Responding to the World of Sovereign Wealth

Each day seems to come both with headlines of a new sovereign wealth bid and a policymaker suggesting a response, making it a good time to wonder what sort of consensus might emerge and how the world of sovereign wealth might respond.

Note: This post incorporates recent investment guidelines from the UAE (related post) and a recent joint statement by Abu Dhabi, Singapore and the US (related post) regarding sovereign wealth funds.

First, the latest developments.

The European Commission sends a sortie into the code of conduct development process. Its goal: to avoid an uncoordinated response among EU member states and make sure any responses fit with EU law. In other words it seeks to avoid CFIUS-lite. See the Draft paper here (hat tip IPEZone)

Several EU member states are reviewing their investment practices. Germany might limit foreign stakes to under 25%. Worries are up – particularly triggered by Chinese and Russian SOEs. France topped up its stake in a joint venture with the Italian government.

Australia’s FDI review asks extra questions of public funds to ensure commercial not political motivations. Such scrutiny may extend to private equity bankrolled by sovereign wealth.

US pushes for more transparency from funds as part of the IMF process to improve transparency and accountability. Given their size, buy-in from the likes of ADIA and GIC is essential for any transparency process. The biggest takeaway from this initiative (which has involved much shuttle diplomacy) is a joint statement by Singapore and Abu Dhabi and the US that sovereign funds should state unequivocably that they do not have political aims at stake in their investments. But while they state that increasing disclosure would limit uncertainty in financial markets and build trust, its uncertain how much disclosure might result.

It also calls on them to meet existing disclosure requirements - which as far as I know they do. These tend to be relatively limited until stakes become large enough to encompass control. Many have suggested this deal is more political than economic - and may be an attempt to prove that all parties are serious. The administration in particular is hoping to avoid protectionist responses at a time when US still needs foreign funds, especially those from official sources.

Congressional worries about the funds are rising – with the argument that legislation is possible if the multilateral IMF process doesn’t satisfy. But a legislative response is tricky and after all the US revised its FDI review last year. At least three congressional hearings have touched on the issue and a new house taskforce aims to push for transparency and investment guidelines. Perhaps they are trying to catch up to the EU and make sure something comes out of the IMF process. Or perhaps like the EU they are trying to contribute to a coordinated response.

Collectively this reveals a multi-pronged approach

1) multilateral process to encourage more transparency, better governance and the commercial nature of decisions. a consensus or mantra has developed.

2) assessing national investment policy to make sure they meet national security concerns and legislation/regulation to close any loopholes

3) suggest that countries with large surpluses open up to investment (reciprocity) and move towards freer currencies.

Items 1) and 2) have been the focus as estimates of SWF assets, potential growth and higher profile purchases have emerged. As most funds are opaque about size, assets and investment strategy, fears include that of a large strategy shift.

but 3) or rather assessing the changes in the international financial and monetary system is ultimately a key part. It addresses the imbalance of which funds being collected in sovereign coffers are the symptoms. The EC notes: "the accumulation of reserves for investment by SWFs should not become an end in itself." However solving this problem is probably trickier than the symptoms.

On the part of the sovereign funds themselves, they are coming around to the idea of more disclosure, perhaps in part because political storm doesn't help them. But it remains to be seen how they will respond. Other funds will likely have to sign to such terms. But the question still remains, will we end up with a patchwork of regulatory responses?

The IMF is collecting good practices of sovereign investors, good practices because they recognize that sponsoring countries have different goals based on their financing structure and level of economic development. (Some clues here and updated here). The IMF intends to have a draft available this spring for comment and a ‘final’ version by the fall.

The OECD is engaged in a similar process from the perspectives of recipients. They will release a draft by June. They are also looking at public pension funds.

US and European efforts seem largely designed to make sure a substantive code of conduct emerges. Furthemore their efforts also seem intended to build a coalition domestically (or at the multilateral level).

The EU suggests that as a global issue, a multilateral approach is needed - and a common EU approach better enabling European influence on such dialogue, as well as protecting the EU internal market. It also suggests some of the existing national and multilateral practices that might be used should transparency be in order.

To whom do guidelines apply?

In practice recent guidelines have referred mostly to a narrow definition of sovereign wealth funds. but they might also apply to other sovereign business such as holding companies who are more likely to seek actual control.

