Sovereign Wealth Funds: Legitimacy, Governance, and Global Power

Sovereign Wealth Funds

Sovereign Wealth Funds

Legitimacy, Governance, and Global Power

Gordon L. Clark, Adam D. Dixon, and Ashby H. B. Monk

PRINCETON UNIVERSITY PRESS

Princeton and Oxford

Copyright © 2013 by Princeton University Press

Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540

In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW

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Library of Congress Cataloging-in-Publication Data

Clark, Gordon L.

Sovereign wealth funds : legitimacy, governance, and global power / Gordon L. Clark, Adam D. Dixon, and Ashby H. B. Monk.

pages cm

Includes bibliographical references and index.

ISBN 978-0-691-14229-6 (hbk. : alk. paper) 1. Sovereign wealth funds. 2. Sovereign wealth funds—Law and legislation. 3. Investments, Foreign—Case studies. I. Dixon, Adam D. II. Monk, Ashby H. B. (Ashby Henry Benning), 1976– III. Title.

HJ3801.C53 2013

332.67'252—dc23

2012048975

British Library Cataloging-in-Publication Data is available

This book has been composed in Minion Pro and Myriad Pro

Printed on acid-free paper. ∞

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

For

_________________________________

Peter and Shirley Clark,

_________________________________

Fay Dixon and Olga Thönissen,

_________________________________

Henry, Beatrix, and Courtney Monk

_________________________________

Contents

List of Figures and Tables ix

Preface xi

Acknowledgments xix

1 Introduction 1

2 The Rise of Sovereign Wealth Funds 13

3 Rethinking the Sovereign in Sovereign Wealth Funds 30

4 The Virtues of Long-Term Commitment: Australia’s Future Fund 46

5 The Ethics of Global Investment: Norway’s Government Pension Fund 67

6 Insurer of Last Resort: Singapore’s Government Investment Corporation 86

7 Legitimacy, Trade, and Global Imbalances: The China Investment Corporation 105

8 Modernity, Imitation, and Performance: The Gulf States’ Funds 121

9 Conclusion: Form and Function in the Twenty-First Century 137

Appendix: Scoping Best Practice 155

Notes 163

References 173

Index 195

List of Figures and Tables

Figures

Figure 1.1.   The rise of sovereign wealth funds 4

Figure 4.1.   Australian trade and government accounts (1990–2008) 52

Figure 4.2.   CPI and housing investment (Australia 1990–2008) 53

Figure 4.3.   Income and unemployment (Australia 1990–2008) 54

Figure 5.1.   Year-end market value of the GPF-G (NOK billion) 73

Figure 5.2.   Structure, authority, and responsibility 75

Figure 7.1.   U.S. trade with People’s Republic of China 1984–2008 (US$) 110

Figure 7.2.  U.S. dollar exchange rates (normalized to base 1, 1994) 111

Figure 7.3.  Schematic of CIC governance (excluding Central Huijin Investment) 114

Figure 8.1.   Trends and volatility of crude oil prices 1861–2010 123

Figure A.1.  Schematic of governance budget and risk budget 156

Tables

Table 2.1.   Example reasons for the establishment of SWFs 15

Table 5.1.   Companies excluded from the investment universe by the Ministry of Finance upon recommendation by the Council of Ethics 81

Table 6.1.   Asian economic growth 91

Table 6.2    Singapore macroeconomic indicators 94

Table 7.1.   CIC – Strategic investments by purchase price (2007–2009) 117

Table 8.1.   Gulf States’ adoption of SWFs 126

Table A.1.   Best-practice factors 162

Preface

Global financial flows have come to dominate national macroeconomic policymaking around the world. This is true for Organisation for Economic Co-operation and Development (OECD) countries, the margins of continental Europe, and the developing countries of Asia and Latin America. As a consequence, national economic policymakers are keenly aware of the vagaries of global financial markets, not least because most currencies are vulnerable to the depredations of currency arbitrageurs and speculators. One lesson of the 1997 Asian financial crisis was that developing countries could benefit from the accumulation of foreign currency reserves so as to dampen or insure against similar events in the future. Another lesson was that nation-state macroeconomic planning had to take a long view of the future, setting aside a portion of short-term export earnings for the stabilization of long-term economic growth. The global financial crisis brought home to the West these same lessons discounting claims of global hegemony and the virtues of Anglo-American financial markets.

