Sovereign Wealth Funds

Milton Friedman’s metaphor of a “helicopter drop” in money can be aptly adapted to explain the latest buzz phrase in the international financier’s lexicon - the sovereign-wealth fund. For those who have not tracked the surge of this phenomenon to the forefront of the international stage, sovereign-wealth funds (hereafter referred to as SWFs) are essentially state-owned funds that invest excess foreign exchange reserves; notably assets which have been amassed in large part due to increasing and high oil prices as well as burgeoning export volumes.This year alone these funds, collectively estimated to have more than $2 trillion at their disposal, have taken sizeable stakes in companies very much at the core of western finance. Citigroup, Merrill Lynch, Morgan Stanley and UBS, all huge players in the investment banking field, have experienced injections this year thought to be in the region of $40bn from SWFs, such as the Government of Singapore Investment Corporation (GIC). Some already speak of the an “invasion of the sovereign-wealth funds”. (The Economist)

The interest and capital of SWFs has not been lavished exclusively on the finance sector, yet a pattern has seemingly emerged whereby the state-owned wealth of nations, predominantly in Asia and the Middle East (Abu Dhabi, Singapore, Saudi Arabia, Kuwait and China comprise the six largest SWFs, the Government Pension Fund of Norway being the odd one out) has found its way onto the balance sheet of Western financial corporations. Late last year it may have been possible to analyse this trend merely as funds taking advantage of equity in influential financial companies at bargain prices due to the workings of the sub-prime mortgage fiasco and ensuing credit crisis. As explanations go, this deserves a level of credence, yet the first few months of 2008 have shown SWFs are to become important mainstays in international finance and economics, demonstrated in no small part by the concern that Western policymakers have expressed regarding the transparency and objectives of these financial vehicles.

It may surprise you to learn that the first registered SWF (the Kuwait Investment Board) was created in 1953, and indeed they are not a new phenomenon. This particular SWF was mandated to invest Kuwait’s oil revenues in commodities, and this contrast provides an implicit explanation of why SWFs have been such a consistent hobbyhorse of financial commentators of late.

The effects of the sub-prime mortgage market meltdown (house loans granted to people whose credit history means their likelihood of defaulting is higher than normal, usually reflected in higher mortgage repayment interest rates) are still working their way through the financial system. Yet this crisis undoubtedly reveals at least why a favourable climate exists for SWFs to take ownership stakes in some of the keystones of western finance, shifting the balance of global financial power as they do. Two movements represent how this changing environment have ushered SWFs to be key shareholders in Western finance.
The first is a straightforward tale of large investment banks’ exposure to securities that depend on sub-prime mortgages; as the market began to dry up for the re-packaged financial instruments that often comprised these mortgages, banks found they were due to make huge losses (the aptly named ‘write-down’). Citigroup has to date experienced a sub-prime write-down to the tune of $18bn, the current loss at UBS is thought to be $13.5bn, whilst Merrill Lynch’s affliction is denominated at $14.1bn. It seems to follow that these banks would be only too pleased to accept the gracious offers of SWFs with trillions of dollars at their disposal that would otherwise be sitting in reserves.

The second movement too originates in the current financial turmoil, and unfortunately requires the deployment of some jargon. As well as the write-downs, investment banks have been forced to make, due to sub-prime exposure, the ever-increasing sophistication, and complexity, of the process of securitisation (by which firms are able to convert, in this case, mortgages into marketable securities and sell them on, with the buyers able to repeat this process), a bout of jitteriness has been unleashed whereby banks are unsure of just who bears significant sub-prime exposure in their assets, the result being an unwillingness to lend to each other. The point being that such lending is how many banks have come to finance their daily operations. SWFs are known to be unaffected, in even vestigial form, by sub-prime problems and due to the huge pool of resources they have, are able to complete deals with less leverage (leveraged deals are those where a high amount of debt has been created in order to finance the deal).

In the very cautious atmosphere that has descended on financial centres on both sides of the Atlantic, with firms more concerned with shoring up their own positions before doing business with each other, the capital injections of SWFs have provided a relatively safe way for banks to recover some of their losses and finance future activities, without the headache, or risk, of what lies within that ominous package of collateralised debt obligations.

Added to the relatively low financial risk of the capital on offer from SWFs is the thinking that the investments being made, are prudent for the long term. Many SWFs have chosen to invest such that they have bought debt instruments which only convert to shares (usually yielding higher returns) after a number of years.

It would be a correct assessment to perceive that those at the centre of western finance are content with the role that their eastern counter-parts are playing. However, as alluded to earlier, western governments harbour concerns regarding the growing stakes being bought up by eastern wealth funds. Though as yet largely untouched by the riches of eastern state investment vehicles, leading public figures in the European Union, including Nicolas Sarkozy on more than one occasion, have spoken out in pre-emptive defence of European companies, picking out how the dearth of available information regarding the purposes of SWFs (are they simply profit-seeking or do they seek to pursue goals consistent with foreign policy?), and, as a corollary, the investment strategy they will pursue. Perhaps more revealing is the U.S. Senate. The Senate Finance Committee (whose oversight extends to the interactions of large U.S. banks and SWFs) recently noted that the rapid expansion of the funds raised ‘significant questions and concerns’ about their investment in U.S. assets.

Those in government, it seems, are aware of the changing face of global finance, though with the havoc wreaked last summer improving the credentials of the capital that SWFs have in abundance, their ascendance to the global fore looks set to continue.

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Damilare Tanimowo is a second year undergraduate reading Philosophy, Politics, and Economics at the University of York.