Editor’s note: This article is the third installment in a four-part series on the rise of sovereign wealth funds and what they mean for U.S. investors. Part IV will appear next Friday on GIW.
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Riches in the Sands of Syriana
If only T. E. Lawrence were alive today, he no doubt would be smiling. The British intelligence officer memorialized as “Lawrence of Arabia” for leading the successful Arab revolt against the Ottoman Turks during World War I would surely need a tour guide if he were to return to his old stomping grounds of Cairo, Amman or Damascus. What was once a backwater of political in-fighting among warring Arab clans has emerged a century later as one of the geopolitical “hot spots” of the modern world. Today’s Middle East is a far cry from the world Lawrence of Arabia knew and loved.
The reason, we all know, is simple – oil. And lots of it. The Persian Gulf states are in fact so flushed with it that their export earnings from the commodity has been the single largest source of wealth creation in modern history. Virtually every major oil-bearing country in the region sponsors its own sovereign wealth fund to help manage these growing reserves. Current estimates suggest that those funds derived from oil and gas export revenues account for one-half of the total assets held by all SWFs around the world.
While sovereign funds have existed since the 1950s (the Kuwaiti Investment Authority was the first to be established in 1953) their size and influence worldwide has increased dramatically over the past two decades. In 1990, sovereign funds held about $500 billion. Today, the current total is estimated to be $3 trillion and based on the likely trajectory of current accounts this sum could surpass $10 trillion as early as 2010.
It may surprise some to learn that the Middle East, not China, is at the epicenter of this growth trend. The Carlyle Group declares that the Middle East is now the primary destination for private equity deals and the British bank HSBC estimates that as much as one-third of all project finance involves Middle Eastern projects. According to the U.S. Government Accountability Office (GAO), 28 of the 48 SWFs have been created since 2000, primarily in countries whose foreign exchange reserves are growing through oil revenues or trade export surpluses. The preponderance of those are in the Middle East.
Because the sum of all current accounts around the world by definition add up to zero, there are clear losers and there are winners in this game. For every dollar adding to the growing current account surpluses of oil exporters like Oman or Qatar there is one less dollar in the till for oil-importing countries like the U.S. and France which adds to their growing current account deficits.
Dubai is testament to this shift in global wealth. The city, which lacks the massive oil and gas reserves of its neighbors, has emerged as an investment powerhouse in its own right because of the world-class banking and tourism industries it fosters. The open business environment in Dubai has made it an attractive center for foreign corporations seeking regional presence. In fact, the city has been so successful in courting international bankers that some observers say it could likely challenge London and New York, now the world’s two major finance hubs, as the premier destination for capital.
This trend has led many observers to be concerned about the potentially destabilizing impact of zero-sum financial speculation. Apprehension about the size of these funds is not new – as I wrote in last week’s article – but it is on the rise. These concerns are best reflected in the possibility that a large fund, most especially in the Middle East, may use its purchasing power strategically instead for conventional wealth building purposes. This could include buying key infrastructure assets or acquiring proprietary technology.
There are safeguards built into the system to help guard against these national security concerns. The U.S. Committee on Foreign Investments in the United States (CFIUS) was created in 1975 to provide an objective, nonpartisan mechanism to review and, if necessary, block foreign government investments that may have national security implications. Moreover, the Foreign Investment and National Security Act (FINSA) of 2007 updated CFIUS to further strengthen the evaluation of foreign government investment in the U.S. And the Exon-Florio amendment to the Omnibus Trade and Competitiveness Act of 1988 further authorizes the CFIUS to view and potentially block foreign acquisitions of U.S. companies that may impair U.S. national security.
Nevertheless, despite these safeguards, it is not difficult to conjure up doomsday scenarios which can keep even the most seasoned bureaucrat awake at night. Given how the underbelly of our entire global economic system was exposed by the credit crisis in the U.S., it is easy to see how these funds could wreak havoc at the national or even regional level, if sufficiently motivated. Just consider that the combined assets of four funds in the Middle East – the UAE, Saudi Arabia, Kuwait, and Qatar – account for roughly one-third of the total assets of global SWFs. The power of their purse is substantial and grows every time you and I make a trip to the pump.
In search of better returns, SWFs are becoming more aggressive in how they put their money to work. The Kuwaiti Investment Authority, by example, has recently increased its allocation into alternative asset classes such as private equity and real estate. This investment shift, if it continues, would put Middle Eastern funds in increasing competition for prized “high growth” foreign assets and surely bring out protectionist feelings among policy makers and shareholders in Europe and the U.S. We have already seen some of this. When the Dubai government offered to buy Auckland International Airport in New Zealand for $3 billion, the offer fell through because the city of Auckland (which owns 20% of the airport) refused to sell due to national security concerns. Hardly an example of the free market at work.
According to the Middle East Media Research Institute (MEMRI), most of the Persian Gulf investments that are directed overseas focus on two objectives: acquisition of assets and real estate and the purchase of shares in high quality financial and industrial firms. With regard to the second point, the Kuwaiti Investment Authority has held large stakes in Daimler-Benz (7%) and British Petroleum (3%) for a long time, and recently provided substantial infusions into ailing Citigroup and Merrill Lynch during the credit crisis. The Mubadala Development Company, based in Abu Dhabi, is a top ten shareholder in General Electric and Advanced Micro Devices and has a major stake in the private equity firm The Carlyle Group.
At the moment, heightened scrutiny about the growing wealth of funds based in the Persian Gulf tend to pivot around two central concerns. The first is whether a particular acquisition gives the Persian Gulf leverage on oil production which could impact world prices. The second, and more problematic, is whether an acquired corporation might become a conduit for illicit funding of Islamic extremist activities. Even with tighter money laundering regulations and policies for global banks post 9/11, the general lack of transparency of the SWFs based in the Middle East raises alarm bells for many. According to Sven Behrendt of the Carnegie Endowment for International Peace: “Eventually, the most fundamental and qualitative challenge for sovereign wealth funds, as they rise to global financial roles, has been how to deal with the politics that surround financial markets.”
International financial organizations are realizing these funds are here to stay and have adopted a constructive approach to improving their lackluster governance and transparency through efforts at voluntary reform and oversight. While pragmatism appears to be driving the discussion between representatives of SWFs and officials at the World Bank, IMF and the OECD, knee-jerk protectionism is still very much alive among government officials, especially in France and Germany. For instance, French President Nicolas Sarkozy has repeatedly vowed to use its government sponsored Caisse des Dépôts et Consignations (CDC) to protect French industry against the onslaught of these foreign investors.
The economic and financial power of the West is on the wane and these governments must face the reality that the global economic power equation has permanently shifted. On Wednesday, Robert Kimmitt, the deputy US treasury secretary, said that sovereign wealth funds based in the Gulf states are actively seeking investments in the troubled US economy, declaring: “The United States would welcome investments from sovereign wealth funds as it grapples with the impact of the global financial crisis on its economy.” It is too early to tell if this statement is simply a temporary olive branch spurred by crisis or reflective of a more permanent shift toward greater openness and cooperation.
Throughout its history, the Middle East has long been a geopolitical battleground of great power conflicts and political ambition. After years in the wilderness of modern history, the region is again living up to its characterization as the “Fertile Crescent.” In the 21st century, the countries of the Middle East are using their new-found wealth fueled by petrodollars to reclaim their place in the power play of modern international politics.
Whether Westerners like it or not, sovereign wealth funds of the Middle East will play a prominent role in our global financial system. Time will tell whether these investors will also figure heavily in our political future.
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