Henry Paulson, the US treasury secretary, visited West Asian countries in May to request their sovereign wealth funds (SWFs) to keep on investing in US financial institutions. Perhaps, he had reasons to be anxious for their support. According to economist Brad Setser, most SWFs incurred losses on their investments in the first quarter. They have lost money that does not belong to them. That most SWFs have been set up by governments, which are unburdened by accountability, is no coincidence.
The combination of financial institutions, with incentives that reward returns without due consideration for risks, and SWFs is harmful for the tax-paying public in countries that set up SWFs—and for the stability of the global economic and financial system.
Revenues accrue to governments from their power to tax. Accumulated budget surpluses turn into assets. If they keep rising over many business cycles, then the government is either overtaxing or underspending, or doing both. It should spend more where its expenditure would elevate the potential growth rate of the economy. If it cannot, it should either temporarily or permanently lower the tax rate. There is no need for an SWF.
When there is a positive terms-of-trade shock, such as that accruing to commodity producers now, surpluses would accrue to companies. If governments own them, government enterprises would earn those revenues. The dividends and taxes they pay into the government exchequer should be shared with taxpayers.
Instead of doing that, governments set up SWFs to invest surpluses that belong to the public. Governments are not meant to play that role. They do not have the skills. If they hire foreign talent to do so, they create a fresh set of moral hazards for themselves. The very idea of keeping some of the strategic sectors under government ownership is stood on its head, then.
SWFs would pose serious risks to global financial stability over time, if not now. Conflict of interest arises in the confusion?of roles that occurs? when governments, which are supposed to be regulators protecting public interest from wrongful or criminal behaviour of private players, become investors. An example would make clear the potential for conflict of interest.
According to the Financial Times, Western regulators have recently discovered to their horror that “some banks have been exploiting so many regulatory loopholes in recent years that they have got away with posting virtually no capital reserves against assets, such as the senior tranches of Collateralized Debt Obligations (Gillian Tett: ‘The champagne flows no more’, 5 June)”.
Other systemic risks need to be kept in mind, too. Financial institutions tend to benefit from greater financial liberalization globally. Of course, that this comes at the expense of rising systemic risks is now well known. Carmen Reinhart and Kenneth Rogoff have published a weighty empirical paper on eight centuries of financial crises. One of their conclusions is that “periods of high international capital mobility have repeatedly produced international banking crises”. Would SWFs investing in foreign financial institutions encourage them and/or lobby for international capital mobility knowing these results, in their quest for returns on their investments?
Wall Street sees revenues from the rise of SWFs, and is busy moving executives from London and New York to Dubai and to Asia to intermediate investment deals for them. So, domestic population would be best advised to start from a position of scepticism on the investment proposals that come the way of SWFs from the deal makers. Larger public interest and Wall Street are usually orthogonal to each other.
Writing for Foreign Policy in Focus, Robert Cassidy, former assistant US trade representative for Asia and for China, confesses now that the beneficiaries of China’s agreement to enter WTO have been multinational companies that moved to China and the financial institutions which financed those investments, trade flows, and deficits. Unsurprisingly, it was to China that American and European financial institutions have turned first, not to their own public, when they looked for cash recently.
Viewing SWFs from another prism would help to focus on the danger more clearly. Agency theory led to the creation of incentives to align managers’ interests with those of shareholders. The result, particularly in the US, is there for all to see. With regard to SWFs, the shareholders are the tax-paying public. The government is in the shoes of managers. SWFs invest in firms where managers have successfully been practising the art of enriching themselves more at the expense of workers and shareholders. The risk of collusion between both sets of managers at the expense of the ultimate shareholder is hard to dismiss.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org