Follow the Money

Oil is trading above $120. Saudi Arabia exports more oil than anyone else.     It isn’t unrealistic to think the Saudis oil export revenue could approach $400 billion a year if oil stays above $120. Saudi economic development has lagged the Gulf boom towns of Doha, Dubai and Abu Dhabi.  Paul Murphy, quoting Goldman’s Ahmet Akarli: the Saudi economy has lagged badly behind its peers in the Gulf region in terms of both per capita income and overall living standards – in particular, it lags the rapidly diversifying and prosperous economies of the UAE, Kuwait and Qatar. The right policy course: a bit of austerity.  Yep, spending cuts.   Or least slower spending increases. That at least is what the Saudi central bank governor suggests.    The FT reports: Saudi Arabia’s central bank governor on Tuesday called on the government to fight inflation by curbing public expenditure, warning that economic policies in the kingdom faced “a critical situation” …. “The Saudi Arabian Monetary Agency [the central bank] has taken steps to reduce domestic liquidity by raising the statutory reserve requirement several times. Given the dominance of fiscal policies on the economy, it is necessary to reprioritise spending and programme it to fit the absorptive capacity of the national economy,” Mr Sayari added. The IMF – which has been arguing for maintaining the dollar peg and limiting inflation with spending cuts – presumably approves.   The IMF’s advice to Oman is presumably not that different from its advice to the Saudis.    Not that the IMF’s views matter.   The US, which is rumored to have put pressure on the Saudis to maintain their peg to the dollar, presumably does too. Basically, SAMA and the IMF want the Saudis and the Gulf to spend more on global financial assets – as the fiscal contraction only will fight inflation if the oil revenue is sequestered abroad – and less at home. All just to maintain a peg to a currency that isn’t a good fit for an oil-exporting region. A currency that rises and falls with oil makes a lot more sense for an oil exporting economy than a currency that falls when oil rises and rises when oil falls. Right now, the Saudis are trying to cut spending in the face of a (positive) oil shock in order to squeeze the Saudi economy into a depreciated currency. They should be allowing a stronger currency to create more economic space to enjoy the oil boom.  Or at least room to spread the benefits of the oil boom a bit more widely. A stronger riyal – assuming the rise in riyal was real not cosmetic -- would make more domestic spending and investment consistent with lower levels of inflation. In the 1990s, the Saudis had to cut back because they weren’t getting enough revenue from the oil.   The rising dollar added to strong deflationary pressures.   Real rates rose.  Now, the Saudis face pressure to cut back even as oil soars at least in part because they have pegged their currency to the depreciating dollar. I rather suspect the current policy won’t work.   The Saudis cannot cut spending enough to really bring about a real depreciation of the riyal.   Not with rising public expectations and tons of petrocash. Goldman’s Akarli expects Saudi inflation to soon reach 15%.   I suspect he is right.   And there is a real risk that the resulting period of negative real interest rates will only add to the Gulf’s history of following big booms with big busts.

Henny Sender has an excellent account of China’s decision not to allow the China Development Bank (CDB) to invest in Citibank in January in Monday’s Financial Times. It follows on Richard McGregor’s earlier analysis of China’s decision to allow Chinalco to take a big stake in Rio Tinto – a stake whose purchase Chinalco financed through a loan from the China Development Bank. Together they paint a reasonably comprehensive picture, I suspect, of the way China’s government decides what kind of external stakes Chinese state institutions should be allowed to buy. Sender argues that the CDB’s failure to get a stake in Citi shows that the big sovereign funds aren’t rather like big private investment funds – they have to keep their big shareholders happy as they try to eke out the desired returns. “But as the story of Citi and the Chinese reveals, SWFs have a lot in common with other big funds in the financial world – the same need to keep their investors happy and meet their returns criteria, giving their negotiations a flavour entirely familiar to the bankers and lawyers around the table.” The way Wall Street reached out to these funds and how they responded suggests there is nothing sinister about this two-way courtship. It has instead been a process marked by competition, calculation and miscalculation on both sides. Indeed, its very messiness might provide some reassurance that the sovereign wealth funds hardly seem to have nefarious agendas. However, Sender’s description of the decision making around the China Development Bank’s desire to invest in Citi left me with a strong sense that China’s state investment has a different flavor than investment by private firms: The overall investment process seems incredibly politicized, with the key decisions made by the top level of China’s government. Bureaucratic politics drove the outcome. Sender: Ultimate authority in Beijing resides in the State Council, which acts as the arbiter among competing interests in China. No matter which organisation Citi approached, the fate of the Citi request for cash would come to be decided behind closed doors there. CDB’s Mr Chen returned to Beijing from New York and began making telephone calls. He had two tasks: to convince the authorities in Beijing to approve his ambitious plans; and to do some rapid due diligence checks on Citi. …. The “story” was particularly important at the turn of the year, as the Chinese authorities were becoming apprehensive about overseas investments. CIC’s maiden investment in May had been a $3bn stake in Blackstone on the eve of that group’s listing – an investment in common shares that was struck without any discount or influence, while barring the new fund from selling for four years or making similar investments for a year. By the time the Chinese were talking to Citi, the Blackstone investment had nearly halved in value. Moreover, CIC was already investing in Morgan Stanley. CIC executives were concerned both that they already had enough exposure to US financial groups and that, if