THE US RECESSION, RECORD OIL PRICES AND A COSTLY WAR ON TERROR HAVE ADDED TO THE SENSE OF UNEASE GENERATED BY THE PRESENT, UNPRECEDENTED CREDIT CRISIS. SOVEREIGN WEALTH FUNDS FROM EMERGING COUNTRIES ARE NOW APPEARING AS INDISPENSABLE INVESTORS OF LAST RESORT.
"Do we want the communists to own the banks or the terrorists?" asked Jim Cramer, star analyst of the CNBC financial news network. Then he answered: "I'll take any of it, I guess, because we're so desperate" (1). The near simultaneous entry of a number of Asian and Middle Eastern sovereign wealth funds in the capital of ailing financial institutions has brought a variety of reactions. Banks have generally emphasised the advantages of having "massive, passive and patient" investors on board (2), but the media and politicians have reacted with a mixture of worry and resignation.
The reconfiguration of the banking landscape was sudden and unexpected. The year 2007 started in euphoria: balance sheets of financial institutions were strong and the beneficiaries of easy debt – such as hedge funds or private equity funds – were getting ready for yet another banner year. Problems in the subprime sector first appeared in the spring, but they seemed to be contained.
They were rationalised as harbingers of a soft landing – indeed of a necessary if not salutary correction in the real estate market. The crisis affected a few specialised institutions and posed no threat to large financial institutions.
With the summer came a number of alarming signs. The financial world discovered that its much-touted and ultra-sophisticated risk models were actually quite fanciful; financial products that were well-rated by rating agencies found few takers; and even the most prestigious names in finance seemed unable to value a significant part of their assets (3).
The new rules of deregulated finance were also rife with unanticipated consequences. The new accounting norms (known as mark-to-market) had been designed to ensure stability and transparency, yet they added to the volatility and opacity of the system. A crisis of liquidity combined with a crisis of confidence ensued, threatening giant financial institutions.
'Weapons of mass destruction'
Sovereign wealth funds alone seemed willing and able to contain the disaster. On 27 November ADIA (Abu Dhabi Investment Authority) paid $7.5bn for 4.9% of Citigroup, the world's largest bank. Two weeks later GIC (Government of Singapore Investment Corporation) invested $10bn in UBS, the world's 10th largest bank. On 19 December China Investment Corporation acquired 9.9% of the investment bank Morgan Stanley at a cost of $10bn.
Simultaneous announcements of unanticipated losses and unusual financings have become commonplace. Sometimes institutions that appeared saved from disaster had to go back, cap in hand, in search of more funds. When Merrill Lynch announced on 24 December that Singapore's Temasek fund had invested $4.4bn in its capital, its liquidity problems appeared resolved.
But on 15 January other investors, including sovereign funds from Kuwait and South Korea, made a further investment of $6.6bn. That same day, Citigroup announced that, following another round of fundraising totalling $12.5bn, Singapore's GIC and the Kuwait Investment Authority (KIA) had become shareholders. Over just a few weeks sovereign funds had invested more than $60bn in the western financial system (4).
The world of finance had been turned on its head. In the age of globalisation, just as the triumph of markets was being widely celebrated, governmental funds – almost always from so-called emerging countries – undertook to rescue the West's largest financial institutions. These institutions, which had largely created the new financial order, thought they had tamed risk thanks to highly complex "financial engineering" techniques. In reality these products, which had allowed them to make huge profits, had become, to quote legendary investor (and the world's richest man) Warren Buffett, "weapons of mass destruction" (5). Systemic risk – the collapse of the banking sector – seemed around the corner and with it the spectre of 1930s-style depression.
Abandonment of ideologies
For these reasons, and in a context of widespread panic, central banks, regulators and governments strayed from their principles, rules and ideologies. On 17 February the UK chancellor Alistair Darling announced the nationalisation of Northern Rock. On 16 March the Federal Reserve provided a loan to JPMorgan Chase to finance its takeover of Bear Stearns, the fifth largest investment bank in the United States. And although the Federal Reserve acknowledged that its low interest rate policy during 2001-2006 had fed the real estate bubble, it chose to ignore its anti-inflation goals and engaged in a massive reduction of interest rates.
