Let's get the evidence on sovereign funds

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This was published 14 years ago

Let's get the evidence on sovereign funds

By Veljko Fotak and William Megginson

UNTIL the end of 2007, Western media, governments and regulators often seemed more concerned to protect domestic companies from investments by sovereign wealth funds (SWFs) than to attract their capital.

Politicians in many countries called for the regulation of sovereign foreign investments at a time when they were growing rapidly. During 2006 and 2007, countries that introduced at least one regulatory change making the investment climate less welcoming for multinational enterprises accounted for 40 per cent of all foreign direct investment (FDI).

In early 2008, attitudes began to change, as SWFs temporarily rescued the Western banking system by buying about $US60 billion ($A74 billion) of new equity from US and European banks. As the financial crisis deepened, Western financial firms developed an bigger appetite for foreign capital. At the same time, the source dried up.

Investment in Organisation for Economic Co-operation and Development countries by SWFs declined during 2008, totalling $US37 billion in the first quarter, $US9 billion in the second and $US8 billion in the third. Low commodity prices and the underperformance of investments led to a shrinking asset and funding base, while a renewed emphasis on conservative asset classes and domestic investments reduced investment in foreign equity.

The Western financial system's need for capital, coupled with the sudden drop in foreign investment, are leading to a dramatic shift in attitudes. Rather than discouraging SWF capital, Western governments and businesses are actively seeking it, with increased calls to open financial markets to SWFs. Where observers once feared an excessive push towards the regulation of foreign investment and a consequent stifling of FDI inflows into OECD countries, these fears have been allayed in part by the adoption of the Santiago Principles by sovereign wealth funds and the principal Western nations that want their investment.

Today, we are again facing the risk of overreaction, but in the opposite direction: security concerns, certainly overplayed in the past, are being sidelined. Yet, previous calls for protectionism and current appeals to open markets both lack the support of empirical evidence — very little is known about the impact of SWF investments on target companies and recipient economies.

Governments must promote the analysis of SWF investments and their impact on target companies, with the goal of developing the body of knowledge necessary for the formulation of the proper regulatory response.

In doing so, the following should be guiding principles:

1 The burden of proof should fall on those calling for restricting access to national markets. While we recognising the need for further investigation, it should be noted that, despite more than a half-century of SWF activity, there are no examples of politically charged or otherwise detrimental (to recipient economies) SWF investments. At the same time, the benefits associated with long-term, stable investments are obvious.

2 Beware of excessive transparency. Regulators have singled out SWFs for their lack of transparency. Yet, many other investment vehicles, such as hedge funds, are just as opaque. While transparency is, in general terms, desirable, transparency imposed on select market participants can put these at a serious disadvantage and lead to unprofitable trading; evidence indicates that SWF profitability is inversely related to their transparency. Any measure aimed at increasing transparency should not be targeted at any specific class of investors. SWFs need to provide information to regulators, but should not be subject to any further transparency requirements than are other market participants.

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3 Act multilaterally — involve the World Trade Organisation along with the International Monetary Fund. Past experience with FDI regulation suggests that multilateral action is more effective than bilateral agreements. Accordingly, regulators should act in concert. The IMF brokered the Santiago Principles last year, and should remain involved in negotiations between SWFs and investee nations. Another international body that naturally emerges as a candidate for assuming a true regulatory role is the World Trade Organisation, as it already enforces the General Agreement on Trades in Services that covers most SWF investments.

4 Remember that SWFs are not all equal. Governments must realise that SWFs are a heterogeneous group. They vary dramatically in respect to size, funding, objectives, investment style and sophistication. Accordingly, regulators should resist the temptation to restrict sovereign wealth funds unduly in the event of a fund "misbehaving". Regulation should, a priori, treat all SWFs equally, but any ad hoc response should affect the offending fund, rather than the entire category.

Formulating the proper regulatory response requires striking a fine balance between the need for foreign capital and the danger of foreign governments interfering in sensitive sectors of the economy. Yet, while the benefits are clear, the risks are not yet understood.

Unfortunately, a global financial crisis and recession is not the best time for the development of a

cool-headed, rational, regulatory response. But the actions of Western governments at this time are likely to shape the landscape of foreign direct investment for years to come.

In the short term, regulators should rely on existing FDI restrictions, already ensuring the avoidance of the most pernicious scenarios, and on sovereign wealth fund self-regulation, while encouraging the study of SWF investments.

Veljko Fotak and William Megginson, Are SWFs welcome now? Columbia FDI Perspectives, No. 9, July 21, 2009. Reprinted with permission from the Vale Columbia Center on Sustainable International Investment (www.vcc.columbia.edu).

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