Capital Flows

Capital flows through London are often taken as a proxy for petrodollars. Bloomberg’s Daniel Kruger, for example, argues that the buildup of Treasuries (and I would assume Agencies) in the UK reflects oil money. The Organization of Petroleum Exporting Countries held $153.9 billion in Treasuries at the end of April, Russia had $60.2 billion and Norway owned $45.3 billion, according to the Treasury Department. Combined, that represents a 113 percent increase from 12 months earlier. Oil producers own a majority of the $251.4 billion in Treasuries held in the U.K., an 85 percent increase. Unicredito’s Dr. Harm Bandholz also uses capital flows through London as a proxy for petrodollar flows. This isn’t unreasonable. London probably manages more petrodollars -- and more Gulf sovereign wealth fund money -- than any other financial center. And there is a reasonably close correlation between the UK’s purchases of Treasuries and the price of oil (or my estimate of oil foreign asset growth). Correlation though, doesn’t imply causation. There is also a close correlation between purchases of Treasuries and Agencies through London and China’s reserve growth. And yes, this graph implies that Chinese reserve growth has been quite correlated with the price of oil. That in some sense is the core source of the world’s imbalances: China is running a big surplus and building up its foreign assets at an extraordinarily rapid pace even as the oil exporters’ surplus soars. The pattern of revisions to foreign holdings of Treasury and Agency bonds further suggests that China accounts for more of the Treasury and Agency bonds purchased through London than the Gulf. See the charts at the end of my last post on the TIC data. I’ll provide one more example of a false correlation involving London -- one I know well because I was almost convinced that I had discovered something important a year ago, but fortunately didn’t publish it because I couldn’t quite make everything match up. Up until the end of 2006, rising oil prices and UK purchases of US corporate debt (a category that includes all asset backed securities that lack an Agency guarantee) were highly correlated -- at least if you looked at the 12m sum of corporate bond purchases and the 12m average oil price. That correlation, though, completely broke down in late 2007. The rise in UK purchases of US corporate debt seems to have reflected the expansion of London-based SIVs and the "shadow" banking system far more than "petrodollars." These flows collapsed after August. Oil prices -- and one assumes, petrodollars, kept on rising. It is also interesting to note that purchases of equities by UK investors -- a category that might be expected to pick up purchases of US equities by London-based fund managers playing with Gulf money -- hasn’t tracked the oil price all that closely recently. I suspect this is more evidence that a lot of Gulf money is on the sidelines than evidence that the Gulf isn’t the ultimate source of demand for a lot of the UK’s purchases of US equities. But I am just guessing. London hosts so many different kinds of institutions that it is hard to know -- a priori -- precisely which set of investors is behind any given flow. We might have a better idea if the UK made an effort to produce decent capital flows data. But there isn’t much evidence that the British government is all that interested in understanding the origin of the money that passes through London. And as a result, we are all left making informed guesses.

My initial reaction to Henny Sender’s front page FT article was probably the opposite of most. I wasn’t all that surprised that sovereign funds are reducing their dollar exposure -- though cutting their dollar exposure when the dollar is under pressure does suggest that they, unlike central banks, haven’t been a stabilizing force in the foreign exchange market. I was, though, surprised that "one big sovereign fund in the Gulf" had 80% of its assets in dollars a year ago, and still has 60% in dollars now. 60% is substantially higher than I would have expected. It also is a bit higher than the IMF assumed in its modeling of sovereign funds: their well-established diversified fund was assumed to have 38% of its portfolio in dollars (see the appendix of the IMF’s recent SWF paper) Moreover, if a major Gulf fund is 60% in dollars and the Gulf’s central banks have an even higher share of their assets in dollars (the UAE’s central bank recently indicated that 95% of its assets are in dollars), the Gulf as a whole has even more dollar exposure than Rachel Ziemba and I thought. Sender’s article is full of interesting tidbits. The obvious question to ask is which big sovereign fund in the Gulf had 80% of its assets in dollars until recently. I would assume that major excludes Oman and Bahrain -- and I would also assume that the reference to "sovereign wealth fund" excludes the Saudi Monetary Agency. If Saudis, who are widely thought to keep most of their foreign assets in dollars -- had cut from 80% to 60% that would truly be news. That leaves the funds of Abu Dhabi, Kuwait and Qatar. The Qataris seem to have a lot of exposure to the UK -- and a wildly diversified real estate portfolio -- so they don’t seem like the most probable candidate. Plus, they have previously indicated that about 40% of their portfolio is in dollars. ADIA’s reported portfolio* is also geographically diversified, and its holdings are pegged "to global economic growth." It is hard to see how a portfolio linked to expected growth could be so over-weight the dollar, though Sender reports that currency risk is all managed by a central trading desk. Consequently, some of the currency exposure implied by ADIA’s diverse equity exposure could have been hedged. But it is hard to see how ADIA could be anywhere close to its current rumored size if it had that much