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Tuesday, September 04, 2007

Nouriel Roubini: Bogeymen of Financial Capitalism

Nouriel Roubini on sovereign wealth funds:

Bogeymen of Financial Capitalism, by Nouriel Roubini, Project Syndicate: The sub-prime crisis has diverted attention from rising fears about Sovereign Wealth Funds (SWF’s) as the new bogeyman of global finance. But the minute the sub-prime crisis subsides, anxieties about SWF’s will return. For the emergence of this vast and growing pool of state-controlled funds may have implications more far-reaching, and certainly more politically sensitive, than the hopefully temporary distress caused by the subprime crisis.

Indeed, if SWF’s continue to grow their investments are bound to permanently alter the relative weight of state and privately controlled assets in advanced economies. ... Thus some of the biggest investors ... in financial markets in the coming years will be government institutions. That the biggest of these institutions are in China, Vladimir Putin’s Russia and some unstable petro-states adds another worry to the mix.

The growth of SWF’s is a direct consequence of the accumulation of more than $5 trillion in foreign reserves by emerging-market economies in Asia and among oil and commodity exporting countries...

Initially, these countries invested their foreign reserves in liquid assets -- short-term United States Treasury bills and government securities issued by other reserve currency countries. Then they realized that their holdings in liquid and low-return assets far exceed what is needed to avoid ... speculative runs... [W]hy hold U.S. T-bills with a meager 5 percent return ... when you can acquire foreign firms, invest in real assets, stock markets, or higher-yielding corporate bonds?

The answer seemed a no-brainer. So central banks are transferring their excess reserves to existing or newly created SWF’s, which in turn invest in high-return equities.

But the emergence of SWF’s is creating a political backlash in the form of “financial protectionism.” ... Views about how to respond to the SWF’s vary. The United Kingdom has adopted a laissez faire approach, while political concerns dominate in the US, France and Germany. Some worry about reciprocity: if Chinese firms are allowed to invest in U.S. and EU firms, shouldn’t U.S. and EU firms be allowed to invest freely in any Chinese firm? Others worry about national security: what would happen if “our” ports and security industries or other “strategic” firms were taken over by China, Russia, or Saudi Arabia?

Still others worry about the fact that SWF’s are state-owned: what would happen to corporate governance when investors may have objectives other than maximizing risk-adjusted returns? Similarly, there are concerns about transparency: many SWF’s do not reveal their investment strategies and how they operate. What would happen if a small group of huge state-owned SWF’s made very large investments in a variety of assets? How might equity prices or bond yields be distorted...?

Dire predictions that the rise of the SWF’s means that the global financial system is becoming a form of state capitalism may be exaggerated. But a small group of government players managing a vast amount of foreign assets does create complications. Of course, so long as the US runs annual current-account deficits of almost a trillion dollars, it will need to borrow... So unless the US starts to save more, it will find it hard to complain about the form -- equity rather than debt -- that the financing of its external deficit takes.

It is also true that the massive accumulation of foreign reserves that is now feeding the SWFs’ growth is excessive and driven by misguided exchange-rate policies, with vastly undervalued currencies resulting in current-account surpluses. These countries need to allow greater exchange-rate flexibility and currency appreciation to reduce their external surpluses and thus the need to accumulate huge foreign reserves in the first place.

Indeed, emerging-market economies should reduce their accumulation of foreign assets rather than hope to weather the political backlash against SWF’s in the US and EU. SWF’s are, it seems, here to stay and grow, and they do offer significant benefits. But if they grow too large while their activities remain opaque, widespread “financial protectionism” will become all but inevitable.

    Posted by on Tuesday, September 4, 2007 at 03:51 PM in Economics, International Finance | Permalink  TrackBack (0)  Comments (31)

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