Safeguards needed on sovereign wealth funds

The current phase of globalisation has been characterised by unprecedented growth in world financial assets. They constitute more than three times the world’s gross domestic product, triple the share in 1980.

Sovereign wealth funds (SWFs) are one of the pools of assets (primarily, but not exclusively, international) for achieving the government’s economic, financial, and strategic objectives. The officially stated objectives, however, are couched in neutral commercial terms.

The size of the SWFs is difficult to estimate due to lack of transparency, and absence of international monitoring mechanism.

In a recent testimony to the US Congress, Edwin Truman reported the combined size of the 16 major SWFs in June 2007 at $2.1 trillion and their foreign exchange reserves at $4.1 trillion, giving them control over $6.2 trillion. This compares with $3 trillion in global “hedge funds,” and annual flow of $1.2 trillion in private equity.

India’s foreign exchange reserves of $271 billion, as at November 16, 2007, are quite modest in comparison.

The ongoing commodity boom, reflected in high oil and mineral prices; mercantilist policies of China and other East Asian countries leading to large persistent current account surpluses; high stock of SWFs leading to high annual flows of SWF income, all suggest that SWFs will continue to be a force in the global financial markets.

Morgan Stanley estimates that the size of SWFs may grow to $12 trillion by 2015.

The size and expected rapid growth, along with geographical and investment activity concentration of the SWFs, have raised concerns in both originating and recipient countries.

Thus, the IMF has been concerned about the impact of SWFs on financial stability. There is anxiety, not just in the developing countries, that the SWFs’ investment in their strategic industries may undermine technological flexibility, policy autonomy, and perhaps social cohesion.

The SWFs must be evaluated in terms of their structure, governance, transparency and accountability, and behaviour. A scorecard based on these four factors, prepared by Edwin Truman, gives some of the lowest scores to oil-rich countries, China, and one of the two SWFs of Singapore, raising serious concerns.

The irony in the birth and growth of SWFs is that the role of the state sector in both financial and real economic activities is growing at a time when the idea of increasing the role of the markets has gained ascendency.

Countries with some of the largest aggressive SWFs are far from open societies and participative political entities. The liberal commentators who argue in favor of SWFs see no contradiction in the intrusion of opaque SWFs into privately-run companies in their countries, while they would stoutly oppose their own government’s stakes in privately-run companies.

Closing the avenues for investments by SWFs is neither practical, nor desirable. Fungibility of funds and wide range of financial institutional forms available imply that if investments as SWFs are prevented, their funds will find another avenue for investment.

Moreover, not all SWFs have low transparency and poor governance structures, or are motivated by non-commercial goals. The global financial markets as well as individual countries will need to accommodate them, but with sufficient safeguards.

The policies toward SWFs must be based on sound empirical data and other evidence, and should not provide opportunities for regulatory arbitrage by treating SWFs markedly differently than other financial institutions such as the hedge funds and private equity.

There is a need to better monitor the activities of SWFs, both nationally and multilaterally. The IMF, the World Bank
and the OECD have been asked by G-7 to examine SWF issues and to draw up broad guidelines for both the home and the
recipient countries. The recommendations of the Financial Action Task Force on Money Laundering should also be vigorously applied to the countries with significant SWFs.

Domestically, the countries may consider much more robust and sophisticated monitoring of investments by the SWFs in their respective countries.

In some cases, golden share type arrangements, and quantitative limits on SWF investments may be appropriate. Such limits are better set on a country basis, rather than on the basis of each SWF, as there are countries which have more than one SWF. This is something India must keep in mind in negotiating economic agreements.

Open societies with still-developing regulatory, and data gathering and mining capabilities such as India need to be particularly cautious when the investments by the SWFs are involved in strategic areas such as banks, telecommunications, and ports.

There is a possibility of national policies being undermined by transactions undertaken by SWFs of different countries. India also needs to substantially enhance its regulatory and monitoring capacity for not just approving the foreign direct and portfolio investments, but also their behaviour over time. India should consider developing a database of foreign investments by type of financial institutions, including SWFs.

It was recently reported that a Chinese SWF has approached Temasek Holdings (one of Singapore’s SWFs) to purchase a stake held by the latter in the Standard Chartered Bank (which has large operations in India).

India has granted special privileges to two of Singapore’s SWFs under the Comprehensive Economic Cooperation Agreement. Reportedly, Temasek has declined to sell its stake. Nevertheless, this example illustrates the possible strategic and systemic risks in dealing with the SWFs for India.

As the size of the Indian economy increases from the current $1.2 trillion, the market for corporate control will also become more contestable. Better corporate governance is therefore no longer a luxury but a necessity if the existing owners want to maintain control.

India must also permit its entrepreneurs, state enterprises, and its financial institutions much greater latitude in pursuing investments abroad, and in engaging in strategic alliances.

India should insist on reciprocity in investment access, and in other economic opportunities in the countries of origin of the SWFs, while participating in shaping the international code of conduct for them.

The aim should be to retain policy autonomy and flexibility so as not to undermine India’s medium-term technological choices and growth options.