Sovereign Wealth Funds: The Challenge for Japan
Speech delivered at the Japan Society
© Peterson Institute for International Economics
I appreciate being invited by the Japan Society to participate on this distinguished panel to discuss sovereign wealth funds (SWFs) and their implications for the global economy and financial system. In my remarks, I first will summarize my views about SWFs, the major issues they raise for the international financial system, and how I think those issues should be addressed. I will then offer some comments on the current debate about establishing a sovereign wealth fund in Japan, because we expect that to be the focus of Mr. Tamura's remarks.
SWFs are a politically explosive topic. In combination Japanese policy, in particular, the potential mixture is combustible. For that reason, I would like to emphasize that, although I am a former US government official, I speak for myself. Moreover, the views I express should not be attributed to the Peterson Institute, the members of its board of directors, its advisory committee, or other members of its staff.
"Sovereign Wealth Fund" is, for me, a descriptive term for a separate pool of government-owned or government-controlled financial assets that includes some international assets. These funds have been around for decades. They have multiple forms, objectives, and sources of financing. In particular, they may be financed directly from foreign exchange reserves, directly or indirectly from export earnings, from privatization revenues, pension fund contributions, or otherwise from fiscal surpluses. The central point is that they are financed out of public resources.
In my view, it is useful to include government-controlled pension, as well as nonpension, funds in the universe of SWFs. The basic aims of pension and nonpension funds are essentially the same, and the two types of funds raise identical issues of government control and accountability regardless of their specific structures, mandates, or sources of financing. Moreover, both types of funds are relevant to any consideration of best practices. On this basis, the total assets held by SWFs are around $10 trillion, about $3 trillion in nonpension funds and $7 trillion in government pension funds.
A reasonable estimate is that governments control more than $4 trillion in international assets in their SWFs in addition to their $6 trillion in foreign exchange reserves-another total of $10 trillion.
On this basis, Japan's Government Pension Investment Fund may already be the largest SWF in the world with about $1.3 trillion in assets. Its foreign assets alone, at about $250 billion, would rank it sixth among all SWFs.
Over the past several years, the holdings of all SWFs have exploded. Their growth reflects international diversification trends, as well as the sustained rise in commodity prices and global imbalances. The rise of SWFs has exposed two tensions in the international financial system.
The first is a dramatic redistribution of international (or cross-border) wealth from traditional industrial countries, like the United States and even Japan, 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 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.
A year ago, I proposed the development of a voluntary set of SWF best practices, possibly with the assistance of the International Monetary Fund (IMF). The US Treasury subsequently also called for such an initiative. With additional support from the G-7 and European Union, the IMF executive board in March, 2008, endorsed the Fund's role as a facilitator and coordinator in developing best practices for SWFs. The International Monetary and Financial Committee (IMFC) welcomed that decision last month.
The adoption of best practices by SWFs, in my view, would help deal with two broad international concerns.
First, governments may mismanage their SWF investments to the economic and financial detriment of their countries. This concern is the principal reason why it is in the interests of a country with a SWF to favor internationally agreed best practices for such funds.
Second, investments by SWFs-actual or potential-may produce conflicts with, or protectionist reactions by, the governments of the countries in which they invest. Internationally agreed SWF best practices would help address these concerns and the associated globalization backlash.
Both areas of concern are relevant to the Japanese case to which I will turn in the second part of my remarks. At this point I will only stress that I do not believe SWFs per se pose threats to the national security of the United States or Japan that require a substantial tightening of our regimes governing foreign investment in our countries. In my view as well, SWFs are not cornucopias available to be tapped to rescue the US or the global financial system. For every SWF investment in a financial institution, that fund has to disinvest, or not invest, in some other asset.
However, SWFs are here to stay. The challenge is to make the world safe for them. On the one hand, doing so requires strengthening the open global financial system. On the other hand, that system would be well served by a voluntary set of best practices that would be followed by countries with the largest SWFs.
To demonstrate the feasibility of developing SWF best practices, I have created a scoreboard for 44 existing funds (see Policy Brief 08-3: A Blueprint for Sovereign Wealth Fund Best Practices [pdf], p. 17). The scoreboard includes 33 separate elements grouped in four categories: Structure, Governance, Accountability and Transparency, and Behavior. Let me offer a few summary points.
