November 19, 2007	Monday	Ziqa’ad 08, 1428

For capital-starved developing countries such as Pakistan the world of finance for decades was a simple one. They were not creditworthy to tap large amounts of capital from the international financial markets. They had to rely, instead, on official finance which came from either rich countries such as the United States or development and financial institutions such as the World Bank and the International Monetary Fund.

Official development finance was available mostly for the public sector. This fitted in nicely with the development approach then adopted by most of the developing world.

For about two decades, from the mid ‘eighties until the early 2000s, privatisation was the favoured policy with most development experts. Under The Washington Consensus – the set of policies developed and advocated by the institutions based in the American capital – developing countries were advised to place the assets they had acquired or created in the hands of the private sector. This reversed the thinking in many parts of the developing world.

For about four prior decades developing countries around the globe had followed the approach that called for the expansion of the public sector. This was to be done for the reason that private entrepreneurs could not be trusted to meet the social objectives of most of the regimes in the developing world. Having gained independence from colonial rule, the first generation of leaders was strongly committed to the rapid alleviation of poverty and a more even distribution of income. These objectives, they believed, could only be met if the state occupied the commanding heights of the economy.

The most articulate exponent of this approach was Jawaharlal Nehru, the first prime minister of India. He did not trust the private sector to work for the poor and disadvantaged. That could only be done by the state which needed to control the economy so that it could work for the benefit of the country’s poor citizenry.

One way of expanding the size of the state was to invest heavily in the enterprises that the government would establish and own. This was the strategy pursued by India for several decades. The other was to nationalise the assets developed and held by the private sector. This approach was adopted in the early 1970s by Zulfikar Ali Bhutto, Pakistan’s first elected prime minister.

In either case by the mid-eighties, the state in most of the developing world had become large. It had also become very inefficient and corrupt. That was certainly the case in Pakistan as the companies owned by the government discarded good economic and financial practices in favour of political patronage. But pressures against the continuation of this approach began to build up.

When the increase in the price of oil in the ‘seventies plunged a number of developing countries in deep crisis, and brought in institutions such as the IMF and the World Bank to provide assistance, there was a significant change in the orientation of development thinking and practice. The Washington based development experts told the developing countries to reverse course, shrink the public sector, and encourage the private sector to take the lead. Privatisation of state assets was actively pursued. Pakistan joined the countries that vigorously attempted to implement this policy.

However, over the last few years, the public sector has remerged as an important economic player in an entirely different and unexpected way. This has happened with the establishment of what are generally called the “sovereign wealth funds”. These funds have been created by the governments that have cash to spare and their purpose is to invest where ever good opportunities exist and create an economic base from which the future generations can draw incomes.

There are two classes of countries that have incomes well beyond the current needs of the economies. They are the miracle economies of East Asia that have accumulated large foreign currency reserves by exporting much more than they need to export.

To take one example: China now has foreign exchange reserves of well over one trillion dollars. The other set of countries are the oil exporters who have earned large windfall incomes because of the sharp increase in the price of oil in the early 2000s.

The rise in the price of oil shows no signs of coming to a stop: in mid- November it passed $ 90 a barrel in New York and seemed on track to reach $100. The transfer of incomes from the oil consuming to oil exporting continues to take place unabated.

The sovereign fund as a saving and investment devise was first established by Norway, Kuwait and Singapore. Since their establishment, these funds have been created by a number of other countries. According to a recent estimate, sovereign funds control $2.8 trillion of assets, a significant amount. It is equivalent to 1.3 per cent of the world’s stock of financial assets (stocks, bonds and bank deposits).

The Abu Dhabi Investment Authority with $875 billion in assets is now the largest sovereign fund, followed by the Government Pension Fund of Norway with $350 billion, Kuwait Investment Authority with $213 billion, government of Singapore Investment Corporation with $208 billion, and the State Foreign Exchange Investment Corporation of China also with $200 billion.

Saudi Arabia has created not one government vehicle for investment but several. Their combined assets are valued at $300 billion. The investments made by these and other sovereign funds have brought the public sector into the business of asset ownership. See the table.)

Table: Sovereign Wealth Funds

There are some interesting approaches being followed by these funds that will have significant consequences in the future, especially for a capital deficit country such as Pakistan. The first is that they have not limited their activities to the countries in which they are located. They have not even concentrated their operations in the resource hungry developing world. Most of them have ventured far into the field and have begun to acquire assets in rich countries. This has created an interesting dynamics, particularly in the United States.

The suspicion with which the Muslim world is currently perceived in the United States has created a dilemma for the policy makers in Washington. Should they resist the steady encroachment into their economy by the funds owned by the governments in the Muslim world? If that were to be done – as was the case when a public sector company in Dubai attempted to acquire several port operations in the United States – what impact would it have on the flow of external capital into the country.

One thing that the US shares with several parts of the developing world, including countries such as Pakistan, is that it needs foreign capital to finance its large trade deficit. It cannot afford to discourage the entry of foreign capital. It will, therefore, need to follow a balanced approach which would satisfy the security concerns of those who don’t want to see some of the sensitive assets acquired by those they don’t trust with the enormous and increasing appetite for external capital flows.

Nonetheless, the US apprehension about surrendering some of its precious economic assets to foreign investors has made the latter look at other destinations including Pakistan.

In coming to countries such as Pakistan, the sovereign funds are concentrating on a few sectors of the economy. They are not spreading their wealth widely. In Pakistan they have tended to favour two sectors: banking and telecommunications. Access to both became easy after the aggressive pursuit of privatisation by the administration of President Pervez Musharraf. As a consequence, much of the banking sector and the sector of communications are now controlled by foreign investors, many of them linked with the sovereign funds in the Middle East and East Asia.

What are the public policy implications of the rapid rise of sovereign wealth funds and their willingness to provide large sums of money to countries such as Pakistan? Four areas of policy need to be kept under constant watch by the policy makers in Islamabad.

One, the concentration of foreign investors in a few sectors poses security risks that can not be minimised even if the sources of funds are from the countries that are, at this time, friendly with Pakistan.

Second, by investing in banking and telecommunication assets Pakistan has to deal with contingent liabilities. The returns to the investors from these investments are in rupees which will need to be converted into foreign currency for repatriation. This will create a problem especially when there is already a yawning trade deficit that has to be financed.

Third, the arrival of foreign ownership in two of the most important sectors in the service economy will retard the development of domestic entrepreneurship in these areas. That cannot be a welcome development.

Fourth, and finally, foreigners can not be expected to advance the social objectives of the countries in which they are operating. Pakistan needs to deal with the issues pertaining to poverty alleviation and poor income distribution. How will these be pursued when important parts of the economy are in foreign hands?