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.

News Roundup (30 January 2008): Citigroup chief says Chinese, Russian sovereign funds are top worry; Qatar buys stake in Credit Suisse; Indian SWF?

Concerns over China, Russia SWFs

At a recent finance conference in Brussels, Citigroup chairman Win Bischoff had a very interesting exchange with a German EU parliamentarian (Martketwatch):

“It is the China and Russia syndrome of sovereign wealth funds that is most concerning,” Bischoff told a finance conference in Brussels.

 

China and Russia are the main concern in the debate over whether to regulate state-backed investments, German member of the European parliament Wolf Klinz said. He said German companies are worried that China will steal its intellectual property and fear that Russian President Vladimir Putin wants to use investments “as a political instrument.”

 

“Yes, that’s a very good point,” Bischoff said, nodding at Klinz’s remarks.

Bischoff’s comments are particularly interesting because his firm has recently had several SWF investments approved by the Committee on Foreign Investment in the United States (CFIUS). I would imagine that he is familiar with what the US government’s main concerns have been with SWF investments.

Qatar likely to buy 5% stake in Credit Suisse worth $3 billion

The deal hasn’t been finalized and the stake could be slightly higher or lower. The interesting part of this deal is that Credit Suisse is not publicly recognized as having large subprime related losses, like all the other banks that recently received SWF capital infusions (Marketwatch):

Other than a $1.9 billion writedown related to the sub-prime crisis announced in November, the bank has so far emerged comparatively unscathed from the credit crunch. Sovereign wealth funds from Abu Dhabi, China, Dubai, Singapore and Kuwait have snapped up large stakes in banks such as Citigroup, Merrill Lynch, Morgan Stanley and UBS as they wilted under the weight of huge losses related to the implosion of the U.S. sub-prime mortgage industry.

See more on what the Qatar Invesmtent Authority has planned for the future in this interview chief executive Hamid Al-Thani gave to CNBC at the World Economic Forum last week (Dealbook).

India looking into creating a SWF

Indian government officials have SWF envy (The Economic Times):

While Sovereign Wealth Funds (SWF) owned by big Asian economies invest in assets the world over, Indian policymakers too are looking at whether the country needs to float such a fund. The finance ministry is planning to set up a committee to examine the pros and cons of an Indian sovereign wealth fund.

I’m not sure how much fiscal sense a SWF makes for India. The country is far less developed (infrastructure, education, basic health care, etc) than China and other export-oriented countries with SWFs, doesn’t have an abundance of natural resources, and is a democracy which means the government would likely be held accountable for the fund’s performance. How would the Indian government react to the public backlash from an investment gone bad a la the China Investment Corp/Blackstone deal?

More than a third of India’s population lives in poverty, while in China the percentage of the population living below the poverty line has fallen into the single digits; in absolute terms this is a difference of several hundred million people. How would the Indian government react to hundreds of millions taking to the streets and protesting a government that, from their point of view, is neglecting their dire condition to bailout a foreign investment bank? I just can’t see how there wouldn’t be an immediate change of policy if this type of situation arose in any democratic country, let alone poverty stricken India.

GCC dollar peg, inflation update

Qatar is considering following in Kuwait’s footsteps and dropping the dollar peg (Financial Times):

Qatar is reviewing its currency policy and could revalue or drop the dollar peg as the booming Gulf state struggles to tame inflation while the US reduces interest rates to head off a recession. Qatari officials on Wednesday said the gas-rich emir­ate was considering revaluing its currency or linking it to a trade-weighted basket of currencies as well as other policy proposals aimed at cooling rampant inflation of up to 15 per cent.

Inflation reeking havok on GCC businesses (Arabian Business):

More than half of Gulf businesses have been badly hit by rising inflation, with costs increasing faster than they can be passed on to customers, an ArabianBusiness.com survey has revealed. With inflation rising across the GCC, and predicted to hit a 20-year high of 12% in the UAE this year, 62.5% of respondents to the poll said the price of goods was rising too fast to be passed on.

Sovereign Wealth Funds ‘It’ Topic at 2008 World Economic Forum

2 years ago at the World Economic Forum the hot topic of conversation was hedge funds. Last year, it was private equity. This year, sovereign wealth funds were the ‘it’ topic at Davos.

In a session titled, “Myths and Realities of Sovereign Wealth Funds” a panel moderated by the Financial Times’ Martin Wolf debated and discussed most of the issues making headlines in recent weeks (centering primarily on the topics of transparency, objectives, motivations). The panelists included Lehman Brothers CEO Richard Fuld, Kristin Halvorsen of Norway’s GPF, Muhammad Al-Jasser of the Saudi Arabian Monetary Agency, Russian Finance Minister Aleksey Kudrin, Bader Al -Sa’ad of the Kuwait Investment Authority, Blackstone CEO Stephen Schwarzman, former US Treasury Secretary Larry Summers, and current US Deputy Treasury Secretary Robert Kimmit. Video of the hour-long session below:

Noteworthy comments that were made by the panelists (Reuters):

ALEXEI KUDRIN, DEPUTY PRIME MINISTER AND FINANCE MINISTER OF RUSSIA:

“When there was a period when traditional economies had strong funds and through several funds moved into markets and bought industries, we did not speak of restricting capital.

