What should Europe do about sovereign wealth funds?

Several EU governments have become alarmed about sovereign wealth funds (SWFs). Germany, for example, is thinking of preventing such funds from buying local companies in sensitive sectors. The European Commission is considering how it should respond: should it outlaw such defences, or establish them at EU level? With trillions of dollars now accumulated in SWFs and calls for protection mounting, the EU needs to ensure that any measures taken in response to SWFs do not threaten the openness of its single market.

Sovereign wealth funds – investment vehicles owned and managed by foreign governments – are hardly new. The Kuwait Investment Authority has been around since the 1960s, and the Abu Dhabi Investment Authority, set up in 1977, is now the world’s largest SWF. Why, then, the sudden upsurge of interest in these funds?

SWFs are a symptom of two phenomena: high oil prices and global macroeconomic imbalances. The first is making commodities exporters very rich. Thanks largely to the energy sector, Russia is now earning around $850 million a day from exports, while Saudi Arabia is earning over $500 million. The second means that countries with external surpluses are accumulating vast foreign exchange reserves. China’s reserves now stand at $1.4 trillion.

Until recently, SWFs were largely the preserve of countries such as Norway, Singapore, Kuwait and the United Arab Emirates. These countries were generally friendly to the West, and their investments were primarily concerned with boosting commercial returns. But new actors, such as Russia’s Stabilisation Fund and China Investment, are growing rapidly. China’s SWF is projected to grow by $200 billion a year, Russia’s by about $40 billion. The emergence of these new funds is important because they originate from potential geopolitical rivals that are less likely to play by the West’s rules.

Countries with swelling foreign exchange reserves are becoming more reluctant to hold US Treasury bonds or other liquid but low-yielding assets. They are now looking for more lucrative investments, such as stakes in European and American companies. China’s multibillion dollar investments in Blackstone, a US private equity group, and Barclays, a UK bank, are likely to be the first of many. Morgan Stanley, an investment bank, estimates that SWFs are now sitting on $2.5 trillion – twice the estimated assets of hedge funds.

This shift in financial power from private to public actors raises several concerns. Some critics charge that investments by SWFs amount to nationalisation through the back door: “Why should we privatise our industries and utilities” they ask, “only to see them fall into the hands of the Chinese or Saudi government?”

On close inspection, this argument is not particularly compelling. SWFs have not been buying controlling stakes in monopolies, but minority stakes in sectors that face plenty of competition. Even if SWFs tried to buy majority stakes, it is not clear that host countries should necessarily prevent them from doing so. After all, state-owned companies have been allowed to make cross-border takeovers within the EU: Electricité de France entered the UK’s liberalised energy market by acquiring a handful of companies already competing in it. In most cases, a host country’s response to a mooted takeover by an SWF should be confined to ensuring that it poses no threat to domestic competition. The British government is right not to object to Qatar’s attempts to acquire the supermarket chain J Sainsbury, because there are enough retailers in the UK to ensure competition.

But not all cases are this straightforward. Harder questions will arise when SWFs, or other state-owned entities, seek to buy companies in more sensitive sectors such as energy or defence. Vneshtorgbank, a Russian state-owned bank, has built up a 6 per cent stake in EADS, the European aerospace consortium. Some European countries do not want Gazprom, the Russian gas monopoly, to buy their pipelines and gas storage facilities. Even the UK, which is strikingly open to foreign takeovers, might baulk at China acquiring a media group like Pearson.

The reason for European (and American) unease is concern about the underlying motivation of some of these new investors. Few SWFs publish their management structures or investment objectives. Nor do Russia, Saudi Arabia or China share western conceptions of capitalism and pluralist democracy. So these countries might be tempted to buy firms in certain sectors for reasons other than boosting investment returns. Russia’s use of Gazprom as a foreign policy tool has done nothing to assuage these concerns.

So what should the EU do? To start with, it should avoid providing cheap protectionist ammunition to its member-states. With several countries trying to protect ‘national champions’ in the energy sector and France wielding a list of ‘strategic sectors’ potentially immune to foreign takeovers, barriers are already too high as it is. But doing nothing may not be an option. If the EU fails to agree a common line, individual EU countries will probably take measures of their own. And the barriers that resulted could impede the free movement of capital, both from outside the EU and within.

Germany has proposed that the EU should introduce a vetting procedure for foreign takeovers, modelled on the US Committee on Foreign Investment, a body that examines whether potential investments by government-controlled vehicles have national security implications. The establishment of such a body in the EU might calm European fears of future takeovers. But it would probably take a long time to get 27 member-states to agree on what its mandate should be. Moreover, it could become the target of protectionist lobbying by governments with an excessively broad understanding of what constitutes ‘national security’.

So the EU should discuss alternative solutions that ease fears about foreign political control without succumbing to the temptation of protectionism. For example, concerns about the motivations of SWFs would be alleviated if they became more transparent. Few SWFs will copy the exemplary levels of disclosure practised by Norway’s government pension fund. But the EU could coax them in the right direction by placing curbs on funds that fail to publish audited information about their balance sheets, investment objectives and portfolio breakdowns. One such curb might be to restrict SWFs with low levels of disclosure to buying non-voting shares in European companies.