At the end of 2011, sovereign-wealth funds’ (SWFs) assets under management amounted to US$3 trillion, following 237 direct investments worth US$81 billion that year. Some experts even estimate SWFs’ assets to be worth US$6 trillion. This means that SWFs, the avatars of state capitalism, are now twice as rich as the world’s hedge funds, the totems of liberal capitalism’s excesses.
The growing might of SWFs is causing concern — and, in some cases, inciting virulent criticism — particularly in host Organisation for Economic Co-operation and Development countries, where many fear the redistribution of financial, economic, and political power to emerging countries that have very different political regimes from their own. In fact, of the seven SWFs that control more than two-thirds of all these funds’ assets, three are from Asia (one from China and two from Singapore) and three are from the Middle East (Abu Dhabi, Kuwait and Qatar).
European countries rank first among hosts for SWF investments, accounting for more than 40 percent of the total value of deals in 2011. The US, where opposition to such investments has been stronger, accounts for less than 10 percent.
These countries’ concerns are not entirely unfounded. SWFs pose concrete risks, some of which have already materialized, to the global economy and to financial markets both at home and in host countries.
For example, some SWFs faced temporary, but significant, losses after the US subprime mortgage bubble burst in 2008 and after the EU’s sovereign-debt crisis erupted a year later, owing to a high level of exposure to these economies’ property, financial and sovereign-debt markets. Those that have not been hit have been protected by host-country opposition to projects in strategic sectors and by the fact that SWFs, aware of the sensitivity of their investments and afraid of potential retaliation, have mostly taken small stakes — 1 to 2 percent — in their targets.
There are some exceptions to this pattern. The Chinese Investment Corp’s (CIC) biggest investment last year was a 30 percent (US$3.2 billion) stake in the gas and oil exploration and production sector of the French energy giant GDF Suez. CIC chose to take a significant share in one branch, rather than a small share in the whole group, because doing so offered both a strategic advantage (access to energy resources) and a monetary benefit (investment in US dollar-denominated assets).
In general, however, opacity is a defining feature of most SWFs, exacerbating the risks that they pose. While some SWFs, like Norway’s Government Pension Fund Global, are transparent, little information is available on most SWF’s size, portfolio holdings, investment strategy, performance, or mode of governance.
Enhancing transparency is one of the main aims of the Santiago Principles — a set of 24 voluntary guidelines that stipulate best practices for SWFs. Twenty-five countries have signed on to the principles since 2008, but while they are an important first step toward managing SWF’s legal framework, institutional and governance structure, and investment and risk-management policies, they are unevenly applied and are widely considered inadequate.
Given the geographical distribution of SWFs and their investments, truly global regulation is highly unlikely. However, without closer monitoring, SWFs will inevitably face politically motivated restrictions by some host countries, so it is in their interest to intensify their efforts at self-regulation.
The need to increase the transparency of SWF operations should not be allowed to eclipse their potential benefits. As long-term investors, SWFs can help to reduce market volatility through financial intermediation, as well as contribute to financing projects with positive but long-term rates of return.
Furthermore, SWFs have comparative advantages over other kinds of institutional investors. Unlike insurance companies and pension funds, they have no long-term debt or future payment obligations. And, as public investors, they are likely to have a better understanding of investment projects that depend on public policy. Given these advantages, SWFs play a large — and growing — role in infrastructure finance.
New financial regulations — Basel 3 for banks and Solvency 2 for insurers — are reinforcing these advantages. While the regulations are likely to reduce the likelihood and impact of financial crises, they will also make long-term loans more expensive and investments in illiquid assets riskier.
As a result, banks and insurers might disengage from infrastructure finance, creating more opportunity at lower cost for SWFs. Given that infrastructure is crucial to sustainable development, this could eventually lead SWFs to become key players in this area.
To achieve this, SWFs must alter their investment pattern. In 2011, SWFs invested US$35.2 billion in financial services, US$13.4 billion in property, US$13.2 billion in fossil-fuel resources (mainly oil and gas), US$6.5 billion in infrastructure and utilities, and US$3.4 billion in aircraft, car, ship and train manufacturers. Given that SWF’s primary objective is to transfer wealth to future generations, their high level of exposure to fossil-fuel markets is unsustainable.
Indeed, the remaining carbon-emissions “budget” until 2050, adherence to which is required to limit the global temperature increase to 2oC, is five times smaller than the carbon equivalent of proven fossil-fuel reserves. This means that only 20 percent of these reserves, based on which SWF assets are valued, can be burned unabated.
Some SWFs in the Middle East and Asia seem to understand the risks associated with carbon-heavy investment portfolios and are ready to work together to create a platform to finance resource-efficient, low-carbon, environmentally friendly infrastructure projects. Indeed, the idea was discussed in January at the World Future Energy Summit and the International Renewable Energy Conference in Abu Dhabi.
This initiative should be supported unequivocally, serving as a springboard for a stronger focus on green investment among SWFs. With the right approach, SWFs can offer significant long-term benefits to all.
Emmanuel Guerin is program director for climate at the Institute for Sustainable Development and International Relations in Paris.
Copyright: Project Syndicate