Economics of Sovereign Wealth Funds

Chapter 17 The Future of Sovereign Wealth Funds

Udaibir Das, Adnan Mazarei, and Han Hoorn
Published Date:
December 2010
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Edwin M. Truman

Sovereign wealth funds (SWFs) largely disappeared from the radar screen in 2009, but the issues they raised in home and host countries over the previous two years remain unresolved. Those economic, political, and philosophical issues were somewhat mitigated by developments over the course of 2007–08, but are likely to reemerge as the global economic and financial crisis recedes. The question is whether the international financial system is equipped to restrain the forces of overreaction. This chapter argues that the system is now better equipped, but striking the right balance will continue to be difficult for the SWFs and their home and host countries.


From early 2007 until about the middle of 2008, SWFs commanded increasing attention and concern in the host countries in which they invested. The issues are now familiar. Many of the government owners of these funds are countries with limited stakes or experience in participating in the global economic and financial system as it has developed since the end of World War II. Some are philosophically hostile to that system. Moreover, because the SWF owners are governments, they are by definition motivated, influenced, or constrained by political considerations; those considerations have the potential to be inconsistent with the outlook and orientation of the host countries to those SWFs’ investments. At the same time, politicians, pundits, and the general public in host countries tend to ignore the implications for the home countries of SWF investments—the potential adverse effects of misallocated investments on the home country’s economic, financial, and political stability, and the resulting feedback effects on host countries and the global economic and financial system.

For a brief period at the end of 2007 and in the first quarter of 2008, some observers regarded SWFs as the saviors or white knights of the major western private financial institutions. The economic reasoning underlying this view was always questionable. There were winners as well as losers—SWFs invested in Citigroup by disinvesting, or not investing, in General Motors. Moreover, few foresaw the backlash that was to come in the home countries when these investments soured. That experience will likely color darkly many dimensions of the investment strategies of at least some SWFs in the future.

From a U.S. perspective as of mid-2009, not only have issues involving SWFs dropped from sight, but there is considerably more understanding of these funds. SWFs have been substantially demystified. Those who are inclined to approach issues of international finance and international relations with an open mind have educated themselves and are somewhat reassured. (This judgment is based largely on personal observations, including my own Congressional testimony in November 2007, May 2008, and September 2008.) Senators and Representatives were progressively better informed, expressed less anxiety, and asked more sophisticated questions. Staff members both guided and reflected their members’ attitudes.1

One factor contributing to lowering the heat under the SWF kettle was the process that led to the development by the International Working Group (IWG) on SWFs of generally accepted principles and practices (GAPP) for sovereign wealth funds, known as the Santiago Principles (IWG, 2008). These principles, not entirely by accident, bear some resemblance to the elements in this chapter’s author’s “Blueprint for SWF Best Practices” (Truman, 2008a). The Santiago Principles are an impressive example of international cooperation in a complex and challenging policy area with multiple cross-cutting considerations. They are a good start at establishing a basis for greater accountability of SWFs to their home countries’ citizens, to citizens and governments of host countries, and to financial markets.

On April 6, 2009, via the Kuwait Declaration (IWG, 2009a), the IWG announced the formation of the International Forum of Sovereign Wealth Funds. This voluntary organization will accept other eligible members that endorse the Santiago Principles. The forum will exchange ideas and views among SWFs, share views on the application of the Santiago Principles, and encourage cooperation with host countries. An analysis of the Santiago Principles based on the “Blueprint for SWF Best Practices” reveals that the GAPP scores 74 out of 100 (Truman, 2008b). However, based on the intersection of the GAPP with the blueprint, the SWFs of participants in the IWG complied with only about 60 percent of the Santiago Principles on average as of early 2008. It follows that enhanced application of the GAPP will be an important test for the forum and its members.

Those host countries that are members of the Organisation for Economic Co-operation and Development (OECD) undertook an examination of whether SWF investments in OECD member countries should be subjected to a special regime. The OECD members concluded in the negative; existing OECD investment principles, codes, and declarations were judged to be sufficient to provide an appropriate framework for reviewing this type of foreign investment, in some cases in connection with approval and in other cases, at least formally as in the United States, nonrejection of such investment. However, the OECD countries did not strengthen the openness of their investment regimes. As part of its broader program reviewing investment regimes, a set of guidelines for recipient country investment policies relating to national security was issued (OECD, 2009), but those guidelines apply to all types of investments, not only to government-controlled investments. The guidelines were also essentially an elaboration and codification of the OECD-recommended regime; they were not part of an effort to encourage OECD members as a group to be more receptive to foreign investment by government or nongovernment investors.2

On the basis of the available public record, it can be concluded that no effort to strengthen the collective openness of national investment regimes to SWFs was considered as part of this process. Thus, for example, (1) OECD commitments with respect to the treatment of foreign investment, including by SWFs, apply only to members, and are only extended to nonmembers on a best-efforts basis; (2) individual OECD countries have invoked multiple exceptions to the principles and guidelines even as they apply to OECD members; and (3) the national security exemption is broadly defined, unchallengeable, and cases are not reviewable outside the country in question.3 The Investment Committee of the OECD has agreed to an invigorated peer review process, but that is normally not likely to include participation by nonmembers. The OECD Investment Committee has reached out to nonmember countries, including those with SWFs, but with mixed success as of the writing of this chapter.

