SOVEREIGN WEALTH FUNDS: THE POLITICAL RISK OF FINANCIAL OPPORTUNITY

May 1, 2008

SPEAKERS:
John Green, Director of Research and Asia Practice Head, Eurasia Group
Kotaro Tamura, Member of the House of Councilors; Vice Chairman, LDP Committee on Fiscal and Financial Policy; former Parliamentary Secretary, Cabinet Office of Economic and Fiscal Policy
Edwin Truman, Senior Fellow, Peterson Institute for International Economics
Ann Wyman, Managing Director, Economic and Political Strategies, Citigroup Inc.

MODERATOR:
Bob Davis, International Economics Correspondent, The Wall Street Journal

A distinguished panel of experts from business and government met at Japan Society to discuss the rise of sovereign wealth funds and the risks and benefits of creating a Japanese sovereign fund.

Sovereign wealth funds are not new, "but the size, the scope and the variety of types of funds is unprecedented," said panelist John Green of Eurasia Group. Today, they hold a total of about $3 trillion; one recent study predicts a growth rate over the next few years of 24 percent.

Should pension funds and foreign reserves be included in discussions of sovereign wealth funds? The answer isn't always clear, and in many cases sovereign wealth funds draw their money from these sources, he said. 

There's speculation about what will happen with the $200 billion in foreign reserves that China has put into CIC, its new sovereign wealth fund. Meanwhile, China's State Administration of Foreign Exchange (SAFE), which handles the $1.4 or $1.5 trillion in reserves left over after CIC's creation, has bought small stakes in banks in Australia and New Zealand. "Suddenly people are wondering: SAFE was, we thought, intended to preserve foreign reserves in very low-risk assets. What is it doing making risk investments?" Even if these investments represent just a very small fraction of $1.4 trillion, "it's a lot of sovereign money moving around the globe." 

Often there is a lack of clarity about the operations of sovereign wealth funds, he said. "How big are these funds? What are their investment strategies? What are their relations to government?"

"Countries have a legitimate and well-understood need to diversify and improve the returns on this wealth, particularly foreign exchange over and above what they need for prudential reasons," Mr. Green continued. Singapore's two large funds, the GIC and Temasek, have been used "pretty successfully we think to promote Singapore's industrial policy over the last 20 and 30 years." China hasn't been explicit on the subject of its investment strategies and won't likely be so in future, but "we would expect the CIC to be investing in financial services, which it has, and international energy and exploration and production, which it presumably will."

There are national security considerations as well, though probably not for a country like Japan, he added. "A lot of these sovereign wealth funds countries are small and they live in bad neighborhoods," and for a country like Singapore or Kuwait, "putting some of its wealth abroad where it can be called upon in extremis is probably a good idea."

Capital flows from emerging markets to the developed world are "an interesting and perhaps surprising phenomenon," Mr. Green remarked, and sovereign wealth funds are the most prominent reflection of this. In a time of rising protectionism and rising nationalism, recipient countries are nervous--even when the investment is from a private company--Tata in India, Severstal in Russia, Grupo Carso in Mexico. 

In the U.S. at least, he said, "most people would be more comfortable buying a Chinese product, even if it was competing with a company in their own community and could put that company and its employees out of business, than they are with a Chinese investor coming in and buying that American company, even if the Chinese company was providing resources and investment to keep that company going. We just have an instinctively greater fear for investment than for trade. And I don't think it's justified on economic grounds."

Our particular concerns about investment from China, Russia and the Gulf states may reflect an intuitive understanding that citizens of these countries "either don't have democratic rights of participation, or in Russia's case don't seem to use them very aggressively," Mr. Green observed. There isn't the same check on government as there is in other countries, where sovereign wealth funds are comparatively open about their aims and operations. "In Norway and Singapore and Korea, and I think in Japan, if it founds one, these become big political issues, how to spend this money. Why are we creating a fund for foreign investment when we have plenty of domestic economic needs right here at home?" 

