When the Abu Dhabi government announced late in November that it was buying 4.9% of Citigroup for $7.5 billion, the general reaction was relief that the firm was finding a way out of the subprime mortgage mess.

The same response followed the early December news that UBS was selling a 10.8% share to the government of Singapore and an unnamed Middle Eastern investor for $11.5 billion, for much the same reason.

But is foreign ownership — or, more precisely, foreign government ownership — really a good thing? Many experts think this mushrooming trend bears watching, especially for any sign that these funds are evolving from pure investment vehicles into tools for exerting political pressure on the “target” countries. “I think pressure is a legitimate worry, but I’m not sure we have seen signs of that yet,” says Wharton finance professor Franklin Allen.

There is nothing intrinsically wrong with foreign ownership, suggests Wharton finance professor Richard Marston, but ownership by foreign governments could be different from ownership by foreign businesses. “Clearly, there are industries where we would be concerned about certain countries having an ownership interest,” he says, citing airlines and military contractors. “You do worry that these are governments, and you worry about their motivation.”

Governments, through investment pools known as sovereign wealth funds, have put tens of billions of dollars into Western financial firms this year, from Bear Stearns and Barclays to HSBC Holdings and Blackstone Group, investing at bargain prices amid the subprime crisis. Two Middle Eastern government funds now even own a third of the London Stock Exchange.

None of this investment has drawn the kind of outrage that greeted a 2006 plan for a government-owned business in the United Arab Emirates to buy a firm that ran a number of U.S. ports. Much of that involved unease with a Middle Eastern country having a role controlling potential entry points for terrorists. “A lot of this becomes emotional when you’re talking about the Chinese and Arabs as opposed to the French,” Marston says.

Concerns over Secrecy

Still, some politicians and economists are concerned about the growing power of sovereign wealth funds, most of which are based in the Middle East and Asia. The International Monetary Fund estimates that sovereign funds control as much as $3 trillion in assets, up from $500 million in 1990, and it expects them to grow to $10 trillion by 2012.

While cross-border investments are nothing new, the sovereign funds raise special questions because the investment decisions are controlled by governments rather than individuals or corporations. And, unlike central banks, which tend to invest reserves in assets like U.S. Treasury bonds, the sovereign funds often invest in corporations. This year, the largest target country for such investment has been the United States.

The 20 largest sovereign wealth funds, each worth more than $10 billion, are estimated to control more than $2 trillion in assets, overshadowing the $1.5 trillion thought to be managed by hedge funds, which have been subject to calls for greater regulation because of their market clout. Like hedge funds, most sovereign funds are secretive. There is no comprehensive list of what they own, nor any mandatory reporting of their investment policies.

The Abu Dhabi Investment Authority, established in 1976, is the largest sovereign fund, with assets estimated at $500 billion to $875 billion, according to a widely cited analysis last August by Edwin M. Truman, senior fellow at the Peterson Institute for International Economics in Washington, D.C. Next is the $100 billion to $330 billion controlled by the Government of Singapore Investment Corp., founded in 1981. Singapore also runs $108 billion Temasek Holdings, started in 1974. Early in December, Temasek said it would provide $1 billion to a private-equity fund set up by Goldman Sachs Group of the U.S. to invest in China.

Norway has $308 billion in its Government Pension Fund. Kuwait’s two funds total $213 billion. Russia has a $122 billion fund, and China a $66 billion fund. Other big funds are run by Qatar, Algeria, Australia, Brunei, Korea, Malaysia, Kazakhstan, Venezuela, Canada, Iran and New Zealand.

Though the funds are typically found in countries with big trade surpluses, there is one in the U.S: the state-run Alaska Permanent Fund, founded in 1976 to reinvest oil profits.

The oldest major fund, Kuwait’s General Reserve Fund, has been around since 1960. But the funds are getting more attention now because of their mushrooming size, thanks to soaring oil prices. Truman says the funds could grow even bigger if the countries that run them were to divert more of their foreign exchange reserves into them. China, for example, has $66 billion in its sovereign fund, but more than $1.2 trillion in reserves, mostly invested in U.S. Treasury bonds. According to Allen, China might want to put more money into its sovereign fund for fear that more Treasury purchases would destabilize the Treasury market. “If they put it all into Treasury bonds, they are going to start having price effects,” he says.

