LEVIATHAN'S DOUBLE BOTTOM LINE: SOVEREIGN WEALTH FUNDS AS TOOLS OF STRATEGIC STATECRAFT

Abstract

wealth accounts for a massive, and growing, source of global financial capital. wealth funds (SWFs) hold about $5 trillion in assets, nearly the aggregated assets of the global hedge fund community. capital is markedly more concentrated among a relatively small number of funds (about 40) as opposed to the nearly 7,000 global hedge funds. The concentration and use of these resources has a considerable impact not just on the world's capital markets, but on foreign policy as well. This paper explores the extent to which funds are embodying a double bottom investment approach that allows them to reap financial and strategic benefits simultaneously. Some SWFs are not only earning excess financial returns, but have accrued political influence (intimidation by implication) and a greater ability to meet broader needs as a result of their size, positioning and investment patterns. Power theory helps to explain, in part, how and why a bottom line occurs. Because SWF portfolios remain largely opaque, the paper relies on available public information about SWFs in China, Abu Dhabi and Qatar to examine the extent to which SWFs are benefitting from political and/or policy payoffs alongside their financial returns. Because some critics deem the use of SWFs to serve national strategic goals as potentially destabilizing to global financial markets, this is a controversial idea. Yet while actors may merit a particularly watchful eye, their actions are in fact no more threatening than those of other market participants. SWFs are as legitimate a tool of statecraft as other financial foreign policy implements. funds are shaping a new normal in geoeconomics, in which states lacking the financial resources to pursue this bottom line may find themselves at a disadvantage in foreign policy circles, and ultimately in the ability to serve the long term needs of their citizens. It is possible that in the 2 1st Century, the market will not be guided by the invisible hand, but instead by Leviathan's. Thesis Supervisor: Elena Obukhova Fred Kayne (1960) Career Development Professor of Entrepreneurship Leviathan's Double Bottom Line 2 ACKNOWLEDGEMENTS Few intellectual pursuits occur productively without the support and encouragement of others. In my case, this thesis benefitted greatly from the contributions of many. In particular, I am grateful for the thoughtful and dedicated guidance of my advisor, Professor Elena Obukhova, whose course on Global Strategy first inspired me to consider a longer project on an issue of global significance. Her course's probing of strategically relevant topics beyond U.S. borders sparked the idea to pursue a thesis with international focus. Mark Renton's judicious guidance and patient exploration of the issues was critical to understanding the nuances of wealth and its discontents. John Farley's thoughtful comments and sharp eye considerably (as always) improved the quality of my writing. I am grateful to my many classmates at MIT who supported and encouraged me throughout this process, and my parents and Diana Farley who support and encourage me through life. And of course, for Caroline, who inspires me on a daily basis. Leviathan's Double Bottom Line 3 EXECUTIVE SUMMARY Leviathan is becoming a finance capitalist as well as a captain of industry. The Economist, January 26, 2012 Guo jin min tui ( iAAR) The advances while the private sector retreats. Chinese adage In the seven short years since Andrew Rozanov first coined the phrase sovereign wealth fund, (SWF) these government-owned investment vehicles have been labeled existential threats to saviors in times of crisis, and nearly everything in between. State capital has soared to $12 trillion, making it the 4th largest global asset class. About $5 trillion of this is held in wealth funds, which are fundamentally reshaping debates at the nexus of global finance, politics and diplomacy.' The size and nature of SWFs has given sponsors new political voice alongside the established economic one. The funds' ability to intimidate by implication, which resulted in (among other outcomes) successfully prodding Eurozone banks to conduct stress tests in 2010, reinforces the idea that their 2 economic can subtlety manifest by making others more dependent on you than you are on them. Moreover, SWF investment patterns frequently correspond to the needs of their sovereigns in a way that undermines the idea they are mere coincidence. China's investments in energy, Gulf states' in land or agriculture, or any number of funds working to strengthen domestic economies are not passive occurrences. Such potential strategic payoffs, taken together with new political influence, show that some SWFs embody a