The Brave New World of Sovereign Wealth Funds

Sovereign Wealth Funds, the large investment funds supported by governments, are mostly a positive economic force that can provide a shot in the arm to the companies — and countries — they invest in. They are also a stabilizing force for the nation where the investment originates. Those are some of the main takeaways from a new study, “The Brave New World of Sovereign Wealth Funds,” conducted by Wharton MBA students and sponsored by the Wharton Leadership Center and the Joseph H. Lauder Institute of Management & International Studies. The research suggests there is little reason to worry about these funds acting from political rather than economic motives. In an interview with Knowledge@Wharton, Wharton management professor Mauro F. Guillén, who helped to oversee the research, and two Wharton MBA candidates present some of the study’s key findings. An edited transcript of the interview follows. The complete study can be downloaded as a pdf here.

Knowledge@Wharton: We are joined today by Wharton management professor Mauro Guillén and two Wharton MBA candidates, Gokhan Afyonoglu and Hussein Kalaoui. We will be discussing the just-released study they have been working on called, “The Brave New World of Sovereign Wealth Funds.” Thanks for joining us today. Can you offer a very brief description of a sovereign wealth fund?

Gokhan Afyonoglu: A sovereign wealth fund is a fund supported by the government of a country [and] funded by budget surpluses of that country coming either from exports or from oil revenues.

Knowledge@Wharton: Are the funds typically invested overseas? Or are they invested domestically and overseas as well?

Afyonoglu: It really depends on the fund. Some funds try to deploy these monies domestically. Some deploy them entirely, or for the most part, abroad in foreign assets.

Knowledge@Wharton: Before the global financial crisis, sovereign wealth funds were estimated to have assets of more than $5 trillion. They are big players. What broad themes are important to understand about their behavior? And what are the chief misconceptions about them?

Hussein Kalaoui: I think one of the main misconceptions about sovereign wealth funds is that they are these opaque institutions that invest strategically in assets around the world in order to use them as political tools, given that the funds are owned by governments. Especially in the case of some of the funds that we looked into, for example the Chile fund that I did some in-depth work on, I found that not to be the case at all. Most funds take, if anything, minority stakes in large corporations. And in the case of Chile, for example, they don’t purchase any company stocks or bonds at all. All of their investment is in government paper and is a domestic microeconomic tool as opposed to some kind of strategic, political tool that they look to deploy around the world.

Knowledge@Wharton: Haven’t there been some cases though where the opposite was true?

Afyonoglu: It is certainly true that the size of the investments has become significant. But, again, they are very careful in terms of spreading these investments across a large number of countries, sectors and, of course, companies. One important thing to keep in mind about sovereign wealth funds is that the controversies have become more frequent over the last few years because of the rise of sovereign wealth funds from countries that are a bit less transparent … such as, for example, China or Russia. And also because they have shifted their strategies a little from fixed income and more into equities, but always acquiring really tiny equity stakes in companies.

Knowledge@Wharton: So when there is a problem it’s maybe when they are going for a majority stake? I’m thinking — this goes back a few years also, but there was a Chinese sovereign wealth fund, I believe, that was trying to take over Unocal oil company in California. And I believe that the U.S. Congress intervened and said, no, oil is a strategic resource and we are not going to allow that. Did sovereign wealth funds learn a lesson from that?

Guillén: That was CNOOC, which was a state-owned oil company from China, which attempted to take over a relatively small U.S. oil company and there was this big uproar. Technically speaking, this is not a sovereign wealth fund. It is a state-owned company and, therefore, of course, there is a government behind it and that may have played a role. So I don’t think that is an event that says anything really about sovereign wealth funds as Gokhan defined them at the beginning of our conversation.

Knowledge@Wharton: It’s also true that sovereign wealth funds have helped bail out some U.S. banks during the financial crisis and they did so at a very critical time. Does that suggest that sovereign wealth funds are less of a worry in the minds of critics than they were a few years ago?

