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12/10/2007

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Ryan Brown

$1.5 Trillion (not Billion) aggregrate hedge fund assets under management

Ignacio Concha

Very interesting post. I share your bias towards having governments (or corporations) distribute any resources in excess of what they need to function to its citizens (or shareholders). Otherwise, I agree that such accumulation leads to mismanagement.

However, in the case of governments, I was wondering whether the creation of sovereign funds does not have a role in preventing a drop in the country’s foreign exchange rates and avoiding the so-called "Dutch curse" or "oil curse." Not being an economist, I thought that if governments did not avoid the flood of foreign currency into the economies of their countries, the exchange rate would fall to the point that any other activity could become unprofitable, causing unemployment and a number of other social ills.

Also, in the case the assets in the sovereign funds to be distributed were enough, wouldn’t it be possible that the incentives for the citizens of a country change for the worse? Maybe citizens receiving a (personally unearned) windfall from the government would see themselves as rent-seekers instead of taxpayers. Thus, they may abandon their drive to pressure for good governance. Let us look at what is happening in the USA where many seem to think of themselves as rent-seekers and believe that the government can afford to give them all sorts of (personally unearned) benefits (e.g., universal healthcare, social security, balance the budget, etc.), without concern for fiscal responsibility or prioritizing expenditures, if only it “taxed the rich.”

Many thanks in advance. I thoroughly enjoy your blog and read it every week.

Happy holidays,

Ignacio Concha

Robert

Why would China's trade surplus (alone) give them wealth with which to create a sovereign wealth fund?

Sophia

"Why would China's trade surplus (alone) give them wealth with which to create a sovereign wealth fund?"

China's trade surplus means that it exports more goods than it imports; thus, it also receives more monetary payment from other countries (chiefly the US) than it pays out. That is why it has such enormous foreign reserves, and why China could afford to buy $3 bil of Blackstone earlier this year.

I'm a bit perplexed about this statement in Becker's post, though: "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."

I can see the argument for why these fund managers would be more conservative, but doesn't that simply mean that they will accept lower returns and lower risk, not "have only limited financial incentives to try to achieve higher returns for given risk"? Lower returns for high risk isn't a principal-agent problem; it's just stupidity.

Robert

In response to my question, Sophia wrote:

"China's trade surplus means that it exports more goods than it imports; thus, it also receives more monetary payment from other countries (chiefly the US) than it pays out. That is why it has such enormous foreign reserves, and why China could afford to buy $3 bil of Blackstone earlier this year."

Thank you for answering my question. I understand how a trade surplus works, my confusion is over why a trade surplus translates to the sovereign possessing the surplus funds. Running a trade surplus means the nation as a whole has the money, but why is the Chinese government in control of all of it?

I understand that China is ostensibly communist, but aren't the means of production semi-private? Thus the surplus should be in the hands of these quasi-private corporations, no?

Sophia

I thought I misunderstood the question - you do seem too smart to be asking how trade surpluses work. ;)

I may be wrong, but my understanding is that the trade surplus in China ends up in government hands because all the banks in China are still public. Private companies do the exporting and the money-making, but then they bank their profits and the government takes over from there. If anyone else knows better than I, please correct me.

Raul

Sophia and Robert:

Re the issue of how the government ends up with a big chuck of the surplus:

I'm no expert but this has bothered me for a while! Here's what I think: China does not allow free and full Dollar convertibility of its currency. Ipso facto there are Chinese regulators who can somewhat arbitrarily fix and offer an exchange rate. This, if you think closely, is an alternative was of skimming off some of the incoming dollars.

Let's say you were a Walmart supplier in China. You produced and sold to Walmart 1000 pairs of shoes as a dollar denominated transaction of $20,000. Now once Walmart pays you need these $ converted to yuan to pay for , say, local raw-material, labor , taxes etc. NOW THE CRUX: If the govt. gets to "decide by decree" that 1$=x yuan it automatically allows it leeway to shovel dollar currency to its reserves. {monetary monopoly that nations enjoy allow them to arbitrarily print enough money to cover these transactions; inflation anyone?} In fact, I think thats the way to keep its currency artificially undervalued(to boost exports) too!

