The cost of believing in America

Konstantin Sonin
The Moscow Times
22 Jan 08

Ten years ago, an economic crisis in one developing country could set off a chain reaction among investors around the world. And once investors suffered sharp losses in one place – for example, Thailand, South Korea or Indonesia – they began rolling back everywhere. This time around, the scenario is playing out differently. Although the financial markets crisis that began last year has not yet reached the point where investors are pulling out of developing markets, money continues to flow freely in the opposite direction as the world’s financial giants tap into government funds from former Third World countries.

Citigroup and Merrill Lynch announced multibillion-dollar losses in connection with their mortgage portfolios last week. Citigroup has twice over the past three months turned for cash to so-called sovereign wealth funds. It sold 5 percent of its shares to the Abu Dhabi Investment Authority for $7.5 billion in November, and now it is offering shares to financial corporations controlled by the governments of Singapore, Kuwait and Saudi Arabia. The haste with which Citigroup is seeking investment from the developing world suggests that the company does not see any light at the end of the tunnel for its internal financial problems.

In all fairness, though, this is not the first time Citigroup has resorted to such measures. The Saudi royal family, along with others, first came to Citigroup’s rescue early in the 1990s. In fact, it is difficult to find a global financial giant that is not hunting for cash these days. Merrill Lynch has already turned for help to a Singapore government investment fund, while Swiss-based UBS received $9.7 billion from another Singapore government fund last fall. At the same time, Morgan Stanley received a $5 billion investment from a Chinese government fund.

It is understandable why these corporations are turning to foreign investment funds for badly needed cash. They very well might not know the full scope of their financial losses stemming from the collapse of the subprime mortgage market. But what can be motivating the owners of these sovereign funds to invest? Of course, buying into a “distressed” company often leads to reaping big profits down the line, and there is the possibility that this might actually be one of those rare opportunities that investors dream about their entire lives — to buy a valuable commodity at bargain prices. But there is also a high probability that they could end up on the losing side of this gamble. The owners of sovereign funds understand that, as foreign investors, they are treated as outsiders by U.S. politicians, and this carries a certain element of political risk from them.

The dollar has become the world currency based largely on the belief that the democratic system in the United States will not allow the government to shift to inflationary financing. Thus, Chinese and Singaporean investors are willing to channel huge sums of cash into Citigroup and Merrill Lynch in the belief that U.S. democracy – with its competitive electoral system, independent judicial system and a media acting as a powerful Fourth Estate watchdog – will continue to function as an effective and powerful regulator of financial corporations and guarantor of political and economic stability.

We have already become accustomed to a growing U.S. trade deficit and to the fact that the developing world finances American consumers to a large degree. It may now be the case that taxpayers’ money from developing countries being sent to the United States will end up covering losses incurred by irresponsible bankers and inattentive market regulators.

Keeping faith in the United States’ economy and democracy comes at a price indeed.

Konstantin Sonin, a professor at the New Economic School/CEFIR, is a columnist for Vedomosti.

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