Sovereign Wealth funds should be welcome in Europe and their state patronage should not be of concern as long as the funds have transparent and diverse investments while respecting the host country's sensitivity says the EU Trade Commissioner.
That Sovereign Wealth Fund investment should be welcomed in Europe, and that existing funds had been benign and effective investors for more than thirty years.
That big new funds in Russia and China needed to recognise that they had little track record and faced a difficult political environment and therefore a "heightened need for reassurance".
That although state-backed investment did raise important questions about foreign influence and control, these were often overstated and European states already had the necessary legal means to police inappropriate investment in their economies.
That a global code of conduct developed in partnership with the funds themselves could provide the political reassurance the funds need to operate beyond suspicion. He argues that given their investment record such a code meant only "signing up to doing what they already do and not doing what they freely acknowledge would be a disaster for them".
That following the US agreement with Singapore and Dubai, the focus should now be on a similar multilateral agreement. Mandelson urges funds to contribute to such work: "not as an attempt to restrict their freedom of movement unfairly, but as the necessary political reassurance that will prevent a swing in Europe and the US against openness to their investment". He warns that the "the mixed messages we have heard from a couple of funds can only fuel unnecessary anxiety".
At the end of last year Larry Summers wrote in the Financial Times that the sudden dramatic rise of Sovereign Wealth Funds was 'shaking the logic of capitalism'. I am not sure this is quite right. They are based on fairly old-fashioned capitalism: the need to find a productive occupation, and reasonable return, for surplus capital.
Even the idea that the funds might use their investment for long-term strategic ends doesn’t really distinguish them from conventional commercial investors. What is obviously different about them is that they are operating in the interests of a state, on behalf of its citizens, rather than a company or an individual investor. This raises at least the question of how these funds might seek to use their investments and the leverage they bring. They don’t so much shake the logic of capitalism as ask what happens when states themselves become global capitalists.
Our various attempts to address this question over the last six months or so have created a lot of heat and some light, and have provided an outlet for a fair bit of general anxiety about globalisation and economic change. I want to argue today that a lot of the anxiety about sovereign wealth is substantially misplaced – because the risks attached to the funds can be overstated and our capacity to manage any likely risk is probably understated.
I think that the challenge that the funds present us with is essentially a political one. How do we integrate these huge new players into the global financial system in a way that reassures the recipients of investment without casting the funds as potential villains? I want to suggest how we can do that.
Why the political worry?
My Commission colleague Charlie McCreevy often points out that investment vehicles of this kind have existed for five decades without provoking any concern at all that they use their investments to seek anything other than a good return. He is right. Most of the older funds were founded as a way of helping commodity exporters diversify their income away from volatile oil and gas and mineral prices and build up reserves for future generations. Russia's stabilisation fund was of course set up for this purpose. You only have to compare the volatility of US Treasuries, or even the S+P 500, with oil prices over the last decade or so to appreciate the logic.
The investment of current wealth for the benefit of future generations is the only sensible response when that wealth is generated from exhaustible and diminishing resources. Obviously, those benefits need to be balanced against the conditions that make the accumulation of sovereign wealth possible. China's CIC fund is built on the hard currency reserves from trade surpluses that are inflated by artificially suppressing domestic demand and maintaining a weak currency, neither of which are in China’s long term interests. But there is nothing inherently suspicious about sovereign wealth, or the desire to invest it productively.
So why are we having this debate at all? Looking coolly at the question the answer is – and I will put this as diplomatically as possible – that the biggest new funds are in economies which have raised some sensitivities in our own politics. No one is worried about Norway's plans for global domination. Chinese investment vehicles and the Russian stabilisation fund on the other hand, are new investors, with huge reserves, backed by governments with mixed democratic credentials, substantial foreign policy projection and no track record as investors. This does not disqualify these countries and their funds. But there is a heightened need for reassurance.
Second, there has been a notable change of buying patterns among the big funds – away from Treasury bills and securities into equity and direct investment. This takes them off the inside pages and onto the front page. It raises the question of whether or not the funds might seek controlling stakes in enterprises and whether this will be purely commercial or might act as an extension of foreign policy. There has also been a shift away from dollar-denominated assets into other denominations, which raises the question of how a shift away from dollars could affect exchange rates.
The third reason we are having this debate is because the sheer magnitude of the funds under sovereign wealth fund control has exploded. From current levels of $2 trillion, they are expected to reach more than $12 trillion before the middle of the next decade. The speed at which wealth is being accumulated - on the back of a commodity price boom and heavy trade deficits for the West in Asia – underlies nervousness about how this wealth is being invested.
