When Norway’s sovereign wealth fund exceeded $1trn in value in September 2017, it sent a signal to the markets that states can do it better than private corporations. Apple and Amazon, two of the world’s largest companies, would only surpass this threshold a year later.
When sovereign wealth funds emerged decades ago, they were modest in scope
The Norwegian fund is a colossus of world finance, holding around 1.5 percent of global listed equity, but is far from an exception. Data held by the Sovereign Wealth Fund Institute, a US corporation, shows that assets held by state-owned investment funds, known as sovereign wealth funds (SWFs), exceeded $8.1trn in October 2018, more than double the value in 2007. More than half of these assets are owned by gas and oil-related funds (see Fig 1).
Oiling the cogs
When SWFs emerged decades ago, they were modest in scope. The first, established by Kuwait in 1953, received a fixed percentage of the country’s vast oil revenues nearly a decade before the country gained its independence. The number of SWFs swelled during the 1970s, when most oil producers established ‘stabilisation funds’ to protect their economies from the boom and bust of oil markets.
A second category appeared in the early 1980s, launched by countries enjoying large surpluses due to robust exports, such as Singapore. China Investment Corporation, the biggest of these new SWFs, was created in 2007 to channel China’s vast foreign exchange reserves into assets more profitable than government debt. Originally intended as rainy-day funds, by 2005 stabilisation funds were big enough to become known as SWFs, marking their transition from domestic-orientated financial vehicles to major players seeking sizeable returns in international markets – often quite aggressively.
A more idiosyncratic type of SWFs appeared with the dawn of the 21st century, dubbed by critics as ‘vanity funds’. Their home nations did not enjoy commodity exports or surpluses, and were often notorious for poor fiscal discipline. Governments of vanity funds’ home countries perceived SWFs as vehicles to boost the economy during global slowdowns or to attract international capital. Andrew Bauer, a consultant at the Natural Resource Governance Institute, a US think tank monitoring governance of natural resources, told World Finance: “In some countries, launching an SWF is fully justified. However, in others, debt levels are either too high or natural resource revenues or future fiscal surpluses [are] too small to justify creating a fund. So what explains countries like Ghana and Uganda having established funds, or countries like Lebanon and Kenya considering new funds?”
Critics worry that such funds, often orientated towards domestic investment, are vulnerable to politically driven investment decisions, cronyism or even corruption. A case in point is Malaysia’s 1MDB, which is currently being investigated in several countries for its alleged role in money-laundering violations. In Turkey, President Recep Tayyip Erdogan, the country’s ruler of 15 years, took control of the Turkey Wealth Fund in September.
Many countries hope that, through SWFs, they can gain access to exclusive industry associations and forums, which provide networking opportunities necessary to attract foreign investment. The sirens of international markets are too hard to resist, Bauer said: “Part of the problem is poor advice. Some international advisors mistake having an SWF with good natural resource revenue management. Another challenge is the influence of investment banks. They sometimes pressure governments to establish funds so they can manage the money.”
For emerging markets, launching an SWF has become a symbol of status. More than 40 new funds have been established since 2005 by countries as diverse as Mexico, Russia and Bangladesh, while South Africa is also considering launching its own fund. A notable exception is Brazil, which is currently in the process of liquidating its SWF.
Tensions between the US and countries such as Russia, China and Turkey have rekindled the idea that sovereign wealth should not be deemed a neutral market force
One reason for this growth in the number of SWFs is high oil prices between 2007 and 2014. But politics plays a role too, according to Bauer: “To some extent, SWFs have been used to make global statements about self-determination. They have become symbols of development and progress and are not always promoted as solutions to specific macroeconomic or budgetary problems. This lack of clarity presents a real danger, as poorly conceived funds can undermine public financial management systems and can lead to squandering of revenues.”
For developed countries, SWFs pose a conundrum: until the financial crisis in 2008, they were perceived as predators of national assets and, in some cases, even a potential national security threat. Gawdat Bahgat, a professor of national security affairs at the National Defense University, a US academic institution, said: “When SWFs started accumulating substantial wealth, the US and several European countries became suspicious. SWFs are not private entities, but they do have financial leverage, and gradually western governments have started regulating SWF investments.”
