The Bankers' Bailout: Sovereign Wealth Funds in a Global Economy

As credit markets around the world began to feel the effects of an illiquid US financial system, fears of further liquidity problems have surfaced.  Banks are required to maintain a certain level of capital assets to ensure continued operations, and when banks start writing-down billions of dollars worth of these assets, they need other forms of capital.  Without this capital, a rapidly evolving downward spiral could begin within an institution. 

With the lack of liquidity in the financial markets though, where are banks supposed to borrow money from?  The answer lays outside of the United States, in entities called sovereign wealth funds. 

A History Lesson

Sovereign wealth funds are government-owned investment funds, which manage a government's financial assets with long-term appreciation goals.  These funds invest in a wide range of assets including commodities, currencies, domestic stocks and bonds, and in our case, foreign equities. 

Not surprisingly, the majority of SWFs' capital originates from oil with over 60% of the global SWF assets sourced from oil and gas related profits.  The largest SWF has its origins from oil as well, and is also the most publicized fund.  The Abu Dhabi Investment Authority has over $875 billion in assets; over twice as large as the world's second largest SWF.  The global capital allocated to sovereign wealth funds is estimated to be $1.9-2.9 trillion and puts into perspective the relative importance of SWFs; as it is estimated to be larger than the total assets under management of both hedge funds and private equity (estimated $1.5 trillion and $700 billion respectively).  SWF aggregate assets are also expected to grow at a much faster pace than these pools of capital, with analysts expecting SWF assets to grow to $7-8 trillion by 2012 and $12-15 trillion by 2015. 

Currently, under Section 892 of the Internal Revenue Code, sovereign wealth funds are exempt from income taxes in the United States. This effectively places a subsidiary on state-owned foreign capital investments, and thus encourages such foreign investment in our domestic economy. 

Protectionism Gone Wrong

Throughout the United States a debate erupted about an issue of national security in February 2006. Sovereign wealth funds became a hot topic of debate in American politics as the sale of a port management business in six U.S. seaports to a company based in the United Arab Emirates sparked controversy.  The purchase of these ports by a state-owned company, DP World, made politicians question whether the deal would compromise national security, even after deal was approved by the U.S. Treasury Department's Committee on Foreign Investment in the United States.  Members of Congress moved to delay the deal through legislation however, and on March 9, 2006, DP World stated that it would abandon the deal and turn over operations to a U.S. entity. 

The controversy that ensued from this deal represents a fundamental breakdown in our free market economy.  The security of our nation's ports remains the responsibility of our government's coast guard and border protection, regardless of the investment firms that own controlling stakes.  Our country has traditionally had a policy of welcoming globalization through the opening of our service sectors, including our seaports, to global competition.  Changing our policy to a protectionist stance in the global economy could prove to be disastrous and send the wrong signal to our allies across the world.  As the current economic environment dictates, global investment is a necessity to our economy's prosperity and must be allowed to continue without interference as demonstrated by aforementioned controversy. 

The Subprime Rescue

Since the beginning of the credit crisis in 2007, sovereign wealth funds have injected billions of dollars into some of the largest investment banks, including Citigroup (C), Merrill Lynch (MER), Morgan Stanley (MS), and UBS (UBS).  The total cash infusions by SWFs in these four institutions alone represent over $42 billion as of April 2008.  The investments are made by global funds located around the world and have thus far been non-controlling stakes, meaning the investments represent investments of less than 10% in the institution. 

These investments helped to insure the bank's credit ratings and strengthen their financial positions while losing billions of dollars from subprime mortgages.  Maintaining solid capital ratios at these large investment banks helps create liquidity in a market that sometimes feels nearly illiquid. 

The Move Towards Globalization

To the disbelief of many politicians, we live in a global economy; a rapidly expanding global economy which does not revolve around the United States (many of our nation's greatest economists have predicted that by 2050 the United State's GDP will be overshadowed by China's).  If we begin taxing the investments of sovereign wealth funds, we will be discouraging the investments of other nations in the US.  With a protectionist stance on our financial markets, our economy will expand at a drastically reduced rate. 

Safeguards are in place to monitor the actions of sovereign wealth funds, including a review by the Federal Reserve if a fund offers a controlling stake of more than ten percent.  Thus far in the current credit crisis, sovereign wealth funds have maintained a passive investment strategy and avoided triggering a Fed review for their investments in large financial institutions. 

A tax on the investments of sovereign wealth funds will mark a large step in the wrong direction for our nation's fiscal policy.  Furthermore, a policy of protectionism will have a negative effect on our country's economic development in the midst of a global economy. 

Comments

[mawjr:]

So the Fed is going to watch out for us? You must be joking!

2008 Aug 19 01:20 PM

[Daniel Miller:]

The Treasury's Committee on Foreign Investment in the United States is responsible for reviewing the security implications of foreign investment in the United States, and has been for the past 20 years. The committee includes representatives from various national agencies responsible for our national security, including the Defense Department and Department of Homeland Security.

2008 Aug 19 02:51 PM