Thursday, 14 May 2015

Sovereign Wealth Funds - Cure or Curse?

What a difference one letter ’s’ makes turning cure into curse. The small addition of one letter is linguistically huge as is asking a simple question of the value of Sovereign Wealth Funds (SWFs), as the implications for the global economy are equally as profound.

Many financial market participants and policymakers alike (not to mention, of course, the SWF’s themselves) would consider this question to be nonsensical as their conclusion is beyond doubt; SWFs are overwhelming viewed as a positive. However, given our natural heretical intellectual leanings we instinctively recoil when something becomes so-widely accepted as true and it triggers a desire to question the prevailing wisdom. Just as we study market consensus readings for potential market turns. This readiness to question assumptions recently led to a most fascinating debate over a most enjoyable dinner with a long-standing friend. To be honest the debate was hardly heated as it was more a meeting of like minds, testing the edges of their common thoughts that ran contrary to the perceived wisdom of the net benefits of SWFs.

SWFs have been around for a fairly long time, (Kuwait Investment Authority was established in 1953) and came into being as a result of the dramatic increase in government revenues related to the increased production/export of crude oil. The economic logic for their creation seemed solid. Substantial oil export revenues not only generated sizeable fiscal surpluses, but as the majority of the crude oil was exported it also created massive external trade and current account surpluses. Unchecked these unexpected economic rents would have wreaked havoc given the extremely small size of these oil rich economies relative to the massive positive terms-of-trade shock. The inflow of revenues would have contributed to substantial booms, both in terms of economic activity, inflation and/or domestic asset prices probably on a scale without precedent in modern history or, alternatively, the currencies of these economies would adjust to equilibrate the hugely positive terms of trade shock resulting in massive nominal exchange rate appreciations – “Dutch disease”, (or as we now like to call it “Australian Disease”: a country that has had debates as to the need for their own SWF). At worst both could occur. Fearing the inability of these economies to absorb a shock of such a magnitude their political rulers decided to “save” the windfall gain from oil extraction by investing the excess proceeds offshore.

SWFs are effective at defusing the negative outcomes of trade shock as they effectively export excess returns from the extraction of crude oil/gas, generating an offset to the inflow on the current account. Indeed, as demanded by their decision to use currency pegs as their formal monetary policy anchor, most Gulf States see the current account surplus mirrored by a deficit on the capital account[1].

For the most part, SWFs have tended to be established in countries endowed by substantial mineral resources that they export to the rest of the world[2]. However the exporting of any resource that is vastly in demand by the rest of the world will be subject to the same pressures. China is a good example when, following the reforms of the mid-1990s, it started exporting its greatest natural resource: an abundant supply of cheap labour.

Bringing on-stream the huge supply of what was previously low productivity domestic-orientated labour, provided a substantial positive economic shock to the global economy as it effectively constituted a massive aggregate supply shock, generating a strong disinflationary force in the tradeables sector. Coming at a time when operationally independent central banks were exclusively fixated on achieving their ‘low inflation targets', this was considered a very positive development. It certainly made things much easier for central bankers and allowed them to bask in glory normally reserved for religious leaders. However, the overshoot of such acceptance has come to bite them sorely on the behind as the deflationary pressures are now having to be fought as hard as inflation ever was, leading to central bankers' religious status to be reclassified, in the minds of many, to that of David Koresh or Charles Manson.

What central bankers in the developed world, indeed almost all other global policymakers and the vast majority of investors, missed were the negative consequences following the growth of SWFs - the associated increase in global imbalances.

In a world of free-floating exchange rates global imbalances should, over time, be self-correcting. The currencies of nations running sustained current account deficits tend to experience downward pressure (depreciation) on their currencies which improves the terms-of-trade and hence the relative competitiveness of their export sectors. By contrast, current account surplus nations tend to experience upward pressure (appreciation) on their currencies with the opposite effect (looking at you Switzerland). SWF's are, by design, mandated to recycle current account surpluses by investing in offshore assets, which completely short-circuits such market forces and hence thwarts the natural equilibrating process (again looking at your Switzerland).

This is not a minor economic problem. Even though there were undoubtedly many contributing factors to the Great Recession, in the view of many, including former BIS Chief Economist William White, the huge rise in global imbalances was a significant contributing factor. We totally agree with this assessment.

Despite the recognition of the damage resulting from global imbalances, there has been little criticism directed towards SWFs even though they are an obvious mechanism for their perpetuation. In fact, according to the SWF Institute[3], SWF have total assets under management of USD 7tr (almost 10% of global annual GDP), having more than doubled in just seven years. This accelerated pace of increase is hardly surprising. A nation’s current account balance comprises not just of the external trade surplus but also includes net investment income and other (typically very small) international transfers. Hence, SWF’s not only facilitate the continuation of a positive external trade balance by limiting exchange rate moves but as the net foreign asset position rises, the investment returns from these assets also increases. There is, in other words, a positive compounding effect, which, if unchecked, would result in SWF assets under management rising until they end up owning all of the productive capital in the world or the price of that capital rises due to their demand. [4]

Such an outcome is, of course, inconceivable. Current account imbalances simply cannot be sustained indefinitely, ergo SWFs (the surplus-side of the equation) also cannot – theoretically – exist; at least not in perpetuity.

