Sovereign wealth funds could have dangerous implications for us

The current global economic crisis has led to greater acceptance of the role of government wealth funds (GWFs) as international investors. Sovereign wealth funds (SWFs) are an important component of the GWFs.

In the larger context of global macroeconomic balances, which are unlikely to be resolved soon, this acceptance is primarily due to the short-term consideration, particularly in industrial countries, of the urgent need to recapitalise their banks and to find buyers for an increasing amount of government debt. These debt levels are set to increase, creating huge future fiscal liabilities and risks.

According to the International Monetary Fund’s (IMF’s) October 2009 Global Financial Stability Report, nearly 60% of all capital imports in 2008 was to such debtor nations as USA, Spain, Italy and France. Nearly 70% of global capital imports were by just seven OECD countries, with United States accounting for than two-fifths of the total.

The major capital exporting countries in 2008 were China (24%), and resource-rich countries (36%). Japan is unusual in spite of very high public debt; its high current account surplus enabled it to contribute nearly 9% of global capital exports.

As traditional investors from the industrial countries are less able to provide foreign  direct investment and portfolio flows to the rest of the world, GWFs, which are primarily from resource-rich countries in the Middle East, and from current account surplus economies in East Asia, are increasingly gaining favour in emerging markets as sources of funds.

According to the official website of the Sovereign Wealth Funds Institute(http://www.swfinstitute.org), in September, the total assets of SWFs were $3,752 billion with resource rich areas contributing 61%, and those with current account surpluses and pension assets accounting for the rest. The largest share of the SWF assets was by the Middle-East (44%), followed by Asia (35%).

In 2008, SWF assets were equivalent to 6.2% of global GDP, 55% of global reserves and 11% of global stock market capitalisation. These figures understate the economic leverage, which can be exercised by the SWFs.

First, the SWFs can leverage their assets and partner with other elements of the shadow banking system involving activities and entities (such as private equity funds and hedge funds), which can skirt national regulatory structures. Indeed, they could emerge as the most intractable part of the shadow banking system.

Second, the SWFs are only one of the components of GWFs. These include foreign exchange reserves, state enterprise funds, various endowment funds controlled by the states. As the mandate of all the GWFs is to advance the interests of their country of origin, the economic clout or power they can wield is considerably greater than the gross assets figures for the SWFs alone may suggest.

While there has been short-term acceptance of the financial benefits arising from the SWFs, medium-term implications of such high concentration of financial assets and their potential for leverage, including through largely unregulated entities such as hedge funds and private equity funds merits much greater global debate then has been the case so far.

It should be stressed that this prospect is in addition to increasing economic concentration being evidenced in the domestic economies of many countries, including India. In October 2008, some of the SWFs and recipients of their funds agreed on the Generally Accepted Principles and Practices (GAPP), commonly known as the Santiago Principles after the location where the meeting took place.

These principles, however, are on a voluntary basis, and are primarily concerned with internal governance of the individual SWFs, and not with the overall systemic global impact on financial risks and on economic structures. Moreover, self-regulation, particularly by entities such as the SWFs, created to serve the national strategic objectives, must be viewed with abundant caution, especially by the recipient countries.

Another major limitation of The Santiago principles is that they do not cover other components of GWFs. Many countries have several pools of government-controlled assets, with varying degrees of transparency and accountability.

The current regulations to deal with monopoly power and economic concentration are primarily national, or in some cases, such as the European Union, regional. Each country or sub-region has created its own investment scrutiny or review structures, and systems of recording and monitoring of foreign investments.

But, current reviews and competition laws do not sufficiently take into account the impact of the investments by the GWFs on global and regional monopoly power and on the impact on future dynamics of technological innovations and business formation. As is the case nationally, regional and local monopolies have sometimes even stronger impact on firm behaviour, innovations, and business formation than on a national level.

This is particularly relevant as the GWFs concentrate on a relatively narrow range of
sectors: energy, finance and telecommunications. There are justifiable concerns that just as globalisation of finance permitted financial institutions to create regulatory arbitrage, which in turn created systemic risks, there may be similar impact as GWF investments are able to take advantage of gaps in global and regional competition laws and regulatory capacities.

If competition, current and potential, in key industries and technologies in low and middle-income countries is adversely impacted by investments from the GWFs, this may reduce future economic prospects and dynamism of the recipient countries. The private sector, which does not have recourse to deep-pocket GWFs and state enterprises, will be particularly vulnerable.

Possible constraining of the role of small and medium enterprises will be of considerable relevance as in many countries, including India, their creation and their continued health are vital for creation of sufficient livelihoods for managing globalisation, while sustaining social cohesion.

As competition is rightly regarded as the main spur to efficiency, such concentration of economic and technological power in the hands of the state-owned or directed institutions has profound implications for the dynamics of the global and regional economies.

India should initiate a nuanced and strategic debate on the medium-term implications of the role of GWFs in India’s future economic and technological dynamics. India’s increasing number of WTO Plus economic agreements with countries and regional groups, many of them with substantial GWFs, adds to the urgency of such a debate.

The writer is professor, Lee Kuan Yew School of Public Policy, National University of Singapore and can be reached at sppasher@nus.edu.sg. Views are personal.