The accumulation of large oil revenues, particularly since the early 2000s, has placed oil exporting countries among the world’s largest sources of capital. The bulk of these assets are invested by government-owned and government-managed oil funds, which constitute a large component of broader sovereign wealth funds (SWFs). A recent Morgan Stanley study estimates that by 2015 the financial assets of oil funds and other SWFs will be about $6 trillion each.1
McKinsey Global Institute estimates that at the end of 2006, oil exporters collectively owned $3.4-3.8 trillion in foreign financial assets.
The Gulf Cooperation Council (GCC) statesBahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAEown $1.8 trillionmore than one third of these assetsaccording to an Institute of International Finance report in late 2007.2 3
In addition to older funds such as Kuwait’s Future Generations Fund (1976), the UAE’s Abu Dhabi Investment Authority (1976), and Norway’s Government Pension FundGlobal (1990), the list of new funds includes Algeria’s Revenue Regulation Fund (2000), Iran’s Oil Stabilization Fund (2000), Kazakhstan’s National Oil Fund (2000), Russia’s Stabilization Fund (2004), Libya’s Oil Reserve Fund (2005), Qatar’s Qatar Investment Authority (2005), and Venezuela’s National Development Fund (2005).
The general justification for these funds is that “some share of government revenues derived from the exploitation of a nonrenewable resource should be put aside for when these revenues decline” either from price fluctuations or resources depletion.4 Thus oil funds generally are classified into two categories:
- Stabilization funds. These are designed to reduce the impact of volatile revenue on the government and the economy. When oil prices are high, the fund receives resources, and when prices are low, the fund pays out to the budget.
Stabilization funds are also meant to protect the economy from the so-called “Dutch disease.” This term refers to Holland’s experience in the 1970s, when a strengthening currency made it impossible for local manufacturers to compete. A flood of petrodollars may push up the value of the currency and undermine manufacturing competitiveness. - Savings funds. These are designed to expand the benefits of oil wealth to the upcoming generations. The presumption is that oil revenues belong to all citizens of the exporting country, both current and future generations. Saving and investing a proportion of oil revenues would allow future generations to share oil wealth with the current one.
In most cases oil funds seek to achieve both stabilization and saving simultaneously.
Transparency concerns
In recent years, oil funds have injected billions of dollars into some of the world’s biggest investment banks. Their high-profile activities include Abu Dhabi’s acquisition of a stake in Citigroup and Kuwait’s capital injection into Merrill Lynch. These investments are supposed to help stabilize financial markets.
In theory, international investment is welcome. However, when the source of the investment is a foreign government-owned fund, suspicions can arise. There are concerns that oil funds’ investments might be driven more by political and strategic interests than solely by commercial benefits.
The huge and growing size of oil funds, the general lack of comprehensive investment strategies, and the low levels of transparency and accountability have further heightened these concerns.
Persian Gulf oil funds
In 2006 the Persian Gulf region held 61.1% of the world’s proved oil reserves. Its share of global oil production was 30.1%, while its share of consumption was only 5.4%. The large gap between production and consumption and the massive proved reserves underscore the region’s current and future oil revenues potential.
In the first half of this decade an estimated $542 billion of GCC international assets had been injected into global capital markets, mostly through investments by oil funds.5
Kuwait
Kuwait was one of the first countries in the world to set up an oil fund. In 1953, some 8 years before its independence from the UK, Kuwait founded an Investment Board Fund (IBF) in London to invest its surplus oil revenue.6
Shortly after oil discovery, the role of the state as the provider of basic services such as education and health care considerably expanded to meet the needs of a rapidly growing population. In an effort to organize public finance, the General Reserve Fund (GRF) was established in 1960 as the main treasurer for the government. The GRF received all revenues, including all oil revenues, from which all the state’s budgetary expenditures were paid.7
In 1976 Crown Prince Jaber al-Ahmed al-Jaber al-Sabah, the deputy emir of Kuwait, issued Law No.106, under which the Future Generation Fund (FGF) was established. Article 2 stated, “A special account shall be opened for creating a reserve which would be a substitute to the oil wealth. An amount of 50% of the available state’s general fund is to be added to this account.” Article 1 stated, “An amount of 10% shall be allocated from the state’s general revenues every year.”8
In 1982 the government established the Kuwait Investment Authority (KIA) to manage the growing increase in oil revenues it allocated for investment. KIA assumed responsibility for managing and developing the financial reserves of the state’s IBF as well as the FGF. The holdings in the former are mostly invested locally and regionally, while those in the latter are broadly diversified.9 KIA’s purpose is to “achieve a long-term investment return in order to provide an alternative to oil reserves, which would enable Kuwait’s future generations to face the uncertainties ahead with greater confidence.”10
KIA holds stakes in big corporations such as DaimlerChrysler and British Petroleum. In 1987 KIA bought more than 20% of then recently privatized BP. The British government became concerned about foreign ownership of such an important company, and KIA sold more than half of its stake.11
In February 2008 KIA said it would invest $3 billion in Citigroup and $2 billion in Merrill Lynch as those two US banks scrambled for capital.12 In July 2007, for the first time, KIA revealed the value of its holdings$213 billion.13
This policy of investing oil revenues has proven crucial for Kuwait’s financial welfare and political survival. By the late 1980s, Kuwait was earning more from overseas investments than it was from the direct sale of oil. Oil revenues were interrupted in 1990-91 as a result of the Iraqi invasion and occupation of Kuwait. The government and population in exile relied exclusively on investment revenues. These revenues also were used to cover international coalition expenses, postwar reconstruction, and repair of damaged oil wells and other facilities.
