Saturday, April 5, 2008

Sovereign Wealth Funds (S.W.F.s): Are These Funds Friends or Enemies of the North American and European Economies?

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April 5, 2008


ABSTRACT — Sovereign Wealth Funds (S.W.F.s) are state entities that manage a country's savings with the plan to obtain high-quality returns from the financial assets in which they invest. S.W.F.s are not a new phenomenon but what has been changing consistently in the last years is their dimensional growth (they administered around $3 trillion at the end of 2007, an amount that will continue to augment also in the coming years. These funds belong for the most part to developing countries, and they invest primarily in the financial markets of North America and Europe. Since last year on both sides of the Atlantic Ocean has emerged a debate about the necessity to set up some rules in order to regulate S.W.F.s. The aim of this paper is to try to understand what these S.W.F.s are in reality and what are the possible proposals in the U.S. and in the European Union (E.U.) in order to create a legal framework in which the funds will operate in the next future.   

Introduction

In Western countries, for the first time foreign direct investments (F.D.I.s) from emerging markets — the definition "emerging market" is commonly used to describe business and market activity in industrializing or emerging regions of the world — are close to the amount of F.D.I.s done by North America and Europe in Asia, Russia, South America and the Middle East. Similarly astonishing is the fact that two Arab countries have decided to enter into the capital of the Nasdaq (New York), the London Stock Exchange (London) and the Omx (Stockholm). In other words, there are relevant economic resources that are transferred from emerging economies to the Western markets. This condition would have been absolutely unimaginable only a few years ago and many questions are emerging about the opportunities, the risks both economically and politically, that this flow of assets could create to the world's financial system. In particular, to which point will it be possible to open up Western markets to these resources? In Europe and North America discussions about this subject are more and more present in the political arena. The attention and focus given to this issue are important because they corresponds to fears on both sides of the Atlantic Ocean, fears that cannot be defined  as simple and pure economic protectionism. Investments from emerging countries into Western markets are not a new phenomenon. For example, already thirty years ago Labico (a company from Libya) bought a relevant quota of the Italian automobile manufacturer FIAT and, similarly, twenty years ago in the United Kingdom (U.K.) Prime Minister Margaret Thatcher started a legal battle to impede Kuwait Investment Office from buying British Petroleum (BP). And many other examples like these exist in relation to North America. Today, the dimension of these investments and the importance of the new targets are rather new. The explosion of this phenomenon as a consequence of the interest of emerging countries — specifically China, Russia and the Gulf states — to invest in Western countries has four different origins:

  • The appearance of China on the world economic stage with its huge economic impact.
  • The high development rates of China and many other emerging countries both in the Persian Gulf and in Asia.
  •  The huge increase in the price of both oil and other commodities induced by the Chinese and Indian demand of these commodities for their economic development.
  •  The high capital gains and the availability of relevant economic resources for many emerging countries as a consequence of both the increase of oil prices and the value of their stock exchanges. It is important to underline that in the late 1990s the price of a barrel of oil was just over $10 while in the first months of 2008 it overcame $100 per barrel. 
  • Global trade imbalances contribute to the increase of S.W.F.s. On the one hand, according to a study done in June 2007 by the National Bureau of Economic Research, oil exporters have an unbalanced trade dynamic because the other countries are always eager to purchase oil.  On the other hand, non-oil-exporting countries accumulate reserves for other reasons. For example, China and East Asian countries “have seen their exports soar because of favorable — and some say skewed — exchange rates”[i].     


The emerging markets’ huge reserves of capital, their account reserves deriving from the commercial surplus linked to the increase of commodities prices, and the stock exchange gains, have no immediate possibility of reinvestment in the domestic markets[ii] (typical examples are the United Arab Emirates or Kuwait), which are very limited. The narrow opportunities procured by the domestic markets are the reason for which these countries started to invest abroad, principally in assets linked to energy, natural resources, steel, finance (banks, stock exchanges and private equity), utilities and infrastructures. What is shocking is the nature of the investors from these emerging markets because they are chiefly public sovereign wealth funds (S.W.F.s), while with traditional F.D.I.s the main actors have always been private entities.

First Paragraph: What Are S.W.F.s?

At the moment there is no clear and universally accepted definition of S.W.F.s. The U.S. Treasury defines S.W.F.s as “government investment funds, funded by foreign currency reserves but managed separately from official currency reserves”[iii]. Normally if a foreign asset is to be classified as a reserve asset it has to be decided on a case-by-case basis. In fact, sometimes over some assets that are invested into liquid and marketable instruments the central bank has the right to use them for requirements linked to the balance of payments. In such a case these are not labeled as S.W.F.s but as official reserves. In other cases, some assets are invested in much less liquid and marketable instruments, but the Central Bank has no right over them. In this second hypothesis these assets are S.W.F.s and not official reserves.    