In the United States, in the wake of the controversy over the proposed Dubai Ports World investment in the management of six U.S. ports in February 2006, the Congress passed the 2007 Foreign Investment and National Security Act (FINSA), which revised the framework and procedures of the Committee on Foreign Investment in the United States (CFIUS), which was initially established by law in 1988.4 FINSA was enacted before the full force of concern about SWFs had surfaced. The result was a tightening of U.S. procedures, but again without special application to SWFs, although the procedures applicable to investments by governments have been strengthened and the national security standard rubric has been stretched by the implicit inclusion of critical infrastructure and the requirement that the CFIUS report to Congress on investments that may involve critical technologies. One source of confusion about the U.S. foreign investment regime is that the power of the CFIUS to recommend to the president that an investment be prevented is limited to those investments that would result in a controlling interest. Similarly, agreements to ameliorate the potential adverse effects on national security in connection with nondisapprovals are limited to controlling investments. However, for noncontrolling investments, other types of reporting and disclosure requirements are required in the United States, for example, by the Securities and Exchange Commission, on a national treatment basis in which there is no discrimination between the rules and regulations applied to domestic and foreign investors. In 2007–08, suggestions that the FINSA legislation be reopened in light of perceived threats from SWFs did not generate much traction, as noted above.

Nevertheless, this generally positive situation in the United States for SWFs should be qualified in two respects. First, some in the United States would like to subject each dollar of foreign government-related investment in the United States—direct investment of any size and purchases of stocks, bonds, and U.S. treasury securities—on a case-by-case basis to a range of tests, including the current state of U.S. relations with the country making the investment and whether the country offers reciprocal treatment.5 Such a regime would be technically impossible to implement without dramatic changes in today’s globalized financial system.

Second, the reality is that the CFIUS process has been tightened in the United States. The number of cases submitted to the committee for what, in effect, is prior approval has ballooned, not since September 11, 2001, but since the Dubai Ports World episode in 2006. The CFIUS process has become not a disapproval process with respect to governmental investments but a de facto approval process, creating a qualified safe harbor for those state investors. At a minimum, the transactions costs of investing in the United States have been raised, in particular for government investors, and some are unwilling to pay those financial and political costs.

In December 2008, the U.S. Treasury released the 2008 report on CFIUS transactions covering the period 2005 through 2007. A classified version was provided to Congress in mid-November 2008. The release appears to have been a nonevent, with limited press coverage. The report documents the doubling of notices to the CFIUS between 2005 and 2007, from 64 to 138. It does not, of course, report how many investments were discouraged by the CFIUS process because of the added costs of those investments in time (which can be as long as 75 days) and financial resources (legal fees and other expenses). About 10 percent of the 313 CFIUS notices during the three-year period were from countries with SWFs or equivalent investment vehicles of significant size. The same was true for 2007 alone. It is reasonable to expect that U.S. authorities will continue to be vigorous in following the requirements of the FINSA legislation and the treasury regulations implementing that legislation.

More broadly, the economic and financial environment for SWFs has changed since mid-2008. First, SWFs, along with essentially all other global investors, have suffered financial losses although a larger proportion of SWF losses have not been realized. Kern (2009) estimated that the imputed losses on equity investments by SWFs may have been 45 percent between the end of 2007 and early 2009, most of which were not realized. Second, those losses, even on paper, have been subjected to greater scrutiny at home than would have been the case several years ago because SWFs in general are more exposed on home radar screens as well as internationally. Third, the flow of new resources into most SWFs slowed substantially after the first half of 2008. Kern’s estimate is that the assets under management of SWFs had declined 17 percent as of mid-2009 compared with the end of 2007 (Kern, 2009). His estimate reflects inflows, outflows, and the SWFs’ realized and unrealized capital gains and losses. Fourth, many funds turned either by initial institutional design or subsequent ad hoc policy decision from investing abroad to investing at home. For example, stabilization SWFs have used their resources as intended to offset reduced inflows of foreign exchange, and other types of SWFs have acted deliberately to support domestic financial institutions or other forms of domestic investment. All four factors have lowered the profile of SWFs and added an element of realism to their operations as viewed from at home or abroad. In the context of the global economic and financial crisis as of the middle of 2009, SWFs do not bulk as large global economic and financial power brokers or as potential real or imagined threats.


