Sovereign Wealth Funds: Conventional Investing or Strategic Investing?

It is estimated that Government-run funds — the so-called sovereign wealth funds — have invested $48 billion in deals in the U.S. in 2007. And they have probably invested another $16 billion so far this year. In all, the funds hold an estimated $2 trillion capital, and are expected to grow to more than $12 trillion by 2015. In about a decade, these funds are likely to eclipse the private pools of capital. In the recent past, the sovereign funds have given succor to several financial institutions such as Citigroup, Merrill Lynch, Morgan Stanley, and UBS which have all been buffeted by the mortgage crisis.

In general, sovereign wealth funds have adopted two approaches to investment -- conventional investing and a more controversial strategic investing. Conventional investing (e.g., Norway’s and Canada’s funds) seeks profit through well known techniques like asset allocation.

However, strategic funds have evoked serious debate and have become worrisome for many countries because in strategic investing (e.g., China’s and Dubai’s funds) goals other than profit may trump. For instance, a strategic fund may be more interested in gaining access to the technological know-how — intellectual property, research, design, etc. — than in financial return. Such access allows a government to speed up the development of its own domestic industries and markets. Strategic investing may also sometimes be morally challenging. For example, such funds may invest to gain access to markets and countries that are shunned or ignored for several reasons including human rights reasons, lack of maintenance of peace etc. China’s investment in Sudan is cited as an example of this.

In sum, strategic investing is troubling because it is done to gain greater economic and political power, and that too secretively.

So is it possible that a foreign government would try to use its presence in the U.S. economy to advance political aims? Absolutely. Because there is much more to be gained from the US than any other country. However, it is also true that wealth funds bring new capital which could be very productive.

Given these facts, the U.S. should design rules and regulations to manage both the financial risks and the political risks of the sovereign funds. Such rules would include requirements for transparency and accountability -- for example, mandatory audited disclosures by the funds, reciprocity for American investors, and caps on the share of ownership that a government can make in a company or sector. The opponents of regulation argue that it would make these funds less productive or even non-productive. That missed the point because the lack of measured (not burdensome) regulatory mechanisms could lead to monumental consequences -- financial instability and loss of faith in financial markets.