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Sovereign Wealth Funds: Are SWFs the New WMDs?

As the name suggests, the primary characteristic of a Sovereign Wealth Fund is that it is a state-owned and operated investment vehicle. But among the many definitions for Sovereign Wealth Fund used in differing private and official capacities across the globe, the specific scope for what qualifies as a Sovereign Wealth Fund varies widely depending on the objective of the defining entity.  

In the United States, The U.S. Treasury Department defines a Sovereign Wealth Fund as “a government investment vehicle which is funded by foreign exchange assets, and which manages those assets separately from the official reserves of the monetary authorities.   The more ample Government Accountability Office (“GAO”) definition of Sovereign Wealth Funds provides a four-factor test and focuses more on the “outside” focus of the entity.  The GAO classifies SWFs with the most interest to policymakers as those that (1) are government-chartered or sponsored investment vehicles; (2) invest some or all of their funds in assets other than sovereign debt outside the country that established them; (3) are funded through government transfers arising primarily from sovereign budget surpluses, trade surpluses, central bank currency reserves, or revenues from the commodity wealth of a country; and (4) are not actively functioning as a pension fund (money received from individuals).

For our purposes, we will use the broad definition of a Sovereign Wealth Fund created by the privately operated Sovereign Wealth Fund Institute (“SWFI”).  The SWFI defines a Sovereign Wealth Fund as “a state-owned investment fund composed of financial assets such as stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets”.   This expansive definition ensnares over fifty separate Sovereign Wealth Funds spanning all quarters of the globe and thus allows for a more comprehensive analysis of Sovereign Wealth Fund investment in the United States.

While the first Sovereign Wealth Funds to meet aforementioned SWFI definition appeared as far back as 1953 – then referred to as “revenue equalization reserve funds” or other purpose-based labels – the true rise to power for this investment phenomenon has only become most evident in the past 10 years.  Only fourteen such SWFs existed prior to 1990 and the first three of these SWFs were established prior to 1967. Following the original three, five were established during the 1970s; six were established in the 1980s; eight were established in the 1990s; ten were established during the five years beginning with 2000 and ending in 2004; and an astounding nineteen were established after 2004.     

This pattern of explosive growth is easy to understand given the pertinent economic patterns that coincide with the timeline of their creation. Specifically, because so many of these Sovereign Wealth Funds are funded with proceeds from the export of petroleum products, the boom and bust cycle of oil prices and America’s voracious appetite for oil consumption over the same period facilitated the need for many cash infused overseas economies to create these investment vehicles.  Therefore, despite America’s fears and persistent calls for more regulation for Sovereign Wealth Fund investment in the United States, this appears to be a monster of our own creation; perpetually fueled by our dependence on foreign oil and subsequent inability to wean from the petroleum-bearing teat of our perceived enemies.

So why are Sovereign Wealth Funds receiving so much attention from, and becoming downright feared by, the United States government and American investors?  One common misconception is that the sheer size of these Sovereign Wealth Funds and, therefore, their global investment power alone is enough to cause significant concern for the United States. However, when compared to other large investment sectors, the aggregate holdings of Sovereign Wealth Funds are relatively insignificant.  The total assets under management for Sovereign Wealth Funds in 2009 was a hefty $3.8 trillion dollars, but that sum is dwarfed by the $19 trillion under management for pension funds and $22 trillion for insurance companies.   

Two recent high-profile transactions, albeit failed ones, have been credited with fueling the fire of fear towards investments made by Sovereign Wealth Funds in the US economy.  In the summer of 2005, the Chinese National Offshore Oil Company (“CNOOC”) trumped Chevron Oil Company’s bid to purchase Unocal, a California-based oil company.  Despite the $1.5 billion premium offered to Unocal’s shareholders by CNOOC, the concern that Unocal’s new Chinese owners would divert Unocal’s subsequent oil production to China (instead of continuing to sell all Unocal product domestically) and the resulting political opposition by California’s congressional representatives was sufficient to cause CNOOC to ultimately withdraw their bid.  

Shortly after CNOOC’s failed bid was withdrawn, a middle-eastern Sovereign Wealth Fund encountered similar pressures from the United States government when trying to purchase a company that, ironically, isn’t even based in the United States.  When Dubai Ports World (“DPW”), a subsidiary of a Dubai-based SWF, attempted to purchase Britain’s Peninsular and Oriental Steam Navigation Company (“P&O”), American politicians reacted vocally.  The stalwart American concern over this potential SWF acquisition stemmed from the fact that, in addition to managing 12 international ports throughout the globe, P&O also manages six major ports on the east coast of the United States.  In a post-9/11 America, turning over management control of United States ports to a middle-eastern organization was easy and immediate political fodder for those on both sides of the aisle.  Despite President Bush’s contention that Port security was the responsibility of the US Coast Guard, the US Dept. of Homeland Security and US Customs and Border Protection, and not that of the individual port’s management, Congress went to great lengths to block any change in management for the six US ports and, ultimately, killed the deal.  

As is often the case, the fear associated with Sovereign Wealth Fund investment is, at base, a fear of the unknown.  Because the ever-expanding and complex US securities regulations have knitted our domestic securities laws into a veritable “security blanket”, American investors are accustomed to the coddling warmth of over-disclosure that results from this “investor protection”.  With Sovereign Wealth Funds, however, counterparties are dealing with entities controlled by sovereign governments.  Accordingly, these funds do not need to reveal their investment goals or philosophies and the subsequent black hole created by this lack of transparency is often malevolently characterized.  

The combination of this dark veil of secrecy with the sudden appearance of SWFs in the US equities markets and the massive size of their individual investment positions in these markets, has triggered a deep emotional response both in the popular media and in Congress.  “The unique characteristic of a Sovereign Wealth Fund investment is that it is controlled by a sovereign whose true present and future investment intentions are unknown and unknowable.  The economic, diplomatic, and political interests of a sovereign will almost always coincide with the goals of a SWF, but they need not always do so.  At times, diplomatic or political interests could trump traditional investment goals.  This lack of knowledge makes it possible for Congress and the media to see SWFs as a threat.