Thursday, 31 January 2008

Japan does not need a sovereign wealth fund

Sovereign wealth funds (SWFs) are a hot topic at the moment, and it seems that most countries with large foreign exchange reserves are creating their own SWF, so it is no surprise to hear that some Japanese politicians, sitting on the world’s second largest reserves, held mostly in US dollars and worth $973bn at 31/12/07, want a Japanese sovereign wealth fund.

Various arguments have been made for and against SWFs, which may or may not justify their existence in general, but there are two reasons why RebelEconomist considers that a SWF would be a bad idea for Japan in particular:

(1) Japan’s reserves are not sovereign wealth. In most countries with a SWF, the fund represents the accumulation of persistent current account and government surpluses. The foreign currency held in the SWF is typically acquired by the government either directly as revenue from the sale of natural resources by state-owned producers (eg oil producers in Norway), or indirectly by selling domestic currency obtained from taxation of a prospering economy (eg Singapore). Japan does have a current account surplus, presently amounting to about 4% of GDP, and its monetary authorities did build their foreign exchange reserves by intervening against the resulting appreciation of the yen, but, as is well known, the Japanese government has a large budget deficit, of about 4% of GDP, and the yen that has been sold by the authorities was borrowed. In fact, Japan’s net international investment position (ie its overseas wealth), worth about 40% of GDP at the end of 2006, of which about half is accounted for by its foreign exchange reserves, is small in relation to its government debt, worth about 150% of GDP. While it is true that China, which has even larger foreign exchange reserves than Japan, also borrows the domestic currency it uses to intervene, China’s budget deficit and government debt, at about 2% and 20% of GDP respectively, are comparatively small, and the Chinese government retains huge marketable stakes in state-owned enterprises (its stake in PetroChina alone is worth a substantial fraction of its reserves). In short, Japan's foreign exchange reserves are funded out of government debt, and Japan cannot afford to take unnecessary investment risks with its reserves that could leave their value insufficient to cover that debt.

(2) Contrary to the reasoning of many advocates for a Japanese SWF (eg “Japan mulls investment fund to tackle ageing crisis”, Financial Times 23/4/07), conventional investment wisdom suggests that an ageing population makes it appropriate to take less investment risk not more. For example, John Bogle (founder of Vanguard Mutual Funds) recommends that the percentage of bonds in an individual’s pension fund should be equal to their age. This is because a person with many years to retirement can allow time to average out the return fluctuations of more risky assets, whereas someone close to retiring needs more certainty about what they will have to live on. If the state reckons that it does not have sufficient assets to meet its social security obligations, the prudent (as opposed to politically easy) response should be to either save more or for the government to explain that it will be unable to be as generous as expected, not to switch into more risky investments in the hope of making up the shortfall by increasing return.

The usual precautionary motive for holding foreign exchange reserves certainly applies to Japan, and at a stretch could even justify the existing level of reserves (for example, Wijnholds and Kapteyn suggest that a level of reserves representing about 5-20% of M2 is adequate to cover capital flight; Japan’s reserves represent about 15% of M2+CDs). To serve such a purpose, however, reserves must be held in a liquid form like government bonds rather than the equities, corporate bonds, property and “alternative investments” characteristic of a SWF.

A bad argument for Japan to have a SWF, as made by Morgan Stanley's Stephen Jen, is that Japan's reserves need to make a high return to offset prospective appreciation of the yen. The obvious solution to this problem, if Japanese economic policymakers believe that they have more reserves than required for precautionary purposes, is of course to sell some reserves and repurchase yen whenever the yen is on the weak side, like last summer (on July 6th, the day that Jen’s argument was published, ¥/$ stood at about 123, compared with 107 at present, implying a rate of return from switching back into yen that cannot have been matched by many risky US dollar investments in this period). And the yen proceeds of such reverse intervention should be used to pay down government debt and shrink Japan’s swollen government balance sheet – as recent events at SocGen show, risks exist even in a balance sheet that is supposed to be well-hedged.

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