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State Capitalism and Sovereign-Wealth Funds

November 19, 2008


Back in September, just as the collapse of Lehman Brothers was triggering a full-blown financial crisis, The Economist wrote an article about “coming to grips with sovereign-wealth funds.” [“The rise of state capitalism,” 20 September 2008]. Sovereign-wealth funds are huge investment funds owned and controlled by governments — most of them pumped up by petrodollars. The term “sovereign-wealth fund” has only been around a few years (it first gained widespread use in 2005). Sovereign-wealth funds are typically established when governments have budgetary surpluses and little or no international debt. Rather than let the money sit in a bank and earn small returns, the notion was to invest the money and obtain greater returns. Some countries may be rethinking such strategies given the current state of international stock markets; nevertheless sovereign-wealth funds are likely to remain permanent features of the financial landscape. Kuwait is normally credited with starting such funds. It established the Kuwait Investment Authority in 1953, nearly 40 years before the next largest fund, Norway’s Petroleum Fund, was established in 1990. Norway established its fund to counter the effects of the eventual decline in oil income and to smooth the disrupting effects of highly fluctuating oil prices. Any country that accumulates wealth from selling commodities experiences similar budget volatility as commodity prices change.


Sovereign-wealth funds will remain viable since countries have longer investment horizons than most individuals. As a result, they should be able to ride out the current financial downturn and achieve long-term investment goals. The other reality is that oil producing nations will still have to do something with their petrodollars. Even at $30/barrel, Arab sovereign-wealth funds will continue to grow.


Not everyone living in countries with sovereign-wealth funds is happy that sovereign-wealth is invested outside the state. The Economist‘s article begins with a rant by a Chinese blogger who decries the fact that a $3 billion investment by the China Investment Corporation, a sovereign-wealth fund established by the Chinese government, had at the time the article was written already lost $500m. That number is likely to have increased during the intervening weeks. The China Investment Corporation had bought shares of Blackstone, an American private-equity firm, and Blackstone has not fared well since June 2007.

“The Chinese government’s policy of ‘going out’—investing abroad through its companies and new sovereign-wealth funds instead of at home where it was needed—was about showing off to the world, wrote [blogger Wu Zhifeng]: ‘Chinese companies started acquiring businesses here and there in the world so that many countries would shout that “the dragon is coming”.’ If some sovereign-wealth funds are unpopular at home, they are viewed with even more hostility in the rich world, where CIC and others have been splashing their cash lately. Such funds have provided several top Wall Street firms (as well as some of their European rivals) with large injections of cash in the past year—including Citigroup, which received $7.5 billion from the Abu Dhabi Investment Authority (ADIA). That probably saved a few of them from bankruptcy or a Bear Stearns-style forced sale, but it was controversial.”

As credit has continued to tighten, however, some skeptics have come to view sovereign-wealth funds more favorably. Just as the U.S. Government’s price of bailout for some banks involved gaining a share of the business, sovereign-wealth funds are in a position to bargain hard and get good deals in exchange for their money. Most of the funds are well-managed and are gaining influence.

“It is not just banks that have caught the sovereign-wealth funds’ eye. In July the Abu Dhabi Investment Company bought a 90% share in New York’s iconic Chrysler Building. Soon after that, Mubadala, another Abu Dhabi fund, announced that it intended to become one of GE’s ten biggest shareholders. Public criticism of sovereign-wealth funds has subsided a little as the crisis in the developed world’s financial markets has made people grateful for any money they can get. Yet in private there are plenty of worries about the growing size and power of sovereign-wealth funds.”

To put it bluntly, people who worry are actually more concerned about the ethnicity of the governments that own the sovereign-wealth funds than they are about the investments themselves. Most of the funds are owned by countries in the Middle East. Investments from China’s sovereign-wealth fund and Russia’s foreign exchange reserve also raise eyebrows in the West — especially in America. Where concerns about the investments themselves are the main issues, the issue is generally the fact that sovereign-wealth funds are giving governments stakes in private companies. This is a far cry from making such companies government-owned enterprises (it’s the difference between capitalism and socialism).

“In an article in the Financial Times last year, Larry Summers, a former American treasury secretary, wrote that a ‘signal event of the past quarter-century has been the sharp decline in the extent of direct state ownership of business as the private sector has taken ownership of what were once government-owned companies. Yet governments are now accumulating various kinds of stakes in what were once purely private companies through their cross-border investment activities.’ Mr Summers called for a new policy: “Governments are very different from other economic actors. Their investments should be governed by rules designed with that reality very clearly in mind.”