A broad definition of sovereign wealth would capture related holding companies, state owned enterprises and possibly some public pension funds as well. The US Treasury has used such a broad definition since at least the summer to my knowledge – but its becoming more common in the discourse. The EC defines them as "state owned investment vehicles which manage a diversified portfolio of domestic and international financial assets." but there is little to no discussion of other investors backed by sovereign funds.

A narrow definition might just mean that funds are channeled through other actors. More complicatedly, it might mean assessing financial actors funded by sovereign funds – private equity for one. Australia hopes its new review achieves that. The California state legislature may try to take unilateral action to limit what funds Calpers and Calstrs co-invest with. the state pension funds will have to do a labor, environmental and human rights check on the owners of private equity funds it invests with.

Acquisitions by SOEs are probably more concerning than those of SWFs. By their nature, SOEs prefer significant stakes as they usually want to build market share or increasing their supply chain. Voting rights are part of the package.

Even in the same country funds might have very different governance structures and goals. Despite Gazprom’s penchant for threatening cutoffs for delayed payment or resisting new market rates, it is likely that Russia’s new wealth fund will be bound to more disclosure requirements than most of the Gulf funds are currently– largely because it is bound to report to the Russian people.

A clear code of practices would improve the playing field for public and private entities alike – making it more predictable. In fact, many SWFs might like to know what sectors are off limits. Though its worth noting as Ted Truman does, Complete success is not likely to allay many of the concerns some people have about sovereign wealth funds – though reasonable ones should be.

What might be the implications?

One fear is that any additional barriers will deter investment. This may be the case, but smaller countries may be more vulnerable. With lots of funds to invest, sovereign funds are limited in where they can put their funds. Few countries save the US create enough financial assets to absorb these funds. But many may be on the sidelines now in a wait and see position. Given losses and political issues, they may be particularly wary of stepping back into the financial sector.

What is Transparency Anyway?

The term transparency has been thrown around a lot. In general, transparency means more disclosure of regions, asset classes, returns, approximate fund size, investment approach (including use of external managers, size of stake). Governance structure would also be a key area of disclosure, including how decisions are made. Many people have suggested that transparency is a necessary but insufficient condition – more accountability to domestic and perhaps international oversight is likely included in the best practices.

It is unlikely that most funds would go as far as Norway and disclose all of their holdings annually. But that doesn’t mean announcing every deal before making it as KIA’s manager once quipped. But it probably means reports not just press conferences.

The EC suggests that the following be considered for disclosure.

Annual disclosure of investment positions and asset allocation, in particular for investments for which there is majority ownership;

• Exercise of ownership rights;

• Disclosure of the use of leverage and of the currency composition

• Size and source of an entity's resources

• Disclosure of the home country regulation and oversight governing the SWF.

Few funds currently meet these requirements - Norway does definitely, Temasek meets most. Some disclose regulation, and source of funds, but overall this would be a sea-change if signed up to.

The big funds ignite the biggest worries. Hence the reported focus by the Bush administration on Singapore and Abu Dhabi – the two largest non-transparent funds. But the somewhat smaller but more visible funds also raise key issues despite the fact that these funds have actually disclosed more about their holdings and strategies. Their tendency to take large stakes and to use external financing means that more information on Istithmar for example, is public.

Despite or perhaps because of the furor, sovereign funds may wish to increase transparency. Some funds are willing to disclose more (Singapore) Now is the time to do so on their terms. To do so might insulate these funds from the political maelstrom allowing them to prove that they are motivated by non-commercial gains. It might also allow them to know what sectors are off-limits and (hopefully) impose more predictability to to the investment process.

Which brings us to another loaded term - commercial – What is the difference between commercial and strategic? What is the difference between the Dubai financial center buying a stake in a stock exchange and the Toronto Stock Exchange doing the same. A Willingness to sustain losses? The difference might be the regulatory system to which they are subject. And the involvement of government backers does add to moral hazard.

Strategic sectors are in the eye of the beholder – key commodity supply chains might be strategic as might aluminum especially with a consolidating metals sector.

If transparency is insufficient, what form could legislation it take?

