Misplaced concern over sovereign wealth funds

Why are normally cool heads so worked up over sovereign wealth funds and the possibility that foreign governments may come to own substantial shares in domestic companies?  Recently, Larry Summers declared that this issue is "profound and goes to the nature of global capitalism."

The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence.

...

Apart from the question of what foreign stakes would mean for companies, there is the additional question of what they might mean for host governments. What about the day when a country joins some “coalition of the willing” and asks the US president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank?

And Jeffrey Garten thinks that these funds require departures from “conventional liberal orthodoxy concerning global trade and investment flows” He wrote: 

These funds are going to have the ability to buy any global company, to create panic in markets if they move too precipitously, even to dwarf the political clout of international financial institutions. They can no longer be ignored.

What is curious here is that both comments (and other similar discussions) overlook the fact foreign governments (China, oil states, and so on) already own huge assets in the U.S. and other advanced economies--in the form of short-term government securities. Given their existing holdings, foreign governments already have all the power in the world to create the kind of havoc Summers and Garten worry about. If they want to use their assets for non-economic ends--to pressure governments, to cause economic harm, to exercise political clout--they can in fact do so much more easily by dumping government securities and playing with currency and bond markets. They do not need to buy up shares in individual companies. 

The creation of sovereign wealth funds is an attempt to diversify from these low-return investments, not a strategy to increase ownership of U.S. and other assets further. Summers might as well have welcomed this trend by noting that, by his own logic, the global financial system depends on investors and traders acting so as to maximize their economic return.

So what is the big deal? Apparently, it is OK for developing countries to transfer huge amounts to the U.S. and other advanced countries by holding low-return paper, but not OK for them to want to make some money in the deal.

UPDATE: Larry Summers responds.

Comments

[op]

dani

larry wants the thirdees to diversify

he just wants um
to put these funds
in blind trust funds

where they are run
by neutral global welfare oriented managers
prolly on index algorithims

you know ...FUNDS run by
hi fi saints

able to keep their eyes on the logic of capitalism
while all else have heart throbs of kindly killings
or killing kindness

a set up like ...errrr
the IMF

you know howw
filthy
that shop
is
with ....planetary vision

[op]

it strikes me as wildly funny

these sorts in the 90's

were often
telling us
all about
the global marketplace
uber alles
steam rolling
the flimsy local structures in "its" path
stuff like ...well
like nation states
and their central banks

now !!!!!

narrow national interest
rises like so many
oddly dressed abaddons
arms a-waving
flags a flying

their motto

" to hell with
the ways
of divine private profit "

a fearsome godlessness eh ??

each
armed
with a sovereign tender
a sense of agrievement
against
the rampant trans nat corps

sterilizing fingers
blunt
"our nation first "
industrial aims

crypto quotas

funny shadowy ...
inside friends

and lord knows
what else

add
a dash of yahoo
demogogary
and ....

[Per Kurowski]

Jeffrey Garten’s “We need rules for sovereign funds”, Financial Times, August 8, included a mind-boggling list of proposals…“that many will see . . . as having a protectionist thrust”. No kidding? The only conclusion I reached was to tell my daughter to watch up if she was thinking of studying international trade or finance at Yale.

Not only does Garten analyze the issue of sovereign funds as if trying to carve out for himself the role as The High Priest of financial nativism but also, even if he was absolutely right about his deepest misgivings, the type of solutions he proposes, like requiring from the government owned investment companies that they “publish internationally audited reports on their entire portfolios at least twice a year” could not serve any rational purpose and could in fact even serve as a dangerous valium.

What on earth is Garten up to? Trying to extend Sarbanes Oxley to the rest of the world governments? Asking the credit rating agencies to rate the sovereign funds? Allowing these funds only to buy government paper? Good luck! This type of approach would only have much of the current world imbalances try to go underground, making them so much harder to manage. Do I then mean that sovereign funds do not pose any threat? Of course not…some do, the same way that some non-sovereign funds could also be dangerous for any sovereignty.

[Silent Observer]

Dr. Dani, I have no idea what soverign fund is although I start to hear about it these days. Could you suggest quick and simple introduction to the concept? Why it is important?

[samson]

Silent Observer, you can start here: http://blogs.ft.com/wolfforum/2007/07/sovereign-funds.html#more

[hari]

My comments on Summers & Garten think-pieces (FT) was made when the articles appeared in Lond.

1. US/UK and some of its so-called experts are using "racist" arguments to shut PRC/BoC from making inroads into their capital markets. That's it. Why?

2. They know it won't be possible to control such investments (compared to treasuries). Sovereign capital involvement in global markets is NOT desirable, especially NOT Chinese-type. [That's what was called "Yellow Fever"] Yes, that's true!

3. So-called intellectuals of US/UK establishment are being used to mount such arguments on behalf of Ango-American capitalism:
ie. to prevent it from being high-jacked by a foreign ideology or whatnot.

