Gulf investors and the rise of economic patriotism.pdf

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12/21/15, 9:02 AMMarkets Under Attack? Gulf Investors & Economic Patriotism

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Exelenzia Investments Journal

FINANCIAL MARKETS UNDER ATTACK?

Gulf investors and the rise of economic patriotism

Andrea Goldstein

Senior Economist, OECD

&

Fabio Scacciavillani

Director of Macroeconomics and Statistics, Dubai International Financial Center

This paper is prepared for the Chatham House project on The Gulf Region: The Changing Face ofGlobal Financial Power? We thank the editors and an anonymous reviewer for most helpful commentsand suggestions. The views and the opinions expressed in this paper must be attributed solely to the

authorsas they might not coincide with those of the OECD, the Dubai International Financial Center,and/or their respective governments.
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Introduction

The massive current account surpluses accumulated by the Arabic Gulf countries in the wake ofrecord energy prices have spurred an intense outward investment activity carried out through a number ofvehicles, notably, but not limited to, those commonly defined as Sovereign Wealth Funds (SWFs). These

funds, which until recently attracted little attention beyond a few specialised niches of the financialmarkets, have come to prominence over the past two years, in part due to a few high profile acquisitionsand in part because their sheer size has grown dramatically. In fact, the funds increasing sophistication isshaping some noteworthy trends in global financial markets. Since the start of the sub-prime crisis in mid-2007, they have provided substantial liquidity to sustain stock valuation, while behaving as stableinvestors more focused on long-term results than on short-term gains.

In this paper, we first give an overview of the Arabic Gulf SWFs and then sketch the contours aswell as the motivations of their international activities. We examine three cases that have attractedinternational attention and generated considerable controversy the DP World takeover of Peninsular andOriental Steam Navigation Company (P&O), the investments by Qatar and Dubai in European stockexchanges and the failed acquisition of Sainsbury, the British retailer, by the Qatar Investment Authority(QIA). Finally we link these episodes to the debate in OECD countries regarding FDI, national securityand market transparency.

An overview of the SWFs

SWFs have been in operation for some time, at least since 1956 when an investment vehicle wascreated in the Gilbert Islands to manage the proceeds from the sale of phosphates.[1]The first sovereigncountry to form an entity entrusted with the management of its export revenues was Kuwait. In 1960 theGeneral Reserve was launched, followed in 1973 by the Future Generations Fund endowed with 50% ofthe General Reserve and an additional 10% of the yearly budget surplus. Finally, in 1982, the Kuwaitigovernment decided to consolidate all the assets of the Ministry of Finance, as well as the GeneralReserve and the Future Generations Fund, under the Kuwait Investment Authority (KIA). The experienceof Kuwait inspired others. Among high-income economies, Singapore and Norway have been pioneers inthis area, and today a number of large countries and regions (prominent among which Korea, Australia,Russia, China, Alberta and Alaska) have accumulated sizeable assets in SWFs. Table 1 reports a list of themajor SWFs.[2]Also many developing countries, from Botswana to Chile, from Trinidad and Tobago toUganda have set up their sovereign investment vehicles.

Nonetheless, SWFs remain a distinctively Gulf phenomenon. The Emirate of Abu Dhabi institutedthe Abu Dhabi Investment Authority in 1976, which today holds (according to some estimates) almost USdollar 900 billion. Oman in 1980 created the State General Stabilization Fund worth today US dollar 8billion. Another emirate in the UAE, Dubai, controls various funds among which the most active is DubaiInternational Capital founded in 2004 with assets estimated at US dollars 12 billion. Moreover, DubaiGroup (founded in 2000 and with US dollar 7 billion under management) and Isthitmar (in turn owned byDubai World, started in 2003 and managing US dollar 7 billion) act on behalf of the ruling family and itsassociates. The Qatari government has instituted in 2005 the Qatar Investment Authority (QIA). Saudi

Arabia already has many investment vehicles focusing on domestic projects, such as Saudi ArabiaGovernment Investment Company (SAGIA), and the government reportedly was considering the
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constitution of a fund to consolidate and manage foreign investments, which could easily become thelargest in the world. However the latest news have cooled down these expectations as the Saudiauthorities have announced that, at least initially their fund will be endowed with only US dollar 3.4billion. This compares to foreign assets held by Saudi Arabian sovereign entities estimated in a rangebetween US dollar 300 and 500 billion. Furthermore the Saudi government has expressed the intention toopen this fund to international institutional investors, a novel approach which could actually represent asensible way to allay the concerns raised in the West about transparency and undue influence. In essence

this Saudi fund would be more of an investment company than a SWF.

