Sovereign wealth funds (SWFs) are state-run investment pools that most governments utilise to execute purchases of foreign assets. Although they have been making headlines due to their increasingly growing influence of late, SWFs have actually been around for decades.

The Kuwait General Reserve Fund and Abu Dhabi Investment Authority (ADIA) were established in 1960 and 1976 respectively. ADIA has investments totalling roughly $800 billion.

Among the latest entrants is China Investment Corporation (CIC), the newly-created mainland sovereign wealth fund, with an initial capital base of $200 billion. With $300 billion in its petroleum reserve fund, Norway is another very large investor. What is quite significant that sovereign wealth funds are coming to the rescue global banks and giant investment companies.

Severe write-downs relating to US sub-prime debt have sharply raised concerns over the global banks’ underlying fundamentals and earnings growth prospects Global banks are now entering a period of much slower growth as giants like Citi, UBS and HSBC recover from the adverse effects of the mortgage crisis. But what is significant is the manner in which SWFs have bailed out these banking giants. These institutions have witnessed a massive capital injection from investors in Asia and the GCC.

Oil-rich, state-controlled SWFs are getting bigger and bolder. According to estimates the fourteen largest SWFs now control assets of more than $2,300 billion, a sum expected to grow rapidly to over $13 trillion in ten years. The growth in assets of SWFs is being fuelled by high energy prices (Norway, GCC countries) and current account surpluses (China) in manufactured goods.

The rise of SWFs symbolises the growing financial might of the emerging world and their significance is derived from the fact that their purpose is to trade dollar monetary assets (from oil receipts, for example) for real investments, resulting in “asset diversification”. For instance, overseas investment in UK gilts reached a record level of $34.60 billion in the second quarter of this year. If overseas central banks and SWFs are responsible for this surge in investment, many believe these investors are not going away any time soon as currency and asset diversification programmes continue.

SWFs are sophisticated, smart investors. Late last year, ADIA announced that it will buy a near five per cent stake in Citigroup through convertible preferred(s). Each equity unit is convertible into a varying amount of Citi shares at different prices over the next 2.5-4 years and carries an 11 per cent payment rate.

Despite their buying power, SWFs do not necessarily rush into deals as their focus is on generating stellar returns. In November last year, Delta 2 announced that it would not proceed with its 600p per share offer for Sainsbury. The Qatari-backed investment vehicle decided to walk away from the deal as the extra cost of capital would not allow it to achieve the return it was seeking, a private equity-like performance of 15-20 per cent per year.

This withdrawal indicates that SWFs are more disciplined and sophisticated than some suspect. Perhaps, through this decision, Qatar was sending a deliberate signal that future sellers of assets should not view it as an “easy” buyer.

Today China, Russia, the Middle East and other nations are seeking to buy real assets and stakes in real assets as an alternative to holding a never-ending supply of depreciating dollars and bonds. At current prices, oil exports of the GCC countries amount to $610 billion per year. With $44 trillion in oil wealth underground, to be converted into financial wealth, the current GCC SWF holdings of $1.50 trillion of financial wealth reflect a fraction of this multi-generational oil-to-equities transformation.

As Asian countries and Gulf states get richer, they will certainly have the financial muscle to exert more influence. Western policy-makers have concerns that such influence may be channelled in a reckless way. To safeguard their interests and ward-off “some dark geopolitical strategy” in their investments, proponents of protectionist policy want greater transparency in the strategy and governance of SWFs.

Large transactions like ADIA’s $7.50 billion acquisition of Citi or China SWF’s 10 per cent purchase of Blackstone will continue to materialise as SWFs recycle proceeds from oil and goods exports into higher return investments. The trouble of course is that the size, growth, origins and interests of SWFs mean they want to invest on a scale and in a way that the US and Europe find threatening and to which they seem to be increasingly hostile. Western governments are concerned about whether business will be conducted on purely commercial terms or will a more strategic interest prevail.

Although some concerns may be valid, eventually economic dynamics of the equation will dominate and determine whether western institutions, like Citi want cash injections from SWFs to save themselves. The stark choice for policy makers is to either hinder or facilitate the inevitable acquisition of international assets by SWFs in the years ahead.