Invasion force?

Sovereign wealth funds have ridden to the rescue of banks hit by the credit crunch. But are these secretive state-run vehicles really pursuing foreign policy objectives under the cloak of simple investment? Sunil Jagtiani investigates.

The financial crisis roiling both the stockmarket and the world economy has thrown the spotlight on huge but secretive state-run investment vehicles known as sovereign wealth funds, which manage portions of national foreign exchange assets.

Such funds, particularly those from booming Asian exporters and oil-rich Gulf nations, have ridden to the rescue of ailing American and European investment banks recently, providing billions of dollars to plug substantial losses incurred after the default crisis in so-called “subprime” – or riskier – American mortgages. The funds have also taken stakes in non-financial multinationals and high-profile private sector investment groups.

But questions are now being posed about the growing role of sovereign wealth funds (SWFs). Are they are a benign force, simply snapping up share stakes at bargain prices? Or are they, in reality, exploiting financial market turmoil to pursue foreign policy objectives by opaquely taking positions in strategically important international businesses?

Could they pose hidden dangers to the stability of global financial markets, particularly share prices?

SWFs investing in struggling investment banks have had a particularly high profile. For instance, Singapore’s Government Investment Corporation has pumped nearly $16 billion (£8.2 billion) in total into UBS and Citigroup in recent months. Gulf funds from Kuwait and Abu Dhabi have also helped to recapitalise investment banks.

China Investment Corporation, the Asian giant’s $200 billion SWF, has pledged to invest $5 billion in Morgan Stanley. It has also made a multibillion-dollar investment in Blackstone, an American private equity group, and is rumoured to be on the verge of investing $4 billion in JC Flowers, another private equity fund.

The SWF stakes in investment banks came after the latter hit trouble when their holdings in securitised investments backed by subprime mortgage assets collapsed in value. The Group of Seven (G7) rich nations recently said it feared that losses on securities linked to subprime assets could reach $400 billion.

The crisis has ballooned into a global credit crunch, casting a pall over the world economy, with America already in recession according to some analysts.

The cash provided by SWFs in this context has helped to oil the wheels of credit markets that could otherwise have seized up totally. Despite this, national governments, especially the American administration, have become uneasy about the role of SWFs.

“There have been some good bargains out there, which is why the sovereign wealth funds have been in the spotlight,” says Sherman Chan, an economist at Moody’s, based in Sydney. “They have been coming out to support some struggling firms.” Chan is generally sanguine about SWFs’ role in the global financial system.

But Barack Obama, an American Democratic presidential candidate, recently summed up the concerns raised by SWFs.

“I am concerned if these … sovereign wealth funds are motivated by more than just market considerations, and that’s obviously a possibility,” Obama told reporters, according to a Reuters dispatch.

“If they are buying big chunks of financial institutions and their board[s] of directors influence how credit flows in this country and they may be swayed by political considerations or foreign policy considerations, I think that is … a concern,” he was quoted as saying.

Before looking at this issue in more detail, it is worth asking just what counts as an SWF and how big they are in total. There is no agreed answer (see Box A) on the first part of the question, although most analysts would agree with the definition provided by America’s Treasury Department.

The department takes an SWF to be a “government investment vehicle which is funded by foreign exchange assets and which manages those assets separately from … official reserves”.

It says that “SWF managers typically have a higher risk tolerance and higher expected return than traditional official reserve managers” and adds that public disclosure of investment strategies by SWFs “overall is quite limited”.

The department distinguishes two types of SWF. The first comprises ”commodity” funds, established from the proceeds of commodity exports. This refers particularly to funds from the oil-rich Gulf. The second type are “non-commodity” vehicles, seeded from official foreign exchange reserves swollen by trade surpluses. For instance, China put $200 billion of its 1.5-trillion-dollar foreign exchange hoard into the China Investment Corporation, and is set to inject more.

Some experts say that SWFs have been around for decades. The US Treasury points out that two of the largest, the Abu Dhabi Investment Authority and Singapore’s Government Investment Corporation, were established in 1976 and 1981 respectively.

The Abu Dhabi vehicle reportedly has assets of about $875 billion, making it the largest SWF among oil exporters, according to the McKinsey Quarterly. There are notable SWFs in Europe, such as Norway’s, said to be worth over $300 billion.

Morgan Stanley has researched the size of SWFs in total. Last June one of the bank’s analysts, David Miles, estimated the figure at $2.5 trillion, compared with total global financial assets of about $100 trillion. “SWFs could potentially grow to $17.5 trillion in the next 10 years, compared to a figure of around $10 trillion for official reserves,” he says. “During this time, total global financial assets could roughly double.

“By about 2020, the share of SWFs in global wealth is almost four times higher – growing from around 2.5% of global financial assets to over 9%.”

For some experts, SWFs are to be generally welcomed despite this projected growth in their size and power in the global financial system.

