The Future Happened YesterdayDo you ever get the feeling that something's going on in the global economy that we don't fully understand? That while Americans have been focused on fixing our wounded economy and worrying about our lost jobs and battered bank accounts, the world around us was changing in important but nearly imperceptible ways? You'd be right. It did. Enormous economic changes are taking place around the globe, many of them hidden in plain sight, others just plain hidden—kept from the press, the government, and, most of all, the everyday investor. Ever since 2008, when the global financial system melted down, the economic world as we know it has been flipped on its head. Countries and corporations that once dominated the planet have been decimated. Meanwhile, other powers have risen in their place and asserted themselves globally. And although the American economy appears to be recovering somewhat, and a handful of us are beginning to feel more confident about the future, the truth is that we won't be returning to "normal" any time soon.
The structural changes in the global economy have created both dangers and opportunities. If we ignore them, we may suffer mightily—as citizens, as workers, and as investors. Our children may suffer even more. The march of economic history, let it be recalled, is indifferent to your plight or mine. It doesn't care whether the United States becomes, in a few decades, a weakened, second-tier economy riddled with debt and unemployment, and beholden to other countries and a new global currency that is not the U.S. dollar. That could happen, too. However, if we take the trouble to understand the changes now occurring, we might be able to make them work to our advantage. We might be able to get out in front of future economic waves. A few of us may even get wealthier as a result.
In stark terms, here is what has happened: While our economy tanked, nations like China and the small oil-rich states of the Persian Gulf, which still had plenty of wealth on hand, suddenly discovered that they were really rich compared to the rest of the world. So they started using their cash to seize geopolitical power. Wealth and influence crept to the East. Meanwhile, America literally didn't have the money to save itself and the rest of the world from the financial contagion it started. Our banks and investment institutions flat-out didn't have the capital to rescue the financial system themselves. By late 2008, the Bush administration was desperately trying to stave off an economic panic. That fall, you may remember, as the stock market reeled and America's largest banks stared at insolvency, the U.S. Treasury Department sent envoys to China, Singapore, Abu Dhabi, Kuwait, and Saudi Arabia looking for investments of hundreds of billions of dollars. But Bush's envoys were completely rebuffed. The problem was that each of these countries already had been burned by the earlier failures of major U.S. investment banks like Lehman Brothers and Bear Stearns; they had little appetite for taking on more American risk. So America plunged into financial chaos as the government was forced to launch massive bailouts and stimulus programs that will saddle us with financial obligations for decades to come.
Today we are presented with tangible proof that the era of American economic hegemony is over. Our fiscal policies and patterns of consumption over the past few decades have left us with untenable amounts of debt and effectively killed off our financial empire. For decades, the bulk of the liquidity in the global capital markets was provided by multinational banks from the United States and other international financial centers, like the UK and Japan. But today the global need for investment capital far outstrips the cash that the world's largest banks can provide. Instead much larger entities with deep reserves of wealth have emerged to keep the markets flush: a loosely configured, unregulated global "shadow market" that supplies the money that the world needs to grow. With remarkable stealth, this network has largely supplanted the United States as the pacesetter for the global economy. To America, this loss of authority has been a radical comedown. To the rest of the planet, however, the development of the shadow market means that a new global economic force is at play—one that we'll all have to contend with for decades to come.
"The last two hundred years of world history have been a major historical aberration," says Kishore Mahbubani, dean of the Lee Kuan Yew School of Public Policy in Singapore and one of the world's leading authorities on the new wave of globalization. "This is a key point that people in the West have a hard time wrapping their minds around. From the year 1 to the year 1820, China and India consistently had the two largest economies in the world. When you think about it, it's quite amazing that a small continent like Europe was able to conquer and colonize the world. In many ways this global domination by the West continued for a surprisingly long time. But I think it's finally coming to a natural end. So the challenge for the West is, will it accept its loss of power in the global system or will it resist the transfer of power?"
