European Affairs

At the Sovereign Investment Council, we have been devoting quite a bit of attention to discussing SWFs with Washington policy-makers. The Council is the only association in Washington that is solely devoted to monitoring SWF developments to educate policy-makers about SWFs and influence public opinion in support of them.

We believe that the present U.S. political climate for SWFs is very volatile. The U.S. financial system has been severely disrupted; energy costs are skyrocketing; trade imbalances are growing. So, this being Washington, you need to find a reason for problems and a solution. In this environment, sovereign wealth funds can be a perfect political target: SWFs have:

• no U.S. employees
• no union members
• no factories or offices in electorally significant parts of the U.S.
• no constituents in the U.S.; in fact, the very countries maintaining some of the largest SWFs are unpopular in many Congressional districts.

A recent opinion poll showed that 58 percent of Americans think globalization is bad for the U.S., and just 28 percent think it has helped America. SWFs represent many of the negatives of globalization to the public and to some U.S. policy-makers. It is not difficult to find demagogic quotes from protectionist politicians under the guise of “strengthening national security.” These politicians are not uninformed and, in saying such things, they are behaving rationally [for their political needs]. Polling shows American voters dislike many of the governments that control the largest SWFs. It is far easier to side with public opinion than refute it. For most politicians, refuting public opinion could be a career-ending decision.

We believe that in the coming months you will see a number of anti- SWF bills proposed in Congress that will have no possibility of passing, but they will appeal to voters back home who are paying $4 a gallon for gasoline and see that money going to foreigners who have trillion-dollar investment funds.

Collectively, SWFs have not found any strong allies in Washington. Various Washington groups have tucked SWFs into their portfolios [of issues], but SWFs have never been the primary constituency of any interest groups. In fact, our Sovereign Investment Council was created because we saw no group that was willing to publicly provide any positive information on SWFs, no public source of information about the benefits of SWFs or groups that would take a position to educate policy-makers about SWFs. In the U.S. government, at least eight Congressional groups and several federal agencies have claimed some jurisdiction over the SWF issue, on the basis of national security, financial services, securities regulation, foreign relations and other aspects of SWF activity. In Congress, Senate Banking and House Financial Services are seen to be the leaders.

• Senate Banking Committee Chairman Chris Dodd has said that “SWFs have been and will continue to be a high priority for the Committee.”

• Spokesman for House Financial Services Chairman Barney Frank has stated: “We are going to look at the big picture of this phenomenon and try to gauge what are the policy implications for these funds in the U.S.”

On a more positive note, it is true to say that, generally, Congress and the current administration understand that SWFs are very individual, highly complex and have provided substantial investment to major U.S. institutions in time of need. Most policy-makers in Washington privately understand that SWFs have not committed any illegal or unethical acts and should not be presumed guilty because of size or confidentiality.

In addition to the advocacy of our Council, there is a quiet constituency for the SWFs in Washington urging restraint. These quiet constituencies have a great stake in the continued growth of SWFs and, while they have not actively defended SWFs, they have privately urged a reasoned approach. For example, U.S. investment banks have a great interest in participating in the billions of dollars of mergers and acquisitions and other deals that SWFs undertake.

Another significant U.S. industry positively impacted by SWF growth is the asset-management industry. SWFs’ three trillion dollars in assets may pale in comparison to the estimated $20 trillion held by insurance companies and the $28 trillion held by mutual funds, but SWFs are estimated to grow to $12 trillion within the decade. The expertise and diversity that external managers provide ensures that SWFs will continue to use external managers. Given the fees involved, more external asset managers will look to compete in the SWF market.

Using projected SWF assets of $10 trillion, if external management is used on 25-45 percent of operations and management fees earned on 35-50 percent, external management fees earned from SWFs could range from $87 billion to $225 billion annually.

But the SWFs have not helped themselves politically in the U.S. Fiercely independent, most SWFs refuse to be associated with other SWFs. And they strongly believe that they should not be told what to do by other governments. Some SWFs have refused to provide even the most basic information about their operations. Many SWFs refuse to believe that they need to explain themselves to anyone, as they are operating within the accepted confines of investment. They feel that they are playing by the existing rules and no special rules are needed for them.

