The growing power of sovereign funds in global financial markets is starting to make a number of countries decidedly uncomfortable. 
 
Story Melissa Wilkinson 
 
Sovereign wealth funds (SWFs) have been around for a number of years but since the sub-prime crisis in late 2007, they have well and truly moved into the spotlight. They are causing increasing levels of unease because they hold very large sums of money, are autonomous and are only accountable to governments or public sector institutions. Warning bells about their potential impact on the health and stability of the global economy are starting to ring as the size and numbers of SWFs continue to grow at a rapid pace. 
 
SWFs Explained  
SWFs can be defined as special investment funds created or owned by governments to hold foreign assets for the long term. According to the Organisation for Economic Co-operation and Development (OECD), governments set up SWFs to diversify and improve the returns they are getting from their foreign exchange reserves. SWFs are typically funded through the sale of state-owned resources or from general tax and other revenue. Countries can build up budget surpluses from exporting things like oil, manufactured goods or commodities to the rest of the world. All of the profits can’t be pumped back into their respective economies because the extra monetary policy stimulation may hike up domestic inflation, which isn’t a desirable outcome. Sitting on piles of cash is also not really an option. 
 
As a result, exporting nations like Kuwait need to find a home for their US dollars and they want a higher return than the yields available on US Treasury bonds. With record oil prices, the balances of the currency reserves in countries like the Middle East are exploding. Consequently any governments with excess cash parked in an SWF have been hunting around the world for places to put their money to work. 
 
The global credit crunch has hurt hedge funds and private equity firms quite badly, but the outlook for SWFs remains robust. Expected ongoing strong growth in emerging markets and the prospect oil prices will stay at current high levels mean the cash available for SWFs to invest will continue to climb. 
 
SWFs are not new, particularly in countries rich in natural resources. They have been around since the 1950s but they’ve grown dramatically over the last 10-15 years. The size of assets under management and growth of SWFs are turning them into an active investor group or a new type of global institutional investor. 
 
The largest funds in order of size include the Abu Dhabi Investment Authority (ADIA), the Norway Government Pension Fund - Global, the Government of Singapore Investment Corporation (GIC), the Kuwait Investment Authority (KIA), the Saudi Arabian Monetary Authority (SAMA), China Investment Corporation (CIC), the Stabilisation Fund of the Russian Federation, Temasek Holdings (Singapore), the Reserve Fund of Libya, the Revenue Regulation Fund of Algeria and the Qatar Investment Authority (QIA). 
 
The International Monetary Fund (IMF) estimates that the total pool of money in SWFs in 2006/07 was around $US2.7 trillion. It predicts that SWFs will continue to invest in international assets at the rate of $US800 billion per year. This would bring foreign assets under sovereign fund management to $US12 trillion by 2012 – slightly less than the size of the US economy. 
 
Public Pension Reserve Funds 
Given the speculation and intrigue surrounding SWFs in the last 12 months, the OECD has deliberately made a clear distinction between SWFs and another type of large fund called a Public Pension Reserve Fund (PPRF). 
 
These funds differ from SWFs as they are used by governments as long-term financing vehicles for public pensions. Assets in a PPRF are managed to meet clearly defined liabilities and capital is typically sourced from social security contributions or direct fiscal transfers from the government. PPRFs are also expected to experience rapid growth as many developed countries have aging populations that will need to be supported in the future. 
 
The fiduciary role of PPRFs over pension assets means that they are quite different beasts from SWFs. Trustees of PPRFs usually require these funds to have clear mandates, greater levels of governance and transparency than SWFs which usually have much broader investment objectives. 
 
Many PPRFs are subject to rigorous accountability and disclosure requirements. Their governance structures are designed to protect against political interference in the management of the fund. 
 
The investment approach adopted by PPRFs is typically more conservative than that used by SWFs. PPRFs usually invest in domestic assets such as government bonds or equities, although some are increasing their allocations to foreign assets and alternative investments like private equity. Most PPRFs are younger than the more mature SWFs so their assets under management are slightly smaller. The total amount of assets in PPRFs is estimated to be about $US2.2 trillion. 
 
