Growing activity by reserve-rich economies could exacerbate European tensions

published in Financial News on 5th November 2007

The debate about the influence of sovereign wealth funds is a rerun of controversies that flared more than 30 years ago after the first oil price shock in 1973.

Last week, the International Monetary Fund called for more transparency from the funds, which are pools of assets controlled by public sector investment vehicles from reserve-rich economies, mainly from the emerging world. The IMF wants to ease concern that the funds are creating undue influence in the west through fast-growing stakes in companies in the US and Europe. The move parallels efforts made in 1974 by West German Chancellor Helmut Schmidt to control the swell of participation by oil-rich countries led by Kuwait in companies such as Daimler-Benz and Hoechst, the German motor and chemicals groups.

The difference is one of scale. In 1974, West Germany was by far the world’s largest reserve holder with about $25bn in official foreign exchange reserves. The Germans then accounted for about 15% of overall world foreign exchange reserves of $160bn. Fred Bergsten, the American economist and later US Treasury Under-Secretary, now director of the Peterson Institute for International Economics in Washington, in 1974 said West Germany was the world’s second superpower after the US because of its international assets.

The contrast with today’s picture is remarkable. Enormous reserves wielded by China and other emerging economies such as Russia, South Korea and Taiwan far outstrip the official holdings of Germany and other industrialised countries. Germany’s published foreign exchange reserves of more than $40bn make up only 0.7% of declared global foreign exchange reserves, which mushroomed to $5.7 trillion as of mid-2007, according to the IMF. Figures for official foreign exchange holdings understate the amounts at the disposal of emerging economies. Studies from Standard Chartered and Morgan Stanley put the funds’ size at $2.2 trillion and $2.5 trillion respectively, double total official currency reserves. Some of the best-known funds have been around since the 1970s.

The Abu Dhabi Investment Authority, with about $875bn under management, was founded in 1978; the Government of Singapore Investment Corporation ($350bn) and the country’s Temasek Holdings ($100bn) in 1981 and 1974 respectively, Norway’s Government Pension Fund ($300bn) in 1990 and the Kuwait Investment Authority ($70bn) in 1960.

Attention in the past few weeks has focused on episodes such as the Qatar Investment Authority’s backing for a potential bid for UK retailer J Sainsbury, the possible purchase by China’s Citic Bank of a stake in US investment bank Bear Stearns and the deployment of a new $40bn investment fund from Libya.

China remains the main focus. China’s currency reserves are growing by about $1bn a day and total between $1.3 trillion and $1.4 trillion. China has been active for some time in acquiring high-profile oil assets in Africa, signalling its shift into such investments by subscribing in May for $3bn in the initial public offering of US private equity group Blackstone.

Schmidt, the world’s oldest senior commentator on global and monetary affairs, is following the development of the emerging world’s riches. He believes China will deploy more of its wealth in companies in the US, Europe and Africa. Schmidt said China will also take further steps away from buying US treasury bills, thought to account for about 75% of its reserves up to now. Schmidt said the Chinese strategy of relying on the dollar is a “ridiculous mis-investment”.

More active management of Chinese foreign exchange holdings creates a conundrum for US Federal Reserve chairman Ben Bernanke and Jean-Claude Trichet, president of the European Central Bank. Much American international monetary diplomacy has been directed at persuading the Chinese authorities to  accept a higher rate for the renminbi as part of an effort to lower the enormous Chinese trade surplus with the US. American policy on the renminbi is inciting a larger role for the euro in overall reserve currency holdings. If the Chinese central bank lowers its purchases of dollars, allowing the renminbi to float higher on the foreign exchanges, the assumption must be that the share of euros in the Chinese central bank reserves will rise in time. According to the IMF, the euro makes up an estimated 26% of world reserve holdings against 64% for the dollar, down from 69% when the euro was introduced at the start of 1999.  Capturing a greater share of world reserve currency holdings was one of the goals for the Europeans, particularly the French, when the euro was established. However, a further rise in the European currency caused by more aggressive reserve management by reserve holders and sovereign wealth funds would inflame tensions within Europe.

The balance of payments of the euro nations is on par with the rest of the world. But this masks a large current account surplus from Germany and growing current account deficits from the other lending euro economies of France, Italy and Spain. A further rise in the euro might not be unwelcome for Germany and the Deutsche Bundesbank would see it as a means of shielding the country from higher inflation caused by climbing oil prices. However, further euro revaluation would set alarm bells ringing in Paris, particularly after last week’s fresh Federal Reserve interest rate easing.

If the Chinese heed Schmidt’s call to channel more funds into the euro, Trichet can expect still more clamouring for lower euro interest rates from the French Government.

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