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March 6, 2008

Who's Afraid of Sovereign Funds?

David Beim discusses why America has little to fear from opening its markets and much to gain from moderating its appetite for deficits.


During the past 10 years America has become uncharacteristically fearful: fearful of other countries, fearful of terrorists, fearful of immigrants, fearful of foreign trade. The latest subject to provoke shivers of anxiety is the rise of sovereign wealth funds, notably the investment by a number of the funds last year of nearly $20 billion in several leading U.S. financial institutions. These funds represent accumulated current account surpluses by other countries over the past decade and are the counterpart to America’s escalating current account deficits in the same period. They now total about $3 trillion but went unnoticed by the general public until they started bailing out major financial institutions. For example, Singapore’s fund bought a 9.4 percent stake in Merrill Lynch for $4.4 billion, one Chinese fund bought $5.6 billion of securities convertible into 9.9 percent of Morgan Stanley, Abu Dhabi’s fund put $7.5 billion into a 4.9 percent stake in Citigroup and another Chinese fund invested $1 billion in Bear Stearns.

Worried commentators such as former U.S. Treasury Secretary Lawrence Summers, Sebastian Mallaby of the Council on Foreign Relations and Edwin M. Truman of the Peterson Institute for International Economics point out that government funds are inescapably political; they are not just passive investments but means for countries to extend their influence over world events. America must be at risk, they say — what will these investors do, what do they want and will they ever go away? Such commentaries often end with calls for regulation of U.S. investments by sovereign funds or for standards of transparency by such funds.

I find it hard to share these anxieties. To me sovereign funds are just another aspect of globalization. Our largest financial institutions are no longer exclusively “ours” but have become part of the global economy. Opening our borders to flows of goods, services and investment capital has brought many benefits and has internationalized most large business organizations, which have learned how to balance needs and challenges from all sides. America has long extended its investment capital into other countries, and we need to get used to other countries doing the same.

How did the sovereign wealth funds get so large so quickly? The answer is not difficult to see: America has imported dramatically more than it has exported in recent years. Because governments run the foreign-exchange markets in countries such as China, the United Arab Emirates and Singapore, governments tend to collect the dollars that Americans pay for excess imports. As U.S. current account deficits have continued unabated, the sovereign funds have grown rapidly. In the past these dollars were put into passive investments such as government bonds and bank deposits. But the fund managers are diversifying and, in particular, are seeking returns higher than those available on bonds and bank deposits. Equity investments are as attractive to these countries as they are to us.

These funds’ recent investments were a benefit to both sides. The financial institutions got large capital infusions they badly needed after the recent wave of credit losses left them somewhat depleted. If Merrill Lynch, Morgan Stanley and the others had sold stock to U.S. investors in public offerings, the stock prices would have been brutalized. For example, Societe Generale recently suffered an astonishing $7 billion loss due to a single trader but declined to replace the capital by going to a sovereign wealth fund. Instead, it announced a rights offering at a 39 percent discount below its February 8 closing stock price, which had already been knocked down to a three-year low. Similarly, the sovereign funds had a golden opportunity to acquire major blocks of stock in leading institutions without disturbing the public market.

The funds are acting carefully, limiting their future actions. They have expressed no interest in joining the boards of the firms they have invested in. The transactions involve standstill agreements that limit the funds’ ability to expand their positions in these companies. To be sure, large shareholders can exert some influence over management, but their voice will be only one among many. Modern companies have learned how to handle many stakeholders.

I do have some concerns at the macroeconomic level. I see little to fear in the recent transactions taken on their own, but the broader pattern of trading assets for goods is unsustainable in the long run. We have a finite number of investment assets to sell but an apparently infinite appetite for cheap foreign goods. America used to be a fountain of capital to the rest of the world. Now it has become the world’s largest debtor.

I believe we need to moderate our appetite. If we do not, the foreign-exchange markets are likely to drive the dollar ever lower, making our imports ever more expensive until balance is restored. Our huge deficits are enriching the developing world — with an efficiency that foreign aid could never have accomplished — and punishing our currency. There is much we can do to mitigate the global financial imbalance.

We can start with oil. If we could double the fuel efficiency of our automobiles, the effect on oil imports would be dramatic. We also need to rein in our foreign military adventures. Apart from their negative impact on America’s reputation in the world, they are terribly expensive. In fact, if the U.S. government could get its fiscal budget under control, that too would make some contribution to correcting the external trade imbalance.

So I suggest we get over our fears of sovereign wealth funds and concentrate our minds on issues that truly will make a difference to America’s future.
           
David Beim is professor of professional practice in finance and economics and a Bernstein faculty leader at the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.

This piece originally appeared on Public Offering, the Columbia Business School blog. To comment on this piece or to read other blog posts, visit Public Offering.

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