INTERNATIONAL: Sovereign wealth funds draw scrutiny

Analysis

Sovereign Wealth Funds (SWFs) are investment funds owned and sometimes operated by governments (see INTERNATIONAL: Sovereign wealth funds are growing - March 28, 2007). While dating back nearly half a century, attention on SWFs has increased dramatically over the past year:

• Asset accumulation. Estimates place the current level of assets under management from 1.9-2.9 trillion dollars, a sum larger then the global hedge fund industry. Research suggests this will grow to as much as 10-12 trillion dollars within five to seven years, although this will depend partly on global market conditions.
• Investment practices. Several high profile investments in 'blue chip' financial services firms have underscored the increasing importance of SWFs. In the past twelve months, SWFs have invested roughly 75 billion dollars in some of the largest finance companies in the world.
• New players. At least twelve new SWFs have been created in the past three years, many of which are in Asia and the Middle East (see GULF STATES: Investments to be more actively managed - October 9, 2007).

Worrisome wealth. Some view SWFs as source of stability in financial markets, since they are unleveraged (operating without the use of borrowed money), long-term, and usually passive investors with small equity stakes. However, others have raised concerns about their activities:

• Asset mismanagement. Though some SWFs have employed top class managers who have performed well over the years, others may mismanage their international investments in such a way that damages national economic and financial positions, and engenders negative consequences for the global financial system.
• Foreign policy. SWFs are ultimately owned, and sometimes managed by, foreign governments. This increases their potential to become new and powerful foreign policy tools -- a fear not assuaged by the nature of sponsoring governments, as many of the largest SWFs are in countries that do not possess full democratic rights.
• Strategic industries. According to a recent US Congressional Research Service report, many US policymakers are concerned that SWFs will be used to secure strategic investments in important industries -- such as telecommunications, energy resources, and financial services -- thus facilitating technology transfer back to their home countries.

These three concerns could lead to financial protectionism in the countries that are the likely targets of SWF investments, which might create tensions in global trade.

Institutional governance. Several of the largest SWFs have poor standards of institutional governance; addressing this would partially allay the above concerns. One core attribute of a well-governed financial institution that is particularly important for SWFs, as established by Gordon L. Clark and Roger Urwin, is clarity of purpose and mission:

1. Government-owned. SWFs are intimately linked to their sponsoring governments. This makes it difficult to evaluate the logic of existing governance mechanisms, and how these mechanisms discipline investment decisions in relation to fund performance.

2. Objectives. SWFs do not operate like state or sovereign pension funds:

   • Pension funds' objective is to maximize their beneficiaries' welfare by accumulating wealth. They are thus structured with strict investment decision-making protocols, high levels of accountability and transparency, and are generally immune to political interference.
   • However, SWFs were set up in response to the massive accumulation of national wealth -- acting as "accidental financial tourists", in the terms of Keith Ambachtsheer -- and follow a more general principle of benefiting citizens over the long-term. This complicates the governance of SWFs considerably.

CIC. China's launching of its SWF last year was arguably the main trigger of the mounting global debate over SWFs (see CHINA: Financial institutions are going global - November 12, 2007). The China Investment Corporation (CIC) was awarded an initial 200 billion dollars in 2007, about one third of which is expected to be invested overseas. According to Chinese officials, the CIC's purpose is to:

• improve the rate of return on China's 1.5 trillion dollar foreign exchange reserves; and
• soak up some of the country's excess liquidity.

CIC rhetoric about future operations and investment policies is very positive -- representatives have repeatedly stated that investments will be commercially, rather than politically, based. However, some commentators have raised concerns about the investment decision process associated with two of its early investments, worrying whether they foreshadow future problems:

• Blackstone. CIC's 3-billion-dollar direct investment in Blackstone raised concerns within China and abroad about their investment policies. In part, this stemmed from the fact that Blackstone has proved to be a poor investment -- Blackstone's stock price has dropped over 50% since its initial public offering. Concern also stems from the possibility the Blackstone investment was based on non-financial factors: Blackstone's Antony Leung has ties to China's leadership due to his past role as Hong Kong finance secretary.
• Morgan Stanley. Blackstone losses did not prevent another 5-billion-dollar direct investment in Morgan Stanley (though it may have influenced how the deal was structured). Once again, some have argued that personal ties rather than sound financial metrics were also a factor, as Morgan Stanley's Wei Sun Christianson and the CIC's Gao Xiqing were apparently students together and were involved in structuring the deal.

It is difficult to fault the CIC for these two investments, as both targets are considered to be 'blue chip' financial services firms. Yet it is the way investments were undertaken that has flagged concern about CIC's institutional governance. Rather than working through an intermediary -- which would minimise the potential for political or personal influence over CIC's decisions -- each was a direct investment.

CIC shift. CIC appears to be taking steps towards good institutional governance:

• It has indicated that it is now more interested in company "portfolios" instead of direct investments -- perhaps due to backlash within China over Blackstone.
• In addition, the CIC is moving toward acting through intermediaries -- it is rumoured to be investing 4 billion dollars as a limited partner in a new fund set up by the US private equity firm JC Flowers.

Mounting scrutiny. How SWFs are governed will often have implications for how they make investment decisions. Therefore, calls for developing a 'best practice' code of conduct have been widespread, though remaining problematic:

• Effort at the IMF appears to have stalled (see INTERNATIONAL: IMF exercised by sovereign wealth funds - October 25, 2007).
• Some suggest that the WTO might be called upon to facilitate such a best practice initiative.
• Several national governments are seeking new legislation for SWFs. For example, US Senator Charles Schumer is considering proposing legislation to improve the transparency of SWF investments in the United States in order to ensure that they are not based on "non-economic motivations".
• Most recently, the European Commission on February 27 threatened binding regulation if SWFs do not sign up to a voluntary code of conduct, while it has already been an issue in Germany (see GERMANY/INTERNATIONAL: Sovereign funds raise fears - August 1, 2007).