In this opinion piece, Vinay B. Nair, a senior fellow at the Wharton Financial Institutions Center, discusses why Indian investors should pay attention to — but not be alarmed by — sovereign wealth funds. In addition, Nair is a senior fellow at the Center of Law and Business at New York University and a Visiting Professor at the Indian School of Business.

On October 17, the Bombay Stock Exchange Sensitive Index (or Sensex) plunged more than 9% in a few minutes after proposals by Indian regulators to place controls on foreign investments became public. It was a stark reminder of the importance of foreign capital in the country’s markets. The inflow of foreign money into India has been the subject of much heated debate; critics have blamed it for its effect on the rupee as well as the short-term orientation that contributes to volatility of stock prices. But foreign capital inflows come from many different sources. Not all of these are as well known as hedge funds and private equity funds nor should they cause as much alarm, though investors in India and elsewhere should pay close attention to them.

Consider a couple of major deals that took place a few weeks before the shudder ran through the Sensex on October 17. The Qatar Investment Authority bought 20% of London Stock Exchange Group in a deal worth about $1.2 billion. On the same day, the Carlyle Group sold a 7.5% stake to Mubadala Development, the strategic-investment arm of the Abu Dhabi government, for $1.35 billion in cash. These transactions followed a $3 billion investment in Blackstone Group by China Investment Corp.

What all these deals had in common was the type of investor: They were all made by so-called Sovereign Wealth Funds (SWFs), which are rapidly moving to the forefront of international finance. Broadly defined, these are investment entities that manage and invest the national savings of different countries. Several estimates, using reasonable assumptions, suggest that, today, such funds house $2.5 trillion. Morgan Stanley predicts this figure will increase to $5 trillion by 2010 and $12 trillion by 2015. Clearly, the way these funds invest will have a significant impact on asset prices.

Reasons for Vigilance

While investors have reasons to welcome the liquidity that such funds bring, many governments have reasons to be vigilant. Could these investments be used for strategic purposes by international governments? Won’t the objectives that drive a government’s investment go beyond simple financial objectives? Such questions have worried many politicians in Europe and the U.S. — especially after Dubai’s bid for the ports operator Peninsula and Orient, and China’s takeover bid for Unocal, a Californian oil company. Both these proposed deals ran into trouble and were the subject of negative media attention. French President Nicolas Sarkozy and German Chancellor Angela Merkel have both spoken up against foreign buyers.

Some experts propose enacting laws that restrict the activities of SWFs. Surprisingly, even many traditional free-market advocates have not dismissed these concerns as easily as they normally do. For example, in an article published in the Financial Times on July 28, former Harvard president Lawrence Summers asked: “What about the day when a country joins some ‘coalition of the willing’ and asks the U.S. president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank?”

Not all sovereign funds are similar. Moreover, in my view, laws curbing foreign capital inflows are unlikely to be helpful. Such regulations are often blunt instruments. Capital is an important ingredient of development — especially in India, and the country needs to attract overseas investment to sustain the world’s second fastest pace of economic growth. At such a time, laws that place investment barriers on SWFs would be a step in the wrong direction.

At the same time, a blanket law blocking the entrance of sovereign fund capital into India would exclude an important financial player from the country’s equity markets and thwart developmental potential. Those who advocate such restrictions ignore an important benefit of SWFs: These funds sometimes open the doors to reciprocal investment opportunities. For example, when Temasek Holdings, Singapore’s SWF, was recently allowed to double its stake in ICICI, a major Indian bank, India and Singapore also agreed to expand the presence of two banks in their respective countries.

Pay Attention to Motives

That is why I believe the presence of such funds, at this stage, merits attention, not alarm. It is important to pay attention to the nature of the SWF. After all, governments have several objectives, and it would be naïve to believe that all SWFs exist solely to maximize financial returns. Funds of countries where the investment process is far removed from the politics and those based in democratic regimes are relatively safe options. Such funds are less likely to use political motives in the choice of assets they own and are more likely to have better disclosure standards.

Until the International Monetary Fund — or the World Bank — draws up a list of best practices for SWFs to follow, Norway’s fund remains the model. It invests in a wide range of securities, keeping its investments diversified. Investments typically don’t exceed 1% of ownership. As governments are growing uneasy about foreign ownership, this appears to be a conflict-free approach to investing. The fund also discloses its holdings, as funds of democratic countries should, and conforms to the UN principles of responsible investment. It recently withdrew its investment from Wal-Mart, citing human rights violations. These are important lessons, should India ever decide to set up a sovereign wealth fund. On October 2, P. Chidambaram, the finance minister, stated that there are no such plans.

In the long run, equities have a stellar record and remain the favored choice of investment. They also provide a good hedge to many commodities. Such hedging needs are important for many SWFs, such as those in Qatar, U.A.E. and Russia. These funds have accumulated their reserves from natural resources and the commodity boom. While investing these reserves, these funds are likely to consider assets and sectors that help them diversify their dependence on these very natural resources. Among various sectors, financials, telecom and technology are likely to provide the greatest diversifying service to commodity-rich sovereign SWFs.

Since most investors agree that the global engine of growth is moving towards Asia, the allocation to equity markets in Asia is likely to be important. Many sovereign funds want to avoid political risk. Such risk is heightened in non-democratic countries, as Temasek recently discovered when its investment in Prime Minister Thaksin’s Shin Corp led to riots, a botched election and a coup d’état in Thailand. Another less extreme, but more likely, aspect that increases political (and regulatory) risk is a high ownership stake. Sectors where large dollar amounts can be invested without an accompanying high ownership stake will generate less attention and will be attractive. As a result, sectors with large firms are likely to benefit. Financial services, again, are an important example. Such political risk can also be mitigated through sovereign investments in private equity firms that then own large chunks of firms.

All this makes Indian equity markets particularly attractive for SWFs. For long-term investors in the Sensex, notwithstanding gyrations in the short term, Russia, China and Japan are allies. To sum up, stopping foreign inflows into Indian markets is undesirable, but getting to know the identity of foreign capital through better disclosure is a good idea.