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Definitional Challenges of Dealing with Sovereign Wealth Funds

Published online by Cambridge University Press:  28 October 2010

Andrew ROZANOV
Andrew ROZANOV*
Affiliation:
Permal Group, United Kingdom
*
arozanov@permal.com
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Abstract

International policy-makers so far have successfully pre-empted any new major national legislation in the G7 countries aimed specifically at sovereign wealth funds by getting the International Monetary Fund to work with them on formulating a set of best practices commonly known as the Santiago Principles. However, some observers stress that this is just the beginning. How does one measure and evaluate compliance with these principles? Is voluntary self-regulation really sufficient? Or is there a need for new rules and regulations? As the discussion shifts from policy and economics to governance and regulation, we move firmly into the realm of law—legal norms, rules, and statutes. However, the required clarity and commonality of definitions and terms have been elusive. There does not seem to be universal agreement about the precise meanings of even the most fundamental terms in the SWF debate. This article hence focuses on the definitional challenges inherent in this debate.

Type
Symposium: Sovereign Wealth Funds
Information
Asian Journal of International Law , Volume 1 , Issue 2 , 14 June 2011 , pp. 249 - 265
Copyright
Copyright © Asian Journal of International Law 2010

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Footnotes

*

Managing director, Head of Sovereign Advisory, Permal Group. Permal Group is one of the oldest and largest alternative asset management firms in the world. In the last seven years, the author has focused exclusively on advising and servicing central banks and sovereign wealth funds on various aspects of reserve management. He has a Master’s equivalent degree in Oriental studies from Moscow State University and holds designations from the CFA Institute, the CAIA Association, and the Global Association of Risk Professionals.

References

1. This is not necessarily to suggest a rigid sequencing of steps, i.e. agreeing to universally accepted definitions before considering the rationale and specific content of potential new rules and regulations. Both can and often do go together in law-making.

2. One important caveat that needs to be disclosed up front is that the author is not a legal expert and does not have formal legal training. The discussion that follows is presented from the perspective of an SWF expert and a financial practitioner, and as such draws on the author’s knowledge and expertise in macroeconomic policy and global financial markets. While the article stresses the need to clarify and agree SWF-related definitions so that economists and jurists can communicate on a “legal common level”, the author does not purport to be sufficiently qualified to propose “final” definitions according to international laws, existing customs, and treaties. The objective is to raise awareness in the legal community of the definitional challenges and ambiguities surrounding SWFs and to invite legal experts to contribute to this debate.

3. See ROZANOV, Andrew, “Who Holds the Wealth of Nations?” (2005) 15 Central Banking Journal 4Google Scholar [Rozanov, “Wealth of Nations”]. This author also predicted that growth of SWF assets would come not only from commodity exports, but also increasingly from carving out and separately managing “excess” central bank reserves. Since then, we have seen the Republic of Korea and China go down this path, establishing well-capitalized government investment corporations. We are also witnessing debates about the potential merits and challenges of setting up reserve-funded SWFs in other parts of Asia—from Japan and Taiwan to Thailand and India.

4. The most obvious misuse of the term was evident whenever it was wrongly applied to describe the foreign bidders in the CNOOC-Unocal and the Dubai Ports transactions. Equally misguided were references to SWFs when discussing Russia’s state-owned resource companies and banks, or China’s state lending banks and state-owned enterprises.

5. This section draws from two previous publications by this author: Rozanov, “Wealth of Nations”, supra note 3; and ROZANOV, Andrew, “A Liability-Based Approach to Sovereign Wealth” (2008) 18 Central Banking Journal 31Google Scholar [Rozanov, “Liability-Based”].

6. For example, Abu Dhabi may be a subfederal entity within the United Arab Emirates, but it enjoys full sovereignty over both its oil reserves and its financial assets. Resource-based funds in Alaska, Wyoming, and Alberta are in a similar position and should be rightfully counted among SWFs, as they are policy driven, funded by excess commodity revenues, and owned by local taxpayers. They therefore have much more in common with commodity-based national SWFs than with their subnational brethren, such as public pension plans.

7. While there is no hard-and-fast rule for determining the adequate level of foreign exchange reserves, there are several widely accepted measures which, when applied collectively, can indicate with a fairly high degree of confidence the presence of considerable excess reserves. Such measures typically include number of months of import coverage, coverage of short-term public debt falling due within one year, ratio of reserves to the M2 monetary aggregate, etc.

8. See JEN, Stephen and ST-ARNAUD, Charles, Sovereign Pension Funds (London: Morgan Stanley, 2007)Google Scholar, online: Morgan Stanley 〈http://www.morganstanley.com/views/gef/archive/2007/20070824-Fri.htmlanchor0861dbc5-419f-11de-a1b3-c771ef8db296〉.

9. The importance of this distinction was clearly demonstrated during the recent financial crisis. While a government cannot direct a “genuine” pension fund to invest in any asset for any policy purpose other than fulfilling its fiduciary duty to beneficiaries, it can certainly do so with an SWF. Consider the case of Ireland, where legislation was amended so that the government could direct NPRF to invest an amount equivalent to almost half of its assets to recapitalize local banks.