The US Congress voted in favour of Keynesian measures, while an administration committed to "free market solutions" multiplied relief packages in favour of distressed debtors and their lenders. With the economic slowdown and the risk of collapse of the banking sector, emergency measures were necessary – and they included inviting sovereign wealth funds inside the walls of the "financial fortress".
Before the subprime crisis, most of these funds were not exactly welcome. The "gated finance" system was based on de facto exclusion. As in those gated cities where a small number of privileged people are protected from their chaotic environment, the globalisation elite enjoyed freedom and the privileges of self-regulation, but at the price of greater vigilance toward the outside world (6).
Despite the rhetoric of free enterprise and open capital flows, the system's flagships were not to be sold to outsiders. In 2005 the attempt by China's CNOOC to acquire the oil company Unocal was foiled. The following year the prospect that Dubai Ports World could control six American ports resulted in a major political outcry.
However, attitudes changed as the financial crisis worsened. A more welcoming attitude toward sovereign wealth funds was nonetheless accompanied by self-imposed constraints (typically, no representation on the board of directors, keeping under certain thresholds – such as 10% – to avoid triggering regulatory controls).
In the words of Kristin Halvorsen, Norway's minister of finance, whose sovereign wealth fund (the world's largest after Abu Dhabi's) controls an estimated $322bn: "They don't like us but they want our money."
Consider the evolving attitude of French president Nicolas Sarkozy. On 10 September 2007, following a meeting with German chancellor Angela Merkel, he said that "particular attention" must be paid to those areas where competition was "distorted by sovereign funds".
On 8 January 2008 he warned that "France would not remain passive in the face of rising hedge funds and sovereign funds whose strategy has no economic rationale". Yet less than a week later, during a trip to Saudi Arabia, Sarkozy backtracked: "France will always be open to sovereign funds whose intentions are unambiguous, whose governance is transparent, and who offer reciprocal treatment to foreign capital."
Codes of ethics
The contradiction will be resolved with the adoption of codes of ethics. The Organisation for Economic Cooperation and Development, the International Monetary Fund, the World Bank and many other international organisations are working on such codes. Abu Dhabi's sovereign fund ADIA, the world's largest, has already announced its own. Two essential principles – "transparency" (a commitment to report relevant statistics, recipients and objectives) and "responsibility" – are designed to reassure. It should be said though that transparency has been the order of the day of global finance for two decades and it did not prevent the current debacle.
As for responsibility, that can be interpreted in diametrically opposed ways. It has traditionally meant (at least for certain types of investors) non-interference in management. At the same time, the modern paradigm of corporate governance suggests that the responsible shareholders should put constant pressure on managers to generate a maximum "value" (7).
What are these sovereign wealth funds with assets estimated at some $3 trillion, and what do they want? Are they predators, saviours, or dupes? Beyond the fact that they manage government revenues, these funds – to which one should add a number of public or quasi-public enterprises – differ greatly in terms of their characteristics, ambitions and management styles. The main cause of worry is their dual nature – their potential to switch from financial to political or strategic goals, or from passive investors to consequential decision-makers.
Not entirely new
Although they recently started attracting wide notice, they have been in existence for more than 50 years. Kuwait's Reserve Fund for Future Generations, established in 1953, was the first of what were not yet called sovereign wealth funds. Now known as KIA (Kuwait Investment Authority), it has invested over the years in major western companies, among them Germany's Daimler Benz (in 1969) and the UK's British Petroleum (in 1984). According to its top executives, the fund has always behaved as a "responsible" shareholder, concerned about receiving dividends without interfering with strategic matters.
In 1990, when Iraq invaded Kuwait, the KIA barely escaped Saddam Hussein's control. The fund was greatly weakened by mismanagement and fraud. Only with the recent jump in the price of oil did it recover its position of major financial player.