4. China (India also)) are going to make serious inroads into world capital markets - one way or another - irrepective of anglo-american capitalist system.

5. My argument is to allow them into the established system and carter to their needs (surplus capital!) and don't be chicken! Because they'll anyhow render you harmless in time.

[Rich C]

"The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares."

If Larry Summers is right, then capitalism is in a lot of trouble. By and large (at least in the US) shareholders really don't have much of an opportunity to do this. Moreover, actions by companies that might "maximize value" in the short run are often inimical to strategies that maximize value over the longer term. Big long term holders - including sovereign funds - have the potential to focus company management on long-term returns, precisely because they can overcome the collective action problems associated with small, highly dispersed shareholders. Why Summers would view this as a problem is beyond me.

[hari]

I forgot to add -

* Suppose, for argument, a sovereign capital fund of Israeli origin/nationality,
can you imagine similar arguments being used to STOP them from entering the global capital markets?

* Japan - in 1980s - was scourge of US capitalism beause they had means to buyout American icons! I suppose our memories are rather short...

[Joe]

"These funds are going to have the ability to buy any global company, to create panic in markets if they move too precipitously, even to dwarf the political clout of international financial institutions."

Doesn't this statement echo what former Malaysian president Mahathir bin Mohamad has been saying about Wall Street funds? I believe that every country must have the freedom to exercise their right to regulate Global capital--sovereign or otherwise. The bottom line, to me (and as Dani implied), is that it is very easy to make grand pronouncements as long as they do not affect you; but when you are at the receiving end of such pronouncements you get real! Will the Washington Consensus ever stop patronizing developing nations, and let them decide their policies themselves?

[wjd123]

Why not give soverign funds a mission to help ensure financial and social stability form the dangers of international speculation and national irresponsibility through international government with the use of international regulations. Do it in a way that would force speculators, stock holders, and central bankers to become more attuned to the workings of the soverign funds mission.

How this would be done, I don't know. But the suggestion will probably put a scare into free market capitalists around the world. Good, there are too many national and regional financial crises and too much contagion.

[jonfernquest]

The Chinese government is effectively pooling savings and acting as a financial intermediary in typical Asian collective action fashion just like Lee Kuan Yew in Singapore.

The power of the collectivity is greater than the sum of the parts. It's a winning strategy and goes against western notions of freedom, here individual investors in China investing overseas.

Wealthy investors pooling their funds in opaque private equity funds give them collective power too and look at how they object when for instance, Lonestar in South Korea is prevented from literally walking away with a bank.

The Chinese government is just making the best use of the tools of the western financial system that it is presented with. Power goes to the aggregate so smaller countries like ASEAN better get their act together, solve their disputes, and pool their resources.

[Larry Summers]

Dani, I think you are uncharacteristically broad brush in addressing this issue. There is it seems to me a profound difference between direct investments that provide control of an enterprise and indirect, passive financial investments. I was clear that my concern was only with the former and that any of the kind of investments university endowments or pensions typicallydo was fine for sovereign wealth funds with the concern coming principally as they took control of entitites.

[samson]

Larry Summer? Really? I'd expect a more eloquent and careful response. I say impostor!

[Rich C]

Just to respond to Larry Summers' comment: where is the line between a "passive investment" and a controlling interest? Activist hedge funds, after all, have shown that even fairly small stakes in a company can serve as a platform for challenging managerial strategy. And to be honest, it is not unusual for pension funds or endowments to take controlling stakes in companies through co-investments or direct investments. Usually, we're not talking big companies here, but sometimes (Alabama Public Employees and USAir) we are. Again, I think that the underlying problem is that you are unwilling to acknowledge that in a "second best" world, companies operate like polities, and managerial decision making is a political process. The question becomes not "how do we ensure managers operate according to a textbook recipe for success" but "how do we ensure an equitable representation of interests such that long-run win-win bargains can be struck." Sovereign funds, along with democratically controlled pension funds, can play an important role in generating this kind of positive outcome.

[BE]

Summers' point is influence and incentives. Our current capital systems rests on optimization of economic welfare (Pareto) through competition.

The incentive of a profit seeking shareholder leads to higher efficiency. The incentive of a foreign government may be different (in fact, is likely to be different) than that of a rentier.

Since the incentive of a foreign government is likely to lead to non-Pareto results, it is a bad thing.

A foreign government holding US govt debt means that that govt has some influence on US govt policy, but it is a totally different ballgame than foreign governments owning our means of production.

[Dani Rodrik]

BE --
If a foreign government mucks around with the value of the dollar or US interest rates for political reasons, that screws up the efficiency conditions as much as it would when ownership rights are exercised for political purposes.

[BE]

I agree that foreign government influence on the value of the dollar interferes with the conditions. China and Japan clearly have economic reasons for their massive interventions and their continued willingness to supply the US with funds.

I just don't see (and maybe there's some research on this I don't know about) how that could be equal to the potential influence direct ownership of means of production.

