by Edwin M. Truman, Peterson Institute for International Economics
Op-ed in Handelsblatt
September 18, 2007
English version © Peterson Institute for International Economics.
The rapid globalization of international finance is a salient feature of the early 21st century. The phenomenon has been promoted by technological innovation, substantial elimination of restrictions on international capital flows, and the conviction that those flows reflect individual decisions of multiple private investors responding to market forces.
Globalization of international finance is not without its detractors. They argue that it contributes unnecessarily to economic and financial volatility, further impoverishes the poor, and principally benefits the wealthy. Now those detractors have a new target: sovereign wealth funds.
Are sovereign wealth funds a serious new challenge to the global economy? They are not new, but their scope and scale are expanding rapidly. Consequently, they are a source of uncertainty and potential instability for the countries sponsoring the funds as well as for the international financial system. Policymakers no longer can ignore them.
Sovereign wealth funds are designated pools of international (for the most part) assets owned and managed directly or indirectly by governments to achieve various economic and financial objectives. Those objectives include economic stabilization, income maximization, and intergenerational wealth transfers.
In my research, I have identified 32 active funds in 29 countries. Their international assets total about $2 trillion. Five countries have funds with holdings of more than $100 billion. The first fund was created by Kiribati in 1956 to manage revenues from its phosphate deposits. A number were established in the mid-1970s. Ten have emerged since 2000. The vast majority are linked to the accumulation of revenues from the exportation of resources, in particular energy, including Norway’s Government Pension Fund-Global and the funds managed by the Kuwait Investment Authority.
Several large sovereign wealth funds are not based on revenues from resources including Singapore’s Government of Singapore Investment Corporation and Temasek Holdings and China’s Central Huijin Investment Company and proposed state foreign exchange investment company. Moreover, since 2001 foreign exchange reserves have increased more than 150 percent, and holdings of nonindustrial countries have doubled.
At least half of the more than $5 trillion in foreign exchange reserves are in excess of the holders’ immediate needs. Governments, including in Western Europe, are understandably interested in generating higher returns on those assets than are offered by traditional investments in bank deposits and short-term government paper. These facts are leading governments to manage their reserves more actively and, in some cases, to transfer them to sovereign wealth funds.
In addition, many countries have substantial holdings of external assets that are not included in reserves or sovereign wealth funds. The Saudi Arabian Monetary Authority reports more than $200 billion in nonreserve holdings of international assets on and off its balance sheet. Government owned companies, banks, and other investment vehicles also manage significant international assets.
A conservative estimate of all crossborder government financial assets is $8 trillion, and the total is more likely closer to $10 trillion. The lower figure is 12 percent of all international financial assets, and since 2001 the share has doubled at least. For many individual countries the government share of crossborder assets is more than 60 percent. Large concentrated holdings of international assets owned and managed by governments conflict with the conventional notion of a market-based international financial system dominated by individual decision making by many investors.
Sovereign wealth funds and other substantial government holdings of international assets pose many challenges for the citizens and governments of the owners of the assets, for the citizens and governments of the countries in which they are invested, and for the smooth functioning of international financial markets. Many of those challenges flow from the fact that the operations of sovereign wealth funds are often obscure. They lack structures that are transparent and management processes that are domestically and internationally accountable. This contributes importantly to additional potential concerns.
Chief among those concerns is the risk that the assets will be managed to pursue political objectives such as leverage over neighboring countries. Closely related is the concern that the objective may be to increase the economic power of national champions, turning them into world champions and promoting crony capitalism globally. An energy producer does not diversify its portfolio by investing in offshore energy projects.
The often murky motives of governments in managing their international investments, in turn, may contribute to political confrontation. Conflicts may be fueled by national security concerns. In some cases, they may be justified, but in others they are manifestations of economic nationalism. Whatever the motivation, a potential consequence is an increase in financial protectionism in host countries and associated counter measures in home countries that carry with them a much greater potential to destabilize the global economic and financial system than does trade protectionism. The reason is that there are no generally accepted rules of the game in this area or a multilateral institution like the World Trade Organization to enforce those rules and, thereby, to cause countries to think twice before embracing protectionism.
The scope and scale of sovereign wealth funds also increase the potential for deliberate or accidental financial disruption. In a period of global financial turmoil such as we have witnessed in the past few months, can the managers of those funds be counted upon to act in a stabilizing manner or are they more likely to be contributors to it?
Another concern is the potential for conflicts of interest on the part of private firms that compete for investments by sovereign wealth funds or for mandates to manage portions of those funds. While acting as agents of the governments, are they likely to exploit inside information to gain financial advantage? Can they be counted upon to adhere to international norms when those norms are not embraced by the ultimate investors?
