The US has accumulated hundreds of billions of dollars in trade deficits in the past few years. Some of the deficit may be due to undervalued currencies, particularly the Chinese renminbi, but most of it would probably have occurred even if the renminbi was much stronger during this period. The truth is that the US has shifted a vast amount of its production abroad and must deal now with the resulting accumulation of external imbalances that are now being placed in sovereign wealth funds.

Clearly, the US can no longer be too picky on what kind of capital it will accept. For many decades, the US assumed that Asian countries would accumulate forex reserves and purchase Treasuries, as the ramifications of currency appreciation were as bad for them as a rout in the USD/Treasury market was for the US. The Bush administration even condoned Japan's massive yen interventions in 2003-2004. But now that Asian SWFs are being created, they undoubtedly will be investing in equities soon; it is just a question of the timing and the method.

Many voices in the US government now say that this accumulation of reserves is illegitimate as it was caused by currency intervention, and that Asian governments should not be allowed to buy large portions of the US. While there are justifiable concerns about a communist country such as China owning controlling stakes in many “national interest” industries in the US, the general fear of Asian equity ownership is unfair and impractical. The US allowed this unbalanced system to develop and the natural consequence is for Asians, whether citizens or their governments, to own large portions of US assets, and not just Treasuries. With appreciating currencies, the Asian SWFs must seek higher risk assets such as high-yield bonds, equities and real estate in order to achieve acceptable returns.

The safest way to avoid an asset/trade war is to allow SWFs to invest passively in equities via indexed products or via external, long-only, diversified investment managers. Both sides should agree on a simple reporting system regarding such purchases, with restrictions that would be triggered if the overall SWF ownership level rises above 30 per cent.

If this is not achieved, Asian SWFs may rapidly diversify away from the dollar, with the euro bearing the greatest brunt of appreciation, and also likely causing a sharp rise in commodity prices. Trade protectionism and acrimony would certainly follow. While this has not yet occurred, China's recent creation of its massive SWF and its growing influence in the world changes the rules. This trend will gain momentum very quickly, so it would be best to seek agreements on the above items as core principles of “SWF best practices” rather than wait for a long negotiation over a complete set of such principles.

For their part, Asian SWFs should refrain from making large or sensitive acquisitions in the West. However, it is certainly possible to envisage an Asian SWF negotiating with a large western company for a passive 5–10 per cent stake, as did China with Blackstone, with such shares being newly issued so as to prevent major disruption to equity pricing. If the company concerned hosts this proposal, partly in the hope of better business relations within China, the deal need not arouse official concerns. Certain technology transfer would undoubtedly occur but, as long as that does not directly impact on military-related affairs, it should be considered normal.

Furthermore, Asian governments should begin to sell the fixed income receipts of their forex reserves, so as to restrain continued accumulation of forex reserves.

As for Europe, while it is true that it has maintained relatively balanced total trade accounts for many years, its trade deficit with Asia, particularly China, is soaring. So it should be no surprise that Asia SWFs wish to purchase European equities with some of the proceeds.

In sum, western governments should quickly allow, if not promote, Asian SWFs to invest passively in their equities. At the same time, Asian governments should avoid confrontational acquisitions and allow their currencies to continue appreciating. In this way, a major disruption in trade and capital flows can be avoided.

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