Edwin M. Truman
Peterson Institute for International Economics
May 21, 2008
House Committee on Foreign Affairs
The Rise of Sovereign Wealth Funds:
Chairman Berman, ranking member Ros-Lehtinen, and members of the House Committee on Foreign Affairs, it is a pleasure to testify before you today on the rise of sovereign wealth funds and their potential impacts on U.S. foreign policy and economic interests.
The broadest definition of a sovereign wealth fund (SWF) is a collection of government-owned or government-controlled assets. Narrower definitions may exclude government financial or non-financial corporations, purely domestic assets, foreign exchange reserves, assets owned or controlled by sub-national governmental units, or some or all government pension funds. I use “sovereign wealth fund” as a descriptive term for a separate pool of government-owned or government-controlled assets that includes some international assets. I include all government pension, as well as nonpension, funds to the extent that they manage marketable assets. The basic objectives of both types are essentially the same. They raise virtually identical issues of best practice – the focus of my research and analysis – in government control and accountability regardless of their specific objectives, mandates, or sources of funding.
wealth funds are funded from foreign exchange reserves, earnings from commodity
exports, receipts from privatizations, other fiscal revenues, or pension
contributions. (Table 1 lists 56
sovereign wealth funds of 38 countries.)
These funds have been around for more than half a century with a range
of structures, mandates, and economic, financial, and political (domestic and
international) objectives – normally a mixture. Consequently, it is perilous to generalize
about sovereign wealth funds and associated potential threats to
Nevertheless, my summary conclusions are three:
sovereign wealth funds do not pose a significant new threat to
SWFs are one of the many challenges of global economic and financial change in
the 21st century. Whether
these particular challenges of globalization are appropriately addressed will
have profound implications for the
is useful to place the activities of sovereign wealth funds in a broader
perspective. At the end of 2006, the
estimated size of global capital markets was $190 trillion. A conservative estimate of financial assets
owned or controlled by governments is $15 trillion, or about 8 percent of
global financial assets. Governments in the
assets owned or controlled by governments are at least $10 trillion: $6
trillion in foreign exchange reserves, $2.7 trillion in assets of nonpension
SWFs, and at least $1.3 trillion in government pension funds. Excluding our modest holdings of foreign
exchange reserves, international assets of U.S. SWFs are about $800 billion
mostly in the form of the pension funds of state and local governments. Thus,
As an additional
point of reference, at the end of 2006,
Over the past five years, the size of the global capital market has doubled, but asset holdings of SWFs have at least tripled. The explosive growth of SWFs reflects the sustained rise in commodity prices as well as global imbalances. However, the increased international diversification of financial portfolios – the weakening of so-called home bias – is as least as important as macroeconomic factors in explaining the growth of SWFs.
The increasing relative importance of SWFs has exposed two tensions as part of the ongoing globalization of the international financial system.
The first is the
dramatic redistribution of international (or cross-border) wealth from the
traditional industrial countries, like the
The second is the fact that governments own or control a substantial share of the new international wealth. This redistribution from private to public hands implies a decision-making orientation that is at variance with the traditional private-sector, market-oriented framework with which most of us are comfortable even though own system does not fully conform to that ideal.
These twin tensions, in turn, are manifested in five broad concerns.
First, governments may mismanage their international investments to their own economic and financial detriment, including large-scale corruption in handling the huge amounts involved. It is a well known, though often ignored, regularity that governments are not good at picking economic winners; for example, government-owned banks tend to be less profitable than private banks. This concern about mismanagement is the principal reason why it is in the interests of every country with a SWF to favor the establishment of internationally agreed SWF best practices. Moreover, greater accountability of such funds is in the foreign policy interest of the United States because the mismanagement of SWF investments could lead to political as well as economic instability in countries with such funds.
Second, governments may manage SWF investments in pursuit of political objectives – raising national security concerns – or economic power objectives—for example, promoting state-owned or state-controlled national champions as global champions. Such behavior contributes not only to political conflicts between countries but also to economic distortions.
Third, financial protectionism may be encouraged in host countries in anticipation of the pursuit of political or economic objectives by the funds or in response to their actual actions. Development of and compliance with SWF best practices would help to diffuse this source of backlash against globalization. At the same time, countries receiving SWF investments should be as open as possible to such investments subject to the constraints of national security considerations narrowly defined.
Fourth in the management of their international assets, SWFs may contribute to market turmoil and uncertainty. They also may contribute to financial stability, but their net contribution is difficult to establish a priori, in particular if their operations are opaque but also because judgments can only be reached on a case by case basis.
