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WASHINGTON UPDATE - Some Observations

The U.S.-China Strategic and Economic Dialogue Economic Track Joint Fact Sheet of July 28, 2009, states that “The U.S. reaffirms its commitment to the open and non-discriminatory principles for recipients of sovereign wealth fund investment as identified by the OECD.” http://www.ustreas.gov/press/releases/tg240.htm

The Fact Sheet affirms that the U.S. agrees to the OECD principles that the U.S. has already agreed to – nothing more. Interestingly, in the Fact Sheet China agrees to to commit itself to the implementation of GAAP, but the U.S. does not make the same statement. Why didn’t the U.S. make that commitment? Perhaps merely an oversight, but given the detail in which
such documents are made, reviewed and approved, perhaps not.

At the OECD Ministerial Council Meeting on 4-5 June 2008 in Paris, Ministers of OECD countries, the U.S. representative agreed that where national security concerns do arise with respect to sovereign investment, any investment safeguards by recipient countries should be: transparent and predictable, proportional to clearly-identified national security risks, and subject to accountability in their application. http://www.oecd.org/dataoecd/0/23/41456730.pdf

In May 2009 however, the United States Government Accountability Office issued a report to the Committee on Banking, Housing, and Urban Affairs, U.S. Senate entitled “Laws Limiting Foreign Investment Affect Certain U.S. Assets and Agencies Have Various Enforcement Processes” which states that “Legal experts representing [sovereign investors] investing in the United States told us that they now take their clients to meet with members of Congress prior to initiating a transaction that might be viewed as politically sensitive to try to mitigate any potential concerns or resistance that could disrupt a planned transaction.” http://gao.gov/new.items/d09608.pdf at page 14 .

There are no reports of what funds met with what members of Congress, what transactions were proposed or completed, what political concerns were addressed, what action either the funds or the members of Congress took or promised to take, what conditions were applied, what resolutions were reached, and how any mitigation of concerns have been actually applied. It
is doubtful that funds and their counsel would conduct such meetings if there were not substantive results, nor would members of Congress likely meet with the funds and counsel if there were not matters of import. The fact that such meetings are ongoing and necessary confirms the same.

Private Congressional meetings and unreported resolution or enforcement seem to be well short of the OECD requirements of “transparent and predictable, proportional to clearly-identified national security risks, and subject to accountability in their application.” Things have changed in Washington, but perhaps not all for the better.

 

RECIPIENT NATIONS NEED TO ATTRACT, NOT PUNISH, RESPONSIBLE SOVEREIGN INVESTMENT

 

The economy is in big trouble and investment capital is on standing on the sideline.  One significant source of investment capital is the trillions of dollars in sovereign investment funds, whose portfolios have been ravaged and whose reputations have been savaged.

 

Infusing these massive investment pools back into the markets would provide a significant boost to the economy and would reinstate much of the confidence that has evaporated.  The nations that best understand the needs of responsible sovereign investors are the nations that are most likely to attract and retain this much needed investment.

 

According to the European Central Bank Monthly Bulletin, January 2009, sovereign investment can generate net capital flows between major regions of the global economy and contribute to a widening of the long-term investor base for risky assets. At the same time, measures aimed at restricting sovereign capital flows into developed countries entail the risk of curtailing these benefits.

 

JPMorgan Research opines that industrialized countries are best advised to engage sovereign investment funds and their governments, not villainize them. Sovereign capital flow restrictions could also lead to distortions as they deprive companies in the industrialized countries of long-term risk capital and undermine the development efforts in emerging economies

 

In 2008, sovereign investors were the targets of fear and loathing in the press and in the halls of governments around the world. Now in 2009, they are increasingly marginalized as second tier players, if that. But there is little factual basis for the former view and the latter view requires a fairly unfounded belief that oil and other commodities will remain cheap, while trade imbalances will go away.

 

To resolve the unfounded fears, the leading sovereign investment funds have bended to the global pressure and agreed to a voluntary code of conduct. Rather than adopting a similarly accommodating posture, some leading industrial nations now seem to be considering how to respond to the present economic problems with more and more investment protectionism.  As the sovereign funds have certainly appeared to have acted in good faith, perhaps the time is now right for the leading investment bound nations to figure out how to better attract and retain responsible sovereign investment.

 

What is a sovereign investor? Sometimes deemed “sovereign wealth funds”, sovereign investors are simply designated pools of government-controlled financial assets that have investment – rather than merely spending – mandates. Sovereign investors have a wide a wide variety of structures, operations, experience and objectives, with estimated collective assets under management ranging from $2 to 6 trillion.  Most of the sovereign investment that can be identified is responsible and economically based.  Sovereign investors have, however, been rather poorly understood as they – as a rule and for arguably good reasons – have provided relatively little significant disclosure to sources outside of their host government.

 

In this dearth of public information, great fear and trepidation of sovereign investors has grown in media and policy debate. There have been little or no real problems with sovereign investors that anyone can actually point to, but their size, potential market influence and government control has given rise to a number of possible problems being associated with sovereign investors.  .  The most widely voiced concerns are – at the risk of overgeneralization – that sovereign investors might invest in companies that can endanger national security, invest for political rather than economic purposes, and/or upset proper market forces by the weight of their investment power.

