Sovereign Wealth Funds – The New 800-lb Gorilla

Sovereign Wealth Funds – The New 800-lb Gorilla - By Ramesh Ramanathan

May 21st saw yet another story on China, but with a difference: this one has such deep significance that it could reshape the world’s financial markets. The country announced a $3 billion investment in Blackstone, one of the world’s premier private equity firms. Behind this $3 billion is another $1.2 trillion of governmental reserves - the trickle coming out of the sluice gates of a gigantic dam that could wash away many vessels in the financial waters. The event will have players looking fearfully over their shoulders as they determine demand-and-supply for global assets, wondering how economic nationalism would play out.

China joins a growing tribe of country-led strategic financial investors. Collectively called Sovereign Wealth Funds (SWFs), this group has crept up on the global financial community by stealth. While experts are divided on the long-run implications of SWFs, there is no question that they will be the biggest force on the markets for the next few decades.

I want to talk about two specific aspects of SWFs, one in this piece, and the second in my next column. But first, a quick primer. To begin with, their size: $2.5 trillion, projected to go up to $12 trillion by 2015. They are already larger than the global hedge fund industry. By 2011, they will exceed the total foreign reserves of countries. SWFs hold over 40% of total cross border flows already, and are equal to the total global FDI and portfolio investments.

Countries with SWFs include UAE, Kuwait, Norway and others, with Singapore as a rare non-commodity driven player. Stephen Jen of Morgan Stanley – one of two prolific writers on SWFs - states, “Currently, SWFs from oil and gas exports account for two-thirds of the total, with the rest mainly controlled by the Asian exporters. The share of oil-centered SWFs is expected to decline, reaching 50% by 2015.”

How important are SWFs to their countries? Andrew Rozanov of State Street – the other - says, “One example may best illustrate the point: Kuwait managed to regain its independence and rebuild the country after the Iraqi invasion in large part thanks to the large pool of assets accumulated and managed by KIA. This lesson is not lost on Asian sovereign wealth managers.

The SWF phenomenon should not come as a surprise: after all, why should countries continue to hold low-yielding US government bonds, in amounts far exceeding prudent norms? Like Singapore’s Temasek investments, several countries had established fund management arms while retaining access to the funds for emergency. China’s move pushed the needle one notch further: investing in an independent professional manager.

However, SWFs need not be innocent excess funds of a country being deployed for superior returns – they can be the spearhead of economic protectionist forces, taking stakes in strategic interests like natural resources, intellectual property or industry market share. SWFs could replace war and occupation to control resources. The best part is that it can be done through legitimate market channels, greased and facilitated by intermediaries like private equity firms. Viewed in this light, China’s investment in Blackstone seems not just an act of outsourcing core competence, but of purchasing very credible camouflage.

As the debates on SWFs begin, much of the criticism will be ideological: one more reason to indict market forces and greedy capitalists. However, the real issue is the regulatory architecture for these fund flows. SWFs have exploded so quickly on the global financial community that the checks-and-balances on these instruments are almost non-existent. Most SWFs are in weak democracies with poor governance systems even within their own borders. With the exception of Norway, no SWF has any publicly available information on their investments. Normally, regulations are defined and administered by governments to check private excesses. What is new about SWFs is that countries have themselves become market players. So who will guard the guards?

Current financial regulations on these cross-border flows are like wire-meshes to protect against the flu. We need a new set of global regulations, designed by governments and monitored by agencies that are yet to be set up. Almost ten years ago, in the midst of the last financial crisis, Gordon Brown said, “We need a new co-ordinating mechanism to ensure proper standards (for) international capital flows.” Aiming to define how “global markets can work in the public interest”, he suggested, “We must examine the scope for a new permanent Standing Committee for Global Financial Regulation, so that the necessary international standards for financial regulation and supervision are put in place.”

With SWFs, the need for redefining global financial regulations couldn’t be more acute. After all, there is a very fine line between a free market and a free-for-all market. _______________________________________________________________________
The author is Co-Founder of Janaagraha.