Wall Street tends not to be too choosy about where it gets its money. Normally, one investor’s dollar is as good as any others. But lately, that’s not been the case. With their balance sheets squeezed by the global credit crunch, many US banks and financial firms have opened their arms to so-called “sovereign wealth funds” –investment vehicles controlled by foreign governments. The move has got some people very worried.
The US Senate recently ordered the Government Accountability Office (GAO) – a financial watchdog – to investigate the activities of sovereign wealth funds, after a string of investments topping $35bn in blue chip firms such as UBS, Bear Stearns, Morgan Stanley, Merrill Lynch and Citigroup.
The concern is that funds owned by foreign governments might use their financial clout to somehow exert improper influence. According to a recent Morgan Stanley study, such funds represent some $2,300bn in assets and could reach $12,000bn by 2015. These funds are mainly held by oil exporting countries, such as Norway, Alaska, Russia, Dubai and Qatar, which have seen a large growth in trade surpluses because of rising energy prices. It’s not likely that Norway’s intentions are going to worry anyone, but most of the sovereign wealth funds are run by governments in Asia and the Middle East. Their recent deals with the Wall Street institutions represented their first significant investments in key American companies.
It’s not just the US Senate that is worried about the influence of sovereign funds. The recent growth of these special state-owned investment funds have caused disquiet among many governments, which fear political influence by other states on strategic sectors, such as energy and defence.
The GAO, according to press reports, is trying to find out how much money these opaque funds control, where it has been invested and how the investments have been treated. It is also examining what information the funds are required to disclose on their investments and what action can be taken to discipline them if they misuse their power. David Walker, head of the GAO, told journalists that sovereign wealth funds did not initially cause too much of a stir in Washington, “But as the number of these kind of transactions rises Congress is becoming interested.”
That follows comments last year from Clay Lowery, the acting under-secretary for international affairs at the US Treasury, who said the spread of sovereign wealth funds could create new risks for the international financial system and spur hostility to cross-border capital flows. Lowery called on the International Monetary Fund (IMF) and the World Bank to develop a set of best-practice guidelines for such funds. He said there was a danger that imprudent risk management by sovereign wealth funds could affect financial market stability.
“Little is known about their investment policies, so that minor comment or rumours will increasingly cause volatility,” he said, adding that such funds “are typically not regulated by their domestic regulators, and the extent of indirect regulation may also be limited.”
Lowery also warned that, over the medium term, the size, investment policies and operating methods of these funds could fuel financial protectionism. “There will likely be much public attention to whether sovereign wealth funds exercise the voting rights of their equity shares and, if so, how,” he said. Lowery warned of the danger that, in the absence of good checks and balances, these funds could invite corruption. He cautioned that funds could become “self-perpetuating” interest groups and urged countries to tackle the causes of reserve accumulation, including undervalued currency regimes.
Other US agencies have voiced concerns, too. The rise of sovereign wealth funds raises questions of “particular significance” for US financial regulator the Securities and Exchange Commission (SEC), including concerns about enforcement, transparency and market efficiency, the chairman of the agency said recently. Christopher Cox said the issue of conflicts of interest arise when the government is both the regulator and the regulated. “Rules that might be rigorously applied to private sector competitors will not necessarily be applied in the same way to the sovereign who makes the rules,” said Cox.
Cox highlighted enforcement as one issue and said that if foreign private issuers are suspected of violating US securities laws, the agency almost always expects the full support from the foreign government and regulatory counterpart in the investigation. “If the same government from whom we sought assistance was also the controlling person behind the entity under investigation, a considerable conflict of interest would arise,” he said.
Cox raised questions over whether government-controlled companies and funds would use business resources in the pursuit of other government interests. He also highlighted transparency as an issue for the investor protection agency and said in many industrial countries the ability of citizens to inquire into government affairs, or to criticise the conduct of government, is severely limited. “In some countries, criticism of government policies lands you in jail, or worse. Is it reasonable to expect that these same governments will be magically forthcoming with investors?” Cox said. “This raises significant questions for regulators such as the SEC, whose mission includes investor protection.”
It’s not just the Americans who are worried. In Australia, a government study has also called for the IMF to impose standards that would stop investment funds owned by sovereign governments from buying a majority or controlling stake in foreign corporations.
“Attempts by foreign interests to purchase controlling stakes in strategic industries or iconic domestic companies can sometimes cause broadly based domestic concerns,” the study from the Australian Treasury says. “Resistance can be even stronger if the purchaser is an overseas government, and can raise suspicions over whether the purchase is … for strategic or other non-commercial reasons.” The study says the biggest problem is that the funds are highly secretive about their investment practices, which raises concern about their motivation. Most provide no public reporting.