The global economic and financial crisis that started in 2007 will come to an end. Whether the not-so-old pattern of SWFs investing increasingly vast sums abroad will reemerge is more difficult to forecast, but SWFs will recover and many will resume or accelerate their foreign investment activities.

One issue is the extent of the damage suffered by the international financial system in the meantime. Many specters haunt the international environment as of the middle of 2009: the worst global economic contraction since the Great Depression, the collapse of many financial institutions around the world, and a potential reversal of the process of real and financial globalization that started at the end of World War II. This last specter—an outbreak of financial protectionism—is most troubling and relevant with respect to SWFs.

Protectionism in all forms lies just below the surface in all countries. A survey released on February 9, 2009, found that two-thirds of respondents said that it is a good idea to require the U.S. stimulus funds to be spent on U.S. goods to keep jobs in the United States and only a quarter of respondents said it is a bad idea because it risks trade retaliation (Pew, 2009). The questions might have been phrased differently and, as a result, have elicited a narrower margin between the two responses, but the interesting point is that no significant difference emerged between the views expressed by self-described Republicans, Democrats, and Independents. If these reported views are examined alongside those in a poll a year earlier (Public Strategies, 2008) that found that only 6 percent of 1,000 U.S. respondents had seen or heard anything recently about SWFs, but that 49 percent thought that investments in the United States by foreign governments have a negative effect on the U.S. economy and 55 percent thought that they have a negative effect on U.S. national security, one can appreciate that financial protectionism is just below the surface in the United States. The United States is not unique. Many actions by governments in the crisis served to fan these flames, for example, unilateral actions to raise deposit insurance limits, guarantees of the senior debt of banks but primarily domestically chartered banks, closure of financial institutions while ignoring the concerns of their foreign creditors, and criticisms of foreign banks for pulling back on lending to domestic borrowers.

Moreover, the low market values of many financial and industrial enterprises will at some point make them attractive to foreign buyers, including SWFs.6 Economic nationalists viscerally oppose selling off national champions, particularly at bargain-basement prices. Thus, the actual or potential establishment by France and Japan of funds, which some advocates in those countries describe as sovereign wealth funds, to invest in key domestic firms can be viewed as attempts to support domestic firms as well as to reduce the risk that these firms will fall into the wrong—that is, foreign—hands. Similar motivations can be found in all countries.

As a result, the degree of openness to SWF investments, which was never 100 percent, may shrink substantially in the years ahead. It is no accident that the IWG meeting in Kuwait City on April 6, 2009, welcomed the April Group of Twenty Communiqué and its pledge to do whatever is necessary to promote global trade and investment and to reject protectionism (IWG, 2009b).

Beyond the issue of financial protectionism, the global economic and financial crisis that began in 2007 has transformed the role of the state in all economies and the way in which many think about the government’s proper role. At this point, these dramatic events’ longer-term influence on the actual and perceived roles of governments in the future is subject to speculation. It is reasonable to suppose that more people are more comfortable with a larger role for their governments in their economies than several years ago and that those attitudes will translate into acceptance or encouragement of an increased role for governments in economies. Some might argue that as a consequence greater acceptance of the role of governments generally should reduce conflicts over state-sponsored foreign investments via SWFs. A less sanguine prospect is that the increased role of governments in all economic and financial systems will fan the flames of national competition and of efforts by governments to save and to create jobs at home in an environment of less-than-robust economic growth.

With respect to SWFs in particular, the current trend of countries to redirect a larger proportion of SWF investment inward—although understandable and in many cases appropriate in the current environment, especially for SWFs with stabilization objectives—could lead to problems going forward. First, the SWFs may squander their financial resources in low-return domestic investments. Second, the potential for corruption associated with the large amounts involved is amplified by increased spending on domestic investments, through which deals that pass funds into personal accounts are easier to arrange. Third, once SWFs get into a pattern of investing in the domestic operations of financial and nonfinancial firms, it will be natural for them to invest more heavily than at present in the foreign operations of those firms, which raises many sensitive issues in the countries in which they invest, including with respect to fair international competition, again raising the issue of the role of the state in the global economy. The issue of state capitalism and its effects on the global competitive playing field received fresh attention in mid-2009 when the Financial Times on July 21 reported that China’s Premier Wen Jiabao endorsed a strategy of using China’s foreign exchange reserves to support the foreign expansion of Chinese industries (Anderlini, 2009).

