SWF Money - to Invest or to Spend?
Cash is king! Thus spells many a seasoned business man's motto as she knows only too well how those alluring credit and debt markets may not be so accommodative come tomorrow. In the current environment only the most blatant optimist would dare to disagree with the idea that at all points in time it is nice to have a war chest from which to be able to extract resources when the rain rolls in over the hills; or in the case of the US et al. a trusty creditor who does not shut the door. However, how much cash do you need and to what extent do you wish to build your wealth upon claims on others' willingness to spend? These two intertwined questions struck me as I read Stephen Jen's recent elaborations on Morgan Stanley's Global Economics Forum. As often before Jen frames his argument in the immediate context of the sovereign wealth funds which is not of course coincidental. SWFs, which are basically state sponsored investment vehicles in charge of investing the proceeds of foreign exchange rate accumulation and/or external surpluses (which essentially amounts to the same thing), have fast become a catch-all paraphrase for excess global liquidity and by consequence global capital flows. As a result the writings on SWFs have grown almost exponentially over the course of the last 6 months. In particular Roubini's RGE analysts as well as Morgan Stanley's research team have been studying these entities closely. Here at Alpha.Sources it has been equally impossible for me to avoid the SWFs in my writings on the global economy and her markets. Essentially, there is nothing wrong with this. The SWFs are becoming an efficient way to operationalize the flows of global savings on a sovereign level obviously conditional on the fact that they divulge their portfolio compositions; most do not in fact but the power of deduction rarely fails, just ask the blogosphere's in house detective Brad Setser. However, I have always felt that while the SWFs clearly represent one of the main legs in the whole discussion of excess global liquidity/savings as a counterpart to profligate deficit nations (i.e. the global imbalances) it is not the only important issue. In fact, without seeing the emergence of the SWFs together and in the context of the rapidly changing composition of global demographics we are not getting the whole story. To be fair to Jen here he does in fact mention demographics often in this context but I just feel that we need to 'mention' it a little bit more.
What am I talking about here then?
If we return to Stephen Jen he makes the initial reasonable point that SWF funds need to eventually be spent. I agree but I also think that spending is the wrong word here since none of these proceeds from FX reserve accumulation and bulging trade/income surpluses is spent in the traditional way of consumption expenditures but rather it is invested in assets which are suppose to generate income/cash flow which can then be spent. At least I think we need to get our definitions straight here since channeling FX reserves into spending as understood in traditional economic terms would also amount to dissaving which is an entirely different thing. The reason why I am making a niggle out of this is quite simply that is important to understand the implications for global investment and capital flows depending on whether we are talking about spending or investment.Perhaps I am picking on a straw man of Jen's argument since what I do like about his piece is the point about how investment of FX reserves are subject to intergenerational dynamics and thus by consequence demographics.
SWFs are meant to be spent, either for the current population or for future generations, and how they are invested and managed should be a function of the ‘opportunity costs’ of not spending the money now on physical investments. Some countries have a more urgent need for tapping these resources today than others. For example, the likes of Russia, Saudi Arabia, Brazil and India have legitimate needs for significantly more spending on infrastructure to enhance the overall efficiency and diversification of the economy. The recurrent and lasting benefits of significant spending today could easily be justified in some cases, assuming that the government has the capacity to implement these projects efficiently. At the same time, countries like Norway, Japan, Korea and Singapore already have fairly good infrastructure and therefore investing in overseas financial assets through SWFs, so that their future generations can decide on how to spend the wealth, is quite clearly preferable.
I fundamentally agree with the idea behind the dichotomy presented above but there I have two major objections. The first relates to the grouping of countries. According to Jen we are able to identify three overall sources of more or less perpetual external surpluses. Number one would be surpluses driven by commodities exports, number two non-commodity exports, and under door number three Jen identifies 'capital flows'. These definitions are a bit spurious but more importantly I think Jen is forgetting one major driver, namely demographics. In order to understand what I mean in the context of the concrete article at hand here let us go back to the point about intergenerational spending. As Jen puts it; some nations will have a preference for spending/investing today and some will have a preference for spending/investing later. However, this strikes me as a bit too simplified. Why would the latter group not want to invest their savings today? The key point is that they wont be spending them at home. This is also why I think we might be able to tweak the grouping presented above. Couldn't we thus say those countries in the latter group with little propensity to invest their savings at home will want to invest them abroad in order to earn income which can then be used for domestic spending? In order to explain why such dynamics might exist we consequently need to turn to demographics. As countries age as proxied by the median age of the society we can expect that exports of both goods and capital to account for an ever increasing share of total growth. If this is true and I think there is ample evidence to suggest that it might we may be able to provide a more satisfying explanation of the global capital flows.
Conclusively and this is one of the things I ultimately intend to investigate in the coming future I think that this inter temporal effect of investment/saving and spending that Jen is scratching at is in part a direct result of the global demographic transition. If we couple this idea with the economic concept of 'capacity' ageing economies quite simply have to export and invest their proceeds abroad in order to earn income to attempt to induce consumption which in turn will spur growth thus (perhaps) ultimately allowing these countries to preserve their welfare societies and in the context of the most rapid agers keep the rating agencies at bay. What I am suggesting as a working hypothesis is then the following. As a result of the global and ongoing demographic transition there will be a tendency for countries to develop the same inter temporal preference for accumulation of savings/investment over consumption. This is what Jen talks about when he mentions intergenerational spending of SWF money. However, there is more. This 'crowding' of countries in one end of the intertemporal spectrum of savings/investment and consumption is not coincidental and perhaps most importantly it will result in important global externalities. The drivers of this tendency (to the extent that it exists) need to be found in terms of life cycle dynamics aggregated to population levels. At this point I feel that we are far away from really pinning this one down. However, one part of it is related to three potential hypotheses that I am working with in terms of consumers life cycle pattern. 1) people do not dissave to 0 since they do not know when they will end their existence. 2) Rising life expectancy will induce consumers to save more and longer during their life cycle. 3) Ageing societies are likely to, one way or the other, promote forced savings in order to ease the societal burden of the intergenerational skewness as the dependency ration rises. If we add this together with the decline in home bias currently observed in Japan (the oldest society on earth) we consequently run smack into the externalities I was talking about before. Consequently, if we go back to the point on intergenerational preference for spending we need to understand that ageing economies will indeed attempt to invest their accumulated savings. They have to in order to earn income but they cannot invest it in their domestic economies. Thus we have the externality in the sense that as the world ages we are likely to see a process by which more and more countries will develop a propensity to 'export' in order to sustain growth. As we can then see this rudimentary theoretical framework which tries to explain global capital flows as result of a process of 'over-crowding' towards one end of the inter temporal spectrum of investment/saving and consumption has ageing as a decisive trigger effect since it is ageing which induces the externality described above. At this point it should then be clear that this cuts right across the whole discourse about de-coupling/re-coupling, global imbalances and the existence of a global savings glut of excess liquidity.
Finally, you may feel that I am circumventing Jen's arguments here. I did not intend to. As I have repeatedly noted I do think that Jen generally is very much on the right track. So Jen, if you by any chance reads this ... keep digging!