Fifth, foreign government owners of the international assets may come into conflict with the governments of the countries in which they are investing. For example, government ownership adds a further dimension in balancing open markets and appropriate macroprudential regulation.
At this point, these concerns, with the important exception of the first – potential adverse implications for the home countries – are largely in the realm of the hypothetical. The others are much more salient in the context of cross-border investments by government-owned or government-controlled financial or non-financial corporations. Nevertheless, a loud, often acrimonious, public discourse about SWFs is underway in many countries, and not only in countries receiving SWF investments.
In my view, the challenge is to make the world safe for sovereign wealth funds through the establishment of an internationally agreed voluntary set of best practices. The natural place to start is with the current practices of individual funds today. To this end, I have created with the assistance of Doug Dowson a scoreboard for 46 of the 56 funds listed in table 1, including the 12 pension SWFs. The scoreboard rates funds on their current practices and includes 33 elements grouped in four categories: structure, governance, accountability and transparency, and behavior. We have scored the funds based on systematic, regularly available, public information. At least one fund receives a positive score on each element. In fact at least several do.
Table 2 attached provides a summary of the scoreboard results for all elements and for each of the four categories. These results point to three take-away observations:
First, all sovereign wealth funds are not the same. Nor is there one cluster of “good” funds and another cluster of “bad’ funds. The overall scores range from 95 to 9 out a possible 100. The rating of each of them can be improved. The funds fall in three broad groups: 22 funds with scores above 60, 14 funds with scores below 30, and 10 funds in a middle group. Moreover, the grouping of scores is essentially identical if one examines only the category of accountability and transparency.
Second, although each of the 12 representative pension SWFs is in the top group, that group of 22 funds also includes 10 nonpension SWFs. Thus, it is not unreasonable to hold nonpension SWFs to the standard of accountability of pension funds. Chile’s pension and nonpension SWFs both score in the top group. On the other hand, China’s National Social Security Fund is in the top group, but the China Investment Corporation is in the bottom group.
Third, it is essentially impossible to correlate the ratings of the individual funds with the economic or political characteristics of their government owners. For example, the top group includes seven of the 14 funds with estimated assets of more than $100 billion, but four are in the second group, and two are in the third group. The top group includes funds of a number of developing countries, including Azerbaijan, Chile, China, Kazakhstan, Thailand, and Timor-Leste. The middle group includes funds of non-industrial countries as diverse as Russia, Mexico, Kuwait, and Singapore, whose two funds are in this group. Singapore’s two funds have close-to-identical overall scores, but their scores differ on many individual elements. The bottom group includes three funds from Abu Dhabi each of which has an excellent reputation in financial markets.
For some this diversity of current practice illustrates the challenge in developing a common set of best practices. In my view, it illustrates the opportunity to converge on a common high standard. A senior representative of the Abu Dhabi Investment Authority is co-chairing, with the director of the IMF’s monetary and capital markets department, the International Working Group of Sovereign Wealth Funds to develop “a set of SWF principles that properly reflects their investment practices and objectives.” The decision by the authorities of the United Arab Emirates to provide a co-chairman for this group implies a commitment by them to enhance substantially the accountability and transparency of their SWFs.
In his letter of invitation to testify before this committee today, Chairman Berman raised three issues, other than the phenomenon of SWFs and their accountability and transparency, on which I have not yet commented explicitly.
First, he asked whether sovereign wealth funds have the potential to disrupt financial markets. All investors with large portfolios have the potential to disrupt financial markets whatever their motivation. However, the very size of their portfolios helps to inhibit them from doing so, in other words, discourages them from shooting themselves in their feet.
At the same time, it is inappropriate in my opinion to view SWFs as cornucopias available to be tapped to rescue the U.S. or the global financial system. For every SWF investment in a U.S. financial institution, that fund has to disinvest, or not invest, in some other asset, normally in the United States or at least in U.S. dollars.
Some observers of private equity firms and hedge funds have concerns about their implications for the stability of our economy and financial system. I do not share most of those concerns though I have long favored increased transparency for large private equity firms and hedge funds. However, the facts do not support those who argue that SWFs are not like hedge funds and private equity firms in their speculative activities. Sovereign wealth funds invest in hedge funds, in private equity firms, and in other highly leveraged financial institutions whose activities, including the use of leverage, are indistinguishable from hedge funds and private equity firms. In effect, sovereign wealth funds are providing the capital that those firms subsequently leverage to generate high rates of return for the funds. They are no different from other investors except that their stakes may be measured in the billions rather than in the hundreds of millions of dollars.
