Protectionist Sentiment Dominates US-China Investment Congressional Hearing

Last Thursday several members of Congress, representatives from the Securities and Exchange Commission, Department of Treasury, and several NGOs testified before the US-China Economic Security and Review Commission, a bipartisan congressional advisory panel. The full day hearing intended to examine the national security implications of investments made by sovereign wealth funds in the US. Unfortunately, it missed achieving this objective by a long shot. The testimony by several of the panelists was very one-sided. Fear mongering, conspiracy theories, and downright xenophobia were the major themes that won the day.

The panelists’ prepared statements can be accessed here: (US-China Economic Security and Review Commission)

Some of the highlights:

Linda Thomsen, director of the SEC’s Division of Enforcement suggested that SWFs pose an insider trading risk (Securities and Exchange Commission):

…sovereign wealth funds, like hedge funds, have, by virtue of their substantial assets, substantial power in our financial markets. However, in addition to this financial power, sovereign wealth funds, unlike hedge funds, have power derived from being governmental entities, which may give them access to government officials and information that is not available to other investors. There is the potential for these powerful market participants to obtain material non-public information, either by virtue of their financial and governmental powers or by use of those powers, to engage in illegal insider trading using that information.

I understand the issues that the SEC is concerned with. It’s their job to be vigilant about insider trading risks. But it’s important to point out that any investor can legally have as much access as they want to government officials by simply hiring a lobbyist. The lobbying system in the US puts the onus on each individual party (government official, lobbyist, client) to not do anything illegal. If we want to be objective, then SWFs and their governments should be held to the same standards as everyone else. Also, it’s not fair to say that SWFs, who to my knowledge have not been involved in any investment scandals, are guilty until proven innocent while hedge funds, mutual funds, investment banks, ratings agencies, and lobbyists are given the benefit of the doubt even after being mired in scandal after scandal. To suggest otherwise seems needlessly conspiratorial.

Senator Jim Webb argued that that passive, minority stakes taken in US corporations by SWFs posed national security risks (U.S.-China Economic and Security Review Commission: Webb testimony):

All proposed foreign investments that have national security implications are potentially subject to review by the Committee on Foreign Investment in the United States. I have been particularly concerned regarding passive investments that may nonetheless provide foreign governments and state-owned corporations with control over sensitive national security information.

 

Holding a small minority of shares or not taking a board seat does not provide a guarantee that there will be no influence or control. For example, Saudi Prince Walid Bin Talal, who holds a 3.9 percent stake in Citibank, was closely consulted in the ouster of Chuck Prince from Citibank as its CEO. Prince Bin Talal does not sit on the board. You do not need a seat on the board, however, to have a seat at the table.

 

Prince Bin Talal has invested his money, not his government’s, and he is held up as a responsible and conscientious investor. The Prince’s role in another Prince’s ouster, however, speaks volumes to those who suggest that you need to be on the board to exert influence.

I don’t think the comparison Webb is making here is particularly relevant. Prince al-Walid is a private investor, so Webb is not comparing apples to apples. Further al-Walid has had a long relationship with Citigroup and most of the senior managers there. Comparing al-Walid to a SWF doesn’t make any sense, but if Webb wanted to be less transparent he could have examined the relationship between al-Walid and the rest of his portfolio holdings, which include substantial minority stakes in dozens of US companies. If all Webb was trying to do was say al-Walid is a foreigner, foreigners run SWFs, so all foreigners will exert influence, then mission accomplished. Of all people, Jim Webb should know better than to use this card.

The Treasury Department has thus far been the voice of reason in the debate over SWFs and played that role again at the hearing (Forbes):

Robert Dohner, deputy assistant Treasury secretary for Asia, told the panel. “There is a risk that the rise of sovereign wealth funds could provoke a new wave of investment protectionism, which would be very harmful to the global economy,” Dohner said. “Protectionist sentiment could be partially based on a lack of information and understanding of sovereign wealth funds, in part due to a general lack of transparency and clear communication on the part of the funds themselves.”

Forbes goes on to make some of the most important points that were inconspicuously absent from the debate at the hearing last Thursday:

(Sovereign wealth funds) see themselves as passive, long-term investors, driven solely by the need to make a good return on their country’s surplus cash.

 

That mostly is their track record, but their Achilles’ heel is their perceived lack of transparency and a persistent concern that they will be motivated by more than just market considerations, which provides ammunition for the conspiracy theorists among their critics and feeds the forces of protectionism stirring in this U.S. presidential election year.

