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Rising giants

Container vessel in the port of Hamburg / Container-Schiff am Hafen in Hamburg

Container vessel in the port of Hamburg / Container-Schiff am Hafen in Hamburg

At least since the launch of the China Investment Corporation in September, finance experts worry about the growing role of investment funds owned by governments. These funds offer new opportunities to developing countries, but they also go along with risks. [ By Ronny Bechmann and Stefan Jansen ]

The topic of “sovereign wealth funds” (SWF) is not new for the people of Kiribati. The Pacific archipelago with a population of 100,000 has been dealing with this recently much-discussed phenomenon since 1956. Back then, the British colonial administration created the Revenue Equalisation Reserve Fund to manage revenues from the export of phosphate deposits, which were fast becoming depleted and would soon be exhausted. Over time, several sources have contributed to financing the Fund, and fees from fishing licences currently serve that purpose. With managed assets worth more than $ 500 million, the Fund’s volume today is nine times greater than Kiribati’s annual GDP. Its stable investment portfolio yields returns amounting to more than 30 % of the income of the island nation.

Not all the news is good with regard to SWFs, however. Such funds may also have a downside. When Temasek, a sovereign wealth fund from Singapore with great financial clout, bought Thailand’s Shin Corporation in February 2006, the deal sparked massive protests against Shin’s previous owner Thaksin Shinewatra, who was serving as prime minister in Bangkok at the time.

A particularly sensitive aspect of the deal was that a Shin subsidiary, which now belongs to Temasek, operates the satellite and mobile technology used by Thailand’s military and intelligence service. It is virtually impossible for outsiders to judge, however, whether Temasec’s motive for purchasing Shin was strategic, economic or both.

A military coup in Thailand in September 2006 finally quelled months of escalating unrest in the capital. Demonstrations had accused Thaksin of signing an illegal pact with a foreign government for his personal advantage. Thailand has not yet returned to democracy.

As this example illustrates, the pure pursuit of profit, largely undisputed in the case of private investors, can assume a political dimension with SWFs. The ramifications of the Shin sale are still serious for the entire region of Southeast Asia.

Foreign exchange reserves

According to IMF estimates (2007), government-owned wealth funds manage assets valued at $ 1.9 to $ 2.9 trillion worldwide. This volume already exceeds that of private hedge funds (about $ 1.5 trillion), and will continue to rise. The IMF forecasts that by 2012 about $ 12 trillion are likely to be managed by governments in the form of official reserves or sovereign funds.

One reason for the rapid increase in volume and influence of SWFs is the significant rise in foreign exchange reserves of many emerging and developing countries. As the IMF reports, from 1999 to 2006 Mexico’s foreign currency reserves doubled to $ 76 billion, India’s increased fivefold to $ 171 billion and Nigeria’s increased eightfold to $ 42 billion. This trend was made possible by the exports of commodities as well as manufactured goods and cross-border services.

Until now most sovereign wealth funds are based on revenue from natural resources. More than 60 % of the capital they have invested worldwide stems from oil exports. The largest fund is managed by the Abu Dhabi Investment Authority, with capital assets estimated at between $ 250 and $ 875 billion. But copper (Copper Stabilisation Fund, Chile), diamonds (Pula Fund, Botswana) and other raw materials are also important capital sources for state-run investment funds.

Experts, however, believe that funds based on other sources of revenue will fast gain in importance. The share of manufactured goods and services from newly industrialising countries has grown on global markets in the past few years, and will presumably continue to do so. The China Investment Corporation (CIC), launched in September, is the most significant fund not based on resource revenues, so far. It started out with holdings of $ 200 billion, which, at least indirectly, can be traced back to China’s for-ex reserves (see p. 454).

Useful instruments

SWFs that accumulate savings and actively manage investments in foreign currencies can be very useful instruments for governments. They help to stabilise income from comparatively inconsistent sources. They maximise long-term returns from temporarily high revenues. This can be very helpful, especially when volatile commodity prices make state revenues fluctuate in line.

There may also be macroeconomic advantages to SWFs investing abroad. As a result, for instance, booming commodity exports do not drive up the exchange rate of the domestic currency, which, in turn, would obstructs other exports (“Dutch Disease”). Domestic demand, moreover, remains unaffected too.

Government-run stabilisation funds allow resource-rich developing countries to use periods of high commodity prices to fund poverty-reduction measures in the long run. In the same way, other temporary or one-off returns (from the privatisation of public enterprises, for instance) can be made use of long-term, instead of spending everything in a sudden flurry of activity.

SWFs are even capable of stabilising official development assistance (ODA), which tends to be erratic over the years and is thus difficult to estimate in advance. ODA funds were used to set up the Poverty Action Fund in Uganda in 1995, for example. This fund was intended to bankroll rural poverty reduction projects for several years. In 1998, additional money, which had been freed up in the context of the debt-relief initiative HIPC, was put into this fund.