Second, Chairman Berman asked more generally whether the foreign policy and national security interests of countries with sovereign wealth funds pose a threat to the United States. It follows from what I have already said that my short answer is no.
I am not an expert on the foreign policy and national interests of each of the more than 30 countries with nonpension SWFs to say nothing of the additional countries that only have pension SWFs. However, it is clear that the interests the individual countries are diverse, and perceptions of those countries fluctuate over time, in part, reflecting differences in the development and evolution of their political and social systems.
Policymakers are primarily interested in issues of underlying investment control even if they do not agree on how to define that concept. In this context, government owned or controlled financial and nonfinancial corporations are much more relevant because, in general, their activities are more focused and more easily integrated with foreign policy and national security objectives.
Although some SWFs do take controlling interests via their investments, more than half of the 46 funds we scored have explicit policies against doing so. A substantial proportion of the remaining 22 funds also do not seek controlling interests, but they do not have explicit, public policies in this area. Of course, it is possible to pursue foreign policy or national security interests without taking a controlling investment interest, but it is more difficult, and the investment interest is likely to be more narrowly focused and more easily identified. The essential point is that the activities of a few countries that have sovereign wealth funds and may use them to pursue political and economic interests should not be conflated with the motivations of the vast majority of countries that have such funds.
Finally, Chairman Berman asked for thoughts on how the U.S. Congress and the Administration can best “manage” sovereign wealth fund investing in the United States. I interpret his question as asking how the Congress and Administration should best respond to the phenomenon of sovereign wealth funds.
Notwithstanding my view that the greatest risks associated with SWFs are to the citizens of the countries whose governments have accumulated the large stocks of international assets, authorities in the United States and other countries where those assets are invested also have legitimate concerns about how they will be managed. Those concerns focus primarily on acquisition of large or controlling stakes by foreign governments in private institutions. As noted, at present this is the exception not the rule for SWFs. However, one area of concern and potential conflict is the apparent use by a few countries, such as China and potentially Brazil, to use their SWFs to promote the expansion of their own economic enterprises.
Of course, the current, largely benign pattern could change, and foreign government-owned or government-controlled financial and nonfinancial corporations do acquire stakes in companies in other countries, including controlling stakes. The 2007 Foreign Investment and National Security Act (FINSA) revised the framework and procedures of the Committee on Foreign Investment in the United States (CFIUS). With these changes and the existing powers of the Securities and Exchange Commission as well as other U.S. financial regulators, we are well positioned to evaluate and, if necessary, to mitigate, to block, or to pursue any U.S. acquisitions or investment by a SWF or other foreign government entity to protect our national security or to enforce our laws and regulations governing financial markets and institutions.
With respect to economic security concerns, the greatest risk to the U.S. economy is that we will erect unnecessary barriers to the free flow of capital into our economy and, in the process, contribute to the erection of similar barriers in other countries to the detriment of the health and continued prosperity of the U.S. and global economies. We may not in all cases be comfortable with the consequences of the free flow of finance and investment either internally or across borders, but on balance it promotes competition and efficiency. We should exhaust all multilateral approaches before pursuing bilateral remedies, and any such bilateral remedies should be narrowly focused.
To this end, I endorse the Administration’s support of the OECD process designed to strengthen the framework that the United States and other OECD member countries use to govern foreign investment including by governmental entities. At present that framework does not, in principle, extend to non-members of the OECD though often it does in practice. The United States should support its explicit extension to all countries.
My hope is that the OECD process will provide sufficient reassurance to countries with sovereign wealth funds so that, with the facilitation of the IMF, they can reach agreement on and fully comply with a voluntary set of best practices for their funds.
How should that IMF-facilitated effort be judged when it is completed in the fall of this year?
One test is whether the resulting set of best practices covers substantively all the elements included in my scoreboard. Of course, it is not essential to cover them precisely in the form outlined in the appendix to this testimony. However, each element should be adequately addressed. A significant omission should be seen as falling short of expectations.
A second test of success is whether the best practices are embraced by substantially all countries with large SWFs. Table 1 lists 14 SWFs with more than $100 billion in total assets. If each of them were to adhere to the prospective set of best practices, it is less critical that the others do so immediately. For each country, including those that choose not to adhere fully or at all, the minimum expectation should be that the country would comply, or it should explain why it does not do so in whole or in part.