To sum up, S.W.F.s are pools of money that governments want to use to get good profits and, when dealing with S.W.F.s governments have a propensity for higher risk tolerance and higher returns in comparison to the standards they use with the classic official reserves. The accumulation of official reserves for S.W.F.s is not the only way through which countries hold money and according to Deputy Secretary of the Treasury, Robert M. Kimmitt there are four different ways in order to store sovereign wealth:

  •   S.W.F.s
  •   International Reserves
  •  Public Pension Funds
  •  State-Owned Enterprises[iv]


In general, S.W.F.s are used to increase the wealth of the state and they do not serve to repay any specific debt. S.W.F.s:

typically seek to diversify foreign exchange assets and earn a higher return by investing in a broader range of asset classes, including longer-term government bonds, agency and asset-backed securities, corporate bonds, equities, commodities, real estate, derivatives, and foreign direct investment.[v]

S.W.F.s raise some questions because the investment decisions are controlled by governments and not by individuals or by private corporations and “unlike central banks, which tend to invest reserves in assets like U.S. Treasury bonds, the sovereign funds often invest in corporations”.[vi] In addition to this, like hedge funds, the majority of S.W.F.s are secretive, and any comprehensive list of what they own and any binding reporting of their liabilities or policies do not exist. Until now there has not being any serious case of S.W.F.s that have used their power in a bad and politicized manner. But how long can this assumption hold in the future? An example of a sort of politicized behavior happened in 2006 when the Norwegian Fund sold its $400 billion of Wal-Mart shares. The reason for this move was that the company was badly treating its workers.     
    
S.W.F.s may be divided into two categories with reference to the different source of the foreign exchange assets:


  •  Commodity Funds — These funds are created from commodities exports (oil producing countries account for two-thirds of the total wealth of all the S.W.F.s.) both owned or taxed by the government. These funds are established with different targets like stabilization of fiscal revenues, balance of payments sterilization (a sort of way to prevent foreign exchange funds to spread inflation. The funds would be a buffer impeding to an excess quantity of money to enter the country in the same time) or savings for the future generations. As a consequence of last years' high oil prices, many funds that were established for fiscal stabilization have since evolved into saving funds. The latter funds have a broader range of investments compared to stabilization funds that invest primarily into liquid and secure assets. With reference to exporters of nonrenewable resources, the International Monetary Fund (I.M.F.) encourages these countries to build up such a kind of funds in preparation for the so-called "rainy day." The falling American dollar is another incentive for exporters to get rid of their currency reserves “given that oil is currently priced in U.S. dollars.”[vii]  
  • Non-Commodity Funds — This kind of S.W.F.s is generated through the transfer of assets from official foreign exchange reserves. Large current account surpluses — sometimes coupled by capital account surpluses — have been the key (especially in Asia) for non-commodity exporters “to transfer “excess” foreign exchange reserves to stand-alone funds”[viii].           

Given the fact that:

Commodity S.W.F. assets often derive from foreign currency accruing directly to the government, the foreign currency is not converted to domestic currency, does not enter the domestic economy, and therefore does not need to be sterilized through the issuance of domestic debt to avoid unwanted inflationary pressures. In contrast, non-commodity SWFs assets often derive from at least partially sterilized exchange rate intervention and may therefore be thought of more as “borrowed funds.[ix]

In 2007, resource-rich countries started to consider that they probably had invested too much in U.S. dollars and that they would like to start to diversify these holdings through S.W.F.s. Recently, OPEC members  have discussed with reference to this diversification the possibility to price oil resources in different currencies. This could permit them to scale back their dollar holdings. In any case, initially countries that want to build up foreign exchange reserves invest in liquid assets (like Treasury bonds), but then, when they have sufficient reserves to cover all the short-term needs, “they can afford to tie money up on long-term investments that offer better returns”.[x] Another implication that S.W.F.s have is the possible destabilization of financial markets. In this regard, it is advisable to remember that “the impact of a particular pool of money on financial stability depends not only on assets under management but also on the potential leverage (i.e., debt) used in investment strategies”[xi].

S.W.F.s are not new tools because their naissance can be traced back to 1950s (the term S.W.F.s would not exist for another 50 years) when in 1953 it was created the Kuwait Investment Office for investing oil revenues, and then in 1956 it was created the Kiribati Revenue Equalization, which today is related to phosphates but that at that time had to manage the revenues coming from the guano mining activity.[xii] Two other important S.W.F.s like the Abu Dhabi Investment Authority (ADIA) and Singapore’s Government Investment Corporation (G.I.C., this is not based on oil income) were created in 1976 and 1981 respectively. They have now more than 25 years of operative experience. The largest S.W.F. is today ADIA, which controls around $875 billion in assets while in second and third positions there are respectively the Norwegian Government Pension Fund — Global ($380 billion) and G.I.C. ($330 billion). Furthermore, it should be noted that though S.W.F.s “are typically found in countries with big trade surpluses, there is one of them in the U.S.: the state-run Alaska Permanent Fund, founded in 1976 to reinvest oil profits.”[xiii]

What is important today is their weight and the new actors that are using them like China with the China Investment Corporation (C.I.C.) and Russia with the Stabilization Fund (Russia wants to create a sort of buffer against volatile commodity prices) and its huge public giant companies like Gazprom. In the past, S.W.F.s principally invested into bonds and treasury bonds but in the last years their aim has been to maximize the yield of the allocation of their national reserves into foreign currencies. For this reason, their targets are more companies and banks in Europe and North America. If we trace a list of Western firms where there is a presence of S.W.F.s we can name among them many entities like Daimler-Chrysler, Deutsche Bank, HSBC, Standard Chartered, Barclays, Airbus, Sainsbury and Ferrari.