dollar exposure and thus missed out on currency gains from holding euros and the financial gains from holding non-American equities over the past few years. That leaves Kuwait -- which hasn’t disclosed much about its portfolio. It was also fairly conservative until recently. But even there the fit isn’t perfect -- Kuwait has hinted in the past that its large stakes in BP and Daimler imply that its equity portfolio at least is geographically balanced. * The data in Business Week indicating that North America accounts for between 40 to 50% of ADIA’s portfolio explicitly excludes ADIA’s investment in private equity, hedge funds, real estate, infrastructure and cash. It consequently could understate ADIA’s dollar exposure. And ADIA could have hedged out the currency risk on its European and Asian portfolio. Sender’s article also notes that SAFE is seeking out European private equity firms -- and even encouraging "private equity firms with which it has relationships" to invest in natural resources companies. China’s State Administration of Foreign Exchange (SAFE) has been looking to strike deals with private equity firms in Europe as a part of a strategy to reduce its dollar holdings. ... By allocating money to Europe-based private equity firms, SAFE could diversify away from the dollar, at least at the margin, without spooking the currency markets and driving the dollar down in a disorderly manner. In addition, SAFE is encouraging the private equity firms with which it has relationships to make investments in natural resources companies in markets outside the US - in part, to hedge its exposure to the dollar. SAFE, not the CIC. The central bank, not the sovereign fund. PE funds investing in natural resource companies aren’t exactly a standard part of a typical central bank’s reserve portfolio. Here though I would note that the enormous scale of China’s reserves means that even large investments in private equity firms could be overwhelmed by SAFE’s ongoing bond purchases. Still, it is interesting to know that SAFE is looking to invest not just in oil firms like BP and Total but also is encouraging PE firms to invest in natural resources. But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy -- and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly. Sovereign wealth funds have played a leading role in helping to recapitalise faltering US banks, but have lost money so far on such investments. Continuing market turbulence has further shaken their faith in US policy and policymakers. .... Behind the scenes, fund officials are questioning the credibility of the Federal Reserve and US Treasury in defending the dollar and maintaining financial stability. Reacting to last year’s collapse of structured investment vehicles, the head of one Middle East fund said: "I thought the problem of off-balance sheet had gone away with Enron." The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows. If the US economy spirals down along the lines that some are expecting -- and if the Fed cuts rather than raises rates -- there is at least a hint that a few important creditors might balk at providing even more financing to the US than they do now.

If oil stays at $140, the Gulf -- based on projections that imply GCC spending and investment will rise so that the GCC needs $55 to $60 oil to cover its import bill -- the big GCC funds and central banks should add close to $400 billion to their foreign assets in 2008. That isn’t bad for a region whose total GDP was about $400 billion as recently as 2003 (see the IMF). It is also a reminder that the institutions that manage the Gulf’s foreign assets will do more than determine the size of some investment bankers’ bonuses. They increasingly will shape global capital flows. The graph showing the estimated overall increase in the GCC’s assets also shows the estimated inflows into individual funds. That is my little contribution to increasing global transparency. Each of the big Gulf funds is worth getting to know a little bit better. SAMA is the Saudi Arabian Monetary Agency. It now has around $365 billion in foreign assets -- and manages additional funds for the Saudi pension system. Its asset allocation isn’t disclosed, but it is likely to be the most conservative of the big Gulf funds. ADIA is the Abu Dhabi Investment Authority. It has a revamped, but still not very informative website. SAMA isn’t as slick, but it releases more data - and the Saudis aren’t known for their transparency. Business Week’s profile of ADIA has far more information than the web site). That said, we now pretty much know that ADIA doesn’t have as much money as some investment banks are claiming. The IMF’s Moshin Khan has said as much. So has Abu Dhabi’s emir-- Sheik Khalifa. He is among the few who certainly knows ADIA’s true size. Unless someone has better information (or believes that Sheik Khalifa is understating ADIA’s size), I would argue that journalists should stop using $825 billion as an estimate for ADIA’s size -- let alone the $1.25 trillion estimate sometimes thrown around. It is very big -- especially given Abu Dhabi’s small population -- but not quite that big. There is a risk that the Setser/ Ziemba estimate ($650b at the end of 2007) may be a bit on the high side. $250 billion was bandied about a little less than two years ago. QIA is the any website">Qatar Investment Authority. It isn’t a beacon of transparency. Don’t look for a website. But as a result of the QIA’s stake in Barclays, we now know that the QIA’s chairman (and Qatar’s Prime Minister) , Sheik Hamad, often invests alongside the QIA for his personal account. Sheik Hamad’s fund -- Challenger -- is putting $1 billion into Barclay’s; QIA is putting in a bit more -- up to $3.4 billion. Sheik Hamad’s co-investment is consistent with a lot of the informal "color" about the Gulf. The dividing line between a