Adapting to the state’s growing role in global equity markets

Central bank purchases of traditional reserve assets still dwarf sovereign wealth fund purchases of riskier assets -- as well as central bank purchases of equities. But over time, it is reasonable to expect that many over-reserved sovereigns will diversify their portfolios. The recent decision to increase the share of the CIC’s initial $205-210 billion in capital that it can invest abroad and SAFE’s increased willingness to purchase equities as well as bonds are examples.

I didn’t agree with everything that Knut Kjaer (the former director of Norway’s Government Fund) wrote last Monday in the Financial Times. But I thought he framed the core issue raised by sovereign wealth funds, central bank purchases of equities and state-backed firms expanding abroad quite well. The basic issue is how institutions in both the “investing” and “receiving” countries need to adopt to a world increasingly defined by state rather than private flows.

Kjaer doesn’t dance around the fact that the rising presence of the state in the market is a real change:

A far more challenging issue is how the huge increase in financial assets managed by potentially non-economic agents will affect the efficiency of the global capital market and the allocation of risk and resources. ….

Parts of Kjaer’s framing – notably the risk that non-economic actors will distort the allocation of resources -- differ the framing favored by many of those looking to earn fees managing sovereign funds. They tend to argue that sovereign funds have been around for a long time, so there is nothing “new” about sovereigns investing in equities.

It is true that many (though not all) sovereign funds have been around for a long time. But that doesn’t mean that nothing has changed.

The existing oil funds -- who have long been active in the equity market -- have a lot more money with oil at $115 than with oil at $20-25 – or with oil at $50.

And then there is China. China enormous foreign asset growth in the first quarter implies that it might be able to add more to its reserves and sovereign fund in 2008 than all the oil-exporters combined even if oil stays at its current levels. Even if China falls a bit short of the oil-exporters, it still looks to be close race.

China consequently has an enormous latent capacity to alter the composition of global capital flows by changing the composition of its portfolio: right now it could put another $200b in the CIC and still have $500b left over for other state institutions to play with. Those kinds of sums are new – as is possibility that China might soon be a big buyer of equities.

The potentially dramatic increase in sovereign investment in equities over the next few years raises a host of issues. (More follows)

Kjaer highlights one risk – namely the risk that concerns about state control will mean that the formal owners of an asset won’t be able to exercise their ownership rights.

The offsetting risk is that state owners of assets will in some sense abuse their ownership rights, and use their rights to promote “state” objectives. One state objective – making money – overlaps well with the core objective of most private investors. Other state objectives may not. Many sovereign funds seem keen to use their ownership stakes of foreign companies to promote their own economic development. Such “development” policy objectives are part of many funds mandates. Qatar’s advertising in Forbes says as much: the QIA’s evaluation criteria include “added value to the State of Qatar" such as "economic synergies or benefits for Qatar and its people."  Mubadala has made a string of investments (Ferrari, the “National”) designed to elevate the profile of Abu Dhabi.

Gerald Lyons of Standard Chartered recognizes that China is likely to face pressure to do the same. Stephen Foley reports:

Gerard Lyons, chief economist at Standard Chartered bank and a leading expert on SWFs, said in a recent panel discussion in Washington that funds’ behavior is likely to be a mixture of commercial consideration and "state capitalism", where investments are likely to reinforce particular government goals, such as spurring the development of natural resources in Africa – already a key area of Chinese government investment. The limits of what is acceptable, he predicted, will be tested in the UK – and sooner rather than later.

Kjaer puts more emphasis on the first risk, arguing that the solution to the second is more professional management of state assets.

Particular regulations for SWFs would be a step in the wrong direction. Instead, we should discuss what conditions are needed for the professional management of publicly owned financial assets. The free flow of capital contributes to efficient allocation of risk and resources. Regulation of SWFs risks creating inefficiency by curbing market forces at a time when we need to strengthen both the power and the professionalism of capital owners.

However Kjaer’s description of the institutions that Norway has in place to assure that the professional management of its state resources also highlighted how different Norway’s practices are from the practices of other funds.  That gap almost certainly reflects the gap between Norway’s political institutions and the political institutions of the sponsors of the other big funds.