Over the last two decades of the twentieth century, the developing economies of the East experienced a remarkable surge in the accumulation of financial assets. When combined with a cultural predisposition to high rates of household saving, economic development in the East has been a major contributor to the accumulating stock of global assets. Of course, the periphery of the global economy has, on occasion, also experienced episodes, or bursts, of significant national saving through commodity price booms and the like. Countries participating in the OPEC oil cartel have benefited from the premium on energy prices associated with global economic growth and market speculation in relation to the short-term limits on energy production. However, the wealth generated by recurrent commodity price booms has often been squandered by recipient countries such that consumption, corruption, and poor investment strategy have often discounted the long-term value of nations’ resources.

The combination of pension fund capitalism in the West, neo-mercantilism in the East, and commodity price booms at the periphery of the global economy have produced a map of global financial stocks profoundly different to that of fifty years ago. Whereas it was once meaningful to talk of global economic integration through commodity production and trade where finance was simply a means to an end rather than an end in itself, by the turn of the twenty-first-century global financial stocks had overwhelmed the global real economy. The significance of this fact of life was largely ignored until the global financial crisis exposed the consequences of global imbalances for financial stability, economic growth, and employment. Put simply, the accumulating financial stocks of the East and of commodity-producing countries have been hoarded in a new form of institutional investor, the Sovereign Wealth Fund (SWF).

The new global reality is one in which the emerging map of twenty-first-century global capitalism favors the holders of financial assets over the domestic institutions and macroeconomic circumstances of Western countries. As such, the hegemony of the United States as the surviving superpower of the twentieth century has been undercut by the financial clout of East Asia, and in particular China. Equally, it is demonstrable that the distinctive economic and social institutions of particular countries and blocs of countries such as Germany, continental Europe, and the Atlantic economies are subject to the pricing power of financial markets and the holders of financial assets. Their stake in maintaining European traditions is quite marginal relative to their stake in realizing a long-term return on those assets consistent with national interests. In play, therefore, is the emerging map of twenty-first-century geopolitics as well as the contingency of nation-states and their particular customs and traditions.

Countries hold wealth in the form of financial assets for a variety of reasons. For some, these assets represent a form of self-insurance against the worst-case scenario, whether related to global economic and financial instability or geopolitical claims on their autonomy and national self-determination. So, for example, Singapore has pursued a long-term development strategy buttressed by the accumulation of global financial assets to protect itself against global financial instability and the possible encroachment of its near neighbors on its success as a Western Asian economic miracle. Likewise, some countries have sought to manage their wealth in ways that strike a balance between current generations and future generations, reconciling current consumption with long-term investment for the prospects of unborn citizens. Notwithstanding the diversity of motives and intentions, there is a most remarkable commonality: the use of SWFs to manage the rate of return on accumulated financial assets through the investment in a broad range of asset classes and regions of the world. For some commentators, it is an unparalleled institutional innovation. We believe it is better seen as a variation on existing institutions found in the West: in particular, the funded supplementary pension schemes that are responsible for the long-term welfare of nominated beneficiaries and whose investment strategies are reliant upon financial markets and the global financial services industry.

Apparently similar form and functions belie an ever-present fact of life: SWFs are also the strategic instruments of nation-states, conceived, in part, to underwrite their sponsors’ geopolitical interests. As such, SWFs are very different from pension institutions because their legitimacy is framed in terms of their domestic constituents as well as their role in international relations. By this logic, there is a premium on the transparency of SWFs’ investment decision-making as well as full disclosure of their motivations and intentions when investing beyond national borders. As a consequence, sponsors of SWFs have adopted many of the governance mechanisms and decision-making protocols of pension plans, while setting out in more detail than might be expected the logic behind their asset allocation strategies and investment decisions. When SWFs invest in particular sectors and opportunities in the West, domestic politics often intrude upon the reception of such flows of assets. It might be argued that such reactions are entirely parochial; equally, it could be argued that these reactions reflect a much wider realization that the global hegemon is no longer in control of its destiny.

