Policy must combat rising protectionism

Sovereign wealth funds (SWFs) have garnered significant attention recently due in large part to their rapid growth in number and size. Concerns about these developments are giving rise to protectionist pressures in the US, Europe and Asia. While greater vigilance is appropriate, many of these concerns have been exaggerated, often due to lack of understanding about SWFs and how they invest.

SWFs, as large pools of government-controlled capital invested cross-border in private markets, do raise legitimate policy questions. But it is necessary to consider carefully the implications of their growth before prescribing a policy response.

What is a SWF?

There is no universally accepted definition of a SWF. However, a SWF can be thought of as a government investment vehicle funded by foreign exchange assets, and which manages those assets separately from official reserves. SWFs generally fall into two categories: commodity funds, which are established through commodity exports, either owned or taxed by the government; and non-commodity funds, which are typically established through transfers of assets from official foreign exchange reserves. Large balance of payments surpluses have enabled non-commodity exporting countries to transfer ‘excess’ foreign exchange reserves to standalone funds.

It is important to distinguish SWFs from other sources of sovereign investment. There are similarities, but also important differences. International reserves are external assets that are readily available to and controlled by finance ministries and central banks for direct financing of international payment imbalances. Reserves are by definition invested in highly liquid and marketable securities.

Public pension funds are investment vehicles funded with assets set aside to meet the government’s future entitlement obligations to its citizens. They differ from SWFs in that they are denominated and funded in local currency, usually with relatively low exposure to foreign assets.

State-owned enterprises can be defined as enterprises where the state has significant control, through full, majority, or significant minority ownership. State-owned enterprises may undertake foreign direct investment and occasional portfolio investments, but the majority of state-owned enterprises do not invest abroad.

Why all the attention?

Sovereign wealth funds are not new. They have been around since the 1950s. However, the recent rapid growth in their number and size has created more interest, and raised some concerns.

In 2000, there were about 20 SWFs managing total assets of several hundred billion dollars. Twenty new funds have been created since 2000, more than half of them since 2005. Those funds currently manage total assets of between $1900bn and $2900bn, and their assets are projected to grow in the region of $10,000bn to $15,000bn by 2015.

Total SWF assets are only a fraction of the estimated $190,000bn in global financial assets or the roughly $55,000bn managed by private institutional investors. But SWF assets are currently larger than the total assets under management by either hedge funds or private equity funds, and are projected to grow at a much faster pace.

SWFs are already large enough to be systemically important, and their growth clearly has implications for the international financial system.

The SWF effect

There are a number of issues to consider. First, does the creation of a SWF perpetuate undesirable underlying macroeconomic and financial policies? It is critical that countries do not use SWFs that are non-commodity funds as a mechanism to accumulate more foreign assets as a way of avoiding exchange rate appreciation.

Second, what is the potential impact of SWFs on financial stability? SWFs are in principle long-term, stable investors who can provide liquidity to the markets. They are typically not highly leveraged and are unlikely to liquidate positions rapidly. To date, they have not caused financial market disruption. However, they do represent large, concentrated and often non-transparent positions in financial markets.

Third, transactions involving SWFs, like other types of foreign investment, may give rise to legitimate national security concerns. As with any form of foreign investment, recipient countries of SWF investment need to ensure that any national security concerns are addressed, while continuing to maintain open economies – and the benefits they bring. In the US and Europe, and around the globe, the biggest policy challenge is to resist the new wave of protectionist pressures that have emerged.

Policy considerations

SWFs and recipient countries of SWF investment share responsibility for promoting financial stability and working to maintain a global open investment climate. As a basis for policy discussion, we have considered two sets of principles: one for recipient countries of SWF investment and another for SWFs themselves.

SWFs should invest commercially, not politically. They should convey institutional integrity through transparent investment policies, strong risk management systems, governance structures and internal controls. They should compete fairly with the private sector and respect host country rules by complying with regulatory and disclosure requirements.

For their part, recipient countries of SWF investment should strive to avoid protectionism. They should uphold fair and transparent investment frameworks. Within these frameworks, recipient countries should not direct SWFs on how to invest their money and should treat investors equally.

The US is staying true to these principles. The Committee on Foreign Investment in the United States (CFIUS) conducts its reviews of foreign investments in a manner that both safeguards national security and reinforces the long-standing US commitment to open investment. CFIUS focuses solely on genuine national security concerns, not broader economic or national interests.

This year’s reform law that made improvements to the CFIUS process reinforces the US commitment to open investment, which president George W Bush reaffirmed in his Open Economies Statement on May 10, 2007. Foreign investment strengthens the US economy by improving productivity, creating good jobs and spurring healthy competition.

It is in the US’s interest to be open to market-driven investments even if other countries are not. Therefore, the principle of reciprocity – reciprocal openness to investment – is not on the list of principles despite the fact that many countries with SWFs are themselves far too closed to foreign investment. However, the reality is that investment policy decisions are made in a broader political context in which reciprocity is taken into account.

Best practices

Taking the principles above into consideration, the US has suggested developing two sets of voluntary best practices. It has proposed that the Organisation for Economic Co-operation and Development (OECD), based on its extensive work on promoting open investment regimes, should identify best practices for countries that receive foreign government-controlled investment.

In parallel, it is proposed that the International Monetary Fund (IMF), with support from the World Bank, should help to develop best practices for SWFs, building on existing best practices for foreign exchange reserve management. These would provide guidance, reduce any potential systemic risk and help to demonstrate to critics that sovereign wealth funds can continue to be responsible, constructive participants in global markets.

The US Treasury Department has taken the lead by initiating extensive bilateral and multilateral outreach to SWFs. In October 2007, US Treasury secretary Henry Paulson hosted a G-7 dinner with finance ministers and heads of SWFs from eight countries: China, Kuwait, Norway, Russia, Saudi Arabia, Singapore, South Korea and the United Arab Emirates. The participants expressed a common interest in maintaining open investment and promoting financial stability.

The next day, the International Monetary and Financial Committee, a ministerial-level advisory committee to the IMF, tasked the IMF with identifying best practices for SWFs. The OECD, meanwhile, is taking forward its own work on best practices for recipient countries’ investment regimes.

The increase in SWF cross-border investment is projected to continue, as sustained high commodity prices and accumulation of official reserves continue to fuel SWF growth. Given that, it is imperative to have a policy discussion now to combat rising protectionism and ensure continued global financial stability.

So far, it appears that SWFs are seeking to generate higher investment returns without generating political controversy. If SWFs continue on this path, investing on an economic – not political – basis, the US and other countries will continue to benefit from keeping their borders open to SWF investment.

A longer version of this article appears in Foreign Affairs magazine.

Robert M Kimmitt is deputy secretary of the US Treasury.