Gold Sovereigns



By Bruce Stokes

Congress returns to Washington in September, and members are probably thanking their lucky stars that they weren't in town during Wall Street's stomach-churning roller-coaster ride in August. You can expect Capitol Hill to hold hearings about what went wrong with the subprime mortgage market; they are the kind of backward-looking exercise that is Congress's forte. But if lawmakers focus on the domestic financial markets' immediate woes, they're likely to ignore the next white-knuckler around the corner, and this one could be coming at them from abroad.

Global money markets are being transformed in unpredictable ways by the rapid emergence of new financial players: sovereign wealth funds. These enormous pots of money, controlled by foreign governments with large export earnings, are already bigger than the more publicized and highly controversial private hedge funds. And by 2011, these sovereign funds will exceed in value all official foreign-exchange reserves. In recent years, these funds have swelled with earnings from oil and merchandise exports that far exceed the prudent nest eggs of foreign exchange that governments keep around to ensure the stability of their currencies. And, unlike official currency reserves, which are held in short-term, highly liquid cash-type accounts, sovereign wealth funds are invested in longer-term, less liquid investments such as stocks, real estate, and other commercial assets around the world.

"The scope and scale of these activities raise profound questions about the structure and stability of the international financial system in the first decade of the 21st century," said Edwin Truman, a senior fellow at the Peterson Institute for International Economics in Washington.

Truman is no Chicken Little. A sober, veteran economist, he directed the Federal Reserve Board's international finance division for two decades. And his concern is echoed by former U.S. Treasury Secretary Lawrence Summers; Jeffrey Garten, former dean of the Yale School of Management; and a variety of U.S. government officials, among others -- individuals who have long championed foreign investment but are now sounding the alarm about too much of the wrong kind of foreign capital.

"Sovereign wealth funds are reaching a size that we have to look at them in the context of the global economy," Robert Kimmitt, deputy Treasury secretary, said in an August interview.

The tremendous growth of these sovereign wealth funds means that in world financial markets power is shifting from private actors to public ones. For years, Arab, Chinese, and Russian holders of huge dollar reserves were content to be passive lenders, buying safe, fairly liquid U.S. Treasury notes that helped Washington live beyond its means. Now these sovereign actors are becoming direct investors in the West. Their activities raise questions about their investment practices: Who is calling the shots on their deals -- money managers or politicians? What regulators, if any, are looking over their shoulders? And are they pursuing broad commercial objectives, or narrow nationalistic foreign-policy goals?

"No Western government has had the courage to admit that dealing with sovereign wealth funds may require departures from the conventional [hands-off] orthodoxy concerning global trade and investment flows," Garten said. Among measures that might be considered are new disclosure requirements for these funds; limits on foreign ownership and foreign shareholder voting rights in U.S. companies; and initiatives to constrain the buildup of these kinds of national funds.

But the current ideological hesitancy to interfere with an investor's decision-making -- even decision-making about a fund that a foreign government controls -- could disappear overnight depending on events. In the wake of this summer's Wall Street subprime mortgage debacle, all it may take is a Russian or Chinese effort to buy a major stake in a weakened European or American financial institution to trigger a public backlash akin to last year's uproar over a Dubai firm's attempt to take over major American port facilities. Imagine the outcry if, say, the American Express centurion logo was replaced by the visage of a terra-cotta soldier from Xian? Chinese Express, don't leave home without it.

Given the enormous resources increasingly available to sovereign wealth funds, such controversial investments are inevitable -- if not now, then soon. "This is a tinderbox waiting to be lit," predicted Michael Wessel, president of the Wessel Group, a Washington lobbying firm, and a longtime Democratic adviser on trade. Kimmitt agreed: "We are all in this to try to avoid any storm before it hits."

OLD BUT NEW
Public investment funds under the control of foreign governments have been around for a long time. Kuwait has channeled its oil revenues into such a fund since 1953, as has Canada since 1976. But today, sovereign wealth funds are exponentially larger, and the players are no longer only allied Western governments and friendly Persian Gulf states. They are the West's geopolitical rivals: China and Russia.

Sovereign wealth funds now total $2.6 trillion, according to estimates by Stephen Jen, head of currency research at the investment house Morgan Stanley. The Abu Dhabi Investment Authority alone controls $875 billion, and the Government of Singapore Investment Corp. $330 billion.

To put these staggering sums in perspective, sovereign wealth funds could buy a fifth of all the shares on the New York Stock Exchange. And the Abu Dhabi fund alone could purchase the entire economy of Australia, with enough change left over to buy Denmark's.

If burgeoning oil revenues and mounting merchandise trade surpluses continue, sovereign wealth funds could control $12 trillion in assets by 2015, Morgan Stanley estimates -- an amount only slightly less than the current value of the entire U.S. economy.

