Sovereign wealth funds remain much in the news with Brazil just announcing a new $200 billion fund. While ?sovereign wealth? appears almost like an oxymoron, since governments are known far better for their deficits than for their wealth, when we consider the long march of history, State deficits are a relatively recent phenomenon. The pre-modern State always had a surplus on the current account because, small city states with strong merchant classes excepted, there was no way to fund State expenditure other than through domestic taxes and the spoils of war. The former risked domestic rebellion because taxes were one-way extractions without pretence of welfare, while war was a dangerous zero sum game. The State was primarily predatory, with few commitments other than defraying the costs of war and upkeep of the royal family and local elites.
Sovereign wealth, consequently, has a long history. It was the rise and establishment of modern finance and banking that enabled the State to ?borrow? against future tax receipts and run huge deficits. State expenditure and functions expanded enormously as laissez faire led capitalism accommodated socialist concerns, constantly nudged by competitive electoral politics, all post 1850 phenomena. Over the last three decades there have been attempts by governments to balance their budgets, but without significant liquid assets. All of a sudden a number of sovereigns have accumulated substantial liquid assets, and threaten to become an influential international investor group. Morgan Stanley and the IMF estimate that about a dozen countries, mostly in the Middle East, China, Singapore and Norway have SWFs aggregating $3 trillion, equivalent to half of official global reserves. SWF holdings are projected to swell to $12 trillion by 2012 (IMF) or 2015 (Morgan Stanley), equivalent to 1.5 times official reserves.
The ultimate source of most of this new found sovereign wealth is the fundamental global imbalance deriving from the current account surpluses of developing and oil exporting countries whose cumulative surplus from 2000 to 2006 alone totaled US $1.43 trillion.
Also, private capital flows deriving from the trade surpluses of developing countries were bought up by Central Banks loathe to letting their currencies appreciate as part of their strategy of export-led growth. The falling dollar and rising sterilisation costs are now pressuring sovereigns to seek higher returns by transferring a portion of these reserves, currently parked in risk free highly liquid hard currency instruments (US treasuries) to special purpose vehicles seeking higher returns. According to a recent ICRIER paper, India?s opportunity cost of holding excessive reserves is equivalent to 2% of GDP.
The shift from creditor to owner increases returns and risk. The sub prime crisis is a cautionary tale of how liquidity risk, not captured in credit ratings, can be ignored only at one?s own peril, since a good portion of this sovereign wealth has counterpart liabilities in the form of relatively high cost domestic debt. The exchange rate transactions of developing countries have had the result of vastly inflating money supply that may have to be reversed to keep inflation in check. Secondly, in countries like India big current account deficits are worsening by the day. Foreign currency reserves have been largely built through volatile capital flows such as short-term debt, non-resident and foreign institutional investment. These can reverse in the event of worsening macro-economic conditions.
Coming after decades of privatisation, SWFs are widely perceived as a form of backdoor re-nationalisation and the primacy of strategic over commercial objectives, especially since authoritarian governments control the biggest SWFs. But for the same reasons they also have longer horizons, and are arguably the answer to the capital crisis in Western banks, the looming ageing crisis, and the huge infrastructural requirements of developing countries.
The writer is a civil servant. These are his personal views