Sovereign Wealth Funds may still be dwarfed by standard pension and investment funds, but they now control more than twice the assets under hedge fund control. Of course it is important not to talk about the sovereign funds as if they were an amorphous block. They do not have a single brain or governing mind. We are in fact dealing with 40 funds – if you exclude the sub-national state-backed investment funds. Only 10 of these have assets over $100 million and they are all making independent investment decisions – no more likely to act in unison than pension or hedge funds. Still – it is a large pool of money.
How should Europe respond to sovereign wealth funds?
Should we be worried about these things? My politician's answer is yes and no. Yes, because obviously there are some parts of our economies where full control or ownership by foreign states would create concern. Defence production is one. Energy supply and distribution might under some conditions be another. Yes, because we have to at least ask if ownership of large enterprises in our economies could give unreasonable political leverage to the foreign governments sponsoring the funds in dealing with our own. Yes, if we think that there is a possibility of a dramatic shift into euro-denominated assets by the funds, which could have an unwelcome effect on euro exchange rates.
But the no to the question whether we should be worried is, in my opinion, more important. The challenge for Europe and the United States is to respond to the growth of these funds in a reasoned and reasonable way. Where sovereign wealth is invested transparently it is a valuable source of capital. The funds have demonstrated their value over the last few months in illiquid capital markets. A number of major banks under sub-prime pressure can vouch for that. We should be much more worried if these investors were not interested in Europe. If they did not rate the euro as a safe reserve currency. If they did not want to invest in euro-denominated assets. Our response should emphasise the positive rather than the paranoid. I can't say that too clearly.
There is also a fine political line in this debate between sovereign wealth fund investment and the need to sustain foreign investment flows generally. We have no interest whatsoever in a protectionist turn in global investment markets or encouraging Europeans and Americans to see foreign investment and ownership suddenly as a bad thing. This is especially true in the current political atmosphere in Europe – not to mention the US, where the isolationist rhetoric of the Presidential campaign trail has been striking.
Our policy and public language must reflect this. Europe is by far the biggest exporter of foreign direct investment as well as a huge beneficiary of inflows. If politicians and policy makers encourage the public belief that foreign investment is a bad thing or even questionable, this will surely boomerang on our own investments abroad – let's remember that. Foreign direct investment capitalises huge chunks of our stock markets and underwrites literally tens of millions of European jobs. We need to encourage it, not counter it.
There is also a tendency to lump Sovereign Wealth Funds in with state-owned enterprises. We routinely hear the Dubai Ports deal, the China National Offshore Oil Corporation bid for Unocal and Gazprom's activities invoked as salutary warnings. But not only is there nothing inherently wrong in these companies' international ambitions, none of the bids actually involved sovereign wealth funds at all. And while sovereign wealth funds generally take non-controlling equity stakes, Dubai Ports was, perfectly legitimately, about the takeover of one operator by another. Both kinds of asset sales can in certain circumstances raise important issues. But treating them the same ignores the difference between a state acting like a business and a state acting like an investor.
What should we expect of sovereign wealth funds?
So when we clear away all these misconceptions we are left with a question: what expectations should be placed on states that wish to become investors? That is the question that the European Commission offered an answer to a month ago and on which the OECD and the IMF are doing important work. I think we are starting to see the shape of an answer emerging from the global debate.
What the Commission argued earlier this month – and what Secretary General Gurria echoed in Beijing last week – is that we don't need new regulation or new laws. Why not? Because, despite the political temptation to believe otherwise, OECD states already have the legal tools they need to regulate the establishment and the actions of foreign investors. We don't need new laws. What we need is reassurance that the benign conduct of funds in the past will remain a useful and consistent guide to the future.
What the Commission backed – and what EU governments have now endorsed - was the drawing up of a voluntary code of conduct with the funds themselves that sets basic standards of governance and transparency. Funds should disclose the regulation and oversight to which they are subject and should be able to show that their investment decisions are taken by professional investment managers charged with delivering long-term commercial returns. They should subscribe to a certain minimum degree of transparency about their investment strategies and objectives – not least because they need to be aware of their weight and their ability to move markets with large shifts in their positions. This can be as simple as periodic reporting and publication of business plans. I do not believe that transparency obligations should be either onerous or extraordinary, compared to other investment vehicles.
