May 26, 2009

The Vital Role of SWFs in the GCC’s Future

The nations comprising the Gulf Cooperation Council (GCC) have generated large amounts of foreign exchange reserves over the decades, mainly from the production and sale of oil. Since oil prices have been volatile since the early 1970’s, the GCC countries have historically used the money as a buffer against changes in commodity prices, to balance their budgets, to maintain economic stability and to create intergenerational savings. The investments made to achieve these goals needed to be liquid and safe. The return on those investments was less relevant than preservation of principal.


Evolving Role of SWFs

Over the past decade, however, the role of SWFs has been evolving. “With globalization of international markets, SWFs worldwide are taking a more proactive investment role that aims to complement their countries’ socioeconomic strategies,” stated Richard Shediac, a partner at Booz & Company. For example, SWFs of countries like Malaysia and Singapore have very active roles in socioeconomic development in local and regional markets. One of the key principles for Malaysia’s Khazanah Nasional Berhad is growth through investment in equities that improve the productivity and skills of the people. These funds seek specific knowledge transfer through investments in private equities of technology and startup companies and in R&D investments and joint ventures with multinational corporations (MNCs). In Singapore, Temasek Holdings invested $3.2 billion in the technology industry in 2007 in addition to other investments in life sciences and telecommunications. Temasek invests in established and startup companies in Silicon Valley that provide the United States with high-tech products.

“In the GCC region, the UAE attempts to enhance socioeconomic development through strategic investments,” explained Hatem Samman, the Director and Lead Economist at the Booz & Company Ideation Center. Dubai International Capital (DIC) invests in both established and developing primary markets, and its potential contribution to economic growth can go beyond investment returns. For example, its anchor investments in ART Marine Holdings provide it with the opportunity to develop the boating and marina sectors in the region. Other anchor investments of the DIC are in aerospace manufacturing services, airports, and education. This provides a means to “import” aerospace technology and form international partnerships that contribute to worldwide growth. Similarly, Mubadala Development Company’s 5 percent stake in Italian sports car maker Ferrari points to an increasingly strategic investment mind-set. The Ferrari investment brings with it the potential for increased tourism in Abu Dhabi as the Ferrari theme park nears completion in Yas Island. More recently, Mubadala’s $8 billion R&D partnership with General Electric provides access to commercial finance, healthcare, and clean energy technology, as well as aircraft maintenance expertise and other beneficial exchanges essential for the UAE’s socioeconomic development.


Mounting Calls for SWFs Regulation

With the rise in their number and financial reach, there has been a mounting call for the regulations of SWFs in recipient countries—led by the United States—who are voicing concerns about the possible negative effects foreign investments can have on their markets and foreign investor’s control over their strategic industries. “The April 2007 $7.5 billion investment of the ADIA in Citigroup, for example, raised concerns about how much influence such funds can wield on strategic businesses like banks, and their subsequent potential effects on the global economy” said Samman. According to the IMF, possible actions by recipient countries to influence SWF investment include:

  • Imposing reporting requirements on holdings thresholds

  • Applying market integrity rules to govern insider trading, fiduciary responsibility, and the like

  • Subjecting investments in supervised financial institutions (e.g., banks, insurance companies) to prudential rules

  • Imposing restrictions on SWF holdings beyond certain levels

  • Restricting SWF investments based on national security considerations

  • Subjecting SWF investments in certain sectors to more legal scrutiny

  • Scrutinizing SWFs for antimonopoly or take-over restrictions


Lessons from Global SWFs

There are lessons to be learned from SWFs’ evolution of investments in selected countries outside the GCC region. Three countries in particular are examples of the diverse characteristics of their SWFs: Norway, Singapore and China.

Norway’s SWF is an important best-practices example because the fund operates in a well-governed and extremely transparent manner. Its governance and transparency have allowed it to optimize financial returns on revenues from the sale of oil and promote macroeconomic stability while being a responsible social agent. “Norway’s GPF-Global has ethical guidelines for investments which identify corporations in which it will and, most important, will not invest,” Shediac commented.

Singapore’s success in promoting socioeconomic growth offers a positive example for the GCC SWFs. “Singapore’s Temasek Holdings successfully manage government-linked companies, as well as champion the development of industries in technology, transportation, and logistics,” added Samman.

