Role of Sovereign Funds in Today’s Globalization

Evolution of Sovereign Wealth Funds

1. Sovereign Wealth Funds have been around for a long time, since the 1950s. The oldest is the Kuwait Investment Authority set up in 1953. Abu Dhabi Investment Authority, ADIA - reportedly the largest SWF - started in 1976 and since 2000, at least 10 new SWFs have been set up¹ in countries like Australia, South Korea, Brazil, China and Russia, while others like India and Japan are debating if they should also establish such funds.
2. How did SWFs originate? Some two thirds of the SWFs are funded from oil or commodity revenues, while a third of them manage part of their countries' foreign exchange reserves. A small minority are funded from receipts from privatization of government-owned operations and from the fiscal surpluses of the governments. There is little commonality among these funds - they have a range of governance, structures, mandates, as well as economic, financial and political objectives.
3. The Kuwait Investment Authority², the Abu Dhabi Investment Authority³ and the Alaskan Permanent Reserve Fund⁴ were all financed by oil revenues. Kiribati, a group of tropical islands in the Pacific, founded their Revenue Equalisation Reserve Fund in 1956, with revenues from the sale of guano, or bird manure containing phosphates used for fertilizers. Recent oil, gas or commodity funded SWFs include those from Russia, Brazil, Dubai and Qatar. In terms of scale, the combined funds of UAE, Saudi Arabia, Kuwait and Qatar reportedly account for more than half of the estimated US$2.5 trillion managed by all SWFs globally. This should not be surprising given the rapid increase in oil and energy prices, particularly since 2003.
4. Despite SWFs having been around for some 60 years now, the term itself was coined just three years ago by Andrew Rozanov⁵. There is no agreed definition of what a Sovereign Wealth Fund is. It has become a catch-all phrase - a generic term for pools of capital, invested by governments for high returns.
5. Recent concerns over SWFs are triggered by the phenomenal rise in a very short time, of a number of 'new kids on the block' - each controlling large amounts of money. This is the outcome of a number of countries having rapidly accumulated surpluses from oil and gas revenues such as the Gulf States, Norway and Russia. At the same time, others accumulated foreign reserves from persistent trade surpluses and continuous foreign direct investments. China's SWF for example, draws the bulk of its funds from trade surpluses arising from manufacturing exports and net capital inflows.
6. While various estimates exist, Morgan Stanley reports that the cumulative funds under investment today by SWFs, range from US$2 to 2.5 trillion - a figure expected to balloon to US$12 trillion within the next 10 years. We should not however, exaggerate the impact of SWFs on the global financial system. All in, their assets under management are less than 5% of those held by private sector participants such as pension, insurance and mutual funds, as well as hedge funds and private equity players⁶. They account, in fact, for only 2% of the total size of the global equity and bond markets. And the Bank of England estimates that even with some of the fastest growth projections, the Assets Under Management of these SWFs would reach only about 6% of global financial assets in five years. And even though SWFs have more assets under management than hedge funds, their impact is smaller as, unlike hedge funds or even private equity funds, most SWFs are not leveraged.

Concerns Surrounding SWFs

7. The increasing prominence of SWFs has had an undeniable impact on ongoing economic globalization. A number of 'structural' shifts have taken place, literally affecting the foundations of the international financial system. Of these shifts, I would like to dwell on two key ones. In a sense, they can be considered as corollaries of each other and their combined effect is noteworthy.
8. The first shift has been the redistribution of cross-border wealth from the developed countries (mainly the OECD nations) to developing countries - countries that have historically not been major players in the international finance arena. The second is the fact that governments own or control a substantial share of this new 'wealth' through their agencies, the SWFs. This is the natural result of surpluses arising from positive trade balances and capital inflows, as these appear in the foreign exchange holdings of Central Banks - which are government entities.
9. Larry Summers, former US Treasury Secretary puts the point in context - "The US, the world's greatest power, is also the greatest debtor." The debtors in the emerging markets are becoming creditors.
10. When SWFs diversify away from investing in the host government papers to seek higher returns in the private sector of the host country, the ensuing pain to the government finances of the deficit country can have strong political ramifications. Such investments may easily be regarded as unfriendly acts, by one government against another. When the Norwegian oil fund (renamed Norwegian Pension Fund - Global in 2004) started shorting the bonds of Iceland 's over-stretched banks about two years ago, Iceland 's Prime Minister was not amused⁷.
11. It is tolerable if the countries with surplus capital invest it in Treasuries and bonds. It appears to be quite another story if these countries start diverting their money into non-government investments. The ensuing anxiety is compounded if these investments are considered "sensitive" or are made in iconic national assets.
12. For example, many of you will remember the very strong national sentiment against the Japanese purchase of the Rockefeller Centre, and the Pebble Beach Golf Course in the 1980s. You may also remember the refusal recently in 2005 to allow a bid by US-based Pepsico for the French yogurt producer, Danone. Bear in mind that these were investments by private sector investors.
13. When the investor is government owned, the reaction is even more acute. For example, in 2006, Dubai's proposed purchase of some US seaports (as part of its larger purchase of P&O) was blocked by the US Congress even though the deal was given the green light by the US Administration. In 2005, China's China National Offshore Oil Company (CNOOC) dropped out of a bidding contest with Chevron for UNOCAL, a California-based oil company, after it aroused much public controversy, despite the fact that most of UNOCAL's assets were not in the US, but in Asia. These fears are not new - when the Kuwait Investment Office bought 20% of British Petroleum in the 1980s, Margaret Thatcher forced them to reduce their stake to 10%. Today, Britain is certainly much more welcoming of foreign investors, both private and public.
14. There have been many comments made on the risks and dangers of having SWFs as investors. And these comments are couched mostly as national security concerns or socio-political fears.
15. One think tank has captured the five key concerns that SWFs appear to be embroiled in:

