By Megan Bowman & George Gilligan

SYDNEY: 1 August 2013 - There are significant impacts of the increasing global prevalence of state capital. Pools of state capital are difficult to define in a prescriptive sense and powerful state actors that do not welcome scrutiny are often active in state capital investment. This has created difficulties not only in measuring the scale of state capital activity and its effects, but also in evaluating regulatory responses. Recent CLMR research by Gilligan, Bowman & O’Brien sheds light on these issues. It examines the global impact of state capital by analyzing state capital trends and potential implications for Australia in the context of diminishing global demand for resources and growing competition globally for foreign investment.

1.          State Capital: Definitions and Motivations

State Capitalism embodies a form of hybrid capitalism in which a government actively promotes economic growth by picking and/or backing national champions while also using capitalist tools to this end, such as stock market listing and external financing and subjecting those champions to global competition. This is to be contrasted with Liberal Capitalism, in which regulation of market actors is low interventionist or ‘light touch’. The comparison might best be conceptualized as the visible hand of the government massaging economic prosperity versus the invisible hand of the free market system (see e.g. The Economist Debate in 2012).

Nonetheless, over history and in the present, both developed and developing nations can boast state capital actors. The main groups of state capital actors or ‘state pools of capital’ comprise Sovereign Wealth Funds (SWFs) and State-Owned Enterprises (SOEs).

Sovereign Wealth Funds (SWFs)

We classify SWFs into three main types or sub-grouping, namely Reserve Investment Corporations (RICs), Commodity Stabilization Funds (CSFs), and Sovereign Pension Funds (SPFs).

RICs enable countries to self-insure via investment of foreign exchange reserves. Countries with large stockpiles of foreign reserves can invest their assets in higher yielding securities to diversify their portfolios by using a RIC as opposed to their central bank, which is less fit for this purpose.

In contrast, CSFs reflect a burgeoning awareness by policymakers that there is utility in converting physical assets ‘in the ground’ into financial assets for the long-term. They help to restore a certain amount of stability and autonomy to resource-rich countries that are vulnerable to global economy change. In so doing, CSFs are also a means of securing inter-generational equity by managing finite resources for future generations in an uncertain world.

Finally, SPFs are a policy response to looming social welfare costs of a nation’s aging population. They embody a politically palatable alternative to increasing industry superannuation fund contributions or cutting benefits. Unlike private pensions or very large pension funds run by governments but where the assets are actually owned by the beneficiaries (e.g. CalPERS), SPFs have no designated claimants on the available assets. In this way SPFs, like RICs, can facilitate inter-generational as well as intra-generational benefit.

The International Monetary Fund (IMF) recognizes that SWFs are a heterogeneous group with five main objectives: (i) stabilization funds whose primary objective is to help insulate the economy from the effects of commodity (usually oil) price swings; (ii) savings funds for future generations that mitigate the effects of Dutch disease; (iii) reserve investment corporations; (iv) development funds; and (v) contingent pension reserve funds which provide for unspecified pension liabilities on the government’s balance sheet. Using the IMF categorizations, we can analyze where and why several large SWFs fit into which categories, belying their motivations. Some examples follow.

Norway is primarily a resource dependent economy (petroleum) and therefore vulnerable to changes in the global market for commodities. Its Government Pension Fund - Global fits within category (ii) as it was established to mitigate Dutch disease and the ‘curse’ of resource wealth that leads to currency appreciation, declining manufacturing, substantial restructuring costs and accompanying unemployment. It also fits within category (v) given its second purpose is to ‘facilitate government savings to finance rising public pension expenditures’.

Similarly, the Australian Future Fund, established through the privatization of Telstra, straddles categories (ii) and (v) as a tool for managing commitments to future generations via a state-run pension fund structure designed to meet pension liabilities for public sector employees.

Similar motivations prompted the creation of SWFs (in the form of SPFs) in Ireland and New Zealand that invest assets in equities for long-term social welfare benefit.

In contrast, category (iii) SWFs have become prevalent in Asia over the past decade. This can be traced to lessons derived from the liquidity dislocation found in the 1997 Asian financial crisis, with China and South Korea establishing SWFs similar to that of Singapore and Hong Kong in the form of Reserve Investment Corporations. The main objectives of these RICs are threefold: self-insurance in the event of another crisis; stabilizing foreign exchange rates to mitigate another crisis; and wealth augmentation via the investment of accumulated (‘hoarded’) assets in less liquid securities for higher returns.

