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Commercial Question

Sovereigns Reign Supreme

updated on 08 July 2008

Question

What are sovereign wealth funds?

Answer

In an economic market where tales of financial restructuring, redundancies and insolvency are fast becoming the norm, sovereign wealth funds (SWFs) have flourished and caught everyone's attention. Their status is predominantly due to their rapid growth. They currently hold over $2.5 trillion in assets, which is more than hedge fund and private equity industries combined, and the total is estimated to rise to $12 trillion by 2015.

SWFs are state owned investment vehicles and are responsible for investing excess foreign exchange reserves allocated to them by their respective governments. Each SWF is different and is ultimately the product of its individual government. Some countries (eg, the United Arab Emirates) have more than one.

SWFs can take many forms; some of the operation vehicles that are used include:

  • a department within the government;
  • a state agency; or
  • a separate entity working with the government or central bank.

The following table lists the world's leading SWFs:

Country Year  established Assets under management ($ billion)
Abu Dhabi - Abu Dhabi Investment Authority (ADIA) 1976 875 (estimated)
Norway - Government Pension Fund of Norway 1990 367
Singapore - Government of Singapore Investment Corporation (GIC) 1981 215
Kuwait - Kuwait Investment Authority 1953 213
China - China Investment Corporation 2007 200
Singapore - Temasek Holdings 1974 108
Libya 2007 40
Russia - National Wealth Fund, formerly part of the now defunct Stabilisation Fund of Russia 2008 32
Korea - KIC 2005 20

Rapid growth

There are two reasons that can explain the rapid growth of SWFs. The first is in relation to the source of the funds which SWFs use to invest. The monies come from the excess cash reserves of a government, which tend to result from increasing trade surpluses. Currently trade surpluses are being recovered from buoyant markets such as oil. This is exemplified in the table above as it contains the biggest oil producers, namely Russia and the Gulf.

The second reason that can explain the rapid growth is linked to the current economic market and the so-called credit crunch. Private equity and hedge funds cannot access debt as easily for their typically high leveraged investments. SWFs, however, do not need debt to function due to their large amounts of core cash capital. Not only do they have a more accessible and deep pot of money but there are more investment opportunities due to many companies desperately needing capital injections. A perfect example of this can be evidenced by the recent wave of SWF investments into financial institutions. For instance the Government of Singapore Investment Corporation and the Abu Dhabi Investment Authority have each invested in Citigroup; Kuwait Investment Authority, Temasek Holdings and others have invested in Merrill Lynch; and the Government of Singapore Investment Corporation has invested in UBS.

Issues and concerns

There has been a lot of controversy surrounding the regulation (or lack thereof) and accountability of SWFs. They are currently free from any substantive regulation, albeit some will have rules to abide by, set by their own governments. As a result, they have the ability to conduct their business behind a cloak of secrecy. 

Concerns about the lack of transparency are rooted in a belief that each SWF is ultimately steered in the direction of national political goals or foreign policy. For example, the investment targets of an SWF may reflect a desire to obtain technology and expertise to benefit national strategic interests. Further, if SWFs seek to take controlling stakes or seek a formal role in decision-making in companies people fear that there will be a risk of political influence. There are also national security concerns and a debate as to whether some investments should be off limits to SWFs.

Regulation

Due to the concerns outlined above, there have been discussions to implement regulations governing the conduct of SWFs. In a European Commission's communication to the European Council it outlined how this issue should be combated. The main concern of the commission was to preserve one of the four freedoms of the single market - the free movement of capital - while simultaneously regulating SWFs sufficiently to protect public interest. This resulted in the proposal to create a voluntary code that contains overriding elements of transparency and good governance. By virtue of it being voluntary, SWFs would not have to abide by this code. However, a similar code for private equity funds was, in the majority, taken up.

This approach has been adopted by the International Monetary Fund when it created an international working group on SWFs to agree a common set of principles and practices. Its main aims are to improve transparency, predictability and accountability of SWFs. Additionally the Organisation for Economic Cooperation and Development (OECD) issued a report agreed by all OECD members and other non-member states containing principles to help governments design and implement their own policies when dealing with foreign investments, especially from SWFs.

The United States has taken a different approach, creating a set of principles whereby it contracts individually with SWFs. It entered into an agreement with the Abu Dhabi and Singapore SWFs to control how and in what they can invest within the US jurisdiction. An example of a clause from this agreement highlights that there is great concern as to the motivation behind SWF investments: "Sovereign wealth fund investment decisions 'should be based solely on commercial grounds, rather than advance, directly or indirectly, the geopolitical goals’ of the government that controls the fund."

Conclusion

Whether regulation of SWFs will lean towards a voluntary code or whether most countries will contract their own protection remains to be seen. However, it is promising that the focus on transparency and accountability has not resulted in a backlash against the funds themselves. 

The media attention surrounding SWFs has not waivered - last week an article in the Sunday Times had a headline which read "Sovereign wealth funds set for global spending spree". With such a strong political undercurrent, the focus is not likely to change for some time. It will be interesting to see how SWFs progress and develop to take account of new hurdles such as voluntary codes, contracts limiting investment and media scrutiny, while still focusing on their primary concern - managing their investments.

Christina Newton is a trainee in the corporate department of Reed Smith.