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Sovereign Wealth: A Shift in the Global Economy
21 Aug 2008
Alex Barrett, Global Head of Client Research, Standard Chartered Bank, discusses the balance of power in the global economy.
Decoupling
China Currency Policy
Drivers of inflation
Should the GCC depeg from the dollar?
In recent years there has been a paradigm shift in the global economy. The US sub-prime crisis has had a knock on effect in the financial markets and coupled with escalating fuel and food costs, the US economy has gone into a downturn. While Europe to a degree followed in US footsteps, it remained unclear how the rest of the world would respond. As it stands now, the global economy is facing some difficult challenges and central banks are having to tread a very fine line in terms of growth, the weak dollar and inflation.
US consumer debt and government borrowing to fund a huge current account deficit have left many economies vulnerable to a weak dollar and rising oil, food and commodity prices have led to rapid increases in inflation. However many economies have benefitted from booming growth, exports and income from oil. These huge current account surpluses have brought rise to ever increasing sovereign wealth funds, the size of which have brought about concerns over their long term investment strategies. Although sovereign funds have been in existence since 1953, it is their rapid growth that has brought them to international attention and raised questions over their transparency. Worth an estimated $3 trillion, Standard Chartered has identified a concentration of wealth in a ‘Super Seven’ which are Abu Dhabi Investment Authority (ADIA) ($625 billion); Norway ($322 billion); GIC of Singapore ($215 billion); Kuwait ($213 billion); CIC ($200 billion); Russia ($128 billion); and Temasek of Singapore ($108 billion)
Conversely, SWFs have stepped in to rescue floundering western financial institutions which have suffered at the hands of the US financial crisis. They have pumped money into Citigroup, Merrill Lynch, Morgan Stanley, Barclays and UBS. However, questions have been consistently raised over the commercial or strategic ambitions of these funds, particularly China and the GCC funds, because details of their portfolios and long term objectives have never been made public.
Sovereign Wealth Funds are significant in another respect – they represent the growing dichotomy between the economies of which they are representative and those of the western world. In March 2008, Standard Chartered bank published a report which examined the economic prospects of the US and the rest of the world. The principle question was: will China, India and the rest of the world be slowed by the US downturn or will they power ahead? Alex Barrett, Head of Client Research at Standard Chartered and one of the authors of the report, discusses some of the challenges facing the world economy and the shifts in the economic balance of power.
“Generally sovereign wealth funds have been making commercial investments. The concern about state capitalism is the possibility that investments are made not for commercial purposes, but that funds are making investments strategically which might disturb the balance of the market. Now what is strategic? That depends on where you are sitting. In France that might be a yoghurt manufacturer - a big French food producer could be off limits. Generally people would be more concerned about the defence and oil industries falling into other sovereign hands.
“The issue with state capitalism is that it is not just the sovereign wealth funds and we have to take a wider view of that, particularly when you look at somewhere like China. All the different arms of the state in some way end up back in the hands of the State Council, whether it is CNOOC, which is China’s oil company, the CIC or some other state entity – even SAFE is now taking positions in equities. These are all potential avenues for China to make investments and if they were at off market prices that would be of worry.”
In 2007, China’s official sovereign wealth fund CIC was developed from the State Administration of Foreign Exchange (SAFE). This has made it very hard to distinguish within China what is a government driven investment and what is a purely commercial investment. The US in particular has been wary of Chinese investment.
“Certainly the US is talking about the bids of CNOOC for Unocal as being driven by the Chinese Government which they prevented happening back in 2005. Again in Saudi Arabia the Saudi Arabia Monetary Agency (Sama) holds all the money at the moment. They are still continuing their role as a central bank and are managing liquidity etc. But as part of managing the reserves they are also probably taking more equity investments and more non-government bond investments much like ADIA does for Abu Dhabi.”
A further concern is the investments some of these funds are making in countries or regions which might require greater scrutiny and where quid pro quos are in operation.
“The obvious examples are in Africa where China has made significant investments. Now a lot of those are very positive investments. Look at what they are doing in the Democratic Republic of the Congo, building roads, putting in infrastructure which hasn’t been there before in exchange for rights to minerals. It is probably a good thing all round but it is definitely a concern to certain western governments that this may not be, necessarily, market driven - this quid pro quo which is going on.”
Likewise, Dubai-operated DP World has a significant presence in Africa and is undertaking major infrastructure projects on strategic ports. New projects include a US$400m investment in the Doraleh Container Terminal in Djibouti, an investment of US$163m in the existing facilities in Dakar, Senegal and a further investment of US$476m on a second phase.
The second issue surrounding SWFs is their exponential growth over the last few years. There have been two main drivers of growth, the first driver being oil prices. This category includes the Gulf funds such as ADIA and Saudi Arabia; Norway; Russia and to a certain degree the smaller funds such as Alaska and Alberta. The second group are the funds that have been developed by the current account surpluses that have been run in China and other South East Asian nations. China in particular have accumulated an enormous amount of foreign currency reserves over the last five to seven years.
