The Sovereign Wealth Explosion

When Congress failed to pass a restrictive bill last year that would have threatened foreign direct investment in the U.S, we thought we'd escaped a bullet. Now, another challenge to FDI world-wide has appeared on the horizon.

Policy makers and politicians on both sides of the Atlantic have recently expressed concerns over investment by state-owned or affiliated funds, known as sovereign wealth funds. Citing "new elements" that distinguish state-controlled funds from other private funds, German Chancellor Angela Merkel has called for an EU-wide investment screening mechanism. Similarly, the Canadian government has indicated that it will consider the creation of a national-security review process for foreign investment.

The United Kingdom and the United States have taken more balanced approaches, with key figures in both countries emphasizing that investment from sovereigns should be welcome, but must adhere to market principles. Whether this level-headedness continues, particularly as the U.S. moves into an election year, will be an important determinant of investment flows in the coming year.

The good news is that following last year's outcry over Dubai Ports World's proposed acquisition of U.S. port terminals, cooler heads have prevailed. Recently adopted reforms, passed with large bipartisan majorities in Congress, clarify the national-security review process for foreign mergers and acquisitions administered by the Committee on Foreign Investment in the United States (CFIUS). The new law provides greater transparency and certainty both to Congress and investors. The law also improves the political environment for investors, with great benefits for the U.S. economy. Along with the administration's statement on open investment issued last May, the new CFIUS reforms effectively recognize that FDI is critical to the health of the American economy.

Sovereign wealth is hardly a new phenomenon. Sovereign wealth funds, which at their core are government funds that invest savings on behalf of governments or pensioners, have been around in various forms for some time. In Europe, Norway has invested oil revenues since 1967 and uses the income from these investments for both the annual operations of the Norwegian government and as savings. France has a $42 billion fund. The German government also has a fund and controls a number of large international companies. Numerous other nations (Korea, Brunei, Malaysia and Chile, to name just a few) run similar funds.

Alaska and Wyoming invest the proceeds from natural-resource income, and other states such as California and Alabama have prominent pension funds. Many of these funds have invested in other private equity, hedge and venture funds, as well as individual companies, for many years.

So why the increase in concern now? There are at least two reasons. First, while sovereigns investing their surplus wealth to generate additional income are not new, the amount of wealth now held in reserve and being driven to sovereign funds is unprecedented. A recent report from McKinsey & Company notes that Asian central banks held more than $3.1 trillion in reserves at the end of 2006 -- more than triple the amount held in 2000.

Estimates of the wealth held by sovereign funds for investment are about $2 trillion globally. And they are rapidly growing: Petrodollars are feeding funds in the Persian Gulf, other oil rich nations and, notably, Russia (leading to Ms. Merkel's concerns). China, South Korea and Singapore have announced plans to move as much as $480 billion of their foreign-exchange reserves from more conservative investments, such as government bonds, to more risk-taking investments in equities, acquisitions of companies, trading strategies and hedge funds.

Second, where the funds are forming, and in turn where the investment will come from, have contributed to the rise in concern. Policy makers in the West are particularly focused on the funds being created in China and Russia. Principals and managers of Middle Eastern funds also obviously must be attuned to the politics of their investments, as evidenced by Dubai Port World's experience and, more recently, the proposed investments by Dubai and Qatar in Nasdaq and the London Stock Exchanges.

Such concerns are not entirely without merit, especially when sovereign wealth funds or state-owned enterprises (SOEs) seek control of companies that have a bearing on national security. For example, the prospect that oil and gas companies controlled by the Russian government would advance state-driven, as opposed to commercial, objectives must be taken seriously. Investments in certain sectors (telecom, IT, energy and defense) by Chinese state-owned companies might raise legitimate national-security considerations. More broadly, transparency, preservation of free markets and fair competition are all legitimate issues for policy makers to take up in assessing investments by sovereign wealth funds and SOEs.

The path forward, however, is not to demagogue or exaggerate the risk of investments from sovereign funds or SOEs. Such investments have a vital role in providing liquidity to global markets and in generating wealth both for their home countries and receiving markets. As long as oil prices remain high and current account imbalances large, that role will only increase.

Investments from sovereign funds and SOEs should generally be welcomed by the U.S. and other countries. At the same time, policy makers, global institutions and the funds/SOEs themselves can and should take constructive approaches to ease concerns over issues such as intentions of the investors, management and transparency.

Sovereign wealth funds and SOEs should disclose financial results, investment strategies and the limits of any government role in decision making. Funds can help by making clear that cross-border investment decisions are being made by investment professionals to maximize financial return, as opposed to advancing national champions or pursuing political or foreign-policy objectives. Disclosing investment philosophies and strategies for growth, such as through annual reports, would be an important step.

G-7 countries wisely have called for work in the IMF and World Bank to identify best practices in transparency and accountability that sovereign wealth funds would be encouraged to adopt. At the same time, the G-7 recently called on the OECD to promote best practices that investment-receiving countries could adopt to ensure that their policies with respect to sovereign wealth funds are transparent and non-protectionist. This is a thoughtful appeal for careful deliberation, not hasty overreaction.

Sensible national review laws, such as the recent CFIUS reform act in the U.S., also may help, provided they are adopted and implemented with the same care and policy balance that CFIUS seeks to follow. There is a real difference between passive portfolio investments and foreign investment that leads to control of a corporation's activities. A mechanism that limits such reviews strictly to investments that establish control, and that present true national-security issues, is a mechanism that can balance security requirements with a policy of open investment. This would be reassuring and confidence-building for markets, investors and constituents.

The environment in the U.S. today is better for foreign investment than it was a year ago, precisely because the recently enacted reforms have enhanced an already mature review process. The U.S. government and leaders on Capitol Hill must maintain this momentum by remaining open to sovereign wealth, while also working with partners to develop confidence-enhancing measures in which wealth funds and SOEs can participate.