The UAE
With about $875 billion in assets Abu Dhabi Investment Authority (ADIA) is the wealthiest oil fund in the world.14 ADIA invests the oil surplus of Abu Dhabi, the richest city-state within the UAE, which also includes Dubai.
ADIA was established in 1976 by Sheikh Zayed bin Sultan al-Nahyan, the founder of the UAE, and is currently chaired by UAE president Sheikh Khalifa bin Zayed al-Nahyan. The goal was to invest the Abu Dhabi government’s surpluses across various asset classes. At the time, it was novel for a government to invest its reserves in anything other than gold or short-term credit.
In February 1977 Abu Dhabi Investment Co. was established by decree. The company was majority-owned by ADIA and National Bank of Abu Dhabi before ADIA’s shares were transferred to Abu Dhabi Investment Council in 2007.15
The ADIA portfolio has always been diversified across regions and asset classes. Like other oil funds, ADIA has taken special interest in emerging markets in recent years, particularly in China and India.
While the recent decline in the value of the dollar is making investment in the US cheaper, many investors are holding back out of fear that the dollar will decline further, diminishing the value of their dollar holdings.
In addition, some oil investors are worried about potential political reactions. In 2006, DP World in Dubai, which is not a sovereign fund but a state-owned company, was blocked from taking over management of American ports. ADIA, which has always adopted a low profile investment strategy, learned from DP World’s experience and is not likely to put itself in a similar situation.
In 2007 ADIA invested in private equity giant Carlyle Group and microchip maker Advanced Micro Devices. These large deals were subjected to intense scrutiny. In late November 2007 ADIA agreed to invest $7.5 billion in Citigroup but would have been keen to invest more. The deal gives ADIC 4.9% of the New York-based bank, making it the largest shareholder, just below the 5% at which the US Federal Reserve has to take a look.16
Iran
Iran’s Oil Stabilization Fund (OSF) was established in 2000. Like the other Persian Gulf states, Iran has enjoyed massive oil revenues since the early 2000s. But, unlike its Arab neighbors, the Islamic Republic has been under intense US economic sanctions since the 1979 revolution and more recently under UN sanctions. These sanctions have had negative consequences for the country’s economic outlook, particularly the energy sector.
The tightening of economic sanctions in recent years due to Tehran’s nuclear program has put more pressure on foreign banks not to provide loans and credit to Iran.
In December 2006 oil minister Vaziri-Hamaneh said, “Foreign banks are refusing to grant us capital or to participate financially in oil industry projects under various pretexts.”17
One solution Iran’s government is promoting is to dip into the OSF to finance oil and gas developments. Information on the actual level of the fund is difficult to access because the government has been drawing against it for various purposes.