 

Although there have been no significant instances of such conduct by sovereign investors, some of the largest sovereign funds agreed in October 2008 to the Santiago Principles. These principles are a voluntary code of conduct designed to provide for adequate operational controls, risk management and accountability; as well as ensure compliance with applicable regulatory and disclosure requirements in the countries in which sovereign investments are made.

 

But as sovereign investors begin to implement such risk management and local compliance controls, the recipient nations in which the sovereign investors look to invest provide many differing standards and a dizzying array of rules for the sovereign investors to apply. 

 

There are no uniform standards for national security, political investing or market regulation by the recipient nations, and in some markets there are few if any documented rules for these issues. Where the existing standards are actually documented, they are often not clearly identified, transparent or predictable in interpretation or application.  The OECD and partner countries have done a great deal to help define the issue, but the country-by-country implementation of workable standards for sovereign investors has remained very challenging.

 

Put another way, sovereign investors have all of the investment risk challenges of other investors – credit risk, financial risk, interest rate risk, liquidity risk, market risk, etc. - and then sovereign investors may be subject to greater scrutiny, higher levels of suspicion, more political grandstanding and more vague standards than any other class of investors.

 

Sovereign investors have been told by the world to adopt proper risk management procedures, and they have agreed to do so.  But proper risk management for sovereign investors requires clarity, transparency and predictability of the recipient country’s unique requirements for sovereign investment. Recipient countries looking for responsible sovereign investment should also understand how they and competing countries locally address these risks. Companies in these recipient nations that want responsible sovereign investment will need to understand any unique risks that their host nations may pose to sovereign investment.

 

In examining this question, our Sovereign Investment Council has reviewed and rated more than thirty leading FDI nations, based on input from local investment development agencies and publicly available data, on the questions of national security, political investing, market regulation and other relevant factors unique to sovereign investment. Our focus was not to find the “best” country for sovereign investment, but rather to identify the level of clarity, transparency and predictability that these nations afford sovereign investors with respect to the recipient country’s unique requirements for sovereign investment. 

 

Our findings confirmed the lack of any significant level of uniformity in these local regulations and a corresponding wide range of investment risk for sovereign investors.  We are now working with sovereign investors to incorporate these findings into their internal investment risk management procedures.  Knowing what rules do and do not exist in any given country will allow the sovereign investors to understand and mange the attendant risks. We will also work with the recipient nations,  to help them better understand how their local rules are perceived by sovereign investors, how other recipient countries address the issue and how these rules may be adapted to attract and retain more responsible sovereign investment.

 

Even that is but a baseline platform for risk management of this unique political risk.  A more complete analysis for a specific proposed investment will require the sovereign investor to address numerous other related questions. What is the potential for the local political opposition to change these existing rules during the life of the proposed investment? What is the ability of any “veto player” - a political actor who has the ability to decline a choice being made - to operate outside the limited rules that do exist?  What is the local position of the media and popular press toward sovereign investment to prevent or impede the proposed investment? How is the exit strategy of the proposed investment impacted by these local regulations, or lack thereof?

 

The City of London has been very active in working with sovereign investors. The director of Japan’s Ministry of Economy, Trade and Industry’s industrial finance division was recently quoted as saying “We want to increase the flow of risk capital into Japan, especially from long-term investors like sovereign-wealth funds.” This is a common theme of many recipient nations and companies within these nations that are hoping that responsible investment by sovereign investors can ease the present economic burdens.

 

Sovereign investors may also be part of the answer to other large problems, such as the energy issue. Brad Sterley, director of renewable energy for Standard Chartered, is quoted as saying that there was “huge demand” for early stage capital for renewable energy schemes and sovereign funds are very interested investors.  Nations that have the largest energy problems would greatly benefit from sovereign investment capital for renewable energy. 

 

The present credit crisis is based on a lack of confidence, as sovereign investors and others stash their trillions of dollars in investment capital at home or cash.  But like all economic cycles, this lack of confidence will eventually dissipate. The there will likely be a challenging global race for capital, where the advantages will go to the nations that present the greatest opportunities and the least burdens on investors.

 

Sovereign investors have significant assets to invest and they have adopted a code of conduct to provide comfort to the recipient nations.  These recipient nations still need to provide sovereign investors with sufficient information to make responsible sovereign investments. The time is right for these recipient nations to now understand the unique political investment risk that they pose to sovereign investors, and to assist responsible sovereign investors in understanding and managing that unique local risk.  

 

The author is President of the Sovereign Investment Council, a non-profit trade association for sovereign investors, located in Washington, D.C., which assists sovereign investors to operate more professionally, use more commercially understandable investment programs and to educate the markets, regulators and public about the goals, organization and operations of sovereign investors. (www.sovereigninvestor.org)

 

"A Lot to Learn: Many Sovereign Wealth Fund Managers Come up Short in Measures of Sophistication" According to the online Wharton business journal, a recent study found that the management sophistication of many sovereign funds "has hardly reached its adolescence" and "many funds don't adhere to basic norms of modern money management."

"Insurance Firms: The Missing Link in the Sovereign Wealth Fund Acquisition Spree" Deloitte Research has sent us a copy of their new publication which examines why SWFs have acquired interests in global banks, but have not included significant investments in insurers. "The lack of adequate attention paid to the role of insurance services in the development of these financial centers seems striking when considered in conjunction with the current state of local and regional insurance markets in the Middle East and Asia." For a look click here.

How do SWFs differ from public pension funds ? Professor Gordon L. Clark of the University of Oxford makes some particularly astute observations here.