“In the last several decades, sovereign wealth funds have come to play a major role in international financial arrangements. Sovereign Wealth Funds lays out a masterful analysis of this subject. The book discusses three vital dimensions of these funds: their history and geography, their varying governance structures, and their deployment as strategic national resources. A clear grasp of these dimensions is essential for dealing with the rapidly shifting relations between finance, globalization, and the nation-state. This book is an outstanding scholarly contribution to understanding the emerging world of the twenty-first century.”–Allen J. Scott, University of California, Los Angeles

“In this pathbreaking study, three leading financial geographers elucidate the origins, activities, and implications of state-owned investment funds. Today’s policymakers as well as scholars across a range of disciplines confront the challenge of understanding the dynamic relationship between governments and globalizing capital markets. This highly original book examines a vital and increasingly important aspect of that relationship. Future policy debates and analytical explorations must begin here.”–Louis W. Pauly, University of Toronto

“State-owned investment funds are growing in size, influence, and power. We need to understand them, yet they are diverse. Clark, Dixon, and Monk tell us what attributes these institutions share and how they differ. I particularly like their series of detailed case studies of major sovereign funds. This book is illuminating and I highly recommend it to readers.”–Elroy Dimson, London Business School and chairman of the Strategy Council for the Norwegian Government Pension Fund–Global

“This original book sheds light on the forms and functions of sovereign wealth funds, and maps at the same time the global influence of these institutions. Providing an original classification of these funds, the authors offer a series of in-depth case studies that combine broad perspectives on the world economy with specific national examples.”–Valeria Miceli, Università Cattolica, Milan

Gordon L. Clark is professor and executive director of the Smith School of Enterprise and the Environment at the University of Oxford, and the Sir Louis Matheson Distinguished Visiting Professor at Monash University. Adam D. Dixon is lecturer and university research fellow at the University of Bristol and visiting research associate at the University of Oxford. Ashby H. B. Monk is a research director at Stanford University and senior research associate at the University of Oxford.

Sovereign Wealth Funds

Legitimacy, Governance, and Global Power

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

PRINCETON UNIVERSITY PRESS

Copyright © 2013 Princeton University Press
All rights reserved.
ISBN: 978-0-691-14229-6

Contents

List of Figures and Tables………………………………………….ixPreface…………………………………………………………..xiAcknowledgments……………………………………………………xix1 Introduction…………………………………………………….12 The Rise of Sovereign Wealth Funds…………………………………133 Rethinking the “Sovereign” in Sovereign Wealth Funds…………………304 The Virtues of Long-Term Commitment: Australia’s Future Fund………….465 The Ethics of Global Investment: Norway’s Government Pension Fund……..676 Insurer of Last Resort: Singapore’s Government Investment Corporation….867 Legitimacy, Trade, and Global Imbalances: The China Investment
Corporation……………………………………………………….1058 Modernity, Imitation, and Performance: The Gulf States’ Funds…………1219 Conclusion: Form and Function in the Twenty-First Century…………….137Appendix: Scoping Best Practice……………………………………..155Notes…………………………………………………………….163References………………………………………………………..173Index…………………………………………………………….195

CHAPTER 1

Introduction

Over the past few decades, the global economy has witnessed successiveparadigm shifts: the Soviet Union collapsed; the United States ushered inthe Internet economy; Brazil, Russia, India, and China, among other rapidlygrowing emerging-market economies, were integrated into the global supplychain; the China–U.S. economic alliance blossomed but then hit “choppy-waters”;and finance, with all its associated agents and institutions, came toovershadow, and eventually derail, the real economy. Overall, the marketbecame an incontrovertible force for change in the world, rewriting the geographyof the global economy and revolutionizing the interplay betweenvarious public and private actors and institutions. From liberal democraciesto authoritarian and even communist regimes, capitalist systems of economiccoordination have become pervasive.

The decisions by nation-states to deepen economic integration and facilitateglobalization are premised on the idea that, when sovereign nations cedesome portion of their domestic autonomy to a global system of coordination,they are compensated through efficiency gains, such as the discounted costsof 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 economicrealities underpinned by global competition for capital, industry, jobs,goods, and services (among other things). States have willingly adopted posturesmotivated by a market-based logic, legitimated by vaguely specified notionslike “competitiveness” (Monk 2008a). As Gertler and Wolfe (2004, 45)note, “communities and regions, like companies, need to innovate and adaptto remain competitive.”

