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| Author: | Lee Hudson Teslik, Associate Editor |
|---|
January 18, 2008
Creating funds to manage government wealth is not a new phenomenon. But over the past five years, wealth accumulated in existing funds has ballooned and the number of new funds has spiked. The International Monetary Fund (IMF) estimated in September 2007 that sovereign wealth funds, or SWFs, control as much as $3 trillion, and that this tally could jump to $12 trillion by 2012. The sheer size and rapid growth of these funds increasingly commands the attention not just of economists, but also political analysts. Some argue that these funds will help nations dependent on natural resources to diversify their economies, but others worry about abuses of power and urge greater transparency at SWFs.
Sovereign wealth funds, as defined by the U.S. treasury (PDF), are government investment funds, funded by foreign currency reserves but managed separately from official currency reserves. Basically, they are pools of money governments invest for profit. Often, this money is used to invest in foreign companies. For instance, China’s SWF recently purchased stakes in the U.S. financial firms Morgan Stanley and the Blackstone Group. Dubai’s SWF has bought up shares of several Asian companies, including Sony.
No. Robert M. Kimmitt, deputy U.S. treasury secretary, distinguishes among four different kinds of sovereign wealth in a 2008 Foreign Affairs article: SWFs, international reserves, public pension funds, and state-owned enterprises. International reserves are the funds countries hold for use by their treasury or finance ministries and central banks. Public pension funds hold the funds that states promise their citizens (Kimmitt notes that these funds have traditionally kept low exposure to foreign assets). State-owned enterprises are companies fully or partly managed by the state, each of which may have its own assets and investments.
In contrast to these other forms of government assets, SWFs typically seek riskier investments and a higher rate of return. Ostensibly, they are run purely to increase the wealth of the state, not to pay off any specific debt.
No. Some SWFs trade using funds earned solely from commodity export revenues, and others use solely foreign exchange reserves. Kimmitt notes in Foreign Affairs that these two types of funds often serve very different purposes for the countries managing them. Commodity funds can be used for several purposes, including fiscal revenue stabilization and as a check to prevent foreign exchange funds from fanning inflation (in the latter case, the fund would essentially work as a buffer, preventing too much money from entering the country’s economy all at once). Non-commodity funds, on the other hand, are more commonly used to make stand-alone investments, particularly when a country feels it has accumulated “excess” foreign reserves in a particular currency. Some countries, particularly resource-rich states, signaled in 2007 that they believe they are overly invested in U.S. dollars and intend to diversify these holdings profitably through investments made by SWFs. At recent meetings of OPEC, the Organization for Petroleum Exporting Countries, member states discussed the issue and said they will study whether oil should be priced in a currency other than dollars, to help them scale back their dollar holdings.
According to September 2007 estimates from Morgan Stanley, the largest sovereign wealth fund, the Abu Dhabi Investment Authority (ADIA), controls around $875 billion in assets. As of early 2008, the total assets of SWFs, estimated at nearly $3 trillion, surpass the $1.5 trillion managed by hedge funds worldwide—but are dwarfed by the $53 trillion managed by institutional investors like pension funds and endowments. A September 2007 article in the IMF’s journal Finance & Development summarizes that the assets controlled by SWFs worldwide are “significant but not huge” compared to the total amount of assets denominated in dollars worldwide (more than $50 trillion). The article notes, however, that SWFs can carry great economic sway in developing markets—the total value of all traded securities in Africa, the Middle East, and emerging Europe combined amounts to roughly $4 trillion.
The following table lists the world’s largest sovereign wealth funds and September 2007 estimates by Morgan Stanley as to the size of their total assets:
A rapid rise in the price of major commodities over the past decade has greatly increased the cash holdings of some exporting countries, enabling them to seek new ways to diversify their wealth. The Economist said in May 2007 that oil-producing countries account for two-thirds of the total wealth of global SWFs. In January 2008, crude oil for the first time sold for $100 a barrel, marking a dramatic rise from prices of just over $10 per barrel in the late 1990s as reflected in this Wall Street Journal interactive. The falling dollar has added another incentive for exporters to sell their currency reserves, given that oil is currently priced in U.S. dollars. This trend could well continue. A December 2007 report (PDF) by CFR’s Brad W. Setser and Rachel Ziemba, published by RGE Monitor, says “With oil at or above $90, the future size and market impact of the large gulf funds is hard to overstate.”
In contrast to these other forms of government assets, sovereign wealth funds typically seek riskier investments and a higher rate of return.
Broader geoeconomic trends like global trade imbalances also contribute to the boom. A June 2007 paper from the National Bureau of Economic Research, a nonprofit research organization based in Cambridge, Massachusetts, outlines the process through which countries have accumulated large currency reserves. When it comes to oil exporters, the explanations for this lopsided trade dynamic is clear—other countries need oil. But other exporters have accumulated dollar reserves for other reasons. China and other East Asian countries have seen their exports soar due to favorable—and some say skewed—exchange rates. In a June 2007 interview with CFR.org, U.S. Treasury Secretary Henry M. Paulson said the exchange rate of the China’s currency has become “severely unbalanced” and “doesn’t reflect reality.” Paulson noted that this exchange rate has allowed China to build large dollar reserves—reserves which Beijing now seeks to diversify, in part through SWFs.