Finally, China’s SWFs are important to study both for the manner in which they reflect China’s aggressive pursuit of socioeconomic development and the way in which they deal with scrutiny in their investment targets.
 
Several lessons emerge from studying the history, attributes and performances of global SWFs and their best-practices:

  1. SWFs are important both as savings and as stabilization tools.

  2. Long-term investments are a key feature of successful SWFs’ investment strategies. 

  3. Successful SWFs seek both financial and social returns.  

  4. SWFs play an important role in their countries’ socioeconomic development by investing domestically to spur the growth  of strategic sectors.

  5. SWFs focus some of their foreign investments on sectors that further local economic growth strategies through knowledge transfers and FDIs. 

  6. Regional and global investments can increase regional and international cooperation. 

  7. SWFs can be transparent and continue to have good returns on investments, as in the case of Norway. 

  8. It is possible to group government-linked companies covering different economic sectors under one holding that acts like a private enterprise to take advantage of the economies of scale and scope. Temasek Holdings has done that successfully with reduced business risk and cheaper financing. 

  9. SWFs should gradually move towards better practices in structure, governance and investment behavior.


Enhancing the GCC SWFs’ Socioeconomic Role

GCC SWFs play several favorable roles in the region including creating economic stabilization, investing for the long term and seeking high financial returns. But there are additional steps they can take to further enhance their roles. “These include helping transfer knowledge through investments, boosting economic activities by managing government enterprise and supporting strategic projects, fostering regional and international cooperation and instituting best-practices reforms,” Samman explained.

1. Transfer Knowledge through Investments
GCC SWFs should support local economic growth strategies through their international and domestic investments. International Investments, for example, provide means of collaboration with management and an understanding of business models, operations and strategies. Investments in MNCs help bring in sought-after technologies and knowledge by providing incentives to and pressures upon MNCs to add value locally and transfer intangible technology capital, like expertise and knowledge. In addition, GCC SWFs should spearhead local investments targeting industries that complement their international investments in order to spur economic growth.

However, the transfer of knowledge through investments must ensure that enablers, such as qualified human capital, infrastructure, and efficient institutions, are in place to allow for the absorption and development of transferred knowledge.

2. Leverage State-owned Enterprises
Government-linked enterprises dominate the GCC economies. Opportunities may exist to manage groups of SOEs under one holding. “This will allow governments to reap important business synergies, as well as economies of scale and scope,” stated Shediac.

3. Mitigate Economic Downturns
GCC SWFs should use their wealth in slow economic times to spur economic growth and maintain funding of critical strategic investments. Norway’s SWF, for example, is supporting infrastructure projects in the aftermath of the global financial crisis in order to sustain Norway’s economic growth. 

4. Enhance Regional and International Cooperation
GCC SWFs should consider the establishment of joint funds both at the regional and at the international levels. “Regionally, benefits from joint funds include sharing of risk, and increased investment opportunities,” Shediac explained. Internationally, joint funds can facilitate market penetration and enhance knowledge transfer mechanisms. The China Dubai Capital (CDC) joint fund, announced in April 2008 is a good example. The fund plans to invest in infrastructure, the oil industry, healthcare and other activities that will create synergies with the UAE’s economy, while providing China with good investment opportunities in the region.

In addition, investments that serve the communities of recipient countries—without compromising profitability—enhance international cooperation and reflect positively on SWFs.

5. Institute Reforms and Garner Trust
GCC SWFs need to gradually undergo structural changes to improve governance and transparency. “Concerns about the impact of transparency on financial performance, for example, can be avoided by publishing reports with a time lag in order to prevent any dissemination of critical investment information,” commented Samman. Beyond trust, these reforms come with other benefits. For example, they challenge SWF management to adhere to best practices and be accountable for results.


Conclusion

Although SWF assets will undoubtedly be revised in the aftermath of the world financial crisis, the outlook for SWFs is expected to be positive. With an eventual rebound in world economies, SWFs will continue to expand in size and number. Thus, SWFs in general and GCC SWFs in particular, will continue to be a growing financial power. More important, their role in socioeconomic development will remain significant despite any intermittent financial setbacks.