A line in the FT’s recent leader on sovereign wealth funds jumped out at me. The rise of sovereign funds, the FT opined, was an irony in a era of market-led globalization.

The irony, then, is that an era of market-led globalisation is making government-controlled funds more important than ever before.

That argument didn’t ring quite true to me.

The part about the rising importance of government-controlled funds is hard to dispute, especially given their role in the recapitalization of the US financial system. But I would argue that the rise of sovereign wealth funds — and more generally, the rise of what Martin Wolf called "state capitalism" — is the almost inevitable result of the state’s leading role in the current process of globalization, not a irony in a market-led era.

That isn’t the conventional wisdom, I know. But I have a hard time reconciling the enormous role governments now play in the global flow of capital with the idea that the current era is marked by "market" as opposed to "state" led financial globalization. Consider the following graph*, which tries to show the annual increase is government’s cross-border assets. Total government asset growth is now nearly two times the size of the US external deficit.

A set of developments (the rise of China, higher energy prices) and policies (exchange rate management in Asia, fiscal surpluses in the commodity exporters) has concentrated the world’s financial firepower in the hands of states in emerging economies.

State flows, after all, now dominate global capital flows.The IMF’s data makes this crystal clear. The IMF’s WEO data tables suggest that $500b in (net) private capital inflows to the emerging and developing world won’t fund a current account deficit, but rather will combine with a a roughly $700b current account surplus to finance $1200b in official capital outflows. My own work suggests the IMF underestimated official outflows by about $200b.

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The attached graph — used with permission — comes from an excellent November 12 paper by Goldman Sachs’ Hong Liang. It shows quite clearly that the recent surge in Chinese growth hasn’t come from a surge in domestic demand; domestic demand is actually weaker than it was in 2003 and 2004. Rather it stems from a bigger contribution from net exports.

The data for 2007 is an estimate, but the final data for 2007 will unquestionably show a significant ongoing contribution from net exports to Chinese growth.

Liang’s paper — "China’s Renminbi: An unbearable straightjacket for the central bank" — would make for an excellent Economics focus piece. It also touches on a set of related but often neglected points: the link between the RMB’s depreciation against the euro on the rise of China’ surplus with Europe; the PBoC’s rising financial losses (when its foreign exchange reserves are marked to market in RMB terms) from holding more reserves than China needs; and the dramatic fall in domestic foreign currency deposits.

The only way I can reconcile the fall in household fx deposits with the banks rising fx position is an increase in the fx that the banks are managing on behalf of the central bank.

Hong Liang’s emphasis on the contribution net exports have made to China’s growth is important for another reason. Many smart, intelligent commentators highlight the rise in Asian demand, arguing that Asia has been a driver of global growth. But a region’s net contribution to global demand is a function of the difference between demand and supply growth. Recently, Asia has contributed more to supply than to demand — leading Asia’ surplus to widen even as Asia’s commodity bill has soared.

Asia has been a huge source of demand for commodities. But when it comes to manufactured goods, Asian demand hasn’t kept pace with Asian supply. That implies ongoing growth in Asia’s surplus with the US and, now perhaps even more so, in Asia’s surplus with Europe.

China has decoupled to a degree from the US over the past two years. The US hasn’t been the engine of demand growth globally over the past two years. Net exports only subtracted 0.1% from US GDP in 2006, and they contributed 0.5-0.6% to US GDP in 07. US import demand has slowed — with real imports in 2007 growing more slowly than real consumption (in part due to the fall in residential investment). Europe, by contrast, has emerged as an engine of demand — growing more rapidly than the US. That has meant that China has shifted from relying on US demand to relying on European demand. Up until now, China has offset the slowdown in the pace of growth in its exports to the US with strong growth in its exports to other parts of the world.

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With the Fed now aggressively cutting US interest rates to keep the bursting of a real estate bubble from devastating the US financial system and economy, is the dollar about to turn into the yen- that is, the key funding currency for the global carry trade?

Mark Gongloff of the Wall Street Journal — citing a set of currency traders — posed the question yesterday:

Japan’s yen has been the carry-trade vehicle of choice for years, given the country’s superlow interest rates. The Swiss franc has been another. If the Fed keeps cutting rates, carry-traders might line up to ride the dollar like a birthday pony, with important implications for markets and the economy.

In my view, it will be hard for the dollar to emerge as major funding currency. At least not in the absence of truly unprecedented generosity from the world’s central banks.

Why?

Fundamentally, because the US has a huge external deficit and needs to borrow money from the rest of the world even in a slump, while Japan’s slump added to Japan’s external surplus and thus the supply of funds it could lend to the world.

Funding currencies usually have — in addition to low interest rates – lots of savings, and consequently spare funds to invest globally. That doesn’t sound much like the US.    

The United States own need for funding limits the dollar’s ability to serve as a global funding currency.The US saves far less than it invests, and has to make up the difference by borrowing from the rest of the world. That is a constraint on the United States’ capacity to supply dollars to investors who want to sell (borrowed) dollars to buy higher yielding currencies.  Read more »

Gordon Brown argues that the ‘transparency deficit" in the global financial system needs to be corrected.

