By Marla Singer and Geoffrey Batt
In the wake of the crumbling of certain sandcastles in the sky, sovereign wealth funds in the middle east have baited our analytic gaze over the last month or so. It takes very little, therefore, to prompt us to take careful notice now just about whenever one is mentioned. Today, the Kuwait Investment Authority (hereinafter the "KIA") and its brutal body-blow to Citi demand our attention.
While pinning solid figures on any of the sovereign wealth funds in the middle east is a speculative effort at best, it is difficult to come up with figures much smaller than $150-200 billion for KIA's assets under management, at least assuming no major losses in the last 24 months- potentially a generous modeling gift. Moreover, the KIA, residing as it does within the borders of a "close friend" of the United States, has often enjoyed direct and indirect encouragement therefrom. Further, a demonstrated willingness to invest in Western European concerns (e.g., Daimler) and American enterprises (e.g. Citigroup), particularly in times of distress, has cemented bonds between the United States and these petrolpowers. The honeymoon might be over. To wit:
The Kuwait Investment Authority has held internal discussions about scaling back its banking relationship with Citigroup in a move that could include transferring funds currently deposited with the US bank, people familiar with the matter say.
A withdrawal of KIA funds from Citi would mark another setback for the bank as it seeks to recover from the financial crisis and pay back government bail-out funds.
Indeed. In one fell swoop KIA might undo the Herculean YouTubeian pleadings by Federal Deposit Insurance Corporation Chairwoman Shelia Bair begging Americans to please, really, seriously, please just stop taking money out of absolutely, totally safe and solvent banks. Oh, and paying off TARP is pretty much right out if Citi faces this kind of capital flight.
Well, how bad could it be exactly? Again, the Financial Times:
According to KIA officials, most of Kuwait’s oil revenues are deposited at Citi – a decades-long relationship.
Ouch. Well, that might not be all that much. Right?
KIA manages a series of assets (not least for the Ministry of Finance), but, probably more significantly, also the Kuwait Future Generations Fund (hereinafter the "FGF") and the Kuwait General Reserve Fund (hereinafter the "GRF"). By law, the FGF slurps in 10% of the general revenue of... well... all of Kuwait... every year.
An amount of 10% (ten per cent) shall be allocated from the State’s General Revenues every year, as from the fiscal year 1976/1977 .
A special account shall be opened for creating a reserve which would be a substitute to the oil wealth “Future Generation Reserve” into which those amounts would be credited.
The Ministry of Finance shall employ these funds into investments, and the profits accruing therefrom shall go into this account.
And an amount of 50% (fifty percent) of the available State’s General Reserve Fund is to be added to this account, when this Law comes into force.
It is not permissible to reduce the rate stated in Article One of this Law, or to draw any amount from the Future Generations Reserve.
Unlike some other funds we know, these people are not screwing around. (We are looking at you, Dubai).
Figures are difficult to come by (disclosure to the public of KIAs strategy or operations is subject to penalties by law), but FY 2004/2005 contributions to FGF were on the order of $3 billion. Several years of that sort of accumulation adds up to a tidy sum, in theory.
Pointing out that a large bit of capital flight would be a blow to Citi is an act of profound understatement. Pointing out that this sort of thing has rather serious strategic implications for the United States should cause colleagues to credit you with a mastery of the obvious. In fact, the United States has worried about this sort of quasi economic warfare for some years in another context. Consider, for example, this text from a declassified 1976 National Security Council memo to none other than Alan Greenspan from Robert Hormats discussing oil embargo contingencies.
In the event of a continued deterioration of the Arab/Israeli situation, Arab oil producing states would be increasingly motivated to use their control over oil resources, and possibly such economic power as might be available in the use of their finance assets, to place a range of pressures on the United States and the industrial world to achieve political ends in the Middle East.
