Public Footprints in Private Markets

Sovereign Wealth Funds and the World Economy

Robert M. Kimmitt

From Foreign Affairs, January/February 2008

Summary:  The massive growth of sovereign wealth funds -- pools of capital controlled by governments and invested in private markets abroad -- should not cause alarm. But it does raise legitimate questions for the United States, pointing to the need for new policy principles for both the funds and the countries in which they invest.

ROBERT M. KIMMITT is Deputy Secretary of the U.S. Department of the Treasury.

In 1953, eight years before its independence from the United Kingdom, Kuwait established the Kuwait Investment Board to invest its surplus oil revenue. That was perhaps the first-ever "sovereign wealth fund" (SWF), although the term would not exist for another 50 years. SWFs are large pools of capital controlled by a government and invested in private markets abroad. Today, they are growing rapidly in both number and size. Twelve SWFs been established since 2005, and altogether SWFs control roughly $2.5 trillion -- a figure now growing, according to some estimates, by $1 trillion a year.

These developments should not cause alarm, but they do raise legitimate policy questions. Governments should consider the implications of SWFs' growing importance with calm and precision. Many concerns, aired frequently in policy debates and prominently in the media, have been exaggerated, in part because of a lack of understanding of SWFs and other vehicles for sovereign investment. A fuller picture of SWFs' history, purpose, size, growth, and broader systemic implications is needed. Such an understanding, along with a set of clear policy principles for both SWFs and the countries in which they invest, will help preserve openness to foreign investment and promote financial stability worldwide.

THE FOUR SOVEREIGNS

To frame this policy discussion, it is useful to differentiate among four kinds of sovereign investment: international reserves, public pension funds, state-owned enterprises, and SWFs. International reserves, as defined by the International Monetary Fund (IMF), are external assets that are controlled by and readily available to finance ministries and central banks for direct financing of international payment imbalances. Countries typically keep reserves on hand to cushion an export shortfall or to intervene to defend the currency in a financial crisis. Reserves are by definition invested in highly liquid and marketable securities, which usually means highly rated industrialized-country government bonds.

Public pension funds are investment vehicles funded with assets set aside to meet the government's future entitlement obligations to its citizens. Public pension funds differ from SWFs in that they are denominated and funded in the local currency, usually with relatively low exposure to foreign assets. However, it is expected that pension funds will increasingly invest abroad, in some cases using national SWFs to manage their assets.

State-owned enterprises (SOEs) are companies over which the state has significant control, through full, majority, or significant minority ownership. SOEs can themselves undertake foreign investment. This category includes a wide variety of entities, including manufacturing and financial firms.

Finally, SWFs are generally defined as government investment vehicles funded by foreign exchange assets and managed separately from official reserves. SWF managers typically have a higher tolerance for risk and seek higher returns than do official reserve managers.

SWFs generally fall into two categories according to the source of the foreign exchange assets. Commodity SWFs are funded by commodity exports that are either owned or taxed by the government. These funds serve different purposes, including fiscal revenue stabilization, intergenerational saving, and balance-of-payments sterilization (that is, keeping foreign exchange inflows from stoking inflation). Given the current extended rise in commodity prices, many funds initially established for the purposes of fiscal stabilization or balance-of-payments sterilization have evolved into intergenerational savings funds.

Noncommodity SWFs are typically established through transfers of assets from official foreign exchange reserves. Large balance-of-payments surpluses have enabled noncommodity exporters to transfer "excess" foreign exchange reserves to standalone investment funds that can be managed for higher returns. Noncommodity funds often arise from an exchange-rate intervention involving a domestic liquidity increase that has to be absorbed by issuing domestic debt to avoid unwanted inflation. Their net return depends on the difference between the yield earned on investments and the yield paid on domestic debt. The assets of this type of SWF, accordingly, may be thought of more as borrowed money than traditional wealth.