In this book, we suggest that the significance of SWFs is to be found in their emblematic status as representatives of the global transformation of nation-state economic prospects over the past decade and the next fifty years. As we show in our case studies, the forces propelling the adoption of the SWF institution have varied by country and by reference to the source of financial wealth. Like Mark Roe and others who are sensitive to the political origins of financial institutions, we believe national heritage counts; nonetheless, we find it remarkable that so many countries have adopted such a distinctive type of investment institution with identifiable commonalities of form and function that match the core institutions of Western financial markets. If there are differences in the governance and strategic importance of these institutions by country, the legitimacy of SWFs is to be found, in large part, in their commonalities rather than their differences.

Our book has three objectives. The first is to explain the development of SWFs around the world, playing off national interests and traditions against the common form of such institutions. The second is to look inside SWFs, going beyond their stated purposes to a close analysis of their governance and investment management. We suggest that the legitimacy of these institutions is to be found in the degree to which the design and governance of sovereign funds match expectations in the West in regard to the discipline imposed on the investment process. The third objective is broader and more diffuse: we seek to undercut commonplace notions about the world inherited from the twentieth century and ready-made assumptions about the emerging world of the twenty-first century. This is obvious in the changing status of the United States in relation to China and to East Asia in general. But there is more to it than the rivalries between superpowers. Even small countries with large and globally oriented SWFs are likely to play a significant role in international relations. Mapping the global footprints of these national institutions is thus the overarching goal of the book. Accordingly, we link institutional and local information collected through fieldwork with larger stylized facts and conceptualizations of global political economy, drawing on data from hundreds of semi-structured interviews, primary accounts of SWFs by insiders, corporate and regulatory filings, and secondary sources.

The book comprises nine chapters, beginning with an introductory chapter that sets the scene of our research and the analytical approach taken. Chapter 2 provides an introduction to the formation and development of SWFs around the world. In this chapter our argument is largely about form and function, emphasizing the functions that SWFs provide for nation-states in the context of the global financial system. Our purpose here is to classify and explain the rise of SWFs, making links to the relevant literature in the social sciences on institutional innovation and change. We also emphasize the importance of SWFs as an institutional innovation consistent with and drawing legitimacy from fundamental changes in the global financial system that have prompted governments to seek ways of managing their place in a system subject to considerable volatility, risk, and uncertainty.

One way of characterizing SWFs is through their financial functions, which link to the principles and practices of investment management. While very important in underwriting the legitimacy of these institutions, SWFs, as we argue in chapter 3, must be understood in relation to nation-state sovereignty. This chapter goes beyond functionalism to a conception of nation-state sovereignty that is increasingly contingent upon national heritage and the capacity of national elites to sustain that heritage in the face of global financial imperatives. While chapter 2 provides a functionalist classification of SWFs, chapter 3 provides a rather different typology focusing upon the interests of nation-states and their place in the global financial system. This is important for what follows: the selection of our case studies is based, in part, on recognition of the distinctive situations facing nation-states as they encounter market imperatives. In some cases, nation-states simply use SWFs to hold market imperatives at bay. In other cases, however, state-sponsored SWFs are strategic instruments focused on the global financial system but acting to realize national interests in the international community.

Chapter 4 presents our first case study, looking past the geopolitical concerns that have plagued SWFs and focusing on the competing domestic political interests embedded in sponsoring countries. In other words, this chapter examines the domestic, political claims on SWFs and the principles and practice of governance used to discipline those interests. As we show, there is an ever-present temptation that faces SWF sponsors: the option of spending the assets for current political advantage. Through the case study of Australia’s Future Fund (FF), we examine how governance can, in effect, tame political temptation. Indeed, the Australian government specifically addressed the question of political temptation in its design of its SWF. The chapter focuses on the principles used to design the FF and references recent research on the principles of best-practice investment management (the Appendix reproduces these principles).

