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The sovereign wealth fund debate continues

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13 December 2007 08:04

Reader Paul Dickie has this to add to the debate, which started with my post here, and continued with responses from Kerry Duce and Peter McCawley:

Investors and policy makers are now up at night worrying about sovereign wealth funds, those in-the-news investment funds controlled by foreign governments. Not small by any means, they currently control in the neighborhood of $3 trillion dollars, and if the International Monetary Fund projections are correct, they could control up to $12 trillion by 2012 at current exchange rates.

So who are the holders of sovereign wealth funds?

The most prominent is China, which has created the China Investment Corporation, capitalized at $200 billion and which has notably taken a $3 billion stake in the high profile US hedge fund Blackstone. But additionally, Chinese state-owned banks have been taking stakes in Barclays, Bear Stearns and South Africa’s Standard Bank. And in addition to investing in mineral resource developments in Africa, the current concern, as reported by the Financial Times, is that one of the Chinese state entities may attempt to acquire Rio Tinto, which has been a takeover target of BHP Billiton. Naturally as a large consumer of iron ore, a state-owned Chinese investor would like to keep iron ore prices low by blocking this merger. Interestingly, a holding of more than 15% of dual-listed Rio Australian shares could be blocked under foreign ownership rules. However, the balancing of such competitive concerns is more appropriately within the domain of the concerned regulatory bodies that will be called upon to rule on any potential BHP Billiton-Rio Tinto merger.

The largest single group of these sovereign wealth funds that accounts for over half of these funds resources is based upon oil wealth, given the recent high prices. Norway has one of the more successful funds, but these oil based funds are also found in Canada (the Province of Alberta) as well as in Alaska, Russia and the Middle East. Abu Dhabi recently took a US$ 7.5 billion stake in Citibank in one of the recent high profile investments in American banks suffering from sub-prime mortgage losses.

But the United States and Europe are now putting pressure for disclosure on these sovereign wealth funds, given the current concerns about financial stability. The International Monetary Fund is being asked to examine their behavior and to develop codes of conduct and information disclosure rules. And this pressure seems to be working to some extent, as the China Investment Corporation for example has recently indicated that it will be more transparent.

 In the United States and Europe, the concern seems to be that political concerns will influence sovereign wealth fund decisions as opposed to being determined solely by commercial interests. In the extreme, foreign governments through these sovereign wealth funds are feared as they may be able to create havoc in global markets.

But really?  Foreign governments already have such powers through their ownership of government securities held as part of their foreign exchange reserves. If they wanted to use their assets for political ends, the potential to disrupt markets is many times higher through the use of foreign exchange reserves than through sovereign wealth funds that only represent their excess reserves.

So perhaps it is the fear that they will buy companies instead of Treasury Bills? The purchase of a company puts the money in the hands of the former owners, which is wealth enhancing or they would not have agreed to the sale.  And the sale actually enhances national security in that the company now owned by a foreign government is now a hostage in the host country. How much more security can you get?

There are even some further lessons from this broader class of stabilization funds that had their day in the sun during the 1960s and 1970s. These were meant to smooth out the income from commodities such as coffee and cocoa as well as from minerals, given that their prices fluctuated widely. Generally such funds failed because of the lack of appropriate incentives for their continued sound operations in up as well as down markets. The enviable lure of the commodity stabilization fund with positive balances meant that they were subject to all kinds of pressures to squander their available resources thorough inappropriate pricing and bad investments. It turned out that the biggest risks from these funds were incurred by their owners. These risks were even more evident in the recycling of the oil wealth from the first and second oil price shocks in 1974 and 1979/1980.

Sovereign wealth funds should be openly and warmly welcomed as unambiguously wealth enhancing. While full disclosure and transparency may not do any harm to the competitive interests of these funds and is otherwise desirable, there is no need for any such rules over and above those mandated for privately held investments. Governments as owners in competitive markets pose no threats. In fact, given their ownership in competitive markets, the likelihood is that sovereign wealth funds will function as self liquidating credits.

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