There are several ways in which the demise of SWFs will occur.

One possibility is that SWF assets are run down as a result of an increased domestic absorption of the savings held by these funds, for example China having to make up for the aging population or Gulf states suffering the reverse problem of having extremely young and fast growing populations. Further compounding the problem in the Gulf is the fact there is a lack of incentive to boost non-resource extraction growth sources combined with an increased sense of entitlement amongst the younger generations (dare we provocatively say again 'Australian Disease’?).

A further possibility is that it is the result of legislation amid increased political opposition in the advanced economies to the increased ownership of domestic assets. Indeed, there have already been instances where SWFs have sought to purchase assets that have been judged to be against the national interest.

There is another, arguably more Machiavellian, possibility – one we would not rule out. The global economy has, and continues, to be plagued by excess debt – both public and private. Indeed, despite all the chatter about deleveraging total debt as a percentage of world GDP is higher now than at the start of the Great Recession, which speaks volumes about the efficacy of the Keynesian policies adopted in response. No matter how you split it, someone, somewhere, will have to bear the cost of this debt crisis.

What better candidate than the pools of foreign capital built-up during the boom years, namely SWFs. They would prove to be very effective, politically acceptable, loss-absorbers. Such an argument might appear far-fetched but it is worth recalling that only a few years ago when the global economy was tail-spinning towards another Great Depression, US policymakers managed to convince leading SWFs to provide much needed capital injections. At the time these investors basked in the glory of their superman role, but as it transpired the quality of the investments was “dubious” to say the least and generated substantial investment losses.

No doubt having been bitten once, SWFs will be more careful in the future, but it will be hard to avoid such an outcome in our opinion. Moreover, such an outcome would have a certain sense of karma. SWFs definitely were a contributing factor behind the debt bubble in the advanced economies. And rather like Syriza is doing presently and US homeowners before them, there is a valid argument that some of the burden of adjustment should fall both on the shoulders of creditors and debtors.

This raises another question. Is there any wisdom in a country creating an environment that facilitates the need for a SWF in the first place? In the broadest sense exporting an asset, whether it be a natural resource or labour supply, in return for cash which is then recycled into assets held overseas is just a version of portfolio diversification. The value of the exported asset may change over time so swapping it for a broader portfolio makes sense if that portfolio is carefully constructed to reflect the future needs of the nation. Much as my personal pension should probably be 30% food, 30% energy and shelter and 40% health care is a nation’s future needs covered by holding trillions of US debt? China’s hoarding of commodities and commodity production in Africa is probably the most sensible use of accumulated reserves. In addition, there is another trade off. SWFs effectively exchange the “commodity” directly under their control for an asset that, while under titular control, is in effect under the control of the nation where that asset is domiciled. The net result, therefore, is risk diversification but this comes at a price in terms of a reduction in total asset control.

Perhaps it would have made more sense for the Gulf states to have only pumped the amount of oil needed to give them a stable and balanced economy without the need for an SWF to soak up the excess. In effect, the SWF asset would be the oil left in the ground for pumping at a later date. Admittedly, there is no diversification but equally there is no ransoming to the whims of overseas asset controllers. For the importing deficit nation encouraging the wisdom of SWFs within exporter nations is to be encouraged. The importing nations gain the assets they need (oil, commodities, labour) in exchange for an IOU as the cash returns via SWFs to the importer’s government debt or company stocks, which the importing nation can always default on (the Greece/ Germany scenario) or impose an asset freeze upon (the US/ Russian or Iranian scenario).

So what has the SWF actually achieved? What do they actually hold? As with any form of ownership of money it buys power and control over other people. Own a company and you tell the staff what to do, to a point. Even a company has to keep its staff sweet, through either pay or conditions. And so it is with owning assets based offshore. The offshore country can renationalise your assets if you become too much of an annoyance.

All that said, we conclude that the economic logic is inescapable: SWFs CANNOT exist in perpetuity. Such institutions might exist for some time, in some place, but the investment behemoths that we have come to recognize over the past few decades will not be around indefinitely. A home truth that is, much to our continued astonishment, not more widely recognized and is one worth remembering the next time you visit one of their shiny glass offices.

The discussion we had over dinner was a relatively straightforward application of basic economic principles, leading us to wonder why such arguments are not more widespread. Most likely this reflects the fact that it is not in the interests of sell-side firms, buy-side firms, SWF host nations domestic political interests, or as mentioned above, debtor nation policymakers to bite the hand that feeds them.

Until of course they need a scapegoat.

[1] For the majority of the Gulf oil exporting nations the currency peg is versus the USD reflecting the fact that crude oil is typically denominated in USDs. Kuwait is, however, a notable exception as it was re-pegged to a basket of currencies in 2007.
[2] Just over a half of SWFs have oil/gas extraction as their funding source.
[4] At this point in the dinner debate we wondered if Apple could be considered a form of economy distorting SWF considering its huge stockpiled cash surpluses generated by becoming the monopolistic supplier of a good so much in global demand.

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