 

At Davos, Bader al-Saad, managing director of the Kuwait Investment Agency, the oldest sovereign wealth fund, which has had a stake in Daimler since 1969 and BP since 1986, politely but pointedly noted, America’s own hedge funds and bond-rating agencies are perhaps equally deserving of such a code.

 

But logic has little to do with this debate.

Major Sovereign Wealth Funds Deals through January 2008

According to Thompson Financial via Gulf News:

 

News Roundup (6 February 2008): Temasek/Tui deal; No SWF for India?; Japan looking to thwart China; Saudis to be modest

Slow news week and I’m swamped at work so not much news analysis this week. I’m working on a few substantive pieces that I hope to get up as soon as things calm down, possibly this weekend.

Temasek merger with Tui

Germany doesn’t seem to have the same issues that the US does with allowing foreign entities to own transportation infrastructure (Financial Times):

Temasek, the sovereign wealth fund, and Germany’s Tui are in talks to merge their shipping operations in a deal that could see the Singaporean group take a stake of more than 20% in the Hanover-based travel group.

India not in a good position to start SWF

Echoing some of my own thoughts on the possibility of an Indian SWF (LiveMint):

Unlike established SWF rivals, India’s reserves are not a result of high commodity prices or excess savings. The country runs a current account deficit of 2% of gross domestic product (GDP). It needs to keep a fair amount of cash on hand just to ensure that trade keeps flowing.

More important, India is still very poor and crying out for investments. Investment accounts for 33% of GDP in India, far below China’s 43%.

The government recognizes the problem. Its latest Five-year Plan includes $492 billion of infrastructure spending, but it expects the private sector to come up with two-thirds of the cash. It would make sense to use any extra unneeded foreign currency to increase the government’s share.

In the long term, the returns on even modestly well thought out domestic investments will surpass those earned by a sovereign wealth fund.

Saudi reconsidering plans for SWF

Much larger country than the other commodity-based SWFs, much more political unrest, couple that with the Western backlash to SWFs, the risks of having a SWF seem to outweigh the rewards for Saudi. Especially, when they can at any point ‘appropriate’ a larger portion of any excess reserves to members of the royal family (Business Week):

Don’t expect Saudi Arabia to be a big player in the Sovereign Wealth Fund space. That was the message from a senior Saudi financial official I encountered recently. He said Saudi Arabia was considering a modest fund of around $6 billion.

Japan wants global SWF ‘rule book’ for protection from China

China Development Bank is attempting to ‘dominate and control’ the Japanese steel industry. Any global rules or regulations on SWFs are likely to be voluntary so I don’t think Japan would get much protection from those. It will be interesting to see how this plays out (Times Online):

“We need governments everywhere to come together to make rules that would prevent the disorder caused by these funds,” Hajime Bada, president of the Japan Iron and Steel Federation said. “Some countries are using their state funds to dominate certain industries.”

Japanese steelmakers see the impending bidding war for Rio as a crisis in the making, with potentially devastating iron ore pricing power going to BHP Billiton or, worse, to an aggressive Chinese player with the financial backing of the State. Caught between what it sees as “two worst-case scenarios”, the Japanese steel industry is pinning its hopes on government intervention.

From Russia with NO Love: A New Sovereign Wealth Fund

Russia officially announced that it’s splitting the Oil Stabilization Fund into two separate entities (International Herald Tribune):

The larger of the two funds, now called the Reserve Fund, retains the initial purpose of the Russian rainy day fund of insuring the country’s budget against a steep fall in oil prices. It will hold $125 billion and be maintained in future years at a size that is roughly 10 percent of Russia’s gross domestic product, as it is now.

 

The other, called the National Welfare Fund (NWF), with $32 billion, is intended to buoy the pension system. Under a law passed last spring, it can be invested in foreign stocks and bonds.

Morgan Stanley, in a report titled, “Celebrating the Birth of Russia’s SWF,” (PDF) says that the NWF will initially invest conservatively:

…for now, the NWF will initially be invested very conservatively, with the following guidelines:

 

(i) All must be in foreign debt, denominated in USD, EUR or GBP, rated at least AA-, from Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Luxembourg, the Netherlands, Spain and the US.

(ii) At least 50% in foreign government debt, with the rest in foreign private/corporate debt.

(iii) Up to 30% in foreign agency debt and central bank debt.

(iv) Up to 15% in debt of international financial organisations (ADB, EIB, etc.).

(v) Up to 30% in foreign bank deposits.

Morgan Stanley estimates that if oil remain at current levels the NWF could reach $320 billion in the next 5 years, with their best guess being $140 billion.