Reinvesting Oil Profits, for Now

Most of the sovereign funds that are soaring in size have rising oil prices to thank. In fact, it’s no coincidence that the biggest funds belong to oil-producing states, which are using the funds to reinvest oil profits so there will be new sources of income when the oil is gone, Marston notes, adding that Norway’s fund, considered the poster child of well-run funds, was established to reinvest North Sea oil profits. “They basically said, ‘Well, we want to put some wealth aside rather than distribute it immediately, so we will have an annuity for the Norwegian people to make up for the fact that the oil is running out.”

Countries that build up foreign-exchange reserves typically invest them in liquid assets like U.S. Treasuries. But once reserves are big enough to cover any short-term needs like currency intervention, countries feel they can afford to tie money up on long-term investments that offer better returns, says Wharton finance professor Richard J. Herring. “If you have your liquidity needs taken care of, then you start thinking about making longer-term investments. It’s a very natural thing.”

Since sovereign funds have traditionally taken a long-term approach to investing, they have had a stabilizing influence on world financial markets, Herring says. But because the top 20 sovereign funds are so large, they do put a lot of concentrated economic power under the control of a small number of people, often in autocratic countries. The smaller sum controlled by hedge funds is divided among thousands of players.

Writing in the Financial Times last July, former Treasury Secretary and Harvard president Lawrence Summers noted that government shareholders may not always have the same interests as ordinary shareholders. “The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares,” he wrote. “It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence.”

Governments of target, or “host,” countries could find themselves in awkward situations, he said. “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 to bail out a company, much of whose debt is held by an ally’s central bank?”

So far, there have not been any serious cases of this power being used for political or other non-investment purposes. One of the few examples is relatively mild: In June 2006, the Norwegian fund sold its more than $400 million in Wal-Mart holdings, criticizing the way the company treated its workers.

Still, the temptation to use financial clout to further non-financial goals is ever-present, Herring says, recalling that many American universities and pension funds divested themselves in the 1980s of companies doing business in South Africa. “You had many large players reallocating their portfolios for other than economic reasons. That’s simply the nature of things when government [of a fund] is in part political.”

An Inside Look at Western Companies

According to Herring, the sovereign funds’ investments in financial-services firms may be motivated not just by hopes of good investment returns, but by the desire to learn how those Western companies operate. In addition to the recent deals, China earlier this year paid $3 billion for a 9.3% share in Blackstone Group, the New York-based private-equity firm. “My guess is that these [investments] are substantially different than the kind of passive portfolio investment you see out of Norway.”

Even so, he adds, that’s no cause for alarm, as the U.S. government can step in if it sees a real problem. “The rules can change if we should become enormously concerned that, say, the agricultural-refining business is of strategic importance.” U.S. law welcomes foreign investment so long as it poses no security risk.

For many observers, the biggest concern today is not the potential for political shenanigans but uncertainty about how sovereign funds might affect the financial markets. In an article this fall in Finance & Development, a quarterly publication of the International Monetary Fund, IMF research director Simon Johnson noted that: “Unfortunately, there’s a lot we don’t know about sovereign funds. Very few of them publish information about their assets, liabilities or investment strategies.”

If the funds emphasize a buy-and-hold strategy, as is widely thought, they help stabilize markets, he said. At the same time, he cited some anecdotal evidence of sovereign funds investing in other funds, such as hedge funds, that multiply their impact through borrowing. Leveraging can destabilize markets when bets go wrong.

The global value of traded securities is about $165 trillion, so $3 trillion in sovereign funds is not yet a major concern, he wrote. But if the figure rises to $10 trillion, and if many funds do employ leverage, the funds will bear watching, he added.

The Peterson Institute’s Truman advocates “a quantum increase in transparency and accountability” for sovereign funds. At a minimum, he says, the funds should publish annual reports detailing investment strategies and holdings. This fall, the U.S. Treasury Department called on the IMF and World Bank to develop a “best practices” guideline for sovereign funds.

Allen, Herring and Marston agree that greater transparency would be good. But Herring notes that such requirements would not be easy to impose: “It’s hard to see how you get compliance with so-called ‘voluntary’ guidelines when the people who are making the investment decisions are really not involved in putting together the guidelines.”