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A New Global Force?

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Sovereign wealth funds — government-owned funds often amassed from petrodollar surpluses and geared toward investment in foreign industrial and financial assets — have become seemingly overnight a major force in global financial markets. Estimates of their current size range to $3 trillion, and recent projections expect them to swell to between $13 trillion and $15 trillion by 2015, larger than the current US GDP.

Concern in Washington about this kind of money deployed to buy companies in sensitive sectors has been growing, resulting in the passage of the Foreign Investment and National Security Act, requiring that acquisitions of U.S. companies by foreign state-owned entities undergo a 45-day review by the Congressional Committee on Foreign Investment. For once, the United States and its allies in Europe see eye to eye on this issue. French President Nicolas Sarkozy and German Chancellor Angela Merkel have spoken out against such investments and are considering legislation to protect strategic domestic companies and sectors.

Naturally, not all sovereign funds are a source of concern. The one owned by the government of Norway, for instance, is not the target of this legislation despite amassing some $360 billion on its books. Norway is a member of NATO, and besides, its sovereign fund is extremely transparent. It can buy no more than 5 percent of any company it invests in, but its actual average stake is far smaller, measuring around half a percent.

The Peterson Institute for International Economics, a Washington think tank, has ranked sovereign funds based on a variety of factors, including transparency, accountability and investment goals. Not surprisingly, while the Norwegian fund scored near the top of the rankings, funds controlled by such countries as China, Venezuela, Sudan and oil-rich Persian Gulf countries were all well below average.

Massive Amounts of CashAbu Dhabi Investment Authority (ADIA), the world’s largest sovereign wealth fund, is believed to hold an eye-popping $900 billion. The United Arab Emirates have announced recently the creation of a new investment fund called the Emirates Investment Authority, to invest its oil profits and generate revenues for the government. And Saudi Arabia, with its sea of petrodollars, has plans to establish an even larger fund that would dwarf the ADIA.

For all the legitimate political concerns, it will be difficult to prevent such sums from reaching the markets — especially since world stock prices have started to wobble and the global financial sector is going through a dangerous patch.

The truth is that over the past two decades, corporate takeovers have been the driving force of the global economy and equity markets. Both actual acquisitions and the threat of a hostile bid have powered cost cutting, innovation and increased efficiency. This underpinned the rally in stock prices, boosted fees for investment banks and law firms and made quite a few among those who played the game fabulously rich.

The M&A game, however, has changed considerably since 2000. During the late 1990s, acquisitions were spurred by rising stock prices and most takeovers used shares of the new owner as currency to buy out existing shareholders. Leveraged buyouts, on the other hand, were rare, following the frenzy of the 1980s and the Drexel Burnham junk-bond scandal.

But LBOs made a spectacular comeback in this decade, after the Internet bubble burst and stock prices imploded in 2000-2001. More to the point, borrowed funds became remarkably cheap, whereas financial institutions were flush with cash and eager to back corporate takeover firms. For private equity investors, the use of cheap leverage greatly enhanced returns on their own money. Top corporate managers, who stood to make a fortune in an LBO, were only too happy to be approached by private equity firms.

Since an LBO is by definition predicated on easy access to cheap credit, it is hardly surprising such activity has been curtailed sharply since mid-2007, when the environment of tighter credit set in. Increasingly, deals are being postponed because private equity firms are failing to find funding. Even blue chips, such as Blackstone, have been impacted. Blackstone, for example, has not been able to finance its $1.7 billion buyout of PHH, a mortgage lender. Even worse, a jittery stock market has made exit strategies for private investors more problematic. Last year, the number of buyout-backed IPOs fell to 32 from 59 in 2006. Worse, rising interest rates and bad loans have made carrying massive amounts of debt ruinous. The shares of Blackstone Group, which went public in mid-2007, traded at less than half of their IPO value by mid-January.

Volatile and declining stock prices have created opportunities for cash-rich sovereign funds to get a foot in the door in some key strategic sectors. In particular, they have been piling into the global financial services industry, which has begun to totter under the weight of the subprime mortgage crisis in the United States. The ADIA invested $7.5 billion into Citibank, while China Investment Corp plowed $5 billion into Morgan Stanley. Temasek, the Singapore fund, has been looking to invest in UBS and Merrill Lynch. U.S. regulators, grappling with the need to bolster the U.S. banking system and to steady investors’ nerves, welcome the infusion of funds, never mind their source.

Humble OriginsBut could fears of sovereign funds be overblown? Not only political fears, such as concerns that the governments of China, Russia or Persian Gulf states could use their accumulated cash to buy into vital industries in the West and to advance their own murky national or religious agendas, but economic fears as well?

For all their financial muscle, sovereign funds are creatures of necessity, not tools of aggressive M&A policies. Norway’s fund was set up because the government realized that its oil reserves will start running out some time after 2020 and decided to put money aside for future generations. More immediately, the inflow of petrodollars was stoking domestic inflation and pushing up industrial wages. Norway risked contracting the so-called Dutch disease, i.e., losing competitiveness and suffering deindustrialization because of its commodity exports.

When Norway started its stabilization fund in 1996, other oil producers were not in the picture. Oil prices were on their way down, bottoming near $10 per barrel late in the decade, and commodity exporters, including Persian Gulf oil producers and even mighty Saudi Arabia, were going through major difficulties. Far from flexing their financial muscle, they were scouring international capital markets for loans. Nor was China in such a great financial state. In 1997-1998, it suffered a speculative attack on its currency. Russia went through a debt default and devaluation in 1998. Its hard currency reserves, which now measure over $400 billion, tumbled below $10 billion.

Less than a decade ago no one could suppose that the world would soon start to worry about those countries flexing their formidable financial muscle. This means that sovereign wealth funds, despite their huge cash holdings, may not prove to be such lasting players in global financial markets. They may disappear as swiftly as they burst onto the stage. Oil exporters live and die by the price of oil, and China, Singapore and other exporters of consumer goods rely on consumer demand in the United States and other rich markets. Countries such as Russia and China, which have to support very large populations, may be forced to liquidate their sovereign fund holdings quickly, and even low-absorption nations in the Persian Gulf may suffer considerable reversals.

In the late 1980s, Japan Inc., a secretive national business empire, was loathed and feared around the world. Conspiracy theorists suspected that Japanese conglomerates were buying up the rest of the world, using the dollars they amassed from their enormous trade surpluses. Japanese investors did buy some U.S. movie studios, golf courses and office towers. But most of those investments went sour and Japanese investors had to withdraw ignominiously. Sovereign wealth funds may prove to be another such non-threat.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected] His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.