sovereign wealth fund and the sovereign’s personal wealth sometimes isn’t completely clear. KIA is the Kuwait Investment Authority. It also has revamped its website -- and it provides a bit more information than ADIA. Like ADIA, it doesn’t disclose data on its size on its website. Unlike ADIA, it reports that data to Kuwait’s Parliament. We know it had $264.4 billion at the end of March 2008. That is somewhat less than SAMA’s foreign assets. Sum it all up though and it is clear that the Gulf had a lot of money even before oil rose to $140 billion. The graph above just shows the estimated inflow into the Gulf funds from surplus oil revenues. It doesn’t include the returns on the Gulf’s existing portfolio. Such returns aren’t going to be very impressive this year. But it doesn’t really matter. Not if oil stays this high. Qatar, which has close to a million inhabitants, had a per capita GDP of around $80,000 in 2007, when oil was about 1/2 its current level. That calculation includes Qatar’s guest workers. But the oil revenue goes to Qatar’s native inhabitants, who number less than 200,000. The per capita income for native born Qataris could be north of $300,000 a year. Qatar has more oil (and gas) relative to its population than most. But the other Gulf states aren’t doing badly. Oil, it seems, isn’t much of a curse if the price is high enough.

Sovereign funds have attracted a lot of attention recently. With some cause. They have the potential to get very large very fast. Not all sovereign funds are content to be pure portfolio investors. Sovereign funds are evolving as they are expanding. But their current impact on financial markets is easily (and often) over-stated. The overwhelming majority of the enormous increase in government foreign assets still comes from the growth in central bank reserves. The majority of central banks’ foreign assets are still invested in Treasury and Agency securities. The shift to a world where sovereign investors primarily buy equities has yet to happen. That is what the US balance of payments data for q1 shows. The following graph, which draws on the monthly TIC data to show the rolling 3m sum of foreign purchases of long-term Treasuries and Agencies relative to both official purchases of equities and the rise in official holdings of short-term Treasuries and Agencies, tells the same story. Immediately after the August crisis central banks piled into short-term Treasuries and Agencies. In December and January, some well-established funds -- together with the CIC -- famously bought some equity in US banks, generating the upward blip in official purchases of equities. But those investments haven’t worked out so well. Now central banks are back to buying enormous sums of Treasuries and Agencies. Here is is important to remember that the TIC data understates official purchases of Treasuries and Agencies and purchases by emerging economies. Remember all those London purchases? The pattern of revisions to foreign holdings of Treasuries suggests after the US survey data is released suggests that a large share of China’s purchases, not just the Gulf’s purchases, comes through London. Indeed, I would argue that central bank purchases are likely to be closer to total foreign purchases of Treasuries and Agencies than recorded official purchases. I actually am not going out on much of a limb here. The US Treasury agrees with me. Read the fine print of the latest survey. The Treasury writes (p. 14): "Foreign official holders were responsible for all of the increase in total foreign holdings of log-term Treasury securities during the June 2006 to June 2007 period. ... Foreign official holders also accounted for about three-quarters of the increase in total foreign holdings of US agency debt securities during the intra-survey period. Although the survey measured foreign official holdings of U.S. long-term securities of more than $2.5 trillion in June 2007, it is likely that this figure somewhat underestimates true foreign official holdings. ... However, the degree of the undercount is less in the annual surveys than in the monthly transactional data." I suspect Francis Warnock would agree with me here as well. He has occasionally used total Treasury purchases in the TIC data as a proxy for official inflows. And anyone who reads John Jansen’s ongoing bond market commentary will quickly learn that central banks are a big player in the market. Why does this matter? 1) The central flow of the global economy -- and dominant means of financing the US external deficit -- continues to be the sale of US Treasury and Agency bonds to foreign central banks. Recorded official purchases of Treasuries are nearly as high as they were in early 2004 -- when Japan’s huge purchases were a big story. Total foreign purchases of Treasuries -- which are likely to be a more accurate measure of true central bank demand -- over the past three months reached $150 billion. That is higher than the 2004 peak. Total foreign purchases of Treasuries and Agencies over the last 3ms easily topped $200 billion. That is enough to cover the entire US current account deficit. 