“Now (it is the other way around) we are having discussions about the aim of investment.

“It’s an interesting discussion – there is no cause for concern, but we are discussing a code of practice. Perhaps we are ahead of ourselves.

“So far, we have not identified any negatives but we are already talking about a code to protect us. Let’s first define what could give rise to concern.”

ROBERT KIMMITT, U.S. DEPUTY SECRETARY OF THE TREASURY:

“At this point, the history with sovereign wealth funds is they are generating higher investment returns without generating political controversy.

“Importantly, both fund management and investment decisions we have seen have been made on commercial not political grounds. We welcome that kind of investment in the United States. We don’t fear such investment.

“However, the growth in the size and the number of these funds is such that vigilance is required.

“Since Dubai Ports World, we have had over 200 cases that have come through the Committee on Foreign Investments in the United States — none of those has been blocked.

“The new investment law passed last July and further implemented by an executive order passed just yesterday…has struck a better balance on investment review between encouraging investment and protecting national security.”

LAWRENCE SUMMERS, FORMER U.S. TREASURY SECRETARY

“I would agree that the world is a better place because of those transactions that have taken place over the past three months. There’s not much that sovereign funds (have done) to date that one can be critical of.

“I do think there is potential grounds for concern here.

“Given we have made a decision that we are not going to invest our country’s money in companies because of the risk of politicisation, then it’s legitimate to be concerned about other countries’ use of those funds.

“The question is if we believe in market economies and we work very hard to create open markets and private enterprise — shouldn’t we be concerned with transactions that have an element, albeit a small element, of cross border nationalisation?”

STEPHEN SCHWARZMAN, CHAIRMAN AND CEO OF BLACKSTONE GROUP:

“Our experience with sovereign wealth funds is they are smart, long term, highly professional. All they are looking for is higher rate of return.

“We have a sovereign wealth fund as our largest stakeholder. It is indicative of the way a sovereign wealth fund would think. The first thing about that investment is it is a non-voting investment – that was important for them.

“We had originally asked them to vote with us, and they’d said they (would rather not). They are also a long-term shareholder.”

KRISTIN HALVORSEN, NORWEGIAN FINANCE MINISTER:

“The fund is an extremely long-term investor. In principal we are going to be shareholders forever. We are extremely transparent. Our investment guidelines are discussed in parliament each year.

“We have a very long-term horizon and that is not only to stabilise the Norwegian economy but also to stabilise global economy. We have ethical guidelines, to avoid our investments contribute to unethical acts. We are exercising these guidelines through our ownership rights.”

MOHAMED AL-JASSER, VICE GOVERNOR OF SAUDI ARABIAN MONETARY AGENCY:

“They have always taken a long-term stabilising role in financial markets.

“I don’t think there are any difficulties in understanding who is investing where. Regulators… make sure it is well-known and compliant with regulations.

“We should not look at sovereign wealth funds as a risk and a danger.

“Between the years 1983 and 2002 we had 20 years of budget deficits. “We need to provide oil for the world economy. We have managed that well for the sake of our economy but also for the sake of the global economy.

“Basically we’re trying to address a hypothetical situation — we’re talking about trying to regulate something that may happen.”

Al-Jasser said when there were similar calls for regulation on hedge funds the response was that would disrupt financial markets.

BADER AL SA’AD, MANAGING DIRECTOR OF KUWAIT INVESTMENT AUTHORITY:

“There is a lot of worry about sovereign wealth funds, but all of them are assumptions, they are not about real cases.

“Kuwait has been a shareholder in DaimlerBenz since 1969, it has probably been one of the most stable shareholders.

“Kuwait investment authority has one of the most regulated investment authorities. It is really well governed.

“For 55 years, we never had politically enforced decisions for our investment.

“We look at the bottom line, we don’t look at anything else. We have been passive in all our investments. We haven’t been active in any of our (holdings). All this fear about sovereign wealth funds has no real basis.”

Related stories of interest:

• Growth of soveriegn wealth funds seen as positive development (World Economic Forum official press release)
• SWF Seeks Loving American Man: The hottest session at Davos is about … sovereign wealth funds? (Slate)
• Sovereign wealth funds seek balance against Western regulation (International Herald Tribune)
• Who’s afraid of sovereign wealth funds? (BBC)
• SWFs belle of the ball at Davos (Arabian Business)
• Davos 2008: Policymakers clash over sovereign wealth funds (Times Online)
• Wealth Funds Hear Disclosure Warnings in Davos (Bloomberg)
• Saudi, Kuwait Resist Sovereign Fund Code of Conduct (Bloomberg)
• Foreign Capital Must Not Be Blocked (Financial Times)
• Sovereign Wealth Funds: Guilt until proven innocent? (Reuters)
• Sovereign Wimp Funds (Wall Street Journal)
• Blackstone CEO: Sovereign, pension funds the same (Pensions and Investments)

My take:

The overall discussion was relatively balanced. The only complaint that I have is minor. I would have preferred to see some representation from the Southeast Asian, export surplus-orientated SWFs on the panel. I thought the format was really good and that Martin Wolf did an excellent job moderating (not surprising, his FT columns are also excellent).