Apart from stabilisation and transfer objectives, SWFs can also modify risk-return ratios of state investments according to varying requirements. In any case, they have more leeway when managing capital than central banks do in the management of foreign-exchange reserves. Under competent leadership, they can even help to cushion off the negative impacts of external shocks (such as a falling dollar, for instance).

Funds that provide for pensions or intergenerational asset transfers are geared towards an even longer time frame. Norway’s Government Petroleum Fund (GPF) is an example. With managed assets worth € 218 billion, it is now the world’s second largest pension fund. Since 2004, it has also made its mark by investing funds in accordance with certain ethical guidelines. In 2006 it was decided that shares in Boeing and EADS would be excluded from investments because of their defence-industry relevance. Wal-Mart was also excluded – because of serious and systematic violations of human and labour rights.

Business and politics

Ethical standards, however, do not eliminate the potentially problematic mix of business and political objectives mentioned above. Fund managers are – unarguably – obliged to increase the value of the assets entrusted to them. On the other hand, the politicians monitoring them may well have their own, farther-reaching goals.

Business newspapers discuss the topic of inadvertent technology transfer. This might happen if, for instance, a Russian SWF bought into a German high-tech business. There are concerns that the foreign investor would automatically gain access to crucial knowledge. This fear, however, fails to look at the wider picture. Private investors from other countries can engage in industrial espionage just as easily as sovereign funds. All summed up, therefore, the growth of SWFs does not really make a difference in this respect.

As the Shin/Temasek example illustrates, however, business and political interests can become interlinked. The issue is not necessarily one of militarily relevant technology. An SWF from a poor country might, for instance, buy into a pharmaceutical company in another developing country. If pressure was then put on the government of the host country to ease drug-approval regulations, higher returns for the SWF might coincide with declining quality in healthcare in the host country.

There are ways, however, to prevent such conflicts of interest. Appropriate guidelines can ensure that fund managers are not subject to political pressure when making decisions. Lawrence Summers, a former US treasury secretary, suggests that SWFs be managed by trustees who are not subject to the directives of the executive (Summers, 2007). Similar guidelines could perhaps remove the threat of international standards of employment, human rights and governance being compromised by a mix of different interests. Then again, it seems doubtful that the Chinese government, which does not adhere to such standards at home, would make those very standards binding for its investment company CIC.

So far, the question of reciprocity has not been discussed much. Norwegian sovereign wealth funds can invest in Singapore virtually without restriction – and vice versa. But although China’s CIC is free to invest in Norway, the opposite is not the case. The options for Norway’s GPF to acquire shares in China are limited. The threat of growing financial protectionism is therefore very real. In order to avoid the vicious circle of protectionism, it would matter a lot to take timely countermeasures and sharpen awareness of the risks inherent in unrestricted capital movement on the one hand and excessive control on the other.


Another controversial issue is the limited transparency of SWFs. In this respect, they are similar to hedge funds and private equity companies. There is certainly little danger of small players, such as the Chilean Copper Stabilisation Fund with its $ 3.9 billion in assets, turning the market upside down by not informing other market participants about their activities properly. But it would be a very different story, however, in the case of large funds.

By suddenly selling major shares packages they could unleash fierce volatility – especially on relatively small stock-markets with minimal market capitalisation, as is typical of developing and emerging-market countries. Consider that total market capitalisation of African stock-markets was only $ 245 billion in 2002 (Yartey, 2007). In view of the great financial clout of SWFs under no or only little democratic control, that sum is indeed only small change.

It is therefore important that major SWFs elaborate publicly their investment strategies, regional alignments and time projections. Such practices would avoid panic reactions by other market participants that are surprised by high transactions. On the other hand, there needs to be a balance. If sovereign wealth funds were obliged to announce every single transaction, private actors would gain an unfair advantage and anticipate fluctuating prices.

Political recommendations follow from such deliberations. In principle, SWFs can be constructive instruments. How to build the relevant capacities is an important job for consultants, particularly in resource-rich developing countries. For good reason, the IMF is already active in this field. The issues of how to design and manage stabilisation funds institutionally will always be challenging, not only from a technical and politico-economic point of view, but also with respect to questions of governance.

Governments in developing countries, moreover, will need advice on how to deal with SWFs funds wishing to invest significant sums in their markets. The issue here, among other things, is to balance out information asymmetries between strong investors and institutionally-weak governments. Adequate transparency is also critical from a democracy point of view, for public officers to be held accountable.

As actors on international capital markets, SWFs must also be made transparent in order to pre-empt protectionist measures. Although protectionism would limit the risks, that approach would also thwart the opportunities that SWFs offer. Transparency and information-sharing can help build the trust needed to allow foreign investment in the home country. Ultimately all countries would benefit. The IMF and World Bank have important roles to play in this context.

Fear of powerful governmental investors from China, Russia or other emerging powers is never a good adviser. The formation and growth of SWFs needs to be managed constructively at an international level.