December 10, 2007
Sovereign Wealth Funds
Why Sovereign Funds? Becker
The growth of large government managed funds during the past few years has been spectacular. These funds are estimated to manage between $2-3 trillion, and their assets are increasing rapidly. Sovereign funds have grown mainly because of the run-up in fossil fuel and other commodity prices, although China is creating a large fund with the capital earned from its trade surplus in goods. If present energy and commodity prices continue, sovereign funds could have over $10 trillion in assets within a few years. I do not believe that the scale of these funds is a healthy development for these countries.
The largest fund is that by The United Arab Emirates, which is thought to have assets of about $900 billion. Next in size are the funds from Singapore, Saudi Arabia, Norway, and China: each has capital of about $300 billion. Following these giant government funds are another 20 or so funds with much smaller amounts of capital. Oil producing countries have about two thirds of the capital of all sovereign funds. The aggregate assets of sovereign funds greatly exceed the approximately $1.5 billion invested in hedge funds.
During the past couple of years, sovereign funds have begun to invest more aggressively in international companies. For example, the Abu Dhabi Investment Authority recently gave cash infusion of $7.5 billion to Citigroup to help replace bank capital that had been depleted due to the credit crunch. China's State Foreign Exchange Investment Corp invested in the IPO of the large private equity company, Blackstone, and was embarrassed after the stock declined greatly from the issuing price. Sovereign funds have made other investments in private companies, and many more are expected.
With only a few exceptions, such as the fund of the Norwegian government, sovereign funds are secretive and not at all transparent. Lack of transparency is a major obstacle to citizens of countries with secretive sovereign funds in determining whether the money that automatically flows to the funds is being well spent. Even estimates of the total assets of most sovereign funds have to be arrived at through guesswork, and except for an occasional well-publicized transaction, their asset allocations are kept private. While private equity and hedge funds have also been criticized because they are little regulated- I do not share this criticism- they are paragons of voluntary disclosure and good governance compared to the vast majority of sovereign funds. Private equity and hedge funds voluntarily disclose information mainly because they compete vigorously for funds, whereas sovereign funds automatically get their resources because of government ownership of oil producing and other commodities.
Compounding the adverse effects of the extreme secrecy is that managers of these funds, being government employees on fixed salaries, have only limited financial incentives to try to achieve higher returns for given risk. Even when those in charge of sovereign funds hire private managers for some of their capital, there is still what economists call a principal-agent problem because government officials choose the managers. As a result, one would expect that the management of these funds would be excessively conservative to avoid investment blunders and bad publicity, or that managers would be tempted toward corruption by companies that want to attract investments from these funds. Or governments will use the funds for other government purposes, such as the just announced unwise decision by Brazil to create a sovereign fund to intervene in the foreign exchange market to shore up that country's currency. Given that little information is available, it is very difficult to discover whether a fund is managed too conservatively, or whether corruption affects investments in a significant way.
A major reason behind the growth of sovereign funds is the desire by oil producing and other countries to avoid what happened during previous booms in commodity prices. Vast revenues in the past were spent with little concrete results to show later on. Countries now recognize that the enormous boom in their export prices, such as oil close to $100 a barrel, is not likely to last. That makes it prudent to save rather than spend most of the revenue that is being collected. The desire to save the surplus is commendable, but that consideration alone does not imply that governments rather than households should do the saving.
Central banks and fiscal agencies should accumulate assets during years with high oil and other commodity prices, or what are in other ways unusually good times, in order to protect against the adverse effects of bad times on fiscal and foreign trade deficits. However, the Abu Dhabi fund and the other large funds, and many smaller ones, have far more assets than is necessary for cyclical management of government portfolios. Instead of government funds retaining the excess assets, they should be distributed as national dividends, or as reductions in taxes.
One advantage of distributing most of a funds' assets as dividends, or reduced taxes, is that since families at different stages of the life cycle have very different investment needs, they would invest such a dividend in ways that best suit their individual needs. Younger couples that are investing in children, and actively accumulating wealth, will spend their dividends on buying homes, cars, and other consumer durables, saving for the education of their children, and investing in mutual funds and other financial intermediaries. Since older persons with adult children already own their homes and other durables, they would spend their dividends mainly on conservative financial instruments.
