Countries have used sovereign wealth funds (SWFs) as instruments through which to buy assets with their surplus foreign exchange since the 1950s when Norway and Singapore, and soon after Kuwait, sought new strategies to insulate themselves from exchange rate fluctuation. Central banks employed SWFs only as buffers for currency stabilization when countries had little or no international debt and large current account surpluses. Today, SWFs have become quite common. As of March 2007, the United Arab Emirates (UAE) and Saudi Arabia had, respectively, the first and third largest SWFs internationally, and Kuwait ranked sixth. Because of burgeoning oil prices, Persian Gulf sovereign wealth funds have become the preferred investment vehicles of Kuwait, Qatar, and the United Arab Emirates. As SWFs blur the line between public and private investment, however, Western nations worry about the security implications of foreign countries, including Persian Gulf states, acquiring important positions in key industries and companies.
Oil Boom Profits
Since 2003, oil producing states have reaped a revenue windfall. As oil increased from $27.69 per barrel on average in 2003 to as much as $79 per barrel in 2006, Saudi Arabia, for example, saw its gross domestic product (GDP) increase by well over $130 billion over that time period, and the United Arab Emirates took home more than an additional $80 billion. Such revenues have generated enormous liquidity among the Gulf Cooperation Council (GCC) states—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates—and created unprecedented opportunities for large-scale overseas investments.
At the same time, the oil boom has effected a decrease in the percentage of government debt relative to GDP in the GCC countries. In 2004, government debt constituted 44.4 percent of GDP, but by the end of 2007, this figure had fallen close to 16 percent of GDP. At the same time, foreign exchange reserves have risen from $57.4 billion in 2004 to almost $100 billion. In just three years, per capita income in GCC countries rose from $14,251 in 2004 to $22,222. And these numbers only comprise the average: According to International Monetary Fund data, per capita GDP in Qatar has surpassed $70,000, the third highest in the world behind Luxembourg and Norway. The United Arab Emirates enjoys a per capita GDP of $42,000. Consumer confidence in the region is at an all time high, and spending is soaring in Kuwait, Saudi Arabia, Qatar, and the United Arab Emirates.
China and the Persian Gulf emirates, with the exception of Kuwait, accelerate the growth of their respective SWFs by accumulating dollars rather than letting their exchange rates appreciate; in a pure market system such as the one used by Europe and Japan for their exchange rates, the increasing volume of dollars would cause the value of the dollar to drop. The artificially high exchange rate has the effect of preserving the value of the SWF holding when expressed in local currency; were the Chinese yuan to rise to a market-determined level, the value of China's U.S. holdings would be the same in dollars but that would translate into fewer yuan. For the Persian Gulf states, accumulating dollars is made all the easier by the dollar-denominated oil revenues.
Most of the Persian Gulf investments that are directed overseas focus on two objectives: acquisition of assets and real estate, and the purchase of shares in high quality financial and industrial firms. According to the pan-Arabic daily Asharq al-Awsat, the Persian Gulf countries invested $140 billion overseas between 2004 and 2007, an investment blitz that has transformed some of the Persian Gulf emirates into key actors on the international financial stage in a short period of time.
Morgan Stanley identifies the Abu Dhabi Investment Authority as the world's largest SWF, with assets of $875 billion. Several Saudi funds are, combined, worth $300 billion. The Kuwait Investment Authority oversees two state funds—the General Reserves, established in 1960, and the Future Generations Fund, created in 1976—which are jointly worth $213 billion.  The Qatar Investment Authority, which operates overseas through an investment arm known as Delta Two, had an estimated value of $40 billion at the end of 2006.