State-Owned Enterprises (SOEs)

In contrast, SOEs are widely deemed to be state-owned operating companies rather than investment mechanisms like SWFs. The OECD has classified SOEs as a commercial enterprise in which the state has control through total, majority or significant minority ownership. Instead of making portfolio or indirect investments like SWFs, SOEs tend to make commercially strategic direct investments, such as mergers and acquisitions (M&A). However, unlike private corporations, SOEs are administratively and financially controlled by a state entity. So, in a jurisdiction with significant levels of state capital such as China, central or local government will be a controlling shareholder of an SOE, whereas in a liberal capital jurisdiction such as the US or Australia, that controlling entity would more likely be private institutional investment.

SOEs are traditionally conceived as national corporate champions purpose-built to fulfill government investment mandate abroad. Accordingly, they have tended to invest in areas of nation-wide priority: natural resources, utilities, telecommunication services. However, there is growing debate about the extent to which SOE investment decisions are being exercised independently of their sovereign sponsor given that: multiple external parties are involved in SOE investment decision-making abroad, including domestic consultants, corporate partners and financiers; and SOEs are evincing commercial motivations by making capital investments to secure stable and high-quality supplies of natural resources, mergers and acquisitions to acquire new brands and technology, accessing new markets, and exporting home brands.

2.         State Capital in the Global Economy

The increasing investment role of SWFs and SOEs reflect changing relationships in the global economy, especially the economic rise of the BRIC countries (Brazil, Russia, India and China). As the strategic economic and political importance of these countries increases, so does the need to understand how international regulatory infrastructures might evolve in order to accommodate such changes.

This rapidly rising pool of state investment capital is part of the story of the decoupling effects of contemporary fundamental changes in East:West capital flows with attendant global imbalances regarding the management of exchange rates and reserves. Specifically, a changing of the economic guard is currently underway. China has emerged to rival the US as the most important economy in the world. Jorgensen and Vu predict that, by 2020, China will have replaced the US as the world’s largest economy and the US share of global GDP is expected to fall. Changes are not confined merely to China and the US because there are also regional forces at work between the G7 (Canada, France, Germany, Italy, Japan, UK and US) and the Asia 7 (China, Hong Kong, India, Indonesia, Singapore, South Korea and Taiwan).

On these projections, China is likely to be the dominant global economic power before the middle of the century. This constitutes a dramatic shift in economic power; and history demonstrates that these economic shifts influence change in other arenas such as foreign policy, strategic alliances and regulation in multi-lateral contexts. This new international financial environment and geo-political reality, in which existing and future state-related pools of capital are likely to become increasingly proactive and influential, will contribute to financial markets and the broader economy globally and domestically in Australia.

Jurisdictions that might previously have slotted comfortably into the category of recipients of state capital have become more active state capital investment actors themselves. Importantly, emerging economies have significant state capital investment actors. For example, China, the UAE, Saudi Arabia, Kuwait, Hong Kong, Russia and Qatar are amongst the countries that possess the ten largest SWFs by assets under management at March 2013.

As reported previously on the CLMR portal by CLMR Director Justin O'Brien, there is concern by recipient countries about the political (rather than commercial) motives of SWF- and SOE-directed foreign direct investment (FDI). Four key sectors are considered ‘strategic’ or germane to a recipient’s national security and national interest: energy and power; telecommunications; materials (including non-renewable resources); and high technology (with potential military use). Interestingly, the majority of government-related investment deals in ‘sectors of strategic concern’ tend to be undertaken by SOEs and not SWFs. From 1990 – 2009, 63% of the largest 50 SOE foreign investment deals took place in the four sectors of strategic concern and only 10% of the 50 top deals were made by SWFs in those sectors. Specifically, a growing number of nations that hoard foreign currency, such as China, are seeking broader portfolios in which to invest it, rather than putting these reserves in low-risk/low-return US Treasury bonds.

Thus we suggest that SWFs are a state capital actor of less concern than SOEs. However, little differentiation at this granular level is evidenced by policymakers. Australia is a partial exception. It calibrated the policy governing state-capital investment in the aftermath of a contested raid of the Rio Tinto share register in London.

