European Affairs

Sovereign wealth funds – essentially investment funds controlled by foreign governments – are not a new financial instrument. They were prominent after the oil crises in the 1970s when oil- exporting Arab states used state-run agencies to “recycle” their surplus cash into dollar-denominated investments, notably U.S. Treasury bonds. It was a mutually satisfactory exercise at the time, but nowadays the game has changed dramatically, mainly because of historic macroeconomic shifts between developing nations with huge export surpluses and capital-starved Western countries. For the newly rich countries, they can expect massive account surpluses for the foreseeable future: for some, oil prices have risen very high (and seem likely to stay that way), and for others, such as China, their export balances are also enormous and growing. Another part of the shift is that the new sovereign wealth funds are not buying short-term securities: they are buying into banks and other businesses, where they will remain as investors with part ownership. So far, this practice has been restricted to non-controlling minority shares, sometimes without voting rights. But these new investors are not only major players of a much bigger dimension and with very different objectives; they are also government-controlled. So the question arises: do they operate with normal business objectives that are likely to be beneficial to the companies they want to partly own? Or might these investors weigh on the decisions of Western corporations in ways designed to serve the political interests of their governments. The answer is not in. Certainly the potential is there for a political agenda by the sovereign funds’ owner-governments – which these days tend to be governments that are not necessarily well-disposed to Western interests.

The scale of the stakes is truly enormous. China’s new sovereign fund (generated by export profits, not oil or other resources) has $200 billion to invest by itself. Altogether, such state-managed funds (including those of Norway, Singapore, Russia and the Arab states) seem likely to control as much as $12 trillion by 2015, making them major players in the roiling global markets.

With the dollar so cheap, U.S. companies are for sale at what amounts to discount prices. In late 2007, prominent Wall Street banks (including Merrill Lynch, Citigroup and Morgan Stanley, plus the private-equity fund Blackstone) have sold stakes in themselves to these funds, pressed to do so in order to replace their steep losses in the global capital upheaval. Looking for acquisitions that are deeper in the American financial pyramid, these government-controlled foreign entities have bought stakes in U.S. companies in sectors as varied as steel-making, energy and real estate. The relatively low production costs in the United States (due in part to exchange rates) have also attracted European manufacturers (for example, in cars and specialized textiles) because they export their “made-in-USA” goods duty-free to customers in Canada and Mexico under the North American Free Trade Agreement. The new American manufacturing jobs are welcome – but the prospect of foreign government control is a bugaboo with a long history in the United States, even during times when protectionist feelings were more dormant than they seem likely to be in the next few years.

The history of foreign investment in the United States is fraught with complications. Theoretically welcome, these inflows have often triggered a backlash: in 2006, a Dubai-owned company was blocked when it tried to buy American ports, and since then, the Bush administration has overhauled the semi-secretive U.S. Committee on Foreign Investments (CFIUS), seeking to streamline and clarify the rules of this regulatory agency that reviews takeovers of U.S. companies by non-American buyers. Despite these bureaucratic fixes in Washington, the overall question of foreign investment in the United States may suffer fresh tensions stemming from the fact that these new players’ big money is tied to their governments – and therefore perhaps influenced by these governments’ politics in a crisis.

“This is a phenomenon that could be called the growth of state capitalism as opposed to market capitalism,” Jeffrey E. Garten, a former U.S. Treasury official who is now a trade expert at Yale University. “The United States has never been on the receiving end of this before.”

Explaining the change, analysts point out that funds of this nature used to be largely the preserve of countries (such as Singapore and Kuwait) that were generally friendly to the West. They were inclined to play by Western rules and their investments were aimed at making a commercial return. Now, “these new funds originate from potential geopolitical rivals that are less likely to play by the West’s rules,” according to Philip Whyte and Katinka Barysch of the Centre for European Reform in London.

The problem is a major challenge because the funds also reflect global economic imbalances, with exporting countries piling up huge surpluses while the United States and Europe need fresh injections of capital, often selling companies cheaply in order to stave off collapse. With so much money swirling around them, both the U.S. and the EU face calls from their electorates for protectionist measures. As Whyte and Barysch insist in their paper, “the EU needs to ensure that any measures taken in response to the SWFs do not threaten the openness of its single market.”

One problem with this new phenomenon is the lack of transparency in the SWFs, meaning that they generally do not have a stated philosophy of how they plan to manage their investments and what their rules of operation will be. Until now, they have tended to be passive investors, taking small stakes and not seeking seats on the boards of directors of the companies in which they invest. But that could change. U.S. and European authorities reviewing their policies toward SWFs would be more comfortable if they could have a clearer understanding about the rules that the SWFs intended to follow. Norway and Singapore have now done this, and there are calls for other, newer SWFs to do likewise. Concerns about their motivations will be eased with more transparency.

