Higher and Mightier

China is putting its surplus billions to work, in what is effectively the official state hedge fund. Beijing is set to inject some $200 billion into a new sovereign-wealth fund for investment abroad in assets including stocks, real estate and commodities—anything that earns the government greater returns than the money its central bank has parked in U.S. Treasury bills. And that's just the opening gambit. Stephen Green, chief economist for Standard Chartered Bank in Shanghai, expects China to channel an additional $100 billion or more into the fund in 2008, with further infusions if all goes well in year one. Initially, he says, in-house fund managers will tread softly. "[But] once they feel they have the hang of it, they'll get more adventurous. At this point it's toes in the water."

Not all those toes are Chinese, either. Over the past three years the list of sovereign funds has grown, and now includes Russia, South Korea, Australia and many others. Already such funds control an estimated $2.5 trillion in assets, some $1 trillion more than all hedge funds combined, and Morgan Stanley recently estimated that they could balloon to $12 trillion within a decade to become the dominant force in global finance.

The money comes mainly from oil-exporting nations flush with petrodollars, and East Asian governments struggling to cope with massive trade surpluses. A third driver—national pension funds—is gaining power. Most funds have the same goal: "higher returns earned by taking greater risk," says Kim Young, head of planning for the Korea Investment Corp. (KIC) in Seoul, which launched its sovereign-wealth fund in 2005.

Sovereign wealth represents a powerful new player. In the past, governments were satisfied with the nominal returns that their central banks delivered, which left hedge and mutual funds to battle among themselves in emerging markets, new technology sectors or whatever else looked hot. With sovereign money now in the fray, many analysts expect further asset inflation in stocks, commodities and real estate. And because these funds fly flags and serve strategic national interests, every move they make will attract scrutiny, much as China's state enterprises do whenever they acquire a foreign rival. "Political risk is one challenge," says Grace Ng, a Hong Kong-based Greater China economist at JPMorgan, in reference to China's new fund.

The lack of transparency at virtually every sovereign-wealth fund (Norway's being the lone exception) only heightens suspicions. Last week investment guru Nicholas Vardy called them "secret societies that make hedge funds yesterday's news" and warned that tracking their activities is "nearly impossible." IMF chief economist Simon Johnson recently described sovereign funds as "black boxes," adding: "We don't know what happens [inside them], and we should worry about that." His concerns include the possibility of rogue trading, currency speculation and excessive lending leading to a sovereign default.

Singapore is the model for sovereign-wealth management. Its Government of Singapore Investment Corp. (GIC), which oversees the city-state's reserves, and the Finance Ministry's investment arm, Temasek, together control more than $180 billion in assets. By comparison, Goldman Sachs Asset Management is valued at $33 billion and Blackstone, the largest private equity fund, has $80 billion in assets under management. The GIC acts as a national pension fund, but has earned roughly double the 4 percent that central banks traditionally do when managing foreign reserves. Temasek, which began an aggressive acquisition drive in Asia four years ago, has earned average annual returns of 18 percent since its inception in 1974. But it has also ruffled nationalist feathers abroad, most notably in Thailand, where its purchase of the media conglomerate Shin Corp. from the country's then prime minister precipitated a political crisis that led to Thaksin Shinawatra's ouster in a bloodless coup last September.