Sovereign Wealth to the Rescue

Former U.S. Federal Reserve Chairman William McChesney Martin once claimed that the role of the central bank is to take away the punch bowl just as the party gets going. Today, ironically, several of the world's central banks may be doing exactly the opposite. Just when the great global bull market of the past decade seemed to have run as far as it could run, and with deep rumblings in real estate and credit markets, the actions of several central banks in Asia may give global markets another big push toward rising prices and tightening credit spreads.

Every period of globalization in the past has had its origins in one or more events that gave a big boost to global liquidity. As liquidity expanded and risk appetite rose, capital poured into various risky ventures -- from nimble new companies exploiting the latest technology to developing countries at the fringes of global markets. Whether it was the rapid creation of new joint-stock banks in the 1860s, the massive accumulation of gold in the U.S. in the 1920s, or the recycling of petrodollars in the 1970s, the secular bull markets that are a part of every globalization cycle were fueled by events that created growing underlying liquidity and rising risk appetite.

The most recent globalization cycle had its beginnings in the increase in liquidity caused by the securitization of U.S. mortgages, which converted one of the largest pools of assets in the world from very illiquid bank loans into some of the most liquid securities. But it seems reasonably certain that what has powered the boom in the last decade is the recycling of the massive U.S. trade deficit. As central banks and sovereign funds accumulate reserves as the flip side of the U.S. trade deficit, excess U.S. consumption is being converted into global excess savings.

If this is the case, predicting the ability of this bull cycle to continue means predicting two things: the future size of the U.S. trade deficit, and how it is recycled. Predicting the future path of the U.S. trade deficit involves complex predictions about currency, economic and political changes. But it's probably safe to assume that whatever happens to the trade deficit, the changes will take place slowly and gradually.

The way the trade deficit is being recycled, however, seems to be undergoing a material shift. With currency reserves among Asian central banks and OPEC nations swelling to levels never before achieved, governments of surplus nations increasingly focus on achieving higher returns than those with which their central banks have traditionally been happy.

When the primary goal is to protect a country from interruptions in its ability to pay for imports and to service external debt, reserves were invested in very safe, liquid and, for that reason, low-yielding securities. But Japan is estimated to need only one-quarter of its $1 trillion in reserves for normal liquidity purposes. China, probably needs not much more than its nearly $1.5 trillion. Smaller Asian countries, and the OPEC nations as a bloc, are also carrying levels of reserves well beyond their liquidity needs.

One of the hottest questions in reserve management has been what to do with the excess. In this respect China has been among the leaders. For years there have been rumors of Chinese central bankers stretching for yield by purchasing securities that were riskier than those normally held by central banks -- bonds issued by certain Latin American governments, mortgage residuals and the like. Earlier this year the government approved a more explicit measure. It plans to carve out $200 billion of reserves to be managed separately and more aggressively by a separate government entity.

With China's reserves currently accumulating at the rate of over $100 billion per quarter, this already large number can easily grow. Other countries are explicitly or implicitly following China's lead, and although the total amount of money that is being driven into riskier assets is murky, there is little doubt that it is large.

With massive reserve hoards being invested down the credit spectrum into riskier assets, the net result will be a material increase in global risk appetite that will show up in ever tighter credit spreads. From time to time, as happened with the emerging-market correction in May 2006, and as is happening now, the overall trend of the market will be interrupted and the market filled with momentary panic. But when this happens, markets will quickly stabilize and resume their upward trend.

Credit spreads for risky assets are at historic lows, and certainly for older and more experienced traders and investors it is hard to imagine any good fundamental reason for spreads to stay at these levels or, even harder to imagine, to continue narrowing. But whatever the fundamental arguments, there are good technical reasons for assuming that the party isn't over yet. The large-scale shift of global reserves into what are being called sovereign wealth funds may provide the party with at least one more bowl of industrial-strength punch. Tomorrow's hangover may get nasty, but for now the party is still going strong.