“I think so far sovereign wealth funds have been a source of stability in global financial markets as investor confidence has declined due to the US subprime problems,” Chan says. “Asian SWFs particularly and Middle Eastern ones, I think they are a positive thing. From what I see, such as China’s investments, they don’t seek controlling stakes, they are seeking investments.

“China’s investment in Blackstone was deliberately under the limit where they would have a say in the decision-making process. They didn’t want to get involved in that kind of thing. All these SWFs also seem to have a pretty long-term investment horizon. I don’t see them as a big problems.”

Robert M. Kimmitt, the deputy US treasury secretary, writing in Foreign Affairs, a journal, says SWFs raise legitimate questions but should not cause alarm.

“It is hard to escape the conclusion that the ongoing increase in SWF cross-border investment represents a potential structural shift in the global economy … The evidence so far suggests that SWFs are seeking to generate higher investment returns without generating political controversy,” he says.

“Although it is imperative that the US government remain vigilant, so long as SWF activities are consistent with free and fair competition based on agreed best practices, keeping the United States’ doors open to investment from SWFs will continue to promote growth and prosperity, both at home and abroad.”

But other commentators are more concerned about the national security implications of governments owning large stakes in important enterprises such as investment banks or private equity funds, which themselves may house, or have access to, key intellectual property.

Larry Summers, a former US Treasury Secretary and now a Harvard professor, has said that how sovereign funds are invested is a key issue. Writing in the Financial Times, he says “the question is profound and goes to the nature of global capitalism”.

“The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares,” he writes. “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.

“Apart from the question of what foreign stakes would mean for companies, there is the additional question of what they might mean for host governments. What about the day when a country joins some ‘coalition of the willing’ and asks the US president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank?”

Summers suggests that it would be better if SWFs invested through intermediary asset managers, much like pension and endowment funds bidding to maximise risk-adjusted returns. The most plausible reason why many do not is that they are pursuing other objectives and want to use government status to increase returns, he writes.

Peter Navarro, a business professor at the University of CaliforniaIrvine, told an American Congressional hearing this month that “sovereign wealth funds are neither good nor bad, but governments make them so”, adding that Norway’s and Abu Dhabi’s SWFs may be cheered, but that “those of China, Russia, and Saudi Arabia should rightly be feared”.

“Most broadly, China’s SWFs threaten a loss of American sovereignty,” Navarro told the lawmakers. “This danger lies in the … ability of China to use its vast foreign reserves to destabilise the international financial system in times of conflict – and thereby bully American politicians into submission.

“In this sense, if China’s central bank represents the atomic bomb in China’s ‘financial nuclear option’, its rapidly growing SWFs will eventually represent a much higher-megatonyielding hydrogen bomb. Any one of a number of future conflicts with China could trigger the use of these financial nukes – from skirmishes over fair trade to the perennial open sore in US-China relations, Taiwan.”

Navarro said that America should demand full transparency from SWFs buying American assets, adding another option would be to limit them to index funds or small stakes in individual firms. He recommends they be banned from economic or militarily strategic sectors.

The debate over the national security implications of SWFs for both European and American firms is likely to rage for some time (see Box B). Many onlookers are wary that it could lead to protectionism.

Simon Johnson, the economic counsellor at the International Monetary Fund, has said: “The real danger is that sovereign wealth funds (and other forms of government-backed investment vehicles) may encourage capital account protectionism, through which countries pick and choose who can invest in what.

“Of course, there are always some national security limitations on what foreigners can own. But recent developments in the world suggest there may be a perception that certain foreign governments shouldn’t be allowed to own what are regarded as an economy’s ‘commanding heights’. This is a slippery slope, which leads quickly and painfully to other forms of protectionism. It’s important to pre-empt such pressures.”

But if that can indeed be avoided, SWFs could yet boost investor returns, according to some experts.

Phil True, Credit Suisse’s head of UK institutional equities for asset management, says: “In terms of where the SWFs invest, there seem to be motivations other than diversification of the asset base and a need for higher immediate returns. The hope for Western financial institutions is that they can have a reciprocal relationship and cultivate relationships within China to sell their own products and services within China.”

True says that there may be “opportunities to pick out some stocks in the UK market which are undervalued relative to their potential strategic importance to a SWF”, although he adds that SWFs may have a much longer time horizon than many investors.

Morgan Stanley’s Miles, meanwhile, has said that global risk tolerance in financial markets could rise as SWFs grow in size, reducing the attractiveness of bonds and increasing the allure of riskier assets such as equities.

“We believe that the rising importance of SWFs will remain an important theme for the coming years,” he says. “Whether national governments and central banks are able to remain committed to riskier portfolios remains to be seen, as their resolve will be tested by periodic draw-downs. However, based on our back-of-a-large-envelope calculations, we estimate that the emergence of SWFs could … push up ‘safe’ bond yields over the next ten years by 30-40 basis points and reduce the equity risk premium by 80-110 basis points. These are not small effects.”

What is a sovereign wealth fund?

There is no agreed definition of sovereign wealth funds, according to research conducted in 2007 by Stephen Jen, an economist at Morgan Stanley.