Larry Summers hypothetical examples, while certainly plausible to debate in theory, have never even shown signs of manifesting in reality and are thus not fair to argue beyond the abstract. Several of the panelists made the prescient point that it wasn’t fair to call for regulation and transparency for SWFs while not holding other large investors such as hedge funds and private equity firms to the same standard, especially considering that the former has had a destabilizing effect on the global financial system time and time again. I suspect that the people making the calls to regulate SWFs and make them more ‘transparent’ are smart enough to know this. There’s something else, something much larger at work here that I’m going to take an in-depth look at in my next commentary piece.

Economist cover story: ‘Invasion of the Sovereign Wealth Funds’

The Economist’s cover story this week is a feature on Sovereign Wealth Funds.

The story gives a good overview of many of the basics such as size of SWFs, how they came about, how they’ve evolved, where they’re headed, and the issues facing SWF investing. It also includes a relatively balanced discussion on the motives of SWFs, which isn’t surprising as The Economist is probably the most fair and balanced mainstream publication around.

One point that The Economist makes, that has been completely absent from the mainstream debate thus far, is that the fear of politicizing foreign investments cuts both ways. The SWFs must be cognizant of possible retaliatory actions, such as asset freezes and/or asset confiscations, that can be taken against their investments for things such as political disagreements or court rulings that hold SWFs responsible for the actions of their host country’s citizens. The Economist cites the example of Britain forcing the Kuwait Investment Authority to divest from part of its’ stake in BP in the 1980s because Margaret Thatcher, in the midst of privatizing national assets, ‘was in no mood to see so much of a national treasure owned by a foreign government’.

Politicians scrutinizing the recent flurry of SWF investments should take care to remember that these infusions are in effect rescue capital that their government’s would likely be on the hook for had SWFs been deterred from investing, and that their own future geopolitical motives should be held to the same standard they want to hold SWFs to.

The article concludes, correctly in my opinion, by saying the chief threat that SWFs pose is that of financial protectionism and that it’s in the best interests of all parties to get along:

The hope is that both host countries and sovereign-wealth funds see that their interest lies in building confidence. The hosts stand to benefit from the funds’ capital. Meanwhile the funds are ruled by the politics of the places where they invest. You are only sovereign at home; abroad, someone else wields the power.

News Roundup (10 January 2008): Banks seek more SWF capital, China approves Blackstone purchase of BlueStar

WSJ: Merrill and Citi Seek Foreign Capital

As subprime related losses continue to mount the two firms that are expected to be hardest hit, Merrill Lynch and Citi, are looking for additional investments from SWFs (WSJ, subscription required also Bloomberg for summary):

Merrill is expected to get $3 billion to $4 billion, much of it from a Middle Eastern government investment fund. Citi could get as much as $10 billion, likely all from foreign governments.

They hope to finalize these deals before reporting worse than expected earnings next week:

Both Citi and Merrill are scrambling to nail down the details before they report earnings next week that are expected to include additional losses stemming from their exposure to mortgage-related investments. Together, these additional losses could reach as much as $25 billion.

Increased US regulatory scrutiny of both banks and SWFs is likely to follow. SWFs will also face more political pressures from US government officials:

Another risk is political. Lawmakers could try to force the investors to submit to more scrutiny by the Committee on Foreign Investment in the U.S., an interagency group led by the Treasury Secretary.

Does this type of scrutiny make sense given that a large portion of the US banking industry is in effect being bailed by SWFs? Do US lawmakers even realize that a bailout has occurred? Or are they just trying to score cheap political points? Who would be picking up the tab for the banks’ subprime-related excesses if not SWFs? The answer to that last one should scare any sane government official into thinking long and hard before trying to score easy political points at the expense of “foreigners”.

China approves Blackstone domestic purchase

China said Thursday it had formally approved US private equity firm Blackstone Group’s purchase of a 20-percent stake in chemical firm China National BlueStar.

Did China Investment Corp’s $3 billion stake in Blackstone make completing this deal easier? (Yahoo!)

UK Treasury asks GCC funds to bail out Northern Rock

No buyers have been able to raise the amount needed to rescue the troubled bank, the UK government hopes the GCC might step up to the table (Arabian Business News):

Goldman Sachs has been hired by the UK Treasury to help find a private sector solution for Northern Rock. Any objections to Middle East oil money being used to save the bank have now been removed, according to UK newspaper reports.

Current bidders, including Richard Branson’s Virgin Money and investment vehicle Olivant, are struggling to raise the necessary funding for an acquisition due to the subprime lending crisis.

Russia Stabalization Fund grows to over $156 billion in 2007

Russia’s Stabilization Fund, which collects windfall oil revenue, stood at just over 3.849 trillion rubles or $156.81 billion on January 1, 2008, the Finance Ministry said. (Interfax)