26 Feb 2009
SWFs: Hedging Bets
Having bet heavily on now ailing or defunct western financial institutions in 2007-2008, sovereign wealth funds are facing a period of retrenchment, Simon Roughneen and Diana Ionescu write for ISN Security Watch.
By Diana Ionescu and Simon Roughneen for ISN Security Watch
Sovereign wealth funds (SWFs) are taking stock of the global downturn, which has not only eaten into their revenue streams, but left the funds with registered losses of 20-30 percent on average, measured against their 2007 asset portfolio.
SWFs recent rise to prominence has sparked some public debate, and quite a bit of pundit and policymaker navel-gazing, with Cassandras lifting their heads to shout their fears of Gulf and Asian covert takeovers of key western banks and even utilities. Now the debate has capsized - with western governments seeking revenues to underwrite pump-priming economic interventions at home.
However, the SWFs are in turn more wary of getting involved in financial systems reeling from often unquantifiable toxic debts.
To illustrate, China Investment Corp (CIC) paid US$3 billion for a 10 percent stake in Blackstone Group just ahead of its initial public offering in June 2007. Blackstone's shares are now around one-seventh of the value when CIC originally paid up. No wonder, then, that during December 2008, CIC Chairman Lou Jiwei said CIC directors "don't have the courage" to invest in western financial institutions anymore.
Flying too close to the sun
SWFs recent emergence as a major player in the global economy has added spice to the debate. Forty-five percent of the existing SWFs emerged after 2000. According to the SWF Institute, total assets under SWF management have reached US$3,976 trillion.
The sources of wealth for these often controversial investment vehicles have been two-fold.
East Asian economies, China in particular, have benefited from large capital inflows derived from foreign direct investment (FDI) and exports. These fed a growing current account surplus (US$191.7 billion in the first half of 2008), a fiscal surplus, and the world's largest foreign exchange reserves (US$1.946 trillion as of December 2008). SWFs were therefore nurtured by direct transfers from official reserves.
The second major category of SWFs is run by oil exporters, beneficiaries of the recent petrodollar boom. Soaring oil prices peaked in July 2008, so Gulf SWFs and central banks registered US$300 billion in inflows from oil exports last year. At an average break-even oil price (the minimum price which yields the necessary revenue to cover regular public spending) of US$50 in the Gulf region, a considerable amount of "excess" revenue was accrued, and this needed to be invested profitably.
Financial markets responded with mistrust to the rapid rise of SWFs, with some fearing the funds might pursue political goals, and others fearing they could become a rival to Wall Street and The City as capital sources. Given the low level of transparency and accountability in some of the largest funds, a default suspicion may have been warranted. Stricter regulation was considered as a countermeasure, which some analysts regard as overly protectionist.
The SWF balloon inflated, if not quite to bursting point. But to mix metaphor with allusion, some SWFs floated too close the sun - and have been burned.
Now, the question remains - how legitimate are the measures taken by certain countries in order to prevent SWFs from investing? However, the impact of the downturn has added a caveat: How necessary is new regulation now that SWFs have been hit, and how politically viable is regulation, given that credit is drying up elsewhere?
Sensible regulation or protectionism?
Some views hold that if large SWFs do not make progress complying with the Generally Accepted Principles and Practices (GAPP), agreed on in October 2008, then further investment may be impeded.
The GAPP is supposed to enhance fund transparency and internal governance for SWFs, and allay conspiratorial notions about SWFs as stalking horses for darker political motives.
According to Steffen Kern of Deutsche Bank, European countries - especially Latvia, Belgium and Germany - are the most open economies regarding foreign investments, followed by Japan and the US. China, Russia and India have the most restrictive investment rules. Considering the geographic distribution of SWFs, this draws an interesting picture of regulatory imbalances and the need for harmonization.
The rise of SWFs has produced protectionist reflexes all around the world. The best-known example remains the DP World case, when a state-owned UAE company was to buy US port management businesses from P&O in 2006. The approval of the deal by US authorities resulted in a public outcry. Congress consequently passed a law increasing scrutiny by the Committee on Foreign Investment (CFIUS), which reviews the national security effects of foreign investments exceeding 10 percent. Transactions in "critical infrastructure," "critical technologies" as well as matters of "national security" are subject to review.
The European Commission soon called for more transparency and announced that should SWFs not raise their disclosure standards, tighter controls on "strategic sectors" might follow. "Strategic sectors" is the key term for what seems to be the most valuable asset endangered by SWF investments. So valuable, that nobody has been able to come up with a precise definition yet. In France, gambling is included in this, energy is not.
Fierce reaction came from Germany and France. The German government has decided on an amendment of its German Foreign Trade Act, which will give the government the right to veto takeovers in "strategic sectors" exceeding 25 percent. However, it has not come into force yet.