A final concern is that crossborder government investments may be mismanaged by the governments themselves. A number of countries, for example, Ecuador and Nigeria, have established sovereign wealth funds only to squander and liquidate their funds in response to political pressures that are at best short-term and at worst corrupt. This type of evolution appears to be underway in Venezuela. Such behavior has economic and financial consequences not only for the citizens of the country itself but also for the stability of the global economy.
To date many of these concerns are hypothetical, but they are nonetheless real. Moreover, sovereign wealth funds or their equivalent are here to stay. Their share in total crossborder investment is likely to increase substantially in part because of incentives to diversify holdings, including those faced by government-managed pension funds in an aging global population, and in part because global imbalances are not likely to shrink rapidly and commodity prices are likely to remain elevated.
What should be done to minimize the potential for deliberate or self-inflicted collateral damage associated with these trends? The international investment activities of governments have achieved a sufficient scale and scope that a strong case can be made for a collective effort to establish an internationally agreed set of best practices to guide the management by governments of their crossborder investments. They should apply to the gamut of such activities, starting with traditional foreign exchange reserves and extending to stabilization funds, nonrenewable resource funds, sovereign wealth funds, government-owned or controlled entities such as pension funds, investment holding companies, and miscellaneous international assets.
Best practice in the management of government crossborder investments by sovereign wealth funds and similar entities should cover four basic elements.
First, best practice should establish clearly stated policy objectives for the international investment activities of governments. Their fiscal treatment should be specified, including how the funds are incorporated into the investment portfolio, and how the earnings on and/or principal of the investments should be spent or redeployed. It makes little economic or political sense to etch these features in stone because a rigid structure can be more easily overturned by political forces. At the same time, principles of sound public policy suggest that the structure should not be modified frequently or capriciously.
Second, best practice should clearly establish the roles of the government and of the managers of the investment mechanism. How are the policies set? Who executes polices? What types of assets should be included in portfolios? How should the assets be managed? Where does the responsibility lie for their management lie what risk management strategies should be followed? Accountability arrangements should be in place at each stage of the process.
To the extent that the international investments are anything other than passive investments in financial assets (bank deposits, government notes and bonds, or nonvoting shares), guidelines for corporate governance should be established along with responsibility for ensuring compliance. Some countries may also want to have a process to deal with ethical issues, for example, types of activities or circumstances in which investments should not be made, as has been done for Norway’s Government Pension Fund-Global.
Third, the operations of the investment mechanisms should be as transparent as possible. Transparency promotes horizontal accountability among the interested parties and stakeholders (domestic and international) as well as vertical accountability within the policy process. In practice, transparency should involve at least annual reports and preferably quarterly reports. It would be desirable to have substantial quantitative disclosure about investment strategies, results, the nature and location of actual investments, and the holders of investment mandates. The activities of investment mechanisms should be subject to published, independent audits.
Finally, depending on the type of mechanism, its size, and the scope of its activities, behavioral guidelines for its management should be established . For example, they should cover the scale and rapidity with which the entity adjusts its portfolio. They might also create the presumption of consultation with the relevant countries with respect to the allocation and reallocation among assets denominated in different currencies or located in different countries.
The agreed set of best practices should be applied flexibly. Countries in different circumstances may want to make modifications, but adjustments should be justified by reference to the overall framework.
The basic case for the proposed approach rests on two principal considerations: accountability and protection.
Accountability is important to the citizens of the home country as well as to the citizens of the host country (who may distrust the motives of the foreign government). It is also important to the international financial community in general, including participants in global financial markets who generally value financial stability.
Protection is important for the managers of the investment entity. The broader the investment strategy of the entity in terms of the risk-reward tradeoff, the more likely it is that losses will be made from time to time along with higher overall returns. The aim is to prevent misunderstandings or worse, domestically as well as internationally. Other participants in financial markets also want protection; they do not want to be sideswiped by the actions of governments.
Finally, the government of the home country wants to have maximum freedom to pursue profitable investment opportunities without the risk of capricious intervention by the government or broader political forces in the host country. At the same time, the government of the home country must realize that sovereignty offers limited protection for its activities outside its own borders. Similarly, the government of the host country should embrace the principle of national treatment that is applied loosely today with respect to most but not all crossborder investments. In other words the objective should be protection but not financial protectionism.
The challenge of sovereign wealth funds can be met best by the governments of the countries that own them acting together to establish a set of best practices for the management of their funds and similar holdings. Governments might solicit the technical advice of an international organization such as the World Bank or International Monetary Fund, which have extensive experience in many of the economic and financial issues involved. Standards for best practice require a substantial consensus of support if they are to be effective. That support must be by the relevant governments acting in their self interests. Nevertheless, these are not purely sovereign decisions. Bad decisions can become a source of economic, financial, or political conflict. The global community, private as well as public, has an interest in how sovereign wealth funds are integrated into the global financial system.
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