Sovereign Wealth Funds and Globalization’s Revolution

Sebastian Mallaby has an excellent essay in Monday’s Washington Post on a silent revolution in globalization. He writes:

The next globalization battle lurks over the horizon, but you can already guess its contours. It will be shaped by two revolutions in finance and business: the growth of vast government-controlled investment funds abroad and the muddled progress toward shareholder democracy in this country.

These government-controlled investment funds, or sovereign wealth funds (SWFs) have become a very big story, very quickly. As Mallaby explains, five years ago governments had approximately $1.9 trillion in foreign currency reserves—money used to stabilize their currencies, hold-off financial crises, etc.—but these reserves have grown to over $5.4 trillion dollars, and are expected to continue increasing. Traditionally, governments invested in “safe” investments like U.S. Treasury bills and other sovereign risk-free bonds. But now they are willing to put their excess capital into higher risk investments that have greater rates of return, like, say, the U.S. equities market (see the recent purchase of a stake in the Blackstone Group by the government of China). As finance and investment blogger Nick Vardy explained:

The success of Singapore’s Temasek [an SWF] has inspired the global SWF club of countries — including the likes of Botswana, Australia, Iran, Brunei and Kazakhstan — to take a more active approach to investing foreign reserves.

Vardy estimates that the assets of SWFs may be as high as $2.5 trillion and growing by about $500 billion each year. By contrast, the entire hedge fund sector has assets of about $1.6 trillion. And, as Vardy explains, China’s reserves next year may increase to $1.6 billion (although, of course, only a portion of that may go to an SWF).

Mallaby describes how the growth in SWFs is being driven by petrodollars (especially in Russia, Nigeria, Kuwait, and the UAE) and the global trade imbalance (China and Japan, being the big winners). So, besides a tectonic shift in power in the global investment markets, what does this mean? Mallaby sets it out:

Chunks of corporate America could be bought by Beijing’s government — or, for that matter, by the Kremlin. Given the Chinese and Russian tendency to treat corporations as tools of government policy, you don’t have to be paranoid to ask whether these would be purely commercial holdings.

But the final straw may be that even the least threatening form of investment — the purchase of publicly traded equities — will not escape controversy. This is because of that second upheaval: the advent in the United States of something approaching shareholder democracy… chief executives increasingly live in fear of activist shareholders and directors. Bosses from Harry Stonecipher of Boeing to Carly Fiorina of Hewlett-Packard have been ejected from the corporate suite in a manner that would not have been conceivable a generation earlier.

What if the Chinese are seen to have a hand in the firing of some future Fiorina? The more shareholders exercise power, the surer the backlash against governments that buy up chunks of the stock market.

And this brings us to the title of Mallaby’s essay, “The Next Globalization Backlash,” and the broader point: the rapid increase in sovereign investment in private equity may lead to a retrenchment against economic globalization (as Mallaby put it “Lou Dobbs is going to love this one…”). Thomas Barnett views this as a challenge, not a crisis:

I read [Mallaby’s] piece and remember how the 1990s signaled the oncoming and neverending currency crises that would decimate globalization.

Except the system learned and adjusted and globalization spread even faster. Now, one of those adjustments,the stockpiling of reserves to guard against runs, presents new phenomena that will include both great challenges (to include a new form of “crisis,” I guarantee, that will be sure to signal globalization’s “dooooooooom!”) and new solutions that drive the process ever more forward into terra incognita but likewise more pacifica.

This is a great age to be a grand strategic thinker.

…Or a finance lawyer, I would add.

The revolution will be televised, probably on Jim Cramer’s Mad Money.