Generally, however, the impacts of state capital investment activity tend to be viewed in the aggregate whereby the combined impact of (a) a trend towards investment diversification and risk, and (b) investment in ‘areas of strategic concern’, carries overall implications for cross-border foreign exchange liquidity.

To this extent, OECD ‘soft law’ documents, such as the OECD Code of Liberalisation of Capital Movements of 1961 and OECD Declaration on International Investment and Multinational Enterprises of 1976, advance a general principle of non-discrimination whereby foreign investment should be treated in the same way as domestic investment. Nonetheless, the OECD also recognizes that governments are entitled to protect their national security under international law. Foreign investment may threaten national interests or security if it is for non-commercial (i.e. political) purposes in sensitive areas, such as defence or information technology. The OECD Council on Recipient Country Investment Policies relating to National Security has recommended that, while nations may impose restrictions on foreign investment for national security reasons, those measures ought to be applied in a way that ensures the regime is predictable, transparent, proportionate and accountable. This commitment was recently affirmed by G20 Leaders in June 2013. This ensures that the national security clause of the OECD investment instruments does not become an ‘escape clause’ for nationalism or protectionism in the sectors concerned.

3.         Implications for Australia

Based on the data, we make four key findings:

(1) The largest (by value) acquiring nations in Australian assets over time have been Singapore, China and the UAE; 

(2) Sectoral targets of investment by state capital actors (specifically SOE-led investment) are in the ‘strategic’ areas telecommunications, energy & power, and materials (over 60%);

(3) Energy and power state-led capital investments dominate the Australian FDI landscape, which reflects its relative abundance of natural resources. This has given Australia a comparative advantage as an investment destination in this sector to date;

(4) SOE-led investments dominate the Sino-Australian investment landscape. According to KPMG, investments valued US$5million and above comprised 116 deals by volume of which nearly 80% were made by 45 SOEs; and over 95% of deal value involved SOEs during this same timeframe. According to the Rhodium Group, these percentages are notably higher than average Chinese SOE-led investment deal value figures for the US (65%) and Europe (72%).

The Australian Federal Treasurer has ultimate responsibility for decision-making under Australia’s foreign investment regime and has a broad discretion to decline any foreign investment applications that he or she considers to be against the national interest. The Treasurer receives recommendations on specific foreign investment proposals from the Foreign Investment Review Board (FIRB) which is an advisory not policymaking body that administers the Foreign Acquisitions and Takeover Act 1975 (Cth) (FATA) and Australia’s Foreign Investment Policy (AFIP). Once a review is triggered, chief consideration is given by FIRB to whether the proposed investment will be contrary to the national interest.

Under the current AFIP any 'direct investment' in land or business by a 'foreign government investor' (such as a SOE or SWF) is subject to review by FIRB. An entity is considered to be a ‘foreign government investor’ if a foreign government has a 15% or more interest in it. ‘Direct investment’ comprises an investment of an interest of 10% or more; however, AFIP was amended on 4 March 2013 such that a ‘direct’ investment may now be less than 10% where the 'acquiring foreign government investor is building a strategic stake in the target, or can use that investment to influence or control the target'. Additional Guidelines for Foreign Government Investment Proposals were released in 2008 that set out six factors to which the government will have regard when assessing an investment proposal by a SWF or SOE specifically. These factors are:the degree to which a state actor is independent from their government sponsor and is observing common standards of business behaviour; the degree to which an investment may impede competition in the relevant industry/sector, impact on revenue or other policies, impact on the Australian economy, broader community, and/or national security. The Guidelines purported to ‘enhance the transparency of Australia’s foreign investment screening regime’. However, no guidance was given by the government regarding how these six factors might impact upon consideration of the national interest, or the extent to which government needs to be satisfied about each of them in order to approve an investment proposal.

The phrase ‘national interest’ is not legislatively defined despite the clear importance of knowing what it is in order to protect it. Indeed, under AFIP, cases are decided on an individual basis in the context of the following issues: national security; competition; impact on the economy and community; Australian government policies such as tax; and the character of the investor. In reality, there are many factors that can help to shape the ‘national interest’ including scale and types of FDI, the prevailing economic climate especially the national fiscal budgetary position, broader political influences, and on occasion unfortunately, populism.

Arguably, therefore, the above policy developments indicate shifting ground with a more restrictive and less consistent approach toward state capital FDI vis à vis other forms of FDI capital.