10. See generally Rozanov, “Liability-Based”, supra note 5.

11. In economics, “Dutch disease” is a form of resource curse, whereby excess windfall revenues are brought back onshore, instead of being invested and managed offshore, leading to real currency appreciation and loss of competitiveness in domestic manufacturing and the traded goods export sector.

12. For details of such two-dimensional classification—by sources and uses of funds—and the theoretical impact of respective liability profiles on investment preferences of SWFs, see the Appendix.

13. LOWERY, Clay, “Remarks by Acting Secretary for International Affairs, Clay Lowery on Sovereign Wealth Funds and the International Financial System”, presented to the Conference on the Asian Financial Crisis Revisited delivered at the Federal Reserve Bank of San Francisco, 21 June 2007, online: 〈http://www.ustreas.gov/press/releases/hp471.htm〉Google Scholar.

14. International Monetary Fund, Global Financial Stability Report: Financial Market Turbulence: Causes, Consequences and Policies (Washington DC: International Monetary Fund, 2007) at 45Google Scholar.

15. Given the IMF’s traditional focus on macroeconomic stability and global capital flows, such emphasis on foreign-asset-based SWFs may appear logical. However, the role and functioning of domestic-asset-based SWFs have a direct bearing on the macroeconomic and fiscal frameworks in their respective countries, which should also be of interest and relevance to the IMF. Also, just like Temasek Holdings, such funds elsewhere can be reasonably expected to expand overseas in the future.

16. JEN, Stephen, The Definition of a Sovereign Wealth Fund (New York: Morgan Stanley, 2007)Google Scholar, online: Morgan Stanley 〈http://www.morganstanley.com/views/gef/archive/2007/20071026-Fri.html〉.

17. International Working Group of Sovereign Wealth Funds, Sovereign Wealth Funds Generally Accepted Principles and Practices—“Santiago Principles” (n.p.: IWG-SWF, 2008), online: IWG-SWF 〈http://www.iwg-swf.org/pubs/gapplist.htm〉 [GAPP].

18. Ibid.

19. Ibid.

20. Of this type of fund, only Singapore’s Temasek Holdings has been classified as an SWF within the meaning of the Santiago Principles. While more than 70 percent of its portfolio is currently invested overseas, its international presence is a relatively recent phenomenon for this fund. Temasek Holdings was originally established and continued to operate for at least two decades as a sovereign fund investing exclusively in domestic assets.

21. However, as long as these funds continue to invest exclusively or primarily in domestic assets, one might legitimately argue that the policy issues and challenges they pose may be of a materially different nature to justify a distinct grouping separate from the International Forum of SWFs.

22. Alastair Newton, senior political analyst at Nomura International, calls such central banks “Diversified Monetary Authorities” (DMAs), emphasizing the return-oriented, broadly diversified, multi-asset-class nature of their portfolios, not that dissimilar in their philosophy and structure to SWFs.

23. For more information on the Forum, see the contents of the Kuwait Declaration. See International Working Group of Sovereign Wealth Funds, “ ‘Kuwait Declaration’: Establishment of the International Forum of Sovereign Wealth Funds” (6 April 2009), online: IWG 〈http://www.iwg-swf.org/mis/kuwaitdec.htm〉.

24. This section draws from a previous publication by the author. See ROZANOV, Andrew “The Transparency of Sovereign Wealth Funds” in John NUGÉE and Paola SUBACCHI, eds., The Gulf Region: A New Hub of Global Financial Power (London: Chatham House, 2008) at 204Google Scholar.

25. SOROS, George, “Hedge Funds and Dynamic Hedging” in Ronald LAKE, ed., Evaluating and Implementing Hedge Fund Strategies: The Experience of Managers and Investors (London: Euromoney Institutional Investor, 2003), chapter 36 at 426Google Scholar.

26. Direct sovereign ownership and control introduce an important political dimension to the analysis of SWFs, which makes them materially different from hedge funds and other private sector entities. This political element needs to be carefully analysed and, if needed, addressed in the policy response. However, before any additional formal rules or regulations are considered, it is important to ascertain whether existing legal and regulatory regimes are already sufficiently capable of addressing such concerns.

27. See JORDAN, Dearbail and COSTELLO, Miles, “Mervyn King Attacked over Northern Rock Rescue” The Times (20 September 2007)Google Scholar.

28. International Monetary Fund, Monetary and Capital Markets and Policy Development and Review Departments, Sovereign Wealth Funds—A Work Agenda (2008) at 26Google Scholar.

29. See GAPP, supra note 17, Principle 5.

30. There are two legitimate exceptions to this rule: genuine national security concerns and market efficiency considerations in very small and illiquid segments of global markets. As long as neither of these exceptional concerns is triggered, policy-makers and legislatures would do well to preserve and nurture helpful idiosyncrasies originating from non-commercially motivated investment preferences.

31. KIMMITT, Robert M., “Public Footprints in Private Markets” (2008) 87 Foreign Affairs 119Google Scholar.

32. BARYSCH, Katinka, TILFORD, Simon, and WHYTE, Philip, State, Money and Rules: An EU Policy for Foreign Investments (London: Centre for European Reform, 2008) at 12Google Scholar.