What is the Shadow Market?The shadow market isn't a physical entity. It has no headquarters, bourse, or formal leadership. It isn't even a single zone of exchange in the way that we typically define a financial market. Rather, it's the invisible and ever-shifting global nexus where money mixes with geopolitical power. In specific terms, the shadow market is a collection of unaffiliated, extremely wealthy nations and investors that effectively run the international economy through their prodigious holdings of stocks, bonds, real estate, currencies, and other financial instruments, which they keep in largely unregulated investment vehicles such as hedge funds, private equity funds, and government-run sovereign wealth funds, as well as in vast government-owned holding companies. A 2009 McKinsey Global Institute study concluded that, as of late 2008, more than $12 trillion in assets was controlled by such petrodollar states as Saudi Arabia, Kuwait, and Abu Dhabi; the wealthy Asian nations of China, Japan, and South Korea; and hedge funds and private equity funds. What's more, McKinsey predicted that the assets of nations in Asia and the oil-rich Persian Gulf are poised to grow by more than 50 percent within five years.
This pile of capital is the basis for the shadow market's power, for liquidity is the key to a functioning market. Looking back more than a century, nearly every world financial crisis has been caused by a sudden lack of liquidity—typically during tough economic times, when fear sets in among investors. At that point, banks and other finance companies start hoarding cash rather than investing it or lending it out, which, as the United States learned in 2008, can strangle an economy rather suddenly.
In a capitalist world, the most powerful entities are those that provide the most liquidity. Since wealthy sovereign nations have the deepest pockets, they're in the best position to provide the liquidity the market needs. In practical terms, this transformation can be seen in major real estate transactions throughout Europe and the United States, where shadow market countries have been eagerly snapping up trophy properties for what they consider to be bargain basement prices from their previous highs before Western economies started tanking.
"Real estate investing in the West in 2010 is really about the financial crisis," says Fadi Moussalli, the Dubai-based head of Middle Eastern and North African operations for the global real estate investment consulting firm Jones Lang LaSalle. "Everything that the [Persian] Gulf States and other rich countries are buying today has the smell of blood and flesh and distress in it. Real estate is trading at a discount from its highs of 2007. So this is an opportunity to benefit from the global market dislocation. I don't think they're overpaying for these properties. A lot of these guys are my clients – they are shrewd, they are tough negotiators, and they squeeze every vendor down to get their price. And right now they're timing the real estate market in the West and building their portfolios."
Working together, the members of the shadow market could supply enough capital to stave off any global economic calamity. They have that much money at their disposal. But the catch is that the members are reluctant to work together to solve global problems. Instead they prefer to protect their own interests and zones of influence first. So, wealthy neighbors in the Persian Gulf, such as Abu Dhabi and Kuwait, will readily cooperate on different projects and initiatives. But those same Persian Gulf nations are far less likely to go along with a country like China or Singapore. America once could use its commanding position as the world's unquestioned economic leader as a galvanizing force behind cooperative solutions to global financial problems. But the United States can't dominate this market. Instead it now has to play by someone else's rules.
To get a sense of what this loss of financial control means, recall again the crisis of 2008, when the United States sought help from shadow market countries and was rebuffed. To the shadow market, it was too late to bail out America. As Lou Jiwei, head of the China Investment Corporation (CIC), China's primary sovereign wealth fund, bluntly told the Clinton Global Initiative conference in Hong Kong in December 2008, "China can't save the world. It can only save itself." And that's precisely what China and the other wealthy shadow market countries did.
Starting in late 2008, China pumped $600 billion of capital into its own economy in an economic stimulus plan to bolster the Chinese stock market and the country's businesses. Throughout the Middle East, neighboring countries bailed each other out, the most notable of which was Abu Dhabi's financial rescue of Dubai, which ran into serious investment trouble and almost collapsed. In Kuwait, the country's sovereign wealth fund set up a special multibillion-dollar investment vehicle that was only allowed to buy shares of local companies in order to prop up the Kuwait Stock Exchange, which had fallen nearly 40 percent.
None of these expenditures involved permanently saddling the nations with unmanageable levels of debt. Remarkably, China didn't even have to dip into its stock reserves during the crisis. The shadow market countries had the financial or natural resources to support their own economies. The cash-strapped United States, on the other hand, couldn't possibly embark on such significant capital-intensive projects. It simply didn't have the money in its coffers. So its economy suffered—mightily.
Question: How Big is the Shadow Market?