The Economist is not sure that such concerns are justified, but it does admit that sovereign-wealth funds are becoming more important actors in the financial arena.

“The problem, if problem it be, may be just beginning. According to the US Treasury, sovereign-wealth funds are ‘already large enough to be systemically significant’. But the McKinsey Global Institute in a recent report forecast a dramatic increase in the assets of sovereign-wealth funds over the next few years. It predicts that Asia’s sovereign assets, which at the end of 2007 stood at $4.6 trillion, will rise to at least $7.7 trillion by 2013 on conservative growth assumptions, and to as much as $12.2 trillion if economic growth continues at the fast pace of the past seven years. As for the sovereign-wealth funds of oil-rich states such as Russia, the United Arab Emirates and Saudi Arabia, much depends on what happens to the price of oil. McKinsey looked at the impact of several possible average oil prices over the next five years, all below what the stuff has been selling for in recent months. Even at $50 a barrel (remember?), the assets of these sovereign investors will rise to $8.9 trillion by 2013, from $4.6 trillion at the end of 2007.”

With oil now hovering between $50 and $60/barrel, above McKinsey’s conservative estimate, it is easy to see why sovereign-wealth funds are garnering increased attention. The Economist asks the big question.

“What are they going to do with the money? Will these funds become instruments of a ‘new mercantilism’, with the controlling government attempting ‘to ensure that company-level behaviour results in country-level maximisation of economic, social and political benefits’, as Ronald Gilson and Curtis Milhaupt suggest in a recent article in the Stanford Law Review? Will they be opportunistic, as Larry Summers fears? Will they be politically aggressive, as Russia has already shown itself with Gazprom (not, strictly speaking, a sovereign-wealth fund but certainly a well-endowed corporate arm of the state)? Or are the funds simply investors, looking for nothing more sinister than a decent return on their money? Earlier this year, Yousef al Otaiba, Abu Dhabi’s director of international affairs, in an open letter to America’s treasury secretary, said that ‘it is important to be absolutely clear that the Abu Dhabi government has never and will never use its investment organisations or individual investments as a foreign-policy tool.’ And as Messrs Gilson and Milhaupt note briefly in their article, despite fears that sovereign funds will use their investments to secure technology, gain access to natural resources or improve the competitive position of their domestic companies, ‘no one can point to a reported incidence of such behaviour.’ In fact, there is no such thing as an average sovereign-wealth fund.”

The article points out that some sovereign-wealth funds have been around for decades, like the Kuwait Investment Authority (KIA), and others, like China’s are fairly new. They also different greatly in the amount of money they control.

“The biggest is ADIA, which with assets of $625 billion is almost double the size of the next-biggest, Norway’s. Some, like the KIA, are essentially passive portfolio investors. Others are more active, resembling private-equity firms (Dubai International Capital) or even industrial holding companies (Singapore’s Temasek). Most of them are increasingly shifting their focus to equity-investing. Many of them also invest in hedge funds and private-equity firms. There are big differences, too, in their willingness to use professional managers and in their competence as investors. One reason why CIC bought its stake in Blackstone, and Mubadala its stake in Carlyle, may have been to tap the investment expertise of those firms. Another way of raising the quality of in-house staff is to appoint nationals who have gained qualifications abroad.”

While the Middle Eastern sovereign-wealth funds are set up and managed to make money. The article point out that China and Russia may be horses of a different stripe.

“Russia and China may be exceptions, in that both their governments have been willing to use the companies they own to pursue political goals and might well try to do the same with their sovereign-wealth funds. If that starts to happen, they may need to be governed by different rules from those applying to funds that try to concentrate mainly on getting good investment returns.”

Governments that are simply interested in making money have a difficult time understanding why their investments generate so much concern and criticism. Isn’t investment and profit what capitalism is all about? The concerns arise primarily because most sovereign-wealth funds operate with little transparency. Criticism of sovereign-wealth funds generally fall into one of three categories:


  • They are too influential. As sovereign-wealth funds grow in size and importance, so does their potential impact on various asset markets.
  • They pose a security risk. Foreign investments by sovereign-wealth funds raise national security concerns because the purpose of the investment might be to secure control of strategically-important industries for political rather than financial gain.
  • They are not well regulated. Sovereign-wealth funds are not nearly as homogeneous as central banks or public pension funds. They operate with little transparency and can be a potentially valuable tool for achieving certain national policy and macroeconomic goals.


Of course, sovereign-wealth fund owners and managers are stung by such criticisms.

