Sovereign wealth funds are emerging as important players in global financial markets. As the funds become more popular, they may affect asset prices, develop into a significant source of fees for asset-management firms and help reshape the balance of power in the world economy.

According to some market observers, SWFs are the next big thing. Although there is no strict definition of the term, it essentially refers to government-created investment vehicles that have been spawned by growing surpluses of central bank reserves. Demographic pressures in various countries have made authorities invest the reserves rather than just sit on them.

In the years ahead, the assets devoted to the vehicles are expected to grow substantially. A recent report by Merrill Lynch & Co. Inc. says assets controlled by SWFs will grow by about US$1.2 trillion a year over the next four years, taking them to slightly less than US$8 trillion by 2011 from US$1.9 trillion today. Looking further ahead, Morgan Stanley Capital International Inc. sees SWFs’ assets growing to US$12 trillion by 2015. For context, Merrill puts the current capitalization of the global equities market at $24.2 trillion and the non-sovereign debt market at $13.4 trillion.

At present, analysts can only estimate the true size of the world’s SWFs. Although Merrill values the segment at slightly less than $2 trillion, MSCI had estimated it at $2.5 trillion earlier this year.

The problem with making accurate assessments of the size of the sector is a lack of consistency and transparency in how the funds’ assets are reported. While some are reasonably transparent, funds created in parts of the Middle East and other regions are less so. “At present, SWFs have very low transparency,” the MSCI report notes, “and they will probably remain opaque for the foreseeable future.”

It means both present values and assumptions about future growth have to be taken with a grain of salt. Nevertheless, analysts are confident the funds are growing into increasingly important components of the global financial market.

MSCI predicts the as-sets in SWFs worldwide will surpass the assets held as reserves by the world’s central banks by the end of 2011. It also foresees a shift in the source of SWF assets. Many existing funds have been built on windfall profits from energy resources. MSCI estimates about two-thirds of SWFs’ assets are derived from oil and gas exports. However, it expects non-energy driven funds, such as those from China, to become bigger players in the years ahead, accounting for half of SWF assets by 2015.

The growing importance of SWFs — and the fact that many are based in politically sensitive regions such as China, the Middle East and Russia — is also attracting the attention of policy-makers. There is some fear that as the government-controlled funds become increasingly pressed for places to invest their vast hoards of cash, they will start buying up an ever-larger share of foreign companies, giving rise to the threat of increasing protectionism.

It’s an issue to be studied by the Competition Policy Review Panel, founded earlier this year by the Canadian government. The panel, headed by former BCE Inc. chairman Lynton “Red” Wilson, is reviewing competition and foreign investment rules, including whether Canada’s investment policy framework needs to be updated “to address national security concerns, as well as issues related to acquisitions by large foreign state-owned enterprises with non-commercial objectives.” In late October, the panel released a consultation paper, and its report is expected by June 30, 2008.

Canada isn’t the only government contemplating the issues. SWFs were on the agenda at the latest meeting of the G-7 finance ministers and central bank governors in late October. A statement after the meeting indicates the assembled ministers and central bankers see SWFs as “increasingly important participants in the international financial system.” The statement further notes economies can benefit from being open to SWF investment flows, but adds that there is a need for best practices for SWFs in areas such as institutional structure, risk management, transparency and accountability: “For recipients of government-controlled investments, we think it is important to build on principles such as non-discrimination, transparency and predictability.”

The G-7 statement also calls on various international institutions, including the International Monetary Fund, the World Bank and the Organization for Economic Co-operation and Development, to examine the is-sues. It also pledges to “explore opportunities to enhance investment flows between our economies and continue our discussions on mutual recognition of comparable securities regimes.”

@page_break@For some, the issue is shaping into a philosophical clash. A report from Moody’s In-vestors Service Inc. observes that recent meetings of central bankers, finance ministers and other players have been marked by a fundamental shift in the balance of power among developed and emerging nations. The increasingly powerful emerging-market players are becoming more assertive, Moody’s notes, as seen in China’s resistance to Western demands that it devalue its currency and the Middle Eastern countries’ refusal to curtail the activities of their SWFs, saying this is nothing short of colonialism.