- For most of the twentieth century, the bulk of America's public debt was held by institutions based within this country, such as mutual funds and corporate and government pension funds. But since 2007, more than 60 percent of our debt has been owned by nonresident foreign investors and independent governments—primarily rich Asian nations such as China, Japan, and Singapore. China, the largest owner of U.S. Treasury securities in the world, held $900 billion worth of our debt as of April 2010, according to Treasury Department figures. And Japan, the next largest holder, held $795.5 billion. These figures don't count both countries' significant positions in dollars and U.S. corporate stocks, bonds, and other securities.
- China, Japan, and other wealthy nations also have vast investments in global currencies. For instance, as of July 2010 China's central bank, the People's Bank of China, announced that it controlled roughly $2.5 trillion in foreign exchange reserves, which are held by a government-run agency called the State Administration of Foreign Exchange, or SAFE. In 2006 China passed Japan as the world's largest owner of foreign exchange reserves. By 2009, SAFE's foreign exchange investments accounted for nearly a third of the world's total currency holdings. Still, China and Japan aren't alone. Other major holders of foreign exchange reserves around the world include Russia, India, South Korea, and Brazil. Combined, they're sitting on trillions and trillions too.
- Sovereign wealth funds(SWFs)are now a global phenomenon. These government-owned investment vehicles are managed separately from a country's debt and currency reserves. Aa of July 2010, roughly $3.5 trillion in global capital was managed through different SWFs, up from $1 trillion in 1999, according to the Sovereign Wealth Fund Institute. The largest funds belong to oil-rich nations and industrial powerhouses such as Abu Dhabi, Saudi Arabia, China, Singapore, Kuwait, Russia, and Norway. Abu Dhabi's SWF alone has more than a half trillion dollars in assets even after taking a severe hit during the most recent financial crisis and contributing billions to bail out neighboring Dubai. That's a lot of cash. And what's more, the International Monetary Fund (IMF) projects that the total assets managed through SWFs will rise to more than $10 trillion by 2012 as the size and number of funds explodes. Fast-growing countries such as India and Brazil are developing plans for their own funds. Indeed, SWFs have become the height of fashion in global finance. An example can be found in the fallout of the massive BP oil spill in the Gulf of Mexico that decimated hundreds of miles of U.S. coastline from Florida to Texas. As the cost of the cleanup escalated, the value of BP shares was sliced in half. By July 2010, BP executives had become concerned that the weakened company was vulnerable to a takeover. They needed financial help, fast. So who did they approach? Not Western banks of the governments of the United States or the United Kingdom. Instead, they reached out to the real arbiters of liquidity in the financial markets, the sovereign wealth funds in Abu Dhabi, Kuwait, Qatar, and Singapore, each of which owned a small position in BP. Kuwait rejected the request out of hand, but the others remained noncommittal. So why did BP executives choose this tact? Because they knew that these SWFs controlled enough cash to easily help the company out of a tight spot in the shortest amount of time. That's the essence of their power as investors.
- Private unregulated investment vehicles such as hedge funds and private equity funds now set the tone for the behavior of the financial markets. Hedge funds are unregulated mutual funds that often capitalize on complicated trading schemes to generate profits. Private equity funds, on the other hand, like those owned by ultrasecretive firms like the Blackstone Group and the Carlyle Group, are designed to take over undervalued businesses, clean up the books, streamline the operations, and resell them for a tidy profit. As of July 2010, hedge funds and private equity funds controlled more than $4 trillion in assets. Obviously, that's a smaller pile of capital compared to the vast sums commanded by such superrich countries as China, Abu Dhabi, Singapore, and Kuwait. Still, these funds' innovative and sophisticated investment techniques have given them levels of influence far beyond their size and scope, leading the shadow market herd into new sectors, securities, and asset classes.
- To put all of these numbers and statistics in a broader context, consider that the McKinsey Global Institute estimates that by 2013, the governments of countries in Asia and the Persian Gulf, global hedge funds, and private equity funds will control more than a combined $19 trillion in assets. How much money is that? Well, in 2013 the gross domestic product (GDP) of the United States is expected to be around $16 trillion, according to estimates by the IMF. In other words, a financial force larger than the entire U.S. economy will be at play in the capital markets. On its own, China's central bank, which controls more than $2 trillion in assets, is already the largest single investor in the world, bigger than any major multinational money management firm, from Barclays Bank to Fidelity Investments to State Street Corporation to BlackRock. And numerous other wealthy nations aren't far behind China. When you consider everything on the table, there's really only one conclusion: The shadow market soon will be the most powerful financial force on the face of the earth—if it isn't already.
