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Thursday, January 10, 2008


A force for financial stability
By Janadas Devan

IN 1913, after the British Royal Navy had converted its fleet from coal to oil, the First Lord of the Admiralty, Winston Churchill, made an investment on behalf of the British government. He never had much business sense - accounts gave him headaches, he admitted - but he had very fine strategic instincts.
On the lookout for assured oil supplies within the British sphere of influence, he zeroed in on Persia, now Iran. There he established the Anglo- Persian Oil Company with an initial capital outlay of £2.2 million. The Anglo-Persian Oil Company is now none other than BP or British Petroleum, one of the world's largest and most successful companies. The British government has hardly made a more spectacularly profitable investment since.

How would what Churchill did in 1913 differ from what the Chinese government is doing today, making strategic investments in energy companies throughout the world? On a smaller but no less significant scale, how would what Singapore's GIC and Temasek do, investing on behalf of the Singapore Government, differ from Churchill's grand coup in Persia?

There is really no difference - other than that Churchill was British, White and Western, and Chinese and Singaporeans are not. The British government in 1913 did not make investments through a so-called 'sovereign wealth fund' (SWF), but that is a minor detail. Governments have long made such investments; these investments have long been strategic in nature; Arab and Asian governments were hardly the first in the field.

Indeed, though most of the world's three-dozen odd SWFs today are Arab or Asian, they did not invent the vehicle. As both Mr Benoit Coeure of the French Treasury and Mr Philipp Hildebrand of the Swiss National Bank have noted in recent papers, the world's first SWF was founded in 1816 - France's Caisse des Dep├»¿½ts et Consignations, which still exists.

In the contemporary era, Americans were among the first to establish an SWF - the Alaska Permanent Reserve Fund, founded in 1976, five years before the Government of Singapore Investment Corporation (GIC) was set up. GIC's founders, Minister Mentor Lee Kuan Yew and former deputy prime minister Goh Keng Swee, were bold and audacious - they could not have known in 1981 that Singapore would continue to accumulate reserves in the following decades - but they did not invent SWFs.

So what is all the fuss about? Are SWFs really a threat to free markets, vehicles for the 'cross-border nationalisation' of private companies, as some media commentaries have made them out to seem? Are they so threatening as to need monitoring and regulation?

SWFs have indeed grown in the past decade, largely because of rising oil prices and America's burgeoning current account deficit, 'which currently absorbs about 60 per cent of the world's aggregate current account surpluses', according to Mr Hildebrand. By definition, China, Japan, Singapore and the other surplus countries cannot accumulate net financial claims on foreigners if the United States - as well as the United Kingdom, France and other countries - did not simultaneously accumulate net financial deficits.

The International Monetary Fund (IMF) estimates that the combined assets of SWFs today total between US$1.9 trillion (S$2.7 trillion) and US$2.9 trillion. Arab sovereign funds command more than 50 per cent of these assets and those from Asia only 27 per cent. A recent Morgan Stanley study forecast that SWFs would grow to US$12 trillion by 2015.

That is indeed a large sum. But as Mr Hildebrand points out, 'such simplistic linear forecasts (of SWF growth) will likely prove to have been flawed'. They assume oil prices will remain high and that Asian countries will continue to amass surpluses at the current rate.

More to the point, as large as SWFs have become, they pale in comparison to other players in international markets. Insurance companies, for instance, hold US$18.5 trillion in assets, mutual funds US$19.3 trillion and pension funds US$21.6 trillion.

Indeed, SWFs account for just 1.3 per cent of the estimated US$190 trillion in total global financial assets. That may be a greater sum than the assets of hedge funds, but only seemingly so. As GIC deputy chairman and executive director Tony Tan pointed out recently, because hedge funds operate with substantial leverage, they effectively control larger assets than SWFs.

And though they trade far more actively than SWFs - with destabilising effects sometimes, as we discovered during the 1997-1998 Asian financial crisis - the US government has consistently refused to regulate hedge funds.

In contrast, as US Deputy Treasury Secretary Robert Kimmitt acknowledged in the last issue of Foreign Affairs: 'SWFs are in principle long-term investors, which typically do not deviate from their strategic asset allocations in the face of short-term volatility. They are not highly leveraged, and it is difficult to see how they could be forced by regulatory capital requirements or sudden investor withdrawals to liquidate their positions quickly. In this context, SWFs may be considered a force for financial stability.'

The on-going sub-prime mortgage crisis in the US, during which SWFs have pumped more than US$60 billion into Western financial institutions, proves Mr Kimmitt's point.

There are good reasons for drawing up guidelines for SWFs, as the IMF and the World Bank have been tasked to do by April this year. Better disclosure in the interest of transparency, better internal governance and risk- management practices, clearer investment objectives - these would be in the interest not only of recipient countries but also of the SWFs themselves, which are ultimately owned by citizens.

There can be no objection to guidelines that 'encourage SWFs to operate according to commercial principles with a long-term objective, free from political consideration', as Dr Tan put it. In addition, to prevent a backlash, it may well be prudent if SWFs refrained from taking controlling stakes in iconic First World companies.

What would be tragic is if SWFs - either because of an exaggerated view of their power or a false picture of their activities - gave rise to financial protectionism in developed countries. Both recipient as well as originating countries of sovereign funds will suffer if this were to happen.

SWFs, after all, are now a source of capital flows from what used to be the periphery to what used to be the centre. What was fine in 1913, when the flow went in the opposite direction, cannot not be fine now. Just as parts of the periphery suffered when they restricted such flows before, the centre will too if it did the same.

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