He went on to develop one. As a first step, he said such a fund can be thought of as a government investment vehicle funded by foreign exchange assets managed separately from official reserves.

But Jen expanded on this statement by listing five criteria that a fund must meet to count as a sovereign wealth vehicle. These are that: it must be sovereign; it must have high foreign currency exposure; it should have no explicit liabilities; it should display a high risk tolerance; it should have a long investment horizon.

Jen said there were close cousins to such funds, such as official reserves, but whereas the latter are wholly in foreign currencies, sovereign wealth funds need only be mostly in foreign currency. Singapore’s Temasek Holdings, Malaysia’s Khazanah Nasional BHD and Canada’s Fond des Generations (Quebec) counted as examples of sovereign wealth funds, he said.

Sovereign pension funds (SPFs) counted as another close cousin to sovereign wealth funds (SWFs), and there could be some overlap between them, according to Jen. But while the pension funds can, like wealth funds, have long investment horizons, sometimes stretching over decades, Jen argued that the wealth funds should have a higher tolerance for risk than the pension funds.

However, Jen stressed that there was no hard and fast distinction between sovereign wealth funds and other vehicles that closely resemble them.

He went on to argue that despite the political concerns about wealth funds snapping up stakes in strategically important overseas firms, targeting them alone with regulatory action would not be wholly consistent. He said that “it does not seem to make sense for regulatory authorities and politicians to single out SWFs. SPFs, private pension funds and hedge funds may also have issues regarding transparency”.

Wealth funds “could easily invest in hedge funds and private equity funds to circumvent restrictions”, he added, so that regulating the whole panoply of funds comprehensively would make more sense.

Jen also contended that sovereign wealth funds helped contribute to market stability since, in effect, they could ride out market fluctuations and invest against the tide, given their long-term horizons. “There is a presumption that SWFs could become a source of instability, disrupting and crowding out private capital flows. I disagree,” he saidSome would argue that the funds’ injection of capital into distressed global banks like Citigroup exemplified that point.

“Having such a different ‘temperament’ from private funds, SWFs should reduce the risk of ‘herd behaviour’,” Jen said.

The analysts said that when global equity markets corrected in 2000 after the boom in technology, media and telecoms stocks, Norges Bank heavily bought global equities. Most investors at that time were dumping stocks.

Jen added that wealth funds also boosted market liquidity and were not “herdish” like more flighty short-term capital flows, all of which was good news for markets in general.

“Regulators and politicians should recognise these positive characteristics of SWFs and weigh them against the concerns about governance, transparency and natural security,” he said.

American concerns over sovereign wealth funds

Sovereign wealth funds raise several law enforcement problems, according to testimony given by Linda Thomsen, the enforcement director of America’s Securities and Exchange Commission (SEC), to a Congressional hearing in Washington.

“Government ownership of large investment funds, known as sovereign wealth funds, is not new, but it is a markedly growing trend that raises important issues for policymakers to consider,” she told lawmakers at the hearing this month.

Wealth funds, like other investors putting money into the American capital markets, must comply with federal securities law, Thomsen said, including disclosure and anti-fraud provisions. That meant that they would have to disclose ownership of more than 5% of a firm’s shares, for instance.

But Thomsen said that “we are concerned that some sovereign wealth funds, or persons associated with them, like some hedge funds, or persons associated with them, may undermine market integrity by engaging in insider trading or other market abuses”.

Wealth funds, like hedge funds, were opaque and had substantial power given their sheer size, she added. But their power also derived from their status as government entities, which could make them privy to officials and information off-limits to other investors, raising the possibility of insider trading of large magnitude.

Thomsen also argued that insider trading cases increasingly had an international dimension, and hence required cross-border co-operation to police effectively. She cited the example of a recently settled action against a prominent business and political figure in Hong Kong.

The SEC alleged that the prominent figure, David Li, then a Dow Jones board member, tipped a close friend about an impending offer for Dow Jones from News Corporation, adding that the friend netted a profit of $8.1m after buying Dow Jones stock.

Li did not admit or deny the claims, but agreed to settle the action by paying a $8.1m (£4.1m) penalty. The close friend paid a total of $16.2m in fines linked to the case.

Thomsen said the SEC was helped by the Hong Kong Securities and Futures Commission, adding that this kind of cooperation in far-flung places was essential.

“In the context of sovereign wealth funds,” she warned, “we are concerned that if the government from which we seek assistance is also controlling the entity under investigation, the nature and extent of cooperation could be compromised”. “Indeed, in other contexts, we have seen less than optimal cooperation when foreign governments have an interest in the issue or person we are investigating,” she added.

A presidential working group, the G7 rich nations, the World Bank, the Organisation for Economic Co-operation and Development and the IMF were focusing on issues raised by sovereign wealth funds, Thomsen said.

Apart from insider trading and law enforcement concerns, there is also growing disquiet in America about the national security implications of the stakes taken by sovereign wealth funds in strategically important firms.