It's certainly not clear cut. It probably boils down to a belief about how much influence said foreign government can exert through monetary/trade policy versus how much it can influence through direct ownership.

I could see where the argument is made that the US govt could simply tell the foreign govt to pound sand in the case of sovereign debt obligations as well as FDI.

But in the former case, it's a question of inter-govt policy (which will always influence economic output), whereas in the latter it's a question of the government stepping in and telling private organizations what to do.

So to me it seems the first question is which scenario are we more concerned about from an influence standpoint, and the second question is where and when do we want government interfering with free markets?

[marius]

"""
If a foreign government mucks around with the value of the dollar or US interest rates for political reasons, that screws up the efficiency conditions as much as it would when ownership rights are exercised for political purposes.
"""

It's the difference between concentrated effects and diffuse effects. To make a noticable effect through exchange values or interest rates you have to act on an enormous scale (unless you manage to start a panic, which won't work most of the time)

If we are assuming a political act that iseconomically not optimal for the actor, a large scale action will be very costly, so this creates a double-bind situation that reduces the risk of political meddling.
On the other hand, ownership meddling has concetrated effects, so that an affordable action can be highly noticable.

You could argue that diffuse effects can hurt as much as concentrated effects, even when no-one knows it. But the point of political action is that no-one will contemplate unnoticable actions.

It is easy to imagine a sovereign fund cutting investments in a foreign company it owns under political pressure of local competitors, but who is going to do something unnoticable to the dollar for political reasons?

[Dani Rodrik]

Marius--

Your analysis is not complete. Obviously, if China invests all its foreign assets in ACME corporation, its ability to affect ACME's actions is huge. But why in the world would anyone of us care about what happens to ACME? The ability to affect macro variables may be diffuse, but the effects would be felt by everyone. So I do not see a clearcut difference.

[marius]

Of course, I agree completely. My point was not so much about the effects side, but about the motivation to act.

Let us imagine two possiple interferences open to a SWF, both non-optimal from their point of view, losing
them the same amount of money in both cases, and both hurting a foreign economy on the same scale. One interference is a small-scale operation on fiancial markets, having diffuse effects that are lost in the noise ( not meaning they weren't there, just that they are hard to notice).
The other operation is forcing a company (ACME or XYZ, but I was really thinking Airbus) they have a stake in to make a certain decision, such as moving jobs to the SWF's country, or forcing technology transfer, or a merger with a local company.

Now, by definition both acts are equally unwanted by the foreign country, so there is no difference here. The difference is in the chance the interference will actually happen. After all, if the action costs money from an investment point of view, there has to be some other (perceived) reason to perform it. This reason can be rational in a wider sense ( moving jobs to underployed parts of your country), or the result of pressure on the government ( keeping a company away from markets your internal companies are interested in).

I suspect there will be much more political motivations for the corporate action than for the financial market action.
For example the governments of Russia and China are completely used to using their own companies for political goals and as Airbus shows, other governments as well. ( By the way, a Russian SWF bought a stake in Airbus, with the explicit goal of moving some production work to Russia.)
On the other hand, I can imagine little motivations to meddle with financial markets on an unnoticable scale although I might be wrong on this.

So, while I agree that diffuse effects of ‘non-investor-like behaviour’ are just as likely to be harmful as concentrated effects, I think there is at least a possibility that actual interference will happen more often on comapny scale.

[marius]

I just realize that from my previous post it appears as if I oppose SWF ownership of companies. That's not the case, I think the worst things they could possibly do are no worse ( to the rest of the economy) than a standard hostile-takeover-to-eliminate-a-competitor
, and I believe in make-trade-not-war.
I just think it is wise to keep an eye on them. the rulers of China and Russia are cynical to a level that Rupert Murdoch can't imagine, and if there are ways to misuse company ownership for political goals, they'll do it.

[Ted Truman]

This is not a black and white issue. The issue is size, scale and concentration. SWF are here to stay and they are a device to diversify and get away from home bias. But they can exercise economic power and political power maybe economic power especially when their management is divorced from conservative central banks and finance ministries. There is a lot of nonsense written on this issue, and I hope my Policy Brief for the Peterson Institute does not fall in that category, but I see no reason why large players, including hedge funds, should not be required to disclose more including in their own interest and those of their citizens.

[Per Kurowski]

Re Ted Truman: You are right in your observations but the fact is that they stand out in stark contrast with the recent launched “Portal Market at NASDAQ, August 15, where private companies that does not have to make their financial statements public or submit to regulations such as the Sarbanes-Oxley corporate accountability law will be able to trade.

Among the benefits of that market it has been said that the private markets shields companies from wild swings in their share price that are caused by a temporary drop in earnings or a bad rumor.

Of course as this Portal Market is restricted to those who can evidence $100 million in assets one could say it sounds fundamentally anti-constitutional as why should we discriminate against those with less than $100 million who would sound to me as not liking the wild swings either. Is not the USA the land of equal opportunities?