Friday, December 14, 2007

Will Sovereign Wealth Funds rule the world?

Sovereign Wealth Funds (SWF) are Government-owned funds that invest in global markets. Many fear that they may turn their economic clout into political gain. Sovereign Wealth Funds are huge, and for some scarily big.

Though unknown to most Americans, these ­government-owned funds have been getting lots of attention in the financial press as well as among the world's top central bankers and finance ministers. The Senate Banking Committee heard lengthy testimony on them earlier this month.

These funds are mostly the product of accumulated US dollars by countries like China, with its massive trade surplus, and by oil-exporting countries reaping generous profits from oil at $90 plus per barrel.

How big are they? Estimates vary. The 28 nations with Sovereign Wealth Funds (SWFs) have, in total, assets of $2.1 trillion, figures Edwin Truman, an expert at the Peterson Institute for International Economics in Washington.

By 2011 or 2012, SWFs could have piled up as much as $7 trillion to $8 trillion, guesses Harvard University economist Kenneth Rogoff, a former chief economist for the International Monetary Fund (IMF).

SWF assets could be $3 trillion now and $10 trillion by 2012, reckons Simon Johnson, an IMF research director.

Whatever their size, the huge piles of SWF money ready to be deployed across borders make some financiers edgy.

"Our nation is not doing well in the global economic competition," Patrick Mulloy, Washington representative of the Alfred P. Sloan Foundation, told the Senate Banking Committee on Nov. 14. He cited concerns that SWF money will be used not just for economic reasons but also for political and strategic purposes.

Securities and Exchange Commission Chairman Christopher Cox said in a speech at Harvard in Oct. 24 that "the fundamental question presented by state-owned public companies and sovereign wealth funds does not so much concern the advisability of foreign ownership, but rather of government ownership." These financial and business entities could act in the interests of foreign governments, not necessarily the interests of the United States.

Warren Buffett, the famed billionaire investor, has worried that as long as the US has major foreign trade deficits (some $700 billion a year), it has to "give away a little part of the country" each year. The US could end up with a "sharecropper economy," where Americans largely work for foreign-owned firms.

Mr. Rogoff isn't so bothered by SWFs. He figures SWFs will do "more good than bad" in an increasingly Globalized world economy. He suspects that most of these funds will be "managed inefficiently" in their investments, losing a lot of money in many cases, perhaps getting an average annual return of around 8 percent. That is far less than Harvard gets, for instance, on its endowment money.

But an 8 percent return is almost twice what most nations get with their huge stocks of surplus US dollars invested in US Treasury bills. And a higher return and diversification is what most nations are seeking with SWFs.

China has recently established US$200 billion in an SWF, part of the country’s $1.43 trillion in foreign-exchange reserves, the world's largest. Most of this is in Treasuries currently. China's SWF invested $3 billion last June in Wall Street private equity firm Blackstone Group LP. However the stock promptly sank to $22 from its purchase price of $31.

To most people, $1 trillion is beyond comprehension. For perspective, the value of all traded securities (bonds and stocks) denominated in US dollars is $50 trillion. For the world, it's $165 trillion. If SWFs have $3 trillion, that's twice what global hedge funds manage and twice the size of global private equity funds, reckons the consulting firm McKinsey and Company.
So far the US government is inclined to take a free-market view of SWFs. Treasury Secretary Henry Paulson said on Nov. 18 that SWFs "should be able to invest globally." But he noted that because these funds are large, ­government-run, and often opaque in their investment strategies and portfolios, "questions will arise."

The US has a system, strengthened by Congress last summer, to check on new foreign investment in the US. And the US and other well-to-do nations are pushing for the IMF to develop a system of "best practices" for SWFs.

In fact, the IMF concluded its first "annual roundtable of sovereign asset and reserve managers" on Nov. 16 in Washington. About 60 officials from 28 nations attended, including those of some of the biggest SWFs. It was a preliminary session, but "very successful," says Adnan Mazarei, heading the IMF working group on the issue.

Mr. Truman warns that "a lot of countries" with SWFs must agree before the IMF can institute a "best practices" system. Rogoff says that some Middle East countries with SWFs may not be keen to meet "transparency" standards since national elites may be using the funds to enrich themselves.

My personal observations are as follows : -

In a free market environment SWF should not be restricted in their objective to generate a fair return. However, as SWF are Government owned their investments in foreign business enterprises could result in concerns over control issues;

As SWF are deploying their respective countries’ national wealth that rightfully belongs to their citizens, they should be committed to first investing and supporting their domestic economies;

SWF have to position and execute their investment strategies in such a manner as not to cause disruption in global markets;

Note : I will be addressing these and other related topics at the upcoming Sovereign Wealth Management 2008 Conference in London in March 2008. Join me there.