Funds based on this "fund for future generations" model have appeared in a number of oil-producing countries: the United Arab Emirates, Qatar, Oman, etc. Other sovereign funds belong to Asian countries whose rapid economic growth has generated considerable trade surpluses: Singapore, Korea, Malaysia, Taiwan.
China constitutes, for political and economic reasons, a category apart. With gigantic foreign exchange reserves (some $1.5 trillion), it has more than once brandished this "nuclear financial weapon" (8). Given all the issues opposing the US and China (on currency and exports, human rights, counterfeiting, etc), China is the only country in a position to use its financial power to achieve political goals.
In the fad-driven world of finance, sovereign wealth funds have in the past few months taken centre stage. In a quest for high returns, every country seems to want to redirect part of its foreign exchange reserves (which are typically invested in American Treasury bills) to the creation of sovereign wealth funds.
Russia created its "fund for future generations" on 1 February 2008. Japan, India and Saudi Arabia are considering doing the same. As was the case with Gulf money in the 1970s and Japanese money in the 1980s, everyone seems to be playing the extrapolation game. We are told that by 2015 sovereign wealth funds will control some $12 trillion (9) – enough to feed scary scenarios and whet all appetites.
Especially glamorous are the most "aggressive" sovereign fund managers (ie, those who seek the highest returns) whose background is often comparable to that of the rocket scientists who caused the current debacle (10). They are assiduously and shamelessly courted by hedge fund and private equity fund managers who seek to associate them to their risky bets or (which is often the same thing) to help them ride out a bad patch.
The focus of media attention is primarily on the risks posed to recipients of funds, not on the consequences in the countries of origin. The objective of those "funds for future generations" is to protect savings and allow them to fructify. But in just a few weeks they have suffered heavy losses. Since Singapore's GIC became one of its shareholders, UBS has lost 55% of its value, and Citigroup has lost 40% since Abu Dhabi's ADIA fund rode to the rescue. It is a steep price to pay to gain a foothold in the financial fortress.
China's investment experiences illustrate those dashed expectations even better. In May 2007 the Beijing regime paid $3bn for 10% of Blackstone, the famous private equity fund. Shortly after its official creation on 29 September 2007, China Investment Corporation (CIC) injected $10bn in ailing investment bank Morgan Stanley in exchange for 10% of its capital.
Meanwhile Citic, investment arm of the Chinese government, undertook an ambitious strategic partnership with Bear Stearns, based on cross-shareholdings to the tune of $1bn each. Since those deals took place, Blackstone has lost 60% of its value and Morgan Stanley 26% (11). And Bear Stearns has since become the most spectacular victim of the subprime crisis.
(1) Peter S Goodman and Louise Story, "Foreigners Buy Stakes in the US at a Record Pace," The New York Times, 20 January 2008.
(2) Henny Sender, "Silence not golden for sovereign funds", The Financial Times, London, 17 January 2008.
(3) See Frédéric Lordon, "High finance — a game of risk" and "The market in worse futures", Le Monde diplomatique, English edition, September 2007 and March 2008.
(4) Bob Davis, "Wanted: SWFs' Money Sans Politics", The Wall Street Journal, 20 December 2007.
(5) Simon English, "Apocalypse is nigh, Buffett tells Berkshire faithful", The Daily Telegraph, London, 3 March 2003.
(6) See Ibrahim Warde, The Price of Fear: The Truth behind the Financial War on Terror, IB Tauris, London, and The University of California Press, Berkeley, both 2007.
(7) See Ibrahim Warde, "The rise and rise of the Dow", Le Monde diplomatique, English edition, October 1999.
(8) Ambrose Evans-Pritchard, "China threatens 'nuclear option' of dollar sales", The Daily Telegraph, 10 August 2007.
(9) "Sovereign funds under microscope in Davos, with calls for more transparency louder", International Herald Tribune, Paris, 24 January 2008.
(10) Charles R Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, PublicAffairs, New York, 2008.
(11) "Les investissements des fonds souverains ont fondu en quelques semaines", Les Echos, Paris, 18 March 2008.
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