What to Make of Sovereign Wealth Funds

With sovereign funds becoming more and more active players in global financial markets we could see a variety of interesting "side effects":

1. Rising Protectionist Sentiment (especially for strategic assets).
   
2. A "sovereign wealth" premium: companies viewed as "strategic assets" will increasingly become targets of foreign governments, increasing their market value.
3. The line between between national and economic interests will be blurred even further, sparking many vigorous debates in economic journals and on the RGE Monitor.
   
4. Renewed vigor for running balanced budgets in the US (unlikely).
5. Renewed concerns about our addiction to oil. After all it is estimated that as long as oil is above $70/barrel, over $2 bln worth of petrodollars flows into financial markets every day.
   
6. Hank Paulson being reduced to tears as another foreign government rebuffs his pleadings to appreciate their currency.
7. Increased calls for transparency about the operation and holdings of SWF's. All of which will be rebuffed.
8. Much confusion about why we call these funds "Sovereign Wealth Funds."
9. Concerns that China plans to infiltrate the US using Stephen Schwarzman's "Skull and Bones" connections. Did you know that Schwarzman and George Bush were college roommates?
   
10. SWF's will become a huge issue in the presidential election after China, Singapore, Kuwait, or Abu Dhabi buys a US airline company, port or bank (oh wait . . . ).
    
11. Much overblown populist rhetoric that overextrapolates the growth of SWF's and is used to scare the American people into raising tariffs and enriching more American farmers.
12. Economists finally being able to explain the true cost of "mortgaging our future" to finance frivolous spending and frivolous wars. Yes, when you run deficits you are basically giving away a part of your country . . . its just that until now country's didn't take advantage of their power over us.
    
13. Very little rational, and realistic dialogue about what is likely to happen as we watch SWF's become the trendy thing to do with forex reserves (Thanks John):

The US has accumulated hundreds of billions of dollars in trade deficits in the past few years. Some of the deficit may be due to undervalued currencies, particularly the Chinese renminbi, but most of it would probably have occurred even if the renminbi was much stronger during this period. The truth is that the US has shifted a vast amount of its production abroad and must deal now with the resulting accumulation of external imbalances that are now being placed in sovereign wealth funds.

Clearly, the US can no longer be too picky on what kind of capital it will accept. For many decades, the US assumed that Asian countries would accumulate forex reserves and purchase Treasuries, as the ramifications of currency appreciation were as bad for them as a rout in the USD/Treasury market was for the US. The Bush administration even condoned Japan’s massive yen interventions in 2003-2004. But now that Asian SWFs are being created, they undoubtedly will be investing in equities soon; it is just a question of the timing and the method.

Many voices in the US government now say that this accumulation of reserves is illegitimate as it was caused by currency intervention, and that Asian governments should not be allowed to buy large portions of the US. While there are justifiable concerns about a communist country such as China owning controlling stakes in many “national interest” industries in the US, the general fear of Asian equity ownership is unfair and impractical. The US allowed this unbalanced system to develop and the natural consequence is for Asians, whether citizens or their governments, to own large portions of US assets, and not just Treasuries. With appreciating currencies, the Asian SWFs must seek higher risk assets such as high-yield bonds, equities and real estate in order to achieve acceptable returns.

The safest way to avoid an asset/trade war is to allow SWFs to invest passively in equities via indexed products or via external, long-only, diversified investment managers. Both sides should agree on a simple reporting system regarding such purchases, with restrictions that would be triggered if the overall SWF ownership level rises above 30 per cent.

If this is not achieved, Asian SWFs may rapidly diversify away from the dollar, with the euro bearing the greatest brunt of appreciation, and also likely causing a sharp rise in commodity prices. Trade protectionism and acrimony would certainly follow. While this has not yet occurred, China’s recent creation of its massive SWF and its growing influence in the world changes the rules. This trend will gain momentum very quickly, so it would be best to seek agreements on the above items as core principles of “SWF best practices” rather than wait for a long negotiation over a complete set of such principles.

If you have any thing to add to this list I encourage you to post.