Table 1 The Largest Sovereign Wealth Funds in the World

Name and country Estimated Assets

(in $ bn)

Starting year

Abu Dhabi Investment Authority, UAE 875 1976

Government Pension Fund, Norway 380 1996

GIC, Singapore 330 1981

Various entities, Saudi Arabia 300 NA

Reserve Fund for Future Generations, Kuwait 250 1953

Investment Corporation, China 200 2007

Temasek Holdings, Singapore 159 1974

Oil Reserve Fund, Libya 50 2005

Qatar Investment Authority, Qatar 50 2005

Fond de Regulation de Recettes, Algeria 43 2000

Alaska Permanent Fund Corporation, USA 38 1976

Brunei Investment Authority, Brunei 30 1983


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Others 171 -

TOTAL 2,876 -

Total investments from oil and gas revenues 2,103 -

Source: Morgan Stanley

The combined wealth managed by the SWFs is expected to grow at 15% per year until 2015,reaching US dollar 10 trillion. For many countries, especially in Arabia, this means becoming

increasingly asset-based, rather than commodity-based, economies, as the revenues from foreign assetswill exceed their commodity revenues. As an example, for the Emirate of Abu Dhabi variations in worldinterest rates matter more than the oil price.

Financial markets repercussions of macroeconomic imbalances

The controversy sparked by the recent spate of acquisitions by the SWF might be seen throughdifferent lenses. The starting point is to disentangle the specious arguments, tinged with populistovertones, from the genuine concerns about financial markets soundness.

In developed economies, financial markets are viewed by the general public, by policy-makers, bybanks and by most economists as a place where private investors trade securities in the pursuit of profits.Accordingly, governments participation in these markets is limited to the issuance of public debt (throughintermediaries) and occasionally the sale of state-owned companies. In essence, governments arepositioned on the sell side. Central banks carry out routinely open market operations and, more rarely,foreign exchange interventions, but these are monetary policy tools, not intended to turn profits. It istherefore awkward to realise that public entities are engaged in financial transactions as if they were

private entities. Is this an aberration or should it be considered a legitimate course of action, and underwhat conditions?

To answer these questions and to put into a proper perspective the activities of the SWFs wefollow two intertwined lines of analysis: 1) The macroeconomics of current account surplus management(which provides a rationale for the setting up of SWFs) and 2) the political sensitivities enthused by state-owned entities acquiring a controlling stake in privately owned large foreign companies.

The macroeconomics of current account surpluses


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A well know identity in national accounting states that a country running a current account surplusmust reinvest these proceeds abroad, thereby building up a stock of foreign assets. These investments,according to the prevailing view (and to historical experience), are carried out primarily by the privatesector and, to a much lesser extent, by the public sector through the central bank. Crucially, central bankreserves are maintained in low risk assets to ensure that domestic economic agents have access to foreigncurrency needed for their business, travel or portfolio choices. Central banks are not supposed to engagein active asset management.

Table 2. Energy and non-energy export shares

Energy exports (US$ bn) Energy exports (% of total)

1996 2001 2005* 1996 2001 2005*

Bahrain 3.2 3.9 8.0 67.3 70.3 79.4

Kuwait 14.9 15.0 40.5 95.5 92.4 94.6

Oman 5.9 10.5 15.9 80.3 83.3 84.9

Qatar 3.2 9.8 22.9 84.8 92.4 88.9

KSA 54.3 59.9 163.3 89.4 88.0 89.6

UAE 18.4 24.1 47.4 49.4 49.8 48.2

* Estimates

Source: Gulf Organization for Industrial Consulting

This situation obviously results from the fact that in developed economies exporters (and assetmanagers) are predominantly private companies while the government sector provides public (nontradable) goods. But in the case of GCC countries a large share of the economy is dominated by the publicsector which owns and manages the stock of natural resources, and therefore accumulates most of itsrevenues.

