Taming Leviathan a Regulatory Framework for Sovereign Wealth

Taming Leviathan: a Regulatory Framework for Sovereign Wealth Funds Victoria Barbary Paolo Baffi Center, Bocconi University Bernardo Bortolotti Università di Torino and Paolo Baffi Center, Bocconi University, November 17, 2011 PBC-CAREFIN Seminar “Curbing Volatility: Financial Markets, Credit Rating Agencies, and Sovereign Investment Funds”

1. Background: the trade-off of sovereign ownership Benevolent dictator’s SWF Neo-mercantilist SWF January 19 -25, 2008 SWF as a tool to address market failures in long term investment and domestic economic development 1 Curbing Volatility Seminar Bocconi – November 17, 2011 SWF as a politically oriented arm to assert the geopolitical ambitions of emerging countries

2. Facts: SWF history §ADIA, Abu Dhabi §State General Reserve Fund, Oman §KIA, Kuwait 1953 §BIA, Brunei 1960 §Revenue Equalization Fund, Kiribati 1970 §Temasek Holdings, Singapore 1990 1980 §IPIC, Abu Dhabi §GIC, Singapore Source: Sovereign Investment Lab 2 Curbing Volatility Seminar Bocconi – November 17, 2011 §Government Pension Fund Global, Norway §LIA, Libya §Future Fund, Australia §Investment Corp. , Dubai §State Oil Fund, Azerbaijan §Istithma §Bahrain Holding, r World, Bahrain Dubai §OIF, Oman §DIFC, Dubai §IPRF, Ireland §New Zealand §National Superannuation Wealth Fund, NZ §National Oil Fund, Account, Russia Sao Tomé 2000 §KNB, Malaysia §National Social Security Fund, China §KNF, Kazakhstan 2008 §Mubadala Development Company, Abu Dhabi §CIC, China §Emirates Investment Authority, UAE §ADIC, Abu Dhabi §QIA, Qatar §KIC, Korea §Timor-Leste Petroleum Fund §RIA, Ras Al Khamah §State Capial Invest. Corp. , Vietnam

2. Facts: the largest SWFs by AUM, 2010 Country Source of Funds Fund Name Assets Under Management Founding Date Norway Commodity (Oil) Government Pension Fund-Global $560, 5 bn 1990 United Arab Emirates Commodity (Oil) Abu Dhabi Investment Authority $342 bn 1976 China Trade Surplus China Investment Corporation $332, 4 bn 2007 Kuwait Commodity (Oil) Kuwait Investment Authority $296 bn 1953 Singapore Trade Surplus Government of Singapore Investment Corporation $220 bn 1981 Singapore Govt Linked Companies Temasek Holdings $133 bn 1974 China Trade Surplus National Social Security Fund $132 bn 2000 Russia Commodity (Oil) National Wealth Fund $94, 3 bn 2008 Qatar Commodity (Oil&Gas) Qatar Investment Authority $80 bn 2005 Libya Commodity (Oil) Libyan Investment Authority $53, 3 bn 2006 Australia Commodity (Various) Future Fund $77, 2 bn 2006 United Arab Emirates Commodity (Oil) International Petroleum Investment Company $49, 7 bn 1984 Kazakhstan Commodity (Oil&Gas) Kazakhstan National Fund $41, 9 bn 2000 Republic of Korea Trade Surplus Korea Investment Corporation $37, 6 bn 2005 Brunei Commodity (Oil) Brunei Investment Agency $39, 3 bn 1983 Total Oil & Gas $1. 599, 1 bn Total Other $1. 079, 6 bn Grand Total $2. 678, 8 bn Source: DB Research; Peterson Institute for International Economics; SWF Institute; Nadim Kawach, “UAE’s overseas investment income to rebound in 2009, ” Emirates Business 24 -7, April 2009; Hadfi eld, “Kuwait Investment Authority loses $31 bn in nine months, ” Meed Middle East Business Intelligence, February 11, 2009; Mubadala Annual Report 2008; Brad Setser and Rachel Ziemba, GCC Sovereign Funds: Reversal of Fortune, WP, January 2009 (Council on Foreign Relations, New York: 2009). 3 Curbing Volatility Seminar Bocconi – November 17, 2011

