Finding a place to put all the revenues from trade imbalances has been a problem for net exporters.  In particular, commodity boom bust cycles wreak havoc on economies that are not able to dampen these cycles.  Commodity net exporters found a way to do this, most notably oil exporters.  The idea is to place revenues from trade imbalances into diversified investments to even out the effects of boom bust cycles.

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The first fund was founded in 1953 by Kuwait as the Kuwait Investment Authority.  Since then, other oil exporting nations have placed their excess revenues in sovereign funds, such as Abu Dhabi’s Investment Authority (1976), Singapore’s Government Investment Corporation (1981), and Norway’s Government Pension Fund (1990).    Even Russia has set-up a sovereign wealth fund with their excess revenues from their oil exports.

A most prominent fund in the modern era has been the United Arab Emirates.  The excess revenues from the high price of oil have created a fund that is often making high profile investments and will likely remain in the spotlight.

By far, the largest and one of the newest sovereign wealth funds is China’s sovereign wealth fund which formally began operating with $200B on October 1, 2007.  Prior to that, they had invested $3B into the Blackstone Private Equity Group in May.  By the time Blackstone went public in June, that investment had lost 19%.  It was an inauspicious start, but the need to do something with the $1.33 trillion trade surplus then was insurmountable.  Since then, China’s surplus has grown and the sovereign fund has some $1.2T in assets.

This fund is, by far, the largest sovereign wealth fund and is different than most funds in that it is not related to the price of oil or other commodities.  Rather the fund is from excess revenues derived from Chinese government policy in regards to the valuation of their currency, the Yuan.  The government has recently modified their long term stance of pegging the value of the Yuan to the U.S. dollar by letting it adjust in a very modest range to the dollar, but still keeping the Yuan from floating anywhere close to freely against other world currencies.  Because of this policy, China continues to accrue excess revenues at an alarming rate.

Prior to the establishment of the fund, China was buying U.S. treasuries, keeping demand for these instruments high, and helping to create the situation where the interest rates on U.S. short term debt approached and even briefly became inverted to the interest paid on long term debt.  This is known as an inverted yield curve.

Bank profits have traditionally depended on the spread between rates for borrowing short term money and lending long term money.  With the inverted yield curve, this threatened profits of U.S. banks and was, in part, a factor in their heavy, and sometimes leveraged, investments in CDOs and MBSs.  These investments required CDS to insure against loss and resulted in heightened counterparty risk.  We have witnessed, firsthand, the consequences of these decisions when things began to unravel.

Many Sovereign Wealth Funds (SWFs) have changed their focus from passive investments into strategic investments in high-tech or other companies that can help grow their economies in a more stable way than the export driven approach that created the excess revenues in the first place.

SWFs will be a growing factor in the world economy as they are used to secure assets that ensure continued growth of the economies of countries that use them.  When government policy in these countries also restricts free markets to help provide a natural equilibrium, then the natural adjustment made over time doesn’t occur and when an adjustment finally occurs, the result is a dramatic and destabilizing move, which causes chaos in global market.

We would argue that this is in process at this time, with the housing market as an example of the folly of prolonging cycles through failed government policies.  We also see this in process with the Chinese government policy to peg the value of the Yuan to the U.S. dollar.

We will take a look at the housing market in more detail as we look to a simple fairy tale to illustrate our point.