Senior Associate Dean Bhaskar Chakravorti interviews Professor Pat Schena, Senior Fellow at the Center for Emerging Markets and Adjunct Assistant Professor
Bhaskar Chakravorti: Will sovereign wealth funds tilt the balance of global power?
Pat Schena: The short answer is, no. I don’t believe sovereign wealth funds will tilt the balance of power. