Former Secretary of the Treasury and erstwhile Harvard President Larry Summers (nephew of two Nobel laureates in economics, by the way), raises some very interesting questions on the current trend of governments (eg, China and Dubai, etc.) to invest directly in companies through SWF’s. FT:

the large flow of capital from the developing to the industrialised world has been the principal irony of the international financial system. In 2007 this flow will total well over half a trillion dollars, a figure that will be comfortably exceeded by the build-up in reserves and sovereign wealth funds (SWFs) in developing countries…

Morgan Stanley has estimated on reasonable assumptions that there is now close to $2,500bn (£1,200bn, €1,800bn) in SWFs and that this figure will increase to $5,000bn by 2010 and $12,000bn by 2015…SWFs are now growing at a faster pace than the global rate of new issuance of traditional reserve assets…

A signal event of the past quarter-century has been the sharp decline in the extent of direct state ownership of business as the private sector has taken ownership of what were once government-owned companies. Yet governments are now accumulating various kinds of stakes in what were once purely private companies through their cross-border investment activities…

In the last month we have seen government-controlled Chinese entities take the largest external stake (albeit non-voting) in Blackstone, a big private equity group that, indirectly through its holdings, is one of the largest employers in the US. The government of Qatar is seeking to gain control of J. Sainsbury, one of Britain’s largest supermarket chains. Gazprom, a Russian conglomerate in effect controlled by the Kremlin, has strategic interests in the energy sectors of a number of countries and even a stake in Airbus. Entities controlled by the governments of China and Singapore are offering to take a substantial stake in Barclays, giving it more heft in its effort to pull off the world’s largest banking merger, with ABN Amro…

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?

All of these risks would be greatly mitigated if SWFs invested through intermediary asset managers, as is the case with most institutional pools of capital such as endowments and pension funds. The experience of many endowments and pension funds suggests that this approach is in most cases likely to produce the best risk-adjusted returns.

We agree with Mr. Summers that these nations would be better served by using traditional financial intermediaries and perhaps ownership vehicles in their investment activities. One troublesome suspicion that Summers states from the perspective of investee nations — “the pursuit of objectives other than maximizing risk-adjusted returns” — might be mitigated through the use of such instruments. But we are skeptical that the destiny of the SWF’s is as great as it currently appears to Summers and Morgan Stanley, with its prediction of $12 trillion by 2015.

The current might and will of the SWF’s comes from two principal areas, China’s astounding export growth, and the high oil prices of the last few years. There is no iron law that states the China’s exports grow or accelerate indefinitely (the same was said about IBM in 1970), or that notoriously cyclical oil prices remain high forever. There is an entirely different scenario that can be constructed from fledgling investors riding cyclical waves and making big, fast bets. When the Rockefeller’s sold Rockefeller Center to the Japanese in 1989 at a huge price, there was a certain amount of hysteria in the air. Japan was about to take over the world! The concern was misplaced, however. Within a few years, that concern, and Japanese acquisitions, had almost entirely disappeared. Nothing goes up forever.

This entry was posted on Monday, July 30th, 2007 at 7:38 am and is filed under China, General, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.