It's the new animal, and it's the prowl in the global finance and capital markets. To all those who had repeatedly asserted that capital, especially global capital, does not have colour and hence one needs to encourage free flow of the same, the reversal in their stated position has been remarkably swift.

What is indeed startling is that the flow of capital across borders -- held as the endgame in globalisation -- runs the risk of being reversed. Contrary to popular belief, these wealth funds are not even remotely connected to the tainted or the illegal narco-terror money that has in the past threatened the world of finance. Rather, it is sovereign nations' clean money that now threatens the global financial architecture.

How and why did this turnabout happen? Read on. . .

The recent spurt in the accumulation of foreign exchange reserves (running into several hundred billion dollars) in the past few years by countries in Asia, notably China, and other oil exporting countries, has resulted in the creation of this new instrument -- Sovereign Wealth Fund.

The ostensible purpose behind such a fund is to ensure increased return on such sovereign wealth primarily invested in United States treasury bonds thus far. With global interest rates heading southwards, sovereign funds are now being constituted by countries having significant forex reserves, to invest in capital markets across the globe.

What is indeed a pointer of things to follow is that the US, which prides in being 'independent' from other countries especially in security affairs, is now caught in a quagmire. It has to be constantly in the good books of the Chinese and other Asian governments if it wants to avoid a sudden shock.

Countries that hold large US dollar-denominated forex reserves have a powerful tool in their arsenal -- they could wreck American financial markets at a mere click of a mouse. And that could instantaneously dynamite the global financial system.

Surely, they may have no obvious intent to do so as it would be suicidal and would result in that could mean that forex assets that they are holding could diminish in its value. But if they want, they could well 'engage' the US to discuss political and other issues with them on their terms. The fear for the US obviously would be that should these countries dump their holdings of American treasuries on financial markets, they could probably cause a crash in the financial markets.

According to Lawrence Summers: "It is a new form of mutually assured destruction that has quietly emerged over the last few years."

Setting the cat among the pigeons

What has indeed set the cat among the pigeons is the fact that Chinese government has recently proposed in June 2007 to inject $200 billion into a new government company that will buy assets abroad. Beijing calls this as an effort to make more profitable use of its $1.2 trillion forex reserves. What will distinguish this Chinese fund is not just its size, but that it will be a government entity owned and run by the government of China.

Perhaps learning from the likes of Dubai Ports World and CNOOC's bid for Unocal, some state-backed investors (China, for instance) have strategically proposed to take non-voting shares and voluntary restrict stakes to avoid blocked deals.

Apparently, all this positioning is part of a well-orchestrated plan of the Chinese government to use its reserves profitably as well as strategically.

Further, State-backed institutions take on more risks as they benefit from government support. Further, when SWFs are used to promote outward investment of national companies enabling them to bear the highest risk, the risks associated with markets tend to get subsidized by the state. In the process the very functioning of the markets gets dynamited.

What is worrying analysts is that foreign governments might increase leverage over domestic policy decisions of other countries through such large multinationals, State-run or State-financed.

Evolving policy response: Is it adequate?

To evolve a global policy response it has been suggested that International Monetary Fund and World Bank collect best practices and, perhaps, provide oversight of funds. September's financial stability report reveals a first cut of IMF thinking. Yet the literature available on this subject crucially misses the woods for the trees.

While China continues to hog the limelight for a variety of reasons including the reasons as stated above, what is adding fuel to the fire is that two-thirds of the world's oil comes from troubled emerging economies. What is causing alarm in the US is the growing financial clout of Russia, Venezuela and Middle Eastern countries as a result of sustained high oil prices and their build-up of foreign assets.

What is missed in the debate is that Chinese and the Japanese surplus is dwarfed by those of oil exporting emerging economies. It is estimated that the forex reserves of such countries are expected to increase by $500 billion in 2007; over half of it will accrue in the Middle East (West Asia).

Relative to their economies, the oil producers' external surpluses look even bigger: Saudi Arabia, the United Arab Emirates and Kuwait have an average surplus of around 30% of GDP, making China's 8% seem almost modest. These surpluses are having a huge impact on international capital flows.

What is worrying strategic analysts is that as many of these countries are not favourably disposed towards the US -- Venezuela or Iran, for instance -- they could easily be the potential candidates to destabilise the US financial markets, its economy and by extension the global economy.

Commenting on the net impact of the high oil prices and its impact on the global financial markets the Economist predicts that the net result of this increased liquidity is stirring up 'frothy financial markets.'

Further, it states that such capital emerging from these countries is much harder to track than Chinese capital, because a large chunk of foreign assets are held not as official reserves but in secretive government investment funds.

Moreover, whereas China buys American treasury securities direct from American brokers or dealers, Middle Eastern purchases of bonds are typically channelled through intermediaries in London, hiding their true ownership. No wonder experts have repeatedly pointed out that oil surpluses are also flooding into equities, hedge funds, private equity and property.

Does capital have colour?

But the Chinese dimension to this problem is of a smaller order. What must indeed be tormenting strategic analysts within the US is that many of these countries are not favourably disposed towards the US. In fact, many of them consider themselves to be victims of American hegemony. And in order to extract their revenge, these countries too could be using these financial assets, in tandem with a few others to wreck the value of the US dollar.

To some it obvious that future wars by these countries with the US may well be fought in the global financial markets. And the US perhaps would not even know who the enemy is.

Obviously, all this is not about economics, as it seems on a superficial level. As SWFs deploy their assets, political friction with target countries is likely to accelerate. No wonder many countries have now put in place well-defined foreign investment review processes.

It is indeed time that the Indian regulators too discuss this issue and ensure appropriate policy response to this vexatious issue. Nevertheless, what is ironical to note here is that globalisation had contained the seeds of this protectionist state of play -- a point that was missed by many.

Obviously, the challenge to the policymakers is to find a balance for government-backed funds that contain geo-political issues without discouraging orderly global movement of capital -- a Herculean task considering the inherent paradox contained in the idea.

Naturally issues get blurred when questions are raised concerning direct or strategic investment by SWFs -- i.e. when management stakes, sensitivity and security risks, size and, of course, strategic interests are involved. The response would naturally be equally blurred, diffused and to that extent arbitrary.

Who said capital did not have colour?

The author is a Chennai-based chartered accountant. He can be contacted at mrv1000@rediffmail.com