Total value of assets held by state-owned investment funds globally
Value of Norway’s sovereign wealth fund as of September 2017
of total global listed equity is held by Norway’s sovereign wealth fund
All that changed during the 2008 financial crisis, when SWFs became the white knights of the global financial system by boosting beleaguered banks such as Barclays and Citigroup. Victoria Barbary, Director of Strategy and Communications at the International Forum of Sovereign Wealth Funds, an organisation set up by SWFs at the peak of the crisis, said: “While politicians in the US and EU had previously been concerned about the motivations of state-owned investors’ (both SWFs and state-owned enterprises) acquisitions in their countries, their role in bolstering the international financial sector in its hour of need certainly made many attitudes less hostile.”
However, many interpreted their motivations for purchasing western assets as politically driven. By propping up US and European banks, Gulf states such as Qatar and the UAE won the hearts and minds of policymakers during a tumultuous era in the Middle East. Today, sovereign wealth in the region remains the long arm of the state and the elites who control it, said Bahgat: “SWFs and other forms of foreign investments are used to buy political leverage. The murder of the Saudi journalist Jamal Khashoggi is a case in point. The war in Yemen is another example. Given the huge [amount of] Saudi financial assets, the country is not likely to face sanctions. And if sanctions are imposed they will be [applied] for a short period, sadly.”
A balancing act
Concerns over the clout of SWFs have not subsided. Many experts worry about imbalances in global markets due to investment overconcentration by a small number of funds owned by countries with minuscule populations. For example, Abu Dhabi, with a population of 1.2 million people, runs an SWF worth over $683bn. Some also warn that the funds are partly responsible for the creation of asset bubbles in London and New York.
Population of Abu Dhabi
Value of Abu Dhabi’s sovereign wealth fund
Many SWFs strive to strike a balance between meeting financial targets and pursuing a broader sociopolitical agenda in an era of rising economic nationalism. Some of these pressures come from benevolent forces. In July, six of the world’s biggest SWFs pledged via a charter to invest in companies that incorporate climate risks into their strategies. The Norwegian fund, one of the charter’s signatories, divested from six companies in 2017 due to social, governance and climate change considerations, and excluded another 11 companies from the list of future asset purchases.
It is now expected to exit oil and gas stocks completely in 2019. An increasing number of SWFs are also adopting guidelines on corporate responsibility, while at least four have adopted ethical investment guidelines.
However, geopolitical forces are coming into play as well. China is often accused of using its SWFs to exert influence in the developing world, and increasingly in Southern and Eastern Europe too. At least two of these funds are involved in the country’s ambitious Belt and Road Initiative, which aims to connect China to Europe through several infrastructure and investment projects and, according to critics, help the country boost its political and economic clout via a global trade network.
An increasing number of sovereign wealth funds are adopting guidelines on corporate responsibility
These concerns are not new or completely unfounded, given that many SWFs explicitly state their political mandate. But tensions between the US and countries such as Russia, China and Turkey have rekindled the idea that sovereign wealth should not be deemed a neutral market force. Bahgat told World Finance: “SWFs are likely to further reinforce economic nationalism and protectionism. Significant investments are made in creating jobs for nationals. In almost every oil-producing country, there is a programme to reduce reliance on foreign workers and replace them with domestic ones.”
The International Forum of Sovereign Wealth Funds has issued a list of voluntary standards and recommended practices, dubbed the ‘Santiago Principles’, to address concerns that SWFs mix business and politics and promote transparency and accountability in governance and investment behaviour. Barbary said: “The Santiago Principles were originally established to be a kind of passport to show that each signatory invested on a purely financial basis overseas. But increasingly, those funds that apply the Santiago Principles invest at home. For them, applying the principles is an important sign to their domestic stakeholders that they are committed to applying best governance and investment practices.”
