Sovereign wealth funds as heroes and villains

Paola Subacchi, head of the international economics programme at Chatham House, talks to Tomas Hirst.

Q. What are sovereign wealth funds (SWFs)?


Countries with sovereign wealth funds can be divided into two distinct categories. The first are countries with large current account surpluses due to their trade activities, which is mainly the case in Asian countries. For these countries the funds [SWFs] manage their foreign exchange reserves as a way to look after export income.

Because of the exchange rate regime, they need to have enough reserves to stabilise and control their currency, with a good benchmark usually the equivalent of three months of exports. So they use their foreign exchange reserves to manage their capital flows and also to manage their own exchange rate.

These countries have built up such large amounts of reserves that they could not justify holding them for precautionary foreign exchange rate management. They needed to manage them in a more efficient way and to invest it to get a good return from the capital.

The second group is made up of the commodity rich oil exporting countries whose capital needs to be used efficiently because oil is an non-replaceable asset. They need to ensure that the wealth they extract for the country generates a good return. So these funds, such as the Russian fund, are all orientated towards the future development of the countries, and in particular towards economic diversification away from oil and energy.

Q. Why have SWFs achieved notoriety?


Sovereign wealth funds are not something that just happened last year, In some cases they were around before the formation of the sovereign states, like in the case of Kuwait, so the oldest funds date back as far as the 1950s.

They came into prominence last year because of a combination of factors. These include high revenues from international trade for countries that export either manufactured goods, as in the case of China, or commodities, for example the Gulf states and Russia.

There are also problems related to the development of the financial sectors in their own countries. Faced with a lack of the possibility of using sovereign wealth funds efficiently domestically, they had to look for opportunities abroad as the financial sector and financial services are essential for their development. In other words the capital moves to where opportunities are, so as good opportunities in developed countries present themselves that is where capital flows tend to go.

The big issue with these investment vehicles is that they are state owned and are perceived as extremely poorly transparent. This is the main reason why lots of people feel uncomfortable, in particular in the developed world, about having a fund investing directly in their companies. As such we need to draw a distinction between portfolio investment and direct investment. Portfolio investment has been around for a long time and the problem is only caused when these funds have the potential to invest directly in some critical industries, the so-called “national champions”.

Q. What are their prospects in terms of influence in Western markets?


The prospects at the moment are very good. There was a bit of a frenzy last year during the summer, particularly after the Chinese started up the Chinese Investment Corporation (CIC) [a SWF]. The CIC acquired a large stake in the private equity firm Blackstone in the US, even before the fund was officially created. There followed a couple of acquisitions, including the purchase of a stake in Barclays bank by the China Development Bank (CDB), which started to create a bit of concern among the media.

People involved in these deals, however, feel much more comfortable about dealing with these funds than a lot of market commentators will tell you. Perceptions of SWFs also improved during the credit crunch. Some of them, like the Abu Dhabi fund and potentially now the Kuwait fund, have been active in rescuing financial institutions, which were facing problems following the crisis.

At present they are perceived as rescuers and they have been selective in the exact percentage of the institutions they are buying and careful in the conditions they set down. Things could become much more difficult if, for example, they want larger stakes and if they want investment in critical or key companies. For the moment they have been investing in countries that are notoriously open, such as the UK, which is quite happy to receive investment from abroad.

Q. Is there really a danger of SWFs being used for political purposes?


There are a lot of checks in place, especially in Europe and the United States. It would be difficult for these funds to exercise the kind of political pressure that is deemed to be dangerous or thought to reduce the independence of a sovereign state. I do not think the influence would be much higher than that of the big financial institutions, for example Goldman Sachs, Lehman Brothers or Citigroup, which are all powerful and influential.

The issue is different for countries without the kind of checks that are already in place in the developed world. I am thinking of developing countries in places such as Africa, which are much more vulnerable to external influence. I do not believe, however, that sovereign governments will use SWFs to achieve this kind of influence.

Q. To what extent will governments be able to prevent SWFs from gaining large stakes in strategic industries, and is it really in their interest to do so?


There are already measures in place to regulate any investor, not exclusively SWFs. Companies are dependent on countries to dictate how much they can buy in to other companies without becoming the majority shareholder.

The French, in 2006, issued a quite elaborate statement about what they consider strategic industries and the OECD [Organisation for Economic Co-operation and Development] Investment Committee aims to produce a code of practice for the funds, which follows the IMF [International Monetary Fund] line of thinking. The funds become almost self regulated and it is in the interest of European countries to avoid ambiguity over foreign investment.

Q. Would guidelines and greater transparency be sufficient to allay suspicion about the funds?


It is much more helpful if there is a greater transparency of how these funds conduct their day-to-day business. As far as we know investors and financial markets, people who have been dealing with these funds for many years, seem comfortable. It is difficult to strike a balance between how much transparency you want for the sake of public opinion and how much this transparency is useful for the purposes of these vehicles for the potential of good investments.

Of course it is linked to market conditions as when things are difficult, like at the moment, people tend to be much more tolerant of these funds.

PAOLA SUBACCHI has been head of the international economics programme at Chatham House since 2004 and is also a consultant for the Economist Intelligence Unit. Before arriving at Chatham, she was European economist at Oxford Economic Forecasting and a consultant for Bloomberg. Subacchi was previously a senior fellow in the department of economics at Bocconi University.