Furthermore, economic theory tended to neglect the influence on asset prices of foreign investmentactivities because traditional models assert that current account imbalances are temporary, as real


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exchange rates corrections and/or productivity adjustments reduce the competitive advantage of netexporters. Also, the magnitude of these surpluses was deemed small compared to the stock of outstandingfinancial assets, especially in developed countries. Finally, it was presumed (somewhat unrealistically)that the bulk of these net foreign assets was held in almost riskless government securities and did notaffect much other asset prices.

From the mid 1990s these assumptions looked increasingly unrealistic, as the US continued to run

a widening current account deficit and countries such as China and Japan (together with other Asiancountries and, to a lesser extent, Germany) maintained large permanent current account surpluses.Moreover when energy and commodity prices climbed up after the invasion of Iraq, the GCC countries(and other commodity exporters) saw their surpluses skyrocket. These surpluses obviously are nottemporary and we should wake up to the new reality.[3]It was estimated by the Institute of InternationalFinance that between 2002 and 2006 the Arab Gulf countries accumulated US dollars 1.5 trillion, twice asmuch as in the previous five years. As a matter of comparison this figure is equivalent to about 10% of thedomestic market capitalization of the NYSE at end 2007, more than one third of the Tokyo StockExchange or of the Euronext exchanges, or of the NASDAQ and it would have been almost sufficient tobuy all the companies listed in the Deutsche Brse at end 2006. Obviously not all the windfall has been

invested abroad, but the magnitude has reached such a level that global financial markets are beingseriously affected.

However economists, policy makers, financial institutions and media have continued to view theworld through the lenses of an outdated economic theory, valid, maybe, for the 1960s but not for todaysreality, and therefore the activities of the SWFs have been often misunderstood, little analysed and widelyportrayed through specious arguments. In the next section we try to explain why SWFs, especially fromsmall economies, are an unavoidable consequence of economic reality and what should be the mostappropriate policies for this new environment.

The rationale for establishing SWFs

The basic question to address is why the export revenues are not re-invested mostly in domesticprojects. The answer differs greatly whether one has, say, Russia or Qatar in mind. In the former it is asymptom of broad institutional failure, in the second it is a matter of objective constraints on developmentdue to the size of the domestic economy compared to the magnitude of the export revenues. To be morespecific, Russia is not a functioning market economy. The rule of law and even basic protection of

investors is, at best, patchy. Therefore despite the desperate need of capital for infrastructure,manufacturing, raw materials extraction, etc. few viable investment opportunities exist. The privatecorporate sector, i.e. companies outside the stranglehold of national or local governments, plays anegligible economic role. As a consequence, the Russian government invests abroad those resources thatwould be more desirably used to lift the living standards of the population. Qatar on the contrary is acountry of only 234,000 citizens, with a limited territory, mostly barren. Its government has indeedlaunched a massive program of infrastructure building and structural transformation of the economy inareas such as financial services, tourism, transport services, petrochemicals. As a result the size of theeconomy has tripled in the 6 years to 2006 when measured in nominal US dollars. Investments representmore than 40% of GDP and new investments planned over the next few years are estimated at about threetimes current GDP. The expatriates represent already about three quarters of the resident population. Any

further acceleration in this breakneck expansion activity would run into insurmountable bottlenecks which are already evident in terms of housing scarcity, labour and raw materials shortages, infrastructure
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deficiencies and exacerbate inflation that already exceeds 13%.

Similar arguments can be made for the UAE and to a lesser extent for the other GCC countries. Inessence these countries are compelled to invest abroad a large portion of their export revenues because thesize of their domestic economies, notwithstanding the enormous progress made so far, is limited. Statedsomewhat differently, for small countries such as Qatar, the UAE, Kuwait, but also the likes of Norway orSingapore which have already attained a high per capita income and face objective constraints in further

expanding their domestic economies it makes sense to transfer the wealth accumulated through exports(especially of non-renewable commodities) to future generations. A parallel motivation is diversification:if an idiosyncratic shock hits its domestic economy the country can be at least partly shielded. Largecountries like Russia or China would be better off if they channelled their more of their export proceedsinto their domestic economies after liberalising their business environment.

Small economies face a problem of absorptive capacity of export revenues determined by the sizeof their economy, their population and their territory. Large countries face a problem of absorptivecapacity determined by their institutional and legal set up which in turns results in lower productivity.

