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.

Given that sovereign investment takes these different forms, why has there been so much focus on SWFs alone? First, SWFs appear to be set for rapid and perhaps prolonged growth. Second, SWFs raise issues that also bear on other types of sovereign investment -- financial-market issues, which also relate to international reserves and public pension funds, and investment issues, which also relate to SOEs.

SWFS: THE ISSUES

SWFs have existed in a number of places -- not only Kuwait but also Abu Dhabi and Singapore -- for over 25 years. What is remarkable today is the increase in their number and size. There are now, by some definitions, as many as 40 different SWFs. Estimates of the size of SWFs are hindered by the fact that they are often not transparent, but the IMF approximates that SWF assets are today somewhere between $1.9 trillion and $2.9 trillion. Projections of their future size are also uncertain, as the value of SWFs depends heavily on commodity prices and exchange-rate policies. However, a number of private financial institutions have estimated that SWF assets will reach $10-$15 trillion by 2015.

Whether these are considered large or small figures depends on the metric used. If one wishes to make SWFs appear large, one can note that the current market capitalization of the S&P 500 is roughly $12 trillion. If one wishes to make them appear small, one can note that $12 trillion is only a fraction of the estimated $190 trillion in total global financial assets. SWFs can also be compared to other investor classes. Once again, if one wishes to make SWFs appear large, one can note that hedge funds manage an estimated $1.5 trillion. If one wishes to make them appear small, one can note that assets managed by mature-market institutional investors (such as pension funds and endowments) are about $53 trillion.

Two points, however, are inescapable regardless of the metric. The first is that SWFs are already large enough to be systemically significant. The second is that they are likely to grow larger over time, in both absolute and relative terms, which calls for a discussion of the issues this growth may raise for the international financial system.

The first issue to consider is whether the formation of SWFs perpetuates undesirable underlying macroeconomic and financial policies. Clearly, it is critical that noncommodity funds, made up of excess reserves accumulated through exchange-rate interventions, not use SWFs as a mechanism simply to accumulate more foreign assets in an effort keep the currency from appreciating. The perpetuation of undesirable underlying policies is less of a concern with commodity funds, since governments are essentially replacing a physical asset in the ground with a financial asset in a bank account to be drawn on by future generations. However, even commodity-exporting countries need to make sure that their SWFs operate within a framework of sound domestic fiscal, monetary, and exchange-rate policies.

Second, since SWFs are an outgrowth of domestic and international economic and financial policies, it makes sense to consider them in terms of their potential impact on financial stability. Here, there is much reason to be reassured. SWFs are in principle long-term investors, which typically do not deviate from their strategic asset allocations in the face of short-term volatility. They are not highly leveraged, and it is difficult to see how they could be forced by regulatory capital requirements or sudden investor withdrawals to liquidate their positions quickly. In this context, SWFs may be considered a force for financial stability -- supplying liquidity to the markets, raising asset prices, and lowering borrowing yields in the countries in which they invest. Still, responsible public policy requires a thorough consideration of the potential impact of SWFs on financial markets. SWFs represent large, concentrated, and often opaque positions in financial markets. A sudden shift by SWFs in illiquid markets can cause price volatility. Further, since many SWFs disclose little of their investment policies, mere rumors of SWF shifts may cause the private sector to react.

The third and perhaps most critical set of issues relates to SWF investment that involves taking active control of private firms. The most obvious consideration is national security. As with any form of foreign investment, countries on the receiving end of SWF investment need to ensure that national security concerns are addressed, without unnecessarily limiting the benefits of an open economy. Such concerns do not stem only from cases in which an SWF gains a formal controlling share of a company; they can also arise when an investor seeks board seats or outsized voting rights -- anything beyond a purely passive investment.

In the United States, balancing open investment with the need to protect national security is done through the Committee on Foreign Investment in the United States. CFIUS is designed to review foreign investments in a manner that preserves national security without creating unnecessary or counterproductive barriers to participation in the U.S. market. The CFIUS process supports open investment by focusing only on those transactions that relate to national security.