June 20, 2016

Smart(er) Money in the Gulf

State-owned funds like Mubadala in the United Arab Emirates are consolidating their operations.

The fiscal retrenchment unfolding across the Gulf Cooperation Council since the advent of lower oil prices in late 2014 is bound to have effects on the deployment of Gulf capital, particularly via sovereign wealth funds and state-owned investments. Some evidence of these changes is beginning to appear in three particular shifts.

First, Gulf states are reconfiguring how their state-directed funds place capital, both domestically and internationally, while at the same time strategically restructuring some state funds and holding groups that have underperformed. There is a movement toward perceived safer haven investments, with the United States as a main beneficiary.

Second, there is a pattern of targeted foreign investment with political as well as economic goals, much of it in ownership stakes of blue-chip and high visibility equities. Partnerships are increasing, in infrastructure with Russia and Korea, as well as in investments in icon stocks in the West, like Uber and IAG SA (parent company of British Airways).

Third, there is new evidence of a streamlining or sell-off of sovereign wealth assets, which are put to use to fund new acquisitions and government expenditure. The downturn in oil prices over nearly two years is creating some efficiencies and encouraging a more strategic use of government resources. In effect, Gulf money is trying to get smarter.

State-owned funds like the Abu Dhabi Investment Authority (ADIA), the Abu Dhabi Investment Council (ADIC), and Mubadala in the United Arab Emirates are consolidating their operations, according to sources within these entities, so that they are not duplicating efforts. Other holding groups, like TAQA, are working through a necessary financial restructuring, while subsidiaries under the International Petroleum Investment Company (IPIC) continue to struggle with management and legal issues. This is not a time of Gulf government spending sprees; in fact, there is a concerted effort (see the Gulf Economic Barometer) across the oil and gas producing states of the region to curtail spending, decrease state subsidies of fuel, water, and electricity, and to seek external financing via loans and bond issues to bridge budget deficits.

However, there is a parallel initiative to broaden financial influence through state vehicles investing in publicly-held companies based in New York or London, as well as infrastructure funds and projects of potential non-Western Gulf allies. The growing power of state investment funds, especially those of the restructured and well-financed Public Investment Fund in Saudi Arabia post-Aramco public offering, could herald a new generation of activist investors. Currently, the PIF targets domestic investments, but its recent 38 percent stake in Korea’s Posco Engineering & Construction Co. and a $10 billion partnership with the Russian Direct Investment Fund both point to a shift in orientation, and a willingness to forge business relationships that can also facilitate political goals.

When there might be an Aramco initial public offering, and how much that partial share sale might generate to fund the PIF are still very much issues of speculation. It is also worth noting that the Aramco IPO is similar in strategy to how Russia has managed past sales of stakes in Rosneft. Currently, Russia is considering a sell-off of a large stake, nearly 20 percent, of Rosneft OJSC to China and/or India. Making partners out of customers is a good way to ensure market demand.

Partnerships via ownership stakes in key companies and financial institutions of allies is an excellent bargaining tool, one that the older sovereign wealth funds, like ADIA and the Kuwait Investment Authority (KIA), have used for decades. From their inception, funds like ADIA, the Qatar Investment Authority (QIA), the Saudi Arabian Monetary Agency (SAMA), and KIA have invested heavily in U.S. and European stock markets, with significant ownership stakes in financial services, airlines, retail, and technology companies. The recipients of these investments are often the backbone of capitalist, liberal democracies: companies like Barclays, Citigroup, Deutsche Bank, Volkswagen, and Credit Suisse. Gulf state funds are also placing capital in massive real estate holdings. The recent Saudi PIF investment in Uber is one example of a continued Gulf state fund choosing high profile or prestige investments, but also an example of a newer trend that tries to match policy objectives at home (investment in transportation and increasing mobility, notionally for some women) with a financial strategy that bets on established market winners.

The diversification strategies of the Gulf states rely on the placement of capital earned from oil and gas wealth into international markets. This continues to be a revenue model behind plans like Vision 2030 in Saudi Arabia. As the funds’ capacity to generate revenue becomes more central to state development strategies, there is a parallel effort to attract capital into the GCC, through public-private partnerships, specifically investment in health care, financial technology services (fintech), power generation, and defense manufacturing. Economic interdependence, and the political reach of Gulf capital, should increase.

QIA, Qatar’s sovereign wealth fund, recently increased its holdings to 15 percent of IAG SA, marking the second time the Qatari government-owned fund has upped its ownership in the last few months. The European Commission limits foreign ownership of European Union-based airlines at 49 percent, but the regulation could be loosening. The world of finance knows few borders and the reach of the Arab Gulf states (and their sizable state-owned investment funds) continues to increase even in times of economic constraints.

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Even with these high profile placements, there is a move to liquidate some positions. According to Reuters, Invesco has found that Middle East sovereign wealth funds liquidated or cancelled investments worth about 7 percent of their total assets in 2015. The targets of Gulf sovereign wealth funds are also shifting. The United States is a key and increasingly attractive destination, particularly in U.S. infrastructure investment and real estate allocations. Emerging market allocations by Gulf sovereign wealth funds are considerably smaller and diminished from the last two years. While it is early to call for a massive Gulf sovereign wealth fund sell-off, it is clear that there is a repositioning taking place.

The smarter money aims to benefit Gulf state diversification and fiscal tightening, but it could also prove an opportunity for U.S. and European investors. There is room for increased economic cooperation between Saudi Arabia and the United States – a moment in which numerous sectors, beyond energy and defense, might find interested partners and the possibility for long-term collaboration through public-private partnerships and investment in education, health care, financial services, and legal services. U.S.-GCC political ties may be strained, but any veiled threat of a sell-off of U.S. Treasury notes is as much a risk to the dollar-tied currency regime of Saudi Arabia as it is to the value of U.S. debt, but the underlying economic interdependence is really what is at stake.

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What Gulf states do with their economic power and the intensity of their integration into international capital markets could help shape the nature of global economic interdependence of 21st century finance. The Arab Gulf states understand this. Right now, the Arab Gulf states are doing well at economic statecraft. They are playing a long game – anticipating partnerships and placing investments where they generate revenue and secure political access. With smarter money, even in a time of diminished fiscal revenue, they could become formidable investors.

Market Watch is a weekly blog conceived by AGSIW Senior Resident Scholar Karen E. Young seeking to provide insights from the crossroads of Gulf politics and finance.