The exponential growth in sovereign wealth funds reflects a sea change in nations' investment strategies. For years, oil exporters and trade powerhouses have been content to build up their foreign-exchange reserves as a hedge against a financial crisis that could trigger runs on their currencies, like the one that rocked Asia in 1997. But once national reserves reached a certain threshold -- in China's case about $800 billion in highly liquid assets such as cash and U.S. Treasury notes, an amount deemed more than adequate to cover likely emergencies -- it no longer made financial sense for countries to continue adding low-yielding assets to their national portfolios. So these nations are now seeking higher yields for their investments by purchasing companies, real estate, and other traditional long-term assets.

But even if governments were not looking to maximize their returns, the emergence of state investment funds was inevitable because of the current imbalance in the demand and supply of savings worldwide. Despite Washington's chronic need to borrow abroad to finance its deficits, the pool of money in non-Western hands (held as official foreign-exchange reserves or in sovereign wealth funds) grew by a whopping $1.2 trillion in 2006 alone, according to U.S. Treasury estimates. That was the annual increment, not the total. But the United States, the European Union, and the United Kingdom -- the three principal backers of safe, highly liquid official securities -- issued only $461 billion in new government paper last year. With so much money chasing so few public bonds and notes, Arab, Chinese, and Russian holders of dollars and euros needed new investment outlets.

SIZE MATTERS
The size, nature, composition, and control of these sovereign wealth funds are now getting the attention of Europe and the United States.

Assistant Secretary of the Treasury for International Affairs Clay Lowery, in a remarkably detailed and pointed speech in San Francisco in late June, said, "What may have been tenable in a world where sovereign wealth funds manage only several hundred billion dollars may not be tenable in a world where sovereign wealth funds manage several trillion dollars."

Big investors are worrisome because they can make big, market-rattling mistakes. Kenneth Rogoff, professor of economics at Harvard University and the former chief economist at the International Monetary Fund, testified before the House Budget Committee in late June. "With deep pockets and the potential to draw on vast credit lines," he said, "sovereign wealth funds can potentially take larger and more-leveraged risk positions than even the most aggressive private hedge funds. An ill-considered massive bet by a sovereign wealth fund, or perhaps the actions of a rogue trader within a sovereign wealth fund, could cause a massive price fluctuation in a financially sensitive part of the global economy."

Another problem has arisen. To function smoothly, financial markets often assume that all other investors and government regulators have access to the same information. But Willem Buiter, a professor of European political economy at the London School of Economics and the former chief economist of the European Bank for Reconstruction and Development, recently pointed out on his blog that "most of these funds are as transparent as mud." Almost nothing is known about their investment philosophies, their holdings, and their transactions. This uncertainty fuels the likelihood that markets could move on rumors or on possibly false assumptions that governments will cover losses incurred by a sovereign wealth fund. Such misperceptions could precipitate destabilizing financial crises.

Critics also say that the funds' access to public money effectively provides them with an unfair advantage when they compete for mergers and acquisitions. "As these funds move from investing in surrogates to direct acquisitions of whole companies," predicted Todd Malan, president of the Organization for International Investment, a Washington-based foreign-investors lobby, "you are going to hear more and more from private companies that they believe it is unfair to compete against players who have access to governments' deep pockets."

NEW PLAYERS
Most important, the source of money in sovereign funds is rapidly changing, empowering new actors on the financial stage. Today, two-thirds of the capital in the funds comes from oil and gas earnings, making Persian Gulf states major players. Stephen Jen of Morgan Stanley expects that by the middle of the next decade powerhouses of exported manufactured goods -- China, for example -- will own half of the resources in sovereign wealth funds.

In the 1970s, when petrodollars flowing to the Middle East after the oil-price shocks were first recycled as investments in the West, many worried about the spread of Arab influence. But the oil-producing states proved to be largely passive investors, and the fears subsided. Now new players are again setting off alarm bells.

China's financial reserves exceed $1.2 trillion, and Jen estimates that they will total $4 trillion by 2012, even if Beijing acts to slow the growth of its current account surplus, as Washington has urged. The Chinese government has already announced plans to create a sovereign wealth fund, which is likely to start with $250 billion and grow by $200 billion or more per year. At that rate, China's fund could eventually become the world's largest.

Meanwhile, Russia plans to start its own sovereign fund early next year with what Jen estimates will be $32 billion in "seed capital," a sum that he thinks will grow by about $40 billion a year.

The West has felt only the first ripple of the Chinese and Russian investment tide headed its way. Beijing has already invested $3 billion in Blackstone, the American private-equity firm. The government-controlled China Development Bank will invest as much as $13.5 billion in Barclays Bank in the U.K. And Russian energy giant Gazprom now has investments in 16 E.U. countries. In the future, these funds will be able to afford substantial stakes or controlling interests in almost any global company that catches their eye.

