Sovereign Wealth Funds

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Introduction

Creating funds to manage government wealth is not a new phenomenon. But over the past five years, wealth accumulated in existing funds has fluctuated significantly and the number of new funds has spiked. The International Monetary Fund (IMF) estimated in September 2007 that sovereign wealth funds, or SWFs, control as much as $3 trillion, and that this tally could jump to $12 trillion by 2012--though the total amount held by SWFs declined significantly during the market turmoil and commodity-price bust of late 2008. Economists and political analysts say SWFs merit analysis for several reasons. Some argue that these funds will help nations dependent on natural resources to diversify their economies, but others worry about abuses of power and urge greater transparency at SWFs.

What are sovereign wealth funds?

Sovereign wealth funds, as defined by the U.S. treasury (PDF), are government investment funds, funded by foreign currency reserves but managed separately from official currency reserves. Basically, they are pools of money governments invest for profit. Often this money is used to invest in foreign companies. For instance, China’s SWF purchased stakes in the U.S. financial firms Morgan Stanley and the Blackstone Group in late 2007. Dubai’s SWF has bought up shares of several Asian companies, including Sony.

Are SWFs the only way countries hold money?

No. Robert M. Kimmitt, then deputy U.S. treasury secretary, distinguished among four different kinds of sovereign wealth in a 2008 Foreign Affairs article: SWFs, international reserves, public pension funds, and state-owned enterprises. International reserves are the funds countries hold for use by their treasuries or finance ministries and central banks. Public pension funds hold the funds that states promise their citizens (Kimmitt noted that these funds have traditionally kept low exposure to foreign assets). State-owned enterprises are companies fully or partly managed by the state, each of which may have its own assets and investments.

In contrast to these other forms of government assets, SWFs typically seek riskier investments and a higher rate of return. Ostensibly, they are run purely to increase the wealth of the state, not to pay off any specific debt.

Are all SWFs the same?

No. Some SWFs trade using funds earned solely from commodity export revenues, and others use solely foreign exchange reserves. Kimmitt noted in Foreign Affairs that these two types of funds often serve very different purposes for the countries managing them. Commodity funds can be used for several purposes, including fiscal revenue stabilization and to prevent foreign exchange funds from fanning inflation (in the latter case, the fund would essentially work as a buffer, preventing too much money from entering the country’s economy all at once). Non-commodity funds, on the other hand, are more commonly used to make stand-alone investments, particularly when a country feels it has accumulated "excess" foreign reserves in a particular currency. Some countries, particularly resource-rich states, signaled in 2007 that they believed they were overly invested in U.S. dollars and intended to diversify these holdings profitably through investments made by SWFs. Member states of OPEC, the Organization of the Petroleum Exporting Countries, have discussed the issue and said they will study whether oil should be priced in a currency other than dollars, to help them scale back their dollar holdings. The urgency of this debate lost steam during the second half of 2008, however, as the dollar rose against several other major currencies.

How do SWFs compare to other major funds?

In late 2007 and early 2008, particularly as the price of oil and other commodities surged, many sovereign wealth funds swelled. According to September 2007 estimates from Morgan Stanley, the largest sovereign wealth fund, the Abu Dhabi Investment Authority (ADIA), controlled around $875 billion in assets at the time. As of early 2008, the total assets of SWFs, estimated at nearly $3 trillion, surpassed the $1.5 trillion managed by hedge funds worldwide-but were dwarfed by the $53 trillion managed by institutional investors like pension funds and endowments. A September 2007 article in IMF magazine Finance & Development summarized that the assets controlled by SWFs worldwide are "significant but not huge" compared to the total amount of assets denominated in dollars worldwide (more than $50 trillion at the time). The total holdings of SWFs plummeted, however, as oil prices collapsed in the latter half of 2008. In a working paper (PDF) published in January 2009, CFR’s Brad W. Setser and RGE Monitor’s Rachel Ziemba estimate that the SWFs and foreign-currency funds of the Gulf Cooperation Council (GCC) lost about 27 percent of their assets, or $350 billion, in 2008. The paper only makes estimates for the Gulf region but notes that other countries, including Russia and Norway, also saw significant losses in the funds through which they manage foreign assets. During this period, the holdings of other major investment vehicles, including many hedge funds and pension funds, have also plummeted, so it is unclear whether the percentage of global investments controlled by SWFs shrank much.