All told, the combined funds of the UAE, Saudi Arabia, Kuwait, and Qatar account for more than half the $2.5 trillion total assets of global SWFs. According to the Saudi economic newspaper Al-Iqtisadiya, the assets managed by the Persian Gulf SWFs are equal to one fifth of the total assets of the central banks of countries with SWFs, an amount estimated at $5.3 trillion. The global total of sovereign funds could reach $12 trillion by 2015 as a result of further oil revenues and capital appreciation, and Deutsche Bank estimates that the value of net GCC-owned foreign assets has nearly tripled over the last four years from $472.5 billion in 2004 to just over a trillion dollars. As Morgan Stanley comments, approximately twenty-five largely opaque SWFs manage $2.3 trillion, an amount larger than the entire hedge fund industry. By 2015, the Persian Gulf countries' SWFs could grow to $5-6 trillion. If Chinese, Russian, and Korean SWFs are taken into account, the total global SWF value could top $12 trillion, the current volume of U.S. GDP.
Patterns of Investment
With cash flows growing rapidly, it is neither prudent nor desirable for SWFs to invest entirely in safe, fixed-income assets such as U.S. Treasury bonds or even in individual, publicly-listed companies. Many SWFs have shifted toward a 2005 recommendation, made by an international consulting firm to the Kuwait Investment Authority, that it "decrease the fund's allocations to the traditional asset classes (such as publicly-listed equities and bonds) and increase the allocation into nontraditional and uncorrelated asset classes (such as alternative investments, private equities, and real estate)." In practice, this has led the Kuwaitis and others to shift investment targets from slow-growth economies like the United States, Great Britain, and Germany to rapidly-growing economies—namely, China, India, South Korea, and Turkey. As the chief of the Kuwait Investment Authority asked, "Why invest in 2 percent-growth economies when you can invest in 8 percent-growth economies?"
To get a better sense of how the newly oil-rich Middle East states have begun investing in foreign markets, consider some of the largest recent deals.
Dubai, lacking significant oil and gas reserves, is an investment powerhouse out of necessity. Domestically, Dubai has built world-class banking and tourism industries and opened its real estate market to foreign investors and winter residents. Dubai has also become an attractive shopping destination for wealthy individuals from Iran and India. The business environment has become attractive to foreign corporations seeking regional and international headquarters. Various information technology firms, investment banks, and media corporations are present in Dubai, and officials expect financial transactions alone to quadruple from $3.6 billion in 2006 to $15 billion by 2015.
Dubai Istithmar (investment holding company) bought Barneys department stores for $942.3 million in August 2007. Dubai World has committed $5 billion to MGM Mirage, which manages casinos in Las Vegas. The government also offered to buy Auckland International Airport in New Zealand for $3 billion, but the offer fell through because the city of Auckland, which owns 20 percent of the airport, refused to sell to a foreign concern. Dubai has pending offers for other high-profile firms such as OMX, the Nordic Stock Exchange operator, and has purchased 3.2 percent of EADS, which builds Airbus aircraft, and has acquired 2.2 percent of Deutsche Bank. OMX indicated on November 10, 2007, that it will accept the offer to be acquired by Dubai.
The International Petroleum Investment Co. (IPIC), one of Abu Dhabi's investment arms, agreed to pay $775 million to buy 20.85 percent of Japan's Cosmo Oil to become the largest shareholder in Japan's fourth largest oil refining company. Another investment arm of Abu Dhabi, Mubadala Development Company, bought a 7.5 percent stake in The Carlyle Group, LLP, for $1.35 billion.
Kuwait Investment Authority has a large stake in Daimler-Benz, British Petroleum, and an array of real estate, including office buildings in the United Kingdom, United States, Europe, and China. After the deposit of 10 percent of Kuwait's annual oil revenue into a Future Generations' Fund, KIA invests the highest percentage of the remaining funds, about 60 percent, in stock. The Kuwait Investment Authority, according to its chief, Bader al-Sa'ad, has kept a watchful eye on Yale University's endowment management as an investment model.
Qatar, for its part, bought the Chelsea Barracks, former home to the famed Goldstream Guards, for $1.85 billion from the British Ministry of Defense. Qatar reportedly paid three times the assessed value of the 12.8 acre central London property. Qatar Telecom, a government-owned company, paid $3.7 billion for a 51 percent stake in Kuwait's National Mobile Telecommunications Co., which operates wireless service from Iraq (the fastest-growing market) to Saudi Arabia and Algeria.
