There is an interesting problem for the booming world of Sovereign Wealth Funds. These funds—controlled by national governments and funded by booming trade and petro-dollar surpluses—have a lot of dollars. They’ll want to spend those dollars before the greenback falls even further.

But that may not be as easy as you think, and not because there’s only so many assets you can spend US$200 billion on (the size of China’s state-run fund). The trouble is, policy makers in the US and Western Europe are just now realising that Sovereign Wealth Funds mean that foreign governments can quite legally acquire large and controlling interests in key companies or key industries.

Is that a bad thing? It depends on who you ask. Hank Paulson thinks it can be good, as long as Sovereign Wealth Funds behave the way he would like them too. He urged the International Monetary Fund to develop “best practices” for governing the investments of SWFs that, “demonstrate to critics that SWFs can be constructive, responsible participants in the international financial system.”

“The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares,” added former Treasury Secretary Larry Summers in a Financial Times op-ed piece. “It is far from obvious that this will, over time, be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence.”

Summers’ concerns are at least more interesting than Paulson’s. How do you define a “constructive and responsible participant in the international system?” Is it someone who accepts the status quo without asking questions?

A friend in Dubai writes the following, “The US attitude is amazing. ‘You must take our almost worthless dollars ,but we will not let you spend them here, on anything with value’…I will have to get rid of my remaining dollars before they reach their intrinsic value.”

If the US leads a charge to restrict what kind of assets SWFs can buy, it will reveal the dollar dilemma in all its glory. It will be a great swindle on the Sovereign Wealth Funds….all cashed up with nowhere to go. After all, what good is US$1 trillion in cash if you can only spend it on Treasury bonds?

In the meantime, we expect increased volatility in the financial markets as the US dollar tests new all-time lows. Higher base and precious metals prices will be one aspect of the dollar’s new lows. And a stronger Aussie dollar, favoured by carry traders, will be another.

Dan Denning

The Daily Reckoning Australia

Dan Denning is the editor of The Daily Reckoning Australia. He's also the author of 2005's best-selling "The Bull Hunter" (John Wiley & Sons), and spent five years as editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan draws on his network of global contacts from his new base in Melbourne, Australia. Copyright © 2007 Dan Denning