Do not panic over foreign wealth

Do not panic over foreign wealth
By Gideon Rachman, Financial Times, 28 Apr 2008

It sounds like something from a political thriller by Michael Crichton. Arab sheikhs and Chinese communists amass billions of dollars. They wait for a moment of financial weakness in the US. Then they use their massive "sovereign wealth funds" to buy large stakes in strategic US firms. They secure places on the board. Then, at a crucial moment, they ...

Well, what exactly do they do? Slip out of a board meeting and blow up the building? Deliberately destroy the companies in which they have invested, in the hope of harming the hated Americans?

The fears aroused by the rise of sovereign wealth funds are deep – but vague. SWFs are investment vehicles controlled by governments. They are rich and getting richer. They currently control about $3,000bn and their total valuation by 2015 has been variously projected at anything between $10,000bn and $15,000bn.

A poll by Public Strategies, the consulting firm, in February said that 55 per cent of Americans thought investments by foreign governments harmed US national security. Only 10 per cent disagreed. Daniel Drezner, an academic, notes: "Opposition was particularly pronounced to investments in high-tech or financial firms – and to investments by SWFs headquartered in the Middle East or east Asia."

A year ago most non-specialists would probably have been hard-pressed to explain what a sovereign wealth fund was. It was the credit crunch that ushered the funds into the limelight. Some of the biggest names on Wall Street – from Merrill Lynch to Citigroup and Morgan Stanley – turned to investment funds controlled by foreign governments.

The doings of SWFs have now become the stuff of daily news. Over the past week the FT has reported that China is planning to increase the amount its government can invest overseas by a third, to $90bn, that Iceland is thinking of forming an SWF and that the American government wants to know about the military connections of potential foreign investors. Also, the Americans are thinking of allowing foreign investors to avoid a security review – but only if they agree to give up the right to participate in important management decisions.

Is all this alarm and attention justified? The sight of Wall Street's finest having to be bailed out by Asians and Arabs carried a powerful symbolic message. But there is more than symbolism at stake. It is indeed possible to think up scenarios where foreign governments use their investments for political ends.

Take the controversy surrounding efforts by Gazprom, the Russian state-controlled gas-monopolist, to invest in energy infrastructure in western Europe. Sceptics point out that even if Gazprom buys up distribution networks, the physical infrastructure will remain in western Europe – and cannot be dismantled on the orders of the Kremlin. True enough. But Gazprom-appointed board members might influence commercial decisions with big political implications – such as whether a western energy firm invests in a new pipeline route that bypasses Russia.

Investment by SWFs could also have broader foreign policy implications. Hillary Clinton has put it succinctly by saying that it is hard to lay down the law to your banker. Alan Tonelson, a political analyst, has speculated that America's ability to take a hard line with China in a confrontation over Taiwan might be inhibited if the Chinese government controlled large chunks of Wall Street.

Defenders of SWFs point out that – hitherto – they have usually been model investors: taking a long-term view and rarely seeking to force changes of strategy on unwilling managements (unlike those horrid hedge funds). They have also been determinedly apolitical.

But that need not always be the case. If you doubt it, look how regularly big western investors such as pension funds make politically inspired investment decisions. An early example was the campaign to force foreign investors to withdraw from South Africa. Contemporary campaigns include the left's efforts to force divestment from China over Darfur,and the right's efforts to discourage business and investment in Iran. Large-scale investments do create a political weapon of sorts – even if using the weapon can often damage the investor at least as much as the target.

So it would be foolish to dismiss the idea that SWFs might – one day – exercise political power in ways that Americans and Europeans will find uncomfortable. Political pressure – as well as simple prudence – means that new rules will inevitably be drawn up to regulate SWFs, looking at everything from ownership thresholds to the definition of "strategic sectors".

The trouble is that legitimate caution about sovereign wealth funds could easily spill over into illegitimate hysteria. Foreign investment is still a subject that is easily exploited by demagogues, from the US to France to India. So western politicians should be very careful not to allow considered regulation of SWFs to spill over into ever-broader restrictions on foreign investment in general.

What is more, the most important political implications of investment by SWFs are positive. If governments in China, Russia and the Middle East have large investments in the US and the European Union, then they also have a direct stake in the continuing prosperity of America and the EU.

Of course, deep trade and investment links do not make it impossible for countries to go to war with each other. But it surely must make it less likely that political differences will escalate into conflict. And that is a good thing. Isn't it?