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Over the past five years the wealth accumulated by these funds has spiked and in September 2007, the I.M.F. estimated that S.W.F.s — which are now more than 40 — control today around $3 trillion, which is almost half of the official reserves of all the world's countries. The recent credit crunch has brought an increase in the investments in the U.S. and Europe by S.W.F.s. “with the amount invested in the first two months of this year nearly matching half the 2007 total”[xiv]. This wealth will increase to $5 trillion in 2010 and to $12 trillion in 2012. If countries that have S.W.F.s divert more foreign exchange reserves from their normal utilizations, S.W.F.s can grow beyond the previous mentioned values. S.W.F.s manage more assets than hedge funds ($1.5 trillion) but are still a very small reality compared to the $53 trillion managed by institutional investors (pension funds and endowments). For this reason, S. Johnson of the I.M.F. in an article of September 2007 affirmed that the assets controlled by S.W.F.s were “significant but not huge”[xv]. He also pointed out that these assets were "however, large relative to the size of some emerging markets. The total value of traded securities in Africa, the Middle East, and emerging Europe combined is about $4 trillion; this is also roughly the size of these markets in all of Latin America.”[xvi] In today’s world there are more than 20 countries (among them United Arab Emirates, Qatar, Kuwait, Singapore, China, Norway, Libya and Algeria) that own these funds and at least ten more would like to have S.W.F.s. According to recent data the holdings concentrated in the top five funds account for 70 percent of total assets.   

Second Paragraph: What Are the Issues Sparked by S.W.F.s?

When speaking about S.W.F.s it is appropriate to consider three basic issues:

  • Is the establishment of S.W.F.s creating undesirable underlying macroeconomic and financial policies? This problem may arise easily with non-commodity funds because these funds use S.W.F.s as a mechanism in order to accumulate more foreign assets, through which they try to avoid their currency from appreciating. With commodity funds the problem is less evident because “governments are essentially replacing a physical asset in the ground with a financial asset in a bank account to be drawn on by future generations.”[xvii]  
  • S.W.F.s are an excessive accumulation of domestic and international economic and financial policies so it is relevant to consider them in terms of their possible impact on the overall financial stability. In principle S.W.F.s are long-term investors and do not retire their investments in the eventuality of short-term volatility. Plus:

They are not highly leveraged, and it is difficult to see how they could be forced by regulatory capital requirements or sudden investor withdrawals to liquidate their positions quickly. In this context, S.W.F.s may be considered a force for financial stability -- supplying liquidity to the markets, raising asset prices, and lowering borrowing yields in the countries in which they invest. Still, responsible public policy requires a thorough consideration of the potential impact of S.W.F.s on financial markets. S.W.F.s represent large, concentrated, and often opaque positions in financial markets. A sudden shift by S.W.F.s in illiquid markets can cause price volatility. Further, since many S.W.F.s disclose little of their investment policies, mere rumors of S.W.F. shifts may cause the private sector to react[xviii].  


  • Are they taking control of private firms especially in North America and Europe? Are they a danger for the national security of the countries where they invest? This is an important issue but with a more in-depth analysis it emerges that there are also non-national-security issues involved with S.W.F.s. In fact, according to Mr. Kimmitt:

First, the U.S. economy is built on the belief that private firms allocate capital more efficiently than governments. Second, foreign governments could conceivably employ large pools of capital in non-commercially driven ways that are politically sensitive even if they do not have a direct impact on national security. Examples would include investment decisions made to promote a given foreign or social policy. Third, there is the potential for perceived or actual unfair competitive advantages relative to the private sector. For instance, a government could use its intelligence or security services to gather information that is not available to a commercial investor. With a sovereign guarantee, a S.W.F. could also obtain or extend financing (if needed) at interest rates that a commercial investor could not. It is also possible for a S.W.F. to take an indirect approach by channeling foreign exchange through domestic SOEs [state-owned enterprises], which in turn invest abroad[xix]  

In general, these funds when started to buy both participations also in the most prominent private equity funds (China has an investment of $3 billion in Blackstone and Abu Dhabi an investment of $1.35 billion in Carlyle) and small quotas of Western firms; sometimes they aim to control directly the firms. According to Ferreira, Massa and Matos — who did a research (“Shareholders at the Gate?” done for the Fundacao para a Ciencia e Tecnologia of Portugal (F.C.T.)) about the role of institutional investors in cross borders mergers and acquisitions (M&A):

Companies that have more institutional investors — especially foreign ones — are experiencing their shareholders at the “gates”, which can act as “Trojan horses” to facilitate changes of control. Overall, our paper shows how institutional ownership facilitates the workings of the international market for corporate control[xx].
  