2) They raise questions about arguments that based on a hypothesized shift by governments from liquid cash-like assets toward less-liquid, less-cash like investments. Guillermo Calvo, for example, has argued that a shift by foreign central banks out of cash put upward pressure on US interest rates that the Fed resisted to reach its own policy target, and thus contributed to expansionary monetary policy and the rise in commodity prices. Krugman isn’t convinced. Nor am I, but for different reasons. A shift by sovereign funds away from short-term bills is a central part of Calvo’s argument (at least as I understand it), as "low and momentarily pegged central bank interest rates imply that the fall in the demand for Treasury Bills results in an expansion of the money supply." But the available data suggests a shift into bills by central banks last fall -- not a shift out of bills. Commodity prices were rising then too. And to the extent that demand for bills is now falling, it is because central banks are buying slightly longer-term Treasuries. Moreover, my sense is that there was a strong shift into safe bills by money market funds; that -- I suspect -- is why the Fed has both been able to lower rates without expanding its balance sheet much. The Fed has actually been a large net seller of bills as it tries to meet private demand for safe assets. Its holdings of bills are down $255 billion since last June. Sovereign wealth funds have more money than before. There is a real question whether they are quietly allocating more money to commodity index funds, and thus adding to demand for "paper" commodities. But central banks also have a lot more money than before. The available evidence suggests the vast majority of the growth in official assets is still plowed back into the Treasury and Agency market. That feels like 2003 and 2004. Central banks are basically financing the expansion the fiscal deficit. Less has changed than you might think. Sovereigns are buying more equities than in the past. But they are also adding closer to $1.5 trillion to their assets a year than $750 billion. They are buying far more bonds than in the past even as they buy more equities. And their total purchases of bonds dwarf their purchases of equities. And "paper" commodities.

I found the Times’ article (hat tip, SWF Radar) on the China’s plans to invest abroad to be somewhat confusing. The article’s headline claimed "Plans are are afoot to diversify its [China’s] holdings of reserves without causing political rows." But what are those plans? Well, the CIC "will help [China’s] state-owned companies to expand overseas in a shift of strategy" and specifically will "assist inexperienced Chinese companies in financing, foreign-exchange risk management and handling trade barriers." Yet it isn’t at all obvious -- at least to me -- that using a sovereign fund to assist state firms is a strategy for avoiding political rows. The article jumps between three very different ways China’s government is looking to gain equity market exposure abroad: 1) Supporting Chinese firms -- Haier, Baosteel, no doubt others -- looking to expand expanding abroad; 2) Handing funds over to private equity funds and other external managers; 3) Buying equities in the public market. These are conceptually different different activities, and raise different policy issues. The CIC seems to be doing all three. SAFE doing the last two -- though the foreign exchange it has placed with the state banks is also available to support Chinese state firms. Much of the confusion in the Times article comes because it starts by indicating that Beijing has decided to use the CIC/ SAFE to support Chinese state firms and then jumps to a list of the various investments the CIC and SAFE have made without really explaining how these investments relate to this new reported strategy. And best I can tell, there is no connection. China has plenty of funds to commit to all three strategies. The Times article does include some useful new information though. Caijing apparently has reported that the State Council has authorized SAFE to invest up to 5% of its portfolio in equities. However, the magazine [Caijing] quoted a former official as saying the state council had authorised spending 5% of the $1.7 trillion reserves on shares in foreign companies. SAFE likely now has more than $1.7 trillion -- the last data point we have is for end-April, and we aren’t far from the end of June. 5% of $2 trillion is $100 billion, enough to make SAFE one of the largest sovereign equity investors in the world even though it technically isn’t a sovereign fund. The distinction between a sovereign fund and the investment portfolios of some over-reserved central banks is often very thin. The fact that China is looking to encourage its state firms to expand abroad shouldn’t be a huge surprise. After World War 2, the US ran significant current account surpluses, which combined with capital inflows from central banks needing to build up their dollar reserves -- that in an economic sense financed foreign direct investment by US companies. China is in a similar position. It now has a large -- roughly $400 billion -- current account surplus that could be used to finance direct investment abroad. It has successful domestic firms but those firms have a fairly small global footprint. The outward expansion of private US firms after World War 2 generated plenty of controversy though. I would guess the outward expansion of Chinese firms will generate at least as much. And there is a critical difference between the US then and China now. After World War 2, the dollar was strong, which facilitated private investment abroad by US firms. By contrast, China’s currency is weak. A profit maximizing Chinese firm wouldn’t want to finance investment abroad with RMB. The outward expansion of Chinese state firms consequently hinges on the willingness of China’s state to make the dollars it is accumulating to hold its currency down available to Chinese state firms -- and then making sure those firms do not use the dollars they have received from China’s state to buy RMB. The state’s large role in the process strikes me as a major additional source of friction -- hence my surprise that the Times would indicate that a plan based on supporting Chinese state firms was part of a strategy of avoiding political rows. If China wants to diversify into equities without causing political rows, the obvious strategy is to invest in equity index funds. And to disclose its equity exposure, in much the same way the Swiss do. China clearly hasn’t opted for this strategy.

