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Sovereign-wealth funds too big to ignore
Government-run funds causing heartburn in financial establishment
By William L. Watts, MarketWatch

Last Update: 1:52 PM ET Oct 20, 2007
WASHINGTON (MarketWatch) — The government-run investment pools known as sovereign wealth funds aren’t new, but they’re growing fast, causing heartburn for politicians and policymakers and leading to calls for the funds and their government masters to clarify their practices and intentions.

The concerns were pushed into the headlines Friday when finance ministers from the Group of Seven industrialized nations sat down with representatives of some of the biggest funds to urge them to increase transparency and adopt a set of “best practices.”

U.S. Treasury Secretary Henry Paulson said Saturday the G7 wants the International Monetary Fund to develop guidelines for the funds and argued that a set of best practices would help tamp down the potential for a protectionist backlash in countries where the funds invest.

“Best practices would provide multilateral guidance to new funds on how to make sound decisions on how to structure themselves, mitigate any potential systemic risk, and help demonstrate to critics that SWFs can be constructive, responsible participants in the international financial system,” Paulson said. See full story on Paulson.

Why the attention now?

Rapid growth

Buoyed largely by growing oil profits and foreign exchange reserves, funds controlled by governments in the Middle East and Asia have grown rapidly in recent years.

Merrill Lynch, in a recent research paper, estimated sovereign funds now control around $1.9 trillion in assets. And they’re growing fast, with the potential to surge to about $7.9 trillion by 2011, according to the report. Morgan Stanley estimated earlier this year that the funds could swell to $12 trillion by 2015.

Their current size exceeds the scope of the world’s hedge funds, which are estimated to hold around $1.5 trillion in assets.

No doubt, part of the nervousness surrounding the sovereign funds in the developed world stems from the potential for a political backlash against foreign-government ownership of major companies.

Nasser Al Shaali, CEO of the Dubai International Financial Center, acknowledged that the growing influence of sovereign funds from the developing world is “a bit unnerving for the powers that be.”

But any effort to establish best practices shouldn’t single out the sovereign funds, he said in a panel discussion Saturday hosted by the Institute of International Finance, but should apply to all forms of cross-border investment. Focusing only on the funds merely stirs up unfounded concerns about intent, Shaali said.

Some U.S. politicians squawked when China’s recently launched State Foreign Exchange Investment Corp. bought non-controlling shares in private-equity giant Blackstone, and also quailed at government-owned Dubai Borse’s acquisition of a stake in the Nasdaq stock market.

Profits or politics?

European Union officials had raised warning flags ahead of the G7 meeting, saying they fear some funds may aim to pursue political objectives rather than profits.

Such concerns were further underlined by former U.S. Treasury Secretary Larry Summers in a Financial Times op-ed earlier this year that questioned whether some funds would act in the same interests of traditional shareholders.

“The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares,” Summers wrote. “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.”

Others say worries are overblown.

Some of the biggest funds, including the Norwegian fund and Singapore’s Temasek Holdings, routinely purchase non-controlling shares in enterprises — a method that could serve as a solid model for some of the newer funds that have been stoking worries, said Roger Kubarych, chief economist at UniCredit.

At the same time, some large funds, including a Kuwaiti fund, often do take controlling shares and have shown themselves to be responsible stewards, he said.

But Edwin Truman, a senior fellow at the Peterson Institute for International Economics, argues that the establishment of best practices is in the interest of the countries that control the sovereign funds, ensuring that citizens know what is being done with their nation’s wealth.

Moreover, it’s important for the funds to attempt to get out in front of the issue, he said.

“Time is running out,” Truman said in the IIF panel discussion. “The political calendar has a way of accelerating these things and SWFs are on the political agenda.”

Fund scorecard

Truman has devised a scorecard that rates 32 of the world’s largest funds according to a number of criteria, including structure, governance, transparency and accountability and behavior.

New Zealand’s Superannuation Fund and Norway’s global Government Pension Fund top the rankings, while the Government of Singapore Investment Corp., Qatar Investment Authority, and Abu Dhabi Investment Authority bring up the rear. Read the scorecard.

Meanwhile, strategists are attempting to gauge how the funds’ growing footprint will affect financial markets.

Merrill Lynch economists say the funds are likely to direct more money into riskier assets such as equities and corporate bonds, enhancing liquidity.

“Investors should rejoice in the more balanced global economy and the impetus that SWFs will provide to continued growth and development of global asset markets,” said Alex Patelis, head of international economics at Merrill Lynch. “The impetus from these flows underpins continued growth of global asset markets, and the use of external managers should lessen what we see as overblown fears of protectionism.”

The growing funds may also have implications for foreign exchange markets, said Stephen Jen, a London-based Morgan Stanly economist, in a research note Friday.

The “emergence and maturing” of the sovereign funds will likely help support non-G7 currencies and put pressure on both the U.S. dollar and the euro as the funds seek to diversify their foreign-exchange holdings, Jen said.

“It will not be a tug-of-war between the [dollar and the euro] anymore. [Emerging market] currencies and equities’ impressive performance in recent weeks are consistent with this perspective on the SWFs,” he wrote.

William L. Watts is a reporter for MarketWatch.

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