# Lenders or Owners? How Surplus Countries are going to Change the Playing Field

Date November 12, 2007 Paola SUBACCHI(Head, International Economics Programme, Chatham House)Andrea GOLDSTEIN(Senior Economist, OECD Directorate for Financial and Enterprise Affairs) Pietro GINEFRA(Chief Representative, the Bank of Italy) TSURU Kotaro(Senior Fellow, RIETI)

## Summary

### Paola SUBACCHI

This is work in progress that underlines the important changes in the way global financial power is distributed between countries. According to a recent report published by McKinsey there are four relatively new 'power brokers' in the global economy: the oil-exporting countries, Asian central banks, sovereign wealth funds, and private equity funds. What does the emergence of these new players mean for the global economy? In our research, we look at capital flow and see a fundamental change from Asian central banks and oil exporting countries lending money to current account deficit countries (in particular the United States) to directly investing in developed and developing countries.

Over the last five years there has been a huge build up in foreign exchange reserves which matches the trade surpluses from Asian exporting countries and oil exporting countries. This gives China and oil exporting countries a new role and also presents a strategic challenge, in particular for developed countries. To date, the exchange rate management has been very much based on the accumulation of foreign exchange reserves, but this is changing because there are costs in this kind of policy.

There is a contradiction between these large external surpluses and the development issues in lots of these countries, some of them (particularly China) with a considerable portion of the population living under the international poverty line. We view the emergence of these sovereign wealth funds as a way to capture these key changes and trends in global capital flows. Are these flows going to generate more market volatility and political instability?

The growth of the world economy over the past decade has been the strongest rate of growth in the past 30 years. The fundamentals are quite strong, and therefore we can expect the world economy to continue growing at quite a robust pace. The increased pace of trade integration has generated more growth. The other interesting characteristic of this globalization and economic growth is historically low inflation, but perhaps we are now at a turning point.

Globalization is driving activity, and that generates global trade imbalances. In particular, these are epitomized by imbalances between the U.S., with a large trade deficit, and China, with a large trade surplus. Capital flows are important to explain the global trade imbalances. In the past decade global financial integration has developed more rapidly than trade integration. Total global capital inflows rose from under $1 trillion in 1990 to$4 trillion per annum by 2000. Capital inflows into developing countries rose from $25 billion in the late 1980s to almost$250 billion by 2000. Now, foreign direct investment (FDI) inflows to emerging markets are over $300 billion. It is very important to stress that the outflows from emerging markets are growing, and they are now above$100 billion. Net capital outflows from Asia, Russia and OPEC alone amount to around $1 trillion. Capital account transactions are approximately one-third portfolio flows, one-third FDI and the rest mostly banking operation and foreign exchange management. There has been a large increase in reserve holdings and also a large increase in global wealth. Official reserve holdings have been growing, particularly in emerging Asia, but Japan has also quietly acquired a large amount of foreign exchange reserves. It is interesting to note the growth of non-U.S. financial wealth. China and Japan are big players in this capital flows game. It is estimated that at the moment total reserves have exceeded$6 trillion. Asia accounts for two-thirds of the stock of reserves.

The other side of this picture is FDI inflows: Asia plays a big part here. Latin America has in some respects suffered in terms of FDI inflows, as a result of the emergence of Asia. But it is also important to look at outflows by region. Developed economies have the largest outflows, but the proportion is slowly decreasing, while the portion attributable to Asia is actually increasing.

Previously, the Asian central banks would play the role of lenders to, in particular, the U.S. But now we see the use of government investment funds in a more active way. This is because reserve management is a very expensive game, and sometimes contradicts the need for domestic development. China has over $1 trillion reserves and has moved away from any precautionary reasons for accumulating even more reserves. Particularly in the past year, we have seen the emergence of government investment funds. There are two reasons for this. The first is that a government investment fund is useful to manage your foreign exchange reserves: that is what Asian countries do. The second reason is because of the need to manage depleting natural resources, and this is what oil exporting countries tend to do. Government investment funds are seeking more exposure to risky assets. We can see an impact on the dollar, and on the sovereign bond markets in the U.S., in the Eurozone, and in the UK. We can see, also, more equity acquisitions: M&A activity and FDI. We can see a transformation of current account surplus countries from lenders to owners, because we see more strategic investment coming out of these countries. China has$20-30 billion a month of surplus, and is prepared to use about \$10 billion: that really gives a lot of power to buy companies, to get involved in strategic projects, and so on, just simply through portfolio and investment.

