Asia may benefit as sovereign funds shun U.S. dollar


By Steven C. Johnson and Gertrude Chavez-Dreyfuss
Friday, July 18, 2008

NEW YORK -- The trouble at U.S. mortgage giants Fannie Mae and Freddie Mac may discourage state-run investment funds from buying U.S. dollar-denominated assets but the euro is not likely to be the main beneficiary.

Instead sovereign wealth funds, controlling over $3 trillion in assets, are likely to turn to investments in Asia, a move likely to push the U.S. dollar lower against Asian currencies including the Japanese yen.

"This is not a euro-dollar story. It's going to be a developed world versus developing world story," said Stephen Jen, who heads up Morgan Stanley's global FX strategy.

Authorities in Kuwait this week said the state's sovereign wealth fund, which manages its massive petro-dollar assets, will not buy future Fannie or Freddie debt, opting instead to boost investments in stocks, bonds, and real estate in China, India, and Japan.

A Chinese think-tank also said the travails at the two U.S. government-sponsored enterprises add urgency to China's goal of diversifying its $1.8 trillion stockpile of currency reserves.

At the end of 2007 China Investment Corp., China's state-run fund, was thought to oversee assets worth about $200 billion, while the Kuwait Investment Authority has up to $250 billion, according to estimates by JPMorgan.

The U.S. Treasury and Federal Reserve announced a plan last weekend to shore up the balance sheets of Fannie Mae and Freddie Mac, which own or guarantee $5 trillion in debt, close to half the value of all U.S. mortgages

So far the plan has helped to shore up investor confidence, and recent Federal Reserve data showed central banks were still adding to their agency holdings in the week to July 16.

But sovereign wealth funds have more flexibility to invest in riskier assets, and a change in asset allocations or future buying habits could be the leading edge of a new downleg for the U.S. dollar.

... Once bitten

Recent experience with investing in U.S. financial stocks may give fund managers pause.

Since taking a $3 billion stake in U.S. private equity firm Blackstone Group in 2007 and a $5 billion stake in Morgan Stanley this year, China Investment Corp. has taken sizable losses on the value of its investments.

After sinking $5 billion into Merrill Lynch when shares were trading around $48, Singapore's Temasek Holdings has watched Merrill's shares dive to about $30.

"Sovereign wealth funds that invested in U.S. banks have lost 30 to 50 percent of their investments in the space of six months, so they're becoming more cautious," said Nouriel Roubini, business professor at New York University's Stern School of Business and head of Roubini Global Economics.

In addition, the fear that more mortgage market losses at U.S. banks will force the Federal Reserve to reduce U.S. interest rates again later this year may spell even more trouble for the U.S. dollar.

But Ashraf Laidi, chief market strategist at CMC Markets in New York, said the trend away from the U.S. dollar will outlive the current U.S. market turmoil.

"It's not only reflective of the negative current in the U.S. economy right now, which will turn around at some point, but is also about the increasing investment opportunities around the world, especially in Asia," he said.

Until now the U.S. dollar's decline has been mostly against the euro and other European currencies. Since the start of 2006, the euro has gained nearly 30 percent against the dollar.

Against the Japanese yen, the dollar has lost just 9.0 percent, and losses against managed currencies such as China's yuan have been even more modest.

Assets in fast-growing emerging market heavyweights such as China and India are likely to benefit, and Morgan Stanley's Jen said the yen will also get a boost.

"The Nikkei has some very good companies," Jen said. "It makes sense for investors to hold more yen."

Of course it's tough to know what funds are doing, as most do not disclose their asset holdings, said Carl Linaburg, vice president of the Sovereign Wealth Fund Institute, a California research group. Most, he added, are long-term investors and still concentrated in fixed income.

There's also a strong incentive for oil-rich Gulf states to step up purchases of non-dollar assets, said Laidi.

Because most peg their currencies to the U.S. dollar, they would run the risk of taking huge loss on their dollar holdings if they suddenly revalued to a basket peg.

Some of the Gulf funds are thought to be among the world's biggest. The Saudi Arabia Monetary Authority controls an estimated $330 billion, according to JP Morgan. The Abu Dhabi Investment Authority, the biggest of them all, is thought to control anywhere from $500 billion to $1 trillion.

"The sovereign wealth funds, then, have to reduce holdings to alleviate the inevitable hit they will take on earnings when they eventually revalue their currencies," he said.

"This is not throwing the dollar in the dumpster," he added. "This is just reality."

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