It looks like one of the CIC’s mandates it to support the outward expansion of Chinese firms, particularly in strategic sectors. Via SWF Radar and the Wall Street Journal comes news that the CIC is interested in being a part of a consortium of Chinese steel firms bidding for a Brazilian iron ore mining company. A consortium made up of Chinese steelmakers and China’s sovereign wealth fund is entering the initial round of bidding for a stake in the iron-ore unit of Brazil’s Companhia Siderurgica Nacional SA, people familiar with the situation said Thursday. The group’s interest, though preliminary, shows the importance China places on securing supplies of ore and other natural resources amid the current commodities boom .... CSN, one of Brazil’s leading producers of both steel and iron ore, has invited bids for all or part of Nacional Minerios SA, or Namisa, its unlisted iron-ore unit. Major Chinese producers including Baosteel Group Co., Shougang Group and Shagang Group, as well as China Investment Corp., a $200 billion investment pool run by the Chinese government, are interested in the unit, one person familiar with the matter said. But the final composition of the consortium isn’t finalized yet, this person said. If this story is true, the debate over whether the CIC’s mandate includes supporting the outward expansion of Chinese firms would be settled. On one level, it would be positive for the global economy if China’s balance of payments surplus financed deficits elsewhere in the emerging world -- not just deficits in the US and Europe. Redirecting some of China’s foreign asset growth away from the US and Europe could contribute to such an evolution, as would willingness on the part of those emerging economies receiving inflows from China to allow their currencies to appreciate. Brazil would use money borrowed from China to buy more US and European goods, helping the global economy to adjust. On another level, it is a little hard to see how China can argue that the CIC is a purely commercial investor when it is actively supporting Chinese state firms. It is hard to see how a government fund that has to choose to finance the overseas ambitions of some Chinese companies and not others could be insulated from domestic political pressure. Moreover, the CIC is supporting one of the strategic goal of China’s state, namely helping -- in China’s view -- to secure a reliable supply of the mineral resources China’s economy needs. There is a fair debate over whether owning resources abroad truly is necessary to secure supply, or whether resources will always be available to the highest bidder. But China’s government seems to believe that greater Chinese ownership of mineral resources would help it navigate a world where China’s economy is much less self-sufficient than in the past. China only became a large net oil importer fairly recently. Vertical integration is a common commercial strategy. But vertical integration supported by a government fund investment fund feels more like a scramble by states to secure access to strategic resources than pure commerce.

The CIC claims it wants to be a commercial investor. Gao Xiqing is often quoted to the effect that the CIC "operates on commercial principles" and intends to only take passive stakes. I have always found that those claims sit uncomfortably with the CIC’s current portfolio, which is dominated by stakes in China’s state commercial banks. Those state banks are used to support the government’s policy objectives. Right now, for example, they are being encouraged to hold dollars to help the central bank manage the unprecedented growth in China’s foreign assets. They also can be asked to lend to strategic sectors. However, the CIC’s stake in the state banks can be viewed as a legacy of China’s 2003 decision to use foreign exchange reserves to recapitalize the state banking system. If they are in effect grandfathered in; the rest of the CIC’s portfolio could be determined by risk and return. But it will be very hard for the CIC to make that argument if one of its mandates is to help finance the expansion of Chinese enterprises abroad. And apparently that is part of its mandate. Sender and Guerra of the FT reported, in a story about Haier’s potential bid for GE’s appliance division: Executives at China Investment Corp say that one of their mandates is to help finance such moves abroad. Banks such as China Development Bank could also be tapped to help finance a bid and even take a slice of equity in any deal. Supporting national champions is a separate mission from managing an external portfolio that maximizes risk-adjusted return. For that matter, I suspect it will be hard for the CIC to argue that it is a purely commercial investor if the state banks that it owns aggressively support Chinese state enterprises as they expand abroad. China isn’t Abu Dhabi. It has a competitive, growing domestic industrial sector – sometimes state-owned, sometimes privately owned -- that wants to expand abroad. A company that wants to expand abroad could borrow RMB to buy dollars – and then use those dollars to expand abroad. But that leaves it exposed to the risk of future RMB appreciation. Far better to borrow some of the state’s dollars. As a result, there is pressure inside China to use the government’s foreign reserves to support Chinese firms. Cheng Siwei for example argues that China should be purchasing companies rather than Treasuries. He isn’t alone: some