"I will not be the French president who wakes up in six months time to see that French industrial groups have passed into other hands," President Nicholas Sarkozy said in a parliamentary debate in Strasbourg last November. He suggested European countries launch SWFs of their own. Legislation on investment in France is characterized by sharp differentiation between EU and non-EU investors. A decree issued in 2005 specifies 11 sectors in which deals require the approval of the French Ministry of Economy, Finance and Employment.
As a response to protectionist reactions in the G7, the OECD Investment Committee issued an interim report, "Sovereign Wealth Funds and Recipient Country Policies," in April 2008, which acknowledged the need of key principles for governments to address the trade-off between security and market openness. A final catalogue of best practices can be expected by mid-2009.
Still, the global downturn may derail this. While protectionist noises have grown louder in general economic pronouncements in the US and Europe - with trade-dependent Asian governments reacting with alarm - the flipside is that credit is hard to find. With a G20 summit looming, "emerging" economies with substantial forex reserves and SWFs to draw upon, might find the would-be regulators more willing to being open.
Air out of the balloon
Despite their last year's successes, SWFs have not proved immune to the effects of global downturn.
Huge market-to-market losses were the outcome of a substantial number of investments in western financial institutions. These included Merrill Lynch, Citigroup, Morgan Stanley, UBS and more, which received capital infusions to tune of US$44.5bn from March 2007 to April 2008. The Abu Dhabi Investment Authority is considered one of the hardest-hit SWFs - now carrying a 40 percent paper loss - similar also the Kuwait Investment Authority and the Qatar Investment Authority.
The 2008 oil price collapse cut into petro-based SWF revenues, most of which had ambitious investment projects for 2009. In February 2009, oil was selling at US$41.34 on average, well below break even point, with the consequence being budget deficits in many Gulf states. More ominously, some projections point to some current account surpluses turning into deficits during this year. Cutting domestic spending is not an option, since it might amplify the economic slump, so oil exporters may draw down on reserves to sustain their current spending levels.
In the meantime, non-commodity funds are feeling the pinch from a sharp decline in exports and capital outflows. Chinese exports, contracted 17.5 percent y/y in January. The result is lower current account surpluses, hence undermining reserve growth as a source of capital for SWFs. Central bank interventions to defend currencies and avoid capital outflows have also depleted East Asian official reserves.
At the same time, economies now struggle with domestic markets, where injections and rescue packages are necessary to stimulate growth. When the liquidity squeeze set in, investors pulled out capital from emerging markets, which produced pressure on local currencies. That made banks with large foreign exchange liabilities more vulnerable.
As a result, SWFs in Qatar, China and Norway turned toward domestic markets, taking stakes in state banks and other financial institutions. Russia's SWF invested US$6.7 billion in the domestic stock market, which had fallen more than 70 percent in October 2008, and according to Rachel Ziemba of RGE Monitor, Moscow will be spending funds it planned to invest abroad to meet its large and growing budget deficits in the face of a likely 3-4 percent GDP contraction
Back at the beginning
The end of all our exploring will be to arrive where we started and know the place for the first time – T S Eliot
SWFs may now focus on domestic needs. Many of the funds were originally established as an alternative means of stabilizing markets, cushioning the impact of regular revenue shortfalls, meanwhile making profitable investments.
Rachel Ziemba told ISN Security Watch: "Almost all funds (or their sponsoring governments) have invested more at home to support domestic banks, try to prop up stock markets, maintain or increase spending or to offset the withdrawal of private capital. If they do invest abroad, they may prioritize sectors consistent with domestic development goals. The latter trend began in 2007/08 but may have been accentuated by the reduction in available capital."
Pessimists argue that the current crisis is pulling the rug out from under SWFs by setting global imbalances and adjusting commodity prices to real values. SWFs will therefore lack the sources of wealth they enjoyed so far.
Optimists talk up SWF prospects, believing that the oil prices will swing back up within the next three to five years. Furthermore, the global downturn could bring excellent investment opportunities, as equity prices bottom-out.
Tang Tjun, partner and managing director at Boston Consulting Group and head of its Financial Services Practice (Greater China), told ISN Security Watch: "On the positive, our clients are still looking at growth projects and potential investments, and China still dominates as a high potential target."
Speaking on the sidelines of the annual meeting of the World Economic Forum, Sameer al-Ansari, chief executive of the US$13 billion Dubai International Capital, said that "there [is] going to be a great opportunity in the next year or two to acquire assets at historically unprecedented levels."
However, for now, SWFs may hedge their bets on any expansive investment policy.
Diana Ionescu is a postgraduate student at the Vienna University of Economics and Business and a graduate student at the Vienna Law Faculty.
Simon Roughneen is a journalist based in Southeast Asia. His website is www.simonroughneen.com.
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