Already, the funds testify to the emergence of a new world financial order, with ownership of many of the West’s most productive assets shifting away from the United States and EU. There are some clear benefits for the sellers, beyond the fresh money in their coffers to ride out the current storm and invest for the future. Capital from the SWFs can buffer economic turbulence, and the expanding economic growth in emerging markets can reduce the risk of global recession.

There is another question worth asking about sovereign wealth funds: How big are they in relation to the total sum of investment money under management? The answer, as given by Desmond Lachman writing in International Economy magazine, is that these funds – “at their current level of between $2 trillion and $3 trillion – are approximately double the size of the world’s hedge fund industry. However, they are presently only around one-seventh the size of the $21 trillion of the global investment industry and less than five percent of total bank assets worldwide.” Even so, he concludes, the prospect of an additional $400 billion a year entering financial markets over the next few years should be supportive of global financial markets. But, Lachman concludes, they seem far too small to smooth and stabilize the current global market turmoil.

It seems to be in everyone’s interest to work out some rules of the game to create confidence about this new mass of capital.

Tackling this problem, an enlightening (and enlightened) roundtable discussion on the issue in the American context was conducted in February 2008 with Fred Bergsten, Director of the Peter G. Peterson Institute for International Economics in Washington; Robert Kimmitt, Deputy Secretary of the Treasury ; and James Fallows, writer for the Atlantic Monthly magazine.

The following are edited extracts of their discussion. Published courtesy of The Diane Rehm Show produced by WAMU 88.5 FM American University Radio and distributed by National Public Radio.

Fred Bergsten: A sovereign wealth fund is a financial institution created by governments to invest part of their country’s foreign exchange earnings in a diversified portfolio around the world, in an effort to increase the return to that country for future generations. They’re not new,…some of them have been around for 50 years or more.

But two types of countries have them in particular; one is oil exporters who have earned huge amounts of money from recent high oil prices – Norway, Russia, Kuwait, Abu Dhabi, countries like that; the other is mainly Asian countries running large trade surpluses – China, Singapore… we’ve counted about 54 of these funds now in 38 different countries.

Their total assets exceed $3 trillion, and our estimates are that they’re headed to $10 trillion or so over the next few years…They are becoming very big players in world finance. They invest their funds around the world sometimes through intermediaries like hedge funds, private equity funds, mutual funds, normal investment outlets just like other investors, also sometimes directly in companies, and that raises some questions.

Robert Kimmitt: [The Bush administration’s] position is that because of the growth in the size and number of sovereign wealth funds, we need to be vigilant, but we also need to approach the question with calm and precision. Calm, because these are patient long-term investors who are seeking to generate higher investment returns without generating a political controversy; precision, because sovereign wealth funds are just one type of state holdings.

There are official reserves, pension funds, and also state-owned enterprises. And thus far, sovereign wealth funds, again, seem to be looking for these higher investment returns, but without causing any degree of political controversy…We think that it is very important that the U.S. signal that we are open to foreign direct investment. Over five million Americans work for companies headquartered overseas. Every $10 million of investment creates 30 new direct jobs, 30 indirect jobs. Secondly, I think it’s very important that banks during this time of turbulence are strengthening their balance sheets, because that is how they go about then lending to individuals and to companies…We don’t fear investments made in the United States on commercial grounds. And the track record of sovereign wealth funds for decades is that they are making investments on commercially sound bases. We welcome that kind of investment in the United States.

Bergsten: Just to pick up on the U.S. side of that, I think our attitude toward the sovereign wealth funds actually has to be driven by a single factor – we need the money. In fact, we desperately need the money. We’ve put ourselves in a position where we are dependant on foreign capital to keep our own economy afloat. The United States has become the world’s largest debtor nation; we have a net foreign debt in excess of $3 trillion.

Kimmitt: The free flow of capital going both directions is in our interest. I would say this though on the savings point and the debtor nation point. Our federal deficit last year was 1.2 percent of GDP. It will be higher this year because of the stimulus package. But the budget… still has us on a glide path to balance the budget by 2012. And even with the stimulus package, I think we’ll keep our ratio of debt to GDP under the three percent that the Europeans have set out as the Maastricht criteria.

