Sovereign Wealth Funds, Reserve Diversification, and Capital Flows
By JC Collins
There are wide assumption being made, and rightly so, that the Fed has put itself into a corner and cannot raise interest rates. It’s the hot topic of the week and passions over another delay are running high. Whether there is domestic justification for a rate increase or not, the lack of justification internationally has widely influenced the Feds decisions, as outlined in the official announcement.
It has always been my contention that there are ways out of this seemingly unavoidable trap. Any multilateral framework at some point would have to account for the disparity in interest rates and balance of payments.
The problem the Fed has, which is reflected in the recent international demands not to raise rates, is that the US dollar makes up a large percentage of the currency composition of the foreign exchange reserves. The diversification of these reserves is necessary in order to correct the global imbalances.
It is probable that before there is one supra-sovereign reserve asset, such as the SDR, there will be a broad diversification of reserves into multiple currencies, something like a balance between USD, euro, and yuan in the currency composition of the foreign exchange reserves.
But how could such a diversification take place?
If the Fed raised rates this week it would have caused a massive capital outflow from the emerging economies and additional market and exchange rate volatility. It was my prediction that the Fed would increase rates this weeks, and if not, in October or December, and that the inevitable volatility would cause the existing arrangements and monetary frameworks to shift, leading to floating exchange rate arrangements and further reserve diversification.
Though this may still happen in October or December, it is apparent that the Fed is considering the overall macro stability of the international monetary framework. But in further delaying the rate increase, the Fed is flirting with losing creditability and supporting the conclusion that they can never raise rates.
So what can be done about this situation?
Without a functioning multilateral framework there are limited strategies which central banks of both the developed and emerging countries can implement. The willingness to work together, aside from the 2010 IMF Governance Reforms, is apparent in this weeks Fed decision.
Regardless, the central banks of the emerging countries, China being the largest player, do have a course of action which they can take.
The PBoC could transfer their large holdings of USD denominated foreign exchange reserves into their sovereign wealth fund, the China Investment Corporation. The complexity of such an action would be dominated by the allocation of the USD denominated assets according to actual market capitalization. This would be an opposing strategy to the traditional liquidity considerations which have largely influenced the Feds recent decision.
Such an action on reserves would push official portfolios into having more of an unbiased position on the major reserve currencies. China’s push to have the renminbi included into the SDR composition, and achieve an official reserve status for its currency, would facilitate such a strategy.
This is the interesting part. Any Fed rate increase is expected to cause major capital outflows from the emerging economies and into the developed economies. But under such a reserve diversification strategy as explained above, any pressure caused by a Fed Rate increase would be offset by an increase in capital flows from the developed economies to the emerging economies.
This reversal of capital flows would take place because the existing currency composition of the foreign exchange reserves are over-weighted in US dollar denominated assets, and to a lesser degree, the euro. This is representative of the balance of payments deficits and surpluses which have caused the global imbalances in the first place.
Because the currencies of the emerging economies make up very little of the foreign exchange composition, they would benefit from such a diversification of reserves into sovereign wealth funds as capital would flow from the developed economies.
Sovereign wealth funds could invest those reserves according to market capitalization weights, causing net capital outflows to the developed economies as the emerging economies attracted net capital inflows.
This strategy would in effect be the unwinding of USD denominated assets which we have discussed here previously. All countries, not just China, could diversify their USD denominated reserves by transferring them into their own respective sovereign wealth funds. The large rebalancing flows would be far less constrained than the official substitution of reserves through a process facilitated by the International Monetary Fund.
As such, we could potentially see the emergence of the sovereign wealth funds as very influential international financial participants. Under such a scenario there would be a lack of sovereign wealth fund transparency, a reversal of decades of financial privatization, and enhanced risks to global financial stability further down the road.
There would also be a need to restructure exchange rate arrangements as the large rebalancing of capital flows would put pressure on existing asset valuations.
The interesting part of sovereign wealth funds is that some are already using the SDR as a means of maintaining their accounts, such as the Arab Monetary Fund. Back in July, 2014, I wrote an article titled The Arcane SDR Supra-Macro Asset, where I explained some of this in more detail, along with the rise of regional currency units.
It doesn’t take a big leap of imagination to see how a process of reserve diversification using sovereign wealth funds could lead directly into the substitution of invested reserves for SDR denominated assets in the event of another financial crisis down the road. This in fact could very well be the play as the sovereign wealth funds become bloated with reserves and invest that wealth into the stock markets around the world, leading to new and larger bubbles.
This could very well lead to another commodities boom as the sovereign wealth funds invest in massive infrastructure projects.
In fact, the China Investment Corporation has already stated it is ready and able to work with the Asian Infrastructure Investment Bank (AIIB), which most countries of the world, including US allies, have signed up with as founding members.
Sounds like a great strategy on unwinding the large amounts of USD denominated foreign exchange reserves.
Perhaps we are not in store for a crash in global stock markets, and perhaps we are on the verge of another large expansion of global liquidity through massive sovereign wealth fund investments. The end to this strategy will be similar to what has been unfolding over the last 7 years. The coming of the SDR supra-sovereign asset may not be scheduled for the next 12 month period, it’s engineering and preparation in fact could be used to stave off the next large round of financial instability which will take place 4 or 5 years down the road.
The construction of the multilateral framework is a monumental task requiring years and great patience. I will continue to research and provide a realistic analysis in the months and years ahead. Right now low interest rates are a problem, as are USD denominated foreign exchange reserves. The unwinding of these reserves through the sovereign wealth funds, followed by the large investment in the worlds markets, will facilitate the increase of interest rates and the reversal of the expected capital flows back into the emerging economies. – JC