Mischief With Forex Reserves
Brad Setser at RGE Monitor provide this commentary on the management of foreign dollar holdings. Setser cites several sources on the accumulation by governments around the world — mostly of oil exporting nations — of large dollar-denominated funds.
While it has been common for a while for countries to amass enormous foreign exchange reserves, and to "invest" in government bonds (not really an investment in the economic sense, but loans to support current consumption by governments). Setser reports on an emerging trend of treating these assets as if they were a private-sector pension funds or hedge fund.
- Norway's government fund is also diversified, currency wise. And it is split between bonds and equities. The Norwegians are ultra-transparent. They not only tell you're their basic portfolio composition, but they tell you the outside managers they use! As of September, 40% of the Government fund's 1712.3b krone (@$263b of assets) were in equities.
- The Abu Dhabi Investment Authority is not as transparent. But most people think a large share of its exceptionally large (at least if rumors are to be believed portfolio) is in equities. Probably around 50%. And most people also think ADIA has more than twice as much money as Norway's government fund.
- KIA (Kuwait's investment authority) and QIA (Qatar's investment authority) both have equity portfolios. If nothing else, they own a bit of ICBC. I don't have a good sense of the equity market share of their portfolio, but it is likely to be substantial.
- Who doesn't hold equities, apart from Russia? Libya. Its money is clearly on deposit in the international banking system.
- ...In aggregate, though, the oil exporters invest a higher fraction of their surplus in equities than say China. Norway exports about 3mbd of oil a day, and it deposited about $50b in its government pension fund. Kuwait, Qatar and Abu Dhabi collectively exported at least two times as much oil and gas as Norway, so it seems reasonable to think they added about as much to their oil investment funds even if they rely on oil revenue to fund current spending far more than Norway does.
There is an important distinction between private sector investment and government funds being used to purchase securities, a point entirely ignored by these commentaries. This probably results from a view of financial markets as a set of asset classes that produce risk-based returns, rather than the nexus of entrepreneurial capital allocation. While the former view does not focus on the instutional context, the latter view does. Entrepreneurial allocation of capital only makes sense when private property is put at risk.
The FT, for example, opines:
Many funds have little risk management or even investment expertise, yet only 30% is outsourced. Asset allocation is also a mess: most funds are nearly 100% invested in bonds, when century-long horizons dictate a high exposure to equities.
This statement bears the markings of modern finance, in which the return of assets within capital markets is assumed to depend on the asset classes, where each asset classes has a historical return and volatility. Risk is equated with volatility. Modern finance treats asset returns as historical data, independent of the institutional context of private property and entrepreneurship.
In a recent piece that I wrote for Mises.org, I raise several issues with the the investment by governments of foreign exchange reserves:
- Mises in his celebrated critique of economic calculation under central planning showed that only entrepreneurs in a private property system can allocate capital in an economically rational way. In modern finance, narkets are assumed to be "efficient", meaning that capital has already been allocated to its optimal use. How they can remain so as central planners come to own an increasing share of equity markets is not addressed within the context of modern finance. Mises' point was that financial markets exist for the exchange of paper claims to real capital so that real capital can be allocated within the real economy. This process cannot be separated from the institutional context of risk taking by owners of private property. When government officials, which do not function as true owners of their own funds, start to allocate funds to these financial markets, financial markets will no longer function to allocate capital.
- The large size of thefund flows relative to the capitalization of the world's equity markets is more than a little alarming. Based on Setser's data, the trend seems more developed and the volumes are larger than I had suspected when I wrote my article. I would be interested to see some data on what fraction of the world's equity markets is now held by central bank forex funds.
- In my article I called attention to the inherent politicization of the process, once governments get involved. Predictably, as Setser writes, hedge fund managers in the world's financial centers are lobbying to take over management of some of these funds. Hedge fund fees are typically 2% of the assets plus 20% of returns-relative-to-benchmarks. The enormous size of these flows clearly represents a huge pool of untapped fees for the hedge fund industry.