“Their economy has been growing through exports and so they have now set up a sovereign wealth fund. Previously it was a central bank investing in bonds which was good for the US because it lowers the interest rate and it was non-controversial. Now they have actually transferred two hundred billion dollars into their investment corporation and that has brought it to everyone’s attention. So these two areas are really where the big growth in assets has come from, firstly oil revenues and secondly trade surpluses.”
It is the rapid growth of these funds over the last few years that has brought them to international attention. This in turn has raised questions over their long term objectives and the transparency of their investments. Norway is held up as the example of best practice as the intentions of their fund, details of their investments and returns are publicly available.
“The Norwegians and the Alberta fund are very clear about what their aims are, which is to provide an income in the future off the current revenues to maintain a quality of life and a strong economy. They are very open and are generally a minority investor. However, although they are very transparent about it, they are increasingly coming into problems because they are getting so much money to manage. They have to diversify their investments beyond the equities and the bonds they have been holding up until the last few years.”
“They are starting to get to the point that they have got so much money under management that it is no longer as feasible for them to limit their stakes to very small ones and to not be involved in private equity. Increasingly they and some of the other larger pension funds are starting to look more and more at alternative investments, at more strategic stakes in companies and owning companies outright because that’s the only way they can put the amount of money they have at their disposal into work in the markets.”
However, even the most critical observers recognise there is little doubt these funds are going to get bigger, particularly those driven by oil revenues. For the countries involved, they are absolutely essential as it is impossible to have such high levels of wealth flowing into the country at one particular time, it needs to be spread out over time. But despite the controversy surrounding the growth and aims of SWFs, so far they have been of huge benefit to western financial markets. They have stepped in across the board and invested the proceeds of the oil windfall into some of the sectors which have been suffering. Major investment banks have been recipients of huge cash injections – Singapore's GIC, for example, spent more than £5.5bn on a 9% stake in UBS in 2007. The Abu Dhabi Investment Authority (ADIA) invested $7.5bn in Citigroup bonds. China Investment Corporation's invested $5bn in Morgan Stanley in December 2007 and China Development Bank, though not a SWF, acquired a 3.1% shareholding in Barclays.
All these investments have suffered a huge drop in value but have beenvital to the western financial system: “If you imagine you’ve got a huge removal of purchasing power from consumers globally with the rise in oil prices and this money is accumulating to a few funds. If they saved it all and it was not recycled back into the economy, there would be huge distortions and a massive drain on the world economy and on world stock markets. As it is, what is happening is the money is being recycled back into the stock markets. The other interesting thing is that we’re seeing that there is a shift from investment into western developed markets to increasing amounts being invested into Asian and other developing markets as well which just reinforces the long-term shift in economic power from west to east.”
Despite the fact these investments have possibly been the funds’ least commercial, western governments are still pushing for a code of conduct. In March the US agreed voluntary principles with ADIA and Singapore’s GIC. In July 2008, the International Working Group on SWFs met to draft Generally Accepted Principles and Practices (GAPP). The IWG is comprised of 25 IMF member states with participation from the OECD and World Bank. The draft is due to be complete by the beginning of October although it has since been reported that they are likely to take longer. The aim of the guidelines is not only to help promote transparency but also to ensure that SWFs are treated as fairly and equally as any other investor.
“A code of conduct in principal would be a good thing, I just think in reality it is unlikely to happen. One of the things the sovereign wealth funds will turn round and say is you are presuming us guilty but there is actually little or no evidence that we are behaving in the way that you are worried we will behave in. With the sums of money involved, transparency would be counter productive for them as they try to maximise their return. Why would they open themselves up in that way?”
“If anything, some of the most lauded investments they have made which is the money which they have pumped into the western financial system are probably the least commercial investments that they have made as they have managed to lose anywhere from 30 to 70 per cent of their money.”
“Clearly we would be negative on the US if they were refusing all the investment from the SWFs because the money is coming from the oil states. They are the biggest users of oil and that money is therefore flowing out of the US. If they were completely against receiving it back in any form whatsoever, then inevitably it would go somewhere else and that would mean that their capital stock was being depleted over time.”
The UK has been much more open to investment from these funds and it was reported in April that Safe had acquired a US$2bn 1 per cent stake in BP. Following the announcement, UK Chancellor Alistair Darling publicly endorsed the investment and reiterated that the UK welcomed SWFs. And in June 2008 US Treasury Secretary Henry Paulson gave a speech in Abu Dhabi in which he assured investors that the US would be open to investment from Sovereign Wealth Funds.
As these funds grow and increasingly look to diversify their investments, a further area in which there is growing interest is that of food production.
“If you look at China, although it is not through the sovereign wealth fund, in various parts of Africa we believe there are now about 750,000 Chinese farmers who are working on farms run by Chinese managers providing food which gets shipped to China. So it will be something people view as strategic and that people get involved in. Saudi Arabia has announced that by 2016 it will be phasing out all the production of wheat in Saudi because it is just too costly in terms of water. And this is where the strategic investments come in, oil is one where China is trying to get involved and food production is certainly a theme that we as a bank have been focussing as well as the shortage of water across the most populous and quickest growing regions of the world. Therefore their ability to feed themselves is something we are sure is going to be a very big theme.”
