Do Sovereign Wealth Funds Pose a Risk to the United States?
Remarks at the American Enterprise Institute, Washington, DC
© Peterson Institute for International Economics
Question: Do sovereign wealth funds pose a risk to the United States?
Answer: We live in a risky world, but the economic and political risks to the United States from sovereign wealth funds do not make my top 100.
A sovereign wealth fund is a descriptive term for a separate pool of government-owned financial assets that includes some international assets. They are designed to achieve a variety of economic and financial objectives.
My estimate of the foreign asset holdings of nonpension sovereign wealth funds is $2.6 trillion. (Equally plausible estimates are somewhat higher.) Such funds are five times as large as they were in 2000. In addition, US and foreign government sovereign wealth pension funds hold at least $1.5 trillion in foreign assets. (The total holdings of such US sovereign wealth funds exceed $3 trillion. About a quarter ($750 billion) is in foreign assets.) Thus, combining pension with nonpension sovereign wealth funds, total foreign, or cross-border, holdings of sovereign wealth funds exceed $4 trillion.
Sovereign wealth funds are not a new phenomenon, but the recent growth and expansion of their activities have brought them, generally unwanted, attention. It has exposed two tensions in international economic and financial relations.
First, the growth of sovereign wealth funds reflects a dramatic redistribution of international wealth from traditional industrial countries like the United States to countries that historically have not been major players in international finance and have had little or no role in shaping the practices, norms, and conventions governing the international financial system. Most of the newly wealthy countries are newcomers, and many are not our friends.
Second, governments own or control a substantial share of the new international wealth. This redistribution of wealth from private to public hands implies a decision-making framework that is at variance with the traditional private-sector, market-oriented framework with which we are most comfortable.
Given these twin tensions, it is not surprising the analysis of the sovereign wealth fund phenomenon is often confused, at best, and distorted, at worst. I will cite five current examples of misleading analysis.
First, some argue that governments should not own, or own substantial shares in, private companies. In fact at the federal level, we have exceptions in specialized areas such as financial services. Moreover, at the state and local level, government pension funds actively manage more than $3 trillion in assets, including significant ownership stakes in private companies.
Second, some argue that the activities of sovereign pension funds have been facilitated by our large current account deficits that imply "America is for sale." US fiscal, monetary, and energy policies and the macroeconomic and exchange rate policies of other countries have contributed to those large deficits. However, even if the United States had been running a balanced current account position over the past decade, sovereign wealth funds would be increasing their investments in the United States. Global imbalances are not just about the US external position. International capital flows finance those imbalances, but they also reflect healthy portfolio diversification. In 2006, foreign financial inflows to the United States were 2.3 times our current account deficit. Over the first three quarters of 2007, it was 2.6 times. Finally, countries with persistent current account surpluses, such as Switzerland and Germany, also attract investments by sovereign wealth funds.
Third, some differentiate among sovereign wealth funds on the basis of the proximate origins of their foreign exchange. They neglect the fact that money is fungible, and, in general, foreign exchange markets are not subject to controls. A government entity may acquire foreign exchange via sales of commodities or by resisting the appreciation of its currency. Alternatively, it may purchase the foreign exchange in the market, as in the case of our state and local government pension funds.
Fourth, turning to arguments put forward by cheerleaders for sovereign wealth funds, recent investments in US financial institutions are not financial resources buried in the Persian Gulf and discovered by the leaders of those institutions. The assets of the investing sovereign wealth fund already are invested abroad-by definition. A significant proportion already is in US dollars probably in the United States. Thus, when a fund invests in a US financial institution, only the form of its US investment is changed. The fund sells one US asset and buys another.
Finally, some describe sovereign wealth funds as "pools of patient capital." Along these lines, the authorities of countries with sovereign wealth funds frequently argue that their funds are not like hedge funds and private equity firms in their speculative activities and their use of leverage. Setting aside whether capital should be patient, the facts do not support such claims of innocence. Sovereign wealth funds invest in hedge funds, in private equity firms, and in other highly leveraged financial institutions whose activities, including the use of leverage, are indistinguishable from hedge funds and private equity firms. In effect, sovereign wealth funds are providing the capital that those firms subsequently leverage to generate high rates of return for the funds. They are no different from other investors except that their stakes may be measured in the billions rather than in the hundreds of millions.
What about concerns about investments by sovereign wealth funds? With respect to issues of national security, one can debate the national security implications of foreign direct investment and how our CFIUS (Committee on Foreign Investment in the United States) process should work. However, replaying those debates in the context of sovereign wealth funds makes little sense. Most of the funds' investments are not controlling by anybody's definition. The activities of state-owned or state-controlled banks and nonfinancial institutions are much more relevant to our national security than those of sovereign wealth funds.
Therefore, I will confine my remarks to concerns about sovereign wealth fund investments in the financial sector. In most countries, financial institutions are subject to special regulatory regimes, in part, because they are viewed as quasi-public utilities and, in part, because financial institutions have special privileges in terms of access to discount windows, deposit insurance, and payments systems. The basic question is whether foreign government ownership, even if indirect or noncontrolling, is compatible with this special status.
