Commentary: Why Sovereign Funds Help Global Economy

The issue of Sovereign Wealth Funds activity was an important topic of discussion at the recent G-7 meeting of finance ministers and central bankers, and rightfully so. Some of these funds are expanding at an average annual rate above 20 percent on the back of accumulating excess export revenues, exceeding $3 billion annually — more than twice the total amount of hedge funds. But many Western nations see these funds as a threat to capital markets.

SWFs are a relatively new global phenomenon and demonstrate very active behavior in the world capital market, and are not subject to regulatory constraints. And various extrapolations of SWF trends predict total volume growth of 5 to 10 times over the next decade.

In the past, typical state foreign reserves were held in high-liquid but low-yielding government papers like T-bills or bank deposits in developed countries. This setup was convenient for all parties until some of the export intensive countries decided to enter the world capital markets with large amounts of money to earn high, real returns in excess of scanty interest payments. The first reaction of western policy-makers on the new reality was negative, as the anti-liberal legislative initiatives in the USA and Europe have clearly demonstrated.

Threat of protectionism in the capital market

The main argument against SWF is that they are non-transparent, pursue non-commercial goals and threaten national security. The belief is that stakes in companies are purchased with the purpose of getting access to secret information or putting political pressure on the governments of recipient countries.

These unjust accusations are especially popular with respect to Russia and China. Western politicians talk about a threat of re-nationalization, making meaningless the large-scale privatization campaigns of the '80s and '90s. What would be the reason to privatize the state property if it would again belong to the state, this time the foreign one?

These debates reflect the fact that politicians in developed countries have not yet adopted a rational strategy to deal with the new phenomenon. Instead, they prefer to take a defensive position and to signal that all attempts of strategic investment by the SWF will be subject to tight control by authorities. The latter will have discretion to decide whether or not these funds are allowed to participate in strategic deals, with less priority given to investments from China and Russia.

The last summit of G-7 ministers recognized the new reality “that SWFs are increasingly important participants in the international financial system and that developed economies can benefit from openness to SWF investment flows.” This official statement does not eliminate, however, politically motivated fears roused in Western mass media.

The Need of New Institutions

The Need of New Institutions

The threat of policy bias toward protectionism coincided with the recent global financial turmoil. It was the first time since the speculative attacks of 1992 that a financial crisis generated contagion effects across developed markets. Nevertheless, there is no reason to dramatize the situation. The period of extremely low volatility is over, and the swelling turbulence reflects — besides other factors — dramatic growth and qualitative changes in the global financial system.

The traditional model of this system has become obsolete, primarily because of the global reversal of investment flows. Over many years the developed countries were net creditors for the less developed ones and furnished the latter financial aid in order to maintain overall stability of the global economy. Some of the emerging-market economies were liquidity starved a few years ago and requested international assistance to bail out the state from indebtedness. Today, however, the very same countries are investing billions of dollars in foreign assets.

Seemingly, the IMF body has already recognized the beginning of this new epoch for global finance and is concerned about its new role in the changing world. Some countries have already emerged from the transition period, while for others like many African countries have not yet begun. Some governments/holders of SWF have received financial support from the IMF in the past, but are today able to credit other countries and even establish their own IMF-2 on a cooperative basis if required.

The concerns of international financial organizations about their near-term perspectives are therefore understandable. If external financial resources are no longer needed for macroeconomic stabilization, then new large-scale tasks should be put on the agenda. As a variant, we can mention the still-vacant position of IMF-2 or another international coordinating body for the community of SWF-holding countries.
As global creditors, they are interested in high and stable long-term returns on their financial portfolios and in the solvency of large borrowers.

Similarly to the initial goals of the IMF, a new international financial institution could accumulate financial resources of participating countries to eliminate excessive global risks. For instance, it can assist national monetary authorities of developed countries to mitigate the hazardous effects of liquidity crises. The latter imply global systemic risks that could re-emerge in view of inevitable monetary policy tightening in the USA and Europe. Thus, orderly and coordinated global portfolio rebalancing is critical to preventing panic capital flights out of the dollar-denominated assets. This new international institution could support coordinated international policy efforts towards soft-landing of the global economy.

Mutually Beneficial Rules

There is another reason why the new global financial organization is relevant. Rapid development of the world capital markets entails an urgent need in reordering relations between participants. Unlike international markets for goods and services, the global capital market is still in the early stages of evolution.

Liberalization of cross-country capital flows started in the 1980s. The appearance of new large actors, like SWFs, increases complexity and may weaken stability of the world capital markets, thereby necessitating the adaptation of existing rules. On one side, the SWFs are long-term investors, not highly leveraged and not subject to risks of massive withdrawals. On the other side, they depend on bureaucratic routine and in some cases have to dramatically adapt investment strategies to the principles of market behavior. Russia with its Stabilization fund (Stabfund) should be a proper example in this respect.

First of all, the SWF’s activities must adhere to the general principles of transparency, risk management and accountability. The new rules should be explicit, universal and not limited by the domain and style of activities of investment companies, hedge funds, private equity funds, SWFs and other players. No one should be singled out and discriminated against in terms of the regulatory standards.

