The new role of oil wealth in the world economy

1호 (2008년 1월)

Regulators may worry when Arab investors acquire stakes in Western companies, yet vast reserves of petrodollars have kept down interest rates and buoyed financial assets. What’s the broader effect of the surge in petrodollars?
 
Diana Farrell and Susan Lund
 
January 2008
As oil prices continue to set new records, investors outside Europe and the United States are increasingly shaping trends in financial markets. Petrodollar investors have a newfound influence, and the more than tripling of oil prices since 2002 makes them the largest and fastest-growing component of a broad shift in global economic markets—a shift that also includes Asian central banks, private-equity firms, and hedge funds.1 High oil prices are, in effect, a tax on consumers, generating windfall revenues for oil-exporting nations, which in 2006 became the world’s largest source of net global capital flows, surpassing Asia for the first time since the 1970s (Exhibit 1). A majority of these revenues have been recycled into global financial markets, making petrodollar investors increasingly powerful players.
 

 
Moreover, the influence of petrodollar investors is likely to continue to grow over at least the next five years. The exact size of future petrodollar foreign investments will depend on oil prices, which are subject to considerable uncertainty. Nonetheless, we can estimate the general direction of petrodollar assets using three benchmark price points and research on global energy demand by the McKinsey Global Institute (MGI).
 
At $50 per barrel of oil the annual net capital outflows of the petrodollar countries would amount to $387 billion a year through 2012 (Exhibit 2).2 This total represents an extraordinary infusion of capital into global financial markets at a rate of more than $1 billion per day. At $70 a barrel petrodollar flows into global markets would grow even larger, reaching $628 billion annually by 2012, implying new petrodollar investments of nearly $2 billion a day. By 2012 the total stock of petrodollar foreign assets would grow to $6.9 trillion. Even if oil prices declined to $30 a barrel, petrodollar foreign assets would grow at a robust average rate of 6 percent annually, to reach about $4.8 trillion in 2012, when the oil-producing countries would add $147 billion to the global financial system. That figure is larger than petrodollar surpluses throughout the 1990s.
 

 
Without a doubt, this flood of oil money is creating new dynamics, and the rise of petrodollar investors feeds growing concern about their government connections and influence on markets. Since facts about these powerful new investors have been scarce, our research aims to ground the debate by providing new data and analysis.
 
Where petrodollar assets are held
By our estimate, investors from oil-exporting nations owned $3.4 trillion to $3.8 trillion in foreign financial assets at the end of 2006.3 That sum is invested overseas in a number of ways.
 
Central banks
Some petrodollars end up as resources held by central banks, which invest in foreign assets to stabilize currencies against balance-of-payment fluctuations. The primary investment objective of central banks is stability, not the maximization of returns. They hold foreign reserves, mainly in the forms of cash and long-term government debt—at present, largely US Treasury bills. Among the oil exporters, Saudi Arabia has the largest central-bank funds, with an estimated $250 billion in 2006.
 
Sovereign wealth funds
Most oil-exporting countries have set up state-owned investment funds, often called sovereign wealth funds, to invest oil surpluses in global financial assets. Unlike the reserves of central banks, these funds hold diversified portfolios that range across equities, fixed-income vehicles, real estate, bank deposits, and alternative investments, such as those provided by hedge funds and private-equity firms. Most sovereign wealth funds allocate their portfolios in a relatively traditional way across asset classes, often relying on external global asset managers. To date, the funds have rarely taken majority shares in foreign companies. The largest sovereign wealth fund among oil exporters, the Abu Dhabi Investment Authority (ADIA), reportedly has total assets of up to $875 billion (Exhibit 3).
 

 
 
Government investment corporations
Increasingly, oil exporters channel some of their wealth into smaller, more targeted funds, such as Dubai International Capital (DIC) and Istithmar. These entities invest directly in domestic and foreign corporate assets, shunning the portfolio approach of the sovereign wealth funds. Many operate like private-equity firms, actively buying and managing companies, either alone or with consortiums of investors. Their investments include the Tussauds Group (owner of the London wax museum), purchased by DIC in 2006—subsequently sold to Merlin Entertainments in 2007—and Barney’s New York, which Istithmar bought in 2007.
 
High-net-worth individuals
In almost all oil-exporting countries except Norway, private wealth is highly concentrated among a few wealthy and ultrawealthy individuals.4 These investors place a large portion of their wealth abroad, often using financial intermediaries in London, Switzerland, and other financial hubs, and most have highly diversified asset allocations. They also have some unique preferences, with a penchant for equity and alternative investments. Overall, MGI estimates, private individuals have made 40 percent of all petrodollar foreign investments.
 
