Capital Flows

Sovereign wealth funds have invested about $35b in US financial institutions. Adding in Qatar’s investment in Barclays and Singapore’s investment (through the GIC) in UBS brings the total up sovereign funds have invested in firms with a large US presence to around $55b.* The US taxpayer is now being asked to invest $700b to help recapitalize the global financial system – a sum that is more than 10 times as much as the world’s sovereign funds put in. But, at least as I read Paulson’s initial proposal, the US taxpayer would not get any equity in the world’s large financial institutions in exchange for this help. Now the US isn’t making a pure equity investment, though some – like Doug Elmendorf and Sebastian Mallaby– think it should. It is buying the banks’ illiquid assets. But there is at least the possibility that it will “overpay” for those assets, and in the process effectively contribute equity capital to the US and global banking system. Indeed, there is a real probability it will overpay by more than the $55b sovereign funds have put into the global financial system. There are broadly speaking two ways a government can recapitalize a banking system. One is to put in a lot of equity. That equity can be put in to allow the banks to write down (and eventually sell) their bad assets – or it can be put after the banks’ have down the write down, providing the funds both to make the banks’ creditors whole and to supply the banks with new equity. It works out to the same thing. Such an equity infusion is good for the holders of the financial systems debts (depositors, money market funds, bond holders) and bad for the holders of the banks’ equity. The other is to buy the banks bad debt. That clearly generates a bit of liquidity for the banks – they have more cash on hand, and thus more capacity to make new loans. But it also is risks providing a large gift to the banks equity investors – as they get to move an illiquid asset off the banks books at what may well prove to be an above market price. Most bank recapitalizations have elements of both. The FT – in its usual sensible way – suggests that the US recapitalization should too. I agree. To give a concrete example, the Chinese recapitalized their state banks earlier this decade both by buying bad assets off the banks books (usually by exchanging bad assets for the bond of an asset management company, with bad assets shifted to various asset management companies at book value) and by injecting new public funds (whether new funds from the Finance Ministry or some of the PBoC’s foreign exchange reserves) in exchange for the banks’ equity. Now the state banks were already owned by the government, so it didn’t matter too much – apart from internal accounting -- exactly how the system was recapitalized: Chinese taxpayers stood to gain on their “equity” in the state banks if China’s taxpayers overpaid for the banks bad assets. But the Chinese example still illustrates the range of choices available to the government. Some banks still seem to have faith in the illiquid assets they hold and worry that the government might be getting too good a deal on their MBS and complex securities; it will buy distressed assets at a discount from illiquid institutions, and could end up with a significant financial gain if it holds those assets to maturity. Maybe. The mysterious knzn at least initially believed that this scenario wasn’t entirely unrealistic. The obvious solution to this concern is to give the banks a bit of the government’s upside: if the taxpayers make a profit, some of it could be “given back” to the banks. On the other hand, the government might end up overpaying – perhaps significantly – on the banks’ assets. That helps the banks and hurts the government. The fairly obvious solution here is to give the taxpayers some of the banks upside. Apparently one objection to an “equity” component of a recapitalization is "a gut Congressional reaction against the government taking equity stakes in a broad array of American corporations.” Alas, that cart has already left the barn. The Fed effectively bought AIG last Wednesday – and the Treasury took over Fannie and Freddie the previous weekend. And unless foreign governments’ do not count, governments (though not the government) already have an equity stake in a lot of US financial firms. The governments of Singapore, Abu Dhabi, China, Korea, Kuwait and Qatar (through Barclay’s investment in Lehman) all hold equity stakes in the US financial system. Is it really better to reward the banks’ existing equity investors -- remember, they own the financial institutions that made the bad bets that led the financial system to seize up – to avoid a US government equity stake? * My accounting is as follows: Morgan Stanley: $5.6b (CIC) Citi: $17.4b ( $7.5b from ADIA, $6.88b from the GIC, $3 from the KIA) Merill: $12.5b ($5.9b from Temasek and, per Craig Karmin and Carolyn Cui of the Wall Street Journal, $6.6b from KIA and the KIC) Total: $35.5b UBS: $9.54b from the GIC and $1.8 from an unnamed investor in the Gulf widely thought to be a member of one of the region’s royal families. Barclays: around $9b from a rights issue with substantial participation from both the QIA and Sheik Hamad’s private "Challenger" fund (Sheik Hamad also runs the QIA) Combined total: $55.84b This leaves out some pre-crisis investments – like the CDB’s investment in Barclay’s. And I am not totally confident of the accounting for the increased stake various funds took in Merrill when the initial deal was reopened, or for the Barclay’s rights issue. It is an approximation. Sovereign funds may have provided additional funds through private equity funds or participation in public rights/ convertible issues. I have no way of tracking those investments.

American commentators have argued that Russia’s current financial difficulties are evidence that Russia’s participation in the global financial system constrains Russian geopolitical adventurism. Russians have paid a (financial) price for the conflict in Georgia. The Wall Street Journal notes that some in Russia see things rather differently: they believe that the US government put pressure on US banks not to rollover loans to Russian banks, and thus helped precipitate Russia’s current financial crisis. Gregory White reports: As Russia’s stock market went into free fall this week, conspiracy theories circulated that Washington was egging on American financiers to punish Moscow for its incursion into Georgia last month. The theories gained enough credence that Russia’s finance minister, Alexei Kudrin, spoke with U.S. Treasury Secretary Henry Paulson late Wednesday and sought assurances that the U.S. wasn’t playing politics with Russia in the financial crisis, the Russian Finance Ministry said. Mr. Paulson told Mr. Kudrin that the U.S. wasn’t, according to the Russian side. A U.S. account of the call wasn’t available. …. The question broached by Mr. Kudrin in his phone call with Mr. Paulson reflects a view widely held in the opaque world of the Moscow elite. Russian officials have asked U.S. bankers in recent weeks if the banks have been ordered by U.S. officials not to lend to Russian companies, according to people familiar with the conversations. The banks deny any such order. I believe Paulson. US banks haven’t been willing to lend to anyone, including other US banks, recently. I suspect former Russian President and current Prime Minister Putin does not – perhaps because Putin and others know that they can influence the actions of Russian banks by whispering a few words into the right ears. Rather than concluding that Russia’s financial integration limits his options, Putin may end up concluding that Russia should never have allowed its banks and firms to borrow so much abroad. The potential strategic uses of financial power are a particular interest of mine. Russia isn’t alone in thinking that the US government has, in the past, used finance as a source of pressure on countries’ pursuing foreign policies that the US opposes. The British government, for example, was convinced that the US was pulling its sterling reserves during the Suez crisis. The available data suggests it wasn’t – it didn’t need to. The United States leverage came from the fact that the UK needed a large US or IMF loan in order to be able to defend sterling’s peg to the dollar -- and the US wasn’t willing to support such a loan to a country pursuing policies the US didn’t support. Who seems to have pulled out of sterling then, draining the Bank of England’s dollar reserves? India. And the international oil companies, who worried about the potential impact of a devaluation of sterling on their operations. Such concerns are likely to multiply in a world where governments play an ever rising role in the market, and experiment with more aggressive strategies for managing money. Imagine the furor if sovereign funds -- not US hedge funds – had been shorting the US broker-dealers …. Incidentally, the scale of Russia’s government intervention this week has almost been on the same scale as the United States’ government intervention, which takes a bit of work - Russia on Thursday indicated it would spend $20 billion to buy Russian shares, deposit $60b of the Finance Ministry’s funds in Russian banks (perhaps running down its dollar and euro deposits at the central bank in the process?) and that the central bank of Russia would supply $20b in liquidity to Russian banks.

