[lbo-talk] "Sovereign wealth funds"

[Marvin Gandall]

China's recent purchase of a $3 billion stake in the US hedge fund
Blackstone and its plans to recycle hundreds of billions of its USD and
other foreign exchange reserves into global equity and real estate markets
has drawn excited attention by the financial press to the proliferation and
rapid growth of so-called "sovereign wealth funds" in China and elsewhere,
and the implications of this massive new injection of capital into the world
economy. The following piece from yesterday's Financial Times is indictive;
Barron's, the US financial weekly, is running a similar feature in it's
latest issue.

The export of capital from the developing nations to the advanced capitalist
countries was unforeseen (so far as I'm aware) by the classical theorists of
imperialism, although Western finance capital still stands to benefit hugely
from its management of these surpluses. The scale of the current flows
dwarfs the recycling of Middle East petrodollars in the 70s when the
phenomenon first appeared. It's estimated that the SWF's have some $2.5
trillion available to invest, representing about half the reserves deemed
necessary to protect their currencies. China's investment fund alone will
have at its disposal about two-thirds more capital in real terms than did
the postwar Marshall Plan.

As with derivatives, the other major development in modern global finance,
note the concern about the possible catastrophic consequences on world
markets and the global economy of governments shifting from bonds to riskier
and often more opaque pooled asset funds. Note also there is no mention or
calculation of the current costs to domestic economic and social development
represented by the diversion of these surpluses to the financial markets.
======================================
How sovereign wealth funds are muscling in on global markets
By Tony Tassell and Joanna Chung
Financial Times
May 24 2007

Highly solvent SWF seeks mutually rewarding relationship. That might sound
like an advert in a singles column but it is in fact shorthand for what is
rapidly becoming a huge force in global markets and economies.

A vast arsenal of money to invest in markets is fast being built up by the
swelling ranks of so-called sovereign wealth funds (SWFs), schemes set to
invest the growing foreign exchange reserves and savings of countries from
Norway to China.

Driven by trade surpluses unequalled as a percentage of the global economy
since the beginning of the 20th century, official reserves held by some
governments are now astronomically high and there is pressure to earn a
better return by putting the money with specialised investment agencies.

Morgan Stanley estimated in March that the total funds at the disposal of
SWFs may be as high as $2,500bn (£1,157bn, €1,710bn), already around half
the gross official reserves of all countries. By comparison, worldwide
conventional fund management assets (pension, insurance and mutual funds)
reached $55,000bn at the end of 2005, according to the industry body
International Financial Services London. But SWFs are already larger than
the global hedge fund industry, which is thought to manage about $1,500bn to
$2,000bn of assets – some of which may include existing SWF money.

The SWFs are growing fast as countries reap the benefits of high oil prices
or large trade surpluses. “If we are right that these funds will grow by
roughly $500bn a year, at the expense of official reserve growth, the total
size of the SWFs should be as big as the official reserves in only five to
six years’ time,” Morgan Stanley estimated.

How and where this massive – and often secretively managed – pool of funds
is deployed will be one of the big investment themes of coming years. China,
for example, is setting up an SWF to manage more aggressively a portion of
its $1,200bn in foreign reserves. Plans are still taking shape for the fund,
likely to be called the China Investment Corporation when it opens an office
later this year, but it is expected eventually to have a kitty of up to
$300bn.

“That amount represents the single largest pool of cash that any government
has thrown at anything, ever. Adjusted for inflation, the US’s largest
effort, the Marshall Plan, comes in at just over $100bn,” says Statfor, a US
security consulting intelligence agency.

As significant as the size of the SWF pool is the changing mix of
investments. Until now, the foreign reserves of countries such as China have
been largely parked in passive investments, mostly in US Treasury bonds. The
investment priority of their managers, usually central banks, was security
and liquidity.

But in many countries – such as in the Middle East and China – reserves have
risen to such a level that their managers can no longer pretend they need
more liquidity for the purposes of currency or economic management. In
China, reserves rose by about $1m a minute in the first quarter and the
overall total could double within four years if the country’s trade surplus
continues to expand and Beijing’s currency policy stays the same.

That is what made last week’s news that China is investing $3bn in the
initial public offering of Blackstone, the private equity group, such a
landmark event. China is expected to adopt a gradual approach to shifting
its strategy. The $300bn kitty for its SWF is unlikely to be transferred in
a single tranche for immediate investment, either domestically or offshore.

However, the Blackstone deal was widely seen as a clear signal that China is
preparing to take a more active approach to investing and is willing to take
more risk. “China Inc’s investment decisions are going to have the capacity
to move markets for a long time,” says Brad Setser of Roubini Global
Economics

But the SWF story is more than just China. The global SWF club of countries
taking a more active approach to investing foreign reserves has broadened
out to 25 members, including nations as diverse as Botswana, Australia,
Iran, Singapore, Brunei and Kazakhstan.