It is important to modify these standards and the international regulatory system as a whole because it has become less effective. Regulation has been partially substituted by the rating agencies that have also partially replaced market pricing and proper risk management. It especially concerns illiquid and opaque structured financial products that often received top credit ratings.

The recent collapse in these products necessitates reforming the total segment of the global financial system responsible for supply of adequate information to market participants. The issue of adequacy and responsibility of the rating agencies is, in particular, critical in the light of the recent crisis events.

More generally, the issues of information disclosure and filling information gaps should be given a higher priority. The new market participants — SWFs — are often accused of a lack of transparency in investment strategies. But one has to formulate clear criteria of transparency with respect to institutional and sovereign investors and elaborate procedures of mutually beneficial information disclosure. The similar requirements are attributable to authorities of recipient countries that should also build on principles such as nondiscrimination, transparency, and predictability. The recent G-7 summit came closer to recognition of mutual interests and rights in these aspects, and this should be viewed as a positive shift.
The effective solution of all these problems suggests creation of new international arrangements for reconciliation of potential conflicts between investors and recipients. They can be based on the WTO principles of reciprocity and non-discrimination of defensive actions. A certain SWF may be forbidden to enter the domestic capital market or participate in a certain strategic deal, but the arguments of the recipient country authorities must correspond to clear formal criteria and entail unavoidable and adequate retaliation measures.

These authorities have to demonstrate clear evidence that a takeover is indeed non-commercial and politically motivated, and that access to technological know-how really threatens national security. It is important to note that foreign trade in goods usually results in cross-country diffusion of technology and knowledge spillovers, but nobody would suggest forbidding trade relations for this reason.

I do not see any serious threat from the SWF strategic investments both to political stability and economic security of developed nations. For the last several years I have been involved in vivid political debates in Russia around Stabfund that have accumulated huge windfall budget surpluses. My strong position is that this money should be invested in the globally diversified asset portfolio including corporate bonds, equities, commodities, real estate, derivatives, alternative instruments, etc. Build-up of this fund, similar to Norwegian Global, could contribute to implementation of radical pension reform in Russia and dramatically diminish tax burden in the future. Generations of future pensioners would be interested in long-term portfolio returns, rather than in policy-motivated investment or national secrets of recipient countries. In fact, there are no serious reasons to impose artificial restrictions against purchasing by SWFs of large stakes in foreign companies.

Financial OPEC

Financial OPEC

The initiative of global financial system modernization can come from the SWF-holding countries since they are mostly interested in this. Saudi Arabia and the United Arab Emirates have already begun to negotiate on a voluntary code to regulate their SWFs. This could be the beginning of a new integrative process that Western partners should not ignore. The SWF-holding countries have enough resources and incentives to establish new global financial organizations to get maximum benefits on a cooperative basis.

In particular, one can foresee establishment of a new financial organization similar to OPEC as an alternative or a counterpart to the IMF-2 model of SWF-country integration. Its urgent task would be to coordinate political steps against adoption of anti-liberal legislation in the western countries. Moreover, one should not exclude some coordinating activities in the global financial markets in the future. The SWF-countries have similar goals with distinct priority to long-run yields on financial investment. But in some cases, they could agree about market spheres of interest and coordinate on the strategies of making strategic investment in order to minimize mutual losses and increase pressure on recipient countries. Importantly, attempts of large-scale capital market transactions do not pass without consequences even in the case of failure. By imposing new bans, the developed states would damage the reputation of their markets, entailing serious credibility problems. Coordinated and consistent actions of SWFs will eventually enforce the recipient countries to make concessions.

Such a model of integration is not a pure product of imagination. Recall that OPEC originated in 1960 as a political response of oil-producing countries — initially Saudi Arabia, Venezuela, Iraq, Iran and Kuwait - on unfair pricing by the cartel of trans-national oil companies. The repeated longstanding attempts to take control over the world oil price and to shift profits were unsuccessful and not taken seriously by the developed countries. But ultimately, OPEC's activity resulted in the oil price shock of 1973/1974 and subsequent upward oil price trends that caused dramatic reallocation of incomes in favor of oil-producing countries.

It should be noted that the first-generation sovereign funds of Arabian countries emerged after this first strategic success of the OPEC. If a fair mode of oil income distribution prevailed originally, the oil-producing countries had no incentives to establish their cartel and coordinate on export quotas. Similarly, the current tendency of protectionism against the SWFs can reinforce integrative activity of exporting economies in the financial sphere.

The cooperation of SWF-holding countries on the basis of mutual interests will improve their bargaining position relative to the Western partners. And the best way to reach agreement concerning the global capital market is on a multilateral basis rather than destructive unilateral steps on prohibitive measures. Clearly, the latter is the way to global disintegration and trade wars that are inadmissible in the 21st Century.

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Developing countries need full-fledged participation in the world capital markets, just as developed countries need the potential future profit streams of these emerging markets. As was mentioned in the last G-7 meeting statement, “cross-border, market-based investment is a major contributor to robust global growth.”

Andrei Vavilov is Chairman of the Institute for Financial Studies, founder of IFS Hedge Fund in Russia, a member of the Russian Federation Council and former First Deputy Minister of Finance of Russia.