I have a couple of specific suggestions for UK policy makers looking to flesh out the Prime Minister’s vision.

1) The UK could insist that sovereign funds looking to set up shop in London meet a high standards for disclosure. If the forecasts from banks like Merill Lynch are to be believed, sovereign funds may soon be adding $1 trillion a year to their assets. At that pace, to paraphrase a Ken Rogoff quip, sovereign funds quickly will become the global financial system. Even if those forecasts don’t pan out, some black boxes look set to get big fast. A lot of them seem to have large operations in the UK. Without a bit more (retroactive) disclosure of the broad contours of their portfolios (of the kind in the IMF COFER data), it will be hard to assess their contribution to any future "underpricing of risk."

2) Upgrade the UK’s balance of payments statistics to match the US statistics. Specifically, the UK could provide a breakdown of the geographic origin of inflows to the UK and the official/ private split. As more and more global flows move through London, the absence of more detailed data increasingly impedes real time and historical analysis of global capital flows.

The UK’s data is here. Best I can tell, even in their comprehensive annual publication, the UK only provides a geographic breakdown for the current account, not for the financial account.

If competition among financial centers for sovereign fund business precludes any effective pressure on sovereign funds to increase their transparency, if the political systems of the home countries of many key sovereign funds limit domestic pressure for more transparency and if sovereign funds get big fast, the world will soon have a new transparency deficit …

Conversely, if Singapore starts disclosing the same kind of information as Norway, it would be a lot easier to begin to assess how sovereign portfolios impact a range of markets. Tony Tan of the GIC suggests that change is afoot:

""We have already decided that the circumstances have changed. The right thing to do is to move to a path of more disclosure.

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Sovereign funds — and those managing money for sovereign funds — argue that sovereign wealth funds are intrinsically a stabilizing force in the market. They have a long-term perspective. They aren’t leveraged (actually, that part isn’t totally true – some smaller sovereign are leveraged and the big funds invest in fund managers who use leverage). They are willing to buy when others want to sell, and sell when others want to buy.

Of course, it is hard to actually know if sovereign funds act consistently to stabilize markets since the biggest existing funds are also the least transparent funds – and the new funds don’t exactly have a track record. But it is hard to deny that they currently have the capacity to support markets in the US and Europe. China and the oil exporters have a lot of funds – they added over a trillion dollars to their foreign assets, I would guess, in 2007, though far more was managed by central banks than sovereign funds.

Nonetheless, few market participants are always stabilizing or always destabilizing. Most have a rather more ambiguous impact on the market. Hedge funds can pile on to a trend. Or they can bet that historic norms will reassert themselves. They can bet against a government’s efforts to defend the unsustainable. Or they can bet that large imbalances will remain for some time, and thus sell insurance against any change. They can bring new money to the market, or they can be forced to unwind leveraged positions quickly.

Sovereign funds will get into trouble. That is when they risk adding to market volatility.

The China Investment Corporation is a particular risk — and not just because it is new.  The CIC has been given next to impossible set of tasks. It is supposed to take the risks required for China to offset the losses associated with the dollar’s depreciation against the RMB. But it also is not supposed to lose money either. And it is supposed to do all that while also supporting Chinese state firms. And unlike the oil funds, the CIC is playing with borrowed money – not the fiscal surplus generated from high oil prices.

We don’t yet really know how the CIC will act under duress. It hasn’t even deployed most of its initial allocation. However, we do have a bit of information about the activities of another set of Chinese state investors: the state banks.

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Last week, central banks added $12.14b to their Treasury holdings at the New York Fed (and perhaps more to other accounts — the New York Fed’s custodial holdings are an imperfect measure of the central bank demand), and $11.96b to their Agency holdings. The week before they added $7.13b to their Treasury holdings, and $7.30b to their Agency holdings.*

That works out to an increase of $38.5b in foreign central banks’ Treasury and Agency holdings at the New York Fed over a two week period — or about as much as sovereign funds have spent buying stakes in US banks over the past two months.

If central banks keep adding around $10b to their Treasury portfolio a week, the US will need to increase the size of the stimulus to meet central bank demand. Perhaps the second round of stimulus will be better targeted. And if central banks keep snapping up $10b of Agencies a week, the GSEs will have no trouble raising the funds needed to buy up a ton of jumbo mortgages. That also provides a form of targetted relief, just to slightly different group.

More seriously, the rise in central bank’s holdings of Treasuries and Agencies highlights something I alluded to earlier in the week — the bifurcation of sovereign demand between the some of the world’s safest assets (if you ignore currency risk) and some of the world’s riskiest assets.

Some central banks likely have decided that this isn’t the time to dabble in the asset-backed security market, or in the equity market.

And some sovereign funds seem to have decided that this is the perfect time to buy into their bankers, brokers and money managers.

* I used the change in the average level of central bank holdings, rather than the change in central bank holdings at the end of the reporting week for this calculation. Using the data for the close of business on Wednesday paints a slightly different picture.

Diplomatic sovereign wealth funds argue, more or less, that they have no desire for power – so there should be no restrictions on their ability to accumulate property. Those hoping for a cut of the SWF lucre – and those worried about creeping investment protectionism – tend to agree.

