INTERNATIONAL: SWF definition focuses debate

Analysis

Sovereign Wealth Funds (SWFs) have inspired concern and fear among many Western analysts and policymakers, resulting in new policy initiatives and rules designed to govern and regulate these publicly owned investment funds. This raises the question of which funds will be affected by these new policies and which will not.

Despite the recent unveiling of the Santiago Principles (see INTERNATIONAL: SWF code of practice builds trust - October 16, 2008), protectionist policies remain a distinct possibility in various jurisdictions around the world:

• Some remain concerned that, as government-owned entities, SWFs will be used to advance political agendas rather than commercial purposes -- a concern that is compounded by a general lack of transparency and Western perception of weak accountability and poor governance practices.
• This has led some countries to consider or even implement new protectionist policies designed to alleviate any threats -- be they real or simply perceived (see INTERNATIONAL: Sovereign wealth funds draw scrutiny - March 3, 2008).

Many definitions. The possibility of new rules for SWFs in certain jurisdictions raises the question of which funds will be subject to these rules. To date, there has been considerable confusion as to what actually constitutes a SWF:

• While many public pension funds are adamant that they are not SWFs, Benn Steil of the Council on Foreign Relations and Edwin Truman of the Peterson Institute have both argued that funds such as CalPERS should be considered SWFs.
• The US Treasury defines SWFs as investment vehicles funded by foreign exchange assets and managed separately from official reserves, which would exclude Singapore's Temasek -- this is odd because Temasek was one of the member funds of the International Working Group on Sovereign Wealth Funds.
• In a recent academic paper, Olivia Mitchell, John Piggott, and Cagri Kumru argue that stabilisation funds and SWFs are distinctly different entities. The IMF disagrees and contends that stabilisation funds are SWFs.

Clearly, the disparity among even the most respected academics and institutions presents a serious question for policymakers of what is a SWF exactly.

Finding consensus. In a recent policy brief from the Center for Retirement Research at Boston College, Ashby Monk seeks a consensus -- through a detailed review of existing research -- on a SWF definition. According to Monk, three characteristics emerge as crucial:

• Ownership. Governments, both central and subnational, own SWFs and their assets under management.
• Liabilities. Many SWFs have no liabilities. However, for those that do, these are 'intra-governmental'. Existing SWF liabilities are part of the broader national balance sheet, which means that one arm of the government simply owes another arm of the government money. The implication is that SWF assets are not encumbered by outside, non-governmental owners and property rights.
• Beneficiary. SWFs are managed according to the interests and objectives of the government or sovereign that owns its assets and holds the liability. As a result, the ultimate beneficiary of a SWF is the government, the country's citizenry in abstract, the taxpayer generally or is simply left unidentified. These funds are not constrained by a fiduciary duty to outside beneficiaries -- this is in contrast to public pension funds, for which fiduciary duty ensures commercial objectives.

Suitability. Overcoming the confusion and reaching a consensus on what characteristics make up a SWF is important for several reasons:

1. Heterogeneity. SWFs are a very heterogeneous community of investment funds. Some are funded through mineral royalties, while others are funded through foreign exchange reserves or divestment proceeds. Accordingly, the definition does not elaborate on sources of capital nor does it depend on legal status (which is equally diverse).
2. Objectivity. The term SWF has taken on a negative connotation in the past few years -- and many investment funds have spent considerable energy trying to differentiate themselves from SWFs. While some funds make a good case, others seem to suggest they are not SWFs for the simple reason that they are well governed, accountable and transparent. However, this is an error. A SWF with perfect governance practices is no less a SWF than one with inadequate practices.

3. Vulnerability. Any SWF definition should help to explain why policymakers and analysts in the West are concerned with SWFs. This definition in particular clarifies several points, namely:

   • SWFs and their assets are owned by the government;
   • the liability is held by the government (instead of an outside beneficiary);
   • SWFs are unconstrained by non-governmental property rights or fiduciary duty to any individual beneficiaries; and
   • SWFs invest according to the government's interests.

   Clearly, SWFs are vulnerable to political influence in a way that does not correspond to other investment funds.

Implications. SWFs are government owned and (to differing degrees) controlled. They do not have specific liabilities. Their beneficiary is the government. They are managed for the general welfare of the sovereign sponsor. Viewed through this lens, public pension funds, such as CalPERS, are not SWFs:

• While some public pension funds have clearly fallen short of their theoretical duty to avoid all political investing and focus exclusively on the financial welfare of their beneficiaries -- for example, the divestment policies implemented by CalPERS over the years -- the inherent characteristics of public pension funds make them qualitatively different from SWFs.
• Therefore, public pension funds -- despite the claims of certain analysts -- should not be included in any definition of a SWF. This is important, as the alternative might have constrained the investment options of these funds -- this in turn would have limited, albeit marginally, their ability to generate returns and pay promised pension benefits.