II. Actions Involving Movement of Liquid Assets
The trend of Arab investment policy over the past half year has been toward the placement of increasing proportions of their new accumulations of funds in longer term instruments. Their holdings of relatively liquid funds are substantial and are largely in dollar form. Under the pressure of another Middle East conflict, however, efforts might be made to move some of these liquid assets either for economic or political reasons. The latter motive is not entirely compatible with the former, however, since essentially arbitrary movement of funds could do considerably [sic] damage to the value of Arab portfolios in the process.
Action I: Shifting funds among sectors or institutions in a single country.
Application: To selected countries, specifically including the US.
Effect: Large-scale shifts of funds out of individual banks could post short-term liquidity difficulties for those particular banks, although failures would be unlikely since only the large financial institutions are involved. Individual bank liquidity problems could be mitigated by resort to discount-window emergency borrowing at the Federal Reserve. Moreover, financial markets in the United States as a whole would be readily able to cope with rechanneling flows between sectors and institutions. There might be some initial confusion and uncertainty in capital markets, but in general this type of action poses no threat to the US financial system as a whole.
Action II: Specify oil prices and demand payment for oil in currency other than dollars.
Sounds sort of familiar, no?
Part II of the document goes on to describe potential countermeasures and is a must read, not necessarily because it reflects the present day situation (which is probably more about dollar confidence and liquidity pressure at home for the Kuwaitis), but because many of the countermeasures contemplated as part of a United States response would be difficult or impossible to implement in the country's current and enfeebled state.
A related declassified and heavily redacted CIA document from 1978 discusses similar possibilities, and similar responses. In general, the documents dismiss the possibility of economic warfare of this kind, reasoning that:
The composition of the Saudi portfolio at this time limits its use as a political weapon. Since Saudi surplus funds are heavily concentrated in a few countries and in US dollar assets, any politically-motivated shift out of the US dollar could involved heavy financial losses for the Saudis.
Even though the names have changed, that doesn't seem to be the case any longer.
As one reviews the mindset of a then-alerted and highly nervous apparatus of national security it is difficult not to read between the lines of analysis and realize something very stark and, in the present environment, worrying. Almost every single response available to policy makers in the event of economic warfare of this kind depended on the dollar's status as the reserve currency of choice, its strength, and the absence of other options. (The Swiss Franc and the German Mark were generally expected to see the petrodollar inflows). Since this buffer is now gone it doesn't take much creativity to notice that, today, the United States is in an intensely vulnerable position to actions of this kind.
To get a sense of just how powerless policymakers were, consider these comments about the impractability of the free market itself under econmic pressures (in this case oil embargos):
The Free Market. Complete reliance on price to bring supply and demand into balance would create short-term and mid-term economic problems of sufficent severity that it would be unacceptable as an option. However, price increases would add to the effectiveness of a rationing scheme or allocation program.
Reflect for a moment on the fact that this is a memo from a Goldmanite.
There isn't any reason to think that Kuwait is engaging in overt economic warfare against the United States, of course. However, if economic conditions, a lack of confidence in the dollar, or a pessimistic view of the fiscal black hole that is the United States Congress and the present administration cause pullouts like these, what's the difference in effect? There isn't one.
It seems hard to believe the current party line that Pandit has somehow insulted the Kuwaitis by not visiting often enough or sending flowers to apologize. Too much is at stake for these sorts of pleasantries to dictate policy, and there is likely plenty of reason to consider de-Americaing one's portfolio just now.
Is it also possible that, contrary to popularly entertained illusion, middle eastern petrol dollar wealth simply does not back up quite as much as everyone thinks? If so, is Dubai a hint of what lurks behind the opacity of sovereign wealth funds and other middle eastern enterprises? Opacity works for the likes of Dubai precisely because of investors' willingness to imagine vast sums of crude wealth behind the curtain. Certainly, Dubai shamelessly exploited this economic blind spot. Who else is taking advantage of this bit of investor cognitive bias? With this level of opacity, how responsible is it to assume that we know anything about the solvency or liquidity position of entities like these?