To be sure, countries accumulating some of the largest funds are not at all democratic, so that any national dividend would only go to a relatively small fraction of the total population. But so too are any benefits from the investments of sovereign funds, so a national dividend would not be any worse in this dimension.
Sovereign-Wealth Funds--Posner's Comment
I shall focus my comment on the consequences of the sovereign-wealth funds for the United States; Becker's post focuses on the consequences for the nations that have such funds. Owned mainly by major oil-exporting nations, sovereign-wealth funds have today in the aggregate some $2.5 trillion in assets, and if oil prices remain sky-high this figure may grow to more than $20 trillion in a relatively short time. At that point the funds will be among the world's most important sources of investment capital. (The total debt and equity capital in the world is about $110 trillion, though of course it will be greater when the sovereign-wealth funds reach $20 trillion, if they ever do.)
The rise of the sovereign-wealth funds may well be a positive development for the rest of the world, assuming that the alternative would be for these countries to increase domestic consumption or to invest in domestic infrastructure. The decision to invest on a global basis increases the global supply of capital, including therefore the supply of capital for investment in the United States. As Becker and I argued in our August 7, 2005, postings concerning opposition to the proposed acquisition of Unocal by an oil company owned by the Chinese government, the purchase of assets by foreign nations, even when they are hostile or potentially hostile to us, does not threaten U.S. welfare or security. The purchase of a company from its owners places money in the hands of those owners that they can invest for a higher return--if they did not think they could do this, they would not sell the company. So such a purchase is wealth-enhancing. It does not undermine our national security just because the purchaser is a foreign government, but on the contrary enhances our security because the investment is a hostage. It's as if to guarantee China's good behavior the president of China sent his family to live in the United States. But it is different if the purchase could create a security risk, as was argued to be the case with the proposed purchase by Dubai of a British company that serviced a number of U.S. ports (see my posting of March 13, 2006). The concern (which may have been overblown, however) was that Arabs employed by the Dubai company would obtain in the ordinary course of business information about the ports and might pass it on to Islamic terrorists. Notice that this was a concern about foreign companies whether or not government-owned.
One of the motivations for the creation of the sovereign-wealth funds is the concern of the oil-exporting nations with the value of their huge dollar surpluses; China has the same concern, though in its case its trade imbalance with the United States is not due to oil exports. As Becker points out, at least in the case of the oil-producing nations these surpluses are due to the fact that the governments of the nations are the producers, so they receive the export revenues; if the producers were private companies, the revenues would not go into government coffers. For political reasons, however, the governments are the recipients of the oil revenues, they are paid in dollars, and they want to put their dollars to work rather than just accumulate them or distribute them to their citizens. And rather than just purchase U.S. Treasury notes or other safe securities--which would not make economic sense, since as Becker points out the amount of money in the funds greatly exceeds the nations' liquidity needs--the governments are in effect operating giant hedge funds, investing in diverse assets all over the world. By doing this they are giving hostages to the nations in which they invest. We should welcome the fact that these investments are less liquid than the short-term securities in which governments conventionally invest their reserves. The less liquid an asset, the better a hostage it is; it can't be withdrawn as rapidly. In addition, excess liquidity in the world's financial system can lead to financial instability.
The concern being expressed in some quarters in this country about the rise of the sovereign-wealth funds is ironic in view of the fact that our government's policies have contributed significantly to the growth of these funds. Those policies include failure to exploit our Alaskan and offshore oil resources more vigorously, because of the opposition of environmentalists; our low tax rates, which facilitate consumption, including consumption of foreign goods, which in turn shifts dollars abroad; and, in particular, our very low taxes on oil and on oil products, such as gasoline and aviation fuel. A stiff tax on imported oil, by reducing consumption, would reduce the wealth of the oil-exporting nations and hence the size of their sovereign-wealth funds. Such a tax would have the not incidental further benefit of reducing emissions of carbon dioxide (though from that perspective a tax on carbon emissions is superior to a tax on oil and oil products) and of stimulating the search for alternatives to fossil fuels, a major culprit in global warming.