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Monday, Jan. 21, 2008
Sovereign wealth funds warping market, pose insider-trading hazard
The international profile of sovereign wealth funds is expanding, and the Group of Seven's finance ministers and central bankers are expected to discuss the depth of the funds' risk control, management and accountability when they gather Feb. 9 in Tokyo.
At the same time, however, some people are starting to view the government- controlled funds as white knights who can rescue the west's teetering financial giants from the U.S. subprime-mortgage crisis.
There are four major reasons why sovereign funds have become such a hot topic.
First is that they deal with huge amounts of money. Some estimates show that sovereign funds are handling a combined sum of more than $2 trillion. That vast number is widely expected to rise as the current account surpluses of the oil producers and developing economies expand, giving them ever-increasing clout in financial and commodities markets.
The second reason is the possibility that SWFs, through stock market transactions, might gain control of private-sector companies that are closely involved with the national security of various countries.
One problem here is that some countries with SWFs, like China, have not fully liberalized their own markets. This means SWFs backed by such nations might move to buy stakes in companies from other countries but be unwilling to permit others to invest in their own. As a measure against this lack of reciprocity, governments may start tightening regulations on SWFs — a move that might end up slowing market activity.
To avoid this scenario, countries with huge foreign-currency reserves need to quickly liberalize their own stock and capital markets and foreign-exchange regulations.
The third problem is that sovereign wealth funds' massive investments and fund transfers are having a growing impact on the foreign-exchange and interest rates of many countries. This is being taken particularly seriously by the United States, which covers its current account deficit by using the influx of currency reserves provided by foreign governments.
The euro's recent ascent is proof that not only governments, but private-sector companies as well, are shifting their funds out of the U.S. dollar and into the euro. If the dollar's value falls, oil-producing nations need to hike their dollar-denominated prices. This is because a drop in the dollar's purchasing power will increase the value of their imports from countries using currencies other than the dollar.
The interest rates in euro-zone countries have already topped those in the United States, putting further downward pressure on the dollar. Higher oil prices are meanwhile lifting prices in many countries. The U.S. Federal Reserve has cut interest rates in response to the subprime crisis and slower growth, and the other major economies — including Japan — will sooner or later be allowed to take steps against the onset of stagflation.
The Plaza Accord of 1985 was aimed at correcting the appreciation of the U.S. dollar. Given the lack of an alternative international currency, the major economic powers reached a consensus that the U.S. dollar-based international monetary system must be maintained.
Today, the U.S. dollar is falling even though the United States wants a strong dollar. Given the rise in the relative status of the euro and the presence of oil-producing countries and dynamically developing economies, the prospect of getting the international community to agree on new measures to stabilize exchange rates appears extremely slim.
The fourth and most important point to make about the rise of SWFs is that, as the term "state capitalism" signifies, the basic principles guiding the activities of these government-backed funds — whose operational cost estimates are not necessarily clear — are different from the market-based rules observed by private-sector funds.
Therefore, the growing presence of sovereign wealth funds may seriously distort the functions of the market.
From the viewpoint of private-sector funds, competing with SWFs that are exempt from taxation is unfair and the playing field must be leveled. If an SWF is run by the monetary authority of a country, for example, one question that will inevitably be asked is whether the fund's transactions are being based on insider information about its government's policy decisions.
It is essential to secure transparency in the management of SWFs. The most desirable option would be to outsource their operations to the private sector. That way, SWFs would at least be separated from their governments' foreign-currency reserves and be required to secure the same level of disclosure as their private-sector counterparts.
The author hopes the next G7 meeting will produce effective measures for stopping sovereign wealth funds from distorting the functions of global markets and generate efforts to correct the global imbalances that lie at the root of these problems.
Teruhiko Mano is a professor at Seigakuin University Graduate School.