28 Feb 2008

Unraveling Sovereign Wealth Funds

Quiet in prominence of late, I thought why not run a post on this burning topic which is ing a sore concern for bigger and developed nations. Though the element of law involved is not very high (or some may argue, not at all) and it is more concerned with the economic dimensions of geo-political situation of the world, yet we would try to give a lucid account in the way we have been doing for over two months now.
What are Sovereign Wealth Funds?
As one can make out, these funds have something to do with sovereignty and given the fact that only countries are sovereign in this geo-political world (though a political scientist would frown at this statement), so sovereign wealth funds have almost anything and everything to do with the countries of the world. To put it the other way round, they represent the reserves of a country which it decides to invest (just like an individual investor does) in an activity which it finds profitable and returns yielding.

The starting point of these funds come from the fact that instead of having a deficit (which most countries, including the United States, currently face) a country is having experiences a surplus on its external account. This can be on account of positive difference between its exports and imports or for any other reasons (like remittances from abroad, etc.). This surplus on external account implies that it continues to receive foreign exchange (mostly US dollars, being the principal trading currency of the world) such that it accumulates. In another situation dispute a deficit on external account, a country can continue to receive foreign exchange which may flow in the country may be because investing in that country is profitable and higher returns are expected (as in the case of India) or for other reasons (which are primarily to do with the prospects of the investment made).

In such scenarios, the host country flushes with foreign exchange. Now it is the sweet will of the country to sit on the pile of foreign exchange (which
India is doing currently) or to invest these accumulated reserves in profitable investments (which is economically correct as well and most countries are engaged in). Once a country decides such i.e. to invest its reserves, it can do it either in its own territory or buy/invest in securities abroad, or even give loan to other countries in need of it (as China is doing in most parts of African continent). Sovereign Wealth Funds are one such forms through which investment takes place.

Now, given the fact that the SWFs are generally based in countries rich with foreign exchange, it would not be surprising to find that most sovereign wealth funds come from oil-exporting countries.
Abu Dhabi's ADIA (Abu Dhabi Investment Authority) is at present the biggest sovereign fund. China's CIC (China Investment Corporation) is also in the top ten of SWFs only because of the fact that till now China has been investing in US bonds and has come out towards investing in other forms of assets as of recently. Singapore's GIC (Government of Singapore Investment Corporation) also yields a heavy name when it comes to SWFs.
Why this furore over SWFs?

Well the cause of concern over SWFs has arisen on account of the recent sub-prime mortgage crisis. Banks and financial institutions, quiet negligently I would say, have been swayed into lending money based on securities as assets which were not credible for the amounts of loans offered. Given the sudden collapse of this segment and bursting of property bubble, most banks and financial institutions across the world are finding themselves short of liquidity. Being required to write-off huge sums of money on account of bad debts from these sour turned mortgage loans, these institutions seek infusion of capital for continuing to work normally and it is here that SWFs have come into picture. Most development countries (from which the major banks and financial institutions come) are themselves facing deficits (the United States being the most particular illustration of sorts to this regard with the position of European Union though being comfortable, but still not much better), it is almost impossible for these financial institutions to get finances from their countries. Plus the amounts of money they require are so huge that it is hard for them to find investors who firstly are willing to overlook their falling credibility and reputation in markets and secondly but more importantly are willing to lend them such huge figures.

So SWFs have come out as the lenders of last resort for these financial institutions (though the Northern Rock debacle in UK shows that Central Banks still hinge on their description as the lender of last resort) . Flushed with US dollars to lend, these SWFs have made most of the importune moment when the major financial institutions of the world are in need of money. Just to list a few major players with the SWFs investing in them and the amounts, to show how far deep these SWFs have acquired a position in the markets, one may note the following;
  • UBS Group (Swiss giant) - $9.75bn - by GIC (Singapore) - 9% equity holding
  • Citi Group (largest US Bank) - $7.5bn - by ADIA (Abu Dhabi) - 4.9% equity holding
  • Och-Ziff Capital Management Group (a US based Hedge Fund) - $1.1bn - Dubai Investment Company - 9.9% equity holiding
  • London Stock Exchange - (unknown) - Qatar Investment Authority - 20% holding
  • Carlyle Group (world's largest private equity firm) - $1.35bn - Mubadala Development Co. (Abu Dhabi) - 7.5% holding
  • Barclays (a UK banking giant) - $3bn - China Development Bank - 3.1% stake
  • Morgan Stanley (a US Banking giant) - $5bn - China Investment Corp. - 9.9% stake
  • Merill Lynch (another US Banking giant) - $4.4bn - GIC (Singapore) - (unknown)
It is therefore clear that these SWFs have penetrated deep into the major financial institutions which have an impact on the international affairs in a major way. The bigger the stake in these institutions, the more will be the power these SWFs will yield on the boards of these institutions and the more impact they will carry on the decision making process of these institutions. It has already been noticed that the majority of the large SWFs come from Asia and the Gulf, covering countries which do not give much thought or importance to transparency in governance and management, as the developed nations argue. For example, Wall Street Journal informs about the Abu Dhabi's ADIA publishing none of the information about its activities (purchases and otherwise) (as verifiable from its simple page website http://www.adia.ae/) and thus acts as a major barrier to estimate its interests and role play in other institutions.