James Fallows: In the short term, it’s just simply to America’s advantage. Other people are giving us their money. And that’s a plus [because] we need money for everything from mortgage bailouts to federal borrowing. In the long run, there are two conceptual disadvantages of having us be in foreign government hands. One is the whole transparency issue. This is a recent issue, perhaps not with Singapore or Norway, but in the oil countries and certainly in a lot of the Asian countries and China, there is a question of how exactly they’re making these decisions, what’s the ratio between purely commercial decisions and governmental decisions.

The other is the instability question, which then comes up particularly with China, where you have this largest single pool of funds. (Our countries) have a lot of interest in common, but some not in common, particularly over Taiwan. And so when you have a situation where the nature of it would tend to amplify any shocks that arise rather than buffer any shocks that arise, I think that’s a ground for concern.

Kimmitt: Picking up the point. First, I think that these recent investments that the sovereign wealth funds have (…) made have (…) been very carefully tailored to be minority investments, taking a passive interest (in management). Under 10 percent, no board seats, often an agreement not to buy any more of the company. These are not acquisitions of U.S. companies. These are investments into U.S. companies, but they are minority positions, passive investments. Having said that, I think the point that Jim raises about the potential long-term concerns is exactly why we said we need to be vigilant. And, in fact, have set up a process with the International Monetary Fund to address precisely that issue.

Bergsten: The developments that we’re talking about reflect two fundamental changes in the world economy. One is a power shift among countries. We’re looking here at newcomers to the global wealth scene – the nouveaux riches, the oil exporters, the Chinas, the Singapores – but also an increased role for governments in directing the flow of capital. As long as it’s on commercial grounds, which so far it has been, that’s fine. But there is the potential risk of government manipulation of these funds, and that is the one source of worry.

Kimmitt: The point about governments acting in a way that is more political than commercial in their investment practices – that would be a concern. That is precisely why the United States and the other countries from the G7, a group of industrialized nations, asked the International Monetary Fund and the World Bank to work with the sovereign wealth funds on a voluntary set of best practices that would address transparency, governance, risk management, and other issues, but essentially would allow the sovereign wealth funds to make clear that they’re pursuing these investments on commercial rather than political grounds.

If someone were pursuing an investment for political other than commercial reasons, we have regulatory processes in the United States that could identify that and take the appropriate steps. (For 20 years) we have had the Committee on Foreign Investment in the United States that reviews foreign acquisitions and investments in the United States. We have looked at over 200 government-controlled investments, including from sovereign wealth funds starting in 1989. So we have a process that can identify those security concerns.

(A question is posed by a listener: What would happen if the Chinese decided to stop throwing good yuan after bad, and decided to curtail their buying of our debt?)

Fallows: The normal answer to why they wouldn’t do that is they would hurt themselves very badly in the process. They hurt themselves in two ways. One is: although Europe has now overtaken the U.S. as the source of total purchases from China, the U.S. is a major, major customer of theirs. And so there would be all sorts of ramifications that would come from having the dollar fall in value (and thus curtail U.S. consumers’ ability to buy China’s products).

The other way they’d hurt themselves is so many of their assets are in dollars now. So they’re already losing value against their own currency in dollars. So the argument is it would be like the old balance of terror between the U.S. and the Soviet Union. Neither would attack the other, because they both would be so badly punished in the retaliation.

The counter to that is there are things the U.S. and China disagree about. Again, I mention Taiwan, and would stress that where factors other than pure reason can play their part – we’ve seen that in history – the ramifications increase: that’s the danger.

Bergsten: On that question about the Chinese may be moving out of dollars, it’s critical what they would move into. If they moved into their local currency, then they would push up the value of their local currency, hurt their competitiveness, and reduce their trade surplus. I think that would be a very healthy thing. And in fact, as Secretary Kimmitt said, we want a stronger Chinese exchange rate, because they’re running surpluses that are too large.

The other thing they could do, however, is shift from dollars into euros, into other foreign currencies. That would create a whole different problem. That would push the euro into a much stronger position in the foreign currency markets, probably into an overvalued level that would hurt the European economies. And certainly the Europeans don’t want it.

If the Chinese thought about moving from dollars into euros or into yen, the countries on the receiving end of those currency shifts would be very opposed to it. It would raise a different type of disruption.

(With regard to Fallows’ comparison with mutually assured destruction preventing dollar disruption) remember that his balance of terror worked in the cold war: there was never a hot war and it ended successfully with the demise of the Soviet Union, so that strategies of mutual deterrence actually work. The positive way to spin the financial equivalent now would be to talk about mutual co-dependency.