A third test is the quality of compliance by the countries that embrace the best practices. If they are drawn up properly, the best practices should be self-enforcing. Politicians, the media, financial-market participants, and the general public in the home and host countries should be able to determine the degree of compliance.
On the other hand, if the voluntary best practices agreed under the auspices of the IMF are less precise than they should be, it will be necessary to have some mechanism to report on compliance. That function might be lodged in the IMF or the World Bank, which have experience with respect to overseeing compliance with 12 of the many existing international standards and codes. As is the case with existing standards subject to IMF and World Bank surveillance and oversight, the resulting process of implicit naming and shaming, combined with peer pressure from other SWFs that want to avoid the application of draconian restrictions to their activities, should contribute to a high level of compliance within a short period.
Some may favor supervisory inspections of SWFs beyond those that would be covered by IMF and World Bank surveillance plus published, independent audits as called for in my scoreboard. To my knowledge, no official has said so publicly. However, to advocate this type of supervision would sharply escalate the SWF debate from one about the content of and adherence to internationally agreed voluntary best practices to one about explicit regulation. At this point, such an escalation is neither appropriate nor justified on the merits.
On the recipient side, many countries today have (very diverse) regimes covering foreign direct investment in their countries. Pending the establishment of a broad consensus on those regimes as they apply to government investments, such as is being pursued within the OECD, and perhaps even in that context, the United States and other similarly situated countries might reasonably decide to take account of a country’s voluntary compliance with the international best practices for SWFs as one of a number of factors considered in making determinations about whether a particular SWF’s investment should be blocked because of a threat to national security. For example, in a March 13 letter sent to U.S. Treasury Secretary Henry Paulson, Representatives Barney Frank, Carolyn Maloney, and Luis Gutierrez suggested that a country’s compliance with aspects of SWF best practices could be used by the CFIUS as a factor in determining whether the committee should grant that country a waiver from a full investigation under FINSA of an investment, for example, by a government-owned pension fund.
More controversially, some observers have suggested that an SWF that takes even a noncontrolling stake in a company should be forbidden from voting its shares, presumably increasing the probability that the investment is “passive.” My understanding is that there is no generally accepted legal definition of a passive investment. (I note that the proposed CFIUS regulations implementing the FINSA instead seek to define interests that are “solely for the purpose of investment,” which is a more limited approach.) To limit the voting rights of government investors, if applied uniformly, would disenfranchise as much as several trillion dollars of investments by U.S. state and local government pension funds. If the United States did not apply this type of restriction to domestic pension SWFs, it would still risk disenfranchising U.S. government pension funds in their investment operations abroad. The reason is that it would be difficult to apply such a restriction to foreign nonpension SWFs and not to foreign pension SWFs. As a consequence, foreign governments almost certainly would retaliate in kind.
U.S. Treasury Assistant Secretary Clay Lowery has suggested a more sensible approach: either an SWF should choose voluntarily not to vote its shares or it should disclose how it votes, as is now done voluntarily by some U.K. institutional investors and is required by the Securities and Exchange Commission for U.S. mutual funds. The objective of the SEC rule for mutual funds is to address concerns about conflicts of interest and, as noted earlier, similar concerns arise with respect to SWFs. Presumably, the SWF would not face a formal SEC reporting requirement in this area; that would raise a host of other process and jurisdictional issues and also serve to escalate the SWF debate.
In conclusion, the phenomenon of sovereign wealth funds is a permanent feature of our global economy and financial system. Their potential impacts on U.S. foreign policy, national security, and economic interests may be disquieting, but they do not endanger the United States. U.S. authorities should exhaust all multilateral approaches to make the world safe for SWFs – in the form of SWF best practices and open financial environments – before turning to any additional, bilateral remedies for concerns that to date are between minimal and nonexistent.
Scoreboard for Sovereign Wealth Funds
This appendix presents the elements of the scoreboard described in the testimony. For each of the 33 questions, if the answer is an unqualified yes, we score it as “1.” If the answer is no, we score it as “0.” However, partial scores of 0.25, 0.50, and 0.75 are recorded for many elements, indicated by (p) in the descriptions below.
The four categories in the scoreboard are listed below with subcategories where relevant. The words in bold are keyed to the results presented in table 3 for each SWF on each element.