Continuing with the theme of long-term institutional investment, chapter 5 examines the investment policies of the Norwegian Government Pension Fund-Global (GPF-G). One of the world’s largest investors, this SWF has an explicit mission to integrate long-term investment policies with a two-sided ethical commitment. The Norwegian fund’s ethical mandate is remarkable when compared to other SWFs. However, we note in this chapter that this mandate is best understood in terms of procedural rather than substantive justice. We claim that the primary reason for the ethical policies within the GPF-G is to secure domestic legitimacy; its ethical impact is of secondary importance. Our argument is sustained by reference to recent work on the nature of state authority and legitimacy in democratic societies, the logic of institutional governance, and the functional integration of decision-making. The chapter concludes with implications for situating the functional performance of the fund in the context of changing global financial markets.

In chapter 6 we turn our gaze to Asia. During the financial crisis, a number of East Asian SWFs acted as insurers of last resort for their nation-states, underwriting financial stability and social welfare. In this chapter, we explain how and why this role came to pass, arguing that it serves to sustain the legitimacy of the nation-state as well as justify the separation of SWF assets from the public interest in current consumption and spending. Focusing on the Government of Singapore Investment Corporation (GIC), we suggest that the prospect of recurrent financial crises was an important prompt for its establishment in 1981, reinforced by the experience of many East Asian countries in the 1997 Asian financial crisis. The formal constitution of the GIC, the mechanisms by which its reserves are returned to the government in crisis, and the role of different sections of the political elite in managing those assets are explained. Referencing the principles of best-practice fund governance and the Santiago Principles underwriting the legitimacy of SWFs, we also consider the governance of the GIC, especially in regard to its investment processes. We draw implications for the experience of Western countries, particularly the United Kingdom and the United States, wherein the failure of their banking systems has put untold pressures on current and future living standards.

Chapter 7 then considers the China Investment Corporation (CIC). We explain how China came to own and control the world’s largest strategic investor. The CIC is a product of the original deal with the United States to open trade in the 1970s and is emblematic of the new status of China in the global economy. This chapter thus rehearses the arguments underpinning the rise of China. We also explain why the CIC has eschewed conventional portfolio investment in developed financial markets and replaced it with strategic investments in resources and jurisdictions deemed essential to China’s long-term growth. As such, attempts to rein in its ambitions through the Santiago Principles and the like have been circumvented by a very different approach to investment. The CIC is remaking the rules of engagement in global financial markets, redrawing the nature and scope of the long-term relationship between the two superpowers of the twenty-first century: China and the United States.

Chapter 8 shifts focus to the adoption of the SWF institution in the Persian Gulf States. Here we focus upon the reasons for adoption, the apparent neighborhood effect in the pace of adoption by the Gulf States over the past decade, as well as the importance of adoption as a gesture of commitment to modernity (aimed at domestic constituents and the international community). Most importantly, we reference the academic literature on the putative effectiveness of adopting institutions conceived and developed in other jurisdictions with different traditions and commitments. At issue is whether adoption has been effective in the short run and will realize the promise of the SWF institution over the long term. By our assessment, there are good reasons to suppose that adoption may not pay off in the manner expected. Nonetheless, the commitment of the Gulf States to the idealized institutional form of the SWF is indicative of moves by the governing elites to transform their states into diversified developed economies.

Our case studies were chosen so as to represent the various ways in which SWFs have been conceived and governed around the world. In large part, these case studies counterpose the ideal form of the SWF with the history and geography (economic and political circumstances) of nation-state sponsors. Nonetheless, as we show in chapters 2 and 3, the SWF institution has been adopted precisely because it is widely believed to have a distinctive form superior and different from inherited institutions available to nation-states (such as central banks, reserve funds, and Treasury facilities). With form come the functions needed for nation-states to survive and prosper in the global financial system. In chapter 9, the book concludes with a critique of the ideal form of the SWF institution, referencing the lessons learned from the global financial crisis. Not only have the principles and practical logics underpinning the SWF institution been exposed to the harsh light cast by the global financial crisis, but also a number of nation-state sponsors have come to see the SWF institution as an ideal mechanism for leading economic development. At the moment where the SWF institution has never been more popular, its ideal form is being remade according to the harsh realities of crisis and contagion.