US, and EU processes have held out the possibility of legislation but its hard to see what additional material might be added beyond clarification of existing reviews to make sure national security is not at stake and where possible depoliticizing the process. Anything that would really have teeth would likely be a rather blunt instrument.

Strengthening existing FDI review. The WSJ cites a forthcoming Council on Foreign Relations report that 11 countries have either reviewed or plan to review FDI screening. Some, like Canada, may clarify somewhat murky guidelines that acquisitions have net benefits to the country – more clarity might benefit all involved in such transactions. After all the G7 called for proportionality, clarity and fair treatment from recipients as well as more transparency from originators. See a review of possible changes (a bit dated) and responses from the G7+

The US FDI review is based on a definition of control – the threat that a controlling interest in a US company by a foreign company might pose national security risks.. Some have suggested raising the level at which control might be assumed, but that might be a never-ending process. Most recent investments are primarily portfolio not direct investment – and it must be noted, as Saudi Arabia’s Mohammed al-Jasser did the funds have met by the regulations of the jurisdictions in which they invest. (webcast) Plus no one can seem to find a case that seems objectionable.

Funds might be restricted to small stakes. strategic shares are on the rise from those who used to eschew the sort of public attention that large stakes bring.

Some form of golden shares – a small nominal share to maintain control has been suggested. These have a mixed history though several European countries maintain them. The EC notes that such responses might send mixed signals to investors that Europe is no longer open for business - but the existing legislation does protect against strategic sectors. The EU opposes such golden shares on principle though and it is probably only possible in very limited sectors.

Changing levels at which control is implied. Recent testimony from representatives of the US federal reserve board and SEC added to those of other members of the administration. There is already a certain degree of flexibility in different review processes ranging from CFIUS which makes sure national security concerns are met to banking oversight which make sure that an acquisition does not impair the US financial system or violate divisions between commerce and banking. Assessment of control tends to be relatively flexible - not necessarily tied to a given stake. However, one thing is clear, most stakes have been structured to lack the relationships and be lower than that which implies control. All of which brings us back to the disclosing more about strategy, motivations and governance agenda.

Suggestions to limit sovereign investors to non-voting stakes or deactivating voting rights for the time they are held by a sovereign fund seem a bit inefficient. Such regulation – particularly if it extends to pension funds might be reciprocally imposed.

Many SWFs though don’t seem to want to vote Norway is an exception, as likely are the investment companies of the Gulf for rather different reasons. Yet, rejecting voting rights may pose more problems than it solves as it invites the assumption of indirect influence.

But will some of these changes discourage the shift of funds into sovereign hands? Its hard to imagine sovereign wealth drying up. With oil near $100 that’s a lot of savings, despite spending growth. Import growth would have to grow a lot and exports collapse for China’s trade surplus to decrease a lot. And despite increases in domestic spending and investment in most oil exporters, they can’t spend it all.

Some potential policy choices might reduce the growth of sovereign funds in the global economy – increased private outflows. Commodity rich countries have chosen hike wages and subsidies over transfers – but some have also recapitalized pensions.

So what other channels or vehicles could sovereign wealth take?

Sovereign have long been capital sources for private equity, hedge funds and intermediaries. they are continuing to do so – and the FT suggests private equity is tapping sovereign funds again.

In 2006 and 2007 more of sovereign funds branched out on their own, buying larger stakes – including in the PE firms whose funds they had invested in. Abu Dhabi launched a small but growing strategic equities division in 2006 which invests directly. Larger stakes are consistent with not only high returns but spillovers for domestic development.

Funds could entrust capital to various types of external managers. The CIC is granting external mandates for equity and fixed income and investing in a buyout firm. These decisions might shield China from some domestic and international pressure and skepticism as well as learning some investment strategies.

Countries could channel more funds to other state companies or pensions. Within many countries, institutions are competing for a share of resources and to set an investment strategy. China is a case in point, as Brad Setser details. And Chinese testing of how to manage might only grow. Recently Zheng Bingwen of CASS suggested China launch a new pension fund to get a share of reserves, thinking it would be less threatening to western interests. Though that remains to be seen.

New state actors are materializing – and some domestic investment vehicles are now venturing abroad (ICD for one). Thomas suggests that since its creation in 2006, the Abu Dhabi Investment Council likely received a share of the surplus once primarily sent to ADIA.