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.

PRINCIPLES FOR A POLICY RESPONSE

One clear conclusion that arises from this discussion is that the benefits of SWF investments to the recipient countries depend on the extent to which the behavior of SWFs is economically driven. If these investments are economically, rather than politically, driven, recipient countries have a strong interest in providing an open, transparent, and predictable framework for SWF investment.

Clearly, both the countries in which SWFs invest and SWFs themselves have certain responsibilities. Policy principles are needed for both sides. The U.S. government is now intensifying direct bilateral outreach efforts with both countries that have SWFs and countries that receive their investment.

Countries receiving SWF investment should follow four basic principles. First, avoid protectionism. Countries should not erect counterproductive barriers to investment, regardless of whether the investor holds a controlling interest in national firms. Second, uphold fair and transparent investment frameworks. Investment policies and processes, especially those involving national security considerations, should be public, clearly articulated, predictable, and nondiscriminatory. Third, within those frameworks, respect investor decisions. Having laid out the ground rules, recipient countries should not tell SWFs how to invest their money. Decisions on how to allocate investments across countries and asset classes are for the funds' managers alone, particularly given the potential for losses as well as gains. Finally, treat investors equally. Tax and regulatory policies should not discriminate between foreign and domestic entities.

The principle of reciprocity -- that is, reciprocal openness to investment -- is not on this list despite the fact that many countries with SWFs are themselves far too closed to foreign investment. This is because it is in the United States' interest to be open to market-driven investments -- from both private and sovereign entities -- even if other countries are not. Still, that is not to say that reciprocity is not considered at all: the reality is that investment policy decisions are made in a broader political context in which reciprocity, as well as the protection of intellectual and physical property, is taken into account.

SWFs, meanwhile, should follow five policy principles of their own. First, invest commercially, not politically. SWF investment decisions should be based solely on economic grounds, rather than political or foreign policy considerations. SWFs should make this statement a formal part of their basic investment management policies. Second, convey world-class institutional integrity. SWFs should be transparent about their investment policies and have strong risk-management systems, governance structures, and internal controls. Although not highly leveraged and, in principle, long-term investors, SWFs can represent large, concentrated, and opaque positions and thus may cause worries of systemic risk. Third, compete fairly with the private sector. SWFs should be careful not to be seen as having an unfair advantage in competing with the private sector for transactions, including by financing acquisitions at below-market rates. Fourth, promote international financial stability. As public-sector entities seeking to benefit from healthy global markets, SWFs have a strong stake in and responsibility for international financial stability. During times of market stress, SWFs should be committed to communicating effectively with the official sector to address financial-market issues. Finally, respect host-country rules. SWFs should comply with and be subject to all applicable regulatory and disclosure requirements of the countries in which they invest.

These principles are all predicated on the fact that SWF asset accumulation is appropriate in the first place. Still, the underlying macroeconomic policies creating the resources for SWFs should be under constant review to see that they, too, remain appropriate -- both for the countries with SWFs and the international financial system.

It is also worth addressing the frequently made comparison between the transparency of hedge funds and the transparency of SWFs. Transparency is very important in both cases, but each requires a different approach. Unlike SWFs, hedge funds are private-sector entities. Disclosure is important to foster market discipline, which helps to mitigate systemic risk. The key avenues for hedge-fund transparency are between hedge funds and their investors, between hedge funds and their counterparties and creditors, and among counterparties, creditors, and their regulators. These issues are being addressed through the development of voluntary best practices by private-sector groups on both sides of the Atlantic.

This framework for market discipline to mitigate systemic risk does not apply to SWFs. SWFs are public-sector entities managing public funds, and profit maximization may not be considered the primary objective. Investor discipline depends on citizens and the government, rather than savvy institutional investors. SWFs' counterparties thus may not exercise market discipline, by limiting exposures or tightening financing terms, because they assume a sovereign guarantee will assure full payment. Public disclosure is therefore appropriate for SWFs to mitigate systemic risk.