Arab Sovereign Wealth Funds

Sovereign Wealth Funds: Prospects and Perspectives

The emergence of sovereign wealth funds (SWFs) as financial instruments dates back at least five decades. Fuelled mainly by record high oil prices, what makes their recent rise an important development, and a concern to the West, stems from a number of interrelated and hitherto unprecedented factors.

Middle East: September 09 – 2008, Reprinted January 17, 2009

By Dr. Mehrdad Mozayyan , AME Info

These include the funds’ colossal size (nearing $3 trillion), their rapid growth (surpassing the $10 trillion mark within ten years), the partial reversal in the direction of investment flows, now going with greater intensity from East to West, and the mostly opaque nature of the funds backing those investments.

However, as important as SWFs have become, they are often undistinguished from other investment vehicles or contingency funds.

For example, SWFs differ from Stabilization Funds, though they share similarities.

Generally, both are accumulated by windfall profits, typically from commodity exports, but the latter’s main purpose is to buffer the domestic economy from volatility created by budget shortages, inflationary pressures, and sharp or unexpected decreases in revenues. They are less exposed to risk than SWFs, because their aim is not to generate the highest returns from shorter term investments.

Similarly, Foreign Exchange Reserves (FX) and Pension Funds are distinct financial vehicles. The former generally reside with central banks, are subject to disclosure laws and oversight, are deployed in low-risk liquid assets, and are used to normalize payment imbalances or influence currency exchange rates.

The latter, like SWFs, may be extracted from excess revenues or commodity exports, but they operate more openly and are subjected to much higher restrictions and public scrutiny. For example, they must avoid risk prone or lower grade investments, because their healthy preservation for future generations is the main objective.

Differentiating Sovereign Wealth Funds

SWFs are based on current account surpluses. They differ from other state funds in that they are unregulated, are not uniformly managed, have varied and undisclosed objective, and primarily focus on well above average returns from investments made abroad.

Their global diversification allows them to sample the best opportunities, spread their risks, and by diverting their funds overseas, prevent the overheating of their local economies. They may also use part of their wealth as reserve capital for when their countries’ natural resources are depleted. Importantly, for some of the wealthiest SWFs, their sovereignty is not synonymous with true public ownership.

While SWFs gain from acquiring valuable assets in distressed sectors, they also advantage recipient organizations by ensuring their solvency and growth. They have already injected considerable capital into such major financial institutions as Merrill Lynch, Citigroup, UBS, and the Carlyle Group, increasingly playing the role of the global lender of last resort.

A credible argument made in their support is that they would not act so illogically as to harm the very organizations they invest in, nor will they affect major changes in them, since they rarely possess large enough voting blocks.

Windfall oil revenues alter balance

Until now, mature core Western economies were the sources of capital, with emerging markets situated in the periphery as their targets. This established process has been altered as windfall profits from speculative investments, high oil prices, and large trade surpluses have turned countries like China, Russia, and a number of Middle Eastern oil producers into important global investors.

This outcome has led to politico-economic worries that no state on either side of the current investment flow is fully prepared for.

Indeed, the power sovereign funds wield enables them to not just play an active role in shaping international financial markets, but also to affect the economies and key industry segments of recipient states in unprecedented ways. Therefore, should their approach alarm the West into thinking their actions are politically motivated or their investment decisions are based on quick profiteering schemes with no consideration for the host states’ sensitivities or wellbeing, protectionist measures are likely to follow.

Protectionist measures

Ironically, such a backlash would primarily come from the very governments who have been the main promoters of free flowing capital. Yet, this should not come as a surprise. Western states with dominant economies have stated their intention to protect their ‘strategic assets,’ to which we may also add key cultural sources of identity. In fact, they have already taken preliminary steps to scrutinize and at times minimize foreign ownership of such assets by those whose belief in capitalism and business ethics are at variance with their own.

Thus far, the assets in question have primarily related to national security. Surveillance issues, military matters, and energy concerns fall into this category.

A number of influential groups in Western Europe and the United States argue that the pace and nature of globalization, and the sudden rise of SWFs (in their present form) lead to economic difficulties, increased financial unpredictability, and complications in monitoring the movement of capital, even if they also generate greater economic opportunity and choice.

A main worry about the West becoming increasingly protectionist is the possibility that such a development would derail the progress made during the last two decades in promoting an open and functioning global financial marketplace. Western states can avoid this situation by understanding the evolving nature of SWFs, appreciating the advantages and opportunities they create, and providing them clear investment guidelines with limited restrictions.

International organizations like the World Bank and the IMF also play an important role in establishing unencumbered and clear procedures to help investors build lasting trust and avoid controversy.

Self-regulation for SWFs

On the part of SWFs, this situation calls for more forward planning, self restraint, and openness in promoting their image as financial partners rather than corporate raiders with uncertain agendas. Lack of knowledge or indifference to the political environment, or a feeling of entitlement in acquiring sensitive assets, can only lead to loss of trust and diminished opportunities.

Two recent examples come to mind: First, the purchase by Dubai Ports World (DPW) of a port management business with rights to service six American ports; the second is Gazprom’s efforts in accessing downstream investments in Europe, without effectively addressing an image problem that aligned it with the Kremlin.

To optimize investment opportunities and prevent controversy, statements by key fund managers like Sameer Ansari, Chairman of Dubai International Capital, to the effect that a little self regulation will benefit the system, are welcome developments.

On the flip side, condescending remarks by others that suggest that needy organizations should simply accept the capital made available to them and shut up, are steps in the wrong direction. Those who bend toward the latter stance should not forget the unpredictable nature of politics. It was not long ago when the Iran-Iraq war and large commitments to internal development projects drained the oil producers’ accumulated reserves, all within a decade.

Similarly, as demonstrated by current US economic problems, one or two false moves and an unexpected turn of events can drastically change one’s good fortune. In international economic and political relations, few steps are as damaging to that fortune as those taken with little foresight and a great sense of impunity.

Increasing transparency

Conversely, increased transparency, sensitivity, and trust will promote strong and growing global financial relations. Norway’s sovereign fund (identified as a national Pension Fund) is often sited as a model to be emulated by others, due mainly to its transparency and excellent governance.

Another example is the Irish National Reserve fund which adheres to an international code of best practice by publishing an annual report informing the public of its investment plans and strategies.

As oil prices and trade imbalances grow in favour of SWFs, their opportunities to make positive and lasting change in their respective countries and on the global scene increase. An important objective for fund managers should be to expose the key advantages they provide institutions and states that engage in business relations with them.

Operationally, what facilitates such an outcome is to clearly communicate their objectives, take the needed steps in adhering to international standards, boost their strategic decision making capabilities, and increase their emphasis on longer term planning and profitability.

Likewise, by potentially allocating a percentage of their assets to global infrastructure and development projects (including some in the West), owners of SWF will greatly enhance their international standing and goodwill. While such projects can still generate normal profits, their overall contribution in terms of helping build trust and breaking down unnecessary barriers will be significant.

Related Information:
Dr. Mehrdad Mozayyan is a former Associate professor at the Naval War College in Newport, RI, and a graduate of the Wharton School. He is currently working on business consulting projects in the UAE.

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This story was posted by Staff
Tuesday, September 09 – 2008 at 12:05 UAE local time (GMT+4)

Print Date: Saturday, January 17 – 2009 – 22:46:18 GMT+4

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