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Tough Talk About Sovereign Funds Spawns Fear of Economic Retaliation Against the United States

By , Executive Editor, Money Morning •

William Patalon IIIWilliam Patalon III

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

The United States risks major retaliation against U.S. companies trying to do business overseas if Congress proposes new laws that will force so-called sovereign wealth funds to disclose more about their intent when it comes to U.S. investments, a senior U.S. Treasury Department official warned.

However, U.S. Sen. Charles E. Schumer - who serves as the chairman of the congressional Joint Economic Committee (JEC) - said that with state-run funds from Asia and the Middle East taking huge stakes in such companies as Citigroup Inc. (C), Merrill Lynch & Co. Inc. (MER) and Morgan Stanley (MS), concern was escalating about the potential impact on the U.S. economy and even to U.S. national security.

In fact, Schumer said that if the International Monetary Fund (IMF) doesn't devise a voluntary code of conduct for these state-run funds, Congress would study the need for legislation that forces the funds to become more "transparent" in how they operate.

"The question of the day is whether these huge pools of investment dollars, known as sovereign wealth funds, make the U.S. economy stronger or pose serious national security risks," Schumer said this week.

Controversy Over Sovereign Funds Grows

The debate about sovereign wealth funds - which Money Morning has dubbed the "Global Cash Barons" - has been escalating.

Sovereign-wealth funds currently control more than $3 trillion. The IMF and other experts predict the state-run venture funds could control $12 trillion by 2015. But Money Morning Investment Director Keith Fitz-Gerald thinks the ultimate number will actually be much bigger: Even now, he estimates that the total capital under the control of the global Cash Barons will be more in the region of $20 trillion by the middle of the next decade.

The U.S. Treasury says that 20 new funds have been created since 2000, more than half of them since 2005, bringing the total to nearly 40 funds with total assets between $1.9 trillion and $2.9 trillion.

In October, finance ministers and central bankers from the Group of Seven industrialized nations called for rules to guide international investments of government-run funds. But the G-7 officials weren't making that move because they fear the funds or their motives - they were making the move to head off a protectionist reaction to the funds' perceived lack of transparency.

In December, U.S. Securities and Exchange Commission (SEC) Chairman Christopher Cox said the growth of these state-directed funds may lead to an upsurge in political corruption because governments might attempt to exert influence over the companies or markets they've invested in.

But David McCormick, the U.S. Treasury Department's top diplomat - he serves as the undersecretary for International Affairs - says that sovereign wealth funds can be a stabilizing influence on an economic system. The reason: They serve to keep investment capital circulating throughout an economy.

Restricting them could have serious implications - both financially and politically.

Sometimes, those implications are one and the same.

"If the United States imposed new restrictions, other countries could impose restrictions on U.S. investors, jeopardizing the benefits generated in the United States by U.S. businesses that operate globally," McCormick said in a statement he read to the congressional committee.

Foreign Funds Snap up Banking-Sector Bargains

Citigroup was already struggling with subprime-related problems last fall when it received a $7.5 billion cash infusion from the Abu Dhabi Investment Authority, or AIDA, the first of several investments it would receive.

Then, when it posted its fourth-quarter financial results back in mid-January, Citi posted its biggest-ever loss, slashed its dividend 41% and announced that it had raised an additional $14.5 billion to bolster its sagging balance sheet.

Some of that capital came from Prince Alwaleed Bin Talal, the noted Saudi Contrarian investor who was already a Citigroup shareholder. The rest of the money came from sovereign wealth funds in Singapore and Kuwait, as well as from former Chairman Sanford "Sandy" Weill.

The infusion includes nearly $7 billion from Singapore Investment Corp. Pte, and $3 billion from the Kuwait Investment Authority.

Merrill Lynch, which wrote-down $8.4 billion on its way to a third-quarter loss of $2.3 billion, announced it was getting a $6.6 billion investment from Kuwait, the Korean Investment Corp. and Mizuho Financial Group Inc. (MFG) of Japan.

In December, after booking $9.4 billion of write-downs on its way to a fourth-quarter loss, Morgan Stanley said it had sold a stake in itself to China Investment Corp. for $5 billion.

Code of Conduct the Answer?

McCormick said Treasury wants the IMF, with support from the World Bank, to develop a code of so-called "best practices" for sovereign wealth funds, giving the funds guidance on how they should structure themselves to better control risk.

According to Reuters, the funds, many of them in the Middle East - with additional ones in China and Russia - have soared in size because high oil and commodity prices and the soaring U.S. trade deficit have enabled foreign governments to accumulate massive war chests of cash. Now the state-run funds are looking to invest that capital in such stable markets as the United States.

While he acknowledged the funds' newfound aggressiveness raises concerns, McCormick said a main worry was that Congress would pass laws retaliating against them and choke off a source of foreign investment. That would be a major strategic mistake for the United States, since sovereign wealth funds "are, in principle, long term, stable investors" that offer substantial benefits for the United States, McCormick said.

The governments that operate the funds could also retaliate against U.S. companies trying to do business in their countries, experts say.

McCormick said that all this is unnecessary. The reason: The odds that the funds will actually be disruptive, and harm their own investments, are very low.

Unlike their hedge-fund counterparts, sovereign-wealth funds are "typically not highly leveraged and cannot be forced by capital requirements or investor withdrawals to liquidate positions rapidly," McCormick said.

And that makes them a stabilizing force in the U.S. economy, he said.

During questioning, Schumer expressed doubt about the value of the screening process that is used to ensure foreign investments pose no threat to national security.

It was partly due to sovereign wealth funds that Congress strengthened the laws. Congress made the move after the inter-agency Committee on Foreign Investment in the United States (CFIUS) approved the acquisition of several U.S. port operations by state-owned Dubai Ports World.

Under the new law, CFIUS must keep Congress better informed, and also has to more closely scrutinize deals that are potential problems. But Schumer said that CFIUS is still "an opaque government panel led by Treasury," meaning that it was tough for Congress to know what was really going on.

McCormick countered by saying that the more open the process was while deals were being negotiated, the "more [of] a risk of the decision being politicized."

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Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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