2. Facts: SWF Investment from MENA, 2000 -2010 MENA to Russia & Central Asia 16 deals, $1. 7 bn MENA to Europe 124 deals, $73. 0 bn MENA to North America 60 deals, $40. 2 bn MENA to Asia Pacific 50 deals, $7. 5 bn Within MENA 145 deals, $45. 2 bn MENA to Latin America 5 deals, $0. 5 bn MENA to Sub-Saharan Africa 27 deals, $4. 4 bn Source: Sovereign Investment Lab Transaction Database § Since 2000, MENA SWFs have invested $172, 6 bn primarily in Europe (42%), within MENA (26%), and in North America (23%). § Contrary to Asia, MENA balance domestic investment with international diversification. 4 Curbing Volatility Seminar Bocconi – November 17, 2011

2. Facts: Barbarians at the Gate? SWFs foreign investment by sector, 2000 -2010 Automotive 10% Other 16% Real Estate 13% Telecoms, 1% Aircraft, 1% Natural Resources, 11% Strategic Sectors 21% Transport, 1% Utilities, 7% Banking, Insurance, Trading 40% Source: Sovereign Investment Lab Transaction Database 5 Curbing Volatility Seminar Bocconi – November 17, 2011

2. Facts: SWF activity by type of political regime Percentage of SWF Assets under Management by Political Regime, 2010 SWF Investment Flows, 2000 -2010 US$ Mn Hybrid Regime 17% $80. 000 Authoritarian Flawed Democracy Full Democracy Hybrid $70. 000 $60. 000 $50. 000 Full Democracy 27% Authoritarian Regime 54% $40. 000 $30. 000 $20. 000 Source: Sovereign Investment Lab; 2010 EIU Democracy Index 6 Curbing Volatility Seminar Bocconi – November 17, 2011 Source: Sovereign Investment Lab Transaction Database 2010 2009 2008 2007 2006 2005 2004 2003 2002 $- 2001 Flawed Democracy 2% 2000 $10. 000

2. Facts: Foreign exchange reserves and political regimes $10. 000 Total Global Reserves Full Democracies Flawed Democracies Hybrid Regimes Authoritarian States $9. 000 $8. 000 $7. 000 US$ Mn $6. 000 $5. 000 $4. 000 $3. 000 $2. 000 Source: International Monetary Fund, International Finance Statistics Database; EIU Democracy Index 2010 7 Curbing Volatility Seminar Bocconi – November 17, 2011 2010 M 5 2010 M 1 2009 M 9 2009 M 5 2009 M 1 2008 M 9 2008 M 5 2008 M 1 2007 M 9 2007 M 1 2007 M 5 2006 M 9 2006 M 5 2006 M 1 2005 M 9 2005 M 5 2005 M 1 2004 M 9 2004 M 5 2004 M 1 2003 M 9 2003 M 5 2003 M 1 2002 M 9 2002 M 5 2002 M 1 2001 M 9 2001 M 5 2001 M 1 2000 M 9 2000 M 5 2000 M 1 1999 M 9 1999 M 1 $0 1999 M 5 $1. 000

3. SWF investment and political risk Does it matter? Yes. Political risk could affect the risk and return properties of SWF targets via: § Upheaval risk, transforming the country’s wealth management from savings towards divestiture and public spending to assuage protestors § Geopolitical risk, events could trigger the use of targeted financial sanctions freezing SWF assets (e. g. Libya) SWF metamorphosis: from patient, long-term investor providing capital over the business cycles to a short-term player with unpredictable liquidity needs. 8 Curbing Volatility Seminar Bocconi – November 17, 2011