new double bottom in which nations' investment capital secures not just financial returns, but political or strategic payoffs as well. The implications of this new force for political influence are massive. In 2005, wealth and hedge fund assets were about equal, at around $1 trillion. Since then, wealth has skyrocketed, and SWFs now oversee about 2 2 times hedge fund assets ($5 1 Thecity.uk. Sovereign Wealth February 2012. Available at: www.thecityuk.com/assets/Uploads/SWF-2012.pdf 2 Tett, Gillian. Asian Players Are a Worry for Eurozone. The Financial Times, July 15, 2010. Leviathan's Double Bottom Line 4 trillion vs just over $2 trillion). The assets of SWFs equal about one-third of the total market cap of the SP only about 40 SWFs manage that $5 trillion, whereas nearly 7,000 hedge funds manage the industry's $3 trillion. Some individual funds, like the Abu Dhabi Investment Authority (ADIA) or the Government Pension Fund of Norway, are as big as leading US mutual fund complexes like Vanguard (more than $500 billion). Israel elected to launch a fund to manage revenues flowing from the country's recent natural gas discovery (estimated at 50% of current GDP), rather than utilize other investment vehicles. The rise, size and provenance of these funds concern many, and have raised significant questions around funds' intent, management and scope. Before the 2008 financial crisis, criticism focused particularly on foreign ownership of strategically important firms or industries. Concerns over direct involvement in cross-border investments are age old, but increased market integration and globalization heightened fears over the issue. A Financial Times op-ed by former US Treasury Secretary Larry Summers described SWFs as vehicles that shake the logic of capitalism. 4 Much of this criticism has focused on perceived politicization of investment that as investors, states have unique interests that could serve to weaponize finance and destabilize markets. The 2008 passage of the Santiago Principles, the vital (and largely benign) SWF investments into a number of global financial firms in 2007 2008, and the reemergence of debt as a destabilizer of global markets somewhat dampened criticism. wealth continues to grow, fueling a rise in state capitalism, and keeping a focus on SWFs, who continue to be viewed by some with skepticism and suspicion. Like any other large institutional investor, funds have the potential to move markets. But it is the subtle influence and relationships across global markets not direct acts of 3 Bolton, Patrick, Frederic Samama, and Joseph E. Stiglitz, eds. Sovereign Wealth and Long Term Investing. Columbia University Press, November 2011. 4 Summers, Lawrence. Funds that Shake Capitalist Logic. The Financial Times. July 29, 2007 Leviathan's Double Bottom Line 5 aggression that most strongly indicate SWFs represent a new phase of global finance. Understanding their motives, movements and nuances is a task for financiers and policymakers alike. Power theory helps to explain some of the changing landscape. Former U.S. Assistant Secretary of Defense Joseph Nye coined the phrase soft power to describe the ability to use co-option and/or payments to obtain a benefit, as opposed to hard power, which relies on coercion and/or payments to do so. wealth funds meld the two, a development which may be termed SWFt power. They provide the carrot of sizable, patient capital, and wield a stick via their ability to serve as investors of last resort. This has resulted in wealth funds becoming, in some ways, a proxy for power/influence at home and abroad. The ability of non-OECD states to leverage SWF resources to earn excess financial return and accrue global influence, facilitate domestic economic development or meet the long term needs of citizens is reorienting relationships. Yet the new double bottom remains largely unexamined. The extremes of this debate pit those who see the potential weaponization of wealth at one end of the spectrum, against those who see wealth as nothing more than a benign resource used to earn strictly financial returns. The truth, as the China, Abu Dhabi and Qatar examples (among others) demonstrate, lies somewhere in between. The current rebalancing of economic relationships between developed and developing nations makes this all the more evident and important to understand. For the first time, developed countries (and their firms) have become reliant on developing ones for critical capital infusions. capital's arrival as global financial force may mean that countries who do not seek policy benefits alongside financial returns could find themselves left behind. The question is increasingly becoming why not pursue strategic goals along with financial

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