Mr. Green concluded, "For a country with as vigorous a democracy as Japan, it's something to think about. How will the people of Japan react to the creation of a sovereign wealth fund? How do we manage the kind of political implications of a big pool of money with, at the start, a mandate that hasn't yet been established for investment?"

From the company point of view, sovereign wealth funds as investors have several virtues, said Ann Wyman of Citigroup. 

They offer large pools of capital, in some cases considerably larger than private equity funds or hedge funds when measured by assets under management, Ms. Wyman said. They can take action quickly and efficiently, and have long-term investment horizons. "That's not to say that there aren't political pressures within sovereign wealth funds that look at the short-term returns, but I think it's a quite different dynamic," she commented. Most aren't highly leveraged, so there's less risk that credit-market problems will derail a deal.

Moreover, Ms. Wyman continued, there are partnership benefits beyond just raising money. Thus Mubadala, an investment arm of Abu Dhabi, took a stake in Ferrari, and now Ferrari plans to build a Ferrari World theme park in Abu Dhabi. "Companies that are thinking about receiving sovereign wealth investment also think about how that might open up the Gulf markets or Chinese markets for them"; partnering with a fund from the Gulf could be a route to better access to Middle East oil, important for companies in countries like Japan that depend heavily on oil imports.

One challenge is the risk of negative reactions on the part of government, and historically Japan's openness to foreign investment has been limited, a very recent example being the government's blocking of a bid by UK private equity firm Children's Investment Fund to invest in J-Power, Ms. Wyman said.

Or a sovereign wealth fund may be a competitor, she noted. If the company is in the private equity business, the fund may be starting to set up its own private equity business. Likewise, since "industrial policy is one of the goals of some sovereign wealth funds" and the funds "do support national champions in their own countries," the fund may hold an interest in a competitor. For example, an airline company might think twice about a deal with a sovereign fund that has a large stake in its own country's national airline.

There is some history of sovereign wealth fund investments in Japanese companies, Ms. Wyman concluded. Singapore's Temasek invested in Mitsui Life Insurance; IPIC, owned by the government of Abu Dhabi, invested in Cosmo Oil; and Dubai International Capital took a stake of undisclosed size in Sony, "an example of what could be done with sovereign wealth fund money in Japan if the doors are open." 

Ted Truman of the Peterson Institute said that "sovereign wealth fund is, for me, a descriptive term for a separate pool of government-owned or government-controlled financial assets that include some international assets." 

"As has been already noted, these funds have been around for decades," he continued. "They may be financed directly from foreign exchange reserves, directly or indirectly from export earnings, from privatization revenues, pension fund contributions or otherwise from fiscal surpluses. The central point is that they are financed out of public resources." 

Nonpension funds represent about $7 trillion in assets worldwide and pension funds another $3 trillion; in Mr. Truman's view, it makes sense to lump them together since their basic aims are essentially the same, "and the two types of funds raise identical issues of government control and accountability." 

"On this basis, Japan's Government Pension Investment Fund may already be the largest sovereign wealth fund in the world with about $1.3 trillion in assets. Its foreign assets alone are at about $250 billion, which would rank it sixth among all sovereign wealth funds."

The rise of sovereign wealth funds "has exposed two tensions in the international financial system," Mr. Truman continued: a shift in wealth from industrialized countries to developing countries, and a redistribution from private hands to public hands. "I do not believe that sovereign wealth funds per se pose threats to the international security of the U.S. or Japan that requires substantial tightening of our regimes governing foreign investment in our countries," he said; but neither are they "cornucopias available to be tapped to rescue the U.S. or the global financial system."

In 2007, Mr. Truman proposed the development of voluntary best practices for sovereign wealth funds, possibly with IMF assistance, and in March of this year the IMF executive board approved a project to facilitate and coordinate the development of such a set of standards, he said.

