Sovereign wealth funds from countries such as the United Arab Emirates, Norway and Singapore often are in the news as they invest in companies such as UBS, Merrill Lynch and Citigroup. In Asia, Singapore's Temasek fund and China's China Investment Corp. have been seeking out high-potential deals. These moves have led some experts to argue that India should set up a sovereign wealth fund to buy energy-generating assets. In this opinion piece, Vinay B. Nair, a senior fellow with the Wharton Financial Institutions Center, explains why he opposes the idea. Nair is also a senior fellow at New York University and a visiting professor at the Indian School of Business.

Recent media reports suggest that India, like other Asian countries such as China and Singapore, is planning to set up a sovereign wealth fund -- or a fund that invests the country's national savings in international assets. For example, on February 19, The Economic Times, India's largest business daily, wrote that "the government is planning to create a multi-billion-dollar sovereign wealth fund, [the] first of its kind in India, which aims to invest in energy assets such as oil, gas and coal across the world." In my view, such a proposal is at best risky and, at worst, misguided.

As the citizen of a democratic country, I sometimes liken my role to a shareholder in a company. Good companies carry a cash buffer -- not unlike the reserves that governments maintain -- that is valuable during economic downturns. Just as some companies carry too much cash, so do some countries. Indian reserves have been increasing steadily. Just during the past year, thanks to a massive inflow of international capital, India's foreign exchange reserves have gone up by some $100 billion and they now hover around $300 billion. By most rules, including the famed Greenspan-Guidotti rule, which provides a benchmark, India's reserve strength is formidable.

What would you, as a shareholder, expect a company to do if it was awash in cash and the liquid funds it was hoarding were too high? Perhaps you wouldn't mind if the company placed this excess money in investments that reduce its financial risk. For instance, a Bangalore-based IT company might buy the rupee since a strengthening currency hurts its margins. Similarly, the largest sovereign wealth funds -- such as those owned by the governments of Kuwait, Abu Dhabi and Norway -- derive their revenues from oil and other non-renewable commodities. Given their desire to mitigate financial risk, it is hardly surprising to see these countries reduce their long-term dependence on oil prices by investing in non-oil assets.

India, in contrast, does not depend on oil-generated revenues. Instead, the country is exposed to fluctuations in oil prices since petroleum-based imports make up some 30% of India's total imports. One could argue that India faces the opposite situation than the one that confronts Kuwait or Abu Dhabi. That is why, the argument goes, India should spend its cash reserves investing in energy resources since this strategy would help India mitigate the risk of rising oil prices. Viewed in this light, the proposal to set up a sovereign wealth fund to invest in energy is not without merit. Still, keep in mind that the fraction of imports accounted for by petroleum-related products in India is only 30%. In contrast, the hedging motive for Norway, Kuwait and Abu Dhabi is driven by a significantly higher exposure to oil in their exports.

Further, and perhaps more importantly, the realities of sovereign boundaries and politics make this a risky proposition. These strategic assets are guarded by local governments and politicians. Can one expect them simply to stand by passively while another government tries to acquire these assets? Even when private companies have done so, they have had to jump over several hurdles. Others have had to simply live with situations where their contracts were not upheld: Hugo Chavez's abrupt cancellation of Exxon Mobil's contracts is a case in point.

Many politicians in the U.S. were up in arms when a Dubai-owned company tried to buy an American port-operating company. The target, they claimed, was a strategic asset and should not be controlled by a foreign country. Imagine the furor if the target were a company such as Exxon Mobil or Chevron. Can we expect local politicians to let India's fund acquire strategic energy assets in their backyard? I expect a significant political risk even if such deals are struck. After all, these deals can change as governments change. To complicate matters further, many of the energy assets that India seeks happen to be in non-democratic countries.
 
High Returns?

As a shareholder, perhaps you wouldn't mind if the excess cash were used to make new investments. This would only make sense, though, if the new investments could potentially increase the return to the company stock, something that is unlikely if your company has little skill in managing the new investment. Singapore has done a commendable job in building an infrastructure to detect high-return opportunities and investing in them. This competence, of which Temasek (Singapore's sovereign wealth fund) is a symbol, took a long time to develop; Temasek was founded in 1975. The Singapore government's ability to find attractive investment opportunities is what China, by its own admission, seeks to replicate in its fund.

While it is too early to pass judgment on China's investments, the beginning hasn't been ideal with the investment in Blackstone (down 54% since its IPO). It had also announced a deal to invest in Bear Stearns. Luckily for China, Bear's collapse and bailout occurred before any such investment could be made. It is difficult to imagine how countries can allocate large amounts of capital in high-return opportunities overnight without building the capabilities to do so. It is also difficult to think about the Indian proposal as one that looks for high returns in the near future. Moreover, a proposal that is motivated by high returns is unlikely to restrict itself just to sectors such as energy.

National Dividend

Finally, as a shareholder, perhaps you would want your company to pay the excess cash out as dividends, so that shareholders can use the money in a manner that gives them the highest benefit. In the context of a country, such a national dividend is provided by maintaining a low tax rate. India's current proposal has no such intentions.

While these analogies between companies and governments are useful to see some options, it is also important to remember that a democratic government has a mandate to play a role in promoting public welfare. Governments have a responsibility to invest in projects that generate public good. It is no secret that India needs massive investment in infrastructure, education and health care projects. It is useful to note that among most sovereign funds that have non-oil-based revenue sources, such domestic investment needs are minimal. Governments in China, Singapore and Australia, for example, have addressed these issues.

In my view, India should come up with a two-pronged approach. First, the country should develop a plan where excess reserves are used to fund infrastructure, education and health care needs in a non-corrupt and efficient manner. This would decrease the government's reliance on tax revenues and provide an effective tax cut. Second, India should start building the country's ability to detect high-potential investment opportunities overseas, just as the government of Singapore did. Such a project should start at a small scale and then be developed over time. This dual approach to managing the country's national savings would serve India much better than rushing to set up a sovereign wealth fund to buy energy assets.