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Rise of giant funds sparks fear of global shockwave

Section: Daily Dispatches

By Tom Stevenson
The Telegraph, London
Friday, October, 5, 2007

The rapid growth of sovereign wealth funds, petrodollar investors, hedge funds, and private equity groups poses significant risks for the world economy, claims a report from management consultant McKinsey.

Asset bubbles, excessive lending, market distortions, and bank failures are all highlighted as possible consequences of the increasingly large and influential financial players that have emerged in recent years. McKinsey's New Power Brokers report is the result of six months' research by the consultancy and analyses "how oil, Asia, hedge funds and private equity are shaping global capital markets."

Author Diana Farrell says that "for all of their benefits, the rise of the power brokers also poses new risks to the global financial system."

Ms Farrell, director of McKinsey's economics research arm, said real estate values in developed countries had increased by $30,000 billion (L14,679 billion) between 2000 and 2005, far outstripping economic growth. This partly reflected property purchases by petrodollar investors but was also a side-effect of lower interest rates caused by investment in government securities -- especially in the US -- by Middle Eastern and Asian investors.

"Another concern is that the government connections of Asian central banks and petrodollar sovereign wealth funds may introduce an element of political considerations in their investments," says Ms Farrell.

"This could lower economic value creation and distort the signals that allow financial markets to function efficiently." The size and leverage of hedge funds, and their increasingly illiquid investments, threatened contagion in times of financial crisis, says the report. The dramatic growth in high-yield debt, and looser lending covenants to meet demand from private equity groups, have also increased credit risk. "The evidence to date gives some reason for optimism that the risks posed are manageable; never the less, current concerns are real and justify careful monitoring," Ms Farrell concludes.

Oil investors, Asian central banks, and hedge and private equity funds collectively held $8,400 billion in assets at the end of 2006. These assets had tripled since 2000 and they are now equivalent to 40 percent of the size of the world's pension funds and a similar proportion of global mutual funds. Altogether, they represent 5 percent of the world's $167,000 billion in financial assets.

Crucially, the rate of growth of these four new "power brokers" is much faster than for traditional financial assets. Between 2000 and 2006, the assets held by Asian central banks grew by 20 percent a year, four times as quickly as the world's pension funds.

At the current growth rate, the assets of the four groups will exceed $20,000 billion in five years' time, 70 percent of the size of the world's pension funds.

Biggest of the four is the petrodollar gusher, which has grown rapidly after a tripling in the oil price since 2002 to up to $3,800 billion in foreign financial assets. Even if the oil price were to fall back to $30 a barrel, Ms Farrell estimates, petrodollar assets would continue to grow rapidly over the next five years. Using the consultant's base of $50 oil, an extra $1 billion a day will pile up in the financial markets by 2012.

Central banks, mainly those of China and Japan, are the next most significant player, with $3,100 billion held in foreign reserve assets at the end of last year. Most of this has found its way into US Treasury bonds, helping keep interest rates artificially low.

The central banks of China, South Korea, and Singapore have announced plans to shift a collective $480 billion into more diversified assets, potentially applying a new "liquidity bonus" to world markets.

Hedge funds are less significant but have still grown from less than $500 billion in 2000 to $1,500 billion today. Together with the leverage they typically employ, hedge funds could have $12,000 billion of financial firepower by 2012.

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