The reporting from Asia on Friday suggested limits to the CIC’s interest in Morgan Stanley. Restrictions on the ability of foreign banks to participate in the “TARP” (the current acronym for the bailout) might be another. But the Wall Street Journal’s reporting (see Lucchetti, Enrich and Sidel) suggests that discussions are ongoing: “Wall Street firm Morgan Stanley and Wachovia Corp. plowed ahead with merger talks Friday, even though announcement of the U.S. government’s crisis-fighting plan eased the pressure to race into a deal, people familiar with the matter said. Morgan Stanley’s board was expected over the weekend to discuss a deal, which may take an interesting twist. In one scenario being contemplated in New York, China Investment Corp. would take a significant stake in the combined company.In one scenario being contemplated in New York, China investment corp would take a significant stake in the combined company. … CIC’s interest might be contingent on Wachovia being able to offload some of its mortgage assets. So far, the CIC discussions has been preliminary and hasn’t been broached with Wachovia’s board.” This sounds like a scenario that would need to be contemplated in Washington and Beijing as well as New York. Moving risky assets over to the books of the US taxpayer to create a “good bank” that appeals to the investment arm of China’s state council (an accurate, if undiplomatic, description of the CIC) would be a significant move – even in a week marked by a host of significant moves. The US government would effectively be a party in the deal. I can see how say a voter in Ohio that – correctly – believes that China’s neo-mercantilist policy of accumulating foreign assets to hold its exchange rate down and support China’s export sector has contributed to the difficulties segments of US manufacturing have faced over the past few years might not look favorably on a deal that requires the taxpayer to assume downside risk and gives China’s government the upside. The US Congress has bulked at increasing China’s IMF quota because they haven’t wanted to reward China for intervening in the currency markets. The ideas that Morgan Stanley seems to be considering would seemingly require rather direct bit of US government assistance for a agency that helps to manage foreign assets that the US government doesn’t think China should be accumulating in the first place. Yes, a CIC investment could help the banks raise needed equity capital and thus offers a potential alternative to an even bigger investment by US taxpayers. But a large CIC stake would also start to raise issues about who should provide the government backstop for the combined institution: China or the US? Bailing out US banks is one thing. Bailout out a Chinese-government-owned US bank is another. That question hasn’t come up in the past because governments generally haven’t owned financial institutions with large operations outside their home markets. Singapore I guess is a partial exception; Temasek has large stakes in a lot of financial institutions. But it is at least worth starting to consider who has responsibility for such an institution in the new world of state capitalism. Finally, it is a little puzzling how China’s government could find Agencies too risky without a US Treasury guarantee (Chinese representatives apparently told the US that they expected the US to "do whatever is necessary" to protect the Agencies) and simultaneously find Wachovia/Morgan Stanley’s book attractive. It presumably has rather more risk than most Agency bonds. On the other hand, it probably is a stretch to assume that China has a coordinated external investment policy now that management of its reserves has effectively been split between two (or more) rival institutions …

I think we now know why the US Treasury is selling Treasury bills like mad to raise money for the Fed. $180 billion is a lot of money to lend to other central banks so that they can supply dollar liquidity in their national markets. The ECB is now prepared to lend out more than $100 billion US dollars to European financial institutions: Under the latest action plan drawn up by central bankers, the ECB said it would expand its armoury by offering “for as long as needed” $40bn in overnight funds to eurozone banks. The ECB is also expanding its reciprocal arrangements with the US Fed to increase to $25bn the amount it provides in the market for 28-day funds and $15bn over 84 days. Under the expanded plans, the amount of outstanding dollar liquidity provided by the ECB could reach as much as $110bn – compared with $50bn previously. No doubt the Fed is financing a host of US banks and broker-dealers as well. The Fed’s balance sheet indicates that it provided an additional $100b in direct credit to the US financial system over the last week (look at the Wednesday to Wednesday change in "other loans" rather than the change in the weekly averages) -- "Primary credit" rose by $10b, roughly $60b was drawn from the prime dealers credit facility and another $28b was provided in "other credit." Then throw in another $10b increase in the securities the Fed has lent to dealers, bringing that total to $127b. By my count -- which could be off -- the Fed has now provided around $500b in credit to the US financial sector over the last 12m months.* And given how much has happened, that will probably be a couple hundred billion or so out of date. Or something like that. Financial institutions have loss confidence in each other. American savers may soon lose confidence in money market funds -- a key source of financing for a host of financial institutions. That effectively leaves the Fed -- and other national central banks -- as the only institution willing to supply financing to many financial institutions. Just think how extraordinary it is for the chief economist of Goldman Sachs to say that there has been a complete loss of confidence in the markets. "``There’s a complete lack of faith in the markets,’’ said Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. ``There’s a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act.’’ The FT puts it simply in their leader. "They have now duly become the last resort in a generalised panic in the core of the world’s financial system on a scale not seen at least since the 1930s. Nobody trusts any credit, other than that of governments themselves. In this situation, the rule is simple, clear and well-known ever since the days of Walter Bagehot. Central banks must lend freely against collateral of even borderline value. If the private sector will only lend to the government, the government must finance the private sector. It is as simple as that." It isn’t just the G-7 banks either. Emerging market governments have been intervening heavily as well, led by Russia. $60b is a lot of money for Russia’s three big state banks. Supplying the state banks with cash allows them to lend to other banks - thus helping to address the broader squeeze -- though it hasn’t worked so far: The finance ministry pledged to pump a further $60bn into short-term deposits in the three main state-controlled banks, however, earlier injections had failed to be transferred into the broader system as interbank lending froze. Russia’s government is clearly going to take other steps to support its stock market as well. Its ample reserves give it a lot of options even if it is getting really squeezed by a combination of trouble in global markets (lots of Russian banks need to rollover external credit lines), falling oil prices and a self-induced rise in Russian political risk. And a host of sovereign funds have been supporting their local equity markets. The CIC is buying shares in the big three Chinese state banks (it already owns a majority of these firms stock, so it is adding to its already large position). There is certainly talk that the big Gulf funds should do more to support their local markets. No doubt there are other examples as well. Such support clearly reflects a policy choice about how best to use the state’s wealth -- market stabilization is a government function. It isn’t necessarily the action of an investor motived solely by commercial considerations. The world continues to change at an incredible pace. Just think that a few years ago, China was expected to need to privatize its big state banks in order to develop its own financial system. And today there is a possibility that the CIC will intervene not just to support China’s state banks but also to support Morgan Stanley. Rather than resulting in the privatization of China’s state banks, the current form of financial globalization could lead China’s state to take control of a paragon of American financial capitalism. * Repos increased by around $95b, the term facility provided $150b, other credit adds in $120b (with a big increase this week), "Maiden Lane" (i.e. Bear assets) accounts for about $30b and roughly $125b of securities have been lent to dealers. If my accounting is off, please let me know. I have left out a $60b increase in the Fed’s "other assets." ** Incidentally, the Fed’s custodial holdings of Treasures and Agencies rose by $18.5b over the last week; the quiet bailout continued. Holdings of both Treasuries and Agencies increased -- with Treasury holdings rising by more.