Obviously, this way of thinking is easily applicable to public companies that do not have any controlling shareholder. In fact, in such a situation if between the shareholders there is an S.W.F. the game is really simple because the fund wants to increase its participation and to gain the control of the public company; and for this target it has almost infinite resources. The logic of capitalism is to have companies acting in order to maximize the value of their shares for the shareholders. If the shareholders are governments this assumption is not so obvious anymore. Other experts point out that “a government could use S.W.F.s to learn how companies in other countries operate, then use this information to bolster rival state-run enterprises.”[xxi] Really interesting is the role played by Temasek Holdings of Singapore, which normally invests in the medium/long term in Western companies that do not produce assets or services for the medium class. In all these cases what is important to understand is whether we are facing decisions done only with the goal of an economic profit or of a political motive. In such a situation it is quite normal that on both sides of the Atlantic Ocean a certain alarmism is growing not only in dealing with the economic and financial effects of these operations but also in maintaining the democratic balance of the North American and European countries.

The attempt three years ago to buy the American oil group Unocal by the Chinese company Cnooc and in 2006 the attempt to buy five American ports by Dubai Ports World, which is a state-owned business and not an S.W.F., first got negative answers from the U.S. on the basis of the national interest. Later, after the rejection of Dubai Ports World’ proposal, Congress passed into law a very restrictive law related to foreign investments into the U.S. (without any doubt it was not easy for the U.S. to have a Middle Eastern country controlling potential entry points, which could have been used by terrorists). In 2007, when it was announced the alliance and the cross ownership of shares between the Nasdaq and the Dubai Stock Exchange, President Bush had to intervene to address the problem of verifying the compatibility of so  complex an operation in relation to the security necessities of the U.S. And Democratic senators wrote to Secretary of the Treasury H. Paulson explaining that there was concern about the possible deal between the two stock exchanges because this agreement would have meant to have a strong influence exercised by a foreign government on a basic American economic infrastructure.

In general, the U.S. has always been an open country and the role played by the Committee on Foreign Investment in the United States (or Cfius)[xxii] has never been to impede businesses with foreign entities. Cfius is an inter-agency committee of the U.S. government and its principal task is to understand whether possible foreign acquisitions of U.S. companies may have national security implications. All the companies that can be involved in an acquisition by a foreign firm should notify this possibility to Cfius (it is also in the powers of Cfius to review transactions that are not voluntarily submitted). Cfius reviews start with a 30-day decision to authorize a transaction or to open a statutory investigation. If the Cfius decides to have a statutory investigation the committee will have 45 additional days to decide whether authorizing the acquisition or to order a divestment. In reality, the majority of the transactions are approved with no problem by the Cfius. In fact, in 2006 in the U.S. there had been around 10,000 mergers and acquisitions and of these 1,730 were cross-border transactions of which only 113 came before Cfius. None out 113 deals was blocked by the committee. In summer 2007 Congress passed a new Cfius law, which increased the power of the committee (“additional scrutiny and higher-level clearances for transactions involving foreign government”[xxiii]). 

Today the problem for the U.S. is to thwart an increase of neo-protectionist measures and for this purpose “the President's Working Group on Financial Markets, which brings together key U.S. financial regulators and other members of the U.S. government under Secretary Paulson's chairmanship, has initiated a review of S.W.F.s”.[xxiv] Protectionism would mean to undermine economic growth and job creation. On March 20, 2008, the Bush administration got a commitment from two of the most important S.W.F.s: Singapore and Abu Dhabi, which recently have both stepped up their investments in Citigroup. These funds have to disavow “geopolitical goals” in their investments in the U.S. and should try to be very transparent for their activities in the U.S. (in fact, “of the biggest sovereign funds, only Norway’s provides anything close to transparency. Each year it discloses its investments portfolios and returns”[xxv] and until now it has never sought out management control of its investments aiming only to small ownership shares in the companies). In addition to this, the U.S. has enlisted the I.M.F. and the O.E.C.D. “to develop a code to guide cross-border investments by government funds.”[xxvi] This code of best practices (it is crucial for this code that investors renounce to political motives when they do investments) should be ready for fall 2008 and it is supported also by the E.U. The problem with this project is that it has already stirred resentments among some investing countries like China and the Gulf states. In January 2008 at the Davos World Economic Forum many representatives from Gulf countries explained that this code was not useful and that it was an intrusion in the freedom of doing business. Still from the American side of the Atlantic it is interesting the proposal by Edwin M. Truman with the Peterson Institute for International Economics.[xxvii] He suggests creating an international standard for cross border investments. For this purpose it will be fundamental to consider:


  • The targets of a specific investment.
  • The strategy of a particular fund.
  • The governance of a fund detailing which public officials from that specific country have access to fund information.
  • Transparency.
  • Behavioral guidelines explaining how a fund is entitled to adjust its portfolio[xxviii].