Jennifer Johnson-Calari, director of Sovereign Investments Partnerships at
the World Bank, says there is a huge opportunity cost to “uninvested”
capital tied up in reserves. “This is financial capital that is unexploited,
very much like agricultural land lays fallow, unploughed,” she says.

Even long-established SWFs such as Norway’s giant $300bn Government Pension
Fund are changing tack to adopt more risk. It announced last month it would
increase its exposure to global equities from 40 per cent to 60 per cent.

Russia’s finance ministry has similarly decided to boost equity exposure,
splitting the country’s $108bn stabilisation fund in two. One chunk of
assets will be maintained at a fixed percentage of gross domestic product,
and will be called on to cover emergency budgetary shortfalls. The other
will be a “future generations” fund with no set mandate – except to last
forever. This fund is expected to invest more in domestic and international
equities.

Such shifts will reverberate around markets. Analysts say the evolution from
official reserves to SWFs should be positive for emerging market assets and
positive for risky assets in general. A wholesale move from bonds to
equities by the world’s central banks should also boost the yen.

Only 3.2 per cent of the world’s total official reserves are held in yen.
However, global equity managers typically hold a greater percentage of their
portfolios in the currency – the market capitalisation of the Tokyo stock
market is more than 10 per cent of the world’s total. If SWFs invest funds
in equities in line with Japan’s global weighting, they will have
proportionally more money in yen assets than they would have if they kept
funds in traditional reserves.

The big question, however, is the impact on bonds. The International
Monetary Fund recently cited estimates that central bank buying has
depressed yields on long-term US Treasury bonds by between 30 and 100 basis
points as prices have risen.

If buying eases, bond yields could rise and prices fall. Although countries
with large foreign exchange reserves in US bonds are unlikely to want to
risk damaging the value of their investments through heavy sales of them, a
greater share of new reserve accumulation will flow into non-bond assets.

Such moves have raised the antennae of banks and asset managers around the
world hoping to gain lucrative mandates to advise the SWFs or manage their
“wall of money”.

But the growing role of the SWFs in markets is beginning to attract
criticism, particularly over a lack of transparency. Few SWFs give details
of their operations, with exceptions such as Norway’s GPF. “Monitoring the
currency and asset compositions of official reserves is difficult, but
tracking the sovereign wealth funds would be nearly impossible, as these
funds are blended with the massive pool of private capital,” says one
investment banker.

Gary Kleiman, a senior partner at Kleiman International Consultants, adds
that trying to work out what some SWFs are doing is like chasing a shadow.
“In terms of disclosure on fund performance, investment strategy or even
basic philosophy, many rank below the most secretive hedge fund,” he says.

Some of the newer SWFs appear to be following a similar path to the Abu
Dhabi Investment Authority, one of the first SWFs, which has for 30 years
acted as a savings fund for the emirate’s future generations. It is rated
highly as a professional manager with a diversified portfolio and a cadre of
talented managers. But there are few public details on its operations, with
no official figures released for Adia’s investments. Morgan Stanley
estimates it is the world’s largest SWF, managing as much as $875bn. But
where this money is deployed is a matter of conjecture.

This raises issues about potential systemic problems if SWFs assume a
greater role in markets. Many newer SWFs, more­over, lack the management
experience and systems of a fund such as Adia. “Many governments do not have
the wherewithal to manage risk [in SWFs],” says Ms Johnson-Calari.

The IMF also warned recently of the risks arising from the fact that public
sector institutions such as SWFs are now large players in world financial
markets. “A single institution could make sudden portfolio adjustments that
could have significant price effects on certain asset classes. Market
rumours of such adjustments may lead to volatility as previous announcements
by central banks have shown,” it said in its global financial stability
report.

“Furthermore, if raw material and energy prices fall ...countries may
intentionally run down their funds and international reserves, reversing
past outflows.”

The operations of SWFs can also raise political issues. Even if they are set
up as independent bodies, they still face questions over whether funds are
operating on a purely commercial basis or to fulfil broader government aims.
“In some cases, assets may be shifted for political-strategic reasons rather
than economic and financial reasons,” said the IMF.

Given the size of the funds to be deployed, SWFs also could go on a buying
spree of corporate assets. This could inflame nationalistic sentiment if
they acquire foreign companies seen locally as having strategic importance.
That may be one reason why some SWFs channel their investments through
discreet secondary managers.

One foretaste of the potential for controversy came when Temasek, the
Singapore state investment company that is a model for many other SWFs,
faced a painful backlash in Thailand over last year’s acquisition of
telecommunications group Shin Corp. A senior Temasek official recently
warned that similar problems may be brewing in China, where the group bought
stakes in two state banks at a discount.

In response Temasek, which has faced long-running questions over its
transparency, plans to set up a $330m fund to finance regional development –
an apparent effort to blunt criticism from other Asian countries about its
buying of strategic assets.

Such moves may not be enough to satisfy the critics. As they grow more
powerful, SWFs will face increasing pressure to be more open.