What’s the actual dynamic via which sovereign wealth funds

[hereafter SWFs] pool and move their funds?

Let’s start with the example of the Chinese [the China Investment Corporation, hereafter CIC]. The Chinese government had to issue bonds, which were sold out in three tranches [December 2007]. The payment on those bonds is 5.5%, which puts incredible pressure on the fund managers to meet that rate and do at least a point above in order to make a profit to cover their administrative costs. So the goal for these guys to make somewhere around an 8% return rate. To put that into perspective, the average return rate for Wall Street over a 50-year period is 6%.

Can the US government, which has become so reliant upon foreign capital investment flows, afford to be too strict in demanding greater transparency from SWFs?

One of the leading opponents to the Dubai Ports deal (2007) was Senator Chuck Schumer. He went after the deal by saying the Bush administration was willing to bless this development despite the fact that terrorist funding was probably coming through Abu Dhabi…and was willing to do everything he could to kill the deal before it transpired. He was remarkably successful. Fast-forward to 2009. Senator Schumer in his roles as both fundraiser for the Democratic National Committee and a senator from New York, suddenly becomes an ardent proponent of SWFs investing in the then-failing US financial industry, to the extent that he gets up and says, “I’m willing to push forward on this because it could potentially save 20,000 jobs.” What he didn’t say was, “20,000 jobs in my district.” So you get this precarious balancing act done by US politicians who on one hand are willing to try the need to look at US national security, and on the other hand to meet their constituents’ desires and sacrifice all in order to do that. You have that problem sitting out there as background.

In 2007 they pushed through the Foreign Investment and National Security Act [hereafter FINSA], which essentially tried to add teeth to the process by which we review foreign investment in the US. The legal folks tried to declare that you cannot single out SWFs from any other foreign group trying to invest in the US [to assuage protectionist sentiments without essentially legislating economic isolationism]. So you cannot just blatantly discriminate against these guys. That means the process is subject to review by the Committee on Foreign Investment in the United States process[hereafter CFIUS, 1975]. In order to understand this process you have to go back to FINSA and find the “cut lines”. There was a very stimulating debate in Congress…as to what determined control. The bottom line is, control only really transpires (regardless of who’s investing) at the 10% cut rate. That means you as a foreign national investor don’t subject yourself to a FINSA investigation until you get to 10%. If you think that matters to foreign corporations and SWFs, you’re right. If you go back and look at SWF investment in US financial institutions, they stop at 9.9%. So these guys have figured out how to avoid the legal ramifications and the politics involved in our protectionist system. If you get into the FINSA process, there’s a sequence of reviews and investigations that include the US intelligence community, and then entities from one of various cabinet-level officials supposedly appointed in direct connection with the industry involved. That process happens very rarely. In my book I did the math; if you look at the FIMSA investigation processes between 1996 and 2006, and the number of mergers and acquisitions that occur within the same time period, your probability of being struck by lightning is higher than being subjected to a CFIUS investigation.

To put this into a little more perspective, consider what constitutes majority ownership within any major US corporate entity. Let’s use General Electric [GE] as a case in point. If you look at the largest shareholder in GE today, that individual—or corporate entity—owns 4.4% of GE. I guarantee that they have a significant voice on the board of directors when you own that much of that corporation. So you know you’d have to get close to 10% to have real sway in the way the company’s processes are operated.

You point out that Congress only really got involved in ’08-’09 when SWFs—particularly Chinese ones—began buying up stakes in large US financial institutions. You chronicle an attempt to distribute the inflows of foreign capital to other segments of US industry, particularly manufacturing and infrastructure. What’s to stop SWFs from continuing to buy up whole segments of US industry?

Nothing stops them from doing that. The idea you have in your book about the Abu Dhabi Investment Authority [hereafter ADIA] buying into the taxi industry here is spot on the mark. There’s nothing to stop them from doing that, as long as they don’t pass the 10% point. And then again, you’re looking at what the political entity will want to focus on, versus what the commercial entity will want to focus on. To be frank, you can expect SWFs to do exactly what you describe in your book, because they are diversifying their holdings as would any good investor. The model that we think they’re following is the one used at both Harvard and Yale. And good luck figuring out exactly where Harvard and Yale have sunk their money at this point.

How does one audit a SWF?

You hope they’ll provide transparency within their annual reports. That’s the best you can do. The Norwegians are very good about this. You can go online [now] and they’ll give you about 60 pages, in about eight-point font, as to where they’ve invested their money and what percentage of a specific corporate entity they’ve purchased as a result. They and New Zealand are pretty much the only ones who do that. When you look at the Norwegian annual report you’re talking somewhere around 250 pages; ADIA just put out their first one, and it’s about 30 pages, mostly pictures. The process of trying to winnow through is even more difficult today because SWFs are now sinking their money into private equity hedge funds, and letting them do the investing, so now you really have no feel as to where it’s going.

So you don’t know where the money’s going. Is there any way to know where it’s coming from?

Only if there are wire transfers that allow you to pick it up in the US banking system.

Given the example of the BCCI case some years back, which exposed the limits of US criminal investigations into financial crimes originating in foreign countries, it seems as though if you think there’s a stream of dirty money coming into the US via a SWF, there’s really nothing we can do to stop it, is there?

No there isn’t. Because at this point you don’t know where all the investment streams are going into. For instance, ADIA could have dirty money flowing in that gets mixed in with clean money, and all of it can be invested where you choose. That leaves you in a precarious situation. Unlike, say, blood diamonds, where you could essentially put a flag on the origin of these stones, you can’t do that with the corporate funding that you’re talking about here.

The case of Istithmar, which required a bailout by its sovereign parent (Dubai) shows that SWFs are at the risk of going broke just like anybody else, though on a significantly larger scale. What are the ramifications of systemic SWF failure?

Let’s put this in the simplest format possible. Because we spend beyond our means, we need to borrow money from someplace. That’s as true for the US consumer as it is for the US government. Money is a scarce commodity, unless you’re living in Weimar Germany and going to the grocery store with a wheelbarrow full of cash. The government limits what it prints to avoid inflation. If we have SWF failure, and they stop investing in the US, we will have increasing competition between consumers and the government to borrow money to pay our bills. The ultimate result is a rise in interest rates for the US consumer of 100-150 basis points. Instead of getting a car loan at 6%, you’ll be paying 9%. And that will have a stultifying effect on any effort to revive our economy.

ERIC C. ANDERSON, formerly a senior analyst with the Defense Intelligence Agency, is an Air Force reservist and national security consultant, as well as a teacher at the National Defense Intelligence College. He is the author of Take the Money and Run: Sovereign Wealth Funds and the Demise of American Prosperity (Praeger Security International, 2009).