Guillén: There has been some skepticism about sovereign wealth funds investing in Western companies, mostly in the U.S. and Europe, but especially the ones we visited in the [Persian] Gulf. They were very keen on having us understand that their purpose is totally economic. There are no political decisions involved in their investment process.

From that perspective, they seem to be playing a stabilizing role, especially in this current economic crisis. With their investments in Western banks, they did come to rescue them at a critical moment. From the perspective of transparency, there are some issues with certain funds. But the ones in the Middle East, especially in the Gulf, they are mostly not political and totally economically oriented. They try to maximize benefits for future generations and to diversify their economies and nothing more.

Kalaoui: If you look at the investments and the behavior of the sovereign wealth funds, they appear to be consistent with what you would expect if they were looking to maximize their gains to the shareholders, which, again, is evidence supporting the assertion that these are economic investment tools and methods for the governments to prudently allocate their resources to where they are going to get the highest returns as opposed to anything else.

Knowledge@Wharton: Why do you think there are concerns about sovereign wealth funds? What do you think are the chief trip wires when critics describe their investment methods? What is the position they are taking and why is it often so strong?

Afyonoglu: Most of these sovereign wealth funds are relatively recent. It is true that the oldest one dates back to the 1950s — the Kuwait Investment Office. But most of the sovereign wealth funds that people are talking about these days are relatively new. They didn’t exist two or three years ago. And [if] they existed prior to the new century, they were so tiny that nobody really cared.

So the problem, or the reason they have become so prominent and so visible, and in some cases so controversial, is because of the size. Why have they gotten so big? Because there are all these imbalances in the global economy. There are all these surpluses, especially in the emerging economies because of exports [and] because of their natural resources. These countries essentially don’t have a desire to spend all that money. They want to put it aside, which is a great thing. They should be congratulated for that decision. They want to provide future generations of their countries with some cushion of stability. They also want to avoid short-term problems where you keep so much money in the country from export earnings that inflation is likely to go up and all sorts of microeconomic imbalances are likely to get worse. So it is a good idea to invest that money outside of the country. And, of course, it serves a purpose [in the United States] because some of our banks are under-capitalized. We need money to come in for investment. So as long as they are not making decisions based on political factors, why do we complain? It is money, after all, that is coming here. Most of the time, it is a long-term investment as opposed to investment looking for short-term gains. But, again, it is controversial because obviously some of the countries behind these funds still don’t have the best of reputations. But that is somewhat unfair in many cases. So we will learn how to live with sovereign wealth funds. It is a matter of time.

As they make decisions and continue to have a good track record in terms of not interfering, they will help themselves by building more of a reputation for being reliable long-term investors.

Knowledge@Wharton: Few people are likely to be aware that these big, ultimately government-controlled funds get special tax treatment when they invest in the United States. Could you explain how that works and why it exists? It seems like a pretty big loophole.

Afyonoglu: We don’t get into the details about the tax treatment of sovereign wealth funds. But it is true that they can escape some [taxes] by virtue of their legal status.

Knowledge@Wharton: Because they are government-owned there are special provisions.

Afyonoglu: Exactly. And we discuss some of those, but not really in depth, in the last chapter of the report. By the same token, though, they cannot take advantage of the tax breaks. So it really cuts both ways. There are a lot of countries — including the United States — which have incentives to attract foreign capital. And, the foreign capital is coming with few strings attached in the sense that these funds don’t want to participate in the management of the company. They just want to take a 1% or 3% equity stake.

Knowledge@Wharton: And they tend to be long-term investors?

Afyonoglu: That is a good thing. They tend to be reasonably long-term investors. And then during times of crisis like over the last couple of years they are willing to actually bet on companies and banks in particular, that needed capital. That is something that should contribute to their reputation. They were ready to invest when we needed them to do so.

Guillén: There are studies which indicate that there is effort on the side of sovereign wealth funds to get their people on boards of companies. But there is no indication that these board members act for some political or different ideological reasons or motives. That is why I don’t think we should be concerned even if the funds get their people on the boards of companies. They basically try to get the most economic benefit out of these companies, which is what any reasonable investor would do.