What accounts for swings in the size of SWFs?

A rapid rise in the price of major commodities between 2000 and 2008 greatly increased the cash holdings of some exporting countries, enabling them to seek new ways to diversify their wealth. The Economist said in May 2007 that oil-producing countries at the time accounted for two-thirds of the total wealth of global SWFs. In 2008, crude oil traded as high as $147 a barrel, marking a dramatic rise from prices of just over $10 per barrel in the late 1990s. During much of the 2000s, the falling dollar added another incentive for exporters to sell their currency reserves, given that oil is priced in U.S. dollars. A December 2007 report by Setser and Ziemba, published by RGE Monitor, said, "With oil at or above $90, the future size and market impact of the large gulf funds is hard to overstate." This trend was reversed, however, in late 2008 and early 2009, as oil prices fell sharply, hitting lows below $40 a barrel. In their January 2009 paper, Setser and Ziemba argue that with oil at $50 a barrel, GCC sovereign wealth funds are unlikely to expand, and that lower oil prices might force them to sell foreign assets and contract.

Broader geoeconomic trends like global trade imbalances also contribute to swings in sovereign wealth. A June 2007 paper from the National Bureau of Economic Research, a nonprofit research organization based in Cambridge, Massachusetts, outlined the process through which countries accumulated large currency reserves during the course of the 2000s. When it comes to oil exporters, the run-up in the price of crude clearly had a direct impact on the size of currency reserves. But other exporters accumulated dollar reserves for other reasons. China and other East Asian countries, for instance, saw their exports soar due to favorable--and some say skewed--exchange rates. In a June 2007 interview with CFR.org, then-U.S. Treasury Secretary Henry M. Paulson said the exchange rate of China’s currency has become "severely unbalanced" and "doesn’t reflect reality." Paulson noted that this exchange rate allowed China to build large dollar reserves--reserves which Beijing then sought to diversify, in part through SWFs. While oil prices have swung dramatically, it is unclear whether China has taken a different approach toward the management of its currency. In early 2009, Paulson’s successor, Timothy Geithner, made charges against China similar to Paulson’s in his confirmation hearing (PDF) before the Senate Finance Committee.

What sorts of investments do SWFs make?

Theoretically, SWFs can invest in whatever they want, just as if they were independent investment funds. A December 2007 policy paper by the Federal Reserve Bank of San Francisco said most SWFs do not publicly disclose their investments, making it difficult to get a sense of their assets or their investment strategies. Kimmitt says most SWFs could reasonably be expected to use long-term investment strategies, and presumably wouldn’t deviate substantially from them in the face of short-term market volatility.

Some SWFs have gained public attention for specific investments. China’s fund drew headlines in late 2007 for investments in major U.S. financial firms. Analysts at Morgan Stanley says these purchases represent a broader trend-they estimate that Temasek Holdings, a fund managed by the government of Singapore, had invested 38 percent of its portfolio in the financial sector as of September 2007. In 2005, a United Arab Emirates-owned company, Dubai Ports World, stirred controversy in the United States by purchasing a British-owned shipping company, thus giving it control over parts of several U.S. port facilities. Dubai Ports World is a state-owned business, not a sovereign wealth fund, but the concerns provoked by the incident mirror concerns over SWFs purchasing business interests that had formerly been the domain of private companies.

What are the geoeconomic implications of SWFs?

