July 30, 2007
Sovereign funds shake the logic of capitalism
By Lawrence Summers For some time now, the large flow of capital from the developing to the industrialised world has been the principal irony of the international financial system. In 2007 this flow will total well over half a trillion dollars, a figure that will be comfortably exceeded by the build-up in reserves and sovereign wealth funds (SWFs) in developing countries. Indeed, Morgan Stanley has estimated on reasonable assumptions that there is now close to $2,500bn (£1,200bn, €1,800bn) in SWFs and that this figure will increase to $5,000bn by 2010 and $12,000bn by 2015. Inevitably, and appropriately, countries possessed of publicly held foreign assets far in excess of anything needed to respond to financial contingencies feel pressure to deploy them strategically or at least to earn higher returns than those available in US Treasury bills or their foreign equivalents. Even without this pressure, SWFs are now growing at a faster pace than the global rate of new issuance of traditional reserve assets. There is plenty of room for debate over how large these funds should become. (Does China really need a saving rate in excess of 50 per cent that all but forces hundreds of billions of dollars in reserve growth?) But on any plausible path over the next few years, a crucial question for the global financial system and indeed for the global economy is how these funds will be invested. The question is profound and goes to the nature of global capitalism. 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. In the last month we have seen government-controlled Chinese entities take the largest external stake (albeit non-voting) in Blackstone, a big private equity group that, indirectly through its holdings, is one of the largest employers in the US. The government of Qatar is seeking to gain control of J. Sainsbury, one of Britain’s largest supermarket chains. Gazprom, a Russian conglomerate in effect controlled by the Kremlin, has strategic interests in the energy sectors of a number of countries and even a stake in Airbus. Entities controlled by the governments of China and Singapore are offering to take a substantial stake in Barclays, giving it more heft in its effort to pull off the world’s largest banking merger, with ABN Amro. To date most of the official commentary on the issue of SWFs has been framed in terms of traditional arguments about cross-border capital flows. US and UK officials have raised concerns that focus only on the desirability of reciprocity and transparency and on how to treat sectors that trigger national security questions. Others, particularly in continental Europe, have been less positive and have emphasised nationalist considerations about the benefits of local ownership and control. What has received less attention are the particular risks associated with ownership by government-controlled entities, particularly where the ownership stake is taken through direct investments. The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence. We have seen the degree of concern over News Corp’s attempt to buy The Wall Street Journal. How differently should one feel about a direct investment stake of a foreign government in a media or publishing company? Apart from the question of what foreign stakes would mean for companies, there is the additional question of what they might mean for host governments. What about the day when a country joins some “coalition of the willing” and asks the US president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank? All of these risks would be greatly mitigated if SWFs invested through intermediary asset managers, as is the case with most institutional pools of capital such as endowments and pension funds. The experience of many endowments and pension funds suggests that this approach is in most cases likely to produce the best risk-adjusted returns. To the extent that SWFs pursue different approaches from other large pools of capital, the reasons have to be examined. The most plausible reasons – the pursuit of objectives other than maximising risk-adjusted returns and the ability to use government status to increase returns – are also most suspect from the viewpoint of the global system. None of this is to propose policy. That can come only after the investment policies of SWFs have been much more extensively debated and many details have been clarified. But it is to register a cautionary note about the debates over SWFs so far. Governments are very different from other economic actors. Their investments should be governed by rules designed with that reality very clearly in mind. The writer is Charles W. Eliot university professor at Harvard
Martin Wolf: The issue Larry raises is already important and will become much more so. I think it would help if countries with open capital markets (such as the US and UK) were to put in place some principles and procedures.
Where these sovereign wealth funds are professionally managed on a diversified basis, no issue should arise. But where the money is used to buy a large, or even a controlling, stake in specific companies, the host country should have in place a procedure for vetting the proposed transaction, to identify whether it raises issues relating to competition, security, freedom of information or similarly significant concerns. To put the point bluntly, I would not want to see some of these governments (the Russian or Chinese, for example) buying a big media company.
Furthermore, it would be good to set out these procedures now, to avoid the sort of hysteria that broke out over attempted purchases in the US by Dubai Ports and CNOOC. Finally, in my view, similar procedures should vet purchases by publicly owned companies. I cannot see the sense of privatising our companies, only to have them nationalised by someone else. Again, there should be no blanket bar. But it is reasonable to vet these transactions.
