Concerns about sovereign funds
Business Standard, 15 August 2007
The global equity market and the global bond market have a market capitalisation of roughly $55 trillion each. We are broadly comfortable with their functioning based on myriad small private players. In each traded product, regulators work to ensure that no player has market power. All private players try to make profits. Their ceaseless efforts at maximising returns keeps the system of financial prices in line, and drives the resource allocation of the planet.
New complexities have come about because governments have now become big players in financial markets. Official reserves now exceed $5 trillion, and `sovereign wealth funds' (SWFs) exceed $2.5 trillion. These are massive numbers in the aggregate. In coming years, these numbers are likely to grow sharply.
Governments as players raise a new set of difficulties which call for a fresh regulatory effort to uphold the functioning of a fair and competitive market economy. The key question is: Is a government different from an ordinary market participant? Governments do not maximise profit - this violates our core notions of well-motivated financial market participants leading to a sound risk/reward relationship in the structure of prices. Governments, in fact, can explicitly use their financial holdings in order to maximise ulterior goals.
As an example, consider the gigantic Chinese holdings of US government bonds in their reserves portfolio. Traditionally, holding first-world government bonds in a reserves portfolio is considered harmless. But the game has changed. As a response to protectionist pressures in the US, two Chinese policy advisors have said that China should consider retaliating by dumping US government bonds, thus triggering a crisis in the US bond market and on the US dollar. In China, policy advisors seldom speak without clearance from the communist party, so such sabre rattling has to be taken seriously. The prospect of a foreign government owning a large fraction of your government bonds is less benign than it used to be.
This particular fracas has come out into the public. More insiduous versions could take place in private. China could extract favours from the US government by threatening to sell bonds and thus driving up interest rates. The decision-making of a government could be modified by such threats in a quiet way without anything appearing in the newspapers.
Now China is gearing up to start a sovereign wealth fund (SWF). China Investment Corporation will start operations later this year and is expected to ultimately have assets of $300 billion. For a comparison, the largest ever US financial initiative - the Marshall Plan - was a mere $100 billion measured at 2007 prices.
Drawing inspiration from Norway's fund, which has 60% invested in equities, all SWFs are buying shares. This raises some profound questions about the consequences of political players being involved in corporate governance. When an SWF owns (say) 20% of the shares of a company such as Infosys, it becomes a player in the corporate governance and decision making of Infosys. At the same time, the SWF has no accountability either to make money or in terms of the domestic political system.
The board recruits the CEO and management team. How will a foreign government vote on the choice of a CEO for Infosys? How will a foreign government vote on shareholder resolutions? There is an intimate relationship between blockholders and the management team, who continually discuss business strategy and business development. Board approval is required for all strategic choices of the company. Will a foreign government with 20% in Infosys encourage the setting up of facilities in states which are ruled by friendly political parties? Will a foreign government encourage Infosys to do deals with companies controlled by friendly political parties? Will such deals involve transfer pricing so as to finance friendly political parties?
In all these questions, it is one thing to have investments from a Norwegian SWF, given the democratic institutions, freedom of press, transparency and geopolitical irrelevance of Norway. But the SWFs and reserves portfolios that matter are from UAE, Singapore, Saudi Arabia, China, Kuwait and Russia -- all authoritarian countries. The decision making of each of these SWFs, and thus their behaviour in interactions with investee firms, could reflect the economic strategy, foreign policy and defence objectives of these countries. If Singapore is worried about the possibility of Mumbai as an international financial centre, might that influence the way Temasek votes at ICICI Bank?
Concerns about the potential links between the ruling elite of the UAE and Islamic extremists led the US government to block the sale of five port terminals to Dubai Ports World. The US has introduced legislation to strengthen scrutiny of such transactions by the Committee on Foreign Investment.
These difficult questions have been glossed over in the international debate on SWFs in three ways:
- At the closing stages of a fifty-year effort on achieving convertibility worldwide, liberal economists dislike proposing capital controls. However, the SWF problem is one of regulation so as to make markets work correctly. Governments owning shares undermines the sound incentives and decision making of the market economy. Restrictions on shareholding by governments are not inconsistent with a fully open capital account for everyone else.
- The financial sector makes money through fees and off the incompetence of civil servants making trading decisions, and has an incentive to downplay the problems.
- Many people are offering improved transparency by SWFs as the solution. But even if China matches the transparency procedures of Norway what really matters is the de facto extent to which the fund is a tool of politics. Until China graduates to becoming a democracy, even a highly transparent Chinese SWF will remain a tool of the Chinese Communist Party.
Over the 20th century, we have learned that governments owning shares of companies is a bad idea. We now know that the appropriate task of government is to produce public goods, and to stay out of business. Nationalisation now rarely takes place, and for the last 30 years, governments worldwide have been reversing prior acquisitions of shares. This intuition needs to be brought to bear on SWFs. We are uncomfortable when the Indian government owns 20% of Infosys; surely it is worse when the Chinese government owns 20% of Infosys. Similarly, ownership of Indian government bonds amongst myriad private players should be welcome, but large holdings in the hands of a few governments should not.
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