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.

The paper by Gourinchas and Rey identified US exorbitant privilege as ability of the US to earn much more on its foreign assets (7%) than cost of its foreign liabilities (3.5%). Among many arguments explaining why this was possible is one that US financial markets are biggest, most liquid, with best regulatory framework. I have been arguing for a long time that this privilege will slowly go away amid rapid development of financial markets in other parts of the globe.

Recent paper by New York Fed economist Stavros Peristiani provides a nice overview on this topic, showing that US markets are loosing global importance, in a most pronounced way with respect to global bond markets. It is also worth noticing, that while home bias among investors has been falling (with hedge funds contributing to this process, with Feldstein-Horioka puzzle vanishing in the last decade) at the same time the home bias with respect to IPOs and new bond issuance has been on the rise. It does reflect positive corporate governance developments in Asia, creation of euro market and predatory regulations in US following the Enron case.

Mean-reversion minds are predicting US dollar strengthening from historically low levels. They might be right, but the above trends of strengthening home IPO bias combined with SWF diversification policies argue for further dollar weakness. See chart from Peristiani paper below:

Two links added later:

• Daniel Gross article in Newsweek about IPOs moving outside the US
• PIMCO article by Richard Clarida about US “exorbitant privilege”

IHT published an article on Chinese plans to create new agency, based on Singapore Temasek template, that will manage one trillion of Chinese foreign assets. Article states that it indicates a desire to move towards higher yielding investments, and analysts expect that initial amounts will be modest comparing to overall holdings.

Whatever the amounts are, it seems that we maybe witnessing the beginning of the end of US exorbitant privilege, as stated in a well known article by Gourinchas and Rey. This privilege in short says that US in making 7% on its foreign assets and pays only 3.5% on its foreign liabilities. While this maybe a very long process, already number of large reserve holders (in Asia and in oil exporting countries) indicated their desire to make higher returns than those offered by treasury bond markets.

I have argued for some time, that integration of financial markets in Asia, and possibly even the emergence of asian (ACU, AMU, you name it) as a new currency in 2020 or 2030 will take away this US privilege. I underestimated the speed of changes in XXI century world. Mark-to-market is accompanied by speed-to-market as well.