Cheap credit may be drying up, but emerging market economies are flush with cash and their growing interest in establishing sovereign wealth funds could well drive equity and other capital markets around the world to new heights, say Stephen Jen, Morgan Stanley’s chief currency strategist, and Charles St-Arnaud of MS London.
Major emerging market economies currently have a collective $1,500bn worth of excess reserves, estimate the authors ─ defining “excess” as official foreign reserves exceeding the amount needed for liquidity purposes, based on their “conservative rule-of-thumb”.
After adjustments to reflect what they call “special considerations” – for example, currency valuation, the current account position, structural capital flows, and other considerations – the size of these excess reserves halves, to $750bn – what the authors call a “rough and intentionally conservative guess”.
To be more conservative still, they say, they went through the list of major EM countries and estimated what they might consider to be “excess reserves” that could be invested through SWFs. The conclusion: at least another $350bn worth of new SWFs may be possible, potentially boosting the total size of the SWFs in the world from $2,550bn to $2,900bn.
It may be useful here, say Jen and St-Arnaud, to consider that foreign reserves consist of a ‘liquidity tranche’ and an ‘investment tranche’. The former being what a country needs for liquidity purposes, the latter being money that could be invested as an SWF.
Beyond the emerging markets economies, the real force – to rival a rising China and a couple of other massive SWFs led by Abu Dhabi (at $850bn) – could be Japan, as John Vail, head of global strategy at Nikko Asset Management in Tokyo argued in an FT comment last month.
In a new note, Jen also argues the case for a Japanese SWF and predicts the establishment of a (mega) state investment agency within two to three years.
Of Japan’s total reserve holdings of $911bn, only $225bn may be “needed” for liquidity purposes, he says. This leaves close to US$700bn for investment purposes, he notes.
Structural pressures on the budget, particularly in light of the demographic trend, “do not permit Japan the luxury of neglecting its investment returns today,” says Jen.
To drive his point home, he gives four main reasons why an SWF makes sense for Japan:
Reason 1. Japan’s fiscal position is still weak. Japan’s government fiscal deficit is still around 5 per cent of GDP, and its net public debt is close to 85 per cent of GDP. Japan will need to push its fiscal position to a surplus of 5 per cent of GDP within the decade just to stabilise debt.
Reason 2. Valuation losses from JPY appreciation. Over time, the yen will appreciate, says Jen. “This would translate into valuation losses on Japan’s reserve holdings. In fact, the real return on Japan’s reserves could easily fall to nil, if we incorporate this factor.”
Reason 3. Japan’s aging population will exert more pressure on the budget. Without additional fiscal action, social security expenditure will reach 22 per cent of GDP by 2025 – under estimates from the government’s own Cabinet Office, while net public debt could reach 150 per cent of GDP by then.
Reason 4. Running an SWF is the “responsible” thing to do. Ultimately, the official reserves are wealth that belongs to the general public, says Jen. The government has the responsibility of properly managing this wealth. Already, retail investors in Japan, especially retirees, have elected to take more risk in exchange for higher expected investment returns. The general sentiment in Japan should gradually drift in favour of the government adopting a less risk-averse investment strategy.