I want to stress the shift in investment focus. These surplus countries had been focusing mainly on G7 and mainly on sovereign bond markets, but now they need to broaden their approach and include the emerging markets, in particular G8-G20 markets. The playing field is becoming larger, because both inflows and outflows have increased, so we need more intermediation. We can see the emergence of new international financial and bank incentives with a global outreach to intermediate these capital flows. We need more sophisticated financial products, obviously with more risk. The bottom line here is there is a potential risk for more market volatility.

### Andrea GOLDSTEIN

There are a number of reasons why investment protectionism is on the rise. First and most foremost, in the aftermath of the 9/11 events in the U.S. and the war in Iraq national security issues are increasingly being considered. The increase in the number of cases involving the diversion of cutting-edge commercial technology to military uses is something that is increasingly perceived as a threat to national security. A second, broader issue is what is perceived to be a backlash against globalization and "financial capitalism." A third reason is a global and strategic rivalry between the traditional OECD countries (a grouping which also includes Japan) and certain emerging economies. Just to be very clear, it is obvious that China, and to a lesser extent Russia, are the two countries that are at the core of that debate. The fourth issue is the opacity regarding the ownership structure of new investment vehicles: this is true for state-owned enterprises, for sovereign wealth funds, but it is also true for hedge funds and private equity funds.

The U.S. was the first country to introduce, back in the 1970s and 1980s, a new set of regulations and rules governing foreign takeovers of companies. In 2007, the signing of the U.S. Foreign Investment and National Security Act strengthens the role given to the Director of National Intelligence, as well as the mechanism for ex-post reporting of the activities of CFIUS (the Committee on Foreign Investment in the United States) to Congress. The Act also introduced a mandatory extended review of investment when the investor buying a U.S. company is a state-owned enterprise. Another major development is the addition of "impact on critical infrastructure" to the list of factors that will be considered by CFIUS.

In Germany, there is a concern that a sovereign wealth fund could buy some large German companies including Deutsche Telecom or Deutsche Bank. There seems to be recognition of the importance of national security in the economic realm, but there has been no introduction of more protectionism tools.

In France, Decree No. 2005-1739 of 31 December 2005 set out a clear list of sectors which are considered strategic, and in which investment can be subject to authorization. The national security rationale for this list is quite clear. The Decree has not been applied so far.

In Japan, the list of sectors which are protected on national security grounds has become much longer: 137 sensitive products are now protected. The key change is that now foreign investors must submit, to the government, a notification of their plan 30 days in advance.

In Canada, the sectors where there are national security concerns are mostly those producing and exploiting non-renewable natural resources. Although there is a definition of national interest, the Canadian Government is now considering whether to introduce some explicit reference to national security as one of the criteria used in vetting foreign investment.

In South Korea the concern is with mostly Chinese companies buying into the machinery and shipbuilding sectors.

The responses in each country are slightly different because their respective concerns are different, even if there are some common threats. Each of the countries has its own political life, and the processes leading to change are different.

In fact, investment protectionism is seemingly on the rise in non-OECD countries as well. China has introduced new regulations and provisions that are making it more difficult for foreign investors to buy into Chinese companies.

In Russia, the Bill on Strategic Sectors includes a list of 39 sectors which are considered to be strategic. The Government gives itself a three-month waiting period to review proposed deals. Furthermore, state ownership is one of the factors that allow the Russian authorities to put a cap on foreign holdings in a company.

For OECD countries, there are substantial costs involved in getting investment protection wrong. The price of investment protection is high, and it comes in the form of a slower pace of growth and sustainable development.