Knowledge@Wharton: Could you explain some of the risks and opportunities and the implications of the so-called “race to the bottom” among countries that allow sovereign wealth funds to invest in them? Who are the likely winners? And why does the United States appear to be losing?

Kalaoui: Could you elaborate on what you mean by “race to the bottom”?

Knowledge@Wharton: In the conclusion of your paper you talk about regulations and other factors that affect a sovereign wealth fund’s desire to be in one country over another. So if, as seems to be a trend, there is a move in the U.S., and particularly in Europe, to provide barriers making it more difficult [for the funds to invest], whether taxation or regulatory barriers, the sovereign wealth funds may look to other places and these areas may lose out on the benefits of those investments.

Afyonoglu: In general, and this is manifesting itself in this particular sector of activities — sovereign wealth funds — that capital, of course, will flow to the best opportunities where there are obviously the least barriers, or frictions. And it is not only in terms of getting in but also coming out because long-term doesn’t mean forever, right? So there are distinct time horizons in all of these investments. They may be 3 to 5 years or they may be 10 or 12 or 15 years.

We — especially here in the United States — believe that a well-functioning global financial system is something that is not just good for investors, but also good for the recipients of the investment because we might be able to attract funding for all of our needs at a lower interest rate, on better terms, to the extent that the market works. Leaving aside such complications as systemic risks and all sorts of other things that can create problems, is it a good thing or a bad thing that there is competition among countries to attract investments either from sovereign wealth funds or from other types of funds? I personally believe that it is a good thing that there is competition.

And the race to the bottom, of course, is a term that evokes negative images, as in the case, for example, of dumping, social dumping [or] environmental dumping. Are we investing in a place where we can actually pollute? But when it comes to investments by sovereign wealth funds or other actors, really, it is all about the investment regime. Does the investment regime create too many obstacles or barriers or hurdles? Is it risky or not? Are there institutions that would defend the rights of the investor and so on and so forth? I personally don’t believe that it is bad for the recipient country. I think each country should try to think about what it feels comfortable with in terms of regulations about or concerning foreign investment, including that coming from sovereign wealth funds. And then [countries should] just to stick to the rules, right? It is not that every country needs to be equally forthcoming, or equally welcoming, to foreign investment. They just need to decide what is their comfort level regarding different types of international money flows and then take it from there. But, again, I am assuming it is in the best interest of any country, including the United States, to attract investment at the lowest possible cost.

Knowledge@Wharton: Hussein, could you tell us some of the key findings from the study regarding the Latin American region?

Kalaoui: The most important sovereign wealth fund in Latin America is by far Chile’s Economic and Social Stabilization Fund. If we are to compare it to other funds around the world, it is probably most similar to Norway’s in that it is a mechanism for investing surpluses from the export of natural resources. Chile, due to high copper prices over the last few years, has had a huge balance-of-payment surplus. Instead of taking that money and spending it on infrastructure projects and things like that domestically, which the domestic economy would not be able to absorb, they have instead invested it abroad.

And Chile’s funds, based on what we found, are extremely transparent. During our research they were very willing to talk to us, to share information with us, and to allow us to publish information about their funds and how they operate. They were very open about the purpose of the fund, which is largely [used] as a tool for a countercyclical fiscal government policy. Basically, during boom times they will invest their surpluses in financial securities around the world. And during times of economic contraction, they will dip into that fund to bolster domestic government spending.

Hence, it is a tool for them to better manage and smooth out their government spending over the economic cycle. And so far we have seen them go through one cycle. We have seen them go from boom down to the current recession. It will be very interesting to see if the fund operates in the way it was intended as they go into the fund right now to look for the resources to back up their government spending.

Knowledge@Wharton: Does it look like it is going to be a significant contributing factor to helping them meet a deficit?

Kalaoui: Yes, it looks like it has definitely helped them meet their current spending needs. For example, a huge component of a fiscal stimulus package the [Chilean] government recently put together did come from the sovereign wealth funds. So we are seeing them draw down the funds now and that money is being put to work to stimulate the economy. What is very interesting is there are a lot of guidelines as to what they can invest the money in, what kind of securities they can and cannot invest in, [and] how much they should invest and when.