Table 3. Annual outward FDI from the GCC Countries since 1981

1981-85 1986-90 1991-95 1996-2000 2001-05 2006 2007

Bahrain - 1 25 1 141 661 980

Kuwait 72 451 0 - 275 143 7892

Oman - 0 2 345 0 115 247

Qatar 1 - 2 9 14 126 379

Saudi Arabia 40 349 0 197 376 753

UAE 7 - 4 0 246 1 515 2316

Source: UNCTAD (2007), World Investment report http://www.unctad.org/Templates/Download.asp?docid=9156&lang=1&intItemID=3277

The Gulf countries strategy in foreign investments
http://www.unctad.org/Templates/Download.asp?docid=9156&lang=1&intItemID=3277


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GCC member states have invested petrodollars in the West since the 1970s, generally withoutattracting much attention or criticism. These investments have been sizeable: for example in 2005 the netpurchases of US mutual funds shares was US dollars 260.3 billion. In the same year the total energyrelated export revenues of the GCC countries reached US dollars 297.9 billion. Even if two thirds of thismoney was reinvested abroad, it would have been more than enough to sustain shares prices across the

globe. So the capital flowing from energy and more generally commodity exporter (not only from theGCC) has contributed to reduce the volatility of the stock markets and has exerted a downward pressureon long-term interest rates over recent years.

The international activism of Gulf investors in the second half of 2007 was due to the newopportunities that opened up on the aftermath of the sub-prime crisis. This was a major force underlyingthe resilience of M&A markets, and stock exchanges in general. But in general it did not represent achange in the asset management strategies of the SWFs. Broadly speaking, there have been four clustersof actors/destinations/motivations.

First, obviously, higher returns trough a diversified portfolio. For example, Kingdom Holding aSaudi State-owned company which has been an active private-equity firm since the 1980s targets blue-chip shares and luxury hotels in developed countries, as well as emerging firms in developing countries,including in Africa. In Bahrain, Investcorp and Arcapita Bank use their private equity arms to purchasemajority shares in companies in Europe and the United States. The Dubai government, through its private-equity firms, has made some significant cross-border equity acquisitions, including the purchase ofPeninsular and Oriental Steam Navigation Company (P&O) of the United Kingdom through state-run DPWorld, the worlds third-largest ports operator. Mubadala Development, a wing of the Abu Dhabigovernment, bought a 7.5% stake in Carlyle Group, the big U.S. buyout firm. Mubadala, according toCarlyle, got a 10% liquidity discount, presumably by paying cash. The investment strategy of the GCCcountries SWFs has also produced some notable effects on financial markets.

Table 4. Top acquisitions in 2007 by GCC investors

Date Target Acquirer Value ($ bn)

May 21 GE Plastic (USA) SABIC (KSA) 11.6

Dec. 13 5 Dow Chem plastic divisions Kuwait Petroleum 9.5

Nov. 15 4.9% of Citigroup A.Dhabi Inv. Auth. (UAE) 7.5

Apr. 16 3.1% of HSBC (UK) SAAD (KSA) 6.6

Aug. 9 OMX (Sweden) Borse Dubai (UAE) 4.9


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more speculative positions. In essence their strategy is akin to those of private equity funds. A third typeare publicly funded companies that pursue ventures in specific sectors, especially the real estate orutilities. Strictly speaking these are not SWFs, but often it is their acquisitions that sparks controversy.

Three paradigmatic cases

It is ironic that the first high-profile operation to stir political reactions about SWFs did not involvea SWF but DP World,the state-owned company that runs the Port of Dubai. In winter 2005-06, it tried toacquire P&O, a British company with important operations in the USA. The opposition focused primarilyon the security consequences of having a foreign entity managing the sensitive area of access to US soil.After CFIUS approved the deal in February 2006 (following a standard 30-day review), DPW agreed toan additional 45-day security review. In March, following a 62-to-2 Congress vote forbidding theacquisition, DPW agreed to spin off the American assets.