Drawing on a list of some 33 best-practices criteria, which are consistent with the broad suggestions by officials in the U.S., G7, Europe, the IMF, Singapore and Abu Dhabi, among others, Mr. Truman developed a scoreboard that ranks existing funds' performance based on these criteria, grouped in four categories: structure, which gauges whether the SWF's objectives and investment strategies are clear and whether it is separate from the country's international reserves, among other things; governance, which asks whether the roles of government and the fund manager are clearly defined and whether the SWF has in place corporate-responsibility and ethical guidelines; accountability and transparency, which assesses the SWF's reports and their level of detail; and behavior, which evaluates policies on portfolio adjustments, controlling interests, and leverage, among other matters. 

The scoreboard ranks 44 existing funds based on their actual practices today, he said. "At least one fund receives a positive score on each element. In fact, at least several funds do. However, on no element is current compliance 100 percent. At the same time I do not find one group of good funds and another group of bad funds. No fund receives a perfect score. The performance of each of them can be improved."

"The overarching objective should be accountability to the citizens of the countries with the sovereign wealth funds as well as to the citizens of the countries in which they invest. If the IMF efforts meet this test, sovereign wealth funds would be substantially demystified and [for] host countries many, but not all, political concerns would be allayed. At the same time the citizens of the countries with the funds would have more confidence in their sound operation, and finally the environment for sovereign wealth fund owners and managers would be more stable and predictable."

Japan's vast accumulation of foreign exchange reserves hasn't served the interests of either the international financial system or the citizens of Japan, Mr. Truman said, but "in large part Japan's international reserves are here to stay, and the citizens of Japan today should not be penalized for the flawed policies of past governments. Thus it is reasonable, I believe, for the Japanese government to invest its reserves in a broad arrange of financial assets via the creation of a sovereign wealth fund."

Such a fund, he declared, ought to be separated from Japan's foreign exchange reserves, and there should be greater transparency in its management than there has been with Japan's reserves or its government pension fund. Japan doesn't disclose the currency composition of its reserves, though disclosures by others permit estimates to be calculated, and there's little disclosure about current returns, he noted; Japan's government pension fund has a less than stellar rating on his scoreboard, ranking sixth out of ten pension funds and ninth out of all 44 funds.

Because public opinion in many recipient countries "implicitly focuses on reciprocity by their home countries," Japan's history of discouraging foreign investment presents a challenge, remarked Mr. Truman. He himself doesn't favor reciprocity, "but it is a political reality." If a new Japanese sovereign wealth fund is to avoid becoming a target for financial protectionists, Japan must commit to the highest standard of best practices, he concluded. 

Joining the discussion by high-speed video link from Keio University was Kotaro Tamura, member of Japan's upper house and Vice Chairman of the LDP's Committee on Fiscal and Financial Policy, which is readying the first draft of its sovereign wealth fund plan for delivery to the prime minister.

Japan has assets, very substantial assets, that are publicly owned, which is the first requisite for setting up a sovereign wealth fund, Mr. Tamura said. "Our GDP is one-third of yours, but our balance sheet is five times bigger than yours," and "one-quarter of the whole Japanese territory is government owned. It's like a socialist country." What the country doesn't have, he continued, is a financial institution "that can manage such huge funds at the global competitive level. So, that's why we strongly feel the need to set up" a global-level investment bank "by ourselves."

"I can't tell you right now the very basics of our plan," he added, "but all scenarios share the same view that we need to hire the best and the brightest in the world" and to pay managers on a performance basis just as investment banks and hedge funds do in the private sector.

The goals of the new fund are not only to earn better returns at a time of population decline--almost 70 percent of the public pension funds, for example, are invested in Japanese government bonds, which have very limited returns--but also to protect the public's money in what is expected to be a coming era of inflation, Mr. Tamura said. Finally, a Japanese sovereign wealth fund will be able to put pressure on the managements of the companies it invests in to take steps to raise stock prices.

His panel plans to submit a proposal to the prime minister within the month, with the Diet to vote on it in the fall and investments to begin in April 2009. "The timing is everything," he remarked. "Right now is the best timing. Every risk asset in the world is trying to hit the bottom," so investing now means that in 10, 20 or 30 years "I think we can make a tremendous return."