But there are little to no guidelines about what they would spend the money on once they dip into the fund and look to spend the money domestically. So it will be very interesting to see how they choose to spend the money and if the funds are going to continue to grow through future economic cycles and continue to work in this way.

Knowledge@Wharton: Do they manage it in a way that they don’t dip into the principle when they are spending this money? Or are they dipping into it and replenishing it later, at least in theory?

Kalaoui: I believe they are dipping into principle. So it basically is like a big high-interest-rate savings account. You can think of it that way.

Knowledge@Wharton: Gokhan, tell us more about some of the major themes around the Middle East.

Afyonoglu: I traveled there last summer with two of my classmates and we visited some of the biggest funds there, including the Kuwait Investment Authority. They welcomed us. They gave us a lot of information. And we didn’t only meet with the funds themselves. We also met with investment bankers, with investment management companies and consultants who do business with these funds. And we obtained a great exposure to the region and the funds and how they operate. We realized that they were very willing to show that their intentions are purely economic and they want to contribute to the stability of the global financial system and not become a problem per se. And we reflected that also in our report.

Also, we obtained a good picture about the societies of the Gulf area and what kind of role these funds play in local economies in the region and in developing these countries into full-fledged market economies. These funds are not only important for the global financial system but also for the [growth] of countries in the Gulf and in [other] developing regions.

Knowledge@Wharton: Could each of you give one more point about a major take-away from the study? And Professor Guillén, could you give a wrap-up of something we should have covered that we haven’t that is a major take-away from the study?

Afyonoglu: I think sovereign wealth funds have not really become less important with this crisis. Maybe their asset bases have decreased a little, as every other investor’s has. But going forward they will be very important. The surpluses are not going to decrease. They will continue to become more important players in the global financial system, so they have to be watched carefully. And regulations have to be developed around their investments. The major take-away is that, for me, they need to be paid attention to. We need to talk with them and we need to understand what their needs are and we need to design our system to facilitate their investments.

Kalaoui: What I found very interesting in the case of Chile’s funds is how important the domestic politics are; the domestic purpose that the funds serve, and the lengths that the government has gone to in order to create the fund that represents a legitimate use of taxpayer money. In order for the fund to be successful, to continue to exist in the future, the governments had to get the buy-in of Congress and get the buy-in of the population at large that the government is investing this money on their behalf. We tend to look at sovereign wealth funds as kind of a global phenomenon, as something that has inevitably been developing due to macroeconomic forces around the world. But it is very interesting to [look through] the other lens and examine what the fund means to the investing country and the impact it has on its economy, and how a well-managed fund can be a great tool that will contribute positively to the macroeconomic stability of the investing country in the long term.

Knowledge@Wharton: Professor Guillén, final thoughts?

Guillén: Yes. I think the report offers a great first look at the reasons why these funds have become important — how they operate and the differences among them — depending on the country and the fund itself. I would like to highlight that it is a phenomenon that, because it is so recent, is fundamentally misunderstood in many quarters. It is important that policy-makers and decision-makers, fund managers and so on around the world read more about them. In our report there is an appendix that provides a short reading list of other papers or articles for those who want to dig deeper into the history of the funds or the realities around the world.

Finally, I would like to point out one issue that has not come up, which is that the funds have also suffered as a result of the crisis. They have sustained financial losses. Some of them have lost up to 30% of their asset value in the wake of the crisis. They will recover. But once again I think this underlines that these are not obscure actors that essentially are about to take over the world. They make mistakes just like everybody else. They also incur losses. They will recover to be sure. But to the extent that there are imbalances in the global economy, to the extent that some countries have large current account surpluses, we will see sustained growth of sovereign growth funds. And, once again, it is so much better that many of these emerging economies have sovereign wealth funds and that they don’t spend the money recklessly right now. For many reasons and for many points of view, this is a welcome trend that we have these sovereign wealth funds being set up in various countries around the world.

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