• First - the possibility of governments mismanaging their international investments to their own economic and financial detriment, including large-scale corruption in handling the huge amounts of money involved. Governments have not been good at picking economic winners;
• Second - governments managing their SWF investments in pursuit of political objectives and so raising national security concerns. Or they may pursue economic power - by, for example, promoting state-owned or state-controlled national champions as global champions. Such behavior can - it is said - contribute not only to political conflicts between countries, but also to economic distortions;
• Third - the rise of financial protectionism in host countries - in anticipation of the pursuit of political or economic objectives by these funds or as a response to their actual actions;
• Fourth - the concern that in managing their international assets, SWFs may contribute to market turmoil and uncertainty. They may also contribute to financial stability, but their net contribution is often difficult to assess, given the relative opacity of their operations;
• And finally - the risk that foreign government owners of these international assets may come into conflict with the governments of the countries in which they are investing.

16. The intuitive distrust of SWFs and their investment objectives arises from the assumption that SWFs are created for political objectives and not for optimizing returns on government reserves. This skepticism has at its roots the distrust of the political system and political governance of certain SWF governments. There is a fear for example, that some like the Russian and Chinese SWFs have a strong political motivation and alignment - a fear exacerbated by the perceived lack of transparency, accountability and information on the governance structures or fiduciary controls of these SWFs. Often, such fears also reflect other insecurities or perspectives coloured by the experiences within their own borders. In most countries, being state-owned simply means being state-directed and that often also means being political and non-commercial. In other cases, there is a clear distrust of government involvement in the economy among the thought leaders of society. These find expressions in the suspicion of foreign state-owned entities as well.
17. This suspicion about the future intentions of SWFs translates into pressure for greater transparency. Many OECD governments are now under political pressure to create screening mechanisms for SWF investments.
18. To reduce the risk of barriers to trade and investment being erected, the International Monetary Fund was asked to work with investor countries to develop a voluntary code of best practices for SWFs. In parallel, the Organisation for Economic Co-operation and Development (OECD) was asked to work with recipient countries to ensure that barriers to investments are not erected. These initiatives are currently underway.
19. One must remember, however, that SWFs are typically set up for specific purposes, whether as stabilisation funds to mitigate the risks of a government embarking on very generous welfare schemes, which cannot be sustained (sometimes termed the Dutch disease), in the case of oil or commodity revenues or to seek higher returns in the case of foreign exchange reserves. As such, they have specific mandates for which they are answerable to their own authorities or shareholders. Unfortunately, the names of these various SWFs can be confusing, as those named as pension funds may not have any pension liabilities, while others named as future funds may be set up to meet pension liabilities. Nonetheless, the common thread is that SWFs have all been set up for specific purposes, often via legislation, and are linked either to investment returns, or sustainable long-term returns for intergenerational transfers, sterilization of capital inflows, or for domestic economic development. As such, one must remember that the responsibility of each of these SWFs must be to their own domestic constituency and their relevant supervisory authority, as a matter of good governance.

