Nothing to Fear but Fearmongers Themselves: A Look at the Sovereign Wealth Fund Debate

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Introduction

Reliance of the U.S. economy on foreign investment is as old asthe Republic itself. So, too, are misgivings about externalfinancing and foreign ownership. But the latest manifestation ofthe debate over whether, to what degree, and with what stipulationsforeigners should be permitted to own U.S. assets presents a newwrinkle. By focusing on a particular subset of foreigners-namely,foreign governments-the current debate is framed in terms thatcould win support for greater restrictions of foreign investmentfrom those who might otherwise oppose them.

Government-owned investment funds, also known Sovereign WealthFunds are not new to the international investment scene. Someexisting funds were established in the 1950s and 1960s. What isnew, however, is that the number of SWFs and the value of assetsunder their collective management have increased significantly inrecent years.

Skepticism about the motives and consequences of increased SWFinvestment is growing. Perhaps most disconcerting for some U.S.policymakers is that the governments that have been most active inrecent SWF investment do not necessarily share America's worldview.At issue is whether SWF investment, which could be used to servestrategic or political objectives, should be subject to greaterscrutiny and tighter restrictions than other types of foreigninvestment.

Despite legitimate concerns about governments accumulatingwealth and making investment decisions in the first place, as wellas lingering doubts about the motivations behind those investments,changes in foreign investment policy are unnecessary. Current U.S.rules governing banking and investment strike the right balance;they generally welcome foreign investment while being designed toensure that such transactions do not compromise the integrity ofour financial markets or our national security.

The Sovereign Wealth Fund Explosion

The U.S. Department of the Treasury defines sovereign wealthfunds as "government investment vehicles funded by foreign exchangeassets, which manage those assets separately from officialreserves."1 SWFsare nothing new. Government-owned asset funds financed fromcurrency reserves have existed for more than half a century,pursuing legitimate and rational economic objectives, though notnecessarily optimally. Over the years, governments of countrieswhere commodities account for important shares of their economieshave established SWFs to hedge against declining commodityprices-hardly a worry today-and to ensure that wealth generatedfrom the extraction and sale of its nonrenewable assets isavailable to future generations. To date, these funds haveexhibited unremarkable behavior-that is, their investmentstrategies and performances do not appear to have differed markedlyfrom those of private-sector funds.2

In recent years, the number of SWFs and the value of assetsthose funds manage have increased dramatically, due in large partto rising commodity prices and the accumulation of foreign reservesin countries running persistent trade surpluses. Since 2000 thenumber of funds has roughly doubled to about 40 and the value ofassets under SWF management has increased five-fold to a figureapproaching $2.5 trillion today.3 According to projections from theInternational Monetary Fund and others, SWF assets will increase toabout $10 trillion by 2012 and $12 trillion by 2015.4

Brewing Concerns about SWF Investment

The rapid growth in SWFs has raised concerns among U.S. andother rich-country policymakers. Skepticism about SWFs reflects,among other things, angst about the implications of wealthaccumulation in emerging countries. Among the countriesaccumulating wealth and establishing new SWFs are China, Russia,and other oil-rich nations, whose views about markets, governmentaccountability, and transparency have not always meshed with thoseof the West. This has accentuated the political dimension of theissue. A recent front-page article in the New York DailyNews put it like this:

America is for sale-and the buyers of some of our mosticonic corporate assets are a passel of Mideast oil sheiks, Asiangovernment investment funds and market Marxists.5

And with respect to China and other East Asian countries thathave run persistent trade surpluses, policymakers are alreadysensitive to claims that those surpluses are the product ofcurrency manipulation and other alleged "unfair" trade practices.As the United Steelworkers union boss Leo Gerrard put it:

We've hollowed out our industrial base and run up thismassive trade deficit, and now the countries that have built thedeficits are coming back to buy up our assets. It's like spittingin your face.6