Reuters is reporting that Morgan Stanley has approached the China Investment Corporation (CIC) for additional capital; it isn’t just talking to Wachovia. It order to get the equity it needs, the CIC’s stake would need to be quite large. Bloomberg reports: "Morgan Stanley pared its loss on the New York Stock Exchange after the person said China’s state-controlled fund may buy as much as 49 percent of the New York-based investment bank. The person declined to be identified because the talks aren’t public and may end in no agreement." This kind of investment (some might say "risky bet") would have to be approved by China’s State Council. And I would have to say that the CIC has yet to demonstrate a track record of apolitical, transparent management of its external assets -- in part because it hasn’t been around for very long and in part because it hasn’t been very transparent. It also is obviously something that the US regulators would need to approve -- and especially in light of the Fed’s recent decision to exempt the CIC from the requirements of the Bank Holding Company act. UPDATE: The FT’s alphaville has more. CIC, the Chinese sovereign wealth fund which already owns 9.9 per cent of Morgan Stanley, is definitely talking to the investment bank. The President of CIC even travelled to the US on Tuesday accompanied by Morgan Stanley’s China CEO. CIC was previously part of the Bank of America-led consortium that was considering a takeover bid for Lehman Brothers, alongside JC Flowers & Co. Christopher Flowers manages about $3.2bn of CIC’s money in a fund dedicated to taking stakes in financial institutions. It is very unlikely CIC would attempt a takeover of Morgan Stanley on its own, and the prospect of the Chinese government effectively owning one of the last two investment banks left on the Street would startle US regulators, to say nothing of the US Congress. The last line is certainly right -- the debate over whether China’s government is a political investor (remember Friday’s news about SAFE’s conditional investment in Costa Rican bonds) -- would be turbocharged. Morgan Stanley is also clearly talking to Wachovia.

It is hard to focus on data from over a month ago when a large emerging economy’s stock market is down double digits and the Fed is debating whether or not to extend a lifeline to the largest US insurance company. But the TIC data is stunning in its own right. It tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August. Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior. The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.* That would normally make it hard to sustain a large current account deficit. The US still needs roughly $60b a month in net inflows to cover its external deficit. Net sales of foreign assets of $32b provided some financing -- but not nearly enough to cover the outflow of short-term funds. $75b in net outflows isn’t exactly a good sign, even if the dollar’s rebound suggest more flows (perhaps from large US sales of foreign assets) in August. The same basic trend is apparent in the data for the 12ms through July 2008, which can easily be compared to the 12ms through July 2007 -- think pre-crisis and post-crisis. After the crisis, foreigners have bought roughly: $350b of long-term US treasury bonds, and another $125b of short-term bills -- for a total of $475b of US Treasuries. That explains how the US has financed its fiscal growing deficit. Foreigners also bought around $150b in Agency bonds, $210b of corporate bonds and $55b of US equity ($20b excluding the SWF capital injections into the banks and broker dealers). Before the crisis, foreigners bought roughly: $205b of long-term Treasury bonds (and reduced their holdings of bills by $10b), $285b of long-term Agencies, $540b of long-term corporate bonds and $210b of US equity. Notice a trend? Sovereign wealth fund flows into equities clearly have been trumped by a broader retreat from risk, including a retreat by sovereign investors. There are a couple of other important swings in the data. US investors dramatically reduced their net purchases of foreign assets. US net purchases fell from $280b to $95b. That helped. US capital outflows have to be financed by capital inflows. And US banks dollar liabilities fell by $400b -- producing a huge net outflow that offset much of the inflow. As a result, net "TIC" flows for the last twelve months are only $210b -- well below the current account deficit. Some of that gap could be covered by net FDI inflows, but in general FDI inflows and outflows match up pretty well, so it is hard to see that large an inflow from FDI. The remaining gap is an error term -- we simply don’t know what all is going on. That net flow can be broken into a $67.7b net private outflow (counting short-term flows) and a $277.8b net official inflow. Two points here: The US data consistently understates official inflows. We know $280b is too low for a host of reasons -- not the least the fact that the Fed’s custodial holdings increased by more. The past "survey" revisions have consistently revised official flows up and private flows down. There is no reason to think that this has changed. Indeed, the past revisions would suggest the entire $260b in "private" purchases of Treasuries over the past 12ms in the TIC data are likely official inflows, and that the $90-95b in private purchases of Agencies are too. If those flows are allocated, the net official inflow is over $600b -- and the net private outflow is correspondingly larger. The US data doesn’t seem to be capturing all the flows associated with the unwinding of the shadow banking system. That at least is my perception. I don’t have any other good explanation for the gap between identified flows and the US deficit. Now to the country data. I found one country with large reserves that added to its long-term Agency holdings in July: Hong Kong. Everyone else was a net seller. China, Russia, the Gulf ("the Asian oil exporters"), Brazil, Korea, Singapore, and Japan. So was the UK -- which likely indicates a further fall in official demand. The TIC data indicates a huge reallocation by official investors from Agencies to Treasuries -- and a far larger reallocation than showed up in the FRBNY accounts. Let’s look at five specific countries where central banks and sovereign funds typically generate a sizable share of the flow. China added $20.4b to its short-term holdings and Treasury portfolio, while cutting its holdings of long-term agencies by $3.4b. That strikes me as a flight from risk. China was still buying US corporate debt in July, but in smaller amounts than in previous months. This isn’t a flow I understand well. Chinese purchases of corporate debt have increased recently -- and that presumably has driven the rise in overall "official" purchases of corporate debt. But there were also substantial Chinese purchases from mid-2006 to mid-2007. The mystery: these flows weren’t match by a rise in stocks in the survey data. Count me confused. The Asian oil exporters (i.e. the Gulf) added $7.5b to its short-term holdings, and another $0.8b to its long-term Treasuries -- for a "flight to safety" flow of $8.3b. China and the Gulf account for a large share of the global surplus, so their flows matter. Russia cut its long-term agency holdings by $0.4b while adding $3.1b to its long-term Treasury portfolio. It also added $5.7b to its short-term Treasury holdings while cutting its holdings of other short-term securities (think Agencies) by $4.4b. One great irony in the data is that in the month before the conflict with Georgia broke out, Russia provided $8.8b in net financing to the US Treasury. Recent pressure on Russia’s reserves at least has eliminated that bizarre flow. Korea -- which many claimed might be running out of liquid assets -- seems to have reduced its Agency holdings far more rapidly than its Treasury holdings: its long-term Treasury portfolio fell by $1.1b, its long-term Agency portfolio fell by $3.6b and its holdings of corporate debt fell by $1.4b. That strikes me as sound liquidity management; it didn’t sell off its most liquid asset first. Finally Singapore. Singapore cut its long-term Agency holdings by a modest $0.2b while adding $1.1b to its long-term Treasury holdings. But the big story in the data is that it sold $5.2b of US equity. There is no way to know for sure that these sales came from the GIC or Temasek, but it is certainly possible that they did. All in all, I saw a lot of evidence of a sovereign flight from risk at a time when the market for risk assets was under stress. At the global level. And at the national level. I’ll try to flesh this out with a few charts later. * One data point. The detailed data for Agency purchases here doesn’t seem to match the summary data. I used the detailed data. Agency data should be adjusted for ABS repayment, but that adjustment is complex and it doesn’t affect the basic trend, so I reported the unadjusted number.