Theoretically, SWFs can invest in whatever they want, just as if they were independent investment funds. A November 2007 policy paper by the Federal Reserve Bank of San Francisco said most SWFs do not publicly disclose their investments, making it difficult to get a sense of their assets or their investment strategies. Kimmitt says most SWFs could reasonably be expected to use long-term investment strategies, and presumably wouldn’t deviate substantially from them in the face of short-term market volatility. He adds that most SWFs probably aren’t highly leveraged (they don’t borrow money to make investments), which differentiates them from some large hedge funds.
Several SWFs have gained public attention for specific investments. China’s fund drew recent headlines for investments in major U.S. financial firms. Analysts at Morgan Stanley says these purchases represent a broader trend—they estimate that Temasek Holdings, a fund managed by the government of Singapore, had invested 38 percent of its portfolio in the financial sector as of September 2007. In 2005, a United Arab Emirates-owned company, Dubai Ports World, stirred controversy in the United States by purchasing a British-owned shipping company, thus giving it control over parts of several U.S. port facilities. Dubai Ports World is a state-owned business, not a sovereign wealth fund, but the concerns provoked by the incident mirror concerns over SWFs purchasing business interests that had formerly been the domain of private companies.
Experts say the emergence of sovereign wealth funds represents a fundamental shift in the reasons governments invest money. “To the extent governments have traditionally held investment assets, it was to protect domestic currencies and banks from crisis,” writes the Economist. Modern sovereign wealth funds go well beyond this basic agenda. Writing in the Washington Post, Sebastian Mallaby, the director of CFR’s Center for Geoeconomic Studies, says global government currency reserves have expanded “way beyond their prudential needs and more than triple the amount in the world’s hedge funds.”
Sovereign wealth funds can carry great economic sway in developing markets—the total value of all traded securities in Africa , the Middle East, and emerging Europe combined amounts to roughly $4 trillion.
Mallaby says finance ministries in the past have typically invested currency reserves in U.S. treasury bills and other risk-free bonds issued by wealthy countries. SWFs provide countries with a broader range of investment options. A shift away from U.S. Treasury-backed bonds as the default option for government currency-reserve investments could hold ramifications for global currency markets. Most notably, as many commentators mentioned at a December 2007 CFR meeting examining the consequences of a falling dollar, the world could be witnessing the end of an age of dollar dominance. Benn Steil, CFR senior fellow and director of international economics, cites a “long period of excessively loose monetary policy,” meaning the United States has printed a lot of dollars.
This shift could, in theory, be broadly positive. More efficient government investment potentially means more government money. For the countries making the investments, this could translate into lower taxes, better public works, and stronger state-run businesses. For resource-exporting states concerned about long-term economic viability, SWFs also present a possible source of sustainable long-term capital growth. For the companies being purchased, and the countries in which they are located, capital inflows can also be a net positive. More capital means more money for research and development, and more money to pay salaries. As this policy paper published by the University of Pennsylvania’s Wharton Business School points out, Abu Dhabi’s November 2007 investment in the U.S. banking giant Citigroup was widely cheered as a boon—much needed liquidity at a time when global credit was stretched thin and the financial sector was struggling.
The major looming factor is how SWFs will be used in practice. Will governments use them simply as financial tools and eye investments from a purely financial standpoint, or will SWFs emerge as an implement of political muscle? Former U.S. Treasury Secretary Lawrence Summers wrote in a July 2007 Financial Times op-ed that the concerns raised over SWFs are “profound and [go] to the nature of global capitalism.” Mallaby, in his Washington Post article, notes the protests of Sen. Jim Webb (D-VA), when China purchased a stake of Blackstone, and says more controversy could ensue: “Imagine Webb’s protests if the Chinese do what they say they will do: emulate one of Singapore’s national wealth funds, Temasek Holdings, which buys direct stakes in foreign companies without going through a middleman such as Blackstone.” Other fears could be raised, he writes, if SWFs begin flexing the power they would wield as shareholders in foreign corporations—for instance, what if Middle Eastern or East Asian SWFs banded together to oust the CEO of a U.S. corporation? In corporate governance terms, this would be seen as positive shareholder activism, but when governments are involved, experts are left to guess at whether such clout would be used for financial gain or for political purposes. “The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares,” writes Summers. “It is far from obvious that this will over time be the only motivation of governments as shareholders.”
Experts cite other concerns as well. For instance, a government could use SWFs to learn how companies in other countries operate, then use this information to bolster rival state-run enterprises. As a possible solution, some experts now push for greater international regulation of SWFs. The Wharton paper notes: “There is no comprehensive list of what [SWFs] own, nor any mandatory reporting of their investment policies.” An August 2007 policy brief (PDF) by the Peterson Institute for International Economics offers suggestions for better regulation of SWFs. Edwin M. Truman, the paper’s author, suggests an international standard for cross-border investment. Such a standard, he says, should consider the objectives of a particular investment and the investment strategy of a particular fund; the governance of a fund, detailing which government officials are allowed access to fund information, and which are not; the transparency of fund activity; and behavioral guidelines, establishing how a fund is and is not allowed to adjust its portfolio.
Recent reforms of the U.S. Committee on Foreign Investments in the United States (CFIUS) partially address concerns over SWFs, but a paper from the New America Foundation, a liberal think tank, calls for more sweeping reforms. A policy paper from the conservative Heritage Foundation argues that concerns over SWF regulation shouldn’t be overstated. The paper says the government is already well equipped to address potential problems through CFIUS and other commerce and banking laws already in place.
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