The OSF does not show up in Iran’s national budget. It is run as an account at the Central Bank by a handful of senior government officials.18 In January 2008 Tahmasb Mazaheri, governor of the Central Bank, announced that the OSF holds $10 billion, much lower than other oil funds.19
Given this lack of transparency and high level of uncertainty, the OSF has been under investigation by the state inspectorate organization. Inspectors examine how OSF funds have been withdrawn and spent during the fourth 5-year development plan (2005-10).20
Assessing the poor performance of Iran’s OSF, Jahangir Amuzegar, former finance minister in Iran’s pre-1979 government, concludes, “Handling the OSF has shown the futility, if not indeed the absurdity, of setting up a rainy day fund if it can be freely used while the sunshine had never been brighter.”21
Qatar
Qatar oil fund Qatar Investment Authority (QIA), founded in 2005 and headed by Prime Minister Sheikh Hamad bin Jassim al-Thani, manages about $50 billion.22 It invests in international public markets, private equity, and real estate as well as nonenergy local strategic initiatives.23
In the last few years QIA has invested, or was involved in negotiations to invest, in several high-profile companies in Europe and the US. These include Credit Suisse, the London Stock Exchange, Nordic bourse (stock exchange) operator OMX, Nasdaq, British supermarket chain J Sainsbury, and Warsaw engineering firm European Aeronautic, Defense & Space Co.
In addition to investments in Europe and the US, QIA seeks investment opportunities in Asia, particularly China, Japan, Korea, and Vietnam. According to Kenneth Shen, head of strategic and private equity at the QIA, “Historically, we’ve been heavily invested in the US and Europe, and we’ve been underweight in Asia. We’re going to increase our investments there, though not necessarily at the expense of Europe or the United States.”24
Saudi Arabia
Unlike most of the other oil exporting countries, Saudi Arabia has not established an oil fund. Instead, the kingdom’s portfolio of foreign assets is held by the central bank and the Saudi Arabian Monetary Authority (SAMA). SAMA’s investment policy has been conservative and largely limited to investment in bonds, especially US Treasuries and shares.25
However, SAMA Vice-Governor Muhammad al-Jasser announced that the kingdom will launch its first oil fund in the near future.26 Furthermore, the growing tendency of oil funds in fellow Persian Gulf states to make more-aggressive investments is likely to be echoed in Riyadh, so SAMA likely will diversify its portfolio and begin to pursue riskier, higher-return investments.
Gulf investors bolder
From a brief review of oil funds in the Persian Gulf, several conclusions can be drawn:
- The sustained high oil prices since the early 2000s have substantially added to oil exporters’ financial assets and convinced them to set up oil funds (Table 1).
- There is more diversification in investment paths compared with the 1970s and early 1980s. Persian Gulf investors increasingly are moving away from safe but low-return bonds to invest in alternative assets such as real estate, private equity funds, and hedge funds.
- More money is remaining within the broad Middle East, driven by several developments:
- The growing privatization of public enterprises in several Middle Eastern countries has created more investment opportunities.
- The proliferation of Islamic financial institutions has lured capital that previously would have been invested abroad.
- The concern about political backlash against Muslims and Arabs following terrorist attacks in the US and Europe has prompted oil funds and Muslim-Arab investors in general to invest in other assets outside of Europe and the US.
- Investments are diversified outside the US, although the US has the bulk of them. Europe continues to be a prime recipient, while Asia, particularly China and India, is emerging as an attractive target for both economic and political reasons.
- Most oil funds lack a clear comprehensive investment strategy, and transparency and accountability practices differ substantially from one fund to another, concluded a recent International Monetary Fund (IMF) study.27 This conclusion applies to most oil funds in the Persian Gulf. Very little official information is made public on their investment portfolios. Most of their financial deals are pursued with little, if any, scrutiny by the public or legislative bodies.
Norway’s pension fund
Norway’s well-developed economy has greatly benefited from the utilization of its hydrocarbon resources. Table 2 shows the 30-year North Sea oil prices that have contributed to its prosperity. The country holds the largest proved oil reserves in Western Europe and in 2008 remains the world’s fourth largest oil exporter after Saudi Arabia, Russia, and the UAE.
The Norwegian government in 1990 created the State Petroleum Fund (SPF), which was activated in 1995 following the achievement of overall budget surpluses.
In 2005 the SPF was renamed the Government Pension Fund (GPF). It was set up to manage Norway’s petroleum wealth in a sustainable manner and to meet many of its rising pension and health expenditures. In 2008 the fund is valued at more than $350 billion.28
The ministry of finance delegated operational management of the fund to Norges Bank, a unit of the Norwegian Central Bank. A management agreement, which further defines the relationship between the ministry of finance as delegating authority and Norges Bank as operational manager, also has been drawn up.29
In managing the fund’s assets Norges Bank has adopted a high-return, moderate-risk investment strategy. Thus, the fund’s portfolio is divided into 54.6% fixed income and 45.4% equities.30 Return on investment has averaged 4.6% since the fund’s inception.31
Transparency
Norway’s oil fund differs from those of most other countries in its strong emphasis on ethics and transparency. In November 2004 the government appointed the Council on Ethics, which established ethical guidelines for the fund. Comprehensive accounts and data on the fund’s operations are easily available.
