Emerging Global Finance Giants: The New Power Brokers
The McKinsey Global InstituteThe McKinsey Global Institute (MGI) report for October 2007 explores the rise of petrodollar investors, Asian central banks, hedge funds, and private equity funds as the “new power brokers,” so called because of the increased influence and determination of these actors as participants in international financial markets. These entities have grown measurably in the recent past and possess immense potential for the future. Their compounded assets minus their overlapping investments are equal to US$8.4 trillion, 40 percent of the size of mutual funds, pension funds and insurance companies. Their success is mutually reinforcing, because they invest heavily in each other. All in all, all four “new power brokers” account for about 5 percent of total global financial assets, and their future prospects are even more optimistic. MGI calculates their assets will grow to between $15.2 and $20.7 trillion by 2012.
Strengths and Weaknesses- Petrodollar Investors: Rising oil prices have provided for a constant and increasing flow of petrodollars and have made their private and state beneficiaries into key investors in world finance. Petrodollars come from 60 percent sovereign wealth funds and 40 percent private wealth, neither of which must answer to shareholders or risk capital flight. With their high liquidity, petrodollar investors have the largest pool of capital of four “power brokers”: $3.4-3.8 trillion, mostly from members of the Gulf Cooperation Council (GCC). MGI expects this number to climb to around $5.9 trillion in 2012. Most petrodollar investments are channeled toward global equities ($1.7 trillion), and alternative investments such as hedge funds and private equity. Their engagement with the small but rapidly expanding sector of Islamic finance is important, which goes hand-in-hand with a willingness to invest in emerging markets like the Middle East, North Africa, or Asia. MGI expects this last factor, if aided by more flexible Asian currencies, to have the potential of turning around the region’s financial systems while solidifying the position of several financial hubs. There is concern over whether investment with petrodollars could sometimes be politically motivated, threatening the natural dynamics of the market.
- Asian Central Banks: The economic success of some Asian economies, particularly their year-on-year surpluses, has made their central banks the largest single investors anywhere. This is especially true of the Chinese ($1.1 Trillion) and Japanese (+$865 billion) central banks, but the banks of Hong Kong, India, Malaysia, Singapore, South Korea and Taiwan are also included, with combined assets equal to about $1 trillion. Lacking financial intermediaries and with no need to generate cash flow, these banks have a privileged position. Their past investments have been very conservative, concentrating on fixed-income securities, especially US government bonds. They seem to be keenly aware of their power to disrupt the market and have shown remarkable cautiousness. Nevertheless, the central banks of China and South Korea have expressed interest in higher-risk investment in the near future. As in the case of petrodollars, politically motivated choices could disturb the harmony of the market.
- Hedge Funds: These financial instruments have become permanent fixtures in the global financial landscape. Hedge funds take advantage of the ability to attract a small number of big-ticket investors, creating abundant liquidity and better safeguards on capital flight. This group could be the largest new “power broker,” if leverage is accounted for. MGI considers the flexibility of hedge funds to diversify investment as commendable but worrisome. Banks are too exposed to the success or failure of hedge funds, and there is also the likelihood of systemic contagion across asset classes in case of crisis. MGI also emphasizes the potential for bubbles in the sectors where hedge fund investment concentrates. While no signs of this are evident in the financial markets, effects have already been observed in illiquid markets such as real estate, where MGI sees massive investment by hedge funds as partly responsible for the sub-prime crisis experienced in mid-2007. Some large hedge funds sustained heavy losses, and a handful were even helped by the US government in order to prevent a systemic collapse.
- Private Equity: These funds have grown exponentially recently, but they remain the smallest player compared to the other “new power brokers.” MGI points to a clear correlation between private equity and improved corporate governance. The strength of private equity is investor commitment for the full life of the fund, plus a tendency to be more daring in taking risks. Coinvestment opportunities with other investors facilitate the purchase of larger companies, thus increasing profit potential. Nevertheless, it is still unclear whether these funds can sustain high levels of growth during a prolonged period of time.
In addition to access to enormous amounts of capital, all of these investment vehicles benefit from a set of specific characteristics which provide greater autonomy and independence in their risk assessment. These “new power brokers” also command generous leeway in diversifying their investment choices, while having the capacity to project them further into the future. Yet their activities are perceived as insufficiently transparent, while the volume and scope of their investments pose high risks not only to themselves but to the financial system in general. Although each “new power broker” has had a different investment style up to now, MGI has identified slight changes indicating all four could be moving in the direction of greater risk, seeking higher returns.
The summary above was prepared by the Atlantic Community editorial team based on the third in a series of Energy Watch Group papers on future energy supply and demand patterns. The New Power Brokers: How Oil, Asia, Hedge Funds, and Private Equity Are Shaping Global Capital Markets was published in October 2007 and is available here.
Prepared by Christian Andreas Morris
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