July 22, 2007
Taming Sovereign Wealth Funds in
Taming Sovereign Wealth Funds in Two Easy Steps
Sovereign Wealth Funds are big and getting bigger. Morgan Stanley estimates that assets under management currently amount to about $2.5 trillion. Within five years, SWFs could manage funds larger than the current global stock of foreign exchange reserves (about $5 trillion). By 2015, they could collectively manage $12.5 trillion. A trillion here, a trillion there – pretty soon you are talking real money.
The distinction between official foreign exchange reserves, which are historically invested in highly liquid and safe instruments, generally of short maturity, typically managed by central banks, and state investment assets managed by SWFs, which can be invested in anything, from portfolio equity, to Blackstone, infrastructure and pork bellies, is hazy and not terribly important. Unless a country is committed to a fixed or crawling peg for the indefinite future, true reserves will be very small. Most of the $1.1 trillion still held as ‘reserves’ by the People’s Bank of China, represents in reality excessively cautiously invested SWF assets, even though the PRC appears committed to a de facto crawling peg for the Yuan for the foreseeable future.
Some of the individual funds are pretty big as well. The Kuwait Investment Authority (KIA) is estimated to hold in excess of $500 billion of assets. The Norwegian Government Pension Fund – Global (popularly known as the Petroleum Fund), holds around $333 bn; the Government of Singapore Investment Corporation Private Limited (GIC), which manages the country’s foreign exchange reserves, and therefore is not a SWF in the strict sense, has $100 bn under management. The investment arm of the Singapore governments, Temasek Holdings, has assets of $65 bn of which 25% is currently invested abroad – a fraction expected to increase to 66 percent in due course. The China Investment Corporation has assets worth $200 bn, and the People’s Bank of China still sits on ‘reserves’ in excess of $ 1.1 trillion (and rising). The Oil Stability Fund of Russia currently has assets worth $75 bn. In addition, the Central Bank of Russia sits on foreign exchange reserves of well over $200 bn. Saudi Funds amount to $300 bn.
Does any of this matter? It matters for two reasons.
First, if and to the extent that these SWFs are large enough to be systemically important, a failure by one or more of them – or even a significant loss suffered by one or more of them - could drag a significant number of counterparties into the abyss and thus endanger financial stability worldwide.
Second, since these funds, even when privately managed, are owned by the state and therefore controlled by the state, they could be motivated by non-commercial considerations in their transactions and investment decisions. As agents of the state, these funds are always potential instruments of foreign policy, supplementing conventional diplomatic and military methods for putting pressure on other states. Since many of the largest SWFs are controlled by governments that range from authoritarian to totalitarian, not to say nasty, one cannot view their investment decisions in the same way as the profit-motivated investment decisions of private investment funds and other private investors.
The solution to the first problem is openness and transparency. At the moment, most of these funds - the Norwegian Oil Fund is a notable exception - are as transparent as mud. We don’t know what they have on their balance sheets and what they have invested off-balance sheet. We don’t know anything about how much capital they hold, about their reserves, the liquidity, maturity and currency composition of their investments, their leverage etc. etc. We also don’t know to what extent their owner (the state) is willing and able to stand behind them financially were they to hit trouble.
Governments and regulators of countries whose residents issue financial instruments that are likely targets for SWFs should only allow the SWFs to acquire these instruments if the SWFs provide sufficient regular, independently audited information about their balance sheets, other exposures and investment strategies. Of course, we don’t today require much transparency and independently verified information either from certain privately owned investment vehicles, like hedgefunds and private equity funds. The more demanding reporting obligations I recommend for SWFs should be applied to privately owned hedgefunds and private equity funds as well.
As regards the second problem, the risk of political extortion by a foreign state-owned investor is greatest with equity investments. The risk is not altogether absent in the case of investments in fixed income instruments and other financial instruments that don’t have equity-type control rights attached. Creditors and bond holders have statutory rights that could be exercised in a way that is disruptive for the issuer of the instruments. And, provided they are willing to take a capital loss, large holders of a country’s debt (say the PRC as one of the two largest holders of US Treasury bonds), could threaten to dump them on the market, driving US rates up sharply, unless certain political concessions are made.
Ordinary equity however, gives control rights as well as rights to the residual income of the entity that issued the equity. This creates a real problem. No UK government would or should accept a situation where the Russian Oil Stability Fund buys control of some strategically important gas or power distributor in the UK, let alone of key bits of the pipeline system or grid. It would be equivalent to selling these assets to Gasprom or directly to the Kremlin. Since the Russian state has already chalked up quite a record - in Ukraine, Moldova, Turkmenistan, Belarus and other countries in Central Asia - for using Gasprom as an instrument of Russian foreign policy, the Russian Oil Stability Fund can never be trusted to act as a normal profit-driven investor.
The solution is simple. SWFs should only be allowed to invest in equity that does not have control rights attached to it, that is, non-voting stocks and shares.
Labels: Economics, Financial Markets
