil wealth centrally rather than find ways to distribute more of the revenue to the broad population. This is fundamentally a political choice, one that has had the effect of strengthening the power of many less-than-fully democratic states. Far less of the oil windfall likely would be saved if the windfall was distributed more broadly. Or far more of the oil windfall might end up being invested at home if it was distributed more broadly.

Consequently, I think it is more than fair to view the rise of sovereign wealth funds as by product of a set of policy decisions that continue to impede global balance of payments adjustment.

That would be true no matter whether the resulting pools of foreign assets are invested in safe bonds or potentially risky banks. It would be true no mater whether the funds are managed commercially or invested strategically.

And I worry a bit that the debate over sovereign funds has displaced the debate over global adjustment. Yet absent adjustment – adjustment that no doubt would be facilitated by a US energy policy that helped reduce oil demand – the US will necessarily be selling large quantities of itself to emerging market governments for a long time.

That is a fundamental characteristic of the current global system. The US is running a far larger deficit than private creditors want to finance in good times. And, well, in bad times, it isn’t really clear that private creditors want to finance any US deficit at all …

*Rachel Ziemba and I based our estimate of the increase in the Gulf's sovereign funds on the data made available through the IMF along with an estimate of the surplus oil revenues for each country. Our paper on the Gulf can be found on my CFR web page.