In the U.S. another interesting proposal has been advanced by Jeffrey Garten, a former dean of the Yale School of Management. Mr. Garten thinks that it will be necessary to restrict “S.W.F.s’ operations to reciprocal arrangements, where the ability of a country to buy foreign assets would be conditioned on granting similar access to foreign fund (Economist 2007)”.[xxix] 
With reference to Europe, in summer 2007, Chancellor Angela Merkel of Germany raised a question about the growing presence of S.W.F.s in the ownerships of many German and European firms. What in Europe is also emerging — in relation to economic globalization and the primary role played by S.W.F.s in North America and in Europe — is the different approach between economists and politicians. In fact, in general the economists tend to underline the positive features of globalization and capital flows among different areas of the world. They think that this a very positive process because it permits to multiply the possibilities of investments — overcoming all the political, legal and bureaucratic barriers — and to improve the economic growth of North America and Europe thanks to the attraction that Western countries have for capitals coming from emerging markets.  If the investments from emerging countries in the West are linked to market considerations with no political games involved and to reciprocity criteria, these investments are integral part of the process of globalization and liberalization of the economy. Such a process is positive for both developed and developing countries. But in Europe the problems raised by S.W.F.s cannot be answered only under the lens of economic considerations. The European debate around S.W.F.s is arguing about at least four fundamental questions:


  • Do S.W.F.s’ investments follow market criteria or political targets?
  •  Are these investments coming from countries that apply the concept of the right reciprocity in relation to economic freedom?
  • In Western countries is it possible to consider in the same way the acquisition by a S.W.F. of a hotel chain and the acquisition of a non-replicable asset that is of paramount importance for the development of the country like for example infrastructural networks in the sector of gas, electricity or telecommunications?
  • Is the presence (or the absence) of democracy in the countries from which the S.W.F.s originate an important factor?  
             
Probably, also in Europe there are no other solutions than accepting S.W.F.s as the result of today’s level of economic globalization and encouraging these investments in the European markets. Contemporarily, these investments have to be evaluated thoroughly for reasons linked to European security and economic interests. The game that Western countries have to play is anchored on the fact that North America and Europe should have the maximum level of market liberalization and openness to foreign investments, while at the same time they need to maintain the defense and the development of their democracies, identities and financial and economic interests. And all this should be done avoiding every possible move toward economic protectionism and dirigisme in North America as well as in Europe. To reach these goals many tools could be used. This subject is undergoing a constant modification because also the definition of what is a U.S. national interest and a E.U. national interest is not rigid. The behavior of the emerging countries and the allocation of their resources inside Western economies propose one more time the eternal dilemma between state and market, and the research of a dynamic equilibrium that may not accept static and dogmatic solutions. The European experience suggests applying five guidelines in dealing with S.W.F.s which invest in Western countries:


  • To distinguish, although it is not easy, whether the investments done by S.W.F.s in Western economies are done following market criteria or disputable and dangerous politic aims;
  • To distinguish between acquisitions of controlling quotas and simple financial investments with minority quotas;
  • To value the level of democracy of the countries from which the S.W.F.s originate;
  • To pretend the maximum of transparency and reciprocity of freedom when  Western countries' companies invest in countries from which S.W.F.s originate;
  • To ban S.W.F.s from the acquisition of controlling quotas (or just relevant assets) in sectors that are considered strategic or highly sensible, like the defense sector and the infrastructural networks in the fields of energy, telecommunications, water, railroads and freeways.                   

Some months ago, at the beginning of 2008, two E.U. commissioners explained that S.W.F.s had principally to improve their transparency. Monetary Affairs Commissioner Joaquim Almunia stressed the point that S.W.F.s should understand their responsibilities, but that at the same time they could provide a useful source of investments through “quick and rapid financing to large banks that faced liquidity problems”.[xxx]


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Similarly, Charlie McCreevy, the E.U. commissioner for the internal market, pointed out that S.W.F.s had to improve the quality of their financial information but that at the same time they had positive results for the E.U. economy because they were long-term investors. In Europe there are two options in order to apply these five guidelines. One option is linked to the American experience; and it would like to create a specific agency like Cfius in the U.S. This new agency should have the task of evaluating, selecting, approving or denying the investments of emerging countries' S.W.F.s in Europe. The second option, which has been proposed by Peter Mandelson, the E.U. commissioner for trade, consists of adopting a sort of European golden share (at the E.U. level and not at the domestic level) that could give extraordinary powers to the E.U. authorities when the stake are assets fundamental not only for one E.U. country but also for the interest of all the E.U. member states. Both the two options do not have an easy implementation and have pros and cons.

