America for Sale

Sovereign-wealth funds

The world's most expensive club
May 24th 2007 | HONG KONG
From The Economist print edition

China's investment in Blackstone shows how government investors are flourishing at the heart of the financial system
Satoshi Kambayashi
WITH $1.2 trillion in foreign-exchange reserves and the pool growing by more than $1 billion every day, China casts a giant's shadow over the global financial markets, even if it has mostly used the money to pile up American Treasury bonds. The announcement on May 21st that it would invest $3 billion of its reserves in Blackstone, a New York-based private-equity firm soon to issue shares, shows that it is prepared to barge into murky private markets as well as liquid public ones. It is not the only inscrutable country to be cosying up to the inscrutable private-equity industry. Around the world, a secretive society is emerging of governments flush with foreign assets, some of them petrodollars, that are increasingly calling the shots in international finance. The Blackstone deal is likely to stir others to invest their money even farther away from prying eyes than they do already.

Like China, whose proposed Blackstone stake is part of $300 billion that the government plans to set aside this year for investment purposes, dozens of countries have set up what are now commonly referred to as sovereign-wealth funds. They manage money drawn from reserves, natural-resource payments and the like. China is chiefly concerned to diversify its foreign reserves, but other sovereign-wealth funds own national, as well as international, assets.

The top 12 each have anything from $20 billion to hundreds of billions of dollars to invest (see table). Recently, Japan, Russia and India have reportedly been considering setting up funds along similar lines. Some estimates put the size of the funds at $2.5 trillion by the end of this year (in contrast, hedge funds are thought to have a mere $1.6 trillion), with another $450 billion in transfers from reserves being added annually. Including capital appreciation, the amount could swell to $12 trillion by 2015.


To the extent governments have traditionally held investment assets, it was to protect domestic currencies and banks from crisis. Since the funds were for emergencies, they were of a type that could be liquidated easily—initially the holdings were in precious metals, lately they have been in dollars. The idea of building up an endowment to replace shrinking natural resources did not exist.

That process may have started inadvertently in 1956 when the British administration of the Gilbert Islands in Micronesia put a levy on the export of phosphates—bird manure—used in fertiliser. The manure has long since been depleted. However, a once-tiny set-aside of money has become the Kiribati Revenue Equalisation Reserve Fund, a $520m investment portfolio that has grown to about nine times the tiny atoll's GDP.

A similar approach is now common among oil-producing countries, which, it is estimated, account for two-thirds of the assets in these sovereign-wealth funds, and are keen to diversify their national revenues, aware that their wealth is being pumped away. They have typically invested along similar lines to central banks, holding bonds, dollars and bank deposits. Temasek, a Singaporean entity created in 1974 to pool state-owned investments, started to change the mindset. It subsequently evolved into an even more complex investment vehicle. The heady combination of state-control, success and secrecy, entranced other governments.

Recently, central bankers have also begun wondering whether they have a fiduciary duty to make higher returns from the public wealth under their supervision, which could mean placing at least some part of foreign-exchange reserves in high-yielding, if less liquid, investments. In Asia this question has become increasingly pertinent in the past two years, as reserves have mushroomed.

The result has been a torrent of money into a finite pool of assets. There is no precedent for such fortunes suddenly to find their way into global financial markets, and they help explain the waterfall of liquidity that has driven up the value of risky (and less risky) assets of all descriptions around the world. The world's entire supply of shares is $55 trillion, and bonds account for a similar amount. Sovereign-wealth funds could soon become the most important buyers of such assets, and many others besides. If so, the world will witness the intriguing spectacle of its largest private companies being owned by governments whose belief in capitalism is often partial.

The last time governments were this involved in sinking money into private assets, the process tended to be called nationalisation. Now the funds are invested both abroad and domestically. A new term will have to be coined: internationalisation, perhaps.

Northern light
Of the biggest sovereign funds, only Norway's provides anything close to transparency. Each year it discloses its investment portfolios and returns. Without such a window on their investments, it is hard to fathom the interests of other funds—how they vote on shareholder motions, for example. There are likely to be questions about strategic objectives, too. What will they care about most? Economic returns, political objectives, securing strategic resources? It will be hard to tell.

Andrew Rozanov, of State Street Bank, argues that the lack of well-defined obligations and the ability to retain funds indefinitely while not having to reveal results is an investment advantage. The funds can harvest the benefits of volatility and illiquidity unavailable to the risk averse. It would not be surprising if some did particularly well. On the other hand, the same factors that could lead to higher returns could also lead to corruption and untoward political intervention.

But the kind of assets the funds invest in—big ones—can generate frictions even when run properly. Temasek has been embroiled in controversy in Thailand after it bought Shin Corp, one of the country's telecoms companies, from Thaksin Shinawatra, the country's deposed prime minister. China is no stranger to such tensions. In an event that still rankles, CNOOC, the state-controlled oil company, was blocked in America, supposedly on national-security grounds from acquiring Unocal, an oil company. It is quite possible that by purchasing a non-voting interest in Blackstone, China will be able to bypass the restrictions that might prevent it doing Unocal-style deals in Europe and America.

By choosing a private-equity firm, China will also be able to invest directly in a partner that, notwithstanding its forthcoming share offering, can keep many of its operations out of the public eye. But this is where the ironies of the deal are most apparent. “Crony capitalism? It is a marriage made in heaven—a partnership that does not want investors to ask questions with a country whose firms do not want investors to ask questions. I worry about the serious conflicts of interest this generates. More generally, government entities shouldn't be in the business of investing in private firms,” opines Raghuram Rajan, of the University of Chicago's Graduate School of Business.

Moreover, it is widely believed that by having China as a partner, Blackstone will receive preferential access to China's market (as well as providing China with experience it clearly covets on how to set up its own domestic private-equity industry). This is an advantage for Blackstone, and for its shareholders, China included, particularly so when other private-equity firms complain that the impediments to operating in China are growing.

However, providing an economic incentive to a lucky few, even if that includes the government itself, impedes China's broader need to create a fair and transparent financial market for all participants. That is what would produce the most efficient market for capital.

China still has vast holdings of state assets, and its embryonic stockmarket is bubbling over—if anything it needs more publicly traded companies. Like other countries with sovereign-wealth funds, it would appear to need more expertise in selling companies that it owns, rather than learning how to buy the ones it does not.