Tuesday, August 14, 2007

Separation between market and state

I wrote an article Concerns about sovereign funds in Business Standard today where I worry about placing shares - and thus a say in corporate governance - in the hands of governments, particularly those which lack domestic political accountability. It is related to the problems of civil servants managing large reserves portfolios.

Here's a useful collection of readings on the subject of sovereign wealth funds (SWFs) [wikipedia], organised in chronological fashion. I was dimly aware of the problem for quite a while; Larry Summers, Jeffrey Garten and William Pesek woke me up. The recent fracas about China talking about selling US government bonds is an illuminating episode: it tell us something about what can happen with SWFs in the days to come, and it tells us that the reserves portfolio is not that different from a SWF when it comes to such strategic behaviour. On the issues of both the reserves portfolio and SWFs, I'm reminded about the difficulties of `quasi-nationalisation' that arise in the context of government-controlled pension funds getting invested in equities (see this paper, particularly page 34, for the index fund response to that issue).

1 comment:

  1. The post deals with several aspects but I wish to comment on one aspect i.e. a scenario where the Chinese threaten to sell US bonds (treasuries) which would then drive up US interest rates and affect the value of the US dollar.

    Would or should one take such a threat seriously?

    Consider the Chinese do indeed decide to sell US bonds. Now even the whiff of such an action would invite pre-emptive sales by other entities driving down values in advance of Chinese attempts to liquidate. Assume the Chinese try and do it on sly - however, their holdings are so large (and can't be liquidated quickly) that small sales would drive down values causing losses to the bulk of the remainder of the portfolio. Several other countries too hold large chunks of US treasuries. The Chinese would endanger their ties with such countries. We would have the makings of a first rate international political and economic crisis.

    Now assume that the Chinese trembling hand has pressed the sell button. US rates rise and the dollar wobbles. What would it do to Chinese industry, exports and employment? Nothing short of devastation. The attendant internal political instability in China can only be imagined.

    This is even without taking into account how the US could retaliate (repudiate the bonds??)

    So would the Chinese go and shoot themselves in the foot? Most unlikely, in fact a near impossibility. The US and the Chinese are in it together and they swim together and sink together. So we should see statement by the Chinese and the US too as mere posturing. (About 2 years ago a Chinese oil company attempts to buy a US one had come to nought. Noises were made in the aftermath but nothing material happened)

    Even if relations between the US and the Chinese deteriorated it would be analogous to the the Cold War where an uneasy calm prevailed but nobody pressed the nuclear button. In fact, trade between the NATO block countries and the Soviet Bloc continued. In any case the impact of financial bombs are far more easily reversible than those of nuclear ones.

    There are legitimate issues surrounding SWFs and many are discussed in the post.

    But the Chinese example doesn't seem to belong to the category of a credible threat.


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