“Many sovereign-wealth funds have been upset by the criticism they have received over their recent Wall Street investments. America’s treasury secretary, Hank Paulson, is understood to have spent a lot of time reassuring them, especially about the reaction to their investments in Wall Street, after Merrill Lynch, Morgan Stanley and others persuaded the funds to shore them up. ‘They have lost money and then been subjected to complaints in Congress about the lack of transparency on their balance sheet or their agenda,’ says the private-equity veteran. To try to reduce the criticism, the IMF has been working on guidelines for sovereign-wealth fund transparency. … As things stand, transparency ranges from next to none to a lot. Again, some sovereign funds protest that they are being subjected to far tougher disclosure rules than many big domestic investors in developed countries. It will be no surprise if the IMF proposals are given a lukewarm reception and then largely ignored.”

Some analysts point out that the West has little room to criticize sovereign-wealth funds and it needs only recall the “Asian Flu” financial crisis to know why.

‘”There is a huge amount of hypocrisy about sovereign-wealth funds in the West,’ says Richard Cookson, a global strategist at HSBC who keeps an eye on sovereign-wealth funds. ‘When did the developed world ever not use its economic and political clout to buy assets on the cheap?’ In the Asian crisis of the 1990s, American banks bought into several troubled Asian banks. When local politicians complained, America accused these countries of protectionism, says Mr Cookson. The real reason the developed world is now so upset, he suspects, is that the sovereign-wealth funds symbolise so clearly the shift in the balance of economic power to the emerging markets. Yet when emerging countries set up sovereign-wealth funds, with separate governance and a clear investment mandate, it is often a sign of them ‘recognising that they got it wrong in the past, asking how to improve, and concluding that an endowment/portfolio approach is the best way,’ says Chuck Bralver of the Centre for Emerging Market Economies at Tufts University. ‘Leaving the Russians aside, they are mostly being highly professional.’ Even the Chinese sovereign-wealth funds are expected to hire hundreds of professional investment managers, mainly from developed countries.”

As I have written in several recent posts, emerging markets represent the future of the global economy. This may be a difficult change for Westerners to embrace but the sooner they do the better off they will be. Sovereign-wealth funds create a wrinkle in the international financial landscape that has not been encountered before and exactly how to deal with them remains uncertain. The fact is, the West may have little say in that matter.

“What is certain is that as sovereign-wealth funds grow, which they are bound to do, an increasing number of the world’s companies will end up at least partly in state ownership. And there is a possibility that the sovereign-wealth funds’ good behaviour is a Trojan-horse strategy which in time will give way to mercantilist interference. In practice, sovereign-wealth funds so far have given little cause for alarm. Their biggest downside may be that they lack the capacity to find a sensible home for all the money that is likely to be flooding in over the coming decades, and that much valuable capital will be squandered on ill-advised projects. ‘I’m struck by how responsibly China and countries in the Middle East are behaving,’ says Laura Tyson, who used to chair Bill Clinton’s Council of Economic Advisers and now teaches about emerging markets at Berkeley. The Gulf states are trying to use their wealth to generate ‘higher living standards over the next 100 years, not squandering it on the high life like they did in the 1970s’. Despite much talk about their desire to switch to the euro or even make it the next reserve currency, ‘they are not dumping the dollar, they are continuing to make long-term investments,’ she points out. Indeed, bailing out the developed world’s banking system seems heroically generous of them. All of which, says Ms Tyson, ‘underscores the extent to which emerging markets now recognise that their well-being depends on the stability of the international system.’ Forms of state ownership will become more common, she concedes, ‘but so what? The simple dichotomy between private and state-owned does not tell us very much at this point.’ To be on the safe side, Messrs Gilson and Milhaupt propose that shares in American firms that are bought by sovereign-wealth funds should have their voting rights suspended until they are sold again. This would beef up existing arrangements that protect American firms from foreign ownership where national security is seen to be threatened. Without the voting rights, the sovereign investors could not interfere in the activities of the firms they buy, but if the suspension is only temporary, the funds would not suffer any financial penalties. This looks like an elegant solution, but it is not clear if it could be enforced. Moreover, it would make sense only if there really is reason to worry about the intentions of sovereign investors. If their intentions are good, the proposal would rob capitalists of their ability to play a value-creating role in the governance of the firms they invest in. … Perhaps well-motivated, well-run sovereign-wealth funds with long-term investment horizons could help create a more effective system of corporate ownership than today’s often short-termist investors. Let’s hope so.”

I’m encouraged by the fact the emerging market countries with sovereign-wealth funds are acting in a “heroically generous” way. I’m encouraged that they looking long-term and investing for a better a future — a future they realize they can’t achieve without a growing global economy. The West needs to come to the same realization and work with emerging market countries to create a future that benefits us all.

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