There are two main sub-categories of pension reserve funds. Social Security Reserve Funds (SSRFs) are set up as part of the overall social security system. Inflows are sourced from surplus employee or employer contributions. An example includes Japan’s Government Pension Investment Fund and the Social Security Trust Fund in the US. 
 
The second type of PPRF is a Sovereign Pension Reserve Fund (SPRF). This is a large fund set up by government and is used to finance public pension expenditure at a specific future date. Capital is sourced from direct fiscal transfers from the government. 
 
Australia’s Future Fund, which was set up by the Howard Government in 2006, is a good example of this type of fund. At the end of April 2008, it had $61.48 billion in assets under management. In addition to the Future Fund, three new nation-building funds were announced in the 2008-09 Federal Budget: the Building Australia Fund, the Education Investment Fund and the Health and Hospitals Fund. 
 
A Financial Monster?  
The design, operation and role of these mysterious, opaque investment funds are stirring up considerable debate. Scaremongers suggest that the possibility of unknown Chinese government bureaucrats becoming the new rulers of Wall Street is not completely out of the question. 
 
SWFs have gained increased attention from the markets, policy makers and governments since the sub-prime mortgage crisis in late 2007. It is estimated that SWFs have injected more than $US40 billion since November 2007 into the European and US banks which were hit with huge losses from the sub-prime meltdown. 
 
As the credit crisis has intensified, SWFs’ appetite for shares in global investment banks has increased. Singaporean-owned investment firm Temasek Holdings increased its stake in Merrill Lynch to $US5 billion. Merrill Lynch was hard hit in the sub-prime crisis. 
 
Other firms which have received cash infusions from SWFs include UBS, Bear Stearns, Morgan Stanley and Citigroup. These investments have since prompted the US Senate to order an enquiry into SWFs. An example of another high profile SWF acquisition included the Dubai Ports World takeover of P&O in February 2006. This was subsequently partly reversed after the US Congress ordered it to sell six US port terminals. 
 
The key concerns surrounding SWFs relate to the strategic and political objectives of SWFs and their potential impact on exchange rates and asset prices. SWFs are causing alarm because of their size and lack of regulation. Similar to the debate about hedge funds, commentators are concerned about their capacity to destabilise international financial systems. 
 
In an interview with ABC Radio in March this year, Mark Thirlwell, the director of the International Economy Program at the Lowy Institute in Sydney, said that we’re now seeing developing country taxpayers bailing out rich country financial systems. 
 
“What we used to think about international financial crises were that they happened in developing countries, you know, somebody fell over and then the International Monetary fund came in, lent money to them, bailed them out. This time we’re having what’s being seen as reverse bail-out; it’s the banks in the rich world, the developed world, that have been falling over, or at least have been suffering, and the money has been flowing from developing country governments into those banks to recapitalise them.” 
 
Conspiracy theorists worry foreign government controlled SWFs may be motivated by political rather than profit objectives and represent potential security threats. Questions are being raised about what the governments of countries like China, Russia and Saudi Arabia may look like a decade from now and what their political motivations may be. 
 
Some market participants believe SWFs are making the most of the opportunity to build stakes in the investment banks to tap into developed country expertise in trade finance and financial systems. 
 
Commentators are anxious that some SWFs may end up having more clout than international financial institutions and could deliberately manipulate markets and currencies. The size of investments by SWFs could trigger reversals in capital flows, with potentially destablising effects on both asset markets and economies. 
 
The prospect that one fund could have the ability to buy any global company of its choosing or even create panic in markets if it moves too precipitously is certainly unsettling. Many are calling for some form of global policing. 
 
While each individual fund is not large relative to the size of the global economy, there are still concerns that an SWF’s lack of transparency could contribute to market volatility because of uncertainty about its allocation of assets. The issue is that SWF operate a bit like large black boxes. There is little information about them and their investment practices vary widely. 
 
SWFs are not required to disclose their investment objectives, time horizons or asset allocations. There is nervousness that funds are partnering with hedge funds and private equity groups to partake in higher risk and higher return investments. Commentary such as “irresponsible asset stripping by locusts” are heard in the media. 
 
These questions about transparency and the blurring of lines between government and private economic activity are being raised because governments operating SWFs can be both market players an referees in the financial system. 
 
