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The $2,500 Billion Question

The Good
Sovereign Wealth Funds (SWFs), schemes to invest the growing foreign exchange reserves of nations, have mushroomed in size over the last five years. Morgan Stanley estimated in March that the total funds at the disposal of SWFs amount to approximately $2,500bn – at least 25% larger than the global hedge fund industry estimated at $1,500bn - $2000bn. As countries reap the benefits of high oil-prices and/or large trade surpluses, the growth of SWFs is roughly $500bn a year - greatly outpacing that of hedge funds. The benefits of channeling the foreign exchange reserves of nations into more flexible investment schemes are great: there is a huge opportunity cost involved in tying up this much capital in secure, but low-yield treasury bonds (usually US), as has been traditionally the case. Emerging market assets specifically and risky assets in general will benefit from the increase in liquidity in global financial assets.

The Bad
Tassell and Chung warn that from the perspective of national security, SWFs present a number of potential threats. First, there are issues of global financial stability–-a security concern for every country nowadays. Many newer SWFs lack the management experience to effectively channel their vast assets and calculate risks sufficiently. They also point to the near-impossibility of tracking such funds, since they are blended with the massive pool of private capital. SWFs in general, they ascertain, rank below even the most secretive hedge funds in terms of disclosure of fund performance, investment strategy or even basic philosophy.

Another reason why SWFs are so notoriously difficult to keep track of is because they often channel their investment through discreet secondary managers. This is done to avert nationalist backlashes when purchasing foreign companies seen locally as having strategic importance. There are serious doubts whether these funds are operating on a purely commercial basis or to fulfill broader goals of national governments.

And It Could Get Ugly
Lastly, the authors indicate a direct danger to America’s financial stability – and thus global financial stability – in SWFs. America’s finances are already extremely imbalanced, but it has been able to continue to run high trade deficits because the prime choice of investments for foreign exchange reserves is US Treasury Bonds. If more and more countries chose to invest in other assets, bond yields could rise, leading to fall in value of the bonds. Countries holding large stocks of US treasury bonds will be wary of such a development, as they themselves would damage the value of their investments. Nevertheless, it is clear that the growth of SWFs in recent times will mean that a greater share of new bond reserve accumulation will flow into other assets instead. This, in turn, could spell doom for America’s already stricken balance sheets.


The Financial Times, May 24, 2007 (registration required)


This summary was prepared by the Atlantic Community editorial team from an article originally published in the Financial Times.


Related Material from the Atlantic Community:

• McKinsey: Multinational Acquisition Highlights China’s Strength in a Global Economy
• Foreign Affairs, Hands Off Hedge Funds
  
  
  

  Prepared by Niklas Keller