On the last day of August 2007 the U.S. crossed a historic fiscal milestone some would call it a millstone as the national debt topped $9 billion, according to the Bureau of the Public Debt at the Treasury Department, prompting Congress to once again raise the federal debt ceiling. The interest paid in 2006 on this prodigious sum, which has ballooned nearly 60 percent since 2000, was $406 billion and even more in 2007.
There are several factors driving up the national debt, including military operations in Iraq and Afghanistan, the Hurricane Katrina cleanup and ever rising healthcare costs. But the main culprit appears to be a compulsive borrow-and- spend mentality that has turned the world’s wealthiest nation into the world’s biggest debtor. And that’s not counting the approximately $2.5 trillion American consumers have put on their collective credit card while posting a savings rate of negative 1 percent in 2006, the first negative savings rate since the Great Depression.
Completing this grim tableau, the U.S. also regularly runs a trade deficit, which has burgeoned to a record $818 billion from $31 billion between 1991 and 2007. China alone accounts for about $300 billion of that deficit, which has been aggravated by a sharp rise in oil prices and equals about 7 percent of the nation’s Gross National Product (GDP).
The only mitigating factor, and one peculiar to the U.S., is that our foreign debts are in our own specie, mainly due to the dollar’s unique status as the world’s reserve currency. But after two years of free fall that has seen the dollar hit all-time lows against the euro, multi-decade lows against many other currencies and a 28-year low against gold, it is well on its way to losing that status. That, in turn, would further undermine the dollar’s value with potentially serious consequences for the economy, namely recession. But why worry when you can borrow.
To pay for this imbalance with its trading partners, the U.S. absorbs close to three-quarters of the net savings generated by the world’s exporting countries, an unprecedented and possibly unsustainable situation. In total, foreigners hold about 25 percent of the U.S. debt, about double the 1988 figure of 13%, with about half of that being owed to lenders from Japan and China.
Historically, international capital has steered clear of nations that attempted simultaneously to run large budget deficits and large trade deficits due to concerns that this double negative would preclude sufficient economic growth to service the overall debt. In addition, borrowing on this scale opens the country to significant vulnerability in the event of unforeseen economic shocks that could impede the inflow of new funds, shocks such as the collapse of the housing market, turmoil in the energy markets or a major terrorist attack. Sound familiar?
But, in tandem with a weakened dollar, it also means that U.S. assets have become attractively affordable to foreigners flush with cash, and lately there have been indications that the huge dollar holdings held by China, Japan and major oil producers are translating into notable acquisitions in many areas of the U.S. economy.
Increasingly, the vehicle for this investing is the so-called sovereign wealth fund (SWF). Set up by foreign governments to more productively invest (that is, more productively than, say, amassing plain vanilla Treasury bonds) their surplus capital, these prodigious investment pools now encompass an estimated $2.5 trillion, a total increasing by $365 billion a year at the current pace.
First established back in the 1950s, the influence of these investment vehicles is increasingly being felt globally as managers seek out strategic investment opportunities. A recent study by Morgan Stanley envisions SWFs could swell to $17.5 trillion within 10 years, reflecting the prevailing currents of international trade. With their massive resources and the potential to draw on vast credit lines, SWFs can potentially take larger and more leveraged risk positions than even the biggest, most aggressive private hedge funds.
Sovereign Wealth Funds Estimated Assets Under Management
March 2007, in billions of dollars.
|Country||Fund||Assets $ Billions||Inception Year|
|Saudi Arabia||Saudi Arabian Funds of Various Types||300||N/A|
|Norway||Government Pension Fund-Global||300||1996|
|China||State Foreign Exchange Investment Corp. + Central Huijin||300||2007|
|Kuwait||Kuwait Investment Authority||70||1953|
|Australia||Australian Future Fund||40||2004|
|US (Alaska)||Permanent Fund Corporation||35||1976|
|Russia||Stabilisation Fund Corp.||32||2003|
|Brunei||Brunei Investment Agency||30||1983|
|South Korea||Korea Investment Corp.||20||2006|
Source: Morgan Stanley
Of course, this phenomenon is not entirely new. You may well remember that in the 1980s Japanese investors went on a buying spree of U.S. assets, including trophy real estate such as Rockefeller Center, and a variety of businesses. What sets this latest wave of foreign investment apart is that Asian and Middle Eastern governments are taking significant stakes in financial institutions a cornerstone of the U.S. economy.
