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Monday, December 24, 2007

My strong critic toward sovereign wealth funds (SWFs) was buttressed by Becker's recent piece that explains its fundamental flaws.


Why Sovereign Funds?
by Gary Becker

The growth of large government managed funds during the past few years has been spectacular. These funds are estimated to manage between $2-3 trillion, and their assets are increasing rapidly. Sovereign funds have grown mainly because of the run-up in fossil fuel and other commodity prices, although China is creating a large fund with the capital earned from its trade surplus in goods. If present energy and commodity prices continue, sovereign funds could have over $10 trillion in assets within a few years. I do not believe that the scale of these funds is a healthy development for these countries.

The largest fund is that by The United Arab Emirates, which is thought to have assets of about $900 billion. Next in size are the funds from Singapore, Saudi Arabia, Norway, and China: each has capital of about $300 billion. Following these giant government funds are another 20 or so funds with much smaller amounts of capital. Oil producing countries have about two thirds of the capital of all sovereign funds. The aggregate assets of sovereign funds greatly exceed the approximately $1.5 billion invested in hedge funds.

During the past couple of years, sovereign funds have begun to invest more aggressively in international companies. For example, the Abu Dhabi Investment Authority recently gave cash infusion of $7.5 billion to Citigroup to help replace bank capital that had been depleted due to the credit crunch. China's State Foreign Exchange Investment Corp invested in the IPO of the large private equity company, Blackstone, and was embarrassed after the stock declined greatly from the issuing price. Sovereign funds have made other investments in private companies, and many more are expected.

With only a few exceptions, such as the fund of the Norwegian government, sovereign funds are secretive and not at all transparent. Lack of transparency is a major obstacle to citizens of countries with secretive sovereign funds in determining whether the money that automatically flows to the funds is being well spent. Even estimates of the total assets of most sovereign funds have to be arrived at through guesswork, and except for an occasional well-publicized transaction, their asset allocations are kept private. While private equity and hedge funds have also been criticized because they are little regulated- I do not share this criticism- they are paragons of voluntary disclosure and good governance compared to the vast majority of sovereign funds. Private equity and hedge funds voluntarily disclose information mainly because they compete vigorously for funds, whereas sovereign funds automatically get their resources because of government ownership of oil producing and other commodities.

Compounding the adverse effects of the extreme secrecy is that managers of these funds, being government employees on fixed salaries, have only limited financial incentives to try to achieve higher returns for given risk. Even when those in charge of sovereign funds hire private managers for some of their capital, there is still what economists call a principal-agent problem because government officials choose the managers. As a result, one would expect that the management of these funds would be excessively conservative to avoid investment blunders and bad publicity, or that managers would be tempted toward corruption by companies that want to attract investments from these funds. Or governments will use the funds for other government purposes, such as the just announced unwise decision by Brazil to create a sovereign fund to intervene in the foreign exchange market to shore up that country's currency. Given that little information is available, it is very difficult to discover whether a fund is managed too conservatively, or whether corruption affects investments in a significant way.

A major reason behind the growth of sovereign funds is the desire by oil producing and other countries to avoid what happened during previous booms in commodity prices. Vast revenues in the past were spent with little concrete results to show later on. Countries now recognize that the enormous boom in their export prices, such as oil close to $100 a barrel, is not likely to last. That makes it prudent to save rather than spend most of the revenue that is being collected. The desire to save the surplus is commendable, but that consideration alone does not imply that governments rather than households should do the saving.

Central banks and fiscal agencies should accumulate assets during years with high oil and other commodity prices, or what are in other ways unusually good times, in order to protect against the adverse effects of bad times on fiscal and foreign trade deficits. However, the Abu Dhabi fund and the other large funds, and many smaller ones, have far more assets than is necessary for cyclical management of government portfolios. Instead of government funds retaining the excess assets, they should be distributed as national dividends, or as reductions in taxes.

One advantage of distributing most of a funds' assets as dividends, or reduced taxes, is that since families at different stages of the life cycle have very different investment needs, they would invest such a dividend in ways that best suit their individual needs. Younger couples that are investing in children, and actively accumulating wealth, will spend their dividends on buying homes, cars, and other consumer durables, saving for the education of their children, and investing in mutual funds and other financial intermediaries. Since older persons with adult children already own their homes and other durables, they would spend their dividends mainly on conservative financial instruments.

To be sure, countries accumulating some of the largest funds are not at all democratic, so that any national dividend would only go to a relatively small fraction of the total population. But so too are any benefits from the investments of sovereign funds, so a national dividend would not be any worse in this dimension.