As the graph above indicates, there is a clear correlation between ‘democracy’ and ‘sovereign fund transparency’. However, the composition of countries with sovereign funds is shifting toward large, poor, and often autocratic countries whose interests are less aligned with the U.S. The articles below discuss how policymakers can act to address the transparency and security concerns raised by the growth of sovereign wealth funds. Setser: SWF Testimony Truman: A Blueprint for SWF Best Practices IMF: Sovereign Wealth Funds—A Work Agenda Kimmitt: Public Footprints in Private Markets

The Financial Times seems to have found an obviously non-commercial investment by a sovereign state. And it didn’t come from a sovereign fund. China’s State Administration of Foreign Exchange seems to have discovered that generating diplomatic returns is easier than generating financial returns. Jamil Anderlini of the FT: In January this year Safe bought $150m in US dollar-denominated bonds from the government of Costa Rica as part of an agreement signed last year under which the Central American nation cut diplomatic ties with Taiwan (after 63 years) and established relations with the People’s Republic of China. The agreement .... explicitly links the foreign policy switch to China’s purchase of $300m in government bonds and a grant of $130m. In an exchange of letters from January this year between Fang Shangpu, Safe’s deputy administrator, and Costa Rica’s finance minister, Safe promised to buy government bonds under the terms of the 2007 agreement, but included a clause demanding Costa Rica take “necessary measures to prevent the disclosure of the financial terms of this operation and of Safe as a purchaser of these bonds to the public”. China has long been willing to assist countries that refused to recognize Taiwan. But it generally hasn’t used its central bank reserves to do so. But if a country already has way more reserves than it really needs, well, it has new options. Anderlini: "The purchase of US-denominated Costa Rican government bonds by China’s State Administration of Foreign Exchange (Safe) is the clearest proof yet that Beijing regards its $1,800bn in foreign reserves – the world’s biggest – as a tool to advance its foreign policy goals, as well as a potential source of income.’ I was particularly interested in the FT’s story for two reasons: One, it suggests that SAFE is now something more than a traditional reserve manager. Investing in Costa Rican bonds and investing in equities (I suspect SAFE has a US equity portfolio, not just a British and Australian portfolio) are both signs that China believes it has more liquid reserve assets than it really needs. Two, evidence that the world’s biggest creditor country is throwing its financial weight around should increase interest in my new Council on Foreign Relations Special Report which examines – or tries to -- the strategic implications of the world’s changing balance of financial power. It is a big topic, and it is a big paper. I won’t try to summarize it fully here. But one of the core arguments in the paper is that countries with lots of foreign assets do have options that are often not available to countries that have large foreign debts. Another is creditor countries are, at least on occasion, able to influence the policies – foreign as well as economic policies – of the countries that rely on them for credit. A government’s ability to borrow big sums in times of need is an important strategic asset. Nial Ferguson’s work on Britain’s rose has made this clear. But relying heavily on fairly small number of governments for large amounts of financing can also be a strategic vulnerability. That though isn’t how the US typically thinks about its ability to place quantities of dollars at low rates with the world’s central banks. The dollar’s status as a key reserve currency has traditionally been considered an unambiguous strategic asset for the United States. Central banks need reserves to guarantee their countries own financial stability – and in some sense they traditionally have needed to hold dollars far more than the US has needed other countries to hold dollar reserves. The asymmetries favored the United States. The US lived in a world where it didn’t need to hold reserves – and could count on other central banks’ need to add to their reserves for a (limited) supply of financing on very favorable terms. I worry that this may no longer be the case. There is growing evidence that the countries now adding to their reserves most rapidly already have far more reserves than they need. The US runs the risk that it may be in a position where it needs other countries to add to their dollar reserves more than other countries actually need additional dollars. That potentially shifts the strategic calculus. China’s willingness to link its willingness to buy Costa Rican bonds to Costa Rica’s “one China” policy is an example. China wouldn’t be as willing to buy less liquid Costa Rican dollar bonds (in the right circumstances) if it wasn’t convinced that it already has all the liquid dollar-denominated bonds it needs. I’ll have more on my paper later. For now, though, I would be remiss not to note the FT’s leader – which calls for more transparency from central banks as well as sovereign funds, and also calls for China to adopt policies to reduce the pace of its foreign asset growth. Safe’s dealings with Costa Rica do, however, demonstrate potential dangers. These show that it is ready to invest as a means of applying political pressure. They are also a demonstration of the great lengths to which Safe is willing to go in order to hide its positions. It is an opaque institution, without open oversight of its assets or objectives. As with most other sovereign wealth funds – as well as some publicly owned companies and even some individuals enriched by petrodollars – not enough is known about Safe to be sure it could meet a serious “fit and proper persons” test for control of companies abroad. …. China must realise that its ballooning foreign reserves are a problem. It should allow the renminbi to appreciate further against the dollar, reduce its current account surpluses and, above all, relax capital controls to allow private investors to invest abroad. It will be far easier for the rest of the world to absorb Chinese capital if it does not come wrapped up in ownership by the mighty Chinese state. I agree. China financial integration with the world generates friction precisely is comes with the mighty Chinese state. Indeed, I would argue that FT’s leader understates the challenge posed by the exceptional pace of China’s foreign asset growth. In addition to adding $476 billion to its foreign exchange reserves between June 2007 and June 2008, China added $205 billion to the central banks “other foreign assets” – bringing its total holdings of foreign assets to a little over $2027 billion. This isn’t a secret. The supporting data appears on the PBoC’s balance sheet (look at the fourth line from the top; the 2008 data is only available on the Mandarin site). Of course, some of the $680 billion increase in the PBoC’s foreign assets reflects the euro’s rise over this period. But around $600 billion of the $680 billion increase was real – and that total leaves out the funds moved to the CIC and the funds the CIC injected into the China Development Bank. Unless there are far more fundamental policy changes, China will continue to accumulate very large quantities of foreign exchange – and, since it already has more dollars that it needs, it also has the capacity to use its reserves in creative ways.

A few months ago, Chinalco -- using funds borrowed from China’s Development Bank, which itself had recently received an infusion of foreign exchange from the CIC as part of its recapitalization -- bought a large stake in Rio Tinto. At the time, Richard McGregor of the FT argued: "Chinalco’s purchase was funded by the China Development Bank, a state policy bank, a shareholder of which is the country’s sovereign wealth fund, the China Investment Corporation. The sovereign fund, further, owns the largest Chinese investment bank, which is advising Chinalco. The ambitious CDB itself is no stranger to doing the state’s business offshore. It has been given crucial government mandates, most importantly to fund the expansion of local companies in Africa, primarily for resource projects. In short, you do not have to be a rabid conspiracy theorist to conclude that Chinalco is a front for China Inc. .... Geoffrey Cheng, of Daiwa Institute of Research in Hong Kong, told Reuters. “You’re not going against a corporation. You’re going against a nation.”"* Norway, by contrast, has decided it doesn’t want to hold Rio Tinto. (hat tip SWF Radar) China’s quest for resources meets Norway’s socially-conscious investing. Maybe Norway’s government fund should offer China its mining portfolio in one big block trade? Norway can avoid owning polluting mines, and China, inc could increase its resources exposure ... * McGregor’s argument is worth reading in full; he also believes that the relationship between various Chinese state firms is complicated -- and different firms compete as often as they coordinate.