The rhetoric coming from political leaders in the Russian government announcing the NWF does not seem like the most diplomatic, tactful way to announce the creation of a new SWF, especially given the concerns over possible political motivations that certain SWF host countries might have (Financial Times):

Dmitry Medvedev, Russia’s most likely next president, called on Russian business people on Thursday to copy China and go on a global buying spree of foreign companies to bolster the economy and cut dependence on technology from abroad.

 

In his first speech to Russian big business since being named by Vladimir Putin as his preferred successor, Mr Medvedev pledged Kremlin support for companies seeking assets abroad.

 

“This is a very important task. The majority of powerful countries are engaged in this. Many of them are very active, like China. And we should be active, too,” he told a conference for Russia’s most influential business lobby in the southern Russian city of Krasnodar.

 

“This will allow us to re-tool Russian enterprises with technology, boost their production culture and grant them the opportunity to diversify investments and win new markets,” he said.

Remarkably, Russian finance officials are puzzled at why the NWF is being singled out for criticism (Financial Times):

Pyotr Kazakevitch, the 34- year-old head of the Russian Finance Ministry’s $127.5bn stabilisation fund, is puzzled by the fears in the west about the threat posed by sovereign wealth funds.

 

“The sovereign wealth funds of the Arab world and Singapore have been buying equities in Europe and America for decades and there was no discussion at all,” Mr Kazakevitch told the Financial Times. “I find it really strange that when Russia only starts discussing such a possibility we hear a lot of concerned speeches … I don’t understand why we hear a lot of voices that demonize our activity.”

Russia has disclosed a fairly robust governance structure for the NWF (see Morgan Stanley report (PDF)). The Ministry of Finance will manage the NWF. The Ministry will publicly report monthly, quarterly, and annually on government accumulation, investing, and spending of the NWFs capital. It has also announced pretty clear investment guidelines and objectives (see above).

The rhetoric coming out of the Kremlin leaves a lot to be desired with regards to motive and the potential for politicization of the NWF, but I think it would be best for financial markets, regulators, and government officials to err on the side of not rushing to judgment. Despite what Russian political leaders are saying, the Ministry of Finance has, on its’ own volition (which is the key with SWFs), created a relatively transparent and accountable SWF.

Russia’s leaders would do well to follow China’s example and put on a PR blitz to highlight the NWFs governance structure and assuage some of the regulatory, governmental, and financial communities’ concerns (New York Times):

The head of China’s $200 billion government investment fund, seeking to reassure Americans nervous about the possibility of foreign takeovers, said Thursday that China would invest mostly in portfolios rather than individual companies — except when a “big fat rabbit” like the investment banker Morgan Stanley came along.

 

Mr. Lou, a former finance ministry official in Beijing, was on a visit to the United States to tell American officials that China had no intention of gaining controlling interest in any companies, and that it would be a “good corporate citizen” and not invest in companies that damage the environment, waste energy or produce tobacco.

 

He said he understood that Americans “have concerns about the size of our capital and also people have concerns about our motives” but that his fund was established to invest part of China’s estimated $1.4 trillion in foreign exchange reserves, most of which is in dollar-denominated Treasury securities, to meet Chinese monetary policy needs.

 

Echoing what he said was a pledge by Prime Minister Wen Jiabao, Mr. Lou said that the Chinese government would not interfere in the operations of the Chinese fund or dictate its investment decisions, and that the fund would have its own corporate governance structure.

Weekend Links (2 February 2008)

Some recent articles of interest:

• Bond crisis: Sovereign funds hold their bets (Fortune)
• US Treasury’s Kimmitt stresses benefit of commercially-based SWFs (CNBC)
• OPEC rebuffs call for increase in output (Financial Times)
• IMF’s proposed sovereign wealth fund code ruffles feathers (Bretton Wood’s Project)
• China Investment-Fund Head Says Focus Is on ‘Portfolios’ (Wall Street Journal)
• State-led globalization (RGE Monitor)
• Libya Sovereign Wealth Fund to Shun U.S. (Bloomberg)
• Market convulsions will lead to the return of the state as a major economic force (The Independent)
• Japan’s Nukaga: No plan for sovereign wealth fund (Reuters)
• Ask the Author: A World Without Islam (Foreign Policy)
• The ‘war on terror’ licenses a new stupidity in geopolitics (Guardian Unlimited)
• A Risk Index for Sovereign Wealth Funds (Breaking Views)
• After Iraq: A report from the new Middle East—and a glimpse of its possible future (The Atlantic)
• If $28 Trillion Comes Knocking, Open the Door (Bloomberg)
• Can Emerging Markets Avert U.S. Chill? (Wall Street Journal)
• (Stephen) Roach Says He’s `Optimistic’ on Asian Growth (Bloomberg)

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