Quarterly and annual reports provide detailed information on portfolio valuation, composition, returns, management, transfers to and from the budget, market trends, risk exposure, and administrative costs.
Kristin Halvorsen, minister of finance, emphasizes the significance of transparency, saying, “We believe transparency is a key tool in building trust. It helps build public support and trust in the management of Norway’s petroleum wealth. Openness about the fund’s management can contribute to stable financial markets and exert a disciplinary pressure on managers.”32
Russian Federation fund
Since the late 1990s Russia has emerged as one of the world’s primary energy suppliers. Currently Russia is the world’s largest natural gas producer and exporter and the world’s second largest oil producer and exporter after Saudi Arabia. The prominent, growing role of the energy sector in Russia’s economy raises concern about the most effective way to utilize the massive oil revenues that have accumulated since the early 2000s.
Addressing these concerns, the Russian government established a Stabilization Fund (SF) in 2004.
Three important developments laid the groundwork for the SF’s creation:
- Although the state sold several major oil companies to oligarchs under Boris Yeltsin’s administration, in Vladimir Putin’s administration, the main emphasis was on restoring state power and ownership in energy assetsthe so-called renationalization or deprivatization.
- The more-assertive Putin administration enjoyed substantial oil revenues due to soaring and sustained oil prices.
- Several Russian economists voiced concern that the deepening dependence on energy wealth is transforming the country into a mere raw material provider for the rest of the world and is hurting the competitiveness of other economic industries, particularly manufacturing, raising the threat of Dutch disease.
Following lengthy debates, the law establishing the SF was approved in December 2003 to resolve the challenge of how to manage the expanding pool of oil revenues.33 Several sources contribute to the fund’s revenues: a portion of the export duty on oil and petroleum products, part of the revenues from the severance tax on mineral resources, and a portion of the federal budget surplus at the beginning of the fiscal year. The law also set the base price at $20/bbl for Urals oil, above which revenues start accumulating in the SF. The fund is managed by the ministry of finance. In 2008, the SF’s assets are about $157 billion.34
Investment strategy
From its inception SF ignited an intense debate on the appropriate investment strategy. Business leaders and regional governors spoke out in favor of boosting pensions and social benefits. They also called for utilizing the SF’s assets for various investment projects and distributing them in the form of development loans. Former Prime Ministers Mikhail Fradkov and Yevgeny Primakov were prominent promoters of this approach.
On the other side, Deputy Prime Minister and Finance Minister Alexei Kudrin and many other economists opposed using the SF’s assets in investment schemes, arguing that such spending would produce inflation, leading ultimately to the evaporation of the fund itself. Instead, they called for using the surplus revenues for early repayment of Russia’s foreign debt.
IMF supported the second approach, suggesting that saving oil revenues has served Russia well “as it has prevented even stronger inflationary pressures and much faster real ruble appreciation.”35 Putin and President-elect Dmitry Medvedev expressed similar approval.36
In his budget address in March 2007, Putin called for transforming the SF into two fundsa reserve fund and a national welfare fund.37 This split took place in February 2008. The former will perform the same function as the old SF, accumulating energy profits and holding them in conservative investments to cushion the economy if energy prices fall. The latter will be used to fund shortfalls in the pension system and invest in riskier assets with higher returns such as corporate bonds and shares.38
Policy implications
Analysts have not reached a consensus on the benefits of setting up the oil funds that have proliferated in recent years. Few studies empirically test the efficacy of such funds. A March 2007 IMF study concludes that oil funds have “limited fiscal benefits and are largely redundant.”
Oil funds have not been effective in addressing volatile exchange rates, it said. Instead, IMF suggests that any benefits could be achieved by “improving fiscal policy and administration.”39 To ensure sound allocation of oil revenues, oil fund managers should integrate the funds with the budget, enhance coordination of the funds’ operations with those of the rest of the economy, adopt a clear and comprehensive asset-management strategy, and establish mechanisms to ensure transparency and accountability, IMF said.40
A mounting anxiety
Equally important, oil funds’ investments abroad have ignited a mounting anxiety over their commercial and strategic impact. Oil funds, as the Economist put it, are being “set up as the next villains of international finance.”41 The soaring of cross-border investment represents a potential structural shift in the global economy. Accordingly, economists and policymakers seek to assess the implications of this shift and the appropriate response.