Sovereign Wealth Hunger

This is from the WSJ this morning:

China and the Gulf states are hungry, and they've just sat down for an American buffet. In the last few months alone, state-affiliated funds and companies have taken bites of American icons, picking up small stakes in Advanced Micro Devices, MGM Mirage, Nasdaq Stock Market, Blackstone Group and Bear Stearns.

The deals were designed to be small enough to avoid scrutiny from the U.S. government. This conveniently played into the hands of sellers, who were able to offload pricey positions while giving virtually nothing in return, such as board seats or veto rights.

But the mergers-and-acquisitions story of 2008 will be how these foreign sovereign funds -- sitting on an estimated $2 trillion to $3 trillion of reserves -- direct their appetites. Fattened by the U.S.'s own trade imbalances and encouraged by favorable currency rates, they aren't likely to stay so compliant for long. Further down the buffet line sit entire U.S. companies.

Seven sovereign funds, including those of Abu Dhabi, Kuwait, China, Singapore and Russia, now sit on piles greater than $100 billion. Outside the U.S., these funds have proven more adventuresome, with a Dubai company recently moving to take ownership of the airport in Auckland, New Zealand.

This foreshadows some uncomfortable economic and cultural reckonings for the U.S. The modern gamesmanship of corporate interests is beginning to look more like "The Great Game" of national interests, where capital, as much as armies, can be deployed for strategic effect. And on this field of play, the U.S. looks caught off guard -- not unlike the cocksure Olympic basketball squad, run out of the gym by ostensibly weaker teams.

"When governments act in this field, the motives are different," says Deszo J. Horvath, Dean of the Schulich School of Business at Canada's York University. "The motives are longer-term security issues, which can have nothing to do with current economics."

Sen. Evan Bayh captured the new concerns at a congressional hearing last Wednesday. "The definition of national security interest is broader than it used to be," he said. "[Y]ou'll see the Chinese going around the world acquiring what they view as strategic energy interests, and it is not impossible that financial positions might be used in a similar vein."

That's why this incoming wave of foreign money will reveal more about the U.S. than about countries initiating the deals. Laws overseeing foreign investments were just given a much-needed overhaul. But at its core, the issue is as much about emotion and pride as it is about process, says Ivan Schlager, a partner in the Washington, D.C., office of Skadden Arps, who handles cross-border transactions.

Foreign investments touch a nerve, especially when so much American economic power appears at the mercy of China, which holds U.S. Treasury bills, or the Gulf states, which have such a big say over U.S. energy costs. For 2007, foreign buyers have accounted for 20% of M&A in the U.S., according to Dealogic, the second-highest level since 1995.

"We have not fully grasped what is happening here, and we have no counterstrategy," said Patrick Mulloy, Washington representative of the Alfred P. Sloan Foundation, a group studying technology, business, and economics.

Can the U.S. accept the foreign investments as an essential element for lubricating a dynamic economy? Tighter economic ties create less incentive for war and terrorism. And below the radar, a recent series of foreign investments have closed without incident. "No one raised serious objections when Sabic [a state-owned Saudi Arabian company] bought GE Plastics in a competitive auction. Are we culturally ready? We're a very welcoming and open society," adds Mr. Schlager.

Until it's not. Already the country has proven touchy, famously fretting when a Japanese businessman overpaid for the Pebble Beach golf resort back in 1990, or when a Dubai-backed company looked to take over a series of U.S. ports in 2006, setting off a talk-radio furor that squelched the deal.

It's easy to find conspiracies in these governmental funds, in part because they have such little transparency. The Group of Seven leading nations recently called upon the International Monetary Fund and World Bank to study ways to improve disclosure and accountability.

With a weak dollar and the ever-enriched positions of petro-based economies, it's inevitable that the worries will continue to stew. And it's inevitable that they will one day interfere with a big sovereign-fund investment plan.

The irony is the U.S. is, in essence, funding its own potential takeover. In Wall Street parlance, they call it getting LBOed. "We're moving to a sharecropper economy," said Mr. Mulloy in an interview. "The other guys are going to be owning, and we're going to be working for them."

I think Mr. Mulloy takes it a little bit too far with his "sharecropper" idea, but I do think that this is an issue that many Americans could potentially get very angry about if we aren't careful.