The problem is that there is also another very dangerous tendency, which is currently emerging also in North America. This tendency simplifies the issue of the S.W.F.s by recurring to protectionism both with the creation of the so-called national champions and by raising entrance barriers to the E.U. markets for investments done by S.W.F.s from emerging countries. Not only is this process an obvious stop to foreign investments, but also it represents a halt to the liberalization of the E.U. economies. Behind this protectionist idea there is the illusory search for a sort of economic auto-sufficiency for the so-called “European fortress”, but according to contemporary economic literature this attempt is totally out of time. Notwithstanding today’s difficulties, it is indispensable to think that until some years ago only few capitals from emerging countries arrived and were reinvested in Europe. Normally, they were never evaluated although they were considered with a lot of suspicion. Today’s debate about S.W.F.s is without any doubt an important evolution that can have positive developments for the economies of both developed and developing countries. In the age of globalization, Europe is now divided between, on the one side, supporters of markets openness and, on the other side, supporters of economic patriotism. What is important to do right now is to strike a balance, i.e., a point of convergence between these two alternatives. This convergence does require new rules and, transparency and political will to reach this target.

The E.U. explained its approach to S.W.F.s in February 2008 when it released the Communication (COM) (2008) 115 Final, whose title is “A Common European Approach to Sovereign Wealth Funds.”[xxxi] In the introduction of this document the Commission spoke about the commitment to investments and free movement of capitals — these are among the most important principles of the E.U. framework, especially now in a globalized world.  Then, the Commission explained that investments of S.W.F.s could support the international role of the euro in the medium term. In fact,
      
For foreign exchange reserves, the goal is liquid and safe assets denominated in a currency with low foreign exchange conversion costs – which tends to favor the U.S. dollar. S.W.F.s have more freedom to choose their investments. This is likely to mean a higher share of the euro assets than now is the case for reserves[xxxii].

The Commission pointed out that the recent request for improved governance for S.W.F.s did  not mean that in Europe there was a legal vacuum. In fact, in Europe it exists between the E.U. and its member states a regime that regulates the establishment and actions of foreign investors. S.W.F.s may be included under this legal regime. The W.T.O. and the O.E.C.D. rules and a combination of bilateral and sectorial agreements provide the legal framework in which the E.U. operates today. With reference:

To the E.U. legal framework, investments by S.W.F.s in the E.U. are subject to the same rules and controls as any other form of investment, either foreign or domestic, where the principles of free movement of capital between Member States, and between Member States and third countries stipulated in Article 56 E.C. apply.

The free movement of capital is not absolute. As a fundamental principle of the Treaty, it may be regulated in two respects at the European level under Article 57 (2) E.C.: first, the Community may adopt by qualified majority measures on the movement of capital from third countries involving direct investment Second, it is not excluded that the Community can introduce – by a unanimous decision - measures that restrict direct investments.

 The Merger Regulation allows Member States to take appropriate measures to protect legitimate interests other than competition. Such measures must be necessary, non discriminatory and proportionate as well as compatible with other provisions of Community law. Public security, plurality of the media and prudential rules are regarded as legitimate interests, whilst other interests can be considered legitimate on a case by case basis on notification to the Commission.[xxxiii]

Member states include national instruments that may be used to control S.W.F.s and there are no restrictions on their possibility to develop new tools — compatible with the treaty, proportionate, non-discriminatory and non contradicting international obligations — in order to tackle specific needs if they arise. The European Court of Justice (E.C.J.) brings about additional guidance on how states may take these measures in compatibility with the treaty, explaining that merely economic arguments can never justify positions prohibited by the treaty. The court provides also criteria to assess the proportionality of the authorization system:

  These must aim at the protection of a legitimate general interest and foresee strict time limits for the exercise of opposition powers, assets or management decisions targeted must be specifically listed, and the system’s objective and stable criteria must be subject to an effective review by the courts.

Lastly, there is scope to monitor and control the behaviour of S.W.F.s as investors on an ongoing basis via the regulatory framework, which offers an effective tool to protect public interests irrespective of ownership. This is particularly the case in network industries.[xxxiv]
    
Then in the Com (2008) 115 Final, the commission elucidates what are the five essential principles on which it will be founding its policy in relation to S.W.F.s. The following table will clarify these five principles.


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According to the commission the two main points in order to address the concerns related to S.W.F.s are good governance and improved transparency. For the commission, the principles of good governance include:


  • The clear allocation and separation of responsibilities in the internal governance structure of an S.W.F.
  • The development and issuance of an investment policy that defines the overall objectives of S.W.F. investment;
  • The existence of operational autonomy for the entity to achieve its defines objectives;
  • Public disclosure of the general principles governing a S.W.F.’s relationship with government authority;
  • The disclosure of the general principles of internal governance that provide assurances of integrity;
  • The development and issuance of risk-management policies.

Transparency practices that have to be considered are:


  • Annual disclosure of investment positions and asset allocation, in particular for investments for which there is majority ownership;
  • Exercise of ownership rights;
  • Disclosure of the use of leveraged and of the currency composition;
  • Size and source of an entity’s resources;
  • Disclosure of the home country regulation and oversight governing the S.W.F.