Temasek Holdings - An Atypical SWF

20. At this point, I would like to provide another perspective - an inside out view as Chairman of Temasek - and institution that often finds itself drawn unwillingly into this controversy.
21. As I outline what differentiates us from other SWFs - and these are critical differentiators - let me also tell you a bit about who we are.
22. We are a long-term equity investor with a growing and diversified portfolio of assets.
23. Temasek is 100% owned by the Minister for Finance Incorporated. But we operate as a commercially-driven, independent company with a mandate to seek sustainable long-term, risk-adjusted returns. Since inception, our returns have averaged 18% by market value, compounded annually, including dividends we pay to our shareholder, and net of any new capital injection.
24. While owned by the Minister for Finance Incorporated, Temasek is not a channel to invest foreign exchange reserves on behalf of the Singapore Government. Temasek owns its assets and is not a fund manager in the sense that most SWFs are.
25. This can be explained by Temasek's history - a history tied closely to the economic history of Singapore since self government in 1959. At that time, Singapore was a poor nation-state, with no natural resources, and a per capita GDP of under US$400. The Government put, as a matter of policy, put its full weight behind industrialization, economic development and job creation. Through the Economic Development Board (EDB) it shared the risk by taking minority shares in many ventures to attract local and foreign capital into manufacturing. When DBS Bank was established in 1968, to take over industrial financing, the Government took EDB's equity holdings in these ventures into the Ministry of Finance and held it for a number of years. The government also established new companies like Keppel Corporation as part of the reorganization of the old Singapore Harbour Board and Sembawang Shipyard when it took over the British Naval Base. It also directly owned Singapore Airlines which evolved through a number of stages from the old Malayan Airways.
26. Later, the government decided to move away from managing investments and companies and to focus on developing the economy as a whole. Temasek was an outcome of this decision. In 1974, Temasek was formed to take over a mixed bag of new investments and start-up companies, including Singapore Airlines and various shipyards. Many became successful and were listed in the 1980s. Other corporatised public sector activities like telecommunications, power generation and transmission, and port operations were also injected into Temasek in the 1990s - in exchange for cash or shares in Temasek.
27. Here I would like to make an important distinction - Temasek is not and has never been a conventional SWF. Singapore has no oil money, no natural resources. We are not tasked with managing the country's foreign reserves. We were formed simply to take a load off a Government that had other priorities and to provide an independently focused, professionally managed and commercially disciplined approach to investments.
28. Following an initial asset injection of some S$350 million when Temasek was set up, the Minister for Finance Incorporated - as shareholder - has from time-to-time made additional injections into Temasek. Since inception, we have received a total injection of a little less than S$30 billion in assets and cash.
29. Growing with our blue chip companies and our direct investment activities, Temasek now owns a net portfolio of about S$185 billion at market value as at 31 March 2008. Singapore and Asia account for nearly 75% of Temasek's investments. Developed markets such as the U.S. and emerging economies across the world account for the rest and are a growing part of our portfolio. Our total shareholder return measuring changes in shareholder funds, including dividends paid and excluding new capital, is a healthy 17% compounded annually since inception. This reflects the healthy performances of our portfolio companies and the realized gains from our direct investment activities over the years.
30. We have a diversified portfolio spanning a wide range of sectors and geographies including, among others, banking and financial services (DBS Bank, Standard Chartered Bank, Merrill Lynch, ICICI bank); transportation and logistics (Singapore Airlines, Neptune Orient Lines); telecommunications (Bharti Airtel, SingTel).