Others argue that those who accumulate large amounts of property usually end up with a measure of power. Felix Rohatyn in the New York Times on Tuesday:

“You don’t need to appoint two directors to a board to have influence when you own 10% of the company.”

Andrew Ross Sorkin goes further:

“Let’s be honest. The idea that foreign investors have no influence because they don’t have a seat at the board is laughable.”

Rohatyn (paraphrased by Sorkin) believes that the countries with sovereign funds “want influence on the world stage, despite their insistence otherwise.” He says “there has to be a political objective, above the rate of return.” Otherwise, per Sorkin, it makes little sense for “people with little history investing in such large assets” to make “big ticket … investments … in a matter of weeks” when they have “virtually no way to value them.”

Michael Klein of Citi also doesn’t mince words. He though doesn’t share Rohatyn’s concerns. Hasty, big ticket investments from sovereign wealth funds have helped to stabilize the global financial system:

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Whatever troubles the Fed faces, at least it is still profitable. The same cannot be said for China’s central bank. And while the Fed just has to worry about economic conditions in the US, the People’s Bank of China has to worry about economic conditions in both the US and China.

Those are at least two of the issues now facing China’s central bank. The PBoC’s losses were highlighted by Richard McGregor of the Financial Times; the PBoC’s challenge balancing domestic and external conditions was highlighted by Andrew Batson of the Wall Street Journal. Both articles are well worth reading.

Dilemma 1. China’s central bank is now losing money. At least it would be if it measured its performance like a normal financial institution.

Goldman Sachs’ Hong Liang calculates that — taking into account currency losses — the PBoC is now losing about $4b a month. Richard McGregor:

"Hong Liang, Goldman Sachs China economist, calculates the PBoC is losing about $4bn a month on its bills because of the turnround in the interest rate differential over the past 18 months. “The trend is clearly accelerating as the reserves continue to grow faster than GDP,” she said.

$4b a month is very plausible.

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European policy makers think so particularly those imbalances that in their view originate on this side of the pond. The current account deficit – setting aside the bulge from $90 rather than $60 oil — is heading down. Households seem to be cutting back on other purchases rather than borrowing more as their petrol bill goes up, so perhaps the household savings rate isn’t veering into more negative territory. Painful, sure. But ultimately healthy.

I am not 100% convinced, though, that all imbalances are correcting. To me the biggest imbalance in the global economy is the gap between the current account deficit that private investors want to finance and the current account deficit the US now runs. That imbalance– at least in my view — seems to be getting bigger, not smaller. The deficit that private investors want to finance seems to be falling even faster far faster than the actual deficit.

Of course, when US investors take risk off the table and bring funds home, the dollar can rally. But the trend over the past two years has been pretty clear: as interest rate differentials move against the US, private willingness to finance the US deficit falls. And even back in 2005 private investors weren’t willing to cover the entire deficit.

George Soros says this cannot go on. At some point, Fed cuts in short-term rates won’t bring long-term rates down – as foreign investors will no longer be willing to hold dollars. The US will have to limp through a slowdown without any (additional) boost from monetary policy.

“If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.”

So far, though, there are no signs of trouble. Ten year rates are now around 3.5%. With oil around $90. Two-year rates are even lower: John Jansen of Across the Curve reports they dropped under 2% today.

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Hard as it is to believe on a day like today, those who expressed concerns about the sustainability of the global expansion around this time last year were mocked as worry warts.

A FT headline from Davos 2007 read "Big risks to the global economy receding." Back then, more and more voices argued that global imbalances were a natural byproduct of dynamic globalization. Few warned that if the US couldn’t attract enough (net) private capital inflows to cover its deficit in good times, it would almost certainly fail to attract enough private capital inflows in bad times – and might need, for example, to sell off a large swath of corporate America to sovereign funds to “fund” its deficit.

The dominant debate – if memory serves – around the turn of last year centered on whether the equity markets had fully priced in the fall in macroeconomic volatility. Credit spreads were incredibly low at the time – but that too was thought to be more a reflection of limited macroeconomic volatility  than a reflection of an (overly) exuberant credit market.

The US had, after all, managed to withstand the collapse of the .com bubble with only a mild recession. The seemingly inexorable rise in the price of oil had failed to put a dent in the US consumer or the US economy. Hedge funds had failed — Amaranth — without causing much stress in the market. The risks associated with the trade deficit never seemed to materialize. All was clear.

In an environment marked by little macroeconomic volatility, limited financial volatility, and low credit spreads, equities looked undervalued. There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.

The same basic view marked the foreign exchange market. Low macroeconomic and financial volatility made carry trades attractive. The more leveraged, the better. There was little need to worry about the large resulting deficits in (some) high-carry countries that were the recipient of such inflows.

More somber voices had started to warn of building risks – whether from rising oil prices, speculative excesses in the housing market, low levels of household savings in the US, high levels of investment in the US or a global flow of capital that seemed the reverse of what conventional economic wisdom would expect – back in 2003 or 2004. They had been wrong for an extended period.

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