On a modest scale, through JABIC, the Japan Bank for International Cooperation, Japan already has begun to work with two Middle Eastern sovereign wealth funds on a joint project to support emerging companies in India and China, Mr. Tamura concluded. Japanese funding for the project will come from the international aid budget; the joint investments will be made in the area of environmental and energy-saving technologies.

*** 

Moderator Bob Davis of The Wall Street Journal asked Mr. Tamura:

Most sovereign wealth funds are from poor countries, or if they're from rich countries, they're set up when the country has a tiny population and gets a gusher, like Norway. This doesn't describe Japan. I think that if you do start a sovereign wealth fund you are going to run into tremendous political concern abroad, that here is Japan acting once again as a mercantilist country, which doesn't really work in the general context of Western capitalism. Could you respond?

Given Japan's huge government-owned assets, the Japanese people have to decide which is better: management "by bureaucrats without any disclosure," or management "by professionals who know how to make money, with disclosure," Mr. Tamura answered.

There aren't strategic intentions at present, he added. "In the long term, maybe we will consider trying to make a purchase of certain technologies which have a bright future, or maybe we will be thinking about buying brand names which help the Japanese population in the long term." But right now, the aim is to get professionals to come in and manage assets, and to make this happen, "we need to set up the entity with the pool of the money cut from our balance sheet."

Panelist John Green of Eurasia Group commented, "I don't like the idea of governments controlling massive quantities of wealth, but as long as we have these trade imbalances and high prices for commodities and mismatched savings rates and so forth, we're going to have sovereign wealth," and as long as we do, "it's good to have examples of relatively benign sovereign wealth funds--Norway's, maybe the Kuwait fund, maybe Korea's and Singapore's now, and some of the sub-national funds like Alaska, and then Canada's, to offset the impressions that are forming now about some of the possibly less-benign funds--the Chinese funds, the Gulf funds and perhaps even Singapore's, which have some issues with transparency."

Mr. Green posed a question in turn:

I can't imagine the U.S., even if we had budget and current account surpluses, establishing a fund. Republicans would want the money rebated in tax cuts and Democrats would want it spent on social programs. But either way we wouldn't be comfortable in America with sovereign wealth managed by some elite professionals. Japan has these reserves, and everyone understands they are invested in the least risky assets, so we don't expect it to return very much. But if you put a fund together and you start announcing your returns and maybe you make a few bad investments and lose some money, how are the Japanese going to respond?

When the first draft of the plan goes to the prime minister, there will be a nationwide debate and "we will see," responded Mr. Tamura. 

"I'm saying to the general public there is no risk-free investment," he added. There's risk with professional management, but the alternative is having the public's money "managed by the bureaucrats who never made money, who are always making losses without any disclosure"--the mishandling of the road-construction budget being just one example.

Panelist Ann Wyman of Citigroup commented, "I think at the heart of it here is changing the mindset about the way money is managed. Whether you call it a sovereign wealth fund or you call it a government pension fund or you call it management of reserve assets, is really semantics. And at the end of the day the real true question here is can we move towards a place where Japan is ready to improve its disclosure and actually put professionals in place. I think if you can answer those questions, then what you call it is probably a little bit less important."

She added:

If you do go down the route of opening a sovereign wealth fund or setting up a sovereign wealth fund, I do think that there is a question if you are opening Japan up to a whole lot of criticism about how closed its own economy is.

"Creating a sovereign wealth fund of our own can be a bit of a catalyst for Japanese to think more about investment," Mr. Tamura replied. If the new SWF creates a good track record during the first three years, the attitude of the Japanese people towards asset allocation will begin to change--"otherwise we cannot sustain the size and dynamism of our economy."

Ted Truman asked:

Norway invests a little bit everywhere with some bells and whistles around the edges, but basically doesn't think in terms of picking winners or taking large stakes in entities, the way Temasek does. What is your own view on investment strategies for the Japanese fund?