However, the interplay of two competing counterparties in this new economicparadigm—capital’s global search for higher returns and jurisdictions’global search for capital—has led the global economy into a murky institutionalworld without easily identifiable boundaries. Indeed, the prospect ofpolitical localities being motivated by the same market incentives as the firmslocated within these jurisdictions augurs a degradation of the boundaries thatpreviously separated states from markets. Significantly, a growing number ofstates have become reliant on markets, and in particular financial markets,for the economic and social well-being of their citizens. The rapid rise of pre-fundedpensions in the twentieth century has been the most obvious exampleof this transformation (Clark 2000). While the power of financial marketspromises a great deal for managing difficult public problems, it also leavesthese governments, and their constituencies, vulnerable to the volatility offinancial markets.

The recent global financial crisis is a telling reminder of capitalism’s darkside and the precarious position that governments may find themselves inwhen they rely on markets for national well-being. Take the current globaleconomic environment as an example: highly imbalanced and with a penchantfor extreme volatility and unpredictability, the global economy’s futuretrajectory is increasingly difficult to predict. How then do governmentsmake plans in an era with a flattened distribution of outcomes? The “rare”and “unexpected” events are much less rare and, as a consequence, much lessunexpected than they used to be. Volatility, tumult, and crisis are seeminglyroutine, which makes generalizations (and thus predictions) about economicvariables almost impossible. Indeed, the quantitative models upon which somany analytical frameworks rely have lost their luster. It seems that the worldhas fallen under the spell of a financial capitalism, leaving nation-statespowerless in the face of global economic forces.

But this is where the story turns against those who would claim the worldis converging toward a single model of economic coordination based on free-marketcapitalism. In the face of new and persistent global financial volatility,governments have managed to implement new mechanisms and tools thatmute some of this global chaos at the local level. Indeed, policymakers arecreating new institutions that seek a measure of certainty to domestic planning(Weiss 2005). Recurring crises have served to “jolt” governments intoaction, sending them in search of new ways to claw back (or simply retain)their decision-making authority. Technocrats are cast as institutional entrepreneurs,searching for coping mechanisms that can help their states managetheir precarious position in a rapidly globalizing world.

One such coping mechanism has been the accumulation and sequestrationof government reserves in the form of financial assets. The inspirationfor reserve accumulation almost certainly goes back to the 1997 Asian financialcrisis and, in particular, the resilience of certain reserve-richeconomies therein. For example, Singapore demonstrated at the time that having financialassets on hand (and in large quantities) was extremely helpful in times ofeconomic uncertainty (see chapter 6). Years before, the country’s politicianshad recognized the value of having a dedicated fund that stood ready to mobilizefinancial resources should that become necessary for the stabilizationof the economy. Other countries around the world took note, deciding thatwhat worked for an island nation could equally work for a country of morethan a billion. By 2010, global government reserves had quadrupled fromtheir 2001 levels.

Nonetheless, while reserves had come to represent a new and powerfulform of self-insurance and stabilization, holding these reserves proved costly.The difference between what the reserves earn (if they are invested in financialmarkets) and what the country pays on the domestic debt that is usedto sterilize the foreign assets can be significant. Coupled with increasinglylow yields on traditional reserve assets, such as U.S. Treasuries, a new investmentvehicle was thus needed to facilitate the diversification of accumulatedreserves into higher-yielding assets. This is the purpose of SWFs. In SWFsstates found an institution that could transform sovereign wealth into financialassets for the purpose of investment, either directly or indirectly, in domesticand international financial markets. The idea was that by investingsovereign wealth in riskier assets, and generating higher returns, governmentsponsors could contain the costs of holding such reserves. And while the assetsin an SWF are typically “excess” reserves, not needed for prudential purposes,these reserves could still be mobilized quickly to defend, engage, orsimply stabilize domestic policies or institutions.

Take as an example Russia, which used its commodity-based SWF to stabilizeits spending during the most recent financial crisis; or Singapore, whichalso tapped its reserve investment corporation for the first time; or Kuwait,which used its commodity fund to bolster domestic markets through directinvestments. Even in the United States, Chairman of the Federal Reserve BenBernanke (2010) extolled the virtues of SWFs to state governors, suggestingthat SWFs could be helpful for a rainy day in the future. In short, policymakersof all stripes, from democracies to autocracies, have all come to seeSWFs—be they in the form of a pension reserve fund, commodity fund, or areserve investment corporation—as important buffers against global marketforces that threaten domestic institutions and policies.