Already worried about falling stock and real estate values,soaring oil and food prices, and the specter of stagflation,Americans are now being told that SWF investment is the fourthhorseman of the apocalypse. At a recent House Financial ServicesCommittee hearing on the topic of SWFs, Rep. Paul Kanjorski (D-PA)painted this extreme hypothetical:

If I were China, I'd put my sovereign funds . . . inthe energy field of the United States. I'd buy as many electricalutility companies as I could. And then, at my own desire, ratherthan send an army over here sometime in the future or an airplaneto do damage, I'd just issue the order as the owner of theelectrical utility networks in the U.S. to turn off the power.What's going to stop them from doing that?7

That scenario reflects the growing concern that SWFs mightpursue strategic and political objectives rather than purelyeconomic ones. Not only could foreign purchases of criticalinfrastructure compromise U.S. national security, but the pursuitof non-economic objectives through investment transactions couldadversely affect the ability of markets to price assets correctlyand to allocate resources efficiently.

Although nearly entirely lost beneath the hyperbole of hisexample, there is a trace of merit to Congressman Kanjorski'sbroader point. The same cannot be said of the xenophobic rantingsof the New York Daily News article or the economicilliteracy of Leo Gerard. Loss of faith in the ability of financialmarkets to function properly when major participants in thosemarkets are governments is a thorny issue, and one that concernsSecurities and Exchange Commission chairman Christopher Cox.

In a recent speech at Harvard University, Cox expressed concernabout private interests being at systemic disadvantages becauseSWFs have access to information that is barred from the public,like government intelligence and state secrets. Markets react topolitical and diplomatic events; having foreknowledge of an eventconstitutes an advantage that, if acted upon, could cause investorsto lose faith in markets. An asymmetry of information is not theproblem; markets deal with that routinely. It is the asymmetry ofaccess to information between market participants that mightultimately dissuade participation in markets, which would beproblematic.8

Cox also expressed concern that SWFs present conflicts ofinterest that could impact the SEC's capacity to fulfill some ofits functions. The SEC relies on the cooperation of foreigngovernments to administer its international financial regulationand enforcement efforts. Cox worries that that cooperation mightnot be forthcoming and that the potential for corruption increaseswhen the proposed investments and activities of foreign governmentsthemselves come under the scrutiny of U.S. authorities.9

Oversized Policy Responses

In response to concerns ranging from legitimate to paranoid,U.S. policymakers are considering whether new restrictions of SWFsare warranted. Although no legislation has been introduced yet,several hearings have been held in various U.S. congressional andexecutive advisory committees on the subject already. At present,the IMF, World Bank, and OECD are reportedly working to draft codesof official conduct for SWFs with guidelines concerninginstitutional structure, risk management, transparency, andaccountability.

For some countries, best practices guidelines will not beenough. The French, who have cultivated a reputation for blockinginternational transactions to "protect national champion"companies, have identified 11 "strategic sectors" immune to foreigntakeovers. Meanwhile, Russia, an emergent SWF investor itself, hasdrafted a law that, if formalized, would protect 39 different"strategic industries," relegating industries comprising over 50percent of Russia's GDP off limits to foreign investment.10

Certainly, there are voices among U.S. policymakers and withinthe policy community that would support tighter restrictions orprohibitions of SWF investment, if not all types of foreigninvestment altogether. With the exception of a couple of tokenwitnesses counseling circumspection in the matter, a recentU.S.-China Economic and Security Commission hearing on the topicwas a virtual who's who of trade and investment skeptics. Severalwitnesses called for strict limits on sovereign investment in U.S.assets, including outright bans on investments in sectors,industries, or assets deemed to be strategic for U.S. economic ormilitary purposes (however amorphous those parameters mightbe).11

Typical was the testimony of Alan Tonelson of the U.S. Businessand Industry Council, who draws parallels between the threats tothe United States posed by SWFs, Al Qaeda, the Chinese military,and a resurgent Russia, and suggests that it is naïve to countthe sheiks in Persian Gulf oil kingdoms as allies. Better to err onthe side of caution, which in his estimation means limiting foreigngovernment ownership of any given U.S. entity to 10 percent-because"that seems like a reasonable starting point"-with 1 percent limitscoming from any single foreign government.12

Tonelson seems unconcerned about the costs of such a blanketprohibition. The shortage of U.S. savings necessitates inflows offoreign capital to finance investment. By restricting large sourcesof investment a priori, the cost of capital in the United Stateswould be considerably higher. Surely there are betteralternatives.

