The Rise of Sovereign Wealth Funds: Impacts on US Foreign Policy and Economic Interests

BY: TESTIMONY OF EDWIN M. TRUMAN SENIOR FELLOW, PETERSON INSTITUTE

The broadest definition of a sovereign wealth fund (SWF) is a collection of government-owned or government-controlled assets. Narrower definitions may exclude government financial or nonfinancial corporations, purely domestic assets, foreign exchange reserves, assets owned or controlled by subnational governmental units, or some or all government pension funds. I use “sovereign wealth fund” as a descriptive term for a separate pool of government-owned or government-controlled assets that includes some international assets.

I include all government pension, as well as nonpension, funds to the extent that they manage marketable assets. The basic objectives of both types are essentially the same. They raise virtually identical issues of best practice—the focus of my research and analysis—in government control and accountability regardless of their specific objectives, mandates, or sources of funding.

Sovereign wealth funds are funded from foreign exchange reserves, earnings from commodity exports, receipts from privatizations, other fiscal revenues, or pension contributions. These funds have been around for more than half a century with a range of structures, mandates, and economic, financial, and political (domestic and international) objectives—normally a mixture.2 Consequently, it is perilous to generalize about sovereign wealth funds and associated potential threats to US foreign policy, national security, or economic interests.

First, sovereign wealth funds do not pose a significant new threat to US security or economic interests. We have adequate mechanisms to manage any potential threats they pose, which at this point are likely to be minimal.

Second, SWFs are one of the many challenges of global economic and financial change in the 21st century. Whether these particular challenges of globalization are appropriately addressed will have profound implications for the United States and for the world economy and financial system.

Third, the United States should continue to press countries with sovereign wealth funds to design and embrace best practices for these funds to enhance their accountability to citizens of the countries with the funds as well as to the citizens and markets in which they invest. At the same time, the United States should continue to try to minimize economic and political barriers to foreign investment in all forms from all sources here and around the world. Financial protectionism is the wrong answer to the very real challenges of financial globalization and the associated potential for global financial turbulence.

The United States cannot disengage from evolving changes in the global financial system. If we were merely to hint that we are tempted to do so, we would risk catastrophic damage to the US and world economies.

Over the past five years, the size of the global capital market has doubled, but asset holdings of SWFs have at least tripled. The explosive growth of SWFs reflects the sustained rise in commodity prices as well as global imbalances. However, the increased international diversification of financial portfolios—the weakening of so-called home bias—is as least as important as macroeconomic factors in explaining the growth of SWFs.

The increasing relative importance of SWFs has exposed two tensions as part of the ongoing globalization of the international financial system.

The first is the dramatic redistribution of international (or cross-border) wealth from the traditional industrial countries, like the United States, to countries that historically have not been major players in international finance. The newcomers have had little or no role in shaping the practices, norms, and conventions governing the system.

The second is the fact that governments own or control a substantial share of the new international wealth. This redistribution from private to public hands implies a decision-making orientation that is at variance with the traditional private-sector, market-oriented framework with which most of us are comfortable even though our own system does not fully conform to that ideal.

These twin tensions, in turn, are manifested in five broad concerns.

First, governments may mismanage their international investments to their own economic and financial detriment, including large-scale corruption in handling the huge amounts involved. It is a well known, though often ignored, regularity that governments are not good at picking economic winners; for example, government-owned banks tend to be less profitable than private banks. This concern about mismanagement is the principal reason why it is in the interests of every country with an SWF to favor the establishment of internationally agreed SWF best practices. Moreover, greater accountability of such funds is in the foreign policy interest of the United States because the mismanagement of SWF investments could lead to political as well as economic instability in countries with such funds.

Second, governments may manage SWF investments in pursuit of political objectives—raising national security concerns—or economic power objectives—for example, promoting state-owned or state-controlled national champions as global champions. Such behavior contributes not only to political conflicts between countries but also to economic distortions.

Third, financial protectionism may be encouraged in host countries in anticipation of the pursuit of political or economic objectives by the funds or in response to their actual actions. Development of and compliance with SWF best practices would help to diffuse this source of backlash against globalization. At the same time, countries receiving SWF investments should be as open as possible to such investments subject to the constraints of national security considerations narrowly defined.

Fourth, in the management of their international assets, SWFs may contribute to market turmoil and uncertainty. They also may contribute to financial stability, but their net contribution is difficult to establish a priori, in particular if their operations are opaque but also because judgments can be reached only on a case by case basis.

Fifth, foreign government owners of the international assets may come into conflict with the governments of the countries in which they are investing. For example, government ownership adds a further dimension in balancing open markets and appropriate macroprudential regulation.

At this point, these concerns, with the important exception of the first—potential adverse implications for the home countries—are largely in the realm of the hypothetical. The others are much more salient in the context of cross-border investments by government-owned or government-controlled financial or nonfinancial corporations. Nevertheless, a loud, often acrimonious, public discourse about SWFs is under way in many countries, and not only in countries receiving SWF investments.

In my view, the challenge is to make the world safe for sovereign wealth funds through the establishment of an internationally agreed voluntary set of best practices. The natural place to start is with the current practices of individual funds today.

 

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