Sovereign Wealth Funds and their impact on Global Economics and Financial Markets

Diplomarbeit von Milena Ruland

Introduction:

Global economics is the collectivity of all international economic connections and relations. Global economics constitutes a worldwide integration of different markets, for example financial markets, merchandise markets, labor markets, and technology markets; but also constitutes the creation of a worldwide financial system, which precedes global economic policies. The globalization of the last century brought substantial advantages, especially to developed countries. The openness of financial markets, growth of global players like transnational corporations, and the formation of regional economic zones, expedited this globalization. International institutions like the World Bank, International Monetary Fund (IMF), and the World Trade Organization (WTO), were established to oversee the processes of globalization, promoting growth and managing adverse consequences in the global financial system. Emerging markets have now become bigger players in a global financial system that was lead for the longest time by the United States (US) and Europe.

In the last decade, financial markets around the world grew substantially, generating new financial tools without being regulated enough. The current credit crisis is showing that the existing financial system has weaknesses, and government participants like sovereign wealth funds (SWFs) from developing and emerging countries are, now more than ever before, playing a more influential role in the financial system and on financial markets. The developments in the financial system are showing that SWFs have gone from being unnoticed in the last century, being feared in the first few years of the 21st century, to being welcome saviors in 2007 and 2008. The fear was based on the substantial growth of SWFs not only in size but also in numbers, as well as their lack of transparency. Considering that systemically important countries like China and Russia established funds in the last two years, the issue of transparency became even more important.

The growth of SWFs and the location of the countries where they originate brings with it implications for a shift of global political and financial power. Politics and Finance cannot be kept separate. Countries like Brazil, Russia, India, China and other Asian countries are quite heterogeneous in their growth process but they are all new financial players in a globalized world. Their new financial power brings with it a demand for more political power. Jin Liquin, supervisory board chairman of China Investment Corporation (CIC), indicated in November that it stood ready to help the IMF bail out countries hit by the global credit crisis: ‘The question is whether developed countries are ready to accept China as a major player. If you want China to take out money when the crisis happens, but give China little power when voting, nobody is going to play with you.” Not only international institutions like the IMF are asking for help from countries which hold large foreign exchange reserves and established SWFs, e.g. China, other private participants in the financial system like commercial banks try to make deals with SWFs since they are a provider of needed liquidity as well.

While the global economy is slowing down and many Western financial institutions and private participants are struggling, SWFs have been investing and hence provided Western companies with needed liquidity. Between March 2007 and June 2008, SWFs invested $59 billion into Western financial institutions, including high-profile equity purchases of Barclays, Citigroup, Credit Suisse, Merrill Lynch, Morgan Stanley and UBS. Even though these investments are welcome, fears of SWF investments still exist due to the lack of transparency and the political motivation that might be behind some of the SWF investments.

The central purpose of this paper is to examine the possible impact SWFs have on the financial system, financial markets and economic policies. The primary focus will be on examining the investments of the ten largest SWFs. What investment patterns have occurred, and what are the political policy reactions to the rise of SWFs?

Chapter two will give a brief overview on global economics and SWFs along with the three core concerns about SWFs.

Chapter three will take a closer look at the global financial system and the different participants. SWFs, as government institutions, will be examined in detail, including the evolution, types of funds, and the sources of capital. While looking at the different sources of capital a short excursion on global imbalances and rising foreign exchange reserves will be taken. In chapter three a fund overview will be given. Further, chapter three will describe the impact SWFs have on international institutions, as well as governments, and economic policies.

Chapter four will examine the investment patterns of SWFs. The investment patterns are divided into geography and sectors, as well as asset allocation. A detailed look will be taken at foreign direct investments and joint ventures by SWFs.

Chapter five will examine whether or not SWFs have a stabilizing influence on financial markets. The focus will be on the influence of SWF investments on stock prices, as well as the share size they acquire.

Chapter six will examine the role SWFs play during the current credit crisis. The question will be answered whether or not SWFs had a stabilizing role during this time.

The paper finishes with a conclusion in chapter seven.

Table of Contents:

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Chapter 3.1.2, Central Banks:

A central bank of an economy is an institution designed to regulate the money supply. It can affect the money supply through monetary policy. In a modern economy, the central bank is often seen as the guardian of price stability. All of the tasks of central banks will not be discussed in this chapter. This chapter will look at the central bank as the collector and manager of foreign exchange assets and the relevance for SWFs.

Central banks manage foreign exchange assets largely to protect the country from sudden shortages of international liquidity. The largest accumulation of foreign reserves has been in Asian countries after the Asian financial crisis in 1997-1998, partly because the collective region-wide fear of a repeat of the Asian crisis has prompted the region’s central banks to accumulate foreign exchange reserves for precautionary purposes. The huge amount of reserves protects the region against the most immediate cause of a currency crisis- unexpected shortage of international liquidity.