Rose Yu and Amy Or’s Wall Street Journal story on China’s reduced appetite for Agency bonds is loaded with interesting detail. And not just about the fall in Chinese state banks’ holdings of Agencies. The fact that the Chinese state banks only held $23 billion or so of the $463 billion* or so of Agency bonds that China holds, according to the US data, confirms what I suspect was more or less known: the State Administration of Foreign Exchange holds the lion’s share of China’s Agency bonds. Remember too that the US data almost certainly understates China’s true holdings of Agencies. Two other details in the story were more interesting, at least to me: One: The big state commercial banks have $459 billion in "overseas" assets. That is way more than the CIC. "China’s banks have significant overseas funds to deploy. Bank of China had $240 billion of overseas assets at the end of June, while the other three big lenders had a combined total of $219 billion." That sum exceeds the foreign exchange reserves of all but three central banks (China, Japan and Russia) and (in all probability) all but one sovereign wealth fund (ADIA). The state banks foreign portfolio is way larger than the CIC’s external portfolio.** Though, given that the CIC formally owns the state banks, it may well make more sense to add the state banks’ $460 billion or so to the $100 billion held by the CIC. That would imply that the CIC already could give ADIA a run for its money -- as recent statements by the al-Nahyan family suggest ADIA doesn’t have the $800 billion commonly claimed. Two: China’s state banks haven’t exactly been a stabilizing presence in global markets over the past year. To be honest, I haven’t quite worked out how all the different data sources (the information the state banks disclose to their shareholders, the BoP data and the PBoC data) add up. China’s NIIP data suggests that Chinese investors held $240 billion in external assets -- and most of that is debt. Most of that comes from the state banks, but it also leaves out around $250 billion of the state bank’s total foreign assets. Setting that caution aside, Both China’s balance of payment data and the PBoC’s data on the state banks tell a similar story. The PBoC data indicates that the state banks were big buyers of foreign debt (portfolio investment) from late 2005 to the middle of 2007 -- and then turned into big sellers. Their holdings peaked at above $195 billion in the second quarter of 2007. Data on the PBoC’s mandarin site indicates that they subsequently have fallen to under $145 billion - even as the line items that I think correspond with the bank recapitalization and the state banks’ swaps with the PBoC have continued to grow. That fall is consistent with the Chinese balance of payments data, which shows $13b of sales of foreign debt in 2007 -- after over $100 billion of purchases in 2006. Sales of $23 billion in the second half of 2007 topped purchases of $10 billion in the first half of 2007 (no data is available yet for h1 2008). It also matches up with the US data. The evidence that Chinese state banks have been scaling back their holdings of risky assets is overwhelming. First "subprime." And now Agencies. That leaves the question of how exactly the state banks have been investing the influx of funds from their new dollar reserve requirement unanswered. The reserve requirement really got ratcheted up just when the state banks’ recorded holdings of foreign debt really started to fall. I don’t think the "funding" line items above correspond with the dollar reserve requirement -- as they have a long prior life. I certainly don’t know, but it also isn’t inconceivable to me that the PBoC invests the state banks dollar reserves given that they seem to be listed as "foreign assets" on the PBoC’s balance sheet. China is now a bit like Abu Dhabi. They are a lot different pools of foreign exchange floating around, but all are controlled in one way or another by the state. The debt sales of China’s state banks call into question all the talk about how sovereign investors in general and sovereign funds in particular have been a stabilizing presence in global markets. Whenever I read such a claim (for example, this Reuters’ article on the SWF’s new set of good practices, claims "During the current financial turmoil, which began in the U.S. housing market, wealth funds have proven to be market stabilizers"), I wonder how exactly anyone could know how sovereign investors -- counting state banks and central bank reserve managers as well as the wealth funds -- have impacted the market. After all, there is no aggregate data available on sovereign funds total portfolio. And I don’t think the publicly available data is strong enough to support any strong claims about the overall impact of sovereign investors on the market. We know that sovereign funds have injected money into US and European banks and broker-dealers. And each dollar of bank equity is leveraged up, so it supports a larger portfolio. The new capital injections have limited the extent to which banks have had to scale bank their balance sheets to match their scaled-back capital. That is stabilizing. Absent these investments, there likely would be even more distress in credit markets than there is. But sovereign investors -- paced by the Chinese state banks, who are owned by a sovereign fund and manage external assets for that sovereign fund and the central bank -- also seem to have lost their appetite for most risky assets. Total net foreign purchases of US equities are down over the last 12 months. Chinese state bank’s have stopped buying certain types of US debt. More recently central banks have shied away from the Agency market. That by contrast isn’t stabilizing. The latest BIS banking data suggests that private banks are fleeing risk and stocking up on government bonds. State banks can not really be criticized for acting like private bank and reducing their exposure to risk assets. At the same time they can hardly be lauded for using their deep pockets to stabilize the market. Right now there is no shortage of demand for Treasuries, while riskier forms of debt are available at a nice discount ... Assessing the overall impact of sovereign investors on the market, in my view, requires data that the sovereign funds -- and key central banks -- haven’t been willing to release. There are, after all, persistent rumors that state investors have been large players in the "paper" commodity market. So what are China’s state banks doing with the money they aren’t using to buy US securities? Yu and Or suggests that they are increasingly looking to lend to Chinese state firms seeking to expand abroad. Syndicated lending is one of the few bright spots in the banking business, analysts said, in part because borrowers have shied away from issuing debt in the face of higher yields. Using more of their overseas funds for corporate lending would help build Chinese banks’ international experience. "Given the fact that a lot of Chinese companies are seeking overseas expansion, it’s a good opportunity for cash-rich big Chinese banks to develop a syndicated-loan business," said She Minhua, a banking analyst at China Securities Co. The magnitudes involved are still rather small -- and probably too small to account for the full gap between the state banks’ reported foreign assets and the reported foreign portfolio holdings of Chinese investors other than the central bank. But they easily could grow. I at least have a hard time seeing how Chinese state banks’ current ability to borrow foreign exchange from China’s central bank to lend to Chinese state firms looking to expand abroad quite fits into a story where the state pulls back from the commanding heights of the global economy. The Chinese state’s efforts to support Chinese exports by holding the CNY down have effectively made large sums of foreign exchange available to Chinese state firms looking to expand abroad. Reserve growth has helped to fuel the outward expansion of state capitalism. That, in some sense, is a bit of a surprise. Ten years ago few expected that in the twenty-first century private banks would be cash-constrained and state banks cash-rich. And that the way states invest would matter to more markets than ever before. * This sum includes China’s likely holdings of short-term Agencies. China’s long-term Agency portfolio, according to the US data, was around $446 billion at the end of June. **The CIC, incidentally, doesn’t seem to have made large external equity investments yet; this SWF radar report suggests that the process has only started

Former Republican presidential candidate Ron Paul says he is working to reclaim what he calls the traditional values of the GOP, including limited government and less involvement in military campaigns abroad.