More needs to be done to achieve a level playing field. As Chinese and Middle Eastern SWFs are becoming more aggressive in financial markets, authorities in the US and Europe, particularly Germany, are once again becoming wary of predatory purchases and consider tightening legislation on the grounds of national security concerns. Miles Kimball, a professor of economics at the University of Colorado Boulder, said: “[SWFs] should be diversified internationally, but because of the effect of government purchases of foreign assets on trade flows, guidelines for government purchases of foreign assets should be explicitly negotiated among countries.”
The tech rush
In an era of historically low interest rates, SWFs are striving to generate significant financial returns. Research by Invesco, a US asset manager, shows that SWFs are increasingly shunning active management for equities, favouring instead index-tracking strategies. An exception is the Middle East, where many funds employ active management teams. Some of these funds are becoming more aggressive, venturing into new, riskier areas, such as the tech sector.
A case in point is Saudi Arabia. Despite its vast oil reserves, the country is gripped by rising youth unemployment (see Fig 2). Under the leadership of Prince Mohammed Bin Salman, Riyadh has launched Vision 2030, an economic transformation plan aiming to reduce the oil sector’s grip on the economy and create more than 450,000 jobs. The main vehicle to implement the plan is the $360bn Public Investment Fund (PIF), which has set up and supported companies in a wide range of industries, from technology and energy to entertainment. In an unusual move for an SWF, the PIF raised $11bn in loans in September 2018. It is also behind the recent shake-up of Saudi Arabia’s national champions. Saudi Aramco, the country’s state oil company, is in the process of acquiring a 70 percent stake in SABIC, a PIF-owned chemicals manufacturer, to help the fund raise money for its ambitious projects.
The goals of such an ambitious diversification plan can be self-contradictory, Bahgat said: “In the West, privatisation means less government intervention in the economy. In Saudi Arabia and other oil-producing countries, the government (including SWFs) is leading the private sector. It is an extension of the government, not independent of it.” The project may also put off other investors, according to Dr Karen Young, a resident scholar at the American Enterprise Institute and an expert on the Gulf region: “The PIF is becoming a major outward investor to grow national wealth, but also a dominant partner for FDI inside Saudi Arabia. In that effort, many private firms that may want to compete in the kingdom may find there is a single source of domestic investment: the PIF. This creates some problems of crowding out other investors, and potentially also limiting competition as the firms that receive PIF investment are then favoured by the state.”
But what has really put a spotlight on the PIF is its rapid transformation into an idiosyncratic venture capital firm. Tech companies where the PIF owns a stake include Uber, Magic Leap, Tesla and Lucid Motors. It also holds a $45bn stake in Vision Fund, an investment fund focusing on tech start-ups, set up by the Japanese conglomerate SoftBank and its flamboyant CEO, Masayoshi Son. Young told World Finance: “The PIF has taken a higher risk appetite than traditional SWFs in the Gulf with respect to investment in private technology firms. This is a departure from traditional investments in fixed income, debt and real estate that have dominated most SWF allocations in the region in recent years.”
In an era of historically low interest rates, Sovereign wealth funds are striving to generate significant financial returns
In the long term, tech investment by SWFs may have geopolitical repercussions, said Dr Theodore Karasik, a senior advisor at Gulf State Analytics, a geopolitical risk consulting firm: “The PIF, along with its partners, [sees] the future and power of artificial intelligence across the spectrum of human security, including health and welfare. The triangulation of AI interests between Saudi Arabia, Russia and China needs to be watched in terms of how SWFs may cooperate in advanced technologies.” Furthermore, last October it was announced that the PIF will join the Russia-China Investment Fund, a joint SWF aiming to boost economic cooperation between the two countries.
For the time being, the PIF’s risky strategy encapsulates the dilemmas facing most SWFs, as they strive to strike a balance between serving their present masters and investing in the future. William Megginson, a professor in finance at the University of Oklahoma and the Saudi Aramco chair professor in finance at King Fahd University of Petroleum and Minerals, said: “What Saudi Arabia needs is more private investment rather than state-directed investment. Saudi Arabian investors (state and private) should be nurturing domestic industries that create massive employment opportunities for their well-educated young people and export earnings for the kingdom, not dropping $3.5bn into Uber or putting $45bn into Son’s Vision Fund to invest in Western hi-tech.”