Government-controlled companies
Particularly in the Middle East, with its limited domestic markets, some state-owned companies in oil-exporting nations receive direct or indirect government funding and then invest in companies abroad. A lot of public attention has accompanied some of these deals—notably the recent acquisition of GE’s plastics unit by Saudi Basic Industries (Sabic) for $11.6 billion and the purchase, by Dubai’s DP World, of the British ferry conglomerate P&O for $8.2 billion. In 2005 and 2006 alone, acquirers from the Gulf Cooperation Council (GCC) states spent more than $70 billion on international M&A.5
 
Private companies
Finally, private companies in oil-exporting nations, like their counterparts elsewhere, use retained earnings and capital growth to finance foreign investments. They include Kuwait’s Mobile Telecommunications Company (MTC), the National Bank of Kuwait, and the Kuwait-based logistics business Agility, as well as Egypt’s Orascom. As with government-controlled companies, we do not include the value of the foreign acquisitions of private companies in our estimates of petrodollar wealth.
 
Fueling liquidity—and possibly asset bubbles
Since 2002, oil prices have tripled, and much of the incremental increase has ended up in the investment funds and private portfolios of investors in oil-exporting countries. Most of the money is then recycled on global financial markets, whose liquidity is therefore rising.
 
In fixed-income markets, this added liquidity has significantly lowered interest rates. We estimate that total foreign net purchases of US bonds have brought down long-term rates by about 130 basis points. Twenty-one of them can be attributed to purchases by the central banks of oil-exporting countries,6 an impact as large as that of the capital flows from financial hubs such as the Cayman Islands, Luxembourg, Switzerland, and the United Kingdom, though less than half the impact of Asia’s central banks on US interest rates. Petrodollars have added liquidity to international equity markets as well. Taking into account the allocations of GCC investors,7 we estimate that each year equity markets receive $200 billion in petrodollars, accounting for about $2 trillion—or 4 percent—of their capitalization.
 
Some observers worry that this new liquidity is having an inflationary effect on asset prices, perhaps fueling bubbles. Our analysis shows that this concern isn’t justified in public-equity markets. Although their capitalization has risen rapidly since the 2000 stock market decline, we find that rising corporate profitability and share buybacks (often using debt) are the main reasons. In Japan and the United States, private-equity ratios have declined in recent years, while in Europe they have risen only incrementally. (In China, India, and some other emerging markets, however, they have increased.)
 
The story is different in global real-estate markets. According to research by the Economist Intelligence Unit, real-estate values in developed countries have increased by $30 trillion since 2000, reaching $70 trillion in 2005 and far outstripping GDP growth over the same period.8 This rise reflects not only the preference of petrodollar investors for global real estate but also the home-equity loans and larger mortgages that low interest rates and risk spreads have made possible.
 
Indeed, petrodollars have helped increase global leverage in many forms. Low interest rates and credit spreads have enabled the rise of hedge funds and the private-equity boom, which may have stalled for the moment.9 Although low rates and spreads have created ample liquidity for consumer credit in the United Kingdom, the United States, and many other countries, a reassessed appetite for risk could burst this global credit bubble, causing pain to lenders and borrowers alike. In mid-2007 problems in the US subprime-mortgage market sparked a repricing of credit risk and a credit crunch. A note of caution is therefore warranted, despite the bullish impact of petrodollars on the liquidity of world financial markets.
 
Growing concerns
Despite the many beneficial effects of petrodollars in increasing global liquidity and spurring the growth of various financial-asset classes throughout the world, the rise of investors in oil-exporting countries has created concerns.
 
One worry is that the huge size of petrodollar sovereign wealth funds, coupled with their relatively high appetite for risk, could make global capital markets more volatile. The limited transparency of these funds amplifies the anxiety. Our research, however, finds that their investment portfolios are widely diversified not only across asset classes and regions but also through a number of intermediaries and investors. Diversification reduces the risk that the funds could make financial markets more volatile. Moreover, petrodollar investors have a track record of sensitivity about the broader market impact of large flows and use derivatives and intermediaries to lessen it. ADIA, for instance, reportedly invests 70 percent of its funds through external asset managers—intermediaries who know they must move slowly in markets to avoid adverse price adjustments. Direct petrodollar investors tend to adopt a relatively low profile.
 