The Rise of Sovereign Wealth Funds

If we consider SWFs to be special-purpose vehicles that provide governmentswith the ability to tap into the power of global financial markets, why do governmentswant this power? Put simply, global financial markets offer a readystorehouse for accumulated reserves and, equally, promise a mechanism forefficient diversification. The bigger question, however, is why governmentsneed to accumulate reserves or diversify their assets in the first place. Here weproffer a more complicated explanation: in a world seemingly at the mercy ofglobalization, SWFs offer states an opportunity to reassert their sovereigntyand authority over the hegemonic forces of global capitalism. Through self-insuranceand financial stabilization, SWFs mute global forces at the locallevel. In effect, the rise of these funds is emblematic of a widespread realizationthat accumulating wealth in the form of financial assets is a reasonableprecautionary policy, whether it is to deal with looming pension obligationsor to manage the inevitable problems associated with a country’s integrationinto the global capitalist system. It is also about gaining access to the leadingedge of globalization: global financial markets.

While some funds resembling SWFs have been around for years, economichistorians will inevitably mark the first decade of this millennium asthe beginning of the SWF era. During this period tens of new SWFs were created,accounting for a large proportion of all SWFs in existence today. Governmentsaround the world decided—seemingly en masse and independentof their level of development or the form of government—that these specialpurpose investment vehicles were crucial to achieving their policy objectives.What is more, the economic and financial turmoil of the past several yearshas reinforced this trend; in the period 2009–11 eleven new SWFs were establishedand several more were at some stage of creation or implementation(see figure 1.1). In addition, SWFs’ assets under management increasedcollectively from less than US$1 trillion in 2000 to US$6 trillion by 2012, asmore governments funneled increasing amounts of their sovereign wealthinto these funds.

In effect, SWFs have become a core element in global financial marketsand a constituent part of the related financial services industry. Many expectthis relationship to become increasingly important in the future, as renewedcommitments made by many sovereign entities to their SWFs as well as thegrowing number of newly established SWFs suggest that the institution hasnot been as compromised by the turmoil in global markets as have othertypes of financial institutions. If anything, it seems that their significance hasbeen strengthened. On the one hand, governments are increasingly committedto SWFs as a policy instrument while, on the other hand, the globalfinancial services industry has grown dependent on their assets and commitmentto portfolio investment. If otherwise risk-averse in relation to thepossible political costs (borne directly or indirectly) of high-profilefailures of investment strategy, the long-term nature of SWFs gives these instrumentsthe power and position to drive the frontiers of global investment management.Indeed, SWFs are intimately related to finance-led capitalism, with itsform and functions based on the hegemony of Anglo-American finance overthe late twentieth and early twenty-first centuries (see chapter 9).

While some might have welcomed the addition of SWFs to the tumultuouseconomic environment of the past several years, given that these fundsexist to facilitate macroeconomic stability and invest a country’s assets overthe long term, many in the West initially saw the rapid rise of these funds withconcern and suspicion. To a certain extent, this was due to the fact that thesefunds represented a permanent redirection in investment flows and a shiftin the dominant sources of financial capital. After all, financial markets werehitherto dominated by Anglo-American financial institutions (Clark 2000).The apparent loss of hegemony left some, particularly in the United Statesand Europe, uncomfortable. By blurring the line between finance and politics,there was a fear that SWFs would not only redirect financial flows butalso change the very nature of global markets. Indeed, there was a sense thatforeign governments were resorting to SWFs to (mis)use financial marketsto advance political, as opposed to commercial, agendas (Schumer 2008).Some came to view SWFs as the source of a new “state financial capitalism”(Lyons 2007), or as instruments for hiding attempts by foreign governmentsto obtain technology and expertise to benefit national strategic interests (EuropeanCommission 2008). Others wondered what the introduction of publicinvestors into private markets would do for market efficiency (Gieve 2008).In all cases, SWFs were a new source of political intrigue and concern. Yet,concerns about emerging-market investors are not new (see Moorsteen 1975),and it has been over two decades since Benjamin J. Cohen argued that, “highfinance can no longer be kept separate from high politics” (1986, 3). Still, itseemed that SWFs were an affront to many Western policymakers, and thesefunds came quickly to face a global crisis of legitimacy.