The consensus is that Japan will be like the Norwegians, Mr. Tamura replied. "Maybe amongst several sub-entities we will be thinking about a strategic buyout of technologies or brand names for the better future of our home economy. But the main entity will be a long-term passive investor."

The audience joined in the Q&A:

Politically, it seems to me that you have three different groups in Japan around this issue. There are policymakers, including yourself, who are using this as in a sense a kind of industrial policy to internationalize Japan's capital markets and, as you said, to create a competitive fund management industry. There is a second, very small group at the Ministry of Finance, who want to use it to increase the yield on forex but in a very limited way, using foreign exchange reserves only.And there's a third group who want what could become a source of political largesse, a new kind of FILP or Zaito. How will this play out, and who will decide?

There are ongoing discussions, and it's fairly clear that the SWF monies will come from both reserves and the public pension funds, but "that is as far as I can respond right now," Mr. Tamura replied.

What about the possibility of divvying up the money to the Japanese people directly, as Alaska does?

"Politicians like that idea, especially before the election," Mr. Tamura answered. "Some Middle Eastern countries are now giving to their people divided by the population as a bonus," and that's a possibility in Japan. "The returns to some extent are going to the budget, to some extent divided by the population and divided as a bonus and maybe reinvested. So, we don't have a conclusion, but most of our colleagues love the idea of giving a bonus to the general public."

In your first draft, what is the planned size of the fund and what are the investment strategies?

"It will be somewhere in between the largest sovereign wealth fund and middle-size sovereign wealth fund," based on a consensus after the prime minister reviews several possible scenarios, Mr. Tamura said. Investments will be both inside and outside Japan. "We don't limit the choice of asset. It will be chosen by the professionals who will be hired by the entity."

It's interesting that Saudi Arabia's new fund came out at only about $5.5 billion, which is small for a sovereign wealth fund, "but I think their thought was start small, see how it works and grow," Mr. Green commented.

For an American corporation, what would be the reason to seek capital from a sovereign fund as opposed to banks and other sources in the U.S.?

If your needs are small, a sovereign fund may not be the right fit, Ms. Wyman replied. "But presuming you need a lot of money, sovereign wealth funds can mobilize a large chunk of capital relatively quickly provided you have the right access." 

It's important not to look at the fund simply as someone with a checkbook, because "this is a partnership," she said. "You would want to have a compelling argument for what you would be giving back to that sovereign wealth fund or to the country in which that sovereign wealth fund is based."

How much capital has been injected by sovereign wealth funds into U.S. financial institutions, and has it done anything to mitigate the depreciation of the dollar?

It was $42 billion in 2007 and $24.5 billion in 2008 to date, though some of that is to non-U.S. firms like UBS, Ms. Wyman answered; Mr. Davis said the reporting he'd done on this came to $68 billion, or roughly the same. 

Mr. Truman pointed out that most of this money "was probably already in the U.S. in one form or another." Moreover, he added, "diversification by Japan or any other country modestly over time probably gets washed out in financial markets. Indeed the research I've done or seen support that case."

Mr. Green noted that the Ministry of Finance in Brazil recently proposed a sovereign wealth fund "and it didn't go anywhere, and one of the problems was the minister said part of what I'll use this fund for is to buy dollars in the local economy to try and keep the Brazilian real low," and red flags went up at the central bank--"monetary policy is our purview."

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This BLOG  looks at pensions and their impact on what are called Public Private Partnerships or P3’s these are not really about private funding at all but about two streams of public funding, pensions and government with private capital a third partner.

We will also deal with other pension matters, such as Defined Contribution Plans (DC) vs Defined Benefit (DB) PLANS, the weakness in private plans, the need for pension reform in public pensions to have shareholder rights, directorships and ethical investment directives and policies. 

Finally taking the long view we will show how these funds are forms of evolving social capital that is dominating private capital as we evolve into socialization of capital. 

Click HERE to read more....