Some funds have bridled at such proposals – some fund officials have called them unfair or dismissed the possibility that such a code would be accepted by the major players. Understandably funds don’t like to feel they are being singled out or told what to do with their money. They don't like suspicion they feel is unfounded. I understand that.
Recipient countries need to be careful not to cast the funds as suspect or on probation and they must avoid discriminatory restrictions. But the funds themselves cannot afford to underestimate how important reassurance about systems of transparency and governance is, in ensuring that unfounded suspicion doesn't mushroom into a protectionism that is in nobody's interest. It would be a mistake for them to ignore the political environment in which they are operating.
It's worth noting that the private equity and hedge fund industries have responded to similar concerns about their business models and investment objectives with voluntary codes of conduct. Every top fund official I have met – whether in Beijing, Singapore or Qatar - has told me that it would be directly contrary to their fund's interests to pursue non-commercial strategies or even to be perceived as doing so. So producing a voluntary code of conduct should simply be a question of formalising existing investment practice. In other words, signing up to doing what they already do and not doing what they freely acknowledge would be a disaster for them.
Last weekend's agreement on principles for investment between the US and Singapore and the Abu Dhabi Investment Corporation shows that this does not have to be either hugely difficult or compromising for the funds themselves. As officials from the Abu Dhabi fund pointed out this week, the code simply sets down on paper what they already do. I hope that other funds will take similar steps. Our priority now should be turning this kind of agreement into a stepping stone to a multilateral code of conduct that ensures that we have one code rather than many. Multiple codes would lead to confusion and the risk of discrimination.
I would urge other funds to back such an effort. Not as an attempt to restrict their freedom of movement unfairly, but as the necessary political reassurance that will prevent a swing in Europe and the US against openness to their investment. The current political climate means that this would be the wrong moment for funds to respond with resentment or indifference. The mixed messages we have heard from a couple of funds can only fuel unnecessary anxiety.
Living with state capitalism
The sovereign wealth fund debate taps into a deep vein of anxiety about economic openness in Europe and the US. It confronts us with another manifestation of the growing trade and economic power of economies like China and Russia at a time when most of us are only just beginning to adapt to deep shifts in the global landscape. That anxiety is deepened by the perception – and sometimes the reality that these countries take a different approach to us when it comes to the role of the state in trade and investment – with states directly running businesses transparently or otherwise. They deploy investments. They distort the conditions of trade when it suits them.
There are some in Europe and US who believe the appropriate response to this is for our governments to get back into the business of state businesses themselves or to shelter our economies from state-backed capitalism. I believe this would be a mistake. The existence of state capitalism in some countries is not a rationale for protectionism by others. State capitalism requires vigilance in the US and the EU; it requires that state-owned enterprises that want to compete in our markets meet our competition and monopoly rules, and it may require us defending our own companies and workers from unfairly subsidised imports. It requires that we take a hard-headed approach to tackling barriers to our exports in their markets so that our businesses get a fair deal and our voters see the two-way benefits of openness.
We have learnt the lessons of these kinds of economic nationalism and state intervention the hard way, just as the new state capitalists are likely to learn them through inefficient companies, overheating export sectors or distorted capital markets. But just because some have yet fully to learn from these mistakes doesn't mean that we, in our economies, should start repeating them.
Our economies can engage constructively with state capitalism and they can do it to mutual benefit. Openness to these economies on these terms is in our economic interest and will, in time, drive them to reform. Certainly the desire for stable and sustainable economic growth will make some of the more extreme forms of state capitalism - distorted capital markets for example – very hard to maintain.
In fact I would argue that the sovereign wealth funds debate is a key opportunity for us to engage countries like Russia, China, Libya and the Gulf States, for example, in a debate about multilateral rules in a multilateral system of which they are now a growing and indispensable part. Certainly that system will have little future without them.
So let me summarise my views in conclusion. Sovereign wealth funds are in fact a relatively uncomplicated part of the state capitalism picture. Monopolistic practices, market abuse and distortion of trade by state businesses are a lot more worrying. When sovereign wealth funds invest transparently and diversely, avoiding controversial sectors and acting sensitively in acquiring large stakes – as they have up to now - their state patronage is not in itself a cause for concern. If a fund appears to depart from such practice we are equipped with the legal means to address the issue.
Our focus should not be on demonising them, or stoking public fears about foreign investment. Our chief concern should be integrating the sovereign wealth funds effectively into the global financial system by working with them on a voluntary international code that preserves an open global investment climate and gives the funds the access they want and the recipient countries and publics the reassurance they need. This is the route Europe has settled on, and I believe it is the right one.