As The New York Timesput it at the time in a leader on the P&O deal, it is not irrational for theUnited States to resist putting port operators, perhaps the most vulnerable part of the securityinfrastructure, under [the] control [of an ally whose] record in the war on terror is mixed.[4]After stokingterrorism fear in the public mind, it was of course a paradox that the Bush administration could beaccused of being soft on security matters. In practice, these concerns were overblown as the securityarrangements in the US are not determined by the port facilities operators, but by security and lawenforcing agencies. And definitely the ports are not the most vulnerable part of the security infrastructureas proved by the hundreds of thousands illegal aliens reaching the US via land. Not to mention thehundreds of miles along the Western coast line guarded by only a handful of patrol troops.

Rational arguments however cannot hide the fact that concerns about security and other essentialnational interests are on the rise. Many countries have taken steps to safeguard essential interests that,while not necessarily protectionist in nature, have nevertheless generated considerable public debate.Some European countries have shown uneasiness about international mergers in strategic sectors andsome have taken regulatory action. In the United States, the Foreign Investment and National Security Actof 2007 (FINSA 2007) has strengthened security clearance of investment projects. China has recentlytightened procedures for cross-border M&As. Russian and Indian authorities are reassessing theirpositions on foreign control of sensitive enterprises.

However, to highlight that emotional arguments often play a larger role than thoughtful analysis,one could point at the battle for the acquisition of Sweden's stock exchange. In August 2007, Borse Dubai,DIFXs holding company, announced plans to buy at least 25 per cent of Swedens OMX.[5]A protractedfight started with the Nasdaq Stock Market, ending in September when the two suitors agreed to joinforces not just on an OMX bid but also in a far-reaching deal that could have broad implications for thefast-growing and rapidly consolidating universe of financial exchanges. Borse Dubai will continueadvancing its $4 billion cash bid for OMX Group. But Nasdaq will acquire those OMX shares in a cash-and-shares arrangement that will leave Borse Dubai with nearly 20% of Nasdaq, though its voting rightswill be restricted to 5%. Nasdaq also will become the principal commercial partner and a strategicshareholder in the DIFX, which will be rebranded Nasdaq and use trading technology from Nasdaq andOMX. Finally, Borse Dubai will acquire Nasdaq's 28% stake in the London Stock Exchange for around$1.6 billion.

The outcry in the U.S. about whether an entity owned by the ruler of Dubai is acceptable as a
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major shareholder in a key U.S. financial exchange was limited. Although there were calls for CFIUS tointervene, Dubai's voting rights will be restricted to 5%. On the other hand, the Swedish government is topass a new law to protect the country's stock market from being "Americanised". The government isconcerned the sale of OMX might undermine its competitiveness by exposing it to US corporategovernance rules. But at the end the deal went through.

Finally, the attempted takeover of the British retailer Sainsbury by the QIA serves as a reminder

that not all SWF have the skills to carry out complex financial operations. The Delta Two investmentfund, which is backed by the QIA, started negotiating the purchase in the early summer 2007 andproposed a cash element of around US$7bn. The largest UK union Unite threw its hand up in the air overQatar's long-term intentions for Sainsbury's and the firm's founding family, Sainsbury, still sizeableminority shareholders, were allegedly opposed to the sale. Once it appeared that the fall-out from the USsub-prime mortgage crisis might make obtaining finance harder, Sainsbury's shareholders naturally soughtto reduce the proportion of debt in the deal and Qatar gradually upped its cash injection to close to $10bn,out of the $21.6bn overall cost. The UK's Takeover Panel imposed November 8 as the final deadline to'put up or shut up.' The Qataris eventually cited turmoil in the credit markets as the main reason for itsdecision to drop out of the acquisition in November 2007. While some analysts have said the QIA has

been prudent to pull out of the deal with the cost of borrowing now rising, its obstinacy not to pay theextra sum as it has actually lost a larger amount, over $1bn, in the last few days as the share priceretreated. The Financial Times quoted one person involved in the bid as saying that Qatars reputation asa credible financial investor of international assets has been seriously damaged and it will be a whilebefore another British public company enters into exclusive negotiations with them again. We used tothink private equitys behaviour could be low but what Qatar has done is lower than a snakes belly.[6]

Final Remarks

SWFs and similar entities launched by small countries accomplish an indispensable function byinvesting the current account surpluses into a well diversified asset portfolio as a means to share theaccumulated proceeds with future generations. The prominence of the SWFs activities must be seen inthe broader contest of regulatory changes in FDIs and the efforts to make financial market moretransparent. Since 2004, a spate of regulatory changes around the world, less favourable to foreigninvestors, has prompted many pundits to declare an end to the era of liberalism and raise fear over theadvent of a new era of protectionism, or perhaps of strategic interventionism.