3. The financial performance of SWF targets 0, 00% -1, 67% -2, 15% -2, 00% -1, 51% Adjusted Performance -3, 00% -3, 96% -4, 00% -5, 00% -6, 25% -7, 00% -8, 00% -9, 00% -10, 00% -8, 35% Abnormal Return-on-Equity -10, 47% -11, 00% -11, 83% -12, 00% Investment 6 months 1 year 2 years 3 years Source: Bortolotti et al. (2010), “Quiet Leviathans: Sovereign Wealth Funds Investments, Passivity, and the Value of the Firm”, mimeo. 9 Curbing Volatility Seminar Bocconi – November 17, 2011

3. The EUI Index of political unrest for SWF countries % OF POPULATION UNDER 25 COUNTRY % share Norway 31, 90 0, 81 Singapore 29, 80 0, 76 Malaysia 47, 80 1, 23 China 36, 80 0, 94 Korea 29, 80 0, 76 Bahrain 35, 00 0, 89 Libya 49, 00 Oman GOV'T YEARS IN POWER yrs indexval DEMOCRACY INDEX share indexval CENSORSHIP INDEX share indexval share GDP PER CAPITA PPP value ILLITERACY RATES share % share INTERNET PENETRATION RATE % TOT. share - 6, 80 0, 09 - - 52. 013 0, 18 - - 94, 80 1, 25 2, 33 0, 18 - - 51, 90 0, 65 79, 50 1, 00 56. 522 0, 17 5, 60 0, 45 77, 80 1, 03 4, 24 - 38, 30 0, 48 44, 90 0, 56 73, 40 0, 91 14. 670 0, 64 8, 10 0, 65 64, 60 0, 85 5, 32 0, 21 53, 40 0, 66 86, 00 1, 08 94, 20 1, 17 7. 519 1, 25 6, 70 0, 54 34, 40 0, 45 6, 30 - 26, 70 0, 34 12, 70 0, 16 34, 90 0, 44 29. 836 0, 31 - - 81, 10 1, 07 3, 08 12, 00 0, 36 32, 80 0, 41 77, 20 0, 96 79, 60 1, 00 26. 852 0, 35 11, 20 0, 90 88, 80 1, 17 6, 04 1, 25 42, 00 1, 25 100, 00 1, 25 13. 805 0, 68 13, 20 1, 06 5, 50 0, 07 8, 06 49, 00 1, 25 41, 00 1, 20 28, 00 0, 35 90, 50 1, 13 79, 60 1, 00 25. 439 0, 37 15, 60 1, 25 41, 70 0, 55 7, 10 Qatar 28, 00 0, 71 16, 00 0, 48 13, 00 0, 16 86, 00 1, 00 76, 00 0, 95 88. 559 0, 11 6, 90 0, 56 60, 90 0, 79 4, 76 Kuwait 37, 00 0, 94 5, 00 0, 15 37, 00 0, 46 72, 10 0, 90 60, 00 0, 75 37. 849 0, 25 5, 50 0, 48 39, 40 0, 52 4, 45 UAE 34, 00 0, 87 7, 00 0, 21 19, 00 0, 24 93, 60 1, 17 79, 60 1, 00 56. 580 0, 17 10, 00 0, 80 75, 90 1, 00 5, 46 10 Curbing Volatility Seminar Bocconi – November 17, 2011 n/a share CORRUPTION INDEX 6, 00 n/a 7, 00 n/a

3. The stock return of SWF targets: assessing political instability 11 Curbing Volatility Seminar Bocconi – November 17, 2011 Variable: Buy and Hold Adjusted Returns | Political Unrest Index | | Govt Involvement | | SWF passivity | | Strategic Target Dummy | | SWF Age | | Capital Infusion | | SWF Stake | | Foreign Target Dummy | | Target Market Value| | Target Leverage | | Target Liquidity | | SWF in the Board| | Buy and Hold Returns | (previous year)| Constant | | Number of Obs | R 2 | 1 Year from Investment -. 31309864 0. 0284. 05410613 0. 9327 -. 19614493 0. 2138. 020129 0. 7333 -. 01018229 0. 6413 -. 62466721 0. 7566. 21320963 0. 8604 -. 62759119 0. 0000 -3. 622 e-06 0. 3285. 10698612 0. 4606. 01115337 0. 2823. 13625312 0. 2150 -. 05082958 0. 0090 19. 691. 506 0. 0237 293. 04359465 2 Years from Investment -. 32604307 0. 0747 -1. 4061047 0. 3018 -. 50469912 0. 1473. 04296757 0. 7322 -. 07029254 0. 1436 1. 9326637 0. 4157 -. 8246279 0. 1488 -1. 1820403 0. 0000 -. 00001155 0. 0173 -. 23162654 0. 2909 -. 00152727 0. 9656. 04482498 0. 7342 -. 05358762 0. 0104 4. 4301511 0. 0119 144. 22252844