ADJUNCTS OF FOREIGN POLICY
Deputy Treasury Secretary Kimmitt is adamant that the Bush administration is not worried about the nationality of sovereign wealth funds. And he says that the Chinese have reassured him that "we want to generate higher returns without generating further political controversy."

Nevertheless, the emergence of the sovereign wealth funds has raised worries about whether China and Russia will use their newfound economic clout to pursue national foreign-policy goals. Governments, after all, run the funds. The leadership of the Chinese investment entity, for example, will have ministerial rank and will report to China's State Council. "As agents of the state," Buiter said, "these funds are always potential instruments of foreign policy. Since the Russian state has already chalked up quite a record for using Gazprom as an instrument of Russian foreign policy, the Russian Oil Stability Fund can never be trusted to act as a normal profit-driven investor."

Lowery expressed concern that sovereign wealth funds will promote bad economic policy as they become just another bureaucracy interested in self-perpetuation. In China's case that could mean another powerful voice in Beijing lobbying for continuation of the undervaluation of the yuan, which fuels China's current account surplus, the source of capital for China's new sovereign fund.

So far, the political backlash against sovereign wealth funds has been strongest in continental Europe and more muted in the U.K. and the United States. Already deeply dependent on Russian energy, the Germans fear that Moscow will use its oil and gas revenues to buy up energy distribution networks throughout Western Europe, giving the Russians a stranglehold on European power supplies. A dozen attempts by Russian companies to buy shares in European energy firms fell through in 2006, in part because of local opposition.

The German government is likely to propose legislation in the Bundestag as early as this fall to vet foreign investments, much as Washington does through the Committee on Foreign Investment in the United States (CFIUS), an interagency board of U.S. government officials chaired by the Treasury secretary that looks at the national security implications of foreign investment in U.S. companies. "This is a new phenomenon," German Chancellor Angela Merkel told the Financial Times in July, "that we must tackle with some urgency.... It's responsible to have an E.U.-wide discussion about this." To that end, the European Commission has announced that this fall it will investigate whether takeovers by publicly controlled foreign investment funds are threatening Europe's capital markets.

As the financial intermediary for much existing sovereign wealth investment, London has a vested interest in continuing such transactions. So "The City" -- London's financial quarter -- shrugged off the Chinese purchase of the large stake in Barclays Bank, for example. The bigger challenge will come when the Chinese or the Russians buy a large British financial services firm. "That will really test our tolerance," predicted Jen, who is based in London.

TRANSPARENCY
What can be done about sovereign funds is now a hot debate. Truman contends that Western governments have an inherent right to regulate such entities even though they are arms of foreign governments. "Once a government seeks to operate outside its national borders," he said, "then it no longer is sovereign in most respects."

There is widespread agreement -- at least among American and European analysts -- that wealth funds should adhere to a common set of regulatory principles. Treasury's Lowery has called on the International Monetary Fund and the World Bank to draft best practices for sovereign wealth funds. And the IMF's likely new managing director, Dominique Strauss-Kahn of France, has agreed that the IMF should play a role.

"Transparency is the key," said Garten, Yale's former dean of the management school. "To be treated as normal investors, sovereign wealth funds should be obliged to publish internationally audited reports on their entire portfolios at least twice a year. They should disclose the precise mechanisms by which they themselves are regulated in their home countries. From the sovereign wealth fund disclosures we should know the fund's investment philosophy, its corporate governance process, and its risk management techniques."

Such openness would not only reassure skittish Western officials, it would also protect the stake that individual Chinese or Russian citizens have in their nations' funds. "This is their money," Truman said. "It doesn't belong to the president of the country. It belongs to the people, no matter what their political system. And they have some right to know how it is being managed."

The Norwegians provide extensive information about their wealth fund's investment strategy and results. And the smaller of the two Singapore funds recently began publishing an annual report. But such openness is the exception. The Chinese government still refuses to release much basic economic information, so Beijing is likely to resist sharing its investment plans.

Pursuing transparency in sovereign wealth funds also opens a Pandora's box. The Germans and some Asians have been pushing for greater openness by private American hedge funds, something that Wall Street has vigorously resisted. The coming post-mortems on the current credit debacle are likely to conclude that more transparency is needed throughout the global financial system. But conflating hedge funds and sovereign wealth funds confuses private-sector actors whose wealth-maximizing objectives are relatively clear, however controversial they may be, with public-sector actors whose goals remain unclear. It would be best, Garten said, to address the transparency of hedge funds and the openness of sovereign wealth funds as distinct problems.

RECIPROCITY
Another way of addressing sovereign wealth funds is to insist on reciprocity. Garten, for example, argues that the Russian and Chinese economies should be as open as the country in which their sovereign funds want to invest. The Economist has labeled this proposal "outrageous," however, because reciprocity could result in the Chinese or the Russians simply investing in countries that don't insist on reciprocity. And E.U. Trade Minister Peter Mandelson has warned that the quest for reciprocal market openness could lead to reciprocal protectionism.