In reality, even nowadays the vast majority of regulatory changes lessen the impediments forforeign investors. Nonetheless, episodes such the attempt by DP World to acquire P&O drew attention tothe activities of SWFs and other state entities and to their potential consequences. One argument, popularin Europe, stresses that after having painstakingly privatised large sector of the economy it would beironic if, say, airlines, utilities and banks were to fall prey to a foreign government whose purposes mightnot be entirely linked to economic considerations. Russia and China appear to be stirring specific fears.

When considering the GCC countries, the attitude is more nuanced. The GCC countries have beenin accord with the US (and the West in general) and their interests are broadly aligned with those of

developed countries. But a degree of ambiguity resurfaced, especially in the US, after 9/11. Former USTreasury Secretary Larry Summers, whose views lately are increasingly protectionist, has voiced concerns
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ranging from supposedly hidden motivations behind investment strategies, to the danger that SWFs mightmove the operation of blue chips to their countries and use their political connections to force a bail outshould their investment prove disastrous. These arguments did not prevent his successor, Henry Paulson,from flying to the UAE in an effort to convince the Abu Dhabi Investment Authority to rescue Citibankwhen the bank run into trouble generated by the subprime crisis. The ensuing deal, worth 7.5 billion USdollar, took the shape of a convertible bond with a 11% interest rate over two years, a rather favourableterm for the SWF, but hardly excessive given the liquidity crunch on international financial markets.

Analogous terms were negotiated by the Swiss authorities when they asked the Singaporean SWF andSaudi Arabian public entities to inject funds into UBS. These examples show that, at times of cripplingliquidity worries, SWFs have acted to restore a degree of confidence on the markets.

In essence it would be pointless and counterproductive to stem capital and FDI flows because, asthe integration of international trade progresses, a natural consequence will be increasing capital flowsfrom countries that run a current account surplus into those that run a deficit. OECD governments areconscious of the need to keep restrictions to a minimum, ensuring that markets will remain open toinvestment by SWFs and other entities. However it will also be desirable that any institution active infinancial markets act in line with governance standards that allow markets to function efficiently. For

some SWFs very little is known beyond the name and the country from which they operate. Sometimeseven the names of key officials are confidential while their balance sheets and their assets holdings are notdisclosed. It must be pointed out that often these questionable practices are tolerated by market regulators.For example the habit of concealing the terms or certain deals or the amount paid for stakes in listedcompanies is simply unacceptable.

Furthermore a fundamental principle of reciprocity must be implemented. Countries whosemarkets and companies are not fully open to foreign investors cannot expect that their SWFs be givencomplete freedom to acquire the ownership or a controlling stake of companies from countries adhering tomarket freedom. In a nutshell, greater disclosure of SWFs activities, sound governance, timely reportingof deals and openness to foreign investors will assuage the fears raised by arguments of nationalistic, or

worse, paranoid tenor and minimize restriction on the operations of SWFs.

[1]Since at the time the Gilbert Islands were a British colony, the fund could technically not be describedas sovereign. The fund today is worth about half a billion US dollars.

[2]The listis not exhaustive, as some countries do not fully disclose the assets managed by their investment vehicles.Furthermore, in addition to SWFs some countries have launched other public entities that manage investments in specific sectors.

For example, in Qatar Barwa and Qatar Diar are operating in real estate worldwide, while Dubai Port focuses on transport

facilities and logistics.

[3]Another way to look at this phenomenon is to consider the increase in energy prices as a tax levied on consumers by a government (albeita foreign one). Part of this tax receipts will be spent on providing public goods or infrastructure and the rest will increase governmentsavings, which in turn will be invested in the private sector (domestically or abroad).

[4]The President and the ports, The New York Times, 22 February 2006.

[5]DIFX CEO Per Larsson was elbowed aside from the chief executive position at OM Group, the

Stockholm-based stock exchange, as it merged with HEX of Finland in 2003.

[6]Standing of Qatar laid low following surprise exit, Financial Times, 6 November 2007.
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