The current political climate in the U.S. – particularly in this election year – is for the policy-makers to refrain from any direct immediate action, but meanwhile to publicly question the motives of SWFs and to call publicly for more information upon which a decision can later be made.

The U.S. Department of the Treasury has agreed with Abu Dhabi and Singapore to adopt rules of conduct. New regulations dealing with foreign ownership are being considered by CIFIUS, the relevant inter-agency review body in the U.S. government. A study group at the International Monetary Fund will produce a voluntary code that will also allow Washington policy-makers to be concerned but “wait and see” – which is the watchword.

In another important step – one that I will discuss in detail below – Senator Max Baucus, Democratic chairman of the Committee on Finance, and Senator Chuck Grassley, the top-ranking Republican member, have asked the non-partisan Joint Committee on Taxation to describe and analyze the history, current rules and policy underpinnings of the U.S. tax rules that are applicable to U.S. investment by SWFs.

President Bush has stated that he has no fear of foreign investment, but the likely next President has not been as clear. Senator John McCain has made no statements on SWFs to date. The presidential candidates on the Democratic side were forced to make stronger statements in their contest earlier this year when SWFs were more of a front page issue. For example,

• Senator Hillary Clinton: “We need to have a lot more control over what SWFs do and how they do it.”

• Senator Barack Obama: “I am concerned if these… SWFs are motivated by more than just market considerations, and that’s obviously a possibility. If they are buying big chunks of financial institutions and their board(s) of directors influence how credit flows in this country and they may be swayed by political considerations or foreign policy considerations, I think that is… a concern.” As SWF assets come from the rising oil prices and trade imbalances, there is a very good chance that this will be an issue for the presidential candidates, particularly if any SWFs come into the headlines again with any large steps or missteps. There is also a chance that outside groups will enter the debate as well, perhaps forcing policy-makers to take a stand. As one example, a union is pushing California state legislation limiting the ability of state pension funds to invest in companies associated with SWFs. This is a small, but very important indicator that deserves watching.

To summarize:

• The political climate with respect to SWFs today is that U.S. policy-makers will lead with the general position that a strong America requires greater scrutiny of SWFs.
• Policy makers will challenge SWFs on how they operate, but will not yet be forced into a protectionist corner by tackling the hard questions of what to do next.
• It is far more prudent, reasoned and statesmanlike to seek further information and facts upon which decisions can be made after the U.S. presidential elections in November.
• Without a significant SWF incident requiring action prior to 2009, study and “watchful waiting” should be the rule.
• In 2009, we believe that there will be significant action in Congress and by the new administration to try to find a way to get the growing SWFs to help stabilize the financial system, provide needed funds into the U.S. budget, support global development and a number of other causes.
• Government action concerning SWFs in 2009 is likely to broadly treat all SWFs equally, and not differentiate between “good” and “bad” SWFs.

Let me move on to the potential ramifications of the SWF issues on future transatlantic and international collaboration. Clearly, the IMF-proposed Code of Conduct is being looked to as the answer to many of the problems. The U.S. and the European Commission have gotten behind the IMF efforts as the next best step. Many commentators and SWFs have criticized the role of the IMF in setting this Code, complaining that there is no enforcement mechanism, that it will be too general and allow no further regulatory interpretations. No one expects the IMF code to immediately solve all of the problems, but it is a reasoned first step that is likely to give rise to further cooperation. In that role alone, the IMF will be providing an invaluable service.

We think that a far greater danger for transatlantic cooperation comes from the tax issue mentioned earlier. Governments generally do not tax other governments and SWFs – as government entities – may be exempt from tax. Politically, this is a very important issue.

SWFs mostly have their assets from the sale of oil and exist as a national savings account for their citizens. Paying high oil prices is hard enough, but paying them to a tax exempt entity makes many U.S. citizens angry. In a recent Pew Survey – when asked about their ability to afford necessities – most Americans ranked their ability to afford gasoline, their savings and their taxes as the three most difficult.