A Little Perspective, Please

The growth of SWFs reflects rational investment portfoliodiversification. While there are legitimate concerns about theimplications of government ownership of assets, there is somethinghypocritical about complaints that SWFs might pursue politicalrather than economic objectives. After all, the value of assetswithin SWFs is already a reflection of political choices andnational policies, such as monetary and fiscal policies, including,notably, a government's decision to spend in excess of itsrevenue.

For many years, foreign central banks have invested currencyreserves conservatively, often in low-yielding U.S. governmentsecurities. Over the past few years, as the dollar's decline hasaccelerated, foreign central banks have been losing money on theseinvestments. In 2007, for example, the yield on 10-year U.S.treasury bills averaged between 4.5 percent and 5 percent. Butduring 2007, the Chinese renminbi appreciated by 6 percent againstthe dollar. Accordingly, in terms of its domestic currency, Chinaexperienced negative returns on its investments in U.S. debt during2007.13 Thesame was true for nearly all foreign holders of U.S. treasurybills.

The same people who have complained about the need for morerapid appreciation of the Chinese currency now complain aboutChina's diversification into higher-yielding assets, which isnecessary to allow that appreciation to happen without the Chineseexperiencing huge currency exchange losses.

Furthermore, foreign investment in nongovernment portfolio andphysical assets might curtail U.S. government growth by reducingdemand for government debt, thereby bidding up the cost ofgovernment profligacy. For too long Congress has been able to spendwithout political consequence by thrusting the costs on futuregenerations. There is an important distinction to draw betweeninvestment in the United States that finances currentconsumption-such as purchases of government bonds- and investmentthat is likely to produce future income streams-such as purchasesof U.S. factories, land, or other productive assets. In thatregard, SWF investment is more like an investment and less like aline of credit than the majority of foreign sovereign investmenthas been thus far.

Most anxiety about SWFs is attributable to their rapid increasein number and size. At nearly $3 trillion (the upper end of currentestimates), SWFs are more than twice as large as all of the world'shedge funds combined. But $3 trillion constitutes a tiny sliver ofthe $190 trillion stock of global financial assets or the $62trillion managed by private institutional investors.14 Even with SWF assetsprojected to quadruple by 2015, global asset values are projectedto grow as well, such that the percentages owned by SWFs should notchange much. It is highly improbable that the investment decisionsof SWFs will "move" U.S. markets.

Welcome Investment and Let Our Laws Work

The proliferation of SWFs is not a threat to the United Statesbut an affront to citizens in countries where large amounts ofwealth and too many investment and other economic decisions arecontrolled by the state. When governments get wealthier, theircapacity to exert firmer control over their citizens and tomarginalize civil society grows. It remains the firm hope ofliberal-minded people that economic growth continues to lead toincreased civil and political liberties and a diminution of therole of government, as it has in the past. That that process hasbeen agonizingly slow in some countries is a fact of economic lifethat we should not attempt to mitigate through trade or investmentpolicy.

Instead, we should welcome all foreign investment that complieswith out laws. We have to ensure that any policies we adopt inresponse to SWFs and in the name of preventing market distortionsdon't themselves cause market distortions. Blanket prohibitions orrigid controls on investment from foreign sovereigns are likely tocause resources to be allocated inefficiently.

If SWF investment is significantly curtailed in the UnitedStates and in other rich countries, where most of the world'sassets are parked, it is more likely that those funds will seek outinvestment opportunities in other markets that are lesscapitalized. The total value of assets in Latin American stockmarkets, for example, is estimated to be about $4 trillion. The $1to $2 trillion in new wealth projected to be added to SWFs annuallythrough 2015 could certainly have a major impact on markets thatare less capitalized, like Latin America's and Africa's, where,presumably, the United States has security interests as well.

