US exorbitant privilege (ability to pay very little for foreign liabilities and make high returns on foreign assets) is going away faster that I thought. After capital injections by Abu Dabi into Citi, it was announced that China Investment Corporation buy 9.9% (USD 5bn) stake in Morgan Stanley. CIC is said to remain a passive investor without any special right to name board members.

Think what it means for a moment. In the last few decades US borrowed cheaply from world central banks and private investors at its treasury yield and invested in private and public equities worldwide. With subprime crisis hitting asset values in the US, emerging markets wealthy investors (including SWFs) step in and buy cheaply, which indicates that once situation stabilizes (and it always does, question is when) these investors will be able to enjoy very high returns (as a premium for courage to buy in bad times).

It could still work out in the US favor. It may be that over the next decade returns in emerging markets will be high relative to US markets and EM currencies will appreciate against the dollar, so US makes more on foreign assets than it pays for its foreign liabilities. But this scenario is expected by many investors, so the home bias should fall anyway and Asian and Gulf investors will also buy more EM assets, relative to historical averages. Taking all this into account I draw a conclusion that US will no longer be able to play the global hedge fund role (taking leverage and buying equity, to put it simple). Transactions such as Blackstone, Citi, Morgan Stanley, and maybe more to come do suggest that world has changed, and that many capital surplus nations are accepting higher credit risk in exchange for higher expected return in the longer run.

This must lead to fast changes in the global financial architecture. I expect China financial markets to dwarf those in UK and US, and I expect that it will happen sooner than most people predict. To get a feel for a pace of change recall that China share in global exports of telecom equipment went from 7% to above 20% in just five years, machinery exports from 3 to 9% in five years. So fasten your seat belts, the ride begins …

Later addendum: Merill Lynch has just announced that Singapore based Sovereign Wealth Fund Temasek may buy a 5bn stake in the bank, and that this investment may not be a passive one.

Large western financial institutions which suffered huge losses in the subprime markets have been able to raise additional capital by attracting investors from Singapore and Middle East. FT article describes transaction between UBS, Government of Singapore Investment Corporation (which is a state owned Sovereign Wealth Fund)  and unnamed Arab investor. Few weeks earlier a similar transaction was executed to recapitalize Citigroup (Abu Dabi 7.5bn dollars), who also suffered large losses in the subprime market.

I have been arguing for some time on this blog that in the era of lack of confidence and depressed asset prices it should not be the job of developed countries central banks to restore confidence, as it may lead to large moral hazard and excessive risk taking. Emerging markets central banks and sovereign wealth funds are in a much better position to play that role, as they may step in, buy distressed assets, support the market and make lots of money at the same time. It does appear that the Greenspan put era is gradually replaced with SWFs bid times.

This is also likely to be much more effective. Economists are worried that banks’ balance sheet trimming may ignite recession. It is better to raise new capital than to prevent financial markets -induced recession by providing put option. Every time Greenspan put option is exercised, the next “transaction” notional value will likely be an order of magnitude bigger.

In the 20th century crisis taxpayers paid the cost of the crisis in a form of inflation tax or  direct fiscal burden. In the 21st century the “cost” of a crisis seems to be the transfer of wealth from short-term oriented, liquidity constrained institutions in the North and West to long-term focused and liquidity abundant financiers from the South and East. In old times British Empire merchants traded tea for opium with China and silver was the currency. In 21st century we trade “greed” for liquidity, and the currency is power and control. It is the intangible century indeed.

FT article summary is below:

UBS on Monday became the second big investment bank in a fortnight to be bailed out by a sovereign wealth fund when it announced a SFr19.4bn ($17.2bn) recapitalisation plan after revealing another $10bn of losses on subprime mortgage securities.

UBS was forced to turn to the Government of Singapore Investment Corporation (GIC) and an unnamed investor from the Middle East for funds to shore up its balance sheet after the fresh losses emerged.