Tax proposals involving oil, savings and foreign investors are very likely in the near future. The dangers here are that countries might yield to political pressure and try to use tax laws to make SWFs act in a certain manner to retain tax exemptions, or worse, change the entire government-to-government tax relationships.

This could result in ever further problems with unilateral tax agreements and countries competing by providing special tax incentives for SWFs. The Sovereign Investment Council has been following this taxation issue for months and we believe that it will be perhaps the most important SWF issue going forward.

The concept of competition for the SWFs leads me to my last point on potential ramifications for future transatlantic and international collaboration on this issue. There is a real possibility that some nations will see past the fears of SWFs and perhaps break from the herd to attract SWFs. The chief executive of the British Private Equity and Venture Capital Association described the California bill I mentioned earlier as “deplorable” but he added that, if it passed, the measure would present a great opportunity for Britain to steal the U.S. mantle as the favored destination for SWF money. London has done well as both a clearinghouse and location in which SWFs are managed. A number of funds from Kuwait, Brunei, Singapore and Abu Dhabi have already set up representative offices in London.

London is in the pole position to capture a growing share of this market over the coming years. The City of New York would very much like to be in the position of London with respect to the SWFs. London is in the pole position to capture a growing share of this market over the coming years Companies may compete for SWF investment directly as well. Dell said it is in talks with an SWF about establishing a joint venture to further increase the personal-computer maker’s sales in the Middle East. Japanese companies are known for their aversion to takeovers by foreign buyers, but now some Japanese managements see SWFs as more friendly alternatives to other types of foreign investors like activist hedge funds, because SWFs typically remain passive and stay clear of management affairs.

Big companies such as Asahi Glass and Mitsubishi Heavy Industries have recently begun sending executives to Middle Eastern countries seeking investments in their companies. With respect to future transatlantic and international collaboration on SWFs, I think there is a short-term and a longer-term answer. In the short term, there is likely to be a high degree of agreement among major national governments on the need for and propriety of further study and voluntary codes of conduct. Collaboration will continue as these nations educate themselves further and develop specific responses. More work will be called for to examine next steps and operational answers to technical questions. In the longer term, there is a good chance that competition among nations seeking SWF investment may grow. Just as SWFs are individual, complex entities, nations seeking SWF investment will have their own needs and levels of concern over different issues. Certain nations may be more open to SWF investment and require less of SWFs. As many commentators have begun to rank SWFs on transparency and operations, it is not unlikely that SWFs will begin to rank countries on investment rules and costs. Nations seeking SWFs’ billions will begin to consider competition along with transatlantic and international collaboration on SWFs.

To conclude, the U.S. political issues of SWFs will continue to simmer through and beyond the November elections. Random and vague attacks on SWFs will be made to curry favor with the electorate in this election year. The problems of oil prices, the financial system troubles, trade imbalances, and budget problems in paying for more programs will be portrayed in some ways as a by-product of SWFs, and action against SWFs will be offered as a simplistic solution to these same problems. The issue of what Washington can and should do about SWFs will not go away however, and some action will be taken with respect to SWFs in 2009. Any U.S. steps will be closely eyed by other nations. Some nations will follow the U.S. model; others will play off that model in ways designed to help them compete against the U.S. for SWF investment.

Our Council is committed to helping SWFs educate the public and the policy-makers and to work with SWFs to engage in greater discussion amongst them to develop operational best practices. Our Sovereign Investment Council will continue to lead in monitoring these developments and focusing on SWFs collectively. We will continue to be the authority on the value of SWFs to national and international economies. SWFs will only get larger and both the SWFs and the prudent policy-makers will be well served to understand that the benefits of SWFs outweigh the fears.

Thomas J. Karol is President of the Washington-based Sovereign Investment Council. This article is adapted from a presentation he made to a roundtable under the auspices of The European Institute on April 10, 2008.


This article was published in European Affairs: Volume number 9, Issue number 3 in the Fall of 2008.