The European Union, however, is taking a more benign view of the emergence of sovereign funds, and trying to develop a common approach to tackle its concerns about their activities in Europe.
“There are good reasons for an EU common approach,” Commission President José Manuel Barroso said recently. However, the Commission is seeking to avoid legislative action and envisages soft measures, such as “ground rules or guidelines”, accompanied by efforts to increase transparency on sovereign fund activity. The Commission underlined that it seeks to “avoid all forms of protectionism.”
The Commission’s stance was reaffirmed in a recent speech by Internal Market Commissioner Charlie McCreevy. He pointed out that sovereign wealth funds have been around for decades. The Kuwait Investment Authority has been in existence since 1953 and the Abu Dhabi Investment Authority, one of the biggest with almost €600bn in assets, was set up in 1976. Temasek from Singapore dates from 1974. People have expressed concerns about these funds in the past, he said. “I am old enough to remember the concerns when oil rich Middle-Easterners were buying up prestigious companies and landmark London properties. As time went by and oil reserves tapered off, so did the fuss.”
The public consciousness
McCreevy said such fears have come back thanks to the growth in sovereign funds as a result of rising energy prices and large trade surpluses. “Their size and wider geographical disparity have impinged on the consciousness of policy makers and the wider public.”
What should be done about their growth? “One thing is clear to me: Europe must remain an attractive place for investment,” said McCreevy. “Without continued inward investment our economies will stagnate. We have no interest in erecting barriers to investment.” While they might be unpopular in some quarters, “I suspect in the time ahead we will see many more enterprises seeking investments from such funds,” he added. “Cutting off access to these important sources of liquidity would be like cutting off our noses to spite our faces.”
However, there were aspects of sovereign funds that need to be addressed, he said. “Who controls them? What is their investment strategy? These are legitimate questions? There are also concerns about restrictions on inward investments that EU firms may want to make in the countries concerned.”
“But in raising these issues we must avoid them being used to foment protectionist sentiments. I would not like to see the rise of sovereign wealth funds, which are the by-products of increasing globalisation and benefits of international trade, being used as an argument against the entry of emerging markets investors into the First World corporate sector.”
McCreevy suggested two ways in which the debate should move forward. “Firstly, we need to explain to our citizens that investments which have the potential to compromise national security can be blocked,” he said. “It is often forgotten that a member state is entitled to restrict Treaty freedoms on the basis of legitimate national security concerns. This is true in respect of all investments, be they from sovereign wealth funds, state-controlled companies, private companies or whoever.” A number of EU members have measures in place to restrict investments in the defence sector, the Commission recently proposed controls on investment in the energy sector, and there is already a requirement on investors in European financial institutions to be “fit and proper”.
Secondly, McCreevy said sovereign wealth funds should be transparent in their operations, preferably on the basis of an international code of best practice. “We are working in international organisations and bilaterally, together with our US colleagues, to bring this about,” he said.
The IMF is working on a set of guidelines. Last year its chief economist, Simon Johnson, said the organisation was growing increasingly uneasy over the role of sovereign funds. Concerns focused on the lack of disclosure about their activities and the amount of leverage that funds might employ.
“There are an increasing amount of financial flows going through black boxes. Hedge funds are black boxes. Sovereign wealth funds are black boxes. We don’t know what happens and we should worry about that,” he said. “Black boxes should make us uneasy . . . People are beginning to feel uncomfortable about this.” Johnson added that the IMF’s efforts to understand the potential financial risks from sovereign funds remained at a “pretty early stage”.
In the meantime, what do the countries behind these funds make of all the concern? Writing in China Business News recently, Wei Benhua, deputy head of China’s State Administration of Foreign Exchange, said the developed world should not discriminate against funds from developing countries or subject them to “financial protectionism”. Wei characterised such worries as baseless: “The China Investment Corp drew the attention of international society as soon as it was established, with certain countries intentionally disseminating the view of Chinese investment as a threat,” he wrote.
Sovereign wealth funds would benefit international markets by increasing liquidity and by making global resource allocation more efficient, said Wei. “There should be no discrimination in the treatment of sovereign wealth funds; the funds of developing and developed countries should be treated the same way. International society should clearly oppose investment protectionism and financial protectionism in any form.” As the IMF develops its guidelines, China would get actively involved in discussions, he added. There will be many companies in the developed world – Wall Street Banks especially – that will hope these powerful new funds are not dissuaded from investing: in the current climate especially, they need the money.