“It is difficult to see why there should be specific rules imposed on such loosely defined investment vehicles, unless the problem relates to their fundamental nature, i.e., that they are government-owned,” the Moody’s report says. “However, some of the world’s new wealth centres are unapologetic about their forms of governance and the role played by their public authorities, and the debate is becoming awkwardly political or ‘civilizational’.”

The MSCI report says the West’s concerns about the role of SWFs may be overblown. “There has been much political angst about SWFs,” it observes in a recent note, insisting it doesn’t make sense to single out SWFs as distinct from other investment vehicles such as sovereign pension funds, private pension funds and hedge funds.

And the developed world may not be able to afford to snub SWFs. A recent paper by Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, argues global demographics dictate that emerging-market investors will be needed to support the developed world’s aging population.

“If developed nations keep their capital markets open, if they do not make the mistake of establishing trade barriers, growth in the developing world will offset the slowing of economies in the developed world and future equity prices will be supported,” Siegel writes. “But if globalization fails, if protectionist sentiment rises and developed nations place restrictions on the flow of capital, there will not be enough buyers in the developed world to support the trillions of dollars of stocks and bonds that will be on the market during the next two decades. Keeping the world open to trade is critical not only for developing countries but also for the well-being of the developed world.”

What the developed world will have to get used to, therefore, is much more foreign ownership. Siegel forecasts that by the middle of this century, developing countries of the world will own most of the world’s capital: “I predict that by 2050, the great multinational corporations of today will be owned mostly by Asian investors.”

Currently, 92.7% of the world’s equity capital is in the developed world. By 2050, Siegel predicts, the developed nations’ share will be down to 33%, with China holding 20.3% of the world’s equity capital and the U.S. holding only 16.6%.

Such a shift will probably not occur without political resistance, and that has some analysts concerned about protectionism. Others fear SWFs could become a source of instability in the market, crowding out private capital flows.

MSCI argues that the opposite is true. Because SWFs may have a much longer investment horizon and higher tolerance for earnings volatility, they will weigh against investors’ herd behaviour, stabilizing markets. By adding liquidity, they should also help improve overall market efficiency.

“Regulators and politicians should recognize these positive characteristics of SWFs,” argues the MSCI report, “and weigh them against the concerns about governance, transparency and security.”

Indeed, analysts forecast that SWFs will probably have a supportive effect on equities in the years ahead. MSCI predicts increasing flows into equities at the expense of bonds: “We estimate the emergence of SWFs could push up ‘safe’ bond yields over the next 10 years by 30-40 [basis points] and reduce the equity risk premium by 80-110 bps.”

Merrill echoes those conclusions, saying it foresees a massive reallocation to riskier assets, with the share of SWFs in riskier global assets doubling or tripling by 2011. “This should support riskier assets relative to safer assets and put upward pressure on bond yields; it is unclear, however, whether prices of riskier assets would rise per se,” the Merrill report says. “It also supports the corporate sector at the expense of governments, supports global liquidity and removes one pillar of the private-equity industry.”

To pursue the shift into riskier assets, Merrill expects SWFs to turn to external portfolio managers, both to avoid protectionism and because it is expensive to set up internal management capabilities.

As SWFs become an important source of assets for money managers, Merrill foresees a shift of US$1.5 trillion-US$3 trillion into global asset management over the next five years, generating an estimated US$4 billion-US$8 billion in fees.

Financial services firms may also have an inside track into markets in which SWFs are based. Merrill sees this as another chip SWFs have to play — assuaging protectionist fears by offering access to their lucrative markets. Examples are already in play: China Investment Corp.’s US$3-billion stake in private-equity firm Blackstone Group, and Bear Stearns Cos. Inc. selling a stake to China’s CITIC Securities Co. Ltd.

The Moody’s report says the rise of emerging-market power could be an important inflection point for the world economy. The dramas will play out for years to come. IE