European Affairs

Europe Must Present a Single Market to SWF’s     Print Email
Antonio De Lecea

Sovereign wealth funds have become the latest topic du jour in international finance; their rapid expansion is sparking political debate on both sides of the Atlantic and, it is fair to say, fuelling a certain amount of anxiety as well.

Sovereign wealth funds are nothing new. The very first fund was established by the Kuwait Investment Office in 1953 and the number of funds jumped in the 70s and 80s as rising oil prices allowed oil producers to set up funds.

Despite this, SWFs have aroused political debate because of the various perceptions (or misperceptions) that surround them. First, some see the funds as a potential risk to the stability of financial markets. Although they have been there for quite some time, it is only in the last few years that we’ve seen a worldwide increase in both their number and size. For example, since the turn of the millennium, about 20 new sovereign wealth funds have been set up, including Russia’s Reserve Fund and National Welfare Fund, Korea’s Investment Corporation and the China Investment Corporation. The sheer magnitude of the capital under sovereign wealth fund control has exploded. From current levels of two trillion dollars, they are expected to reach more than $12 trillion before the middle of the next decade.

While the numbers may be huge, we should be careful not to overstate their impact; the total assets of sovereign wealth funds still only account for about one twentieth of those held by private sector participants. Sovereign wealth funds have also been a rather stabilising force during the current financial turmoil because of their long term investment horizons and relative lack of commercial liabilities. They complement other investment actors and are better placed than most private investors to withstand market pressures in times of crisis.

Even if SWFs are not necessarily a threat to financial stability, the large and persistent global imbalances underlying their recent rapid growth do pose serious concerns for the global economy. For countries with large deficits like the U.S., the danger in the imbalance is if investors are no longer willing to finance the deficit and a rapid reversal of capital flows occurs. For surplus countries, the fear with the imbalance is that large foreign exchange inflows often contribute to asset price bubbles and higher inflation. And for the world economy, a disorderly correction of global imbalances could disrupt international trade and fuel protectionist measures that would restrict growth and prosperity worldwide. Key economic powers must recognise their responsibility and act now to prevent future repercussions of the imbalance.

Another perception of sovereign wealth funds is that they are a product of the advanced stage of globalisation; this perception could trigger a rise in protectionism. However, such a fear is most likely unfounded. After all, the European economy is built on the principles of open markets and foreign investment. The EU is the largest trader in goods and services, the largest exporter of foreign direct investment and a major beneficiary of foreign direct investment inflows. We are well aware that investment and openness are the elements that drive our economy forward and that we cannot advance without them. This is why we are committed to maintaining an open environment for investment instead of taking a defensive approach.

If the anxieties about their risk to financial stability and their role in globalisation are mostly based on misperceptions, legitimate questions are fuelled by the way that many of the funds are run. Due to their state ownership and often poor transparency, SWFs are often perceived as – or feared to be – a foreign policy instrument of countries. While so far most funds have behaved as savvy investors seeking long-term financial returns, some of the countries that have recently created funds are relative newcomers to the principles of market economies and don’t have an established track record. Since sovereign wealth funds are owned by states and not private companies, some fear that certain funds are being run to fulfil national, rather than commercial, goals. Their lack of transparency is feeding these doubts. We often know little about their management and very few publish information about their assets, liabilities or investment strategies.

In order to address legitimate concerns over transparency, we must demand proper arrangements for the supervision of government-linked investment vehicles. And the funds themselves need to recognise that new responsibilities come with their growing role in the global economy. There are measures in place in the EU to block any investment that threatens to compromise national security and Member States already possess adequate instruments that allow them to monitor foreign investment and react if a public policy or security concern were to arise. A number of them already use such measures to restrict investments in the defence sector and the European Commission has recently proposed specific controls on investment in the energy sector. More transparency, accompanied by the appropriate use of these existing instruments, should prevent the real danger: that these concerns could fuel sentiments of economic nationalism and draw us into a downward spiral of protectionism. Needless to say, such a scenario would have disastrous consequences for the EU and for the global economy.

In February 2008, the European Commission adopted a policy paper proposing its approach on SWF’s. Endorsed by EU heads of state and government during the European Council last March, the EU position underlines our commitment to provide an open environment for investment. An EU-coordinated approach is also crucial in order to maintain the proper functioning of our single market and to minimize the risk of distortions in capital movements that could result from a fragmented response by the various member states to the funds’ practices. The policy paper calls on SWFs to commit to good governance practices, adequate accountability and a sufficient level of transparency. In particular, it requests a clear division of rights and responsibilities between managers and their sponsor governments and an effective system of checks and balances for investment decisions. These measures will hopefully dispel many concerns and cause the funds to further financial stability rather than trigger financial protectionism.

But SWF’s are not just an issue for EU member states. Their rise is a global development and, as such, we believe a global approach is the best way to address the fears the funds can fuel. In an effort to find a multilateral solution, the EU fully endorses the work currently underway in the International Monetary Fund on a general principles and practices for SWFs that focus on transparency, governance, and accountability. Since transparency should not be one-sided, the EU also supports the Organization for Economic Co-Operation and Development’s (OECD) work in identifying the best practice guidelines for recipient countries. The OECD’s efforts should provide greater predictability for sovereign fund investors and ensure that foreign investment continues to flow into our markets.

The EU approach relies heavily on constructive dialogue and a cooperative effort between recipient countries, the sovereign wealth funds and their sponsor countries. Success depends on all actors taking ownership in the creation of a balanced and stable framework covering SWF investments.

Antonio de Lecea is Director for International Economic and Financial Affairs at the European Commission. This article is adapted from his presentation to The European Institute in Washington on 10 April 2008.