It is therefore clear that with these Gulf and Asian countries getting a bulk share and consequently speaking and influencing power in these financial giants, the repercussions will definitely be seen in the developed world where these financial giants carry huge lobbying powers. Almost all major countries are worried about this power occupation by these SWFs and consequently their host countries, which will play a vital role in shaping of geo-political relations. And the reactions are for all to see.

EU calls for a code of conduct for these SWFs
and while the US Federal Reserve Chief has his own views on this, the United State Congress has come out in full force in a need to govern this increase power-grabbing tactics of the SWFs. The US Congress has already established a sovereign wealth fund task force where its close ally the
United Kingdom is ruing itself for a missed opportunity where it could itself have become a SWF. On the other hand, learning for the Asian initiative, France has sought to adopt an SWF model to regain a place in the world politics. There are concerns all around that this world's largest SWF (ADIA) would take on the Wall Street itself. So all this is happening, and happening fast. Going unnoticed for long now in international scenario, the IMF finds this as the right opportunity to grab a share of lime-light by call for action on this swift rise of SWFs but only to fall on deaf-ears I am sure.

What we have already heard it a vigorous attempt on the part of the developed nations (especially US) to talk behind the scenes to impel these SWFs to adopt transparent practices (in order words practices which will assure them that these SWFs are not trying to seek political advantage of their economic well-being). The concerns loom large in Washington and European capitals that these funds may be gaining outsized political influence and there though there is no available outcome of these talks at present, we anticipate one soon for this rapid control-seizure by the SWFs is surely giving sleepless nights to the developed countries.

As for the law part, what I personally believe, problems like these would not have arisen had there been a strong international investment law. While the 1984 GATT Panel case of Canada-Foreign Investment Review Act (or simply the 'FIRA case') promised much on bringing investment laws within the sphere of GATT (now WTO) ambit, the 1995 Agreement on Trade Related Investment Measures failed to take cues from the case and bring to the world a worthwhile international consensus on investment law. [For a comprehensive account of the position on international investment law, I can recommend this paper of mine posted on SSRN] Now that we do not have a law on that, we surely can expect some rapid measures being brought in force to deal with the current problem, which will further distort a principle-based regime in international flow of funds and investments. Nonetheless that we cannot help the past but only influence our future through the present, lets hope that a positive consensus develops on this account or else the already economically motivated geo-politics scenario would get itself ready to face another clash of civilizations.

Further re
Wikipedia on Sovereign Wealth Funds
Financial Times warning over SWFs
European Union pondering over regulating SWFs
Times Online coverage of major SWFs of the world
United States worrying over the growing influence of SWFs
A fact driven concern over Europe and SWFs
BBC discussion on the size and implications of SWFs
8. IMF coverage on SWF
Post dated additions:
1. Bank of England's policy position on SWF
2. Bruce Winfield Bean's article Attack of the Sovereign Wealth Funds: Defending the Republic from the Threat of Sovereign Wealth Funds? on SSRN.


kirchnet said...

European state-owned funds are not exactly a model for transparency, either. Maybe it would be more expedient for the EU to fix problems closer to home. See http://thedealsleuth.wordpress.com/2008/02/29/beware-of-litigious-state-owned-banks/

Tarun Jain said...

well said Kirchnet (if thats your real name), after all charity begins at home first. but then it looks the civilized nations are too civilized to even think of having tainted hands amongst themselves, less work on improving the things within ...