Returning to the issue of accountability of SWFs, it is important that they raise their scores on the scoreboard in the blueprint, or more specifically, on the GAPP version of my SWF scoreboard in the Santiago Principles. Doing so is essential if the progress that has been made in demystifying the funds is to continue. Conversely, the definition of SWFs is loose, and many countries have mechanisms to deploy their investments internationally other than entities that fall within the IWG’s definition of an SWF. For example, the Saudi Arabian Monetary Agency reported that as of May 2009 the government of Saudi Arabia was managing US$412 billion in international investments other than their foreign exchange reserves, but not in the framework of an SWF as defined by the IWG.7 Saudi Arabia participated in the IWG as an observer, but unless it establishes an SWF, it does not have even an implicit obligation to follow the GAPP in managing its foreign investments.8 Excluded from the IWG definition of SWFs are foreign currency reserve assets (although some reserve assets are part of or are managed by SWFs), operations of state-owned enterprises, government-employee pension funds, and assets managed for the benefit of individuals.9

Thus arises the potential for regulatory arbitrage. If countries perceive that the global standards applied to SWFs are inconvenient or too tough, they will make their foreign investments through other vehicles such as investment subaccounts of their international reserves or through state-owned financial institutions.

As often is the case in the twenty-first century, China is likely to be a particular focus of attention because it is large and increasingly influential in international finance. Its China Investment Corporation (CIC) is an SWF, but its assets under management were only US$200 billion as of the end of 2008, and almost half of its investments were domestic. Much more important are China’s foreign exchange reserves, which as of mid-2009 were 10 times the total size of the CIC. China’s State Administration of Foreign Exchange (SAFE), which is under the People’s Bank of China, is more opaque in its operations than most other emerging-market countries’ foreign exchange managers, which in turn are more opaque than many SWFs, and the SAFE is known to make many SWF-type investments. Perhaps more critical are China’s government enterprises and its government-owned banks. The CIC is the majority owner of most of China’s government-owned banks and is considered a bank holding company under U.S. banking law. When the global economic and financial crisis ends, the world’s economic and financial systems will not revert to the precrisis written and unwritten rules and conventions of international finance and the precrisis roles of governments. The views attributed to China’s Premier Wen Jiabao, noted above, illustrate the changing landscape. China will greatly influence the way in which the environment changes, including for SWFs. In this context, it is also noteworthy that Jin Liqun, Chairman of the Board of Supervisors of the CIC, has been chosen as one of two vice chairs of the International Forum of SWFs.


Substantial strides have been made since late 2007 in making the world safer for sovereign wealth funds.

For the future, SWFs need to build on that progress by embracing the Santiago Principles, participating in the International Forum, and individually increasing their transparency. At the same time, countries receiving SWF investments need to resist financial protectionism and look for ways to codify and strengthen that resistance. This is not to say that doors have to be wide open. SWF investments raise real economic, political, and philosophical problems. Participants in the global system should continue to seek a balanced approach to those issues through the maximum possible application of principles of national treatment, accountability, and transparency. In the future, these issues will become larger, not smaller, and the challenge will not be just for the SWFs but for all forms of cross-border investments by governments.


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1Those who are inclined to express exasperation about the chaotic U.S. political process might be reassured by this experience. None of the hearings (there were more than 10 hearings devoted to SWFs in various committees and subcommittees of the two houses of Congress) was directly connected with pending legislation. The staffs of the members and the committees used the hearings to educate the members and, in the process, lowered the heat about and increased the understanding of issues surrounding SWFs.
2The adoption of these guidelines in October 2008 was initially at the level of officials of the OECD Investment Committee, but on May 25, 2009, they were endorsed by OECD ambassadors as an OECD Recommendation, which raises the guidelines’ political and policy profile.
3The guidelines do recommend a transparent national review process.
4The CFIUS was set up by Executive Order in 1975 to monitor foreign investment in the United States, but it did not have the power to disapprove such investments.
5See the testimony of Gal Luft and the exchanges on pages 64–65 in Committee on Foreign Relations of the U.S. House of Representatives, 2008.
6However, only a small proportion of all SWFs make controlling investments (probably less than a quarter) and a small percentage of total SWF assets (probably less than 10 percent) take the form of such investments. These facts are often ignored in public debates about SWFs.
7See also Chapter 5 of this volume.
8In March 2009, the press reported that Saudi Arabia had established the Hassana Investment Company owned by the General Organization for Social Insurance in Saudi Arabia (Karam, 2009). However, this appears to be a pension SWF that would not be included within the IWG definition of an SWF, which includes pension reserve funds without explicit pension liabilities but excludes government-employee pension funds in which the assets are managed for the benefit of individuals.
9Some public pension reserve funds are included in the definition of SWFs because they are not directly tied to pension programs. Truman (2008a) scores both nonpension and some pension SWFs because both types of governmental investment vehicles raise similar policy issues in home and host countries.

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