Note: this post is by Rachel Ziemba of RGE Monitor, where this post also appears. Many thanks to Brad for letting me fill in again. Today (August 26) two of the most transparent sovereign investors, the Norwegian Pension fund- Global and Singapore’s state holding company, Temasek reported their most recent investment returns. In Temasek’s case, these were for the year ending in March 2008 and for Norway from the second quarter of 2008. Both reported lower returns than in 2006/7 – which is not surprising given asset price moves in this period. Reports from these two model funds, which represent two ends of the sovereign wealth spectrum give us some clues as to how other, less transparent sovereign investors might be faring in the current market. In fact, since many such funds appear to have suffered losses, despite the inflow of capital received by oil funds (Brad and I have been working on a paper that presents some new forecasts) might call into question the expected rate of growth of such funds. Furthermore they raise the question of whether the risk management operations of these funds are up to the challenge. Both funds note that they have been beefing up such operations as they expect the credit crisis to persist for some time to come. How are they faring? Temasek, which primarily takes large stakes that it manages actively - still reported a fairly significant profit – asset sales offset equity market declines. Yet, it sees the year(s) ahead as more complicated. Temasek’s report noted that 2007 was the first year in the last five in which its returns failed to clear the cost of capital hurdle. And that may only get more difficult in the rest of 2008 and 2009 given that credit costs remain elevated and profit expectations are being revised down in many markets. Furthermore, it may have become more exposed to riskier assets – ranging from investments in Merrill to other forays into distressed assets. These may have absorbed much of the new capital injected. By increasing its holdings in the financial sector (which now makes up 40% of its portfolio- up from 38% last year), it may be less diversified. Given large investments in Merrill and Standard Chartered, one might actually be surprised that the exposure to financial institutions is so low. Its new purchases were offset by sales of Chinese and other banks in which it booked profits. And its 19% stake in Standard Chartered, one of the best performing global banks- in part because of its exposure to corporate banking in Asia and the Middle East, has been profitable. Singapore’s holdings in the OECD actually rose in 2007/8, though it continues to up its allocation to Asia ex Singapore and Japan. In this way, like GCC funds it may have actually increased not decreased exposure to the U.S. in light of the crisis. And it may do so in the future. Temasek is a model for many other countries, particularly in Asia and the Middle East who seek both to diversify their economies and improve the returns on their state companies and to increase profits. The Temasek model, if there is one, is to invest in state companies, improve the governance to extract better returns. The next step is (partial) privatization whose proceeds free up capital to be invested elsewhere in corporate stakes. In those investments Temasek also takes on a direct role if not necessarily controlling stakes. Norway’s assets under management on the other hand are actually lower than they were six months ago at least in Norwegian Krone. (See the link for some of my past analysis on the GPF at RGE Monitor). In fact, despite almost $63 billion in new capital, transferred from Norway’s oil revenues, the funds market value increased by only about $10 billion. In part, Norway, which approved an increase in its equity allocation last year, may have diversified either too late or two soon. When equity markets (especially in Europe and Asia) were booming in 2003-2007, their bond- heavy asset allocation, meant they had to keep buying bonds, depressing returns. They began implementing the asset allocation shift about a year ago. While they may have been able to purchase some of their new equities at cheaper prices, they may have bought well above the bottom. Norway’s equity portfolio exceeded half of the total portfolio for the first time in its history in Q2.. Yet, Norway’s purchases – stemming from its need to place $6 billion a month at current oil prices, may have modestly helped support European equities. Norway, which has been the largest holder of European equities for some time, now holds more than 1%. Norway’s managers did manage to provide a small return in excess of the benchmark portfolio and losses were 1.9%, less than the 5.6% in losses in Q1. Norway’s recently approved asset allocation shift to branch into real estate and add several new emerging markets is not yet evident, but it has already laid the groundwork to take larger stakes. Its new risk strategies and capital strategies groups can take larger stakes in the market and across asset classes. Furthermore, todays report also takes a sanguine look at the risk management model, which assumed a normal return curve - and "has underestimated the actual risk in the portfolio" Something they are now supplementing with more analysis. With the big caveat that its impossible to generalize across the spectrum of sovereign investors, it does seem likely that Norway and Temasek are not alone in suffering losses in their portfolios. If key sovereign wealth funds like those of Kuwait and Abu Dhabi held benchmark indices, their assets under management might actually be lower now than they were a year ago – despite large inflows from a near 50% jump in the oil price. Of course such index based returns may understate (or overstate) returns and assets under management. And if they did suffer such losses, that would put them in the company of many private sector counterparts. In fact, of the GCC funds, the Saudi Monetary Agency, with its bond-heavy portfolio and large inflows, likely saw the largest increase in assets. Recent accounts have been critical of the investment strategies of sovereign wealth funds, noting the sharp losses sustained thusfar, in their most visible investments – the investments in US and European financial institutions. Many have lost well over 50% - losses which are only partly offset by high interest payments on the preferred shares. But these aren’t the whole portfolio. The more we know about these funds, the more many of them seem to have asset allocations similar to private sector counterparts, whether they be private equity style funds, scaling up capital with leverage (and increasingly costly thing to do even for cash-rich funds) or more classic endowment like funds. Increasingly a vast array of pension funds, endowment funds, sovereign funds all seem to be coalescing to a similar asset allocation – high equity, more exposure to alternatives, real assets like commodities and less exposure to bonds. And everyone wants more emerging market exposure. Recent research by Olivia Mitchell of Wharton and two co-authors suggests that sovereign funds have a long way to go before they are models of transparency, risk control and optimal asset allocation. In many ways the three go together – and it is possible to have the last two without the first. However without transparency, it is harder to grasp how funds might respond in the future – particularly if they incur losses that could become politically unpopular. Furthermore, a better understanding of the overall liabilities against which these long-term assets are implicitly if not explicitly measured, is needed. While by definition most sovereign funds have no explicit liabilities like a pension fund or a social security trust fund, most are assumed to offset fiscal fluctuation or long-term financing needs. But the sophistication and investment expertise of funds varies. Hopefully such governance and risk control ‘good practices’ are among those being discussed in the IMF’s working group on sovereign funds.

Via SWF Radar comes news that two of the smaller sovereign funds in the Gulf want to gear up. Abu Dhabi’s Taqa looks more and more like a sovereign fund specializing in energy, and it too uses leverage. Some sovereign funds also are interested in a bit more than returns -- they also look to invest abroad in ways that will further the economic development of their home country. Or try too. The closer you look, the harder it is to generalize about sovereign funds. Some are unleveraged and focus on returns, in much the same way as a typical pension fund. Some are leveraged. Some have a mandate that extends beyond financial returns, looking more like industrial policy vehicles than a typical pension fund. And some don’t disclose enough for anyone to know what they really do ... Incidentally, while I don’t agree with every argument that George Abed makes, I do think he did a good job of summarizing the debate over sovereign funds. His FT oped is certainly worth reading closely.