Caveat: Maybe I'm totally wrong. No formal training in Economics! Feel free to correct me fellow blog-readers who are better informed!

Raul

I disagree on several points raised:

(1) "...I do not believe that the scale of these funds is a healthy development for these countries...."

Why not? Collective bargaining is frequently advantageous for entities.

Also, if UAE, say, thinks it does not have many fruitful positive NPV projects I'd be up for it looking outside. i.e. global investment markets!

(2) "....being government employees on fixed salaries, have only limited financial incentives to try to achieve higher returns for given risk....."

Maybe limited risk-taking abilities are a virtue Look at the CDO S&L debacle; are we happy in hindsight of the risk private risk-managers took? I'd argue private sector financial managers have TOO LITTLE incentives for AVOIDING risks! Most CEOs come with a cushy severance package with the express design of promoting (unnecessary?) risk-taking abilities!

(3) "...but that consideration alone does not imply that governments rather than households should do the saving...."

Look at the US; left to their own have the US population saved enough in the last decade? Sometimes it behooves the government to step in to cover the shortcomings of its people.

(4) "....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...."

For most of the middle east we are speaking of developed, infra structurally advanced nations. They aren't withholding money at the cost of infrastructure, education, health-care etc. Maybe they really do have more than they need right now. What's wrong in prudently saving for an unforeseen rainy day ahead?

(5)"....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...."

Isn't the US-Fed actively interacting with our money-markets too? Unless you advocate a truly lassiz faire approach all through I think its double-standards.

Asher

"approximately $1.5 billion invested in hedge funds" I think you mean $1.5 trillion dollars, and according to some estimates it is more. So it sounds like there is actually rough parity between hedge funds (which are only one private investment vehicle) and sovereign funds.

minderbender

$1.5 billion invested in hedge funds? I had no idea they had grown so huge. However, I've read that many hedge funds over-report the amount of money under management, so we can safely assume that the real number is in the tens of millions. Since there are dozens of hedge funds, the average hedge fund probably controls about $1 million. That's still a huge amount of money, though - no wonder those guys are getting so rich!

Jack

Alaska Permanent Fund; perhaps a summary of that public policy would be helpful here.

Alaska had the "problem" of having too much income from our once in eternity extraction of our oil. I say "our" oil as most of it is on state owned land so unlike oil in other states it is owned by the residents of Alaska.

For a time we did spend on the truly unmet needs of our huge, formerly poor, new state. Then as discussed here legislators were tempted to "invest" in flakier and less urgent projects. What to do?

The PF was created with only a small percentage of the oil income headed for Juneau, and invested broadly under "prudent investment" standards used for large retirement funds etc. in a mix stocks, bonds and R/E. The investment advisers are insulated from the demands of legislators and rent-seekers. Today, it is the investment returns, rather than new oil revenue that generates the inflation proofing, dividends and growth of the $35 billion fund.

With few exceptions conservatives, moderates and liberals support the fund due to the dividend that provides benefits to all including kids who may have $20,000 or more toward their college costs. There seems a generational equity aspect in that it moves a bit of our one-time oil wealth forward as new residents are born or move to Alaska.

In Alaska's case the Fund is no threat to anyone as the prudent man investment mandate would prevent anyone or even a board run amok from steering it all in one direction.

Had one the option of starting with a blank slate for an "oil rich" nation such as Iran or Iraq it would be interesting to consider, all or a sizable fraction of the oil royalties accruing to the a permanent fund for the benefit of its citizens, and leaving to the legislators the task of taxing it away to run the nation.

I put "oil rich" in quotes above as there are few nations today who are oil rich. Consider Iran with 65 million population and perhaps 4 million bbls per day. While the income is surely a boost to its public sector that works out to under 3 gallons per day/resident.

W/O picking a side on the nuke power vs bomb issue, these numbers may help to explain why Iran or Alaska would be as interested in cheaper energy alternatives as would any other nation or state; in short; we Alaskans pay as much for our fossil fuels as anyone else and were we to "make it cheaper" for ourselves we'd lose the income from selling it at "the market"/ cartel price.

On the main topic here, of concern about, less than democratic nations hoarding money, I'd be at least as concerned as Posner.