According to the London-based market research firm Dealogic, foreign governments and their associated investment arms have so far funneled an estimated $29 billion into American financial institutions. Other estimates put the figure closer to $50 billion. This has raised some economic and political concerns, in part because the strategies, governance and portfolios of the funds are largely opaque and because, as state-controlled entities, their decisions may potentially be driven by non-economic factors. Congress may well increase its scrutiny of these deals but reaction so far has been tempered, in part because no SWF has, as yet, sought a management let alone controlling role.
But in the wake of the subprime mortgage debacle, big American financial institutions have come under increasing pressure to shore up their deteriorating balance sheets and the SWFs have been only too willing to lend a helping hand, although their significant positions in these companies has also had the effect of diluting the stakes of existing shareholders.
Last June the China Investment Corporation, the Chinese government’s SWF, sunk $3 billion into the Blackstone Group, giving it a stake of more than 9 percent in the high-profile private equity firm. Then in November it was announced that the Abu Dhabi Investment Authority (the world’s largest SWF) would take a $7.5 billion position in Citigroup.
That was followed in January of this year with the news that Citigroup was to receive a further $12.5 billion infusion from a consortium whose principal investors included the governments of Singapore and Kuwait as well as Saudi Prince Alwaleed bin Talal, a long-time Citigroup investor. At the same time, Merrill Lynch disclosed it was receiving $6.6 billion in cash from the Korean Investment Corp., the Mizuho Corp. Bank of Japan and the Kuwait Investment Authority.
Financial institutions, which routinely borrow large sums to boost returns, are natural candidates for SWF largesse. They are in a highly competitive business, leading to questionable (when the bottom falls out) risk-taking. Unfortunately, when normal channels to capital are disrupted, as in the current credit market turbulence, highly-levered businesses can fail rather quickly. It’s truly surprising how such a small variable such as relying on additional debt financing and not any fundamental problem with the business model or market can lead to insolvency in short order. That is the breach into which the SWFs, with their very deep pockets, have stepped.
For now the SWFs are providing a welcome and needed dose of liquidity at a time when the U.S. economy is undergoing a period of slowing growth and financial markets are experiencing distress. A recent study by the International Monetary Fund concluded that SWFs could enhance market liquidity and the efficient allocation of financial resources, serving to dampen asset price volatility and lowering liquidity risk.
As such, apprehension over the growing role of SWFs is probably misplaced, although the possibility of sudden shifts in large capital positions obviously has the potential to unsettle markets. But, in fact, SWFs are often managed by U.S. and European investment bankers and, unlike typical private equity firms (read hedge funds), SWFs are essentially long-term investors. The funds have also been careful to limit ownership in deference to national sensibilities. In the U.S., for instance, any ownership stake of 10% or more would trigger an investigation by the Treasury Department, something the normally low-profile, publicity-shy SWFs would surely rather avoid.
In the larger skein of things, SWF investments are a by-product of the rapid advance of globalization over the past 30 years. They should be seen as strengthening vital economic ties and common political interests by making lender nations active shareholders in the world’s most important economy thereby fostering a long-term interest in helping the U.S. to prosper. At the same time, SWF investments usefully recycle trillions of dollars the U.S. has expended on Gulf oil and cheap imports, which brings us full circle.
While SWFs are providing some relief today, that money does not represent a structural solution for the problems created by America’s gargantuan appetite for debt and deficits. As previously mentioned, one of those problems is the enfeebled dollar, which is stoking inflation by, among other things, making the cost of energy a much more critical factor in family budgets. A weak dollar also makes it easier for foreigners to buy American assets. To this must be added the most daunting fiscal burden facing the country: the fast-approaching retirement of the Baby Boomers combined with the relentlessly escalating costs of healthcare.
Fixing, or even alleviating, this situation won’t be easy and it will likely take some time. It will require consensus, discipline and sacrifice, elements that have hitherto eluded the country’s political leadership. The U.S. economy remains a marvel of resilience and productivity, but the burgeoning obligations of the nation’s unprecedented debt load threaten to undermine the very foundation of that economy. At this point, only two things are certain. We are living in very interesting times and there isn’t a moment to lose.