Temasek and the SWF Debate

31. Temasek is a long equity house and has been a long-term shareholder in many of our portfolio companies. We provide access to patient capital - capital that is not driven by short-term business or economic cycles, capital that rewards value creation and capital that is not easily available from most other sources. Because we have been around for more than three decades, we have seen the ups and downs of several economic cycles.
32. Unlike hedge funds or private equity funds, Temasek is hardly geared at all. We fund our investments largely from our own resources and from commercial borrowings. We have been credit-rated since 2005 by both Standard & Poor's and Moody's at the highest grade of AAA/Aaa respectively. We are in fact, one of the few firms in Asia to hold this distinctive rating.
33. The SWF discussion has raised three issues in the context of who Temasek is and what we do that differentiates us from other SWFs. They are worth examining. The three pillars that differentiate us are ownership, accountability and transparency.
34. On ownership, Temasek's sole shareholder is the Minister for Finance Incorporated. We fund our investment activities from the dividends from portfolio companies, proceeds from our divestments, commercial borrowings, bond issues and capital injections from our shareholder. Our growth is through a combination of the performance of the portfolio companies sold to us by the Singapore Government, as well as significant returns from our direct investments.
35. The Singapore Government expects Temasek to operate on a commercial basis to achieve sustainable long-term returns. We are neither a part of the Government's policy arm nor do we invest Singapore 's foreign reserves. Where investments have to be made for investment promotion reasons it is done by the EDB and not by Temasek. We operate as an autonomous and professional owner-investor, owning and managing our assets and investments. Temasek's record speaks for our focus on commercial discipline: we have delivered an 18% compounded annual total shareholder return by market value since inception and 19% in the last three years. As our sole shareholder, the Singapore Government receives dividends regularly.
36. Temasek's management reports to the company's Board of Directors - the majority of directors are independent with only one member, appointed on his own merit, who happens to be a senior civil servant in the Ministry of Finance. Under the Singapore Company Act, all directors are charged with the fiduciary duty of acting in the best interests of their company and its shareholders.
37. In addition, an 11-member Temasek International Panel, comprising international business leaders, provides the board and management with global perspectives and advice on strategic matters. This panel includes David Bonderman of TPG, a leading private equity fund, Bill McDonough formerly of the New York Fed and Ratan Tata, among others.
38. Temasek's people are our core strength. They are hired from around the world on merit - judged and compensated on performance. Some 40% of our senior management team is non-Singaporean.
39. On accountability, Temasek is incorporated under Singapore's Companies Act, which is modeled after the British and Australian regulations. This means that all the regulations that apply to any other company in the country also apply to Temasek. We pay corporate taxes and our books are audited by international auditing firms.
40. To ensure fiscal discipline and financial prudence, Singapore's Constitution limits the role of the Government in how national reserves can be used. The Constitution empowers the President - elected directly by Singaporeans every six years under our one man one vote system - with a "second key" in the form of a veto power to help safeguard national reserves and significant state-owned companies, such as Temasek, which constitute part of the nation's wealth.
41. To ensure fiscal discipline and prudent protection of national wealth for future generations, the Government is limited to using reserves accumulated during its current term of office. Each general election heralds a new term of Government. To draw on past reserves accumulated by preceding administrations, approval must first be sought from the President. This is to safeguard past reserves from imprudent use by any Government. While the Minister for Finance Incorporated is Temasek's shareholder, the President must also concur with the appointments of Temasek's directors and chief executive. This ensures that the directors and management are buffered from Government influence while operating on commercial principles.
42. On transparency, Temasek is arguably one of the most transparent privately owned companies around. Despite there being no statutory requirement of us, we have been publishing an Annual Review for the last five years. This Review includes information on our portfolio and returns, our structure, mandate, corporate governance and risk management. That we have done this long before the emergence of the SWF debate has helped us. For example, when our people meet policy makers in Washington, they are told that Temasek and the Norwegian SWF set the gold standard for transparency.

Looking Ahead

43. Although Temasek is seen as the gold standard, we still risk collateral damage from any backlash against SWFs. We are seeing growing attempts around the world to apply regulations to cross border transactions. For example in the US, Germany, Canada and Japan we see looser definitions of national security, and more complex regulations to evaluate investments on grounds of security.
44. Take the recent case of the British hedge fund - Children's Investment Fund - which was blocked by the Japanese government on 'national security grounds', from increasing its stake from 9.9% to 20% in J-Power, an electricity company, Or where the Canadian government blocked the sale in April 2008, of a Canadian satellite maker to Alliant TechSystem, a company from the US, Canada's closest ally. When the investor is government-linked, no matter how tenuous - the scrutiny is magnified manifold. A world of more restricted trade and capital flows is not good for Temasek and Singapore, nor for the world.
45. As global financial markets continue to be consumed in the foreseeable future, by uncertainty and anxiety, and SWFs investments rise in profile - as they are bound to in a crisis like this - the focus on Temasek will continue, and our work in this regard will go on.
46. In fact, we are working in conjunction with the International Monetary Fund and other SWFs to help draft guiding principles that should steer investments by SWFs. We hope the process would be a success and help diffuse concerns in the OECD markets about SWFs and their motives. Hopefully it would also help provide the context and differentiators for Temasek from the other SWFs.
47. The SWF issue will not go away - though the fear and suspicion may reduce when the surpluses and deficits in the East and West economies even out. This will take considerable time, resources and economic reengineering. In recent months, the US attitude towards SWFs has been more welcoming as the US deals with the credit crunch. But once the emergency has passed, foreign money may become less welcome again.
48. SWFs are - and will continue to be for some time - one of the many challenges of global economic and financial change in the 21st century. Fundamentally, growth in the number of SWFs reflects fairly deep trends in economic rebalancing, which will continue over the next few decades. How this particular challenge is addressed will have a profound implication on the international world of finance and trade, and the global economy.

Thank you.

Footnotes:
¹ Sir John Gieve, Deputy Governor, Bank of England, 14 March 2008
² Established in 1953
³ Established in 1976
⁴ Established in 1976
⁵ Andrew Rozanov, Official Institutions Group of State Street Global Advisors
⁶ Sir John Gieve, Deputy Governor, Bank of England, 14 March 2008
⁷ "Asset-backed Insecurity", Economist.com, 17 January 2008

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