Posted by: Martin Wolf | July 30th, 2007 at 6:24 pm | Report this commentJeffrey Frankel: Sovereign Wealth Funds, the latest “new new thing”, do carry the possible dangers of which Larry and others have warned. The governance of SWFs should be made transparent and independent, on the order of good governance for central banks. Maximising risk-adjusted expected returns should be their explicitly assigned task, as price stability is the task assigned to central banks. Otherwise, in many countries, cronyism and political shenanigans are sure to intrude, particularly worrying at the international level.
Norway’s Pension Fund is the way to go. So far as I know - correct me if I am wrong - Singapore, Chile, and the UAE have pretty good records too. It is not inevitable that SWFs will make poor capitalists.
There is an irony that should be noted here. Larry (and others) have over the past year (correctly, in my view) been telling developing countries, especially Asians and commodity-producers, that they should diversify their reserve holdings out of US Treasury bills, which have low returns. The move to SWFs among new players like China is an effort to do precisely that.
The advantage of transferring the portfolio to a SWF, is that when the foreign assets are removed from the central bank’s balance sheet, the problem of sterilising reserve inflows so as to prevent inflation is automatically solved. Of course an alternative is to allow the currency to appreciate, and probably China and more Persian Gulf states should be doing that.
But if the producer of a booming commodity wants to avoid the Dutch Disease - real appreciation, loss of manufacturing exports, reduced international investment position - SWFs are one way of doing it. Admittedly, if domestic private sector investors went abroad, which is currently impeded in countries with capital controls, the same goals would be accomplished (saving, and staying price-competitive), while avoiding the tricky question of whether a SWF can stay out of politics.
Posted by: Jeffrey Frankel | July 30th, 2007 at 7:27 pm | Report this commentTed Truman: Sovereign wealth funds certainly are the topic de jour as the Financial Times has demonstrated via its extensive recent coverage. Until recently they were an obscure breed of official investment vehicle, but the problems they raise in terms of domestic management and international tensions are not unique to such funds. The same issues are involved in all cross-border government investments which are at sharp variance with today’s market-based global economy and financial system and carry risks to its continued openness.
These risks may be reduced but not mitigated by the use of intermediary asset mangers. Those asset managers operate under instruction from their investors and often are as opaque as the sovereign wealth funds themselves.
Pratices in terms of transparency and accountability vary. Jeff Frankel is right that Norway sets a high standard, but he is incorrect about Singapore where the Government of Singapore Investment Corporation provides no systematic information on its investment strategy or investments and Temasak only began to release an annual report a few years ago. The Abu Dhabi Investment Authority is also very opaque.
Finally, setting up an sovereign wealth fund does not guarantee avoidance of the Dutch Disease. That depends on how well it is integrated into the country’s fiscal syttem.
Posted by: Edwin (Ted) M. Truman | July 31st, 2007 at 10:41 pm | Report this commentBrad Setser: Dr Summers draws attention to an important set of issues. I also found his recent column consistent with his earlier position. If my memory serves, his earlier argument included a suggestion that sovereigns seeking better returns hand their money over to transparent, independent outside managers.
The scale of the potential shift towards sovereign wealth funds is breathtaking. Until recently, the main sovereign wealth funds came from a set of fairly small oil exporting economies in the Gulf (Kuwait, Qatar and Abu Dhabi), Norway and Singapore. High oil prices and relatively low spending meant that they probably combined to transfer between $100 and $150bn to investment funds in 2006. We also know that Norway transferred $50bn to the Government Fund, and we also know that maintaining a 60 per cent fixed income share of its portfolio in a rising equity market implied that well over 60 per cent of the 2006 flow went into bonds. The small Gulf don’t directly report the size of the transfers to their funds or their portfolio targets but the available data suggests that they probably combined to transfer a bit more to their oil funds and put a higher fraction of the flow into equities.
$100bn plus isn’t small. But it could be much bigger. Saudi Arabia, North Africa, Subsaharan Africa and Russia generally still park their surplus oil revenues in central bank reserves. And in Asia, only Singapore has had an active investment fund. In the first half of this year, central banks – led by China - added at least $500bn to their reserves while the oil funds probably received only a bit over $50bn. The creation of China’s fund and plans for a Russian fund suggest that n the first half of next year, $300bn might be invested through sovereign wealth funds and $250bn as central bank reserves.
That is why it is important to clarify the ground rules now. This could be difficult. Some of the funds that Dr Frankel lauded as well-run are anything but transparent and independent. It isn’t clear to me that the political will exists to force ADIA to be more transparent either – lots of fund managers make a lot of money managing ADIA’s money. China can reasonably ask why its fund should be held to a higher standard than the world’s biggest sovereign wealth fund.
