This week the Financial Times published the following article on sovereign wealth funds.

Sovereign wealth funds: Call for better accountability

By John Willman, Business Editor

Published: October 17 2007 07:54 | Last updated: October 17 2007 07:54

Sovereign wealth funds have hit public consciousness this year, and not just among central bankers and finance ministers at the annual meeting of the International Monetary Fund.

When Homer Simpson and his family arrive in Alaska in The Simpsons Movie, they are greeted at the border with: “Welcome to Alaska. Here’s $1,000. We pay everyone in Alaska to let us destroy the environment.”

The reference is to the Alaska Permanent Fund, accumulated from the US state’s oil revenues to benefit current and future Alaskans. Now worth almost $40bn, it makes an annual payment to qualifying applicants – the dividend this year was, in fact, $1,654.

However, the APF is a minnow in comparison with some of the better-known sovereign wealth funds, whose activities are increasingly attracting the attention of policymakers around the world. The IMF meeting in Washington this week is likely to continue discussions over the impact of these fast-growing funds and the need for greater accountability and transparency.

The accumulation of sovereign wealth funds is a reflection of the global trade imbalances that have left many countries with significant surpluses, particularly oil and gas exporters and Asian countries. The most prudent of the former have been investing revenues on behalf of future generations for decades, but many of the latter have tended to invest them in government bonds, mainly US Treasuries.

Now the countries with enormous foreign exchange reserves are looking for investments that offer better returns, stirring concerns in the countries that they target. Fears over the motivations of some of the sovereign investors are prompting calls in some advanced economies for barriers to what is effectively state ownership of key business assets – particularly in strategic sectors such as defence and energy.

Although sovereign wealth funds have been around since the 1950s, their scale has increased dramatically in recent years. The IMF estimates that, from $500bn in 1990, their holdings have now reached $2,000-$3,000bn and could be worth $10,000bn by 2012.

More than 20 countries have such funds, with the largest being Abu Dhabi – which ING, the Dutch banking group, estimates has as much as $500bn accumulated from oil surpluses since 1976. Norway’s Government Pension Fund is worth more than $300bn, and has recently announced its intention to raise its equities allocation from 40 per cent to 60 per cent. At the other end of the spectrum is a host of smaller countries, including Botswana whose Pula Fund of $5bn invests revenues from diamond mining.

The greatest frisson, however, has been created by two newer arrivals in the shape of Russia’s $127bn Oil Stabilisation Fund (created in 2003) and China’s State Foreign Exchange Investment Corporation, launched this year with an initial $200bn. The latter made its debut with a $3bn investment in June’s initial public offering of Blackstone, the US private equity group – and promptly saw the value of its investment fall 30 per cent, to derision in China.

Earlier in the summer, Simon Johnson, IMF research director, expressed concern that financial flows were increasingly going through “black boxes” and could pose risks to global stability. But in a more relaxed article in the fund’s quarterly magazine last month, he said the $3,000bn of sovereign wealth funds was “significant but not huge” in comparison with the $165,000bn global value of traded securities.

However, he said the sovereign funds were approaching the $4,000bn value of traded securities in Africa, the Middle East and emerging Europe, and the similarly valued markets in Latin America. They were also worth more than the $2,000bn under management by hedge funds, whose activities have caused regulators concern in the past.

“There’s certainly no need for dramatic action,” he said. “But as the level creeps closer to $10,000bn … the phenomenon will likely attract greater attention.”

It already has in some countries. Last year the US notoriously blocked the acquisition of five port terminals by Dubai World Ports, owned by the Gulf emirate, while a Chinese bid for Unocal, the US energy group, was scared off by Congressional opposition.

The German government is drafting legislation to block acquisitions by state-run funds in sectors related to national security and possibly energy. Germany and France are also preparing joint proposals on how to oversee such investments at the European and wider level, such as through the Group of Seven leading industrial countries.

A different sort of concern was expressed in the Financial Times in July by Lawrence Summers, the former US Treasury secretary. He warned of the risks associated with ownership of commercial enterprises by government-controlled entities.

“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.”

Prof Summers concluded that the risks would be greatly mitigated if sovereign funds invested through intermediary asset managers who would be accountable for producing the best risk-adjusted returns, as they are with endowments and pension funds.

Jeffrey Garten of Yale School of Management followed up with a call for greater transparency that would oblige the funds to publish internationally audited reports on their portfolios twice a year and give details of their investment portfolios and corporate governance. He also suggested a 20 per cent limit on government-owned stakes in western companies, plus reciprocity in terms of openness to western investment in the countries with sovereign wealth funds.

The IMF’s Mr Johnson concluded his article by saying there was no need to see sovereign wealth funds as destabilising or worrying. The Fund has, of course, encouraged commodity exporters to make exactly such provisions for a rainy day.

However, without greater accountability, fears will fester over the threat posed by the funds. While the IMF has no power to compel disclosure, which is an issue of national sovereignty, the funds will be encouraged to be more open – in their own interests, as well as those of global regulators.