Assessing the Sovereign Wealth “Menace”

Even while Iran stirs with new centrifuges, the Mahdi army persists in Iraq, and China continues a dodgy PR campaign to abate criticism in the shadow of the upcoming Olympic Games, many Americans are learning to distrust a new foreign menace. The sovereign wealth fund (SWF) is a state-owned fund diversified across numerous asset classes, from bonds and stocks to real assets to sophisticated derivatives. Typically forming in countries with large budgetary surpluses, SWFs seek to forward national interests in the financial arena. The important question—and one increasingly plaguing the minds of citizens in first world liberal societies—is whether SWFs pursue these interests symbiotically or antagonistically. Specifically, are fund managers in the sovereign wealth arena making their investments exclusively on the basis of growth potential and value or are some investments selected for the strategic advantages they gain in the political sphere?

To understand the importance of this question, it is necessary to first understand where SWFs came from and where they are heading as a fund class. In July 1944, delegates from all 44 Allied nations descended on New Hampshire to sort out a consensus on international finance to be emplaced after World War II ended. Most of Europe and several regions in Asia lay in ruins and policymakers knew they would have an inevitably overwhelming rebuilding effort awaiting them after a peace treaty was signed. Moreover, fresh memories of the Great Depression still danced through attendees’ speeches and building on the momentum of the Atlantic Charter, the delegates wanted to create tighter fiscal cohesiveness between states. To an extent, New Deal sensibilities avowing government intervention in markets ruled the talks and the result was the Bretton Woods System of monetary management, “pegging” the US dollar to a designated unit value of gold. The US dollar correspondingly became “good as gold” and rather than keep specie in state coffers, foreign countries started to buy up large reserves of US cash as a type of national insurance policy. Central banks, the old world antecedents of today’s more proactive SWFs, were expanded to make such foreign investments in parallel.

Since that time, much has changed in the world of sovereign wealth funds. In 1971, the United States abandoned the gold standard, and while the US dollar has remained relatively stable (as hard as that may be to believe in today’s economy), SWF investors have not remained equally steadfast in their mandates. Within resource-poor, cash-rich Asian countries like Singapore and Taiwan and oil-rich Gulf states like Kuwait and the UAE, sovereign wealth investments now seek returns beyond those offered by long-term maturity, government-issued bonds. As oil prices continue to surge and as Asian exports heat up on the Chinese dynamo, the funds are stockpiling more and more power in the global economy and they are using this power in non-traditional capacities. Whereas the sovereign wealth market barely capped $500 billion in 1990, it has roared to nearly $3 trillion as of early 2008. Some projections trace toward a $10 trillion mark by 2012, and at that measure, more than 2/3s the size on the entire US economy, we have to wonder whether sovereign wealth gurus are buying up financial instruments alone or whether political leverage is the truer target of their arrows.

In the United States, certain limitations on foreign investments are already in place as per the 1950 Exon-Florio Amendment subjecting foreign direct investments to a Committee entitled to decide whether investments constitute a national security risk. Even so, when on January 15, the governments of Singapore, South Korea and Kuwait were able to effortlessly inject $21 billion into Citigroup and Merrill Lynch, both flailing in the midst of the credit crisis, watchdogs’ eyebrows piqued. Typically we think of things like energy and defense as the most primary factors behind national security, but when foreign governments can now lay claim to mass swaths of the American banking system with mere keystrokes, we have to wonder if a new paradigm is taking hold.

Further troublesome, for obvious reasons sovereign wealth funds are not held to the same levels of scrutiny and transparency as their domestic counterparts. Paralleling the problem of atomic enforcement in the early Cold War era, financial openness is now something rhetorically sought by many and actively sought by few. A xenophobic perspective construes the sovereign wealth phenomenon as a type of imperialism in the age of the merchant.

Ironically, many of the biggest players in the SWF world are nations on poor or uneasy standing with the US and nations that once suffered the brunt of “old-style” imperialism. A place like Norway ($350 billion) is unlikely to harbor secretly aggressive aims in its SWF pursuits but for countries like Saudi Arabia ($300 billion), Russia ($158 billion) and the PRC ($200 billion) such a conclusion is less automatic. Another argument posits that many of the world’s largest sovereign wealth accounts belong to small state entities like Abu Dhabi ($875 billion), Kuwait ($250 billion) and Singapore ($160 billion) that by virtue of their minuscule trading footprints are not fully incentivized to ensure persisting global stability. Bretton Woods, that made the SWF possible in the first place, may be undermined by its own spawn it seems.

But there is a flip side to this rationale resolving that reactionary protectionism on the part of nations like the US and UK has only itself to blame for any woes that might accompany the sovereign wealth boom. Both of the world’s liberal super-economies have firm legislation in place blocking out potentially malevolent investments. More and more often, though, government officials may be confusing risks to national security with risks to international preeminence. Certainly, our policymakers must remain vigilant, but they mustn’t reject honest bids for sole want of preserving the country’s station in the “commanding heights”. If anything, this sort of fiscal isolationism promises to invalidate the US economy even more rapidly than otherwise. Similar measures in Britain that saw Margaret Thatcher compel the Kuwait Investment Authority to divest from a portion of its BP holdings in the 1980s bode for an equally-dark fate: asset freezes enacted by investment recipients and levied against SWFs are nothing but a converse kind of economic hostility motivated by jealously and undirected fear.

In the international security arena, the past twenty years have seen a change from the primacy of the Cold War’s bilateral dealings to the rise of a multilateral world order. Equipped with even the smallest deposit of modern technology in the form of two dozen Stinger missiles and a few hundred walkie talkies, a backward county like Afghanistan launched itself to the forefront of global negotiations and Washington policy talks. Within commerce, we see a similar trend as ex-colonial territories and marginal zones are tentatively liberalizing to accept the full gifts of capitalism. Ultimately, sovereign wealth funds represent one facet of this politico-economic “coming of age” process: previously disenfranchised nations now find themselves with expansive cash reserves and ample opportunities to grow them.

This isn’t all bad when we consider the involved time frames and risk tolerance of national investors compared with their private sector, “hedge fund” complements. Hedge fund managers have certainly helped stimulate the national economy by injecting vital funds into US industries, but private sector investors will oftentimes have de facto short-run investment horizons. In this respect, SWF managers may be a boon to struggling businesses who want to take on investment money without taking on the operational qualifications of change-minded creditors. Despite what some analysts claim about decoupling trends, even small SWF-oriented states are impacted negatively if the US economy plummets. In an atmosphere where US businesses are struggling to avoid stagnation, SWF’s might be just what the doctor ordered. Perhaps US policymakers should seek a regulatory “Bretton Woods” consensus governing such investments long-term but for now it is unreasonable to assume that SWFs seek to undermine our security and unfair to condemn them as guilty before proven innocent.

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