Given the fact that many of these funds are from the emerging markets and are increasingly investing in emerging markets, there has clearly been a shift in the balance of power within the global economy. The question being asked is whether the emerging economies have decoupled from the United States.
“We prefer the term insulation. They are not actually decoupled from the US, the US is just too big an economy. However, increasingly the domestic demand, the trade flows and the investment flows are intraregional within Asia, between the Middle East, China and India. Brazil and China are other examples, the growth in Latin America trade with China has been dramatic. It could soon be as big as trade with the US and China. So there are a lot of positive moves within the regions and these are making all the other regions less affected by the US. They are not unaffected, they are not decoupled but they are insulated.”
A further problem within the global economy has been Chinese currency policy - the Chinese currency needs to appreciate to help rebalance the world economy. “We believe there has been a shift in China’s currency policy and they have moved to a more accelerated rate of appreciation. This is a good thing because of the imbalance they are creating in the world with their huge current account surplus. It is not good for them, they are suffering the consequences now , having an inflation problem. It is the problem of too much liquidity and they are desperately fighting to prevent more liquidity going into the system so they are raising reserve requirements and hiking interest rates.”
“The exchange rate has also been a source of inflation as they have been importing more and more raw materials and have been substantially linked to the weakening US dollar. They have taken most of the downside of higher food prices, higher oil prices, higher metal prices compared with the Euro which has moved along a lot further. However, although they have been suffering from some of these effect, it has been mitigated by allowing their currency to appreciate. Even with the recent rebound in the USD the CNY, though weakening slightly against the USD, has appreciated on a trade-weighted basis.
“The big problem area is in the Gulf where they have had absolutely no appreciation at all, they have been fully exposed to the depreciation of the US dollar plus they are also in the middle of a massive boom driven by high oil prices. They are in the worst of all worlds. Again we have been very consistent in saying that they should revalue their currencies and they should be considering looking at depegging from the US dollar. We don’t believe depegging is going to happen in the near term but we think that should be a goal for them.”
“Generally, the panic of inflation is probably a little bit over done at the moment, we believe. The fundamental issues driving inflation at the moment have been oil prices and, to a lesser degree, food prices. The demand has not really fallen off despite a rapidly slowing economy, particularly in the US, but we believe that will have an effect in two ways. Firstly the high oil prices will slow down and will go slightly into reverse because the world will adjust to using less oil and demand and supply will come back into balance to some degree. Secondly the high oil prices we have at the moment are starting to have a deflationary effect.”
“If you look at the States which is probably the easiest one to look at, you’ve got falling house prices, rising unemployment, real incomes being squeezed as a higher proportion of disposable income is being spent on the basics such as food and fuel, that is squeezing discretionary spending that is available for anything else, particularly services. Services represent about 70 per cent of the US economy which means that if people have got less money to spend they are going to cut back and this is going to feed back into job losses.”
Therefore unless wage rises start to occur in response to rising oil prices then this sort of inflation is not built in, it is a temporary phenomenon caused by the increase in oil prices. As oil prices stabilise, inflation will drop out and the fact that there is a weak labour market will mean that there will be very little follow through into wage increases. “Overall we feel that we will be looking at if anything possibly a deflationary scenario in the US in another six months. We have been calling for the need to cut rates aggressively since early-2007, when this was a distinctly non-consensus call and we still believe we are going to see rates cut in the US as we think the inflation from oil and food will drop off very quickly. We think we will also see rate cuts in a lot of the other countries across the rest of the world.”
The problem countries are those where inflation is starting to become built in to the system and people are expecting wage increases in response to the CPI. “We don’t see that as a problem in China, we think the Chinese have been on top of the situation, they are getting CPI under control but the Gulf countries where the response to a lot of the inflation seems to have been to raise wages and that then feeds straight back into itself which is the second order effect for inflation.”
Should the GCC depeg from the dollar?
Given the GCC’s link with the dollar and inflation problems, the obvious question is should they depeg? “The problem with depegging a single currency is that you need to have the infrastructure in place to be able to do that. And that’s clearly what the GCC is looking to do with its aim to have a single currency by 2010. It is our belief that in the meanwhile, they should be trying to do something with the currency and actually revalue to relieve some of the pressures that they are seeing and to try and break this cycle of raising wages by 100 per cent to try and overcome the increase in food and other prices.”
Overall, the major threat for the world economy is making sure that the current US financial crisis and increasingly economic crisis, does not continue to spiral downwards. “We have been strongly suggesting cuts in US interest rates, we believe that is what is going to have to happen next. The economy is at risk of deflation. If that happens, the insulation will be tested for the rest of the world so it is very important that US doesn’t drop into deflation. Separately it is also important that we don’t get more Vietnamese type situations where you get inflation running out of control and then you have to slam the breaks on. There are a lot issues out there for the world economy at the moment. The central banks have so far been relatively proactive. They are at a very difficult stage at the moment, they are trying to balance threats of inflation with a threat to growth and I believe the threats to growth are more significant because inflation will generally be a passing phenomenon.”
Source: Cityscape Intelligence