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Economics Weekly - Sovereign Wealth Funds importance to the global economy; Weekly economic data preview - US Fed will almost certainly cut interest rates on Tuesday

Economics Weekly  10 December 2007

Sovereign Wealth Funds importance to the global economy

Sovereign Wealth Funds are here to stay…
Global financial markets have awoken to the rise of Sovereign Wealth Funds (SWFs), although they have been around since 1953. But what has made them so much more important and given them prominence recently is their size, their strong potential rise over the coming years and the fact that so much of the increased wealth is in emerging market funds, see table 1. This implies a shift in the balance of power in financial markets from the developed economies to the new emerging economies. This, of course, is a mirror image of the shift in relative economic power taking place, away from the current developed economies to those that are rapidly emerging. The surprise would be if this rise in wealth in emerging markets were not to be happening. The fear for many is that the size of these funds is estimated to rise from around $2 trillion currently to over $14 trillion in a decade, i.e. by 2017, if current rates of growth persist. And that could lead to a takeover of many firms in developed economies and control by foreign governments. But are these fears justified?

...and there is little to fear…
These funds manage national saving in the form of stocks, bonds, property and other financial instruments, much in the same way as traditional fund management firms. They clearly have their origins in the form of rising foreign currency reserves, from the proceeds of exports of a range of goods, including commodities, see chart a. These exports in total are a function of fast economic growth and of commodity price rises coupled with growing demand. Many of these wealth funds are derived from oil and gas and from general exports, see chart a. But they are managed not as reserve currencies but as investable funds as is the case in a conventional fund.

So what is the difference between SWFs, fund management firms and the management of official reserves? The answer appears to be: not a lot. They seek to raise returns so that future income is maximised, to diversify future earnings, and to protect future wealth when current income streams are depleted.

The concern about these funds stems from their sheer size, buying power and a worry that they are or could become tools of government policy. But in our view many of these funds are acting more like actively managed central bank reserves funds, under the auspices of central banks but usually separate from them.

…but transparency from these funds is needed to ally concern
What is needed is transparency, about holdings and underlying business rationale. But this is an issue about financial openness not about national or other risks from these funds. Faster economic growth, in official reserves and so in global financial markets is what is in prospect, see table 2 and chart b. This is why the UK government recently came out and said that it welcomes sovereign wealth fund investments from China, so long as these funds are transparent – the strategic and business rationale is there for all to see - they would clearly be a good thing for the UK.

SWFs will boost global capital markets and raise wealth
The SWFs derive their position from high commodity prices and fast economic growth in the emerging markets. This process is not going to end in the next few years and so we expect the SWFs to become even larger and consequently more important in the years ahead. But these funds have the potential to boost global financial markets, especially in future years, and also to change ownership of many of these assets, though in a much bigger overall market. This should not be feared. For example, there is a lot of evidence that these funds have underpinned equity and bond markets as the turmoil in credit markets has hit global financial markets. The main lesson is that this new wealth has the capacity to revitalise and recapitalise many of the potentially ailing financial companies in the developed economies.

SWFs take equity stakes in firms and invest in the usual range of assets, but rarely take full control. Hence, for many years they will act to underpin the global financial system. Moreover, the rise in the wealth of these emerging markets should be recycled so that borrowers and savers are more easily matched. Not doing so runs the risk of undermining the global economic system, as funds need to be shifted from savers to borrowers (in other words, from exporters to importers) to keep savings and investment in equilibrium. Preventing this process by banning SWF investments could cause future global financial crises, not prevent them.
Trevor Williams, Chief Economist

Weekly economic data preview

US Fed will almost certainly cut interest rates on Tuesday

Comments by Fed members, including Chairman Bernanke, as well as another month of weak data declines in the November ISM manufacturing and services surveys and continued weakness in the housing market - have cemented the market view that US interest rates will be cut by 25bp or even by as much as 50bp on Tuesday. We are calling a cut of 25bp to 4.25%, although given growing concern by some that the economy could dip into recession, a larger 50bp cut is a possibility, although unlikely in our view. With the US Fed ahead with cutting rates, the Bank of England having delivered its first in a series of expected cuts and the ECB holding rates at 4%, despite serious concerns over inflation, markets have largely reacted to data on growth rather than prices. But this may be about to change as inflation fears resurface, leading to a softening in market perceptions of the speed and direction of interest rate movements. This week, data may show strong growth of producer prices and wages, as well as high levels of capacity utilisation, bringing a chilling reminder that inflation pressures are mounting in the major economies. The Norwegian Central Bank and the Swiss National Bank may pause their long run of hikes, holding rates, at 5.0% and 2.75% respectively.

• The US issues a plethora of data this week, which will help the debate about how low and how quickly the Fed can cut interest rates. US jobs and earnings growth data published last Friday were indicative of an economy growing at least at a trend rate, certainly not one facing recession and for this reason we believe that US interest rates will rise in H2 2008. This week, reports could support this view as import prices could rise at an annual rate of 11.1% in November. This may contribute to 6.2% annual growth in producer prices and 2.6% growth in core producer prices. Also, figures may show that US industrial companies were operating at 81.6% of capacity in October. This set of data combined, suggests that Friday's release of November consumer price inflation may show a sharp jump of 0.8% on the month, equivalent to 4.3% on the year - the strongest rate of growth since June 2006. Core inflation may edge up from 2.2% in October to 2.3% in November, suggesting that higher foodstuffs/ energy prices are not the only problem, but prices of manufactures and services are rising as well. On Wednesday, data may show the US trade deficit worsening to $57bn in October from $56.5bn in September. In Q3, foreign outflows of US TICS capital of $24.7bn failed to match the $172.3bn trade deficit, highlighting the possibility of a large external funding gap.

• In the wake of a pre-emptive rate cut by the BoE against slower economic growth, producer prices and labour market data may come as a reminder that near term inflation risks are high in the UK as well. On Monday, November producer input prices rose 1.7% on the month, 10.3% on the year. Producer output price growth accelerated to 4.5% from 3.9% in October, the highest annual increase in 16 years. Although part of this rise is related to higher prices of foodstuffs and commodities, 2.2% growth in core prices (2.3% in October) suggests that inflation is not yet being fully passed on to the wider economy. But jobs and earnings growth data, published Wednesday, may suggest that there is no room for complacency on the inflation front – the unemployment rate on a claimant count basis should remain at just 2.6%, while average 3-month earnings may rise by 4.2% in October from 3.7% in September. A UK trade deficit of £7.7bn is forecast for October, just a touch down from £7.8n in September, bringing the cumulative YTD outcome to £70.9bn. This suggests that 2007 is likely to break last year's record trade deficit.

• November's EU-13 inflation rate will be confirmed at 3% on Friday, highlighting the main reason for the ECB's debate about whether to raise rates from 4%. The ZEW survey of investor sentiment may weaken further to minus 34.5, but this may reflect tight credit conditions and market turbulence rather than any lasting problems with the German economy.
Nichola James, Senior Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500

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