Legitimacy and Governance

Because distrust toward the activities of SWFs could lead to increasing protectionistsentiments (see Levi and Stoker 2000), which could in turn resultin restricted access to key financial markets (see Tucker and Hendrickson2004), there has been a premium placed on trust. One initiative that hassought to build trust is the voluntary Generally Accepted Principles and Practices(GAPP), known as the Santiago Principles, which were developed by theInternational Working Group of SWFs with the support of the InternationalMonetary Fund (IMF). According to Hamad al Suwaidi of the Abu DhabiInvestment Authority and Co-Chair of the International Working Group, theSantiago Principles were designed to establish “trust” between SWFs and recipientcountries. Investment-receiving countries shared this commitment.For example, according to Joaquin Almunia, the European Commissioner forEconomic and Monetary Affairs, “The principles and practices of the GAPPamount to a global public good that can help foster trust and confidence betweenSWFs, their originating countries, and the recipient countries. This iswhat we need in these turbulent times: a strong commitment to enhance mutualtrust.” Similarly, Kathryn Gordon of the OECD notes that their projecton SWFs and the International Working Group’s project are “flip sides of thecoin in the trust-building process.”

Evidently, “trust” is an important stepping-stone for SWFs’ integrationinto the global financial system, and distrust is a problem that requires the attentionof SWFs and policymakers alike. But is trust the primary issue? Trustreflects someone’s belief that an institution is performing in accordance withhis or her normative expectations (Kaina 2008). Hence, embedded in thisnotion of trust is a performance; for SWFs, a performance could be a specificinvestment or asset allocation decision. These performances either conformto a normative expectation and create trust or contradict a normative expectationand create distrust. Subsequently, the question arises whether SWFsinspire concern among policymakers due to undesirable past performances(i.e., investments). The answer is no. Past SWF investments are not the issue.There are few, if any, examples of SWF investments that clearly demonstrate abreach of trust due to politically motivated investing. This would suggest thatconcerns over SWFs are largely unjustified if SWFs are evaluated accordingto their track records.

Rather, much of the concern about SWFs is about codes of conduct and theappropriateness of funds’ investment strategies. Indeed, the current debaterevolves around SWF principles and practices, which refer to the establishednorms and methods for operations and behavior, rather than performanceper se. In short, SWFs inspire fear within certain policy circles, because someSWF principles and practices do not conform to their expectations. Therefore,the issue is less about trust and more about legitimacy. While this mayseem to be simply a semantic argument, it has important implications forgeopolitics. Yet the issue of legitimacy also goes beyond geopolitical concerns.As several of our case studies show, legitimacy is equally a matter ofdomestic politics and the domestic political claims on SWFs.

Legitimacy can be described as the acceptance of an organization by its”environment,” and as the belief that an organization is authorized (legallyand morally) to operate in a certain place and time. In this sense, legitimacyis a constraint (Dowling and Pfeffer 1975; Suchman 1995; Kostova and Zaheer1999). According to Zimmerman and Zeitz (2002, 416), “legitimacy is a relationshipbetween the practices and utterances of the organization and thosethat are contained within, approved of, and enforced by the social system inwhich the organization exists.” Being legitimate means that organizationalprocedures, structures, and principles align with the values, norms, and expectationsof the society or the environment in which the organization seekslegitimacy, at home or abroad. It is a subjective quality that is defined by acertain actor’s perception of an institution’s practices and principles. Beingillegitimate limits freedom of action, which may undermine organizationaleffectiveness. As Massey (2001, 157) notes, “[A]n illegitimate status demandsthat the organization respond, or else organizational failure could result.”

One method for evaluating issues of SWF legitimacy, domestic andinternational—which we adopt as a primary mode of inquiry throughoutthe book—is to analyze SWF governance (see Appendix), as governance andlegitimacy are intertwined (Stoker 1998). Legitimation is a process necessitatingan evaluation of an organization’s governance: the techniques, procedures,categories, and structures through which organizational decisions aremade (Perrow 1970; Suchman 1995). We define governance in financial institutionsas the procedures, policies, structures, and decision-making normsunderpinning operations and investments (see Appendix). Governance is animportant resource for financial institutions, as it provides, for example, thetools to protect against outside influence, stem fraud and corruption, maintainaccountability and transparency, manage new and existing financial risks,and supervise new and existing stakeholders (Clark and Urwin 2008a). In effect,governance ensures that an organization is operating in accordance withthe values and norms of society relevant to that institution (Monk 2009b). Awell-governed financial institution inspires confidence among stakeholders.
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