4. Pecunia non olet? Market failure considerations § Under laissez faire, increased political risk will restrict capital flows and investment opportunities in recipient countries. Contraction of international SWF investment will cause excessive FOREX accumulation, inflationary and exchange rate pressures in emerging countries, impinging economic development. § Political stability in emerging countries is a global public good. Decentralized, market-based systems will not provide efficient solutions. Market sanctioning by SWF targets will not trigger a socially efficient democratic transition abroad. Market failure considerations provide a rationale for SWF regulation 12 Curbing Volatility Seminar Bocconi – November 17, 2011

5. Towards a smart regulation of SWF The current regulatory framework on foreign investment § Not targeted to SWF, varies by countries, generally protects national security and strategic sectors § US: mandatory clearance by CFIUS in case of acquisition by sovereign investor § EU: free movement of capital enshrined in Treaty, but legal barriers are widespread in most member countries The Santiago principles § 24 (voluntary) Generally Accepted Principles and Practices (GAPP) on governance, accountability and transparency § Sponsored by IMF, OECD, and World Bank, undersigned by 23 SWF 13 Curbing Volatility Seminar Bocconi – November 17, 2011

5. Towards a smart regulation of SWF § The current regulatory framework at the national and multilateral level generally fails to address political risk § Targeted sanctions: the UN can adopt resolutions involving restrictive measures (such as asset freeze) to target the political elite in case of violation of international laws § Financial targeted sanctions are extreme solutions and operate ex post, not effective in preventing and mitigating ex ante political risks 14 Curbing Volatility Seminar Bocconi – November 17, 2011

5. Towards a smart regulation of SWF Complementary non-legal measures § GAAP 25: "While members consider being in the mutual interests of recipient countries and sovereign investors to maintain free movement of capital, they also realize that social inequality and political instability in the investing country represent critical risk factors in the international allocation of capital. Upon these considerations, members agree that sovereign investment abroad will be associated with commitments to foster economic prosperity, social progress and political reforms in the investing country". § Amendment of the code of conduct of stock exchanges inviting listed companies to disclose SWF presence as a risk factor 15 Curbing Volatility Seminar Bocconi – November 17, 2011

5. Towards a smart regulation of SWF Complementary legal measures § A CFIUS-style preventive mechanism, requiring a mandatory clearance of SWF acquisitions of the basis of a case by case review of countries' political outlook. § Establishment of the Sovereign Investment Office within a recognized international organization. On the basis of independent assessments, the Office could publish a list of “politically risk neutral” SWFs with a blanket authorization to operate globally, or establish a conditionality on investments based on case-by-case undertakings in the space of human rights, political freedom, constitutional reform and democratic transition. 16 Curbing Volatility Seminar Bocconi – November 17, 2011

5. Conclusions § Recent revolts in the Arab region are causing a metamorphosis of SWF from long-term, patient investors to short-term operator carrying political risk, affecting negatively the performance of target firms. § SWFs assets subject to political risk are worth $2 trillion and thus systemic. § Market failure considerations suggest that a SWF-specific regulatory framework may be desirable. § Self-enforcing solutions could be agreed upon at the multilateral level, given the countries’ mutual interest in open capital markets, peace and security. 17 Curbing Volatility Seminar Bocconi – November 17, 2011