Even in the case of a stake that is less than, say, 5 percent and not associated with board membership, will the government of the sovereign wealth fund shareholder seek to exercise what I would call "undue influence" over the financial institution in its business and investment decisions? Or otherwise come into conflict with US government regulators and supervisors? "Undue influence" is a vague term. Presumably all shareholders, exercising their shareholder rights, seek to influence the decisions of the entities in which they have stakes. Nevertheless, in my view, this is more of a problem in the case of investments in financial institutions than in the case of investments in nonfinancial institutions, which are less portable.
Therefore, I think it is reasonable to ask the supervisors and regulators what procedures they have in place to reduce the probability that the government owners of sovereign wealth funds do not seek to exercise "undue influence" over the decisions of financial institutions in which they have significant stakes.1 On the other hand, it is not realistic to limit investments to so-called passive stakes. First, there is no accepted definition of that term. Second, if passive investment were defined as nonvoting shares, the unintended collateral consequences would be significant. For example, even if we exempted investments by state and local government pension funds, those funds would risk being disenfranchised abroad, in particular because we would find it difficult not to apply our restrictions to the US investments by foreign government pension funds.
At the same time, it is highly probable that foreign investors-governmental or nongovernmental-in US financial or nonfinancial institutions will complicate the enforcement of US securities laws. But this is a fact of life in the 21st century. It does not provide a sufficient basis for limiting or barring such investments. Financial markets are global. This reality presents enforcement challenges. Limiting portfolio investments to countries that are our friends does not eliminate potential problems. As we learned in the case of Crédit Lyonnaise and Equitable Life, which involved the French government, blood is thicker than water.
The challenge facing the United States and the international financial community is how to make the world safer for sovereign wealth funds and maintain our own, open market-based regime in which private-sector actors are the major players. My answer is agree upon a set of best practices, or a standard, for sovereign wealth funds to make them more accountable to their own citizens and governments, to the citizens and governments of host countries, and to participants in financial markets. Transparency has a large part to play in establishing such accountability, but it is only part of the game.
Based upon the "scoreboard" [pdf] for 33 sovereign wealth funds that I have developed, I am confident that the union of the actual practices of those funds provides an appropriate framework for a set of best practices. The reason is that at least one sovereign wealth fund currently, voluntarily complies with each of the 25 elements in the scoreboard.2
All sovereign wealth funds are not equally opaque. Nor do they fall into two groups-one containing New Zealand's Superannuation Fund and Norway's Government Pension Fund-Global and the other containing Abu Dhabi's Investment Authority (ADIA). Among the sovereign wealth funds that have recently invested in financial institutions around the world, ADIA and the Government of Singapore Investment Corporation rate poorly on my scoreboard, but Kuwait's Investment Authority and Singapore's Temasek Holdings are above average and Korea's Investment Corporation is not far from the average.
All of the sovereign wealth funds could raise their scores. None is perfect. Twenty-nine of the 33 funds have a clearly stated objective, but four do not. Twenty of the funds publish their size, but 13 do not. Eight funds publish the currency composition of their holdings, but the vast majority of funds do not. In other words, the practices of sovereign wealth funds vary widely even today. The question is whether the countries with sovereign wealth funds, and the international financial system as well, would be better off with more systematic adherence to a set of best practices. It seems to me obvious that the answer is yes.
As is well known, the International Monetary Fund, with the assistance of the World Bank, is engaged in a dialogue to try to establish a set of best practices for sovereign wealth funds. Rather than rush to try to establish unilaterally a set of national standards, we should see what develops from this multilateral process. One would hope that over the past decade, the United States has learned about the downside risks of proceeding unilaterally even when our motivation is principally defensive.
Some complain that any such standards for sovereign wealth funds would be voluntary. They want something that is enforceable, generally without defining what they mean. In my view, the standards for sovereign wealth funds should be sufficiently clear that it would be obvious whether a country is complying. Absent such clarity, an auditing process will have to be established. The associated naming and shaming, as well as peer pressure, should produce a high level of compliance.
Complete success is not likely to allay many of the concerns some people have about sovereign wealth funds, nor would all my concerns be laid to rest. However, many reasonable concerns would be addressed. In the process, sovereign wealth funds would be demystified and the environment for their owners and managers would become more stable and predictable.
1. I also think it is reasonable to consider whether we need to improve the quality of our statistical information on US assets and liabilities of governments and government-owned or -controlled entities, including sovereign wealth funds. At present, we have very little, systematic information aside from liabilities that are lumped in with foreign exchange holdings.
2. See Edwin M. Truman, Sovereign Wealth Fund Acquisitions and Other Foreign Government Investments in the United States: Assessing the Economic and National Security Implications, Testimony before the US Senate Committee on Banking, Housing, and Urban Affairs, November 14, 2007.