According to FIRB Annual Reports, rejection of foreign investment applications is not statistically a common event in Australia. However  (see Commonwealth of Australia 2012), Australia’s shifting formulation and application of the ‘national interest’ test and its differential policy development for state capital FDI vis à vis other forms of FDI capital may undermine its OECD commitment to transparency and predictability.

Yet can Australia afford to restrict state capital due to shifting policy on ‘national interest’ particularly in the context of diminishing demand for resources and growing competition for FDI?

As previously reported by CLMR colleague George Gilligan, the release in May 2013 of the report Energy in Australia by the Commonwealth Government’s Bureau of Resources and Energy Economics (BREE) fuelled the debate about whether Australia’s so-called ‘resources boom’ has peaked and that the value of committed and potential projects is expected to fall to $25 billion in 2018.

To this end, there is some disparity between domestic jurisdictions within Australia regarding their approach to and the impacts of state capital. In particular, the WA government welcomes foreign investment in mining and minerals resources, particularly from China. WA officials differentiate between ‘stock market miners’ and ‘real miners’ when facilitating inward investment. Given the decrease in commodities’ value, many stock market miners are not activating their exploration rights to actualize extraction and hence royalty accumulation. However, Chinese investors are activating their rights and therefore making real mining investments that manifest real dollars to help perpetuate the state’s long-term agenda. Indeed, the WA-China Memorandum of Understanding on Promotion of Investment Cooperation sends a very clear message that this Australian state is open for Chinese investment. 

The disparity between regulatory approaches at federal and state levels in Australia has led some commentators to speculate whether the nation is operating a 3-speed economy. That is, Tasmania and South Australia may well be moving in reverse (to a recession); WA and Queensland appear to be moving ahead due to intrinsic abundance; and New South Wales and Victoria are sitting somewhere in the middle.

However, this outlook can be questioned based on quarterly ABS figures released on 5 June 2013, Australia’s GDP grew 0.6% in the quarter from December 2012. However, based on ‘state final demand’, the partial measure of state economic growth contained in the national accounts: state final demand in Queensland grew 0.6%, as did Victoria (0.8%) and NSW (0.4%); South Australian state final demand fell 0.3% (the third quarterly fall in a row) and Tasmania fell 1.1%; and WA’s state final demand fell by 3.9%, seasonally adjusted, which is the biggest fall in the country and came on top of a 0.9% decline in the previous quarter. While WA has averaged annual growth rates of almost 8% over the past decade, these state final demand statistics have wiped 0.6 percentage points off the Australian economy in the past year.

While we need to be cautious with causality, arguably the decline in state final demand for WA can be correlated to the declining demand for natural resources. In June 2013, then-Treasurer Mr. Wayne Swan stated that ‘WA is a demonstration of the transition that we are making which is amplified in WA because mining is such a greater proportion of the economy’.

4.         Conclusion

The global activities of both SOEs and SWFs evidence a trend towards investment diversification and a growing desire and capacity for risk. Furthermore, we are currently witnessing the occurrence of a global economic ‘changing of the guard’ as the investment symbiosis between recipient-acquirer nations evolves.

This has important implications for FDI into Australia given that Australia’s ‘post-boom’ economic well-being is increasingly intertwined with neighboring jurisdictions in the Asian region. The prospect of future impacts of state capital in Australia remains uncertain in light of diminishing global demand for resources and shifting domestic policy regarding government-directed foreign actors. What is certain, however, is that Australia will remain a net importer of capital in a world in which competition for that investment dollar is increasing from many countries. Yet it remains to be seen how much the twin pressures of increased FDI competition and declining demand for Australian resources impact upon the realpolitik of Australia’s foreign investment regulatory regime at national and state levels.

Regardless, it is clear that the global economic center of gravity is moving progressively eastward as China develops ever-deepening international linkages. Indeed, the chief economist of HSBC, Stephen King, has described the strategic integration by China of global trading nodes (largely financed through pools of state capital) as the re-emergence of the Southern Silk Road (King 2011). Arguably, concerns about the increasing prevalence and potentially political nature of SWFs and SOEs obscures the real issue of contention which is ‘how do we deal with China?’ Masking the nature of that real debate will not help to resolve it.

We acknowledge the financial support of the Centre for International Finance and Regulation (for project Enter the Dragon: Foreign Direct Investment and Capital Markets, E002), which is funded by the Commonwealth of Australia and NSW State Government and other consortium members (see www.cifr.edu.au).