The challenge Western financial markets face is how to ensure the steady inflow of badly needed investment while simultaneously addressing popular skepticism that these investments might be driven by strategic interests. Such skepticism might strengthen calls for protectionism and imposing restrictions on capital flows from oil funds and could weaken the overall global financial markets.
Addressing fears
To address this challenge, finance ministers from major industrial countriesBritain, Canada, France, Germany, Italy, Japan, and the USmet in October 2007 and called for an international code of best practices by government-owned cross-border investments, requiring greater disclosure of assets and actions. They also called on the World Bank and IMF to participate in setting rules.42
The Committee on Foreign Investment in the United States (CFIUS) is an interagency committee chaired by the US treasury secretary. It seeks to serve US investment policy through reviews that protect national security while maintaining the credibility of the nation’s open investment policy. It also seeks to preserve the confidence of foreign investors and of American investors abroad that they will not be subject to retaliatory discrimination.43
In the US, the Foreign Investment and National Security Act of 2007 became effective in October 2007. It mandates additional scrutiny and higher-level clearances for transactions involving foreign government-owned investments. American officials say they have not seen any evidence of oil funds’ seeking political leverage through investments.
In March, Abu Dhabi, Singapore, and the US reached an agreement on policy principles that would govern their funds’ investments. The agreement guidelines stress that investment decisions should be based solely on commercial grounds. They also call for greater information disclosure, strong governance structure, and the creation of a predictable investment framework with no protectionist barriers and no discrimination among foreign investors.
The European Union faces the same challengeshow to welcome foreign investments from government-owned funds without compromising national security. Europeans are particularly concerned about Russia’s use of its oil fund and government-owned oil and natural gas companies to buy pipelines and other energy infrastructure in Europe.
Unlike Washington, however, Brussels does not have a government mechanism such as CFIUS for scrutinizing foreign investments. The European Commission (EC) takes the view that among the EU and its 27 member states, comprehensive rules governing the activities of foreign investors already exist.
The EC prefers a voluntary approach rather than statutory tactics. In 2008 the commission proposed that each fund wanting to invest would be asked to disclose the size and source of its assets, the currency composition of its investments, and the regulation and oversight under which it operates in its home country. It would also be asked to provide public disclosure of its relationship with government authorities.44
The commission has not ruled out enacting a law to enforce these rules, however. EC Pres. Jose Manuel Barroso said, “We will not propose European legislation, though we reserve the right to do so if we cannot achieve transparency through voluntary means.”45
Resistance to oversight
Calls to regulate these state-run investments will intensify, but a voluntary “code of conduct” instead of rigid and comprehensive rules could encourage foreign investment and smooth the progress of financial cooperation in the global economy.
Many funds, however, resist the pressure to embrace even a voluntary code of best practices on a number of grounds: First, they say, such a code seems unnecessary in light of their track records of abstaining from political interference. Second, the West’s demand for regulation is said to be “hypocritical in light of the failure to regulate European and American banks and hedge funds.”46 Third, Western economies already have mechanisms to regulate foreign investments and prevent abuse by investors.
Anxieties are based less on actions than on suspicion amid such secrecy. Unlike Norway and a few other oil exporters, most oil funds continue to exhibit a low level of transparency and accountability. Despite this secrecy, no credible evidence exists that oil funds have pursued political or strategic gains.
Excessive regulations and a broad politicized hostility to oil funds would come at a high pricefurther deepening mistrust among oil exporters and Western markets. Instead, confidence-building measures and a free flow of capital, trade, and technology would benefit both sides and the overall global financial markets.
References
References are available from the author upon request.
The author
Gawdat G. Bahgat ([email protected]) is professor of political science and director of the Center for Middle Eastern Studies at Indiana University of Pennsylvania in Indiana, Pa. He has taught at the university for the past 11 years and has held his current position since 1997. He also has taught political science and Middle East studies at American University in Cairo, the University of North Florida in Jacksonville, and Florida State University in Tallahassee. Bahgat has written and published six books and monographs on politics in the Persian Gulf and Caspian Sea and has written more than 100 articles and book reviews on security, weapons of mass destruction, terrorism, energy, ethnic and religious conflicts, Islamic revival, and American foreign policy. His professional areas of expertise encompass the Middle East, Persian Gulf, Russia, China, Central Asia, and the Caucasus. His latest book is Proliferation of Nuclear Weapons in the Middle East (2007). Bahgat earned his PhD in political science at Florida State University in 1991 and holds an MA in Middle Eastern studies from American University in Cairo (1985) and a BA in political science at Cairo University (1977).