Still, protecting national interests is obviously a major and legitimate obligation for any government. Basically, there are two approaches for achieving this in a sensible way. The first is the U.S. approach, where there is a voluntary filing system of new investment deals by foreign investors when they anticipate problems. The second is the experience of other countries like France and Japan, notably of having closed lists, where there is a mandatory vetting process. So in order to improve ways to safeguard their national security interests, but without jeopardizing the open international investment environment, the OECD Roundtables on "Freedom of Investment, National Security and 'Strategic' Industries" began in 2006. Reformers within each of the governments can find benefits in participating in this to resist domestic pressures for more restrictive measures.

The Roundtable discussions found that in many cases new laws and provisions are not needed because there are already international investment instruments that allow governments a degree of freedom to judge their security needs, and that there are, in fact, relatively few countries that maintain a discriminatory general screening and authorization procedures to defend their security interests.

Three principles accepted are: there has to be regulatory proportionality (restrictions on investment should not be more costly or discriminatory than needed to achieve the security objectives); there has to be predictability and transparency (sources of misunderstanding should be eliminated or minimized); and there has to be accountability (procedures for parliamentary oversight or judiciary redress should ensure accountability). The G8 Summit endorsed this OECD Freedom of Investment project, and called for a continuation of it. Now Phase 2 has been launched: one of the activities now is to identify in particular the scope of the critical infrastructure notion.

As I said at the beginning, sovereign wealth funds are receiving increased scrutiny as part of the overall change in attitudes toward international investment. On current trends, they will become larger than official reserves in terms of the size of the assets under their management. This is one of the reasons why they risk becoming new scapegoats.

In order to understand the concerns vis-à-vis multinational enterprises and M&As, there is another issue that is important, yet is sometimes neglected: that of corporate headquarters. What happens to countries when companies delocalize their headquarters? The key issue here, is what happens to high value added functions like R&D when the nationality of a corporation changes? In Sweden and Canada this hollowing out risk is taken seriously. The research is still incipient, but it is still an area where more and better work is needed.

Finally, there is what has been called the Wimbledon paradox: U.K. companies are not owned by U.K. investors anymore, in a way, and yet the U.K. economy seemingly has not suffered. How do you explain this? This is an issue that deserves to be studied in the future.

### Pietro GINEFRA

It is often said that capital movements should be distinguished between speculative money and FDI: FDI is good, speculative money is bad. In reality, this is not a real distinction because it is very hard to understand the relationship between these different markets. Free capital movements are one of the ideal conditions for FDI which is widely believed to positively affect economic growth but is also considered to cause international financial instability.

At the beginning of the 1990s, all OECD countries started these free capital movement processes, and in 1994 we saw the first financial crisis in Mexico. In 1997 there was the Asian financial crisis, and in 1998 the Russian crisis. In 2002, there was the Argentinean crisis. Although there have been no major crises in the past three or four years, we do not know what will happen when the yen carry trade unwinds.

How much FDI would materialize if capital movements were not free? Those benefiting from FDI are the same people who suffer during financial crises?

The improvement of technology in the form of total factor productivity is the route to economic growth. A country with a higher level of technology than its competitors has the capability to hold a larger share of the value added of production. Not only capitalists take advantage of technology, but also workers, and governments that can raise taxes. Do capitalists have the right to sell technology to non-residents that can develop competitive business elsewhere? Should lawmakers establish regulations to prevent capitalists from impoverishing their own countries by signing such deals? Do international markets have problems in terms of ownership, against which some measures should be taken?

Q: What are the major reasons for the current glut of capital?

Paola SUBACCHI
A: It is very difficult to predict when the next financial crisis will occur, and how it will develop. Due to financial and trade integration (which generates large surpluses in some countries) there is huge liquidity. There are countries with high savings rates, including China (which has little social security and health insurance, and an underdeveloped financial sector) and countries in continental Europe. We do not know what the natural saving rate is for an economy, but some countries in Europe have over 10% saving rates, which is perhaps too high On the other hand, we have a country like the U.S., where the saving rate is zero. But are we looking at the right variables? Or should we consider valuable assets in portfolios as another form of savings, given the complexity of some financial sectors in some developed countries? As a result of the complexity in capital markets, we are unable to entirely understand what is going on. These movements create more volatility and a greater chance of a crisis occurring, but the risk can be factored in and priced, somehow. As the subprime crisis has shown us, an important factor in maintaining a sort of stability in the markets is confidence. Maintaining confidence in the system is the role of central banks, although the corollary of this is the creation of more moral hazard.