But voters are likely to see reciprocity as an issue of fundamental fairness. As current European popular opposition to Russian energy investments demonstrates, it will prove difficult to defend the sale of high-profile European or American companies to sovereign wealth funds if Western investors continue to be denied the right to purchase Russian and Chinese firms.

Garten suggests imposing a 20 percent cap on ownership of any European or American company by a sovereign wealth fund that fails to live up to basic investment standards. Buiter of the London School of Economics proposes limiting sovereign funds to buying nonvoting stock. But such restrictions are bound to be opposed by free-market economists, who abhor constraints on the free flow of capital, even that owned by the Chinese and Russians. They would be forced, in these economists' view, to be passive shareholders, risking their money without any management control. Limits on wealth funds would also face opposition from some Western business leaders, who say they should have a right to sell their assets to the highest bidder.

Perhaps something can be said for the ambiguity of the U.S. method of vetting foreign investment: Reviews, which take place behind closed doors, are based on variable criteria. "That flexibility is the genius of how the process works in the real world," Malan said. "If you tie it down too much, some smart lawyer will come along and find some way around it." Of course, such subtle judgments require an administration willing to be tough on foreign investors, and not all of them have been.

Furthermore, neither Washington nor Brussels seems to have the stomach for tackling the underlying policies that foreign governments have used to create their sovereign wealth funds: Chinese currency manipulation, OPEC's oligopolistic oil pricing, and Russia's resource nationalism. "A credible commitment to bring down China's current-account surplus needs to be part of any deal that accompanies the shift in China's state portfolio toward equities," said Brad Setser, senior economist at the popular website Roubini Global Economics. Otherwise, China's sovereign wealth fund will just continue to grow, feeding a populist perception that Beijing first holds down the value of the yuan to sell more to the United States and then uses its dollar earnings to buy up bigger chunks of the American economy.

DOING NOTHING
Many economists say that the best response to sovereign wealth funds, at least for the time being, may be to do nothing.

As the world's largest debtor, the United States needs foreign capital. It is certainly better for Americans if the government balances the nation's books by attracting the kind of long-term, job-creating investment that sovereign wealth funds are likely to make. Foreigners' current practice of buying short-term Treasury notes is not necessarily in America's interest, because the capital is highly liquid and inherently unstable: The money can be here today and gone tomorrow.

Critics of sovereign wealth funds also tend to paint Chinese and Russian investors as omniscient, malevolent robber barons. But their track record -- Blackstone's stock has tanked since Beijing's infusion of cash -- suggests that the West may have little to fear from such neophyte investors.

And CFIUS rules that Congress agreed to this summer practically ensure that many future foreign investments in the United States by government-related entities will get special scrutiny. The CFIUS law may go a long way toward assuaging concerns about sovereign investment funds, at least for the next few years while the new procedures are tested. "The CFIUS bill that passed the Congress has helped the political environment significantly," said David Marchick, a foreign-investment specialist and partner at Covington & Burling. "Sovereign investment funds are something that technical experts at Treasury, the IMF, and the World Bank will continue to work away at. But I don't think the issue is going to blow up politically."

The U.S. Treasury's recent statements about sovereign wealth funds may have more to do with bureaucrats' covering their behinds than with substantive fears. The White House was blindsided by congressional opposition to the Dubai ports investment. Once burned, Treasury may now want to be on record warning about sovereign investment funds before some unexpected attempted foreign takeover makes nasty headlines. Cynics have a similar take on the call for new foreign-investor principles that would apply worldwide. By the time the IMF gets around to formulating such a code of conduct, it will be some other administration's problem.

In the next few months, Congress will be worrying about Wall Street's liquidity and stability. A House Banking Committee hearing on sovereign wealth funds, which many in the business community expected this fall, may well slide until next year. The issue is likely to be on the agenda of the G-7 finance ministers meeting in Washington in October, but more-immediate financial market disruptions will probably overshadow any meaningful discussion of the subject.

Such short-term thinking could be, well, shortsighted. "Sovereign wealth funds are about to add a whole new dimension to this black box called 'global finance,' " Garten warned. No one has a clue what to do about it. And Washington is just one controversial investment deal away from a xenophobic reaction that would further poison relations with China or Russia. It could make the Dubai ports fiasco look like a cakewalk.

The suggested cap on the shares of a company that a foreign fund is allowed to own.
The Abu Dhabi wealth fund alone could purchase the entire economy of Australia, with enough change left over to buy Denmark's. Russia, fat with oil dollars, and China, plump with export earnings, could use their funds for political instead of economic goals. Regulators say that the funds should be more transparent about their investments and financial aims.