national enterprises under State-owned Assets Supervision & Administration Commission have advocated that China’s foreign reserve should be invested in industrial and strategic resources. But using government resources to finance the outward expansion of Chinese national champions sounds a lot like an extra-territorial industrial policy -- something that that is bound to generate concerns outside China. Right now, the CIC seems to have five missions: -- supporting China’s exchange rate regime by raising funds in RMB to buy foreign assets. It may also face limits on the extent it can diversify its external portfolio away from the dollar so long as China manages the RMB against the dollar. Massive dollar sales by the CIC that drove down the dollar might put unwelcome downward pressure on the RMB -- managing an inhouse portfolio of foreign securities -- selecting external fund managers to manage a portion of its investment portfolio (a process that assures the CIC will have friends abroad) -- managing China’s strategic equity stakes in the state commercial banks. It is a holding company for the state’s investment in the domestic financial sector. -- supporting Chinese state enterprises as they expand abroad, whether directly or through funds placed with the state banks The first three arguably fit well together, though supporting China’s exchange rate regime could at times conflict with investing in ways that maximize return. But I am not sure that supporting Chinese firms and managing the state’s strategic stakes in the state banks fit well with the CIC’s other objectives. As importantly, I suspect that the CIC was set up without full consensus inside China on what it should do. As a result, there is a constant battle between those who want the CIC to do more to support state firms, and those who want the CIC to focus on external investments. Large losses on the CIC’s high profile investments abroad likely provide those who think the CIC should do more to support state firms with ammunition; they can argue that supporting Chinese firms expanding abroad may produce better returns than investing in say the US equity market – or a US investment bank. The battle over what the CIC should do, in turn, means that its investment process risks being highly politicized. China’s top leadership gets drawn into the debate. It has to decide, for example, if the CIC should bid on Rio Tinto -- or whether the CDB should finance a state firm looking to buy a stake in Rio Tinto. China’s top leadership likely will have to decide if the CIC should help finance Haier. Back in May, the magazine "Emerging Markets" published an article -- an oped really -- where I laid out my concerns about the CIC’s complex mandate. It is now online as well. I touched on many of the these issues -- and the tension between the CIC and SAFE -- in my lengthy January paper on the growth of China’s foreign assets.

SAFE is China’s State Administration of Foreign Exchange. It enforces China’s capital controls -- and manages the foreign exchange reserves of China’s central bank. Lately though it hasn’t necessarily been investing in classic central bank reserve assets. Participating in a TPG fund is something an aggressive sovereign fund might do, but not something a traditional central bank would even consider. SAFE clearly wants to show that with enough flexibility, it can get the same kind of returns (or better returns) than the CIC. If I had to bet, I would guess that SAFE now manages a larger equity portfolio (counting investment in private equity firms) than all but five or so of the big sovereign funds. ADIA, KIA, Norway’s government fund all likely have a bigger equity portfolio than SAFE. Temasek and the GIC likely to so too, though I am a bit less sure on that front. Temasek and the GIC combined likely have bigger equity market exposure than SAFE, but a lot depends on just how much equity SAFE has bought since June 2007 (the last good US data point). SAFE almost certainly has more equity market exposure than the CIC. If China’s reserves continue to increase at $75-80 billion a month, SAFE could quickly become among the biggest sovereign equity investors. The FT’s sovereign fund (and PE) beat reporter Henny Sender was struck by how large SAFE’s investment in the TPG fund was. China’s State Administration of Foreign Exchange has agreed to invest more than $2.5bn in the latest TPG fund, in what could be the largest commitment ever made to a private equity firm, people familiar with the matter say ... Investments in private equity firms are usually not made public, but industry executives believe the largest previous investment in a private equity firm came from pension funds in the US states of Oregon and Washington. The two funds both invested about $1bn to $1.5bn in Kohlberg Kravis Roberts. I though am struck by the fact that $2.5 billion is less than a day’s reserve growth, and thus not really all that much money for China. $75 billion -- really $80 billion after valuation changes are taken into account -- translates into something like $4 billion to invest every business day. The scale of China’s April reserve growth -- and indeed China’s 2008 reserve growth, once the funds China is assumed to have shifted to the CIC in q1 are taken into account -- is truly astonishing. China’s $75 billion in April reserve growth easily tops the United States $61 billion April trade deficit. And $60 billion a month still strikes me as a lot.