Q: Could you use the example of Mittal to elucidate the broader issues?

Andrea GOLDSTEIN
A: The debate concerning the nationality of Mittal is relevant not in terms of pure economics, but rather in terms of policy responses. In fact, Mittal is owned by an Indian individual (who has been living in London for the best part of his life) and is registered in Amsterdam. In France, the relocation of the corporate headquarters of Arcelor to London became an important issue. In 2003, Alcan completed its takeover of Pechiney, another French company, and transferred many of Pechiney's corporate functions from France to Canada. The risk of this happening again in the case of Arcelor-Mittal was one of the big reasons for the great deal of fuss that was made about Mittal's 2006 acquisition.

In explaining these issues, corporate governance is a very important factor to take into consideration. The debate that has taken place around investment protection is more of a crisis of maturity than anything else. During the process of post-Cold War globalization, competition among economic systems has changed from competition for trade (and production of weapons) to investment circulation. Differences among corporate governance systems become important because they are used to justify different valuations for assets which are otherwise equivalent.

Q: What specific issues do we have to address, from a global perspective, regarding this imbalance of capital?

Paola SUBACCHI
A: In terms of global imbalances, perhaps we do not have to do anything. There is a risk in intervening, because we might create further imbalances and instability. So, in many respects, the current weakness of the dollar might be a good way to rebalance some of these imbalances. In the past few years, the mistake has been to look at these imbalances from a pure trade point of view. But in reality, the rebalance of these happens through financial flows. Due to underdeveloped financial markets in a lot of emerging market countries, there are opportunities for investment in developed countries, particularly the U.S., for many reasons including the conservative management of these foreign exchange reserves.

We need to be aware of changes and the new players in the global economy, and the issues related to governance and international institutions. But, frankly, I do not agree with the U.S. Government and the International Monetary Fund (IMF) push to get the Chinese Government to take big steps in the revaluation of their currency. A rushed and badly managed revaluation could create an even worse problem, while a long-term adjustment, which now looks like the strategy (the Chinese Government is managing this very slow appreciation of their currency), might work much better than pushing for a sudden appreciation, or a much bigger appreciation, given the immaturity of the Chinese capital markets.

Pietro GINEFRA
A: The key question today is: Does globalization make the world more stable or less stable? At the end of the day, we need to understand how many goods we can consume today, and how many goods we will consume tomorrow. No-one is sure of that. The less people are sure of, the more they fear other people and the future, and that makes everything more volatile, not only the markets.

Q: What is the impact of increasing financial flows on the role of the dollar?

Paola SUBACCHI
A: I think of the euro as a complement to the dollar, rather than a competitor to it. We are moving toward a two-pillar international monetary order or system, rather than dollars versus euros. Some years ago people thought the euro could actually replace the dollar as a reserve currency. The use of the euro as a reserve currency and as an international currency has grown quite remarkably. The euro is going to remain a strong currency, which opens the question of whether or not the Eurozone has the right policies for a strong currency. But I do not think that the euro is going to replace the dollar, for many reasons, including the fact that we are now in a sort of hybrid system, where you have developed countries with floating currencies on the one hand, and on the other emerging markets with currencies with de facto pegs to the dollar.

There are more issues involved in keeping a currency down than just competitiveness of exports, which is the alleged reason why the Chinese make use of currency manipulation. There are issues related to dollar assets accumulated by residents of countries with a peg to the dollar. The dollar standard is going to remain: it is not going to be replaced by any other currency, because there is no candidate. The dollar is here to stay, even if now it seems to suffer.

Q: What is your view of corporate tax and global activities of corporations?

Andrea GOLDSTEIN
A: It is increasingly being seen that corporate tax policy can be used as an instrument to promote outward FDI. Recently, the European Court of Justice ruled that Spain should reverse some provision in its tax codes that supports the international expansion of Spanish companies.

Environmental considerations are also very important when looking at FDI deals entailing ownership of natural resources.

*This summary was compiled by RIETI Editorial staff.