Conclusion

With S.W.F.s rapidly gaining importance in the monetary and financial system the debate about their nature and their pros and cons is spreading more and more on both sides of the Atlantic. The I.M.F. and the O.E.C.D. are working in order to develop a code of rules for S.W.F.s. This code of good practices should help understand which funds invest properly and which rather invest for different reasons not always based on economic considerations. Summing up:

Sovereign funds are not likely to go away. They're based on current account surpluses and will become less important only if the countries with large surpluses begin to run prolonged current account deficits. Major countries have committed to reducing their current account imbalances, and this would limit the growth of sovereign funds. But the world economy evolves continuously in ways that make it hard to be sure current account imbalances will shrink[xxxv].     
   
Apart from all the expressed considerations, maybe in the end, Anders Ǻslund who is a senior fellow at the Peterson Institute for International Economics has the right understanding about S.W.F.s. In fact, Mr. Ǻslund says that for Americans and Europeans these funds are nothing to be worried about, while “if anyone should worry about them, it’s the people whose governments are amassing them.”[xxxvi] In other words, the governments are really bad in managing money and it should be better to leave these resources to the private citizens. Mr. Ǻslund continues explaining that S.W.F.s are in general created by authoritarian regimes in semi-developed countries where the citizen cannot hope for better results, while in democratic countries:

The politics work differently. The only democratic country with a large sovereign wealth fund is Norway. Since the Norwegian fund was established in 1990, every incumbent government has lost elections because the opposition has promised all kinds of popular expenditures from the abundant fund. Democratically, it is difficult to defend an excessive public reserve fund.

Certain international reserves are always needed, and exporters of commodities with highly fluctuating prices require larger reserves as a safety net. However, sovereign wealth funds are something different. They reflect a paternalistic—and economically illiterate—notion that the ruler knows best while citizens are so irresponsible that they cannot be entrusted with their own savings. It would be more economical and democratic to cut taxes and let citizens save and invest themselves[xxxvii].






For the complete report see: AIZENMAN, J., Large Hoarding of International Reserves and the Emerging Global Economic Architecture, in http://www.nber.org/papers/w13277, accessed on March 22, 2008.
[ii] THE ECONOMIST, The Invasion of Sovereign-Wealth Funds, in The Economist, January 19-25, 2008; THE ECONOMIST, Asset-Backed Insecurity, in The Economist, January 19-25, 2008.
[iv] “International reserves are the funds countries hold for use by their treasury or finance ministries and central banks. Public pension funds hold the funds that states promise their citizens (Kimmitt notes that these funds have traditionally kept low exposure to foreign assets). State-owned enterprises are companies fully or partly managed by the state, each of which may have its own assets and investments”, in TESLIK, L., H., Sovereign Wealth Funds, in http://www.cfr.org/publication/15251/sovereign_wealth_funds.html?breadcrumb=%2Fbios%2F12286%2Flee_hudson_teslik, accessed on March 22, 2008.
[v] FRBSF ECONOMIC LETTER, Sovereign Wealth Funds: Stumbling Blocks or Stepping Stones to Financial Globalization?, in http://www.frbsf.org/publications/economics/letter/2007/el2007-38.pdf, accessed on March 24, 2008.
[vi] KNOWLEDGE@WHARTON, A Closer Look at Sovereign Wealth Funds: Secretive, Powerful, Unregulated and Huge, in http://knowledge.wharton.upenn.edu/article.cfm?articleid=1868, accessed on March 23, 2008.
[x] KNOWLEDGE@WHARTON, A Closer Look at Sovereign Wealth Funds: Secretive, Powerful, Unregulated and Huge, in http://knowledge.wharton.upenn.edu/article.cfm?articleid=1868, accessed on March 23, 2008
[xi] JOHNSON, S., The Rise of Sovereign Wealth Funds, in http://www.imf.org/external/pubs/ft/fandd/2007/09/straight.htm, accessed on March 24, 2008.
[xii] ECONOMIST, Asset-Backed Insecurity, in The Economist, January 19-25 2008.
[xiii] KNOWLEDGE@WHARTON, A Closer Look at Sovereign Wealth Funds: Secretive, Powerful, Unregulated and Huge, in http://knowledge.wharton.upenn.edu/article.cfm?articleid=1868, accessed on March 23, 2008.
[xiv] BURTON, J, Wealth Funds Exploit Credit Squeeze, in Financial Times, March 24, 2008.  According to data coming from Dealogic SWFs invested in 2007 $48.5 billion and in January-February 2008 $24.4 billion. Most of the total invested - summing up to $72.9 billion – was related to banking activities with financial services accounting for $60.7 billion. 
[xv]JOHNSON, S., The Rise of Sovereign Wealth Funds, in http://www.imf.org/external/pubs/ft/fandd/2007/09/straight.htm, accessed on March 22, 2008.
[xvi] Ibidem
[xvii] KIMMITT, R., M., Public Footprints in Private Markets, in  http://www.foreignaffairs.org/20080101faessay87109/robert-m-kimmitt/public-footprints-in-private-markets.html, accessed on March 24, 2008
[xviii] Ibidem.
[xix] Ibidem.
[xxi] Ibidem.
[xxii] CFIUS is chaired by the Secretary of the Treasury. It was established by President Ford’s Executive Order 11858 in 1975. President Reagan delegated presidential oversight to CFIUS by his executive order 12661 in 1988. See:  http://www.treas.gov/offices/international-affairs/exon-florio 
[xxiii] KIMMITT, R., M., Public Footprints in Private Markets, in  http://www.foreignaffairs.org/20080101faessay87109/robert-m-kimmitt/public-footprints-in-private-markets.html, accessed on March 24, 2008.
[xxiv] Ibidem.
[xxv] THE ECONOMIST, The World’s Most Expensive Club, in http://www.economist.com/finance/displaystory.cfm?story_id=9230598, accessed on March 23, 2008.
[xxvi] WEISMAN, S., R., Sovereign Funds Agree to Shun “Geopolitical” Investments, in The New York Times, Friday March 21, 2008.  
[xxvii]  Peterson Institute for International Economic: http://www.iie.com
[xxviii] TRUMAN, E., M., Sovereign Wealth Funds: The Need for Greater Transparency and Accountability, in: http://www.iie.com/publications/pb/pb07-6.pdf, accessed on March 24, 2008. For more sweeping reforms see: REDIKER, D., CREBO-REDIKER, H.,  Foreign Investments and Sovereign Wealth Funds in:  http://www.newamerica.net/files/GSFIWorkingPaper1.pdf, accessed on March 24, 2008.
[xxix] FRBSF ECONOMIC LETTER, Sovereign Wealth Funds: Stumbling Blocks or Stepping Stones to Financial Globalization?, in: http://www.frbsf.org/publications/economics/letter/2007/el2007-38.pdf, accessed on March 24, 2008; see also with reference to this proposal: THE ECONOMIST, Fear of Foreigners, in: http://www.economist.com/business/displaystory.cfm?story_id=9641906, accessed on March 24, 2008.
[xxx] BBC NEWS, EU in Sovereign Wealth Fund Call, in: http://news.bbc.co.uk/2/hi/business/7267506.stm, accessed March 22, 2008.
[xxxi] COM (2008) 115 Final, A Common European Approach to Sovereign Wealth Funds, in: http://ec.europa.eu/commission_barroso/president/pdf/COM2008_115_en.pdf, accessed on March 25, 2008.
[xxxii] Ibidem.
[xxxiii] Ibidem.
[xxxiv] Ibidem. The measures taken by Member States shall not constitute a means of arbitrary discrimination or disguised restriction on the free movement of capital, Article 56 EC.
[xxxv] JOHNSON, S., The Rise of Sovereign Wealth Funds, in: http://www.imf.org/external/pubs/ft/fandd/2007/09/straight.htm, accessed on March 24, 2008.
[xxxvii] Ibidem.


