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June 21, 2007 7:24 pm
Sovereign wealth funds – state-owned entities that invest excess foreign exchange reserves – look set to become the new bogeymen of global finance.
US politicians fear these public sector money moguls are putting a brake on the reform of managed currency regimes in Asia. Others worry that thousands of billions of dollars are now being shunted around international markets with minimal transparency. Yet another concern, especially since China announced it was to launch a sovereign wealth fund, is that global capital flows could become dangerously politicised, thereby increasing systemic risk in banking.
Amid this plethora of worries, one risk has so far gone largely unnoticed. It lies in the threat these flows pose to high corporate governance standards in the developed world.
In essence, the growth of sovereign wealth funds reflects a change in the approach to managing official reserves at a time of mounting financial imbalances. Most Asian countries now sit on far greater reserves than are needed to ward off speculative attacks on their currencies. Instead of the precautionary motive, the driving force behind reserve accumulation in the region is the mercantilist desire to hold down currencies to promote exports.
The problem for Asian governments is that this policy has a high opportunity cost. A majority of reserves are invested in US Treasury bonds and bills giving no exposure to credit risk or market risk, so returns have been low. Reserve managers have therefore opted to diversify away from the dollar and to take on more portfolio risk. The aim is to generate higher returns to offset the cost of holding such mountainous reserves. Having first moved into into US agency debt and corporate IOUs, Asian reserve managers have now started to dabble in equities.
This seems logical, from their viewpoint. It is intended to achieve a more efficient management of national balance sheets. But for recipients of these flows the consequences could be profound and not uniformly comfortable.
The recent upward adjustment in global bond market yields suggests that some of the heat may be coming out of the credit bubble. A change in asset allocation by reserve managers has probably played a part in that. But if surplus liquidity is diverted from bills, bonds and structured credit products into equities, a distortion may end up being shifted from one asset class to another. Instead of the “conundrum” of unusually low interest rates, we will have the conundrum of an artificially low cost of equity capital.
A consequent risk is that the equity market will experience something similar in corporate governance to the collapse in lending quality that has afflicted credit markets, where “covenant-lite” loans have ceased to impose traditional disciplinary yardsticks for interest rate cover and balance sheet ratios to protect creditors’ interests.
In fact this is already happening as the flotation of the Blackstone private equity group indicates. China’s new foreign reserves agency has agreed to buy $3bn (€2.2bn) of equity alongside this week’s initial public offering. Yet that $3bn will go not into conventional equity. Instead of common stock, it consists of mere common units, which have limited voting rights and no right whatsoever to elect Blackstone’s general partner, which is owned by the directors who retain control.
So China has lent support to an IPO where the liability of the general partner to the common unit-holders is limited and the Blackstone partnership agreement reduces or eliminates the fiduciary duties owed by the general partner to the unit-holders in relation to managing the considerable conflicts of interest inherent in the business.
The governance picture is not all bad. There are no golden parachutes, for example. Yet the reality is that the Blackstone IPO currency is no more than junk equity. The prospectus represents a low point in US corporate governance. The Chinese have not used the clout deriving from their $1,200bn reserves to extract better governance.
If China’s reserve managers are such pussies in dealing with US private equity, it is possible that fears about the politicisation of capital flows are overdone. A more realistic verdict might be that this $3bn investment for China is peanuts and that good governance at Blackstone matters less to the Chinese than obtaining access to intellectual capital and management skills for use in China’s fledgling private equity sector.
The message, once again, is that China’s role in globalisation brings costs as well as benefits.
John Plender is chairman designate of Quintain plc
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