Sovereign wealth funds (SWFs) are government-controlled investment vehicles that are stimulating protectionist sentiments in some OECD countries. Their asset size (more than $3 billion) and their owners (governments) create fertile ground for conspiracy theories, such as fear of industrial espionage or geopolitical threats. The funds with assets higher than $100 billion are from oil-exporting countries and East Asia (Table 1).
Table 1. Sovereign wealth funds and saving
(billions USD, 9/2007)
||Gross National Savings, 2000
(% of GNI)
|'Genuine' Savings, 2000
(% of GNI)
|United Arab Erimates
||Abu Dhabi Investment Authority (ADIA)
1.China Investment Corp. Ltd.
2. Central Hujin Investment Corp.
3. State Foreign Exchange Investment Corp. (SFEIC)
||1. Government of Singapore Investment Corp. (GIC)
||Gov't Pension Fund - Global(GPFG)
||Kuwait Investment Authority
|Hong Kong, China
||HK Monetary Authority Investment Portfolio
||Stabilisation Fund of the Russian Federation (SFRF)
Source: Deutsche Bank Research (2007); World Bank (2006)
Development economics points to four major motives for countries to run such funds:
- Foreign exchange reserves – mostly held in US treasury bonds – have grown excessively large: interest rate and currency risk militate in favour of portfolio diversification and central banks cannot control monetary aggregates anymore.
- Responding to expected demographic pressures, while smoothing consumption levels of future generations when resources will be exhausted.
- Reducing resource dependence through vertical and horizontal sector diversification.
- Raising productive efficiency as a future driver of growth.
The largest funds are either financed from export receipts earned from a non-renewable resource or the result of very high corporate or household saving rates and saving surpluses.
An oil-exporting country optimising production should be indifferent between keeping its oil underground (in which case the return is the expected rise in future oil prices) and receiving a market rate of return on its sale (Hotelling’s Rule for efficient depletion). Extracting and selling oil amounts to running down capital, unless the receipts are fully reinvested in financial, physical or human capital (Hartwick’s Rule for intergenerational equity). Funds can also be helpful for stabilising notoriously volatile raw material prices. The law of diminishing returns forces oil exporters to invest a large share of the savings abroad1.
Oil exporters would be forced to disregard both rules if sovereign wealth funds could not invest in OECD countries. The Hotelling rule warns that lowering the returns on investment from oil receipts (preventing investments by SWFs from oil-rich countries) would lead to lower oil supply and higher oil prices.
In oil-rich countries, this would lead to more intense waste and corruption today and lower consumption tomorrow, possibly with harsh geostrategic implications. In Where Is the Wealth of Nations?, the World Bank has calculated that many resource-abundant economies do not follow the Hartwick rule; they have negative “genuine” savings rates and become poorer each year. This highlights the important policy question – how can resource-rich economies avoid the resource curse? A fund can help, in that oil receipts are eventually transformed into other forms of wealth.
In contrast to oil-rich countries, East Asian economies’ sovereign wealth funds are financed by transfers from foreign exchange reserves. For a decade, China provided “cheap savings” to the United States, extending supplier credits to pay for the “cheap goods” it exported and holding the accumulating reserves mostly in low-coupon US treasury bonds. Now, with reserves at almost $1.5 trillion, currency and interest risk are deemed excessive and monetary control has been lost due to exhausted sterilisation capacity. Observing the Guidotti Rule2 of covering all foreign short-term debt plus three months of imports would require China to hold $500 billion in reserves – roughly one-third of what it actually holds. These excess reserves plus future saving surpluses are the funding potential for China's sovereign wealth funds.
To be sure, rapidly ageing populations and limited immigration suggest the need for high savings to sustain consumption levels in the future. When savings become excessive and capital returns drop below the growth rate, however, tax-financed pensions achieve that goal better than fully-funded pensions. Mandatory savings and excessive capital accumulation have resulted in “dynamic inefficiency” in both China and Singapore, as shown by recent empirical research. In most OECD countries, growth is driven by productivity gains, but it is rather factor accumulation that explains growth in East Asia. In countries with “dynamic inefficiency”, so much capital has been accumulated that investment spending tends to exceed capital income; investment is draining resources from the economy rather than augmenting future consumption possibilities.
Diversification and efficiency
Besides shifting out of excessive reserves and saving for future generations and old age, economic diversification and efficiency gains are major economic motives for establishing sovereign wealth funds. The United Arab Emirates are using their fund to rapidly diversify away from oil towards tourism, aerospace, and finance. Such a diversification motive is as legitimate as the desire to raise the efficiency of their economy through acquiring stakes in leading global companies. Efficiency-seeking may well explain the recent rush by SWFs to take stakes in US financial intermediaries battered by the subprime lending crisis.
From the perspective of development economics, there is little need for conspiracy theories to explain what drives the funding and motivation of sovereign wealth funds. Understanding the four major motives described here may help the OECD identify best practices for member countries that receive foreign government-controlled investment.
1 For an overview of the concepts underlying resource economics see Avendano, R., H. Reisen and J. Santiso, “The Macro Management of Asian Driver Related Commodity Induced Booms”, OECD Development Centre Working Paper, 2008.
2 Reserves allow countries to smooth domestic absorption in response to sudden stops in capital inflows. Popular rules of thumb for policymakers have been linked to the current account, such as maintaining reserves equivalent to three months of imports, or to the capital account, notably the Guidotti Rule of full coverage of total short-term external debt.