Monday, December 24, 2007

The March of Sovereign Wealth Funds

In this era of globalization and free-market economy, one would imagine that the state’s role as a market participant would dwindle over a period of time. However, that seems to be untrue in one important respect – the surge of activity in the international financial markets that has been precipitated by sovereign wealth funds that are themselves state players. A sovereign wealth fund (SWF) is defined by Investopedia as “pools of money derived from a country’s reserves, which are set aside for investment purposes that will benefit the country’s economy and citizens. The funding for SWF comes from central bank reserves that accumulate as a result of budget and trade surpluses, and even from revenues generated from the exports of natural resources”.

Although SWFs have been in existence for nearly half a century without much fanfare, they have recently become the subject matter of contentious debate in the international financial circles. The concept of the SWF has assumed significance because of the exponential growth in its size, which is currently estimated anywhere between US$ 2 trillion and US$ 3 trillion. While SWFs in countries like Norway and Singapore (through the Government of Singapore Investment Corporation (GIC) and Temasek) traditionally managed substantial investments, the recent surge in sovereign wealth is due to increase in commodity prices, oil in particular, that has left several SWFs in the Middle East flush with funds (a.k.a Petro Dollars). Examples are the Abu Dhabi Investment Authority, Kuwait Investment Authority, Qatar Investment Authority and similar entities in Saudi Arabia. China too set up its SWF in mid-2007 the form of the China Investment Corporation (CIC) that has been modeled on the lines of GIC.

Over the last few months, these SWFs have made multi-billion dollar investments in stocks of companies situated in various countries around the world. A bulk of these investments have been made in US companies, such as Citigroup (by Abu Dhabi Investment), UBS (by GIC), Blackstone (by China Investment) and even London Stock Exchange (by Qatar Investment). It would not be long before Indian companies begin attracting large sums of money from SWFs, as it is a favourite investment destination for such funds as an emerging economy. Since SWF investment transcends beyond a pure commercial transaction, there could be sensitive issues of national sovereignty that might be affected by these investments. This would require appropriate consideration by the Indian regulatory authorities (such as the Ministry of Finance, Reserve Bank of India and the Securities and Exchange Board of India), which are reportedly seized of the issue already.

Some of the risks that the authorities need to be cognizant of are as follows:

1. Market Impact: Since the investments by SWF could be of gigantic proportions, any withdrawal of these investments over a short period of time could adversely affect stock markets in which investments have been made, as this could trigger a massive fall in stock prices. Such impact was felt by the Asian economies during the Asian financial crisis of the late 1990s when foreign investors such as hedge funds and other institutions pulled out these markets all of a sudden thereby exacerbating the collapse of these economies.

2. Security Concerns: There are certain sensitive industries such as defence equipment, telecommunications, media and the like where investment by foreign sovereign entities would be of grave concern to recipient countries’ governments. Even countries such as the United States (US) that led the free-market and liberal investment policy juggernaut have taken to closed-door policies when it came to such sensitive sectors of the economy. For instance, recent amendments to the US legislation governing the Committee on Foreign Investment in the United States (CFIUS) give wide powers to the US Government to block deals by foreign players that are against US national interest. These legislative changes were triggered due to overtures in the past by the state-owned China National Offshore Oil Corporation (CNOOC) to take over Unocal, and by Dubai Ports World to acquire Peninsular and Oriental Steam Navigation Company, that were eventually warded off by the US. Even key European nations, through outspoken heads of states in the likes of Angela Merkel (of Germany) and Nicholas Sarkozy (of France) have called for protecting important industrial sectors from political influence of other nations.

3. Political Influence: Some commentators perceive a risk that investing sovereigns will exercise political influence by leveraging their large stakes in the markets of other countries, although it is not entirely clear whether such instances have yet occurred. Fears have been expressed that investing sovereigns could lobby for favourable tax treatment, special benefits for companies in which they have invested and the like.

4. Lack of Transparency: Unlike financial investors and commercial entities that are answerable to their shareholders, and thereby have disclosure and reporting requirements, SWFs by and large do not have similar obligations. Hence, their investment policies and strategies are shrouded in secrecy. Information about investment patterns of SWFs may not be generally available in the financial markets or to countries in which they make investments.

In this background, there appear to be two schools of thought emerging with respect to SWFs. The first school takes a more liberal approach, whereby commentators argue that SWFs should not be restricted from investing in other financial markets and ought to be treated on par with commercial investors. They urge a dispassionate and financially prudent strategy on the part of recipient countries. The only area where they call for a different approach is to enhance disclosure obligations on SWFs so that an element of transparency is introduced in their operations. Finance & Development, a quarterly magazine of the International Monetary Fund (IMF) states “[t]here's no apparent reason to see the continued existence of these funds as destabilizing or worrying. In fact, the IMF has strongly encouraged exporters of nonrenewable resources to build up exactly such funds in preparation for a “rainy day.”” Similar views have been adopted in where Vinay Nair, a senior fellow at the Wharton Financial Institutions Centre argues:

“Not all sovereign funds are similar. Moreover, in my view, laws curbing capital inflows are unlikely to be helpful. Such regulations are often blunt instruments. Capital is an important ingredient of development – especially in India, and the country needs to attract overseas investment to sustain the world’s second fastest pace of economic growth. At such a time, laws that place investment barriers on SWFs would be a step in the wrong direction”.

On the other hand, there is another school of thought that adopts a more cautious approach. In an earlier article in DNA - Money, Mukul Asher states:

“Open societies with still-developing regulatory, and data gathering and mining capabilities such as India need to be particularly cautious when the investments by the SWFs are involved in strategic areas such as banks, telecommunications, and ports.

There is a possibility of national policies being undermined by transactions undertaken by SWFs of different countries. India also needs to substantially enhance its regulatory and monitoring capacity for not just approving the foreign direct and portfolio investments, but also their behaviour over time. India should consider developing a database of foreign investments by type of financial institutions, including SWFs.”

In a recent article in Rediff Money, MR Venkatesh argues:

Obviously, all this is not about economics, as it seems on a superficial level. As SWFs deploy their assets, political friction with target countries is likely to accelerate. No wonder many countries have now put in place well-defined foreign investment review processes.

It is indeed time that the Indian regulators too discuss this issue and ensure appropriate policy response to this vexatious issue. Nevertheless, what is ironical to note here is that globalisation had contained the seeds of this protectionist state of play -- a point that was missed by many.

Obviously, the challenge to the policymakers is to find a balance for government-backed funds that contain geo-political issues without discouraging orderly global movement of capital -- a Herculean task considering the inherent paradox contained in the idea.

Naturally issues get blurred when questions are raised concerning direct or strategic investment by SWFs -- i.e. when management stakes, sensitivity and security risks, size and, of course, strategic interests are involved. The response would naturally be equally blurred, diffused and to that extent arbitrary.

Who said capital did not have colour?”

Even though there is no consensus on the approach towards SWFs, one thing appears fairly clear – that SWFs are likely to continue to undertake substantial investments in various countries, and hence investment destinations such as India need to adopt a clear policy stance towards such investments. We could expect pronouncements not only a national level by the Indian regulatory authorities, but also from the World Bank and IMF that are currently exploring guidelines and standards for SWFs. This debate is not likely to fade away soon.
Post a Comment