SWF Supporters 
In an environment of tight liquidity and scarce financial capital, proponents of SWFs argue that an SWF is not the big bad wolf at the door at all. They argue that these funds can be used as a force for good in capital markets. Supporters believe that SWFs play a role in enhancing liquidity of the market and financial resource allocation. They believe that SWFs can help a country make higher returns on any fiscal surpluses and provide diversification benefits. Some SWFs like the Norwegian Government Pension Fund are often held up as a model global investor. Its petroleum fund called the Government Pension Fund-Global is the world’s second largest pension fund and is responsible for managing Norway’s oil revenues. 
 
IMF’s first deputy managing director, John Lipsky, was reported as saying in March 2008: “From the viewpoint of international markets, SWFs can facilitate a more efficient allocation of revenues from commodity surpluses across countries and enhance market liquidity, including at times of financial stress. They also tend to be long-term investors with limited withdrawal needs, which enable them to withstand market pressures in times of crisis and dampen volatility.” 
 
Aref Sherani, director of Investment Strategy of Qatar Investment Authority (QIA), tried to shed light on the role played by SWFs while speaking in June this year at the 15th International Financial Forum of Paris known as EUROPLACE. 
 
“Some see us as demons, when we see ourselves as no more than pensions funds or future funds. We are an important element of stability as we have a long-term vision. We also invest where nobody else does, including US real estate.” 
 
Calls For Global Policing 
OECD and other countries are so concerned about the growing power of SWFs that meetings have been held over the last nine months to discuss ways to deal with these issues without crimping the flow of money through the global economy. The challenge is to balance the promotion of freedom of investment with national security issues. There have been a number of IMF attempts to try and improve the transparency of SWFs. The IMF’s ministerial guidance body, the International Monetary and Financial Committee (IMFC), asked the IMF to work with SWFs to develop a set of best practices for managing IMFs. 
 
A roundtable of sovereign asset and reserve managers met in November 2007 and 40 SWFs gathered at the IMF in Washington in April 2008 to nut out a global voluntary code of conduct. The IMF has also brought together 25 of its member states with SWFs in early May this year to form the International Working Group of Sovereign Wealth Funds (IWG). The IWG is co-chaired by a senior representative of the Abu Dhabi Investment Authority (ADIA) and the director of the IMF’s monetary and capital markets department who were selected by the participating SWFs. 
 
The IWG is charged with developing a set of SWF principles to help maintain the free flow of cross-border investment together with open and stable financial systems by October 2008. 
 
While there is increasing recognition that improvements in transparency are needed, it is also clear that investment review processes in recipient countries also need to be refined. 
 
Countries which export oil or those with fiscal surpluses are going to accumulate so much money over the next decade that it will be burning a hole in the collective government coffers. Their SWFs will be looking for places to invest the money, so in recognition of this, countries like Australia are starting to scrutinise investments from emerging economies in more detail. 
 
In February 2008, Treasurer Wayne Swan released changes to Australia’s foreign investment policies in a bid to tighten our screening process. 
 
The purchase of a large or controlling slice of one of Australia’s key mining companies by a resource hungry country like China clearly raises some national interest issues if it limits competition or local supply. 
 
The Chinese Government’s purchase of a stake in Rio Tinto in February this year made major headlines. China’s state-owned Aluminum Corp of China (Chinalco) teamed up with US aluminium producer Alcoa to buy a 12 per cent stake in Rio’s Londonlisted shares. This gives them a holding of more than 9 per cent, including Rio’s Australian listed shares. 
 
In contrast, some Australian banking institutions are rolling out the welcome mat to SWFs. 
 
At a media briefing in Beijing in January 2008, Michael Smith, CEO of ANZ, confirmed China’s foreign exchange regulator bought a stake of less than 1 per cent in ANZ in December 2007. He was reported to have said: “ANZ would welcome sovereign funds buying stakes and it would be good to have long-term investors such as sovereign wealth funds on the register.” 
 
Looking Ahead 
The power and influence of SWFs is likely to just keep growing as the global economy continues to slow and financial markets remain volatile during the remainder of 2008/09. With greater buying power and a weak US dollar, more corporate activity by SWFs in developed countries such as the US is on the cards. Plus, SWFs are likely to start searching harder for places to invest, as the number of safe, low risk assets get