1. Is the SWF’s objective clearly communicated? (p)
2. Is the source of the SWF’s funding clearly specified? (p)
3. Is nature of the subsequent use of the principal and earnings of the fund clearly stated? (p)
4. Are these elements of fiscal treatment integrated with the budget? (p)
5. Are the guidelines for fiscal treatment generally followed without frequent adjustment? (p)
Other Structural Elements
6. Is the overall investment strategy clearly communicated? (p)
7. Is the procedure for changing the structure of the SWF clear? (p)
8. Is the SWF separate from the country’s international reserves?
9. Is the role of the government in setting the investment strategy of the SWF clearly established? (p)
10. Is the role of the managers in executing the investment strategy clearly established? (p)
11. Are decisions on specific investments made by the managers? (p)
12. Does the SWF have in place and publicly available guidelines for corporate responsibility that it follows? (p)
13. Does the SWF have ethical guidelines that it follows? (p)
Transparency and Accountability
Investment Strategy Implementation
14. Do regular reports on investments by the SWF include information on the categories of investments? (p)
15. Does the strategy use benchmarks? (p)
16. Does the strategy limit investments based on credit ratings? (p)
17. Are the holders of investment mandates identified?
18. Do regular reports on the investments by the SWF include the size of the fund? (p)
19. Do regular reports on the investments by the SWF include information on its returns? (p)
20. Do regular reports on the investments by the SWF include information on the geographic location of investments? (p)
21. Do regular reports on the investments by the SWF include information on the specific investments? (p)
22. Do regular reports on the investments by the SWF include information on the currency composition of investments? (p)
23. Does the SWF provide at least an annual report on its activities and results? (p)
24. Does the SWF provide quarterly reports? (p)
25. Is the SWF subjected to a regular annual audit? (p)
26. Is the audit published promptly? (p)
27. Is the audit independent? (p)
28. Does the SWF indicate the nature and speed of adjustment in its portfolio? (p)
29. Does the SWF have limits on the size of its stakes? (p)
30. Does the SWF not take controlling stakes? (p)
31. Does the SWF have a policy on the use of leverage? (p)
32. Does the SWF have a policy on the use of derivatives? (p)
33. Are derivatives used primarily for hedging?
 Table 1 also lists the dates when the funds were established, the sources of their funding, and estimates of their size. The table includes 44 SWFs that I have been able to identify that are not hard-wired to government pension funds and 12 representative pension SWFs. Note that the data in table 1, in the other tables attached to this testimony, and described in the text include the government pension SWFs of Chile and Thailand that were not part of the analysis presented in my Blueprint for Sovereign Wealth Fund Best Practices released as Policy Brief 08-3 by the Peterson Institute for International Economics, April 1, 2008.
 International Monetary Fund, Global Financial Stability Report, April 2008, table 3. The total includes stock market capitalization, public and private debt securities, and commercial bank assets.
 This estimate includes $6 trillion in foreign exchange reserves, $6 trillion in government pension funds (excluding the U.S. social security fund and government pension funds that invest exclusively in government assets or are not involved in the management of marketable assets), and $3 trillion in assets of nonpension sovereign wealth funds.
 U.S. governmental financial assets include $3 trillion in state and local government pension funds, $50 billion in other sub-national SWF assets, and $40 billion in foreign exchange reserves.
 Based on various estimates, government pension funds around the world hold about $6 trillion in assets and roughly 25 percent of those are foreign.
 U.S. and foreign data on the international stocks and flows of financial assets generally do not distinguish government from non-government holders. The above estimate of assets controlled by U.S. governmental units includes federal government assets as reported by the Commerce Department (The U.S. Net International Investment Position at Yearend 2006, Bureau of Economic Analysis, BEA 07-31, June 28, 2007) plus estimated holdings of $750 billion by state and local government pension funds that are included in our statistics among private sector assets. In the same Commerce Department release, foreign official assets in the United States include foreign exchange reserves and some holdings of sovereign wealth funds, but the data as collected do not distinguish between the two categories.
 We scored the two new Russian SWFs as the single fund it was before its recent transformation. The remaining nine funds, indicated by “c” in table 1, are either too new to score or we could not find sufficient information to do so.
 Table 3 provides the results for each fund on each element. The appendix provides a list of the 33 elements.
 The two exceptions are the National Oil Account of São Tomé and Principe, which drops into the bottom group of funds, and Singapore’s Temasek, which moves into the top group..
 The fourteenth was not scored: the nonreserve holdings reported by the Saudi Arabian Monetary Agency.
 See IMF press release 08/97 dated May 1, 2008, “International Working Group of Sovereign Wealth Funds is Established to Facilitate Work on Voluntary Principles.”