I am a bit less persuaded of the case for using sovereign wealth funds to sterilize the oil windfall and avoid Dutch disease than Dr. Frankel. I see the case for Norway, which will run out of oil soon. I see the case for Russia too – it too will run out of oil relatively soon and has a large population relative to its oil production. Nigeria, too.
But the small sheikdom’s of the Gulf don’t have a manufacturing sector to worry about. Nor is it obvious that they should aim to create one. Why compete with China is you don’t have to? Abu Dhabi has maybe 1 million native born inhabitants. Its oil export revenues are roughly $50bn a year ($50,000 per person). Its production costs are low. It already has perhaps $800bn in its wealth fund. Distributing the income from oil and the investment fund reasonably equitably would be more than enough to guarantee all its residents a very nice standard of living. Rather than using its oil investment fund as a sterilization tool, it would be better served by letting its currency appreciate in real terms.
Posted by: Brad Setser | August 1st, 2007 at 4:43 am | Report this commentGuy Henriques (guest commenter): Many of the comments made in the debate over the dangers of SWFs seem to anticipate a malevolent action by one of the several emerging economies identified. Such risks may exist, but is there any evidence, such as a past event or series of events, that would help to quantify this risk in any useful way?
Comments have been made within the SWF community that certain commentators, notabey in the US, are guilty of some prejudice in assuming that large SWFs were unlikely to put shareholder value as the main priority – or at least would abandon it at the push of a button. It could equally be argued that the very establishment of these funds is a strong indication that their primary goal it to enhance returns. It is always possible to imagine unpalatable international scenarios, but risks must be identified on objective grounds. The presumption that an opaque hedge fund may be more acceptable than an opaque SWF, on the basis that it is more likely to have capitalist principles at its core, has not been thoroughly researched.
(Guy Henriques is the Head of Official Institutions at Schroder Investment Management.)
Posted by: Guy Henriques | August 1st, 2007 at 12:09 pm | Report this commentJohn Willman I am not an economist, but I did write the analysis piece on sovereign wealth funds that was published on the same day as the Lawrence Summers piece. I am also a great believer in privatisation. But I cannot agree with my esteemed colleague Martin Wolf that acquisitions of privatised companies by nationalised industries from abroad should be blocked.
Posted by: John Willman | August 1st, 2007 at 6:12 pm | Report this commentThe reason why I support privatisation is that I do not believe my government is a good owner of commercial assets. It wastes my money as a taxpayer, and it protects monopolies that are not in the public interest. Once privatised, the monopolies are broken up and there are regulators to protect the public interest - either industry ones in utilities or general competition regulators elsewhere. If a foreign government-owned company chooses to buy one of the privatised elements and the regulatory regime is effective, the only person at risk is the foreign taxpayer whose capital is probably being misallocated.
These arguments were rehearsed in the 1980s when the UK Trade Secretary Peter Lilley attempted to block acquisitions of privatised companies by foreign state-controlled industries. The so-called “Lilley Doctrine” resulted in a number of references to the Mergers and Monopolies Commission in the early 1990s. Four of the five cases involved, however, were cleared by the Commission, while the fifth was prohibited on normal competition grounds. The Lilley doctrine was eventually abandoned under pressure from the European Union as discriminatory - most of the references were of acquisitions by nationalised indusries in other EU states.
There has been no observable downside for the British taxpayer or consumer from French and German ownership of water or electricity companies. The Singaporean taxpayer, by contrast, has paid dearly for the poor decisions of GIC and Temasek over the years.
Utilities are particularly straightforward in this context, since - unlike manufacturers or services - they cannot easily be closed down or removed from the country. Meanwhile capital is released from mature industries for investors to redeploy more effectively in growth opportunities (perhaps even in the countries that are home to the acquirors of utilities).
I certainly agree with Guy Henriques that once you start screening acquisitions for the motivation of the acquiror, it is a slippery slope that will lead to similar approaches for hedge funds and private equity. Nobody would benefit from that!
Martin Wolf: I have to admit that I think John is partly right. I certainly have no problem with purchases by EDF. But what is one to think of purchases by companies that are clearly arms of not particularly friendly states - Gazprom, for example? Surely, we should examine such bids. What about a bid by a state-owned company for BAE?
Posted by: Martin Wolf | August 2nd, 2007 at 5:23 pm | Report this comment