Editor’s note: This article is the second in a four-part series on the rise of sovereign wealth funds and what they mean for U.S. investors. Part III will appear next Friday on GIW.
Things that Go Bump in the Night
Sovereign wealth funds have generated considerable fear among both investors and working people. And perhaps for good reason. Simon Johnson, the IMF’s chief economist, believes assets held in sovereign-wealth funds will balloon to more than $10 trillion by 2012, a truly staggering figure. This is causing alarm bells to ring throughout economic think tanks in DC and Brussels and politicians on both sides of the Atlantic are taking a hard look at these well-funded institutional investors.
With the global economic system doing a “full monty” before our eyes (to build off the now often-used analogy of Warren Buffet related to the credit crisis), SWFs can’t seem to get out of the spotlight despite attempts to calm these rising fears. To succeed long-term, these investors (and their PR firms) must convince citizens, policy wonks and, perhaps most importantly, regulators that they are not the boogeyman they are often made out to be. It won’t be an easy task.
Several of these funds have garnered significant public attention over the last few months. China’s new fund, the China Investment Corp. (CIC), drew headlines last year for investments in the U.S. financial firms Blackstone and Morgan Stanley. And in 2005, Dubai Ports World, a UAE-owned private company, raised national security concerns on Capital Hill by purchasing a British-owned shipping company which controlled several shipping port facilities in the U.S. These events, and others, have put SWFs under greater scrutiny in the media.
Sovereign wealth funds have been characterized by some as the “cloak-and-daggers” of the financial world, immersed in a secret agenda to take over foreign governments by controlling their most prized assets – its corporations. But is this characterization the stuff of Hollywood movie plots or based on reality? To begin answering that question, it is important to start by acknowledging an important point – not all sovereign wealth funds are created equal. And to crystallize this point it is instructive to look at two funds which reside on opposite ends of the spectrum.
The CIC officially opened its doors for business on September 29, 2007 armed with more than $200 million in capital. According to the IMF, the CIC is the sixth largest SWF in the world however there is a good chance that this fund could quickly move up the food chain. This is because CIC’s capital base is relatively small compared to the country’s current capital inflows and the Chinese government could increase the size of CIC to over $1 trillion by making more of its foreign exchange reserves available to the fund. This type of growth potential cannot be overstated as some observers have warned that a fund with $1 trillion in working capital would have the power to single-handedly push the U.S. economy into a recession. Additionally, with its current capital base the CIC is armed with the financial firepower to purchase controlling interests in major corporations. James Surowiecki, a staff writer with The New Yorker, recently quipped: “Were China so inclined, it could buy Ford, G.M., Volkswagen, and Honda, and still have a little money left over for ice cream.”
Chiefly underlying the concerns of Surowiecki and others is that China may use the CIC as a conduit to secure energy resources or purchase strategic assets for geopolitical purposes. Therefore, it should not be surprising that many experts are now calling for new standards of transparency and governance (see the Santiago Principles) over concerns about the potential impact of the CIC and other SWFs on financial markets and local economies. One observer recently warned on NPR: “The rise of sovereign wealth funds represents a shift in power from the U.S. to a group of countries that aren’t transparent, aren’t democracies, and aren’t necessarily U.S. allies.” (November 30, 2007 interview with Brad Setser of the Council on Foreign Relations).
Officials at the CIC are good at sticking to the core talking points; its “mission is purely investment return driven” and “it has no intention of buying strategic stakes in big western companies.” But some are not buying it, however, pointing out that it is conceivable that the investment group could be used to pursue collateral political aims when those objectives do not conflict with investment returns. The fact that several of China’s leading political figures sit on its governing board only reinforces the skepticism held by many outside China that the CIC will not be the “strictly investment-driven institution” it proclaims to be.
So far, the current holdings of CIC do not suggest nefarious motives. While its investments are loosely disclosed at this point, it appears at this stage that Morgan Stanley and Blackstone are the only non-Chinese entities in CIC’s portfolio and in neither case do representatives from CIC serve on those corporate boards. And the concern about sensitive technology transfer? One unnamed contact at CIC indicated that the fund will not make investments in foreign technology companies as a means of obtaining advanced technology, stating: “That’s political, and we don’t do that.” (Congressional Research Service, China’s Sovereign Wealth Fund, January 22, 2008).
One thing is for certain; the CIC will come under increasing pressure to open the windows and let the sunlight shine in. To date, CIC’ investments have been non-controlling, passive interests in industries not overtly linked to national security. It’s still early, however, and there will surely come a time when economic ambition collides with political pragmatism. When this occurs, funds like CIC will invite greater scrutiny. The pace in which management at the CIC will become more transparent is anyone’s guess. Lou Jiwei, Chairman of the CIC, publicly conceded last year in London that his fund will “gradually increase transparency” but without harming its commercial interests, qualifying this statement by cautioning: “If we are transparent on everything, the wolves will eat us up.” (Forbes, 12/10/07)
The largely opaque nature of sovereign wealth funds is not a description that accurately applies to the Norway Government Pension Fund (NGPF), the second largest in the world behind the Abu Dhabi Investment Authority. While the CIC does not permit true monitoring of its operations, by most standard measures Norway’s GPF has been a beacon of transparency among its peers and is widely regarded as the gold standard globally. According to the Sovereign Wealth Fund Risk Index composed by Breakingviews.com, NGPF ranks #1 (out of 20) across key measurements of transparency, strategic control and political affiliation. Additionally, NGPF is independently managed by Norges Bank and does not engage in controversial or strategic investments, further eliminating many of the concerns plaguing other SWFs like the CIC, the Qatar Investment Authority and Russia’s Stabilisation Fund.
For all the conjured-up fears out there related to sovereign wealth funds, the reality does not seem to validate the most extreme views raised in the debate, at least not yet. Moreover, it is important to emphasize that not all SWFs should be treated equally as there is significant variation in political openness and democratic orientation among this class of investors. Norway, which opts for a more rigorous and transparent disclosure approach, has chosen to “outsource” its asset management function to a third-party and has adopted a fairly conservative investment style with a large allocation to bonds. In contrast, the China Investment Corp. has failed so far to let the sunlight in from the outside world and has made several high-risk bets early on its history.
The lesson here is that the apple (the fund) does not fall far from the tree (the country). It isn’t a coincidence that the Alberta Savings Trust Fund (Canada) and the Alaska Permanent Fund (U.S) rank at the top of the index while funds sponsored by China, Qatar, Venezuela and the UAE all rank at the very bottom. It stands to reason that countries with more open and democratic societies will naturally sponsor funds which have better governance, greater oversight and more transparency.
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