Qatar's biggest attempted deal to date was an offer to buy J. Sainsbury PLC, the British supermarket chain, for $23 billion, but in early November, they dropped their offer. One individual involved in the negotiations told the Financial Times, "We used to think private equity's behaviour could be low, but what Qatar has done is lower than a snake's belly." Qatar is also in negotiations with Dubai over a package that will involve swapping shares in three stock exchanges: OMX, NASDAQ, and the London Stock Exchange.
Such transactions are complicated by the fact that, in both Qatar and Dubai, there is little differentiation between the respective emirs' private wealth and public assets. Regarding Dubai, the Financial Times observed, "Dubai Holdings belongs to Dubai ruler Sheikh Muhammad bin Rashid al-Maktoum, and in turn owns financial conglomerate Dubai Group, a 20 percent shareholder in Borse Dubai—the holding company for DFM [Dubai Financial Market], and DIFX [Dubai International Financial Exchange]. DIFX is a centerpiece of the government's Dubai International Financial Center, a financial business park, which owns another 20 percent." In March and August 2007, Maktoum offered to exchange $5 billion worth of his private land holdings for shares in Emaar Properties, the largest real estate firm in Dubai. This would have given him a majority shareholding in the company. While Emaar Properties declined the offer, such commingling of SWF funds with private rulers' accounts may occur in the UAE and Qatar, but no public information is available. The most recent example of acquisitions of this nature is the purchase by Dubai International Capital, which is owned by Sheikh al-Maktoum, of a "respectable chunk" of Japan's Sony Corporation. While the official amount of sale remains undisclosed, financial markets estimate it to be in the range of $1.5 billion, or 3 percent of the company's outstanding shares. While Saudi and Kuwaiti rulers take their "cut" of oil revenues up front, again, at least in the case of Saudi Arabia, there is no published data on the state's revenues and how much is distributed to the princes.
Former Treasury secretary Larry Summers raises a broad concern with SWFs: The capitalist system, he says, "depends on shareholders causing companies to act so as to maximize the value of their shares," but governments acting as shareholders might have different, and less economically desirable, motives. "They may want to see their companies compete effectively, or to extract technology, or to achieve influence," he explained.
Western governments remain concerned that foreign interests may take over economic assets with strategic value, be they manufacturing plants, banks, industrial enterprises, or high-tech companies. From a Washington standpoint, for example, there is a major difference between a Saudi acquisition of General Electric's plastics plants and a Saudi purchase of its aircraft engine unit. Several investments have raised U.S. and European concern about possible hidden political agendas.
The first major rejection of an Arab SWF investment involved Dubai Ports World's acquisition of P & O, a British company that operated six major ports in the eastern United States. Concerns about national security led many in the U.S. Congress to try to block the Dubai company's operation of U.S. ports, an issue settled only when, in March 2006, Dubai Ports World agreed to hand over operation of those ports to U.S. entities.
There were similar concerns raised both in New Zealand and Sweden following Dubai's offers to buy the Auckland International Airport, and also the Swedish stock exchange OMX. Though Dubai withdrew its offer for the Auckland airport in the face of opposition, it continues to seek the purchase of OMX, as part of a deal in which it will exchange OMX for NASDAQ's 28 percent share in the London Stock Exchange and an as-yet unspecified amount of equity in NASDAQ itself. At a September 20, 2007 news conference, about the then-pending acquisition of NASDAQ, President George W. Bush said that an investment by a government-owned company in NASDAQ would be subject to review by national security agencies although he provided a provisional welcome of the deal.
