Gulf sovereign funds are source of global financial stability

Gulf sovereign wealth funds (SWFs) have been on the rise in the past few years.

The total for the six Gulf states is estimated at around $1.5 trillion by the end of 2007, and is forecast to reach $3 trillion by 2010, if current oil prices prevail. The figure is significant but not huge when compared with total market capitalisation of bonds and stocks listed on world markets of more than $100 trillion.

Hedge funds valued also at $1.5 trillion have more impact on world financial markets than SWFs because of their ability to use leverage reaching 10 times their capital for particular transactions.

Western policy-makers have criticised SWFs for not being transparent and open about their objectives, asset allocation and targeted rates of returns. They requested SWFs to adhere to certain code of conduct without imposing similar rules on hedge funds or private equity funds, which are by no means more transparent.

After all, the failure to regulate certain activities of banks and hedge funds has been at least partially responsible for the current global subprime crisis. Markets still remember the speculative attack of the hedge fund managed by George Soros on the British pound in the early 1990s.

Asset management

The future of the Gulf region will depend as much on managing the financial assets they have as it does on producing oil and gas. Governments are entrusted to optimise the returns on national wealth in order to preserve sustainable income for future generations.

So far, SWFs have been passive financial investors, pursuing buy and hold strategies with no short positions and with little or no borrowing. They have been sought after by companies in need to raise capital efficiently and in large amounts.

The SWFs, especially those from the Gulf, have no interest in exercising political leverage on companies they invest in, nor do they have the human resources needed to manage these companies. They tend to invest passively and make small acquisitions in companies, and they rarely have board presentation in order not to be seen influencing polices and strategies of these companies.

Up until 2003, when oil prices were stuck in a low trading range, most SWFs from the region were managed as stabilisation funds. These have typically invested in high grade government securities (mainly US Treasuries) and bank deposits, with special emphasis on liquidity and low risk in order to facilitate easy drawdown on these funds to meet shortfalls in budgetary requirements when needed.

With oil prices trading in a higher range over the past few years, and the market view that prices will not drop below $60 a barrel any time soon, sovereign funds are now managed as saving or inter-generational funds, with a much longer time horizon than before. The investment strategy shifted to a more diversified portfolio of stocks, bonds and structured products, i.e. to more risky assets held over a longer period of time to realise substantial gains.

Everyone realises that what global markets need now in the middle of a credit squeeze are ways and means to attract increasingly more investments from sovereign wealth funds, rather than discouraging them by erecting protectionist measures.

Recipient countries should not discriminate among investors and should have in place predictable and consistent investment rules applicable to all.

The SWFs on their part need to implement a strategy that will achieve not only solid returns on their foreign investments but also one that projects a positive image to the rest of the world on how they invest and the important role they play in supporting companies and propping up jobs in the recipient countries. By highlighting such goodwill, and by subscribing voluntarily to a list of 'best practices' and staying away from the politically sensitive sectors, sovereign wealth funds will be welcomed as a stabilising factor in world markets.

Robust regulation

For their own benefit, SWFs should have in place strong governance, internal controls and operational risk management systems.

In a globalised economy, Gulf countries are producing oil at their full potential, and investing billions to boost their production capacity in order to meet future demand for oil.

As responsible global citizens, they are producing all the oil needed to meet rising world demand, generating in the process more revenues than they can absorb. By converting their exhaustible underground resources into financial wealth, governments of the region are expected by their people to preserve this wealth for future generations.

Without having free access to world's markets, they would not be able to invest their financial surpluses in a safe and rewarding way. Devising deterrent investment polices to promote "transparency" will force them to look elsewhere for profitable investment opportunities. This will undermine the spirit of free markets, limit the flow of capital around the world and pose major risks to the global financial system.

- The writer is CEO - Middle East and North Africa, Deutsche Bank.