- Numerous American industries have been gutted automotive, retail, industrial manufacturing, and the media, to name a few—and American consumers have struggled with joblessness, high debt levels, and stagnant incomes. As a result, the United States has stumbled around in a general sense of fear and stasis and political impotence. But not the shadow market. It's kept moving forward. In particular, many of the shadow market countries have launched an unprecedented scramble to buy the world's resources while they're still available. China has been insuring itself future access to oil, minerals, food, and anything else it cannot supply for itself. The number of deals around the globe is staggering, and, in some countries, the presence and power of Chinese companies have effectively created neocolonial relationships, with Chinese corporations and officials calling the shots within their own overseas fiefdoms. China also has projected itself into ownership of the world's cutting-edge technologies in engineering, computers, and high-end manufacturing. Of course it's not only China. Other countries, competing not just with the United States and China but with one another as well, also have been busily scooping up the resources they need to control their destinies well into the twenty-first century.
The shadow market, however, has turned all of that upside down. For the most part, the countries of the shadow market have employed capitalist strategies to amass their fortunes. But even though they've used capitalist tools, many are hardly "free" countries politically or economically. Instead they adopted a nationalistic form of capitalism where the state created companies and investment funds that could participate in the global economy. But the money generated by these entities doesn't belong to the company, its workers, or its stockholders, the way in America IBM's profits belong to IBM. Instead most of the money from these companies and investment vehicles rolls up to the state, giving the government the power to determine how to deploy the bulk of the capital generated by its economy.
That's why the shadow market's rise has fundamentally changed the way we view the economic world. It's not just corporate greed that we have to watch out for anymore, it's geopolitical power plays as well. Major investors can have completely divergent agendas from the countries where they're investing, and sometimes they can make financial moves that have more to do with politics than economics. This helps explain why in June 2009 China jumped at the chance to pay $1.2 billion for forty-five million shares of Morgan Stanley to go along with stock it had bought earlier. The purchase gave China a combined 10 percent ownership stake in Morgan Stanley, which was in addition to its 10 percent stake in Blackstone Group. Now China certainly could turn a profit from its Morgan Stanley position. But investment returns didn't appear to be what the deal was about. Instead let's say that one day in the not-too-distant future, China develops an even greater problem with America's dollar policy. Well, it's one thing for China to approach the U.S. Treasury Department as a rival superpower. But it's quite another to do it as the owner of 10 percent of Morgan Stanley and 10 percent of the Blackstone Group, not to mention the holder of about $2 trillion worth of U.S. currency reserves and debt instruments.
To make matters even more complicated, there's practically no regulatory oversight of the shadow market's activities. Why? Because its deals often take place in foreign countries and therefore are cloaked under the different financial rules established by each country. So we regularly have no idea what's happening until after it's happened. The potential for conflicts of interest can be right on the surface. Yet there's little or nothing we can do about it.
Not that the American government is all that interested in clamping down on the shadow market's activities right now. Indeed, the global economy has become so intertwined that our future success is tied to the shadow market's continued support. As Brad Setser, an economist in the Obama administration's National Economic Council, stated in his influential September 2008 report for the Council on Foreign Relations called Sovereign Wealth and Sovereign Power: "The United States' main sources of financing are not allies. Without financing from China, Russia, and the [Persian] Gulf States, the dollar would fall sharply, U.S. interest rates would rise, and the U.S. government would find it far more difficult to sustain its global role at an acceptable domestic cost."
In other words, through these investments, we've become entwined with rival nations in conflicting and potentially dangerous ways that we never could have imagined just five years ago. That's why Michael McConnell, the former director of national intelligence, told Congress in his 2008 threat assessment report that one of his most serious concerns about America's long-term security is "the financial capabilities of Russia, China, and the OPEC countries, and the potential use of their market access to exert financial leverage to achieve political ends."
These fears have never been more on target and never more true than today. As we are about to see, the countries and entities that comprise the shadow market have been very busily pursuing their new world order, changing the global economy more rapidly than most people, Americans in particular, ever imagined.