Had it not been for a liquidity squeeze caused by the mortgage credit crisis, Abu Dhabi's $7.5 billion, 4.9 percent stake purchase of Citigroup, the largest U.S. bank, may have also raised such concern. The state-owned Abu Dhabi Investment Authority now ranks as one of Citigroup's largest shareholders, as does Prince Walid bin Talal of Saudi Arabia, who bought into the bank in the early 1990s.
When it comes to sensitive industries, though, not all SWFs are the same. There is a difference between the SWFs of countries such as China and Russia, both of which have long-term global strategic interests, and the activities of SWFs of smaller and militarily insignificant countries such as the United Arab Emirates, Qatar, Kuwait, and even Saudi Arabia. Concern about Persian Gulf countries taking over significant Western assets should focus on two key issues: first, whether a particular acquisition strengthens Persian Gulf leverage on oil production and pricing; and second, whether an acquired business might become a conduit for illicit funding for activities that might endanger the security of the host country or its allies. SWFs are in the business of maximizing returns on investment at a minimum risk, and so this concern is minor. In addition, they are unlikely to undertake action that might lead the United States to freeze assets through the International Emergency Economic Powers Act of 1977, which Washington applied widely after 9-11 to terrorists, terror financiers, and proliferators. Moreover, such conduits are not really needed: There is no shortage of wealthy individuals in the Persian Gulf who continue to support Islamist terrorism.
Privately, some U.S. policymakers also cite the Arab boycott of Israel as proof of the danger of Arab SWF ownership because the ban demonstrates the primacy of politics over economics. However, there is less here than meets the eye, since the Persian Gulf states' adherence to the boycott is more rhetorical than real. The Persian Gulf emirates understand how ineffective the prohibition is. They have already renounced the secondary and tertiary elements of the ban. In any event, U.S. law would prevent any U.S. company, regardless of its ownership, from adhering to the boycott.
However, SWFs are here to stay. Given the new global economic reality, Western governments are formulating mechanisms to vet mergers and acquisitions by foreign entities. Perhaps the oldest is the Committee on Foreign Investments in the United States (CFIUS), established in 1975 by an executive order of President Gerald Ford and chaired by the Treasury Department. The Exon-Florio amendment to the Omnibus Trade and Competitiveness Act (1988) authorized the CFIUS to view and potentially block foreign acquisitions of U.S. companies that may impair U.S. national security. Exon-Florio empowers the president to "suspend or prohibit a foreign acquisition … if he finds ‘credible evidence' that ‘the foreign interest exercising control might take action that threatens to impair the national security.'"
Since 1988, foreign companies have sent CFIUS several thousand notifications of intent to purchase U.S. companies, but CFIUS has only investigated a few, and of those, it has blocked only one. That case involved the purchase by the China Aviation Technology Import-Export Corporation—the import-export arm of Beijing's Ministry of Aerospace Industry—of MAMCO, a privately-owned, Seattle-based manufacturer of civilian aircraft parts. CFIUS's impact may be greater, however, since many firms withdraw their offers if it looks like CFIUS may investigate.
There are also archaic restrictions originating from maritime law, such as the Shipping Act of 1916 and the Merchant Marine Act of 1929, that establish limitations for foreign investment in commercial shipping and merchant marines—25 percent ownership for rights to coastal waterways and fresh water routes. U.S. regulators have interpreted this act to protect American airline industries as well. The United States limits foreign ownership of a domestic airline to a maximum of 49 percent, with a 25 percent limit on control. Though an effective domestic airline industry embraces this mechanism as a way to avoid foreign competition, national security concerns remain the chief reason why U.S. flag-bearing ships cannot be sold to non-U.S. citizens without approval from the secretary of transportation.
In 2007, Canada launched a review of the 20-year-old Investment Act to assess whether Ottawa should increase scrutiny over takeovers, particularly those involving companies with "unclear corporate governance and reporting," which may use "non-commercial objectives" in decision-making. This is a clear reference to SWFs.