Traditionally the central bank invests in safe and liquid but low-yielding US government bonds. Doing so with excess reserves is a waste of valuable national resources. The Asian Development Bank concluded that the region’s reserves levels are now higher than what the region requires for precautionary liquidity purposes. Continuing to invest in low yielding US government bonds would constrain the long-term fiscal resources. China and India, for example, are countries with long-term fiscal needs requiring ample fiscal resources. Transferring money from official reserves to SWFs gives these countries the opportunity to use the excess reserves more profitably, so that they can make a bigger contribution to national welfare. ‘Within the region, Singapore is widely seen as a role model in light for the extraordinary success of its two SWFs.’ Additionally it would give central banks the opportunity to focus on the reserves that are needed to protect the country from sudden shortages of international liquidity instead of managing huge reserve accumulations that go way beyond what is required to fulfill their task.

3.2 International Institutions:

International institutions in the global financial system are the World Bank, WTO and the IMF. In this chapter, the World Bank, as well as the IMF will be examined more closely to determine what kind of impact the investments of SWFs have on these international institutions.

The World Bank evolved from a facilitator of post-war reconstruction and development to the present day mandate of worldwide poverty alleviation. The work focuses on poverty reduction and sustainable growth in the poorest countries, especially in Africa. SWFs do not really have an impact on the World Bank. SWFs only mark another source of capital for the poorest countries in this world, especially Africa. The World Bank Group President, Robert B. Zoellick, outlined in his speech on April 2, 2008 in Washington, a plan for SWFs to invest one percent of their holdings in equity in Sub-Saharan Africa as a way of tapping long-term global liquidity to boost investment opportunities and development. Zoellick said there was an urgent need to counter immediate threats in response to the current global crisis while laying the foundations to maximize opportunity and hope for all over the longer term. He specified an initiative to help countries manage their wealth earned from high energy and mineral prices. Further, the World Bank will work with SWFs to create a ‘One Percent Solution” for equity investments in Africa. One percent of SWFs assets would draw $30 billion to African growth, development, and opportunity.

The impact SWFs could have is that through their investments in development, these funds could boost development and growth hence support the world’s poor, which is the main focus of the World Banks work. The role for the World Bank is to help create the platforms and benchmarks for the SWF investments to create growth, development and opportunity.

The International Monetary Fund (IMF) is an organization of 185 countries, working to foster global monetary cooperation, secure financial stability, promote high employment and sustainable economic growth, facilitate international trade, and reduce poverty around the world.

In 1999, on September 30, the International Monetary and Financial Committee (IMFC) was established to replace the Interim Committee of the Board of Governors in the International Monetary System. ‘The IMFC has the responsibility of advising, and reporting to, the Board of Governors on matters relating to the Board of Governors' functions in supervising the management and adaptation of the international monetary and financial system, reviewing developments in global liquidity and the transfer of resources to developing countries; considering proposals by the Executive Board to amend the Articles of Agreement; and dealing with disturbances that might threaten the system.’ The IMFC usually meets twice a year, in September or October and in March or April. In the meeting October 2007, the IMFC highlighted that SWFs have recently been recognized as well-established institutional investors and important participants in the international monetary and financial system and the IMFC expressed the need for further analysis of key issues for investors and recipients of SWF flows, including a dialogue for best practices. In May 2008, the International Working Group of Sovereign Wealth Funds (IWG) has initiated this process, which is facilitated and coordinated by the IMF.

The IWG was established at a meeting of countries with SWFs on April 30-May 1, 2008, in Washington D.C. and comprises 26 IMF member countries with SWFs. The IWG has identified, drafted, and agreed on a set of ‘Generally Accepted Principles and Practices’ (GAPP) that properly reflects their investment practices and objectives.

The GAPP have the purpose of identifying a framework of generally accepted principles and practices that properly reflect appropriate governance and accountability arrangements as well as the conduct of investment practices by SWFs on a prudent and sound basis. The GAPP covers practices and principles in three key areas, which are 1) legal framework, objectives, and coordination with macroeconomic policies; 2) institutional framework and governance structure; and 3) investment and risk management framework. Even though the GAPP are potentially achievable by countries at all levels of economic development they are based on a voluntary basis. Further, the implementation of each principle of the GAPP is subject to applicable home country laws.

The GAPP should help to increase understanding of SWFs to home and recipient countries and the international markets and thus help to calm down the wave of protectionism in some Western recipient countries. The lack of transparency has been the major issue with SWF investments in recent years. Even with the GAPP in place since 2008, governments of Western countries have approved or are considering new laws that would expand governmental oversight on inward investments or directly restrict selected types of inward investments.