Experts say the emergence of sovereign wealth funds represents a fundamental shift in the reasons governments invest money. "To the extent governments have traditionally held investment assets, it was to protect domestic currencies and banks from crisis," writes the Economist. Modern sovereign wealth funds go well beyond this basic agenda. Writing in the Washington Post in mid-2007, Sebastian Mallaby, the director of CFR’s Center for Geoeconomic Studies, said global government currency reserves had expanded "way beyond their prudential needs and more than triple the amount in the world’s hedge funds." He noted that finance ministries in the past have typically invested currency reserves in U.S. Treasury bills and other risk-free bonds issued by wealthy countries. SWFs provide countries with a broader range of investment options. This, experts say, could facilitate a gradual shift away from investments in U.S. government-backed assets, like Treasury bills, and in the dollar. The latter half of 2008 saw the opposite of this, however, as investors spooked by the global economic crisis poured money into these assets as a safe haven, prompting a spike in the value of the dollar relative to many other currencies.

What are the implications of SWFs for governments and businesses?

The gradual rise of sovereign wealth funds could, in theory, be broadly positive. More efficient government investment potentially means more government money. For the countries making the investments, this could translate into lower taxes, better public works, and stronger state-run businesses. For resource-exporting states concerned about long-term economic viability, SWFs also present a possible source of sustainable long-term capital growth. For the companies being purchased, and the countries in which they are located, capital inflows can also be a net positive. More capital means more money for research and development, and more money to pay salaries. As this policy paper published by the University of Pennsylvania’s Wharton Business School points out, Abu Dhabi’s November 2007 investment in the U.S. banking giant Citigroup was widely cheered as a boon--much needed liquidity at a time when global credit was stretched thin and the financial sector was struggling.

What concerns have been raised about SWFs?

The major looming factor is how SWFs will be used in practice. Will governments use them simply as financial tools and eye investments from a purely financial standpoint, or will SWFs emerge as an implement of political muscle? Lawrence Summers, now President Obama’s top economic adviser, wrote in a July 2007 Financial Times op-ed that the concerns raised over SWFs are "profound and [go] to the nature of global capitalism." Mallaby, in his WashingtonPost article, notes the protests of Sen. Jim Webb (D-VA), when China purchased a stake in Blackstone, and says more controversy could ensue: "Imagine Webb’s protests if the Chinese do what they say they will do: emulate one of Singapore’s national wealth funds, Temasek Holdings, which buys direct stakes in foreign companies without going through a middleman such as Blackstone." Other fears could be raised, he writes, if SWFs begin flexing the power they would wield as shareholders in foreign corporations--for instance, what if Middle Eastern or East Asian SWFs banded together to oust the CEO of a U.S. corporation? In corporate governance terms, this would be seen as positive shareholder activism, but when governments are involved, experts are left to guess at whether such clout would be used for financial gain or for political purposes.

Experts cite other concerns as well. For instance, a government could use SWFs to learn how companies in other countries operate, then use this information to bolster rival state-run enterprises. As a possible solution, some experts now push for greater international regulation of SWFs. The Wharton paper notes: "There is no comprehensive list of what [SWFs] own, nor any mandatory reporting of their investment policies." An August 2007 policy brief (PDF) by the Peterson Institute for International Economics offers suggestions for better regulation of SWFs. Edwin M. Truman, the paper’s author, suggests an international standard for cross-border investment. Such a standard, he says, should consider the objectives of a particular investment and the investment strategy of a particular fund; the governance of a fund, detailing which government officials are allowed access to fund information, and which are not; the transparency of fund activity; and behavioral guidelines, establishing how a fund is and is not allowed to adjust its portfolio.

Reforms of the U.S. Committee on Foreign Investments in the United States (CFIUS) partially address concerns over SWFs, but an October 2007 paper from the New America Foundation, a liberal think tank, calls for more sweeping reforms. A November 2007 policy paper from the conservative Heritage Foundation argues that concerns over SWF regulation shouldn’t be overstated. The paper says the government is already well equipped to address potential problems through CFIUS and other commerce and banking laws already in place.