Kuwait - per Henny Sender of the FT -- has developed a taste for discounted mortgage-backed securities. That is a bit of a change. Up until now, at least based on the visible flows, investors in the Gulf have preferred Treasuries and Equities to mortgage-backed securities and corporate debt. Sovereign wealth funds have provided more than half the equity for the BlackRock fund that bought $15bn of troubled mortgage debt from UBS this month, people with knowledge of the matter say .... BlackRock raised $3.75bn in equity for the fund that bought the UBS mortgage debt. The rest of the money was borrowed from UBS itself, UBS has said. Some of the more sophisticated sovereign wealth funds, such as Kuwait Investment Authority , have been looking at acquiring real estate assets in the US, either directly or indirectly. KIA also has acquired stakes in real estate investment trusts, which are trading at bargain levels. Kuwait -- and any other fund that participated in the deal -- could have bought UBS’s mortgage-backed securities outright. It isn’t short of free cash. Not with oil trading above $125. It didn’t though. Instead it put up equity capital for a BlackRock managed vehicle that then borrowed funds -- in this case from UBS -- to buy a portfolio of riskier debt securities. That sounds a bit like a credit hedge fund. Kuwait’s investment authority isn’t the only investor in this vehicle, but it seems to be the biggest one. Sovereign wealth funds can not really argue that they don’t use leverage when they are investing heavily in structures that do. Ted Truman wrote in his recent - and highly recommended -- Peterson Institute policy brief: Sovereign Wealth Funds [SWFs] invest in hedge funds, private equity funds and in other highly leveraged financial institutions such as banks whose activities, including the use of leverage, are indistinguishable from hedge funds and private equity funds. In effect, SWFs provide the capital for firms subsequently to leverage and to generate high rates of return for the funds themselves. .... They [SWFs] should be held accountable for the investment behavior of the institutions in which they invest. He is right. This isn’t meant as criticism of KIA’s investment in the BlackRock vehicle that bought the mortgage debt UBS wanted to unload. The KIA is bringing new money into a market that needs it. It is, though, a criticism of the argument that the big sovereign funds are always unleveraged investors who take a long-term view. Sometimes that is an accurate description. Sometimes it isn’t.

Sovereign wealth funds, many argue, aren’t new. Kuwait set up its fund in the 1950s, Abu Dhabi’s fund was established in the 1970s. True enough. But this argument still misses a key point. In the past, these funds were small. Now they aren’t. The existence of sovereign funds isn’t new. But their current pace of growth is. They now have a far bigger impact on the global economy – and particularly cross-border capital flows – than in the past. And with oil now trading above $125 – and, at least according to Goldman – set to rise further, the Gulf funds in particular are poised to get even bigger. Fast. We still don’t know exactly how big the Gulf funds now are. Abu Dhabi continues to insist that it cannot match Kuwait’s level of transparency. We also don’t know quite how big they will become. But it isn’t all that hard to come up with a guess. If oil averages $115 over the course of 2008 (a price consistent with $125 a barrel oil for the rest of the year), the Gulf’s current account surplus should approach (if not top) $350 billion. The big existing Gulf funds (Qatar’s fund, Kuwait’s fund and Abu Dhabi’s fund) should get about $150 billion of surplus oil revenue to invest abroad. The Saudi Monetary Agency (and the new Saudi investment fund) should get another $200 billion. The math isn’t hard. Brad Bourland calculates that the Saudis’ oil export revenues top $1 billion a day if oil is above $115 a barrel. The Saudis only need $55 a barrel oil to cover their budget. The rest is stashed abroad. And even more will have to be stashed abroad if the Saudis follow the IMF’s advice and tighten fiscal policy to fight inflation … Rachel Ziemba and I have been trying to update our analysis of the Gulf’s foreign assets – and a key part of our analysis is trying to better understand how the big Gulf funds have evolved over time. Since the key Gulf funds don’t report data, this involves making some big guesses. However, it should be possible – using the information that the Gulf funds have released about the contours of their portfolio (most of the Gulf sovereign funds, for example, seem to have around 60% of their portfolio in equities) – and the balance of payments data to produce some estimates. Our preliminary estimates suggest that there is something new about the current size and pace of growth of the Gulf funds. The 2008 increase in the foreign assets of the Gulf oil exporters should be roughly comparable to their total foreign assets at the end of 2000. Consider the following graph – There are two major sources of uncertainty about the size of the Gulf’s official portfolio. The first stems from the lack of data about ADIA, the largest fund in the Gulf. If – as the Wall Street Journal reported in late 2000 -- ADIA only had about $150 billion at the end of 2000 and if its returns matched the returns on a set of broad market indexes, ADIA might only have $500 billion or so today. That is well below most estimates -- and below the trajectory implied in the graph above. To get a total in the $600-700 billion range (as in the chart above) ADIA had to have a sizeable emerging market equity portfolio and to have picked fund managers that outperformed the market. We didn’t explicitly try to model ADIA’s (assumed) participation in some high-flying (until recently) private equity funds; that could be one source of out-performance. And even the $600-700 billion portfolio above is far smaller than some market estimates. The second is that the Saudis are now rather consistently hinting -- see Henny Sender’s FT article -- that they don’t disclose all of their assets. The chart is based only on the Saudis reported assets. Generating a picture requires making some big assumptions. The potential for error is enormous. But there is little doubt that the Gulf funds grew significantly from 2003 to the end of 2007, propelled both by the rebound in global equities from the .com crash and large oil inflows. And there is even less doubt that $125 a barrel oil implies even more rapid expansion. To me, though, the growth in the foreign assets of China’s government over the past few years is even more remarkable than the growth in the Gulf’s funds over the past few years. China has more than kept pace with the Gulf. That is a major change from the last big oil shock. In 1979 and 1980, Asia ran a current account deficit, not a surplus. As a result, the big Asian emerging economies of the time were not building up their foreign assets at the same time that the oil exporters were building up their foreign assets. In 2007, the rise in China’s foreign assets likely topped the combined rise in the foreign assets of all the oil exporters. That likely will change if oil stays at $125 a barrel -- though if hot money flows to China continue, China could be surprisingly competitive. The resulting shift in global financial firepower -- a shift toward Asia, Russia and the Gulf; a shift toward sovereign investors; and a shift away from democratically-elected governments -- is staggering.

