Wooing sovereign funds for capital
By Shahid Javed Burki
Monday, 14 june, 2010
FINANCIAL innovation was the most important feature of the development of the global economy in the 1990s. It was a part of the process that came to be called “globalisation.” By now the story is well known about the use of a technique called “securitisation” and the havoc it wrought on the global financial system. That havoc resulted in the Great Recession of 2008-09.
Banks and investment houses developed new lines of products which they used to package loans they had made into investment products that were then sold to the institutions that were prepared to hold long-term paper. Some components of the packaged products were “toxic assets” – mostly loans made to households for the purchase of residences. There was no possibility that these loans would be either serviced or paid back. When that fact came to be widely known, confidence in the banking system quickly collapsed. Bank systems cannot work without confidence. Consequently the flow of capital virtually ceased for a few months. The rest, as they, say is history.
What is not so well known is the birth and rapid development of an other instrument of finance called the “sovereign fund.” As the name suggests these entities are run by governments. And since they manage vast amounts of money for investment they are gaining enormous clout in both developed countries as well as among emerging markets that are desperately short of foreign finance. The latter group of countries includes Pakistan. A large number of countries are wooing the funds to obtain capital.This is all the more reason why their operations should be fully understood.
Sovereign funds are located in the countries that have large foreign reserve holdings. Most of these were produced by trade surpluses. They are, therefore, mostly to be found in the regions that have enjoyed trade expansion, mostly exports of manufactured goods over long periods of time. This includes mostly countries in East Asia. Or they are in the countries that are large exporters of oil and other minerals. These are not only in the Middle East but also in North Europe. Norway, for instance, was the first country to launch a sovereign fund with the objective of making investments that would yield returns for the country’s future generations.
Now with the demand for commodities and metals increasing particularly by such rapidly expanding economies as India and China, the countries engaged in their production and extraction are also setting up sovereign funds of their own. Australia is an example of the some of the new entrants into this financial game.
Countries that have accumulated large foreign exchange reserves like to place them mostly in safe investments. The United States Treasuries are considered to be the safest assets available even though the rate of return provided by them is low – much lower than available from other types of investments. The conventional wisdom that guided this approach to investment was that since reserves are held to tide over unforeseen crisis they must be kept in the assets that were highly liquid. This meant gold and government paper issued by developed countries. The United States government bonds were highly valued for this reason.
There is no reliable estimate of the amount of money the funds have accumulated in the form of liquid assets as well as investments. The estimates range between $2-3 trillion with Abu Dhabi’s Investment Authority being the richest. Most, but no all, sovereign funds are in the Middle East but countries such as Australia and China are also ex panding their activities in this area.
For capital deficit countries in the Western world – a category that includes the United States and most European nations – sovereign funds helped close the gap between foreign earnings and foreign expenditures. There is some nervousness on the part of the countries that have invested huge amounts of funds in the US Treasuries that their capital may not be as secure as used to be believed. China, of course, has the largest amount invested in the US, close to a trillion dollars. Any significant change in the value of the dollar would result in a serious decline in the value of the total holdings the country has accumulated in America.
The countries receiving investments from sovereign funds have their own worries. On two occasions the United States successfully blocked intended investments by these funds in its territory. Last year a Chinese oil company partnered with the country’s fund to acquire an oil refining company in Texas. But it was not granted permission. On another occasion, a Dubai based port operator attempted to buy the P&O a well known port owner in America. This time the authorities used the powers available to them under national security to deny the sale of American assets.
There is no regulatory mechanism to watch the performance of these funds and to determine how they should be treated by the capital receiving countries. One may evolve as the fund managers begin to meet one another in formal settings.The second such meeting was held in Sydney, Australia in early May. Australia is one of the two developed countries – the other is Norway – that has also established a sovereign fund.The Australian reserves come mostly from the sale of minerals with China being the largest buyer. It calls its fund the Future Fund emphasising, one of its most important aspect: it is creating an asset base to be used in the future when the country’s mineral wealth begins to run out.
Two dozen members of the Forum of Sovereign Wealth Funds were at the meeting concerned mostly with what they called “uneven treatment”. At the same time they have begun to develop voluntary guidelines to improve transparency and governance. In this they are being helped by the IMF which, in 2007, began work with SWF to develop best practices, working with Abu Dhabi’s Investment Authority and Australia’s Future Fund. Leading funds adopted the guidelines that were developed at a meeting in Santiago, Chile held in 2008. They are called the Santiago Principles. David Murray, the head of the Australian fund said in his opening address to the forum that the group was working with multilateral agencies such as the Organisation for Economic Cooperation and Development and some United Nations bodies to foster fair treatment of the funds.
There was great clamour for transparency in the West with the sovereign funds invested heavily in the go-go markets in the early 2000s. The funds were asked to publish annual reports providing list of the assets they held. Most funds were not prepared to go along. Singapore’s Temasek was an exception which produces annual reports. China Investment Corporation that manages $200 billion of assets was not prepared to do this, fearing political pressure in the United States to liquidate some of the assets the people there may regard as being against national security. As these efforts develop it is important that countries such as Islamabad keep watch, taking care that the frameworks that evolve protect their interest as well.
It is incumbent upon the policymakers in Islamabad to develop good understanding of these relatively new instruments of finance and also develop a policy framework within which approach will be made to them to secure resources either for development or for meeting short-term capital needs.