In the last couple of months, giant financial firms such as Citibank, Merrill Lynch and UBS

have been bailed out by sovereign wealth funds.

What are they and why are they important?

In mid-January 2008, the governments of Singapore, Kuwait and South Korea via their sovereign wealth funds provided most of a $21 billion infusion of funds into Citigroup and Merrill Lynch, two financial institutions that have lost billions in the sub-prime credit crisis. In recent years, sovereign wealth funds have proliferated thanks to soaring oil prices and surging Asian exports which, in turn, have exacerbated the world’s savings imbalance. These funds have invested almost $69 billion on recapitalizing the rich world's biggest investment banks since the subprime mortgage fiasco began to unfold in 2007. Prior to their emergence as deep pockets for banks hurt in the subprime mess, their investments had been to telecoms and technology companies, casino operators and even in the aerospace industry. Now, money is flowing from countries with excess savings to those that need it. Although Arab and Asian governments are investing these funds in a relatively professional manner, there are still concerns. The first has to do with the shortcomings of sovereign wealth funds. The second and bigger problem is the backlash they will surely provoke from protectionists and nationalists.

What are sovereign wealth funds?

Sovereign wealth funds (SWFs) are entities that manage national savings for the purposes of investment. The accumulated funds may represent foreign currency deposits, gold, Special Drawing Rights (SDRs) and IMF reserve positions held by central banks and monetary authorities as well as other national assets such as pension investments, oil funds or other industrial and financial holdings. The sovereign nation assets are typically held in domestic and other reserve currencies such as the dollar, euro and yen.

Private analysts put current sovereign wealth fund assets in the range of $1.5 to $2.5 trillion. This amount is projected to grow sevenfold to $15 trillion in the next 10 years. While not a new phenomenon, their recent activities along with their projected growth have stirred debate about the extent to which their size may allow them to destabilize financial markets and their policies may be driven by political, rather than economic and financial considerations.

Some of the funds today are 21^st century creations while others have been around for decades. One of the first dates back to 1956. Usually SWFs are created when governments have budgetary surpluses and have little or no international debt and it is not possible (or desirable) to hold or channel these funds into consumption. An SWF may be created to reduce government revenue volatility and to counter a boom/bust cycles' adverse effect on government spending and the national economy and to build up savings for future generations. Nations dependent on commodities such as crude oil, copper or diamonds would fall into this category. The growth of SWFs may be viewed as an unintended consequence of countries running persistent current account surpluses and accumulating net foreign assets while others such as the United States continually run deficits. Until East and West even out the surpluses and deficits in their economies, sovereign wealth funds will exist.

The recent commodity price boom has led to the accumulation of net foreign asset holdings of commodity-exporting countries where the public sector controls commodity exports or heavily taxes the revenues earned by private commodity exporters. For example, the windfall gains associated with the sharp rise in the price of oil in 1973 to 1974 induced oil exporting countries to increase government spending. However this spending plummeted when oil prices collapsed in the early 1980s. Consequently, some sovereigns have sought to deal with these concerns by saving a share of the gains in SWFs. In some cases these savings are used as a financial stabilizer should commodity prices decline and depress tax revenues. In other cases, SWFs serve as mechanisms to transform concentrated exposure of public assets to volatile commodity prices into a more balanced and diversified global exposure, thereby protecting the income of future generations. The idea that governments should put something aside for a rainy day has a long and respectable history. But today’s windfall is too big to spend without waste and inflation. It is wiser to save for times when oil prices are low or for the generations who will come after the oil runs out.

Current estimates suggest that funds derived from oil and gas export revenues account for some two-thirds of the total assets held by SWFs, with the rest consisting of funds mainly controlled by Asian surplus exporters. The four main Persian Gulf investment funds (Abu Dhabi Investment Authority, Kuwait Investment Authority, Qatar Investment Authority, and Dubai International Capital), launched in the 1970s, now have a combined asset value of over $1 trillion. Norway’s Government Pension Fund — Global (previously called the Petroleum Fund of Norway) was established in 1990 and now holds over $300 billion. Russia’s Oil Stability Fund, established in 2003, currently has over $100 billion in assets. All of Saudi Arabia’s oil surplus funds are managed by the central bank together with its reserves.

In Asia, Singapore’s two government investment funds — the Government Investment Corporation (GIC) and Temasek — have combined assets of over $200 billion. Korea’s Korea Investment Corporation was launched in 2005 with $20 billion in assets. China recently set up the China Investment Corporation with assets worth $200 billion to manage more aggressively a portion of over $1.2 trillion in foreign reserves.