Perhaps a leading concern would be that of energy prices pulling so much money out of the world's economies that hoarding it (or even "re-investing it" by taking ownership of existing corporations and productive assets) is deflationary, ie adding to world wide recessionary pressures as the cash is removed from the consumer demand cycle and its loss magnified by the, then, negative multiplier effect.

Lastly, it may be informative to look at Wiki on hedge funds. It appears that Asher's $1.5 trillion is a good estimate of their assets and the top ten had returns of 30-50%.

http://en.wikipedia.org/wiki/Hedge_fund

Jack

Re: "Those policies include failure to exploit our Alaskan and offshore oil resources more vigorously, because of the opposition of environmentalists...."

Perhaps a truer summary of the "debate" about exploiting Alaska's National Wildlife Reserve is that many of the hold-outs in Congress are insisting upon a package including a more rational energy policy in the US before pumping out one of our last reserve tanks.

A more immediate policy concern is why this Admin along with a cartel of big players have combined to delay this project to front-run costly and inefficient LNG projects before building the long proposed 50" Alaska-Midwest gas pipeline that would supply ten percent of our current NG consumption. The project has been viable for a decade and the cost has doubled since a proposal was put together in 2001. Worse yet, since it's about an eight year project, we could have been expecting the benefits in a year instead of the distant future.

Still, what could be better for a North America facing recession than a, now $50 billion project that spins off jobs in many sectors that will be paid for many times over by domestic production of ten percent of our NG consumption and the dampening effect it would have on all energy prices?

a Duoist

If you cannot afford a nuclear aircraft carrier, start a sovereign fund in order to influence an adversary's behavior. When Iran, Venezuela, and others start their funds, watch geopolitics go commercial. The sovereign funds are governments, not investors, and eventually they will reflect government policy in their investing decisions.

Matt Lykken

Dear Professor Becker:

Based upon conversations with Norwegian friends, I think your observations are supported by the reality on the ground. While the government may have wonderfully good intentions, the paternalistic practices of their government fund clearly are not helping the population as much as they could help themselves if they had control over the funds.

On a related point, should America be particularly concerned about the accumulation of such funds? I particularly worry about the chain of events that could be triggered if one of the proposals to eliminate the deferral of current taxation on foreign earnings was enacted. (My organization, sharedeconomicgrowth.org, is advocating a dividends paid deduction proposal that we think would do great things for the U.S. economy while accomplishing all of the objectives outlined by the anti-deferral advocates.) If such a proposal went through, many U.S. multinationals would suffer a loss in intrinsic value on the order of 25%, a loss that a foreign acquirer could reverse simply by buying the corporation. Between this threat of impairing the value of our own corporations, the weak dollar, and these growing piles of foreign cash looking for equity investments, it would seem that our economy could suffer irreparable damage very quickly.

Geld Lenen

Dear professor,

I must agree with Matt. In a discussion in our class with Dutch students we had almost the same opinion.

Perhaps the difference EU vs. USA?

Strange but true :)

GL

E. Poole

I trust the irony of this critique of sovereign funds is lost on no one given the current backdrop of the ABCP-driven credit crisis and the obfuscation brought about structured investment vehicles (SIVs).

Why not simply work to make the sovereign funds of developing countries as transparent as that of Norway? That has to be an easier challenge than attempting to increase human capital levels in developing countries to the levels of advanced saver nations so households would know how to manage well windfall cash payouts from the state.

Frankly, I don't understand the concern about corruption. A priori the challenge in distributing money corruption-free directly from royalties or over time from a national investment fund must be similar. Though I suspect that immediately distributing all royalties increases the *time inconsistency* challenge for government. At some point, more will be distributed than is socially wise.

The corruption issue is often exaggerated. The USA has managed to plunder and squander significant renewable and non-renewable natural resource wealth through entirely legal means.

Moreover, these countries have good historical reasons to maintain public wealth: national security.

As a matter of empirical instruction, it would be interesting to learn of examples where households and other private entities have successfully managed nonrenewable resource wealth along the lines of the *Hartwick Rule*, without figuratively taking the money and running, i.e., leaving impovershed communities behind.

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