Airbus is looking to source more parts (and produce more) in the dollar zone. Selling a product denominated in dollars with a euro cost structure isn’t currently a recipe for enormous profits. China is part of the dollar zone, for better or for worse. It will soon be making A320s. So is Abu Dhabi, though it is quite hard to see why an oil-exporter with a huge external surplus like Abu Dhabi should be in the dollar zone. Being a part of the dollar zone is a big reason why inflation is very high (and probably far higher than reported) in the Emirates. Abu Dhabi could easily import all the airplanes and airplane parts it wants. $100 billion in export revenues split among a small population produces a lot of buying power. Abu Dhabi’s native-born residents are far too wealthy to spend their time building planes. They prefer flying them ... But Abu Dhabi aspires to do more than pump oil. And its proliferating sovereign funds have the resources to make most dreams come true. Or try too. ADIA is Abu Dhabi’s best known fund, but it is far from alone. Over the past few years it has been joined by Mubadala, the Abu Dhabi Investment Council (a fund set up to manage ADIA’s regional investments) and perhaps Taqa (an ambitious state energy company that is investing in energy projects outside of the Gulf -- and in effect doubling down on Abu Dhabi’s energy exposure rather than diversifying away from it). Wayne Arnold writes: There are at least eight Government-owned or Government-controlled institutions now investing sovereign funds on behalf of Abu Dhabi. Far from just trying to drive up short-term gains, most share the goal of securing the long-term prosperity of the emirate, whether by providing nest eggs for retirement, securing long-term supplies of food and energy, promoting the development of new industries that create skilled jobs and reduce Abu Dhabi’s dependence on oil, or just amassing endowments. While ADIA may have a portfolio that looks rather like a pension fund or a university endowment, Mubadala is more of a "sovereign economic development fund." Its mandate goes beyond returns. It is also supposed to promote Abu Dhabi’s internal economic development. Mubadala was, I think, set up in part to manage the "offsets" -- basically contracts to produce parts -- that came with the emirates purchases of military planes. Abu Dhabi’s ambitions to challenge Dubai in the airline business have made it a new force in civil aviation. Etihad is a big buyer of planes. Mubadala is willing to invest in parts production. Stefania Bianchi of the Wall Street Journal reported last week: "Oil-rich Persian Gulf states, whose airlines have ordered billions of dollars worth of jetliners, now plan to leverage their financial clout into making parts for those planes. As Airbus, Boeing Co. and General Electric Co. struggle with soaring oil prices, slowing economies and squeezed delivery dates, multibillion-dollar aircraft orders from airlines in Abu Dhabi and Dubai, in the United Arab Emirates, provide much-needed investment, cheap labor and state-of-the-art facilities ... Mubadala, which owns aviation maintenance, repair and overhaul firm Abu Dhabi Aircraft Technologies, in a statement said it wants to "work with the world’s very best partners to develop and operate businesses that generate outstanding financial returns." European Aeronautic Defence & Space Co., of which Airbus is a part, and Rolls-Royce PLC struck similar deals to develop aircraft and engine manufacturing facilities in Abu Dhabi, Mubadala said earlier this month. The EADS partnership, which Mubadala expects to generate more than $1 billion of revenue for Mubadala’s aerospace arm over 10 years, will see the Abu Dhabi company produce aircraft components for Airbus and, eventually, construct entire jets. EADS will meanwhile work with Mubadala to develop an engineering center and research-and-development facility in Abu Dhabi so it will eventually be able to design, develop and manufacture complete aircraft in the United Arab Emirates’ capital. Emphasis added. Anyone who claims sovereign funds invest only for commercial returns hasn’t looked very hard. There are a host of funds in the Gulf that are designed to help their respective city state compete with Dubai as a financial center, and to otherwise their own economic development. That isn’t entirely non-commercial, but it isn’t fully commercial either. Does it really make sense for a country as rich as Abu Dhabi to make airplane parts, let alone airplanes? Remember, all the labor will be imported, adding to pressure on rents and the like. An obvious alternative would be to move the factory closer to the labor pool that is expected to staff that factory? Would Mubadala ever invest in a facility in a rival city state like Qatar? Qatar, remember, also aspires to be an airline hub and is building a huge new airport ... It is hard to see how Abu Dhabi’s plans pose much of a threat to the civil aviation industry in the US and Europe. Both Airbus and Boeing have long used parts contracts to help win business. Abu Dhabi simply isn’t big enough to become a major hub for high-tech manufacturing. But the same forces that have pushed Abu Dhabi to create a sovereign economic development fund that invests at home and abroad in projects that sometimes seem motivated at least as much by Abu Dhabi’s internal plans as by a desire for financial returns are present in other, much larger countries. Abu Dhabi isn’t the only country with big plans. That is one reason why I have criticized the decision to have the CIC manage the Chinese state’s controlling stakes in the state banks as well as an external portfolio. It suggests that the CIC isn’t purely a passive financial investor. I am not convinced that China can wall off the CIC from pressure to support China’s own firms as they go forth. I am pretty sure the state banks will face pressure to do so. And the CIC’s current ownership of these banks makes the state banks look a lot like the CIC’s fund managers -- and perhaps the CIC’s own economic development funds. If the CIC is ADIA, is the CDB Mubadala? The FT’s Lex notes that China’s various sovereign investors seem to be jostling with each other as they forth rather acting out a perfectly choreographed central plan. True enough. But they are competing to implement a government policy decision to invest more aggressively abroad. And so long as the State Council has to approve big investment abroad, it ultimately gets the final decision. Coordination may happen at a level above the CIC ... Addition references: Wayne Arnold’s article on Abu Dhabi’s different investment funds provides a synopsis of the style of each fund.