The first time that international investment by a state-owned company aroused controversy in the US was in 2005, when the Chinese National Overseas Oil Company (CNOOC) attempted to purchase Unocal, only to be blocked by opposition from the U.S. Congress. One year later, Congress again blocked the acquisition of a major U.S. operating company by a foreign state-owned enterprise, this time Dubai World Ports’ purchase of operating rights to six key port facilities. Ironically, neither of these foreign companies was a SWF, yet their action fueled the discussion about the political interest of SWF investments and the protectionist actions.

In previous years, 2005-2006, the percentage of new policy actions recorded by the United Nations Conference on Trade and Development (UNCTAD) that were restrictive rather than liberalizing for foreign direct investment (FDI) had risen to some twenty percent of the total each year.

In 2007 the less favorable regulatory changes grew to approximately 25 percent, the highest number since 1992, while the total of 98 policy changes was the lowest number since 1992. The UNCTAD data shows that throughout the 1990s, policy changes were overwhelmingly favorable for FDI and the percentage of less favorable policies never exceeded 14 percent. In 2000, for example, of the 150 regulatory changes, only three restricted rather than liberalized FDI policy. As shown above, this trend has weakened in recent years. This trend has been accelerated by the concerns over SWF investments. Notably as early as 2005 new regulations and legislation came into place to protect sectors of national defense interest or national security.

New is the ‘definition’ of economic sectors and strategic industries that are important or relevant for national security. Since there is no agreement on what constitutes ‘economic security’ or how to identify a ‘strategic sector’ each government can conclude by itself which sector should be protected. Governments started to extend their coverage to additional sectors that could be relevant to national security such as critical infrastructure, energy or technology.

Among some developed countries the main concern appears to be that the funds may buy stakes in strategic industries to gain access to, and knowledge of, the latest technology. The United States Government Accountability Office (GAO) finds that the US, Canada, China, France, Germany, India, Japan, the Netherlands, the Russian Federation, the UAE, and the UK all ‘have enacted laws and instituted policies regulating foreign investment, often to address national security concerns.’ Each of the 10 countries has its own concept of national security and thus, ‘restrictions range from requiring approval of investments in a narrowly defined defense sector to broad restrictions on the basis of economic security and cultural policy.’ The growing role of SWFs as overseas investors has lead to much policy discussion. Germany has on the one hand been actively working with the European Union (EU) to establish rules for SWFs at the European level, but has also approved a national law in 2008 that allows it to block moves by foreign investors to take large stakes in German companies.

In 2005, France issued a new regulation mandating prior authorization for foreign investments in eleven sectors, which could affect national defense interests. Japan followed in August 2007, with regulations of inward investment to address the ‘changed security environment surrounding Japan and trends in international investment activity.’ In February 2008, Australia joined the group with six principles that will govern reviews of foreign investments by SWFs and other government-linked entities.

Even though the discussion about national security in regard to SWF investments has been fueled by some takeovers by SOEs, it should be recognized that SWFs have not caused significant financial disruption, and the majority of SWF investments does not include partial or complete control of firms. Not only for Germany but also for all other developed countries, protectionist actions should be taken with great care. A foreclosure of their markets is not an option since corporations and politicians have an interest in participating in the growth of Asia, Latin America and the Middle East. For a participation in growth the import of capital and goods is just as important as the export of capital and goods.

The security and other political concerns are not specific to the typical recipient countries but can also be observed in the home countries of SWFs. Some SWFs complained about the protectionist backlash but their home economies are significantly less open than traditional industrialized economies, especially the US and EU.

The OECD FDI Regulatory Restrictiveness Index shows that non-OECD countries are a little more restrictive than the OECD countries and that China and India are the two countries with the most restrictions, followed by Russia. Russia has managed to limit foreign participation especially in its hydrocarbons industry and is working on a legal framework to restrict foreign investments in further strategic sectors. China is protecting key industries such as telecommunications and finance, and is prohibiting all FDI to purchase foreign shares in domestic companies greater than 25 percent. The member states of the Gulf Cooperation Council have restrictions, especially shielding their oil markets.

Overall, China and Russia, two of the largest players in terms of sovereign wealth investments in the world, holding together approximately $700 billion in SWFs, are at the same time the most restrictive economies, together with India, when it comes to foreign investments in their countries. French President Nicolas Sarkozy said: ‘I believe [...] in globalization but I don’t accept that certain sovereign wealth funds can buy anything here and our own capitalists can’t buy anything in their countries. I demand reciprocity before we open Europe’s barriers.’ It is important that the liberalization of trade and investment is not taking a step backwards and protectionist actions are continuing to take place under the shield of SWF investments. The OECD guidance for recipient countries and the GAPP for SWFs provide the international community with a robust framework to build trust and confidence in SWFs and their investments through more transparency.