The scoreboard is based on the actual practices of SWFs today. At least one fund receives a positive score on each element. In fact, at least several funds do so. However, on no element is current compliance 100 percent.
At the same time, I do not find one group of "good" funds and another group of "bad" funds. No fund achieves a perfect score. The performance of each of them can be improved.
The scoreboard captures the relevant content of SWF best practices that has been suggested by US, G-7, European, IMF, and other officials, including those of Singapore and Abu Dhabi-homes to several of the largest funds. Thus, I (modestly) have provided a blueprint for the IMF-facilitated process that is underway.
In my view, the appropriate test of success of the IMF effort has three components: First, the resulting best practices should cover substantially all the elements in my scoreboard. Second, compliance by the dozen countries with funds in the range of $100 billion and up should be universal. Third, that compliance should involve more than lip service to a set of general principles.
The overarching objective should be accountability to the citizens of the countries with the sovereign wealth funds as well as to the citizens of the countries in which they invest.
If the IMF effort meets these tests, SWFs would be substantially demystified. In host countries many, but not all, political concerns would be allayed. At the same time, the citizens of the countries with the funds would have more confidence in their sound operation. Finally, the environment for SWF owners and managers would be more stable and predictable.
Against this background, I will conclude with five comments about a possible new Japanese sovereign wealth fund.
First, as I have already indicated, Japan today has one of the, if not the, largest such funds. The issue is whether other Japanese government financial resources, in particular from Japanese foreign exchange reserves, should be used to augment that fund, or whether a portion of Japan's reserves should be used to finance a stand-alone SWF.
Second, Japan has excess foreign exchange reserves by any metric. I would put the amount at about $750 billion out of the $1 trillion total. In my view, however, the accumulation by the Japanese authorities of these vast holdings of international assets has not been in the interests of the international financial system or the citizens of Japan. The Japanese government has systematically sought to prevent the appreciation of the yen for more than three decades. As a result, the international adjustment process and the international financial system have been severely distorted. However, in large part, Japan's international reserves are here to stay, and the citizens of Japan today should not be penalized for the flawed policies of past governments.
Third, it is thus reasonable, I believe, for the Japanese government to invest its reserves in a broader range of financial assets via the creation of a sovereign wealth fund. The fund should be managed transparently and separated from Japan's foreign exchange reserves. For the record, any resulting diversification of Japan's holdings out of US Treasury securities, or dollar-denominated assets more generally, ranks about number 50 in my concerns about SWFs.
Fourth, accountability and transparency is not one of the strengths of the Japanese political system. We all remember the Japanese government's contorted distortions a decade ago with respect to the condition of Japan's banks. More relevant to the topic at hand, Japan is one of only four G-10 countries that does not now disclose the currency composition of its reserve holdings. (The other three are France, Belgium, and the Netherlands.) Because Japan's foreign exchange holdings are large, many other industrial countries do disclose the currency composition of their reserves, and from the IMF we know the currency composition of the reserves of all industrial countries as a group and can estimate the share of the dollar in Japan's reserves-about 86 percent. Of course, the citizens of Japan don't know this, and they are largely kept in the dark about the current return on those investments.
Japan's Government Pension Investment Fund provides additional evidence of the challenge in accountability and transparency that the Japanese government would face if it were to establish another SWF. On my scoreboard, Japan's pension fund scores only sixth out of ten pension SWFs and ninth out of all 44 funds-pension and nonpension.
Finally, the government of Japan has a history of discouraging foreign investment in Japan. The most recent example is the rejection of the Children's Investment Fund's expanded investment in J-Power on the grounds of potential disruptions to "public order." While the power sector is sensitive in many countries, including the United States, I doubt the Committee on Foreign Investment in the United States (CFIUS) would have recommended that President Bush block a similar investment here.
In many countries that receive investments from SWFs, public opinion implicitly focuses on reciprocity by their home countries. I do not favor such reciprocity, but it is a political reality. If Japan were to create a SWF financed by its foreign exchange reserves, which generated international controversy as they were accumulated, the new fund could well become a target for financial protectionists.
Thus, my recommendation to the Japanese authorities, if they go down this path, is that they commit themselves to the highest standard of best practices for their new SWF in terms of its structure, governance, accountability and transparency, and behavior. This will be a challenge for Japan because to date it has had a substantially substandard record in this area of governance.
How Japan meets this challenge will have implications that extend far beyond Japan.