Investment strategies

Central banks generally invest their foreign exchange reserves conservatively in safe and marketable instruments that are readily available to monetary authorities to meet balance of payments needs. But SWFs differ in their strategies for investing abroad — they seek to diversify foreign exchange assets to earn a higher return. Investment choices are made with the help of professional private fund managers and consultants and can include longer-term government bonds, agency and asset-backed securities, corporate bonds, equities, commodities, real estate, derivatives and foreign direct investment.

Little is known about individual sovereign fund activities since very few publish information about their assets, liabilities or investment strategies. The IMF has implored Singapore’s GIC, which was set up in 1981 to manage the bulk of Singapore’s foreign exchange reserves, to be more transparent by publishing account details to no avail. However, Temasek, the Singapore government’s strategic investment arm which was established in 1974 and takes long-term stakes in local and foreign companies, tends to take a more activist approach to its investments. Temasek has released some information about its financial performance since 2004. But the information has been confined to consolidated accounts that do not disclose flows between subsidiary investments and omits historical financial data before 2001.

Why some are concerned

Apprehension about the size effect of funds is not new, reflecting the possibility that a large fund could use its market power strategically, potentially leading to greater financial instability, and occasionally to the benefit of large players. An example of these concerns is the alleged role of large private hedge funds in coordinating speculative attacks on the British pound and other currencies participating in the European exchange rate mechanism in the early 1990s.

There is also the possibility that sovereign funds may use their strategic leverage for narrow nationalistic objectives. Financial globalization has reached the point where the sheer size of foreign savings may distort sovereigns’ incentives, shifting them from beneficial diversification toward zero-sum game policies. These may include supporting domestic “national champion” firms, buying controlling positions in foreign firms with proprietary knowledge, or increasing control of financial and tangible infrastructure abroad (telecommunication, energy, ports, etc.). Such developments could lead to the proliferation of capital controls and financial protectionism, and ultimately risking international trade in goods and services.

The relatively friendly welcome sovereign funds have found in the United States may be temporary. Once an emergency has passed, foreign money can be less welcome. Temasek learned that lesson to its cost in Indonesia. In the U.S. adverse reactions to SWFs have ranged from efforts by China’s state owned oil enterprise CNOOC to acquire Unocal in 2005 and by the United Arab Emirates’ DP World to acquire several major U.S. seaports. The Abu Dhabi Investment Authority’s recent $7.5 billion investment in Citigroup, though, prompted less concern in part because of the Authority’s assurances that it would not seek any control or active management. The Joint Economic Committee has scheduled a hearing on sovereign wealth funds for informational purposes while the Senate Banking Committee discussed SWFs last November.

More transparency would go a long way towards easing concerns starting with an annual report that discloses the fund's motives and main holdings. Investments through third parties such as hedge funds would help by providing an additional layer of insulation against the misdeeds of rogues. Ideally, the funds would eventually take fewer stakes in individual companies, which expose them to the inevitable risks of stock picking and political pressure.

Whatever their motives, sovereign-wealth funds are sure to influence prices and markets. They are expected to distribute funds across industries and economies. And as they spread their money around the world, sovereign-wealth funds will usually be greeted with open arms. Often, however, they will be treated with suspicion. Yet, for all these fears, it is hard to find examples of SWFs abusing their power so far. As with private equity groups and hedge funds, the anxieties owe less to reality than to a mix of secrecy and suspicion. With a few exceptions, like Norway, which opts for disclosure, you do not know what a sovereign wealth fund's objectives are, precisely how much money it manages and where it has made its investments. Already the funds use the full range of investment options, including hedge funds and private equity, which further cover their tracks.

Even now, suspicion of sovereign-wealth funds comes at a price. The hope is that both host countries and sovereign-wealth funds see that their interest lies in building confidence. The hosts stand to benefit from the funds' capital. But the funds are ruled by the politics of the places where they chose to invest. You are sovereign only at home — someone else wields the power abroad. Many U.S. (and European) decision makers remain suspicious about the motives behind sovereign wealth investments.

Bottom Line

Until East and West even out the surpluses and deficits in their economies, sovereign wealth funds will not go away. Ideally, the high-savings countries of the Middle East and Asia would liberalize their economies and allow their own citizens to invest for themselves rather than paying bureaucrats to do it for them.

Sovereign wealth funds are large and growing fast. Secretive and possibly manipulative, they are almost designed to raise suspicions. That is why the chief threat they pose is of financial protectionism. When and where to deploy more cash is a talking point within Asia's sovereign wealth funds, which have helped stabilize world markets with capital injections into distressed investment banks. Obviously more transparency would help to ameliorate these fears.