they took a stake in Citi as well, they would trigger a political backlash in the US, according to Jesse Wang, the number three at CIC. CDB had meanwhile not fared well with the stake it took in Barclays of the UK. There was also a competitive dynamic at work – officials at Safe were arguing to the State Council that only their organisation had the experience to invest sensibly, many people with knowledge of the matter say. ….. On the weekend of January 12-13, as the deadline for the financing approached, the CDB team was tense. Still, when the news came that Wen Jiabao, China’s prime minister, and the State Council had decided to withhold approval in the absence of consensus among all the interested parties consulted in Beijing, CDB officials were stunned. The fear of incurring losses on an investment in Citi – and a resulting loss of face – was a big part of the reason for that outcome. But the opposition of the banking regulators led by Mr Liu and concerns over competing investment arms were other factors, the advisers to CDB say. The fact that the equivalent of China’s cabinet -- though I suspect the inner core of the State Council is a more powerful group than a modern US cabinet -- seems to be the key decision-making body is bound to shape the world’s perceptions of China’s outward investment. If many of the members of the United States’ National Security Council meetings also decided which foreign firms the US should buy, I would suspect that US investment abroad would be viewed with rather more suspicion. To date, China has not set up the institutions that manage its foreign investment in ways that insulate their decision-making from China’s top political leadership. The extensive involvement of China’s top leaders reflects the fact that in many ways China are just starting to invest in foreign equities, so each big investment effectively sets a new precedent and therefore makes policy. It also may be a consequence of the decision to spread the management of China’s foreign exchange among different state institutions (SAFE, the CIC, the big state banks). That decision seems to have guaranteed that disputes over who gets to buy will go to the top level of China’s government to resolve. MORE FOLLOWS One interesting tidbit: China’s foreign ministry was apparently ready to shift its accounts to Citi if the CDB was able to invest in Citi. Some arms of the government were impressed by the image of a Chinese entity helping what was seen as America’s mightiest bank now it was on its knees. The foreign ministry was highly supportive and offered to move its accounts to Citi. “They thought of it as legitimising China,” says one CDB adviser. No wonder US and European firms think accepting investment from China will give them a leg up getting business (or getting approval to do business) from China’s state. It is also striking – at least to me – that China would have been investing at least in part on the belief that Citi was too big to fail. “But to many sovereign wealth fund executives, Citi is America – and they say they believe the authorities would never let Citi go down. So CIC’s Mr Gao and Mr Chen of CDB were greeted enthusiastically in December when each came calling.” China seems to believe that it was buying the US government’s commitment to Citi, not just Citi’s equity. That worries me a little. Suppose China’s government had thought that the US was similarly committed to back Bear Stearns’ equity investors, not just the holders of its debt? When a large institution is taken over by the government to avoid outright insolvency, the equity owners should be expected to take a hit. Moreover, investing in institutions that are too big to fail means investing in institutions that ultimately have to be regulated. Chine bought into Morgan Stanley just before -- one hopes -- the regulatory regime around broker leaders will change. Now that the broker-dealers have access to the Fed, limiting moral hazard likely requires that they accept limits on their leverage – limits that could impact on their future profits. Gideon Rachman thinks that state investment will create ties that reduce political friction between the countries doing the investment and the US and Europe. If governments in China, Russia and the Middle East have large investments in the US and the European Union, then they also have a direct stake in the continuing prosperity of America and the EU. But it seems just as likely to me to create a new source of friction – whether because of a US decision that adversely impacts the value of China’s equity investment or because of a US decision to block a Chinese investment because of concerns about Chinese state ownership that China believes are unfounded. The US government will increasingly be making regulatory decisions that influence the value of the investments that seem to have been personally approved by the China’s top leadership. Read Sender’s analysis of the CDB’s failed deal with Citi. Read McGregor’s account of Chinalco’s successful bid for a large stake in Rio Tinto. I was struck by how different China’s decision making process is from the decision-making process at other sovereign wealth funds (largely because of the number of competing institutions and bureaucracies that shape the final outcome), let alone the decision-making process at a private firm. To me, the decision-making process sounded a lot more like the decision-making process in the US about whether to support a large IMF program to a troubled emerging economy than the decision-making process in a big private firm deciding whether to invest in a troubled financial institution. But I may be bringing my own bias to bear. It isn’t hard to see why all this matters. The foreign assets of China’s government growing by something like $50 billion a month. China consequently has the financial capacity to do many such deals (think a Chinalco-Rio Tinto deal a week, or two-to-three CDB-Citi deals a week) if it decides it wants to – and if the US, Europe and Australia are willing to allow the deals to go through. UPDATE: The Wall Street Journal weighs in on Russia’s new sovereign fund.   Apparently, the investment of a Russian state bank with close ties to the Kremlin in EADS was not welcome -- and that investment has shaped Europe’s view of Russia’s fund.   Setting the ground rules for Chinese and Russian state investment in US, European and Australian equities isn’t going to be easy.