In 2006, Norway’s Government Pension Fund (Global) -- managed by Norges Bank Investment Management – famously bet against Iceland’s banks. Norway claimed this was just business; Norges Bank believed that Icelandic banks were more risky than the market thought, and thus produced a trading opportunity. Iceland claimed Norges Bank’s bet was a hostile act by another government. The Economist: IN REYKJAVIK almost two years ago the Norwegians were throwing their weight around and the locals were furious. Having spotted that an Arctic boom was about to end, a government-owned fund from Oslo must have thought it had found an easy way to make money in a market it knew well. It began to sell short the bonds of Iceland’s over-stretched banks. Only common sense, you might argue. Halldor Asgrimsson, then Iceland’s prime minister, did not see things quite like that. Why was the Norwegian state investing hundreds of millions of dollars to undermine Iceland’s economy? Had not both countries signed a Nordic mutual-defence pact against financial destabilisation? “We must protest against this action,” he told Morgunbladid, a newspaper. In 2008, Norway’s central bank agreed to lend some of its reserves – also managed by Norges Bank Investment Management – to Iceland. Norway, Sweden and Denmark agreed to enter into a swap contract with Iceland’s central bank that allows the Iceland’s central bank to acquire euro 1.5 billion from the other Nordic central banks in an emergency. David Ibison of the FT: Three Nordic central banks unveiled an unprecedented €1.5bn emergency funding package on Friday to support Iceland’s troubled currency and stabilise its banking system as the tiny north Atlantic nation tries to fend off the effects of the global credit crisis. The plan allows Iceland’s central bank to acquire up to €500m ($775m, £400m) each from the central banks of Sweden, Denmark and Norway in the case of an emergency, the first time the region’s central banks have joined forces to help a troubled neighbour. Norway is now effectively long Iceland’s banks – since Iceland’s central bank would, in an emergency, act as the foreign currency lender of last resort to Iceland’s banks. Presumably Norges Bank Investment Management got the message not to bet against itself. Sovereign money ultimately is a little different than private money. Governments use their foreign assets to support their political objectives – helping a fellow Nordic country in its moment of need, for example – as well as to make money. At times a government’s political and its commercial objectives may conflict. Making a commercial bet against the currency, equity market or banks of a friend, for example, can generate a bit of political friction. Those tensions look set to increase over time. Many sovereign wealth funds claim that they want to morph in sovereign hedge funds. They don’t just want to hire external managers to get big returns. They want to learn the techniques their external managers use to get big returns. Those techniques include leverage – and going short as well as long. It isn’t clear to me that countries struggling with concerns that their currency may already be too strong – take Brazil – really want sovereign wealth funds to join the world’s hedge funds and start betting on their currency. Would Brazil welcome a $10 billion CIC – or SAFE -- bet on the real? But it also isn’t at all clear that Brazil would welcome another country’s sovereign fund taking a massive bet against its currency … I will be interested to see if the IMF’s best practices (or perhaps its set of good practices, as there is no agreement on what constitutes best practices) address these issues. I bet not. Iceland, incidentally, isn’t just a good test case for how a sovereign fund’s commercial bets (one assumes) can work against a country’s political goals. It also is a test case for how a small country can be buffeted by global capital flows – with money piling in when rates are high and the currency rising and moving out once the trend breaks. Iceland’s float has been anything but stable. But that is a topic for another time.