A second concern has also attracted growing attention among financial-market regulators in Europe and the United States: the prospect that sovereign wealth funds could use their growing financial heft for political or other noneconomic motives. The rise of large government investors in financial markets is a new phenomenon—and one at odds with the shrinking role of state ownership in real economies. Given the limited transparency and enormous size of these investors, some observers question the motivations underlying their investment strategies. How will state investors behave as public shareholders or owners of companies in foreign markets? Will they seek to maximize value creation and long-term growth, or will their investments reflect the political objectives of their governments and the interests of businesses in their home countries? Financial markets require the free flow of information to function efficiently. The presence of huge, opaque players with noneconomic motives could distort the pricing signals that other investors need. A growing number of economists and policy makers in Europe and the United States now support the creation of disclosure standards for government investors.
 
Most sovereign wealth funds have historically invested at least part of their assets through external managers, which should help ease these anxieties. To the same end, it would be in the funds’ interest to increase their voluntary disclosures about their size, investment objectives, target portfolio allocation, and internal risk-management and governance procedures; this information would allow well-managed funds to stand out and demonstrate a spirit of cooperation. Some observers consider Norway’s Government Pension Fund a model because it makes its asset allocation, investment criteria, and investments available to the public on its Web site.
 
Regulators in Europe and the United States should ensure that they base any policy decisions about the activities of sovereign wealth funds on an objective appraisal of the facts. It will be essential to differentiate between the direct acquisition of corporations by state-owned enterprises and by government investment companies in oil-exporting regions, on the one hand, and the passive investments of sovereign wealth funds in debt and equity markets, on the other. Sovereign wealth funds typically hold a diversified portfolio of assets in public debt and equity securities rather than large stakes in foreign companies.
 
A final concern: the long-term economic impact of higher oil prices. In the 1970s their rise sparked inflation in the major oil-consuming economies and sent global banks on a petrodollar-fueled lending spree in Latin America. Both developments inflicted significant economic pain on the countries involved. Today higher oil prices have been a boon for global financial markets, but, paradoxically, inflation hasn’t risen very much. Can higher oil prices really be good for the world economy? As we have seen, petrodollars are creating inflationary pressures in markets for illiquid investments, such as real estate, art, and companies. If the pressures move beyond those markets, the potential asset price bubbles could burst. So far the world economy has accommodated higher oil prices without a notable rise in inflation or an economic slowdown, but this may change in the future.
 
About the Authors
Diana Farrell is director of the McKinsey Global Institute, where Susan Lund is a consultant.
This article was first published in the Winter 2008 issue of McKinsey on Finance. Visit McKinsey's corporate finance site to view the full issue.
 
Notes
1The full report, The New Power Brokers: How Oil, Asia, Hedge Funds, and Private Equity Are Shaping Global Capital Markets, is available free of charge online.
2Net capital outflows are equal to current-account surpluses, less errors and omissions.
3Determining the true size of the oil exporters’ foreign assets is difficult because no comprehensive official figures exist. Our estimates are based on published data sources, our own research, and interviews with banking experts in the region.
4Some of the wealth that oil exports generate ends up in middle-class and mass-affluent households. However, they are less sophisticated investors and generally keep the majority of their wealth in the domestic financial system. In the Middle East these investors have an estimated $200 billion to $250 billion in assets. Because our focus is the impact of petrodollars on global financial markets, we exclude middle-class and mass-affluent investors from our analysis.
5The total value of foreign acquisitions by all companies in oil-exporting countries is probably much higher and could add a few hundred billion dollars to the pool of petrodollar foreign assets. However, we don’t include the value of these corporate acquisitions in our calculations. First, they are exclusively in companies and not in portfolios of financial assets, and, second, it is difficult to calculate their value—the acquirers typically are not public companies and thus report limited information. The GCC member states are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE).
6We based this assessment on a methodology developed by Francis E. Warnock and Veronica Cacdac Warnock, “International capital flows and U.S. interest rates,” NBER Working Paper 12560, October 2007. See appendix B of MGI’s report for more details.
7See the full MGI report for estimated portfolio allocations of different types of petrodollar investors.
8“In come the waves,” Economist, June 15, 2006.
9Antonio Capaldo, Richard Dobbs, and Hannu Suonio, “Deal making in 2007: Is the M&A boom over?” McKinsey on Finance, Winter 2008, pp. 8–13.
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