Sovereign Wealth Funds (SWF): Heroes or Villains?

Juan Pedro Gómez. Professor. IE Business School

1 July 2008

They are about liquidity and a desire to invest millions in leading international banks in order to leverage the subprime crisis. They are sovereign wealth funds, the new focus of debate in the western world.

In February, the Qatary Investment Authority (QIA), the Qatar government’s investment fund, purchased between 1 and 2% of the Swiss bank Credit Suisse. More recently, rumours of investments by the same fund in the Royal Bank of Scotland increased the British bank´s share price by 5% on the London Stock Exchange on 25 February.

In January this year, Merrill Lynch and Citigroup received a total of $21 thousand million from sovereign wealth funds (SWF) from the Middle East and Asia. Overall, according to Morgan Stanley, since the liquidity crisis began in August last year, more than $69 thousand million have been invested by SWF in financial groups in developed countries. There is not the slightest doubt that the money has been welcome, not only by the banks (who continue to lower the market value of mortgage portfolios and their derivatives), but also by the market as a whole, anxious for liquidity and stability. So far, SWFs are heroes.
At the same time, leaders such as Nicolas Sarkozy and Angela Merkel have promised to protect their investors and managers from the "aggressive practices" of these funds.

[*D Since the subprime crisis broke out, sovereign wealth funds have invested more than $69,000,000,000 in financial groups. *]

The president of the European Commission, Durao Barroso, commented that "we cannot allow non-European funds to be used to carry out geopolitical strategies". The European Commission has recently approved a proposal for the SWF to voluntarily subscribe to corporate government and transparency policies that are common in Western economies. And now, it would seem that for political managers and legislators they are villains.

Who is behind these funds? Are they a recent phenomenon? Should we be concerned about their movements? Are they heroes or villains?

Although the latest and "noisiest" appearances of these enigmatic players have been in the form of funds belonging to Asian countries (such as Singapore´s Tamasek fund) or the Middle East (Qatar’s aforementioned QIA or the KIA - Kuwait Investment Authority), some of the largest funds belong to Western governments, as is the case of the Norwegian pension fund, known as the "Oil Fund".

[*D The rise of prices of raw materials has permitted an accumulation of liquidity in developing countries in the Middle East and Asia. *]

Moreover, some of those who oppose these investment vehicles, such as France, have recently launched their own sovereign wealth fund. In the case of France, this is the FRR (Fonds de Réserve pour les Retraites), responsible for investing in international bonds and shares markets to cover the deficit of the public pension system anticipated as from the year 2020. Although its size (€21 thousand million) is relatively small, other Western public pension funds, such as the Canadian CPA ($120 thousand million) or the Dutch fund for civil servants, ABP ($227 thousand million), are among the largest in the world. Therefore, SWF are not a phenomenon exclusive to emerging economies. Nor are they a recent phenomenon, not even among countries that export oil. The KIA appeared in 1953 and was followed 10 years later by the ADIA (Abu Dhabi Investment Authority), the sovereign wealth fund of the United Arab Emirates, the largest in the world in terms of capitalisation (more than $800 thousand million).

So why this recent popularity of SWF in the media? Basically, there are two reasons: the investors and what they invest in. The continued increase in raw material prices and exports of emerging economies has produced an accumulation of liquidity in developing countries in the Middle East and Asia. At the same time, the financial crisis resulting from the bursting of the United States property bubble and, more particularly, the subprime mortgage segment has created a demand for liquidity in the western finance system. So far, the financial theory holds true: financial markets bring together supply and demand. Most of the Spanish mortgage debt accumulated in the years of property frenzy was securitised and acquired by foreign banks. And nobody seemed to care. The highest risk involved with these investors, like any other, is that they stop investing.

[*D Sovereign wealth funds are not subject to market discipline, but rather to governmental decisions, which can raise some suspicions. *]

However, the model stops working when investors are not subject to market discipline. The Norwegian pension fund, the second-largest SWF in the world, set up an ethics committee in January 2004. This committee´s mission is to ensure that the fund´s investments comply with social responsibility criteria that have led it to, for example, liquidate its positions in Wal-Mart owing to unacceptable working conditions. Ultimately, the decision depends on the Norwegian parliament as to who dictates the fundamental directives to the Norwegian central bank, the manager of the fund. In the case of other countries with a low-level or practically inexistent democratic tradition, the strategic objectives of the SWF are much less transparent. Therefore, they arouse greater suspicion. Especially when they invest in sectors as prone to injuring "national pride" as the financial sector or infrastructures. Finally, and this is the important part, the decision corresponds to a more or less democratic government, not to a board of directors or a general shareholders meeting.

Owing to their very volume, the impact of these "giants" on financial markets and their efficiency is significant and on the increase. Every investor should be concerned. More transparency and better corporate governance are desirable concepts. The same applies for SWF as for any institutional investor (collective investment funds, private pension schemes, insurance companies...): if my portfolio manager loses money, I sell my share in the fund. This discipline is good to me and it is good for the market. Yet, in the case of SWF, who controls the governments?

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