The big Gulf funds effectively report to a single family – and presumably do what that family wants. Kuwait’s fund – which reports to Kuwait’s parliament as well – is something of an exception. So far, those families primarily have wanted to get even richer than they currently are.

China’s fund, like Singapore’s fund, reports directly to the top levels of China’s state. It has yet to build up enough of a track record to show how it will be used. However, China’s management of its state stakes in domestic industries suggests the need for some caution. One example: Three of China’s four large state commercial banks have been listed, but they still aren’t managed in a fully commercial manner. Just think of the various ways they have been used to support China’s exchange rate policy. I still don’t quite understand why it makes sense for the same institution that manages China’s strategic states in the state banks to also manage China’s investments abroad.

The second issue is how “transparent” sovereign funds should be, particularly in a world where some classes of private funds aren’t all that transparent. Transparency is obviously related to the question of how sovereign’s exercise their ownership rights. One aspect of Norway’s institutional structure is that it transparently discloses how it exercises its vote – and which outside institutions manage its money. Other sovereign wealth funds don’t disclose what they own or who is managing their money.

Transparency goes beyond voting. Most European and American public-sector pension funds disclose the size of a fund, how fast their fund is growing and how the fund has allocated its money.

The Peterson Institute’s Ted Truman recently updated his “sovereign wealth fund scorecard.” His impressive and detailed work is worth reading carefully.

Truman’s latest scorecard illustrates how the practices of many large existing sovereign funds – particularly those originating in non-democratic countries – differ from the practices of US state pension funds as well as Norway’s government fund. The institutions for managing the Gulf’s public money right now seem to have a lot more in common with the institutions (think “private banking”) for managing private money than the institutions for managing public money. That leads me to a simple observation, but one that many sovereign funds who do not want to change will find deeply discomforting: the more their institutions for managing sovereign money diverge from the domestic institutions for managing “state” funds in the “recipient” countries, the more restrictions they likely will face.

That clearly hasn’t been the case up until now. But the sheer scale of the increase in sovereign government’s cross-border equity investment will drive changes. Changes in the way some sovereign funds invest will also drive changes: if ADIA wants to be one of the biggest equity owners of one of the largest US banks, it will attract more attention than if it invests in ways that keep it out of the headlines. Banks are – as Martin Wolf noted – regulated public utilities, albeit ones that pay better than most other utilities. Changes in the set of countries investing in equities will drive change: large countries like China and Russia raise different concerns that Norway and the small Gulf states.

Some bankers – like Lyons -- recognize this:

... sovereign funds ``reflect a shift in the balance of power, so the rules need to shift on both sides,’’ Standard Chartered Plc Chief Economist Gerard Lyons said at the Luxembourg conference. ``The rules of the game do imply increased transparency.’’

Kjaer’s framing implicitly raises a third issue, one that I don’t think has gotten enough attention. The surge in sovereign investment in safe government bonds that accompanied the surge in global reserve growth likely contributed to a “bond market bubble” – one that pushed down the real yields on government bonds in both the US. That contributed to a host of additional market distortions, as private investors scrambled to find higher returns. The flat or inverted yield curve pushed intermediaries issuing short-term debt to buy longer-term debt to take on a lot more credit risk, with results that we all know. A surge in sovereign investment in equities could introduce similar distortions.

The most obvious risk – it seems to me – is that transforming a big share of the likely $1 trillion annual flow from central banks into the US and European bond market into the equity market (whether by more central bank investment in equities or the creation of new and bigger sovereign wealth funds) will generate a bubble in the US and European equity markets. P/E ratios would rise on the back of a surge in sovereign demand – and rising equity market wealth would provide a new source of support for consumption growth.

That prospect excites many. It scares me.

The distortions sovereign demand introduced into the bond market – and some of the knock-on effects those distortions had on the credit and housing markets – weren’t healthy. A surge in equity market prices that allows American and increasingly European households to continue (to paraphrase former Chairman Volcker)” to be addicted to spending and consuming beyond [their] capacity to produce” also implies that necessary adjustments in the global economy would continue to be delayed.