Hidden giants

Sovereign wealth funds and transparency

The rise and dominance of sovereign wealth funds (SWFs) is representative of the transformation of the global financial landscape after the 2008 crisis. Two significant factors combine in powering up SWFs as the global economic shift from West to East is reinforced by the new economic status of emerging countries: the ownership of natural resources and the desire to manage financial wealth for future generations.

With 58 percent of their current assets related to revenue streams from oil and gas, SWFs have crystallized this emerging world order as their growth in markets such as the Gulf Cooperation Council (GCC) eclipsed the strength of SWFs in developed economies. It is estimated that SWF assets had grown beyond $5 trillion by mid 2012.

This proliferation of financial power in emerging market SWFs, a key part of which took place from 2005 onward, has given rise to questions regarding their transparency, governance and regulatory frameworks. Especially in the months just before the 2008 global recession, some commentators treated the fastest-growing SWFs as the “Darth Vaders” of international finance — alleging them to be opaque, mysterious and unstable.

The big players in the Gulf

In the last decade, SWF growth has been so incremental that critics have argued that an “unknown” group of investors are de facto controlling trillions of dollars. This criticism has been fueled by the fact that 11 of today’s 12 largest SWFs, each with known assets of over $100 billion, are owned by governments of emerging economies. According to watchdog organization SWF Institute, only Norway’s SWF is owned by an established ‘Old World’ player and only the Norwegian and the Singaporean SWFs are considered highly transparent among the 12 largest SWFs.

One cannot disregard that the mammoth size and limited transparency and accountability of younger SWFs from emerging economies have attracted controversy. It has been argued that SWFs have the potential to disrupt financial markets or could be used as political tools; accordingly they should be more transparent and rendered accountable to the public as a whole.

China’s SWFs have been one target of scrutiny, but the greater attention has been focused on the Gulf arena, as 35 percent of SWF wealth is based in the Middle East. In the GCC, SWFs owned by Qatar, Saudi Arabia, Kuwait, the United Arab Emirates and Oman have been estimated at a collective worth of $1.8 trillion in September 2012 by the SWF Institute. This number is not wholly conclusive and may be higher because the institute’s ranking list has no information on the assets of three SWFs in the GCC.

As developed economies have been hit quite badly by the global financial crisis, Arab SWFs have begun to be viewed less suspiciously by Western policy makers and in some developed countries, attitudes to Gulf-based SWFs have become inviting. Today, the international community regards GCC-owned SWFs collectively as a global powerhouse. Regionally, they are considered as essential tools to invest oil revenues and create wealth for the future.

Among GCC sovereigns, Abu Dhabi has gained the crown for investing substantially through its SWF. The Abu Dhabi Investment Authority (ADIA) is the second richest in the world with $627 billion (Norway’s Government Pension Fund ranks first with $656 billion). Saudi Arabia’s Sama Foreign Holdings is classified second regionally with assets of $533 billion. Kuwait and Qatar are also highly active and classified in the top 10 worldwide by asset size.
The case and legal framework

As the role of SWFs has been highlighted by global needs for cash in the economic downturn, it is today more pertinent than ever to address three crucial questions: Are SWFs beneficial forces in finance? How are they regulated? And, are more regulations required?

The global financial crisis and the Arab turmoil of the past two years have each demonstrated the stabilizing effects of SWFs. Internationally, the importance of having access to financing capacity of high-powered funds in economic downturns was highlighted by the International Monetary Fund, which was reaffirmed as a conduit of stabilization in 2008 and again since 2010 because of the IMF’s ability to mobilize funds in support of struggling European countries.
The value of long-term SWFs as an alternative or auxiliary route to stabilization has been acknowledged by Western governments, which have approached the GCC SWFs for assistance in economic recovery. The stabilizing role of GCC SWFs is even more unmistakable in a regional context, with examples such as the Qatari SWF recently assisting the Egyptian economy by investing billions of dollars in Egyptian financial institutions. 

As illustrated above, it is hard to question that SWFs can play a constructive role in global finance. All-powerful financial entities have detractors who allege they combine political motives with insufficient accountability; the IMF is the biggest example, attracting the ire of academic and political critics, all the way to violent street protests.

However, while protectionist calls against the meddling of foreign funders in the behavior of a distressed economy will generally be counterproductive, it is a fact that the roles and interests of SWFs are not governed by an extensive system of global regulation, transparency and accountability. It has been argued that the absence of regulation allows SWFs too much room to base investment decisions on political motives and makes it opaque how they determine the variety of their investment objectives. The SWF owners sought to address such concerns in 2008 when formulating 24 generally accepted principles and practices, or GAPP, known collectively as the Santiago Principles. GAPP 19, for example, emphasizes that investment decisions by an SWF should be based “on economic and financial grounds” and aim “to maximize risk-adjusted financial returns in a manner consistent with its investment policy.”

In addition to the Santiago Principles and investment rules by the World Trade Organization that are relevant for SWFs, the Organization for Economic Cooperation and Development has recommended standards to countries that receive SWF investments, and the European Union has promoted a common approach to SWFs for member countries. The EU has emphasized transparency regulation for institutional investors while pointing to the importance of the free movement of capital in a globalized system.

It is the author’s view that stringent regulation of SWFs may not be needed, as their managed assets are already constrained by the SWFs’ inherent objectives and governance protocols. These voluntary guidelines on best practices in SWFs provide a subtle and indirect regulatory framework to discipline these mammoth funds. Draconian regulations could be highly problematic as they would limit global investments and activities of funds and restrict global markets and opportunities. At a time when the world’s economy is trying to recover, protectionism via excessive regulations would have the opposite effect.
The constitutional features of SWFs and their wealth-building mission set frameworks for what they are permitted and not permitted to do. For example, the ADIA is known for placing great importance on funds’ transparency and fee structures when making allocation decisions.

Although stringent regulation may not be required, more transparency would certainly not harm the SWFs and provide numerous benefits. GCC SWFs have much room to improve disclosure of information and shareholding notification with respect to voting rights attached to shares. Secondly, accountability of individuals controlling the funds could be rendered more structured and public. Thirdly, dealing with the sovereign in all modern states entails reporting to the people. It stands to reason that today’s core requirements for successful funds management apply fully to SWFs, and these requirements are a sound performance record, proven risk-management tools and impeccable client communication.

Looking ahead

Governance and transparency have become paramount in the post-2008 financial arena. Due to their own size and the size of investment targets they require, SWFs have to avoid damages to reputation if they want to access the best opportunities and realize their financial objectives in preservation of national wealth.

As sovereign funds become more and more influential and well known to the public, their stabilizing effect on the global economy will become more widely accepted and they will be regarded as essential tools for the effective functioning of the global financial system.

Nicole Purin

Nicole Purin is a legal and finance expert based in the United Arab Emirates.