The Group of Seven (G-7) finance ministers have called on the Organization of European Cooperation and Development, the International Monetary Fund, and the World Bank to identify best practices for SWFs in such areas as institutional structure, risk management, transparency, and accountability. The European Commission is still mulling over the issue. However, EU trade commissioner Peter Mendelsohn told the German business daily Handelsblatt, "Europe's interest in maintaining control over important and politically sensitive key industries could be achieved via the instrument of the golden share," a mechanism that gives the holder veto rights in certain circumstances and can be used to protect a company from any takeover deemed to endanger national security.
In Germany, Chancellor Angela Merkel asked the European Union to "protect European companies from unwanted foreign takeover." German finance minister Peer Steinbruck told the Bundestag that his country will defend its companies from takeovers by SWFs that belong to governments whose "social and political systems are not exactly moderate." Germany's greatest concern is over SWFs from Russia and China.
The United Kingdom remains the most flexible of the Western countries with regard to SWFs. Alistair Darling, chancellor of the Exchequer, has argued that economic openness should not be undermined by protectionism. He has maintained, however, that all investors should follow the rules of the market in regard to transparency and governance and that reciprocity should apply.
The SWF Response
Salman al-Dusry, senior correspondent for Asharq al-Awsat in the United Arab Emirates, highlights the contradiction facing Persian Gulf countries. While governments almost everywhere strive to attract foreign direct investments, many Western governments are doing the opposite when it comes to the Persian Gulf region. The U.S. Congress and European governments now are seeking to tighten the scope of opportunities for investments by oil-rich sheikhdoms.
Such a trend leads many Persian Gulf SWFs to diversify geographically, channeling some of their surplus capital to Middle Eastern countries—particularly into housing and tourism projects in Morocco and Tunisia and into South and East Asia. The Qatari daily Asharq, drawing on figures from the Gulf Cooperation Council, suggested that GCC countries have invested $250 billion in China, primarily in service and real estate sectors. But giant deals, such as the purchase of the General Electric plastic business by the Saudi company SABIC for $11.6 billion, can only materialize in the industrialized and free economies of Europe and the United States.
Al-Iqtisadiya has suggested that to allay the fears of undue influence or hidden political agendas by government-owned SWFs, these funds must adopt a greater measure of transparency by publishing periodic reports on their investments and assets. The Pension Fund of Norway, the Norwegian SWF, for example, is a model of such transparency. Absent such reporting, it is difficult to determine whether SWFs might be pursuing a pattern of investment that could be inimical to the national security of the countries in which they invest.
In response to the new challenges posed by ambitious investing from oil-rich Persian Gulf states, the Western world will have difficulty engaging in blatant protectionism as such policies are greatly detested by financial markets. What could emerge from pending legislation in both the United States and the European Union, however, is the introduction of a strict policy of reviewing large acquisitions by SWFs that would make it extremely difficult, or even illegal, for such funds to acquire assets in so-called strategic sectors—infrastructure, telecommunications, media, and energy. In the case of energy, in particular, the EU is already working on introducing the principle of reciprocity, which will target Saudi Arabia, Russia, or any other country where resource nationalism is practiced. One alternative that may develop to blocking access to strategic industries altogether is the implementation of golden shares, retaining effective veto power, and restricting foreign investors to nonvoting shares, so that countries, acting as investors, will not be able to steer the recipients of their investing in any direction they desire.
With their spirit of entrepreneurship, their successful investment activities, and their visible presence in world financial markets, the Persian Gulf SWFs have inspired a new spirit of economic change in the region. The Carlyle Group L.P. says that the Middle East is now the "hot spot" for private equity deals, and the British bank HSBC reports that as much as one third of all project finance involves Middle Eastern projects. This kind of activity could have a significant, long-term impact on the politics of the region as Middle East investors begin to look beyond historical-regional conflicts and focus instead on building their economies and generating wealth.
Nimrod Raphaeli and Bianca Gersten are, respectively, editor and economic researcher at The Middle East Media Research Institute (MEMRI) Economic Blog, at www.memrieconomicblog.org.
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