The risk is if it goes off track. For example, the world loses confidence in the dollar. Secretary Kimmitt’s successors come along and don’t maintain a successful budget correction policy, the U.S. trade deficit soars again, for whatever reason people lose confidence, the dollar starts to tank, and the world bails out. In that case, you could have a very severe [collapse of the dollar]. We’ve put ourselves in a position to suffer that. And then, inflation shoots up, interest rates shoot up, we have a real recession. We are at risk if that mutual co-dependency ever came apart.



Funds Start To Agree with U.S. on Transparency About Goals

The U.S. and the EU – and private equity firms – are all working on plans for a voluntary code of conduct for sovereign wealth funds. The centerpiece of most such blueprints is transparency about each fund’s investment philosophy and information about their holdings. The advantage for regulators in Western countries is that they would have a measure of confidence about the intentions of each of these funds and a standard for their actions. For the funds, the benefit would be some degree of protection against any potential backlash in their target countries that could prove damaging to their interests.

In Europe, it is still unclear whether this issue will be treated in some cases by individual nations or whether the European Union will be able to force a single common front. If individual European member states react with nationalist measures of protectionism of their own, the pattern could jeopardize the arrival of capital in the EU, create barriers to capital flows among member states and jeopardize the continuing momentum of the expanding single market.

In an initial step in this direction, the U.S. Department of the Treasury reached agreement on a set of principles along these lines with the sovereign wealth funds of Abu Dhabi and Singapore, two of the largest players in the field. U.S. officials said that they hoped these initial voluntary commitments will prove to be stepping stones to similar arrangements being worked on by the International Monetary Fund with a view to getting broad cooperation on these guidelines from all the major sovereign wealth funds.

Hoping to get out in front of the debate, the European Commission has proposed a voluntary code of conduct for sovereign wealth funds designed to promote transparency of the kind that Norway has pioneered in its national fund. Both the IMF and the Paris-based Organization for Economic Cooperation and Development are working on similar codes – voluntary rules of the road to be followed by both investors and by the countries receiving such investments.

The Commission has warned EU member states that “uncoordinated responses” could scare off potential investors. Already, Germany has said that it plans to seek legislation of its own that would limit foreign stakes to 25 percent in German companies or in foreign companies operating in Germany in fields deemed vital to national security. The Commission has indicated that it has no plans to call for EU-wide legislation addressing the problems liable to arise from investments by state-controlled sovereign wealth funds.

Describing the Commission’s ideas about transparency, Peter Mandelson, the European trade commissioner, said that a voluntary code should set out publicly the basic standards of governance and transparency for these funds. In these programs, he said, it should be made clear that the emphasis in their investments would be on commercial motivations, not national or strategic considerations of the investors’ own governments. “I think such a code is possible to draw up and would get acceptance from the wealth funds,” he told the Financial Times in February. “If the funds refuse to accept a voluntary code of conduct, pressure may grow for laws obliging them, at the least, to disclose their investments. A voluntary approach is preferable to a statutory one. Otherwise we get into a divisive debate about enforcement and sanctions,” he said.

In the U.S., the funds face pressures, notably in Congress, for closer scrutiny of their activities. A national survey in January by Public Strategies Inc. found that 55 percent of registered voters thought sovereign wealth fund investments would hurt national security, and 49 percent believed that investments would negatively affect the U.S. economy.

Amid these rising concerns, U.S. government officials have been meeting with sovereign wealth fund representatives, apparently seeking to work out an agreement on a voluntary code of conduct that enabled Washington to monitor the funds’ activities more closely and provide public reassurances to pre-empt protectionist pressures against their investments.

Politico, a Washington publication, reported in January that U.S. financial circles were teaming up with the funds to “strategize a defense against the growing political scrutiny” of the funds. According to Politico, these groups oppose any formal joint moves liable to worsen the threatening image of the funds and make them look like, for example, the OPEC cartel on oil exports. But lobbyists are already working to sway government officials towards a favorable attitude about the funds.

These concerns were voiced at the World Economic Forum in Davos, in widely reported comments by former Treasury Secretary Larry Summers: “If you think of an investment made by a state fund, there could be multiple motives [among investors trying to advance the interests of their own country]. Perhaps we want [an airline we buy] to fly to our country. Perhaps we want a bank to do extensive business in our country. Suppose we want suppliers in our country to be sourced. Perhaps we want some disablement of a competitor for our country’s national champion,” he said.

Many in Congress are ready to question whether foreign governments are more interested in making money or gaining political influence via their sovereign wealth funds. They echo Summers’s point that government-related investment entities could politicize the economics of the Western corporations in which they invest.


This article was published in European Affairs: Volume number 9, Issue number 1-2 in the Winter/Spring of 2008.