15 October 2007

Washington: With the annual general meetings of the International Monetary Fund and the World Bank just a week away, treasuries and finance ministries of the rich nations (G7) have accelerated their call for international controls on sovereign wealth funds (SWFs).

In the context of the ever increasing financial clout of these state backed funds, the concerns of the rich states go beyond the normal definitions of economic protectionism and xenophobia. Many in the developed world see these fin-ancial leviathans as potential threat to global financial system and ultimately capitalism itself.

According to a recent Morgan Stanley study, sovereign funds would control more than $12 trillion in 2015 outstripping the financial clout of all hedge funds put together.

Meanwhile, a new report by Merrill Lynch Global Research said on Friday that assets under management in Sovereign Wealth Funds (SWFs) could grow more than four-fold by 2011, surging from $1.9 trillion to $7.9 trillion.

The research report, titled The overflowing bathtub, the running tap and SWFs, states that a massive build up of reserves at central banks is fuelling this rapid growth, led by China, Russia and the Middle East.

According to independent estimates the Gulf states have close to $1 trillion in such funds with UAE, Kuwait, Saudi Arabia and Qatar dominating the list.

To stand up to the ever growing financial power of these funds, France is drawing up a report to protect certain state owned strategic interests from the potential financial clout of these funds.

While, Germany has already expressed its reservations about these funds investing in German assets, Germany's finance minister said in a newspaper interview ahead of the IMF and World Bank meeting that the IMF should examine whether a code of conduct is needed for state-backed investment funds.

Increased transparency

"There should be a debate in the IMF on whether countries that have such funds should not find a code of conduct," Peer Steinbrueck told the Frankfurter Allgemeine Zeitung daily. He said the G7 fin-ance ministers meetings will Washington this week will discuss the issue. Rating agencies and off-balance sheet special purpose investment vehicles would be on the G7's agenda.

While the rich nations are seeking increased transparency and some amount of control on SWFs, the IMF so far has been cautious about its involvement. "The real danger (in control) is that sovereign wealth funds ... may encourage capital account protectionism, through which countries pick and choose who can invest in what," Simon Johnson, economic counsellor and director of the IMF's research department said.

Merrill Lynch econ-omists expect this wave of extra liquidity to benefit world financial markets. sovereign wealth funds are likely to direct far greater allocations towards riskier assets such as equities and corporate bonds with cumulative net flows of $3.1 trillion to $6 trillion into these asset classes.

SWFs are also likely to mandate external fund managers to invest the bulk of their assets - providing a major structural boost for the global asset management industry.

"Investors should rejoice in the more balanced global economy and the impetus that SWFs will provide to continued growth and development of global asset markets," said Alex Patelis, head of international economics at Merrill Lynch. "The impetus from these flows underpins continued growth of global asset markets, and the use of external managers should lessen what we see as overblown fears of protectionism."

Riskier assets

SWFs are projected to grow annually by $1.2 trillion in assets over the next five years, the Merrill Lynch report said. Merrill Lynch economists expect SWFs to double or triple their share of riskier global assets (equities and non-sovereign bonds) by 2011.

In 2006, government authorities controlled per cent of global assets in riskier assets. Merrill Lynch forecasts SWFs will control 16 per cent of this segment by 2011. In the near term, the Middle East should dominate inflows into riskier assets, with Russia and Asia following.

Merrill also forecasts good times ahead for asset managers because of the growing demand from SWFs "High costs and difficulties associated with setting up internal portfolio management teams, together with the risk of a protectionist backlash, point towards extensive use of external asset managers."

Merrill Lynch forecasts a shift of $1.5 trillion to $3 trillion, which could generate fees of $4 billion to $8 billion.

Insight: What are SWFs?

Sovereign wealth funds are a fairly new name for something that's been around for quite a while: assets held by governments in another country's currency. All countries have foreign exchange reserves (these days, they're typically in dollars, euros, or yen). When a country, by running a current account surplus, accumulates more reserves than it feels it needs for immediate purposes, it can create a sovereign fund to manage those "extra" resources.

Sovereign funds have existed at least since the 1950s, but their total size worldwide has increased dramatically over the past 10-15 years. In 1990, sovereign funds probably held, at most, $500 billion; the current total is an estimated $2-3 trillion and, based on the likely trajectory of current accounts, could reach $10 trillion by 2012.

Currently, more than 20 countries have these funds, and half a dozen more have expressed an interest in establishing one.

- Source: Finance & Development, IMF

By Babu Das Augustine

Gulf News 2007. All rights reserved.