Russia’s central bank has indicated that it has cut its holdings of Fannie and Freddie debt by about half since the beginning of the year. Russia’s central bank claims its $100 billion portfolio has been pared down to $50 billion. Russia presumably also holds Ginnie Mae and other “Agency” bonds that have an explicit government guarantee – the US data suggest that Russia’s holdings of Agencies are higher than its reported holdings of Fannie and Freddie debt. So much for the notion that all sovereign investors are always long-term investors, willing to hold difficult positions through thick and thin. Russia likely concluded that the political cost of holding Fannie and Freddie paper isn’t worth the extra yield. Russia’s net sales likely put at least some pressure on Agency spreads. That raises something that I have been meaning to write about for a while now – the tendency to accept uncritically the argument that official investors (notably sovereign funds) have played a stabilizing role in the subprime crisis. To be sure, Merrill, Morgan Stanley, Citi, UBS and Barclays would be in more trouble now if not for the capital they raised from sovereign funds. The sale of convertibles and common stock to sovereign funds (and in the case of UBS, a large “private” investor in the Gulf) in December and January has proved to be a good deal for the banks and a bad deal for the sovereign funds. But it is still, I suspect, a stretch to conclude from these investments that official investors have played a stabilizing role in the crisis, for three reasons. -- Purchases of bank shares represent a very small share of total official flows -- Many key institutions don’t disclose enough information to evaluate whether or not their overall activities have been stabilizing or destabilizing -- The available evidence suggests a flight away from credit risk by some sovereign investors, which added to distress in parts of the market. Let’s cover each point in turn. First, the roughly $50 billion that sovereign investors have invested in banks needing to be recapitalized (here I am setting aside investments made prior to the credit crunch, and ICBC’s purchase of a stake of South Africa’s Standard Bank) represents around 3% of the over $1.5 trillion (or more) in new funds that central banks and sovereign funds have been asked to invest over the last year. The $1.5 trillion number is my estimate, but it is based on real numbers: the IMF’s COFER data, the increase in SAMA’s non-reserve assets, reported inflows into Norway’s government fund and estimated inflows into the big Gulf funds and the estimated increase in the assets of Chinese state banks and the CIC. $50 billion represents an even smaller share of the total stock of sovereign investments. This point applies with particular force to China. The $5 billion the CIC invested in Morgan Stanley represents less than 1% of the likely increase in the foreign assets of the government of China once all the funds that have shifted to the state banks are added in. Evaluating the overall impact of sovereign funds, central banks and state banks managing sovereign money requires looking at overall sovereign flows, not just the very visible capital injections into (formerly?) private financial institutions. That leads to my second point – namely, central banks and sovereign funds haven’t provided enough information to evaluate their overall impact on the market. In the first quarter – and I suspect the second quarter as well, though the IMF data won’t be released for a while – emerging market central banks that do not report even basic data about the currency composition of their reserves accounted for almost two times as much global reserve growth as emerging market central banks that do report data to the IMF ($225 billion or so v $112 billion). Industrial country central banks – who do disclose the currency composition of their reserves – added another $30 billion. But China’s state banks, who also don’t disclose much, accounted for another $15b in the first quarter. Sovereign funds -- on the assumption that about $75 billion was shifted to the CIC and the oil funds chipped in another $50 billion – accounted for another $100 to $125 billion. Sum it all up and the IMF had data on the currency composition of about 1/3 of the $450-500b in sovereign flows in the first quarter. The IMF has no information of the bond/ equity split of the reserves of even reporting central banks – and no information to determine whether sovereign investors have been taking on credit market risk or shedding credit market risk. Central banks don’t report that kind of data as part of the COFER process, and there is no analogue to the “COFER” data for the foreign assets of sovereign funds. This makes me suspicious of arguments that sovereign funds have been a stabilizing force in the market. Unless the IMF has access to additional information that allows them to see how the portfolios of sovereign funds have evolved over the past year, I would think the IMF should be arguing that sovereign investors have not disclosed enough information about the broad contours of their portfolio to allow the IMF to make an informed judgment about their overall market impact. They may be stabilizing. They may not. Absent a bit more disclosure, it is impossible to know. I don’t think sovereign funds can have it both ways: if they want to argue that they are a stabilizing force in the market, they need to disclose enough information for outside observers to be able to verify their claims. Ted Truman has this right. He writes: it is elitist to argue that SWFs should be judged by their past investment track records as privately evaluated, for example, by so-called market professionals. The current IMF-facilitated effort to increase the accountability of SWFs via increasing their transparency should be directed at establishing track records for the inspection by the citizens of the countries with the funds and the citizens of the countries in which they invest. Absent more disclosure and a public track record, it is impossible to know exactly how sovereign investors are influencing markets. But the available evidence suggests a flight away from credit market risk, not a flight toward credit market risk. That is my third point. We know that demand for corporate debt from “sovereign wealth fund and central bank” hubs like London has plummeted. That likely reflects the unwinding of SIVs and conduits, not a big fall in sovereign demand. But it is also indirect evidence that sovereigns haven’t been buying what the financial institutions now need to sell. We know that if you sum up private purchases of Treasuries and Agencies are added to recorded official purchases to produce a proxy for "true" central bank purchases, central banks have purchased something like $525 billion of Treasuries and Agencies over the past year (and another $50b of short-term debt). We know that there has been a very strong increase in FRBNY’s custodial holdings. We also know a few other things. -- India has shifted its deposits out of commercial banks and into the BIS and other central banks. This suggest a flight away from credit market risk, not a flight toward risk on the part of one major sovereign investor. -- Russia has – as noted above – shifted away from the Freddie and Fannie and towards Treasuries and perhaps Agencies with an explicit “full faith and credit” guarantee from the US government. Again, at the margin, this is a shift away from credit market risk. -- China’s state banks – who could be the fifth largest source of sovereign investment in the world, trailing only China’s SAFE, the Bank of Japan, the Bank of Russia and the combined portfolio of Abu Dhabi’s proliferating sovereign funds – have reduced their exposure to US credit market risk. The evidence here comes from the data the PBoC releases about the foreign currency “portfolio investments” of China’s banks. Such portfolio investments rose from about $125 billion at the end of 2005 (and a bit under $90 billion at the end of 2003) to a peak of around $195 billion in q2 2007 (with most of the increase coming in 2006) before falling back to around $165 billion at the end of 2007. China’s hasn’t updated this data for 2008 (More evidence of a fall in China’s overall transparency as the number of institutions managing China’s foreign exchange has proliferated) but I get a sense that the basic trend hasn’t changed. The US balance of payments data for China – released on quarterly basis – also shows a fall in “private” Chinese purchases of US securities. Chinese investors have gone from purchases (on a rolling four quarter basis) of around $20 billion to net sales (in the four quarters through q1) of around $15 billion …. To be clear, these sales are dwarfed by recorded official Chinese purchases. Moreover, the recent US data understates China’s purchases (it will be revised up soon to reflect the last survey results, and then it will be revised up more in a year to reflect the June 2008 survey). My guess is that – given the scale of China’s foreign asset growth – China’s true purchases of US assets are in the $400-500 billion range – or about twice what the US balance of payments data now shows. You can argue that the state banks are banks, not sovereign investors. But that argument seems thin to me. The banks are owned by the CIC after all (which makes it hard for me to take the CIC’s claims that it doesn’t take controlling stakes seriously; at best that argument only applies to their external investments). And they are managing funds placed with them by the CIC and the central bank, whether through the use of fx as part of their recapitalization, swaps with the central bank or the foreign exchange that they are now likely holding as part of their reserve requirement. Moreover, I wouldn’t be surprised if some other sovereign investors who previously had been dabbling in credit risk also have pulled back. The overall story is one where sovereign investors – who now control big bucks – have piled into safe debt and safe assets while shying away from riskier assets. That has kept real rates on Treasuries very low. But it also has contributed to wider credit spreads – and thus a fairly high cost of borrowing for many actors in the US. I would postulate that if full information was available about the activities of the official sector, the mostly likely conclusions to emerge would be that sovereign investors: -- Helped to stabilize the banks’ capital position, though perhaps they also contributed to a sense among the banks that they didn’t need to take decisive action to clean up their balance sheets. -- Helped to keep long-term Treasury rates stable, and quite low, given the rise in inflation. The fiscal deficits of the Bush Presidency have been financed almost entirely by the world’s central banks. -- Helped to keep the dollar stronger than it otherwise would have been, including against the euro. Reporting central banks bought $117 billion of dollars in q1 2008, and only $27 billion of other currencies -- a flow that was heavily tilted toward the dollar when the dollar was under a lot of pressure. Here though it is important to note that institutions that don’t report data to the IMF could have easily overwhelmed the institutions that do report data to the IMF, as institutions that don’t report now account for the majority of official flows. -- Added to instability in the credit markets – and thus hurt the very banks that they – or their brethren -- were recapitalizing. Sovereign funds have seemed more willing to buy the equity of banks that are heavily exposed to credit risk than to actually take on credit risk themselves. -- Perhaps added to pressure in the commodities market by buying into commodity funds. Abu Dhabi’s Taqa certainly seems keen on buying oil and gas assets, even though that hardly helps to diversify Abu Dhabi’s commodity exposure. Taqa is a (leveraged) state enterprise, not a sovereign fund. I would not be surprised if some sovereign funds have been dabbling in commodities. But absent more disclosure on the part of sovereign investors, it is impossible really know. Particularly in a world where the sovereigns that disclose the least are adding the most to their assets. UPDATE: For an example of an article asserting that sovereign funds have stabilized credit markets, see this Market Watch article. "The [sovereign wealth] funds played a role in stabilizing the global credit markets over the last six months, injecting more than $80 billion in bank shares or bank-equity stakes in major American investment banks such as Citigroup" The actual amount committed to US banks and broker-dealers is more like $40b -- not the $80b mentioned in the article. I don’t even think adding in Barclays and UBS would quite get you up to $80b. But $40b is still a substantial sum, and putting capital in a bank allows it to support a larger portfolio of risky debt. However, evaluating the overall impact of sovereign funds (and more importantly all sovereign investors) would require looking at how sovereign investors have acted directly in the credit market, i.e. have they retreated from credit market risk. John Jansen also reports that Agencies remain well-bid, and that Russia’s decision to cut its Fannie and Freddie holdings is atypical.