One lesson to be drawn from our book is that if the recipe for SWF institutional form and function was set at the apogee of Anglo-American financial hegemony, its evolution and reconceptualization will be set by the resource-rich and developing economies of the world. The second lesson from our book goes to the question of nation-state legitimacy: the very idea of holding national assets and income in a remote lock-box far from domestic interests and concerns about public well-being is premised upon the power of the state relative to civil society. It may be justifiable if assets and income are secure and seen to be secure from the greed of privileged elites. But, in some countries, the legitimacy of sponsored SWFs may be undercut precisely because those institutions are intimately related to controlling elites. In these cases, whatever the functional value of a sponsored SWF and its notional commitment to the future welfare of society, the rhetoric of functional utility and commitment may be little more than a convenient cover for the expropriation of national assets. As such, the concerns expressed by many in the West about the lack of independence and professional autonomy of SWFs may be realized in revolutions from below that seek to overturn those who control national resources.

A third lesson to be drawn from our book is that the governance of the global financial system through the multilateral institutions may be rewritten by sovereign nations whose financial power is concentrated in SWFs as opposed to distributed—in a decentralized manner—through private banks, institutional investors, insurance companies and pension funds. This may be an opportunity for the multilateral institutions to bring together the financial arms of emerging economies and markets in ways not possible when the world was dominated by segmented private interests. However, the challenge will be to show the resource-rich and developing economies that the multilateral institutions are in fact relevant to their interests.

Gordon L. Clark, Adam D. Dixon and Ashby H. B. Monk,

Oxford, Bristol and Palo Alto, February 2013

Acknowledgments

This book crosses over continents, countries, and disciplines. As such, we have been fortunate to have the support of many colleagues and friends in allied academic fields, as well as the support of readers and contributors to our website www.oxfordswfproject.com. The topic of SWFs engages academic disciplines, industry groups, national policymakers, and many others as well. We are grateful for their continued interest and encouragement of the project.

We would like to thank the Leverhulme Trust for its support of the research that underpins this book. Without its commitment, we would not have been able to reach out to the rest of the world. Our research would not have had the richness or the sense of urgency that motivates the analytical and case study chapters. Leverhulme also played a crucial role in underwriting the development of our blog. Through the global electronic highway, we have had the opportunity to learn from many people who have the depth of knowledge and insight that academics crave. Importantly, our collaboration with Roger Urwin from Towers Watson on the governance of financial institutions (notably pension funds) has been a vital ingredient in framing our research, the book, and our perspective on the interaction between governance and legitimacy. Likewise, we have been fortunate to enlist the support of Keith Ambachtsheer of the Rotman International Centre for Pension Management (ICPM) at the University of Toronto. Keith has been a long-time supporter of our research and a strong advocate of a deeper understanding of the links to be made between the governance of financial institutions and their financial performance.

Closer to Oxford, we are pleased to acknowledge the support (direct and in kind) of the University, the School of Geography and the Environment, St Peter’s College, and Christ Church. It is invidious to single out specific individuals, but Chris White (web support), Sue Blackshaw and Richard Holden (research services), Jan Burke, and Amanda Diener all played important roles in sustaining the program. Most importantly, Olga Thönissen was an incisive and effective assistant, coordinating the project around the world as well as being a very valuable editor. Editorial assistance was also provided by Amanda Diener, Christopher Coghlan and Lisa Toms. Colleagues and graduate students at Oxford helped with research assistance and criticism on specific papers. Here, we would like to thank Nick Howarth, Jaizhe Sun, and Claire Molinari. As well, Allan Fels, Dean of the Australia and New Zealand School of Government, and Stephen King, past Dean of Monash University’s Faculty of Business and Economics, have provided on occasion a hospitable home for research and writing. In a similar manner, our colleagues Eric Knight (co-author of a version of chapter 5), and Dariusz Wójcik provided encouragement and critical interest in the progress of the book.

We would also like to thank academic colleagues who have remained interested in the project throughout, including Sven Behrendt, Simon Chesterman, James Faulconbridge, Dan Haberly, Richard Higgott, Owen Hughes, Alicia Munnell, Phillip O’Neill, Louis Pauly, Joseph Stiglitz, and Henry Yeung. From industry, we would like to thank Andrew Rozenov, Bill Hunt, Knut Kaiser, Laura Parsons, and Bill Dodwell (Deloitte, London); Marinus C. Huizer, Bernhard Reinsberg, and John Nugée; as well as the formidable Nancy Webman and her team from Pensions & Investments. For help in specific sections of the book we would also like to acknowledge the help and advice provided by David Murray, Juan Yermo, Paul Costello, the Hon. Peter Costello, and Nick Sherry, former Senator for Tasmania, Australia.

