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« Prioritizing China over India in miliary cooperation makes sense | Main | To rejoin world, U.S. must rejoin conversation »
Sunday
Aug192007

Sovereign wealth funds globalization's appetite for risk

As senior managing director of a rapidly growing high-tech company that was — until quite recently — overwhelmingly dependent on “angel” investors, I can readily attest to the joys of financial liquidity. When ordinary individuals accumulate wealth and can invest as they please, good things happen to ambitious entrepreneurs and their start-ups. Call it the wisdom of greedy crowds.

The same principle holds for the global economy: When the system is flush with cash and bursting with investors properly incentivized to spread it around, globalization tends to accelerate. When money is tight, that’s historically when trade protectionism kicks in, along with anti-immigrant sentiment.

Simply put, rising income is a gift that keeps on giving, primarily because investment risk is more easily discounted. The more money I’ve got, the greater my appetite for risky business. Good things may come to those who wait, but even greater sums accrue to aggressive investors.

I offer that remedial preamble before turning to the topic of sovereign wealth funds (SWFs), globalization’s new buzz phrase for state-controlled investment entities armed with significant pools of currency reserves. These reserves are accumulated through trade surpluses: goods and services in the case of Asian economies, energy exports for Russia and Persian Gulf states.

Naturally, the rise of SWFs has many in the West concerned. It’s one thing to practice state-directed capitalism in your own backyard, but it’s quite another thing to use the proceeds for state-directed investments in my free-market economy.

First, there’s the simple matter of fair competition. When China sets aside almost a quarter-trillion dollars for overseas investment by a government entity, it instantly creates a financial King Kong able to place frightening large — and, perhaps, self-fulfilling — bets.

That brings us to a second concern: the competency of those making the bets. Just because formerly communist China and Russia have come into a lot of cash recently doesn’t make them Wall Street wizards. SWFs could also just end up flooding global financial hubs with lots of foolish, impatient money that creates more trouble than it’s worth.

Finally, there’s the fear that SWFs will be manipulated by their source governments to further those states’ national interests in ways that harm our own, such as gaining controlling shares of strategic sectors like energy, infrastructure or national security.

But I would contend that the primary reason many in the West fear the rise of SWFs is because they’re relatively new, and the global economy doesn’t have a coherent rule set for dealing with them. This is a classic case of one-thing-leads-to-another amid globalization’s rapid advance across the planet over the past quarter-century.

Remember the currency crises of the 1990s, like the Asian Flu of 1997 or when Russia suffered sovereign bankruptcy in 1998? Well, a lot of emerging markets took a very important lesson from those events: You can never have enough foreign reserves on hand to defend yourself from a run on your national currency.

But, strangely enough, it turns out that you can.

When these same states stockpiled foreign reserves — primarily American dollars — over the subsequent decade, they amassed holdings far beyond any perceivable requirement for defending their economies from outside speculation. As their confidence grew, these governments inevitably grew dissatisfied with the low returns they can obtain from safe U.S. Treasury bills.

Since emerging economies typically face demographic pressures over the long haul, as urbanization and industrialization inevitably reduce fertility and thus rapidly age their populations, there is the added urgency to generate higher yields from these reserves to finance rapid economic advance while the worker-to-retiree ratio remains strong.

This is especially true for China, which has hundred of millions still living below the poverty line just as its elder population is set to skyrocket over a generation’s time.

So what began as a much-needed fix for the 1990s version of globalization is quickly becoming a powerful new tool for extending its march in coming years — like it or not.

Will there be busts along with booms? Most definitely, and each round of instability will generate new global rule sets to regulate the behavior of SWFs. But, over time, the greatest pressure to tame these behemoths will arise from inside the source countries themselves, as ordinary citizens invariably demand greater accountability and transparency from these state-directed funds.

Sovereign wealth fund managers will learn with time that hell hath no fury like a pensioner scammed.

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