A heavy-handed response to SWF growth also could spark atit-for-tat trade and investment war. U.S. policymakers should beaware of the stakes. For example, in 2005 the parents of U.S.multinational companies exported $456 billion in goods to foreignmarkets, but their foreign subsidiaries sold nearly $3 trillion ofgoods abroad that year. U.S. multinationals serve foreign marketsprimarily through host country affiliate sales.15

Whether controlling or passive, direct or portfolio, sovereignor private, foreign investment in the United States should bewelcomed with the presumption that it will be mutually beneficial.Its presence reduces the cost of capital to businesses and the costof credit to consumers, whose investment and consumption decisionsdrive the economy.

But foreign investments should be vetted to ensure that anyrisks to national security posed by such investments are minimaland that proposed investments that do present legitimate nationalsecurity risks are blocked or restructured. The interagencyCommittee on Foreign Investment in the United States, whoseprocedures for reviewing proposed foreign investments were justrevamped by the Foreign Investment and National Security Act of2007 (FINSA), has the tools and authority to do just that. Andwhere ownership of U.S. financial institutions is concerned, a hostof banking laws exists to ensure that our financial system remainssafe.

The one extra assurance that will reduce risk even further belowtolerable levels without repelling investment is voluntarytransparency. If SWFs are forthcoming about their investmentstrategies, their portfolio allocations, and their governance, andthey are made aware that the consequences of false representationsor insider trading would result in severe penalties and futurerestrictions, there should be no problems. If SWFs refuse todisclose, there should be an adverse presumption that leads toinvestment restrictions.

Finally, to allay some of the deeper fears, like those roused byRepresentative Kanjorski's depiction, foreigners would never beable to turn off the power in the United States. The first stopgapwould be CFIUS, which would not allow foreigners to obtainpotentially dangerous levels of ownership in U.S. utilities.Second, the operation of utilities and other assets in the UnitedStates are subject to U.S. laws and, ultimately, to U.S. actions tomitigate the problems associated with nefarious aims.

We should welcome foreign investment, in whatever form it comes,without a priori exclusions. Our laws are already well-suited toidentify and discipline bad actors, when necessary.

Notes


1 David H.McCormick, Undersecretary for International Affairs, U.S.Department of the Treasury, Testimony Before the U.S. House ofRepresentatives, Committee on Financial Services, March 5,2008.

2 StefanSchonberg, "Sovereign Wealth Alarm," The InternationalEconomy, Winter 2008, p. 58.

3 McCormickTestimony. Many sources cite current SWF asset values between $2and $3 trillion.

4 Ibid. Manysources cite projected growth of SWF asset values to between $10and $15 trillion by 2015.

5 DouglasFeiden, "American Corporations Selling Chunks to EconomicPowerhouses," New York Daily News, January 16, 2008.

6 Peter Goodmanand Louise Story, "Overseas Investors Buy Aggressively in U.S.,"New York Times, January 20, 2008.

7 CongressmanPaul Kanjorski, Comments During Hearing in the U.S. House ofRepresentatives, Committee on Financial Services, March 5,2008.

8 ChristopherCox, "The Role of Government in Markets," Speech before the John F.Kennedy School of Government, Harvard University, October 24,2007.

9 Ibid.

10 Schonberg,p. 58.

11 PeterNavarro, Professor of Business, University of California-Irvine,Testimony before the U.S. China Security Commission, February 7,2008.

12 AlanTonelson, Research Fellow, U.S. Business and Industry Council,Testimony before the U.S.-China Security Commission, February 7,2008.

13Congressional Research Service, CRS Report for Congress,"China's Sovereign Wealth Fund," January 22, 2008, p. 16.

14 McCormickTestimony.

15 Matthew J.Slaughter, Associate Dean and Professor of International Economics,Tuck School of Business, Dartmouth University, Testimony Before theU.S. House of Representatives, Committee on Financial Services,March 5, 2008.