Along the way, we have given numerous talks about our research. We have relied upon the comments and thoughts of those who have participated in the related conferences. Sponsors of presentations have included Oxford University, Oxford Analytica, New York University Law School, National University of Singapore Law School, Cambridge University, Columbia University, the Association of American Geographers, Institutional Investor, HSBC, and the Asian Development Bank.

Initial ideas for the book were enthusiastically embraced by Richard Baggaley (then of Princeton University Press) and Peter Dougherty of the Press. More recently, we have relied upon Seth Ditchik to usher the book into production and publication. We are very grateful for their interest and commitment.

The chapters of this book draw upon previously published papers from the project. Here we would also acknowledge the permission of publishers to use portions of those papers and essays:

Pion Ltd. (London) for Monk, A. H. B. (2012), Sovereignty in the era of global capitalism: The rise of sovereign wealth funds and the power of finance, Environment and Planning A 43(8) 1813–32; and Clark, G. L., and Monk, A. H. B. (2010), The legitimacy and governance of Norway’s sovereign wealth fund: The ethics of global investment. Environment and Planning A 42(7): 1723–38, www.pion.co.uk and www.envplan.com.

Cambridge University Press for Clark, G. L., and Knight, E. (2011), Temptation and the virtues of long-term commitment: The governance of sovereign wealth fund investment, Asian Journal of International Law 1(2): 321–48.

Taylor and Francis Group for Monk, A. H. B. (2009). Recasting the sovereign wealth fund debate: Trust, legitimacy, and governance. New Political Economy 14(4): 451–68; and Clark, G. L., and Monk, A. H. B. (2010). Government of Singapore Investment Corporation (GIC): Insurer of last resort and bulwark of nation-state legitimacy. The Pacific Review 23(4): 429–51, http://www.tandfonline.com.

Maney Publishing for Clark, G. L., and Monk, A. H. B. (2011), The political economy of US-China trade and investment: The role of the China Investment Corporation, Competition and Change 15(2): 97–115, www.maney.co.uk/journals/com and www.ingentaconnect.com/content/maney/com.

John Wiley & Sons for Dixon, A. D., and Monk, A. H. B. (2012). Rethinking the sovereign in sovereign wealth funds, Transactions of the Institute of British Geographers 37(1): 104–17.

Walter De Gruyter for Clark, G. L., and Monk, A. H. B. (2012). Modernity, imitation, and performance: Sovereign funds in the Gulf. Business and Politics 14(1), DOI: 10.1515/1469-3569.1417. The previous version of this article can be found at www.degruyter.com.

Sovereign Wealth Funds

1

Introduction

Over the past few decades, the global economy has witnessed successive paradigm shifts: the Soviet Union collapsed; the United States ushered in the Internet economy; Brazil, Russia, India, and China, among other rapidly growing emerging-market economies, were integrated into the global supply chain; the China–U.S. economic alliance blossomed but then hit choppy-waters; and finance, with all its associated agents and institutions, came to overshadow, and eventually derail, the real economy. Overall, the market became an incontrovertible force for change in the world, rewriting the geography of the global economy and revolutionizing the interplay between various public and private actors and institutions. From liberal democracies to authoritarian and even communist regimes, capitalist systems of economic coordination have become pervasive.

The decisions by nation-states to deepen economic integration and facilitate globalization are premised on the idea that, when sovereign nations cede some portion of their domestic autonomy to a global system of coordination, they are compensated through efficiency gains, such as the discounted costs of consumption and a more productive supply chain. Without this benefit, countries would universally reject trade agreements and treaties. Instead, politicians have embraced, albeit begrudgingly in some cases, these new economic realities underpinned by global competition for capital, industry, jobs, goods, and services (among other things). States have willingly adopted postures motivated by a market-based logic, legitimated by vaguely specified notions like competitiveness (Monk 2008a). As Gertler and Wolfe (2004, 45) note, communities and regions, like companies, need to innovate and adapt to remain competitive.

However, the interplay of two competing counterparties in this new economic paradigm—capital’s