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BIBLIOGRAPHY


AIZENMAN, J., Large Hoarding of International Reserves and the Emerging Global Economic Architecture, in: http://www.nber.org/papers/w13277


BBC NEWS, EU in Sovereign Wealth Fund Call, in: http://news.bbc.co.uk/2/hi/business/7267506.stm

BURTON, J., Wealth Funds Exploit Credit Squeeze, in Financial Times, March 24, 2008.

COM (2008) 115 Final, A Common European Approach to Sovereign Wealth Funds, in: http://ec.europa.eu/commission_barroso/president/pdf/COM2008_115_en.pdf


FRBSF ECONOMIC LETTER, Sovereign Wealth Funds: Stumbling Blocks or Stepping Stones to Financial Globalization?, in: http://www.frbsf.org/publications/economics/letter/2007/el2007-38.pdf

KNOWLEDGE@WHARTON, A Closer Look at Sovereign Wealth Funds: Secretive, Powerful, Unregulated and Huge, in: http://knowledge.wharton.upenn.edu/article.cfm?articleid=1868

JOHNSON, S., The Rise of Sovereign Wealth Funds, in: http://www.imf.org/external/pubs/ft/fandd/2007/09/straight.htm

REDIKER, D., CREBO-REDIKER, H., Foreign Investments and Sovereign Wealth Funds in:  http://www.newamerica.net/files/GSFIWorkingPaper1.pdf

SUMMERS, L., Funds That Shake Capitalist Logic, in Financial Times, July 29, 2007.


THE ECONOMIST, Asset-Backed Insecurity, in The Economist, January 19-25, 2008.


THE ECONOMIST, The Invasion of Sovereign-Wealth Funds, in The Economist, January 19-25.

THE ECONOMIST, The World’s Most Expensive Club, in: http://www.economist.com/finance/displaystory.cfm?story_id=9230598

TRUMAN, E., M., Sovereign Wealth Funds: The Need for Greater Transparency and Accountability, in: http://www.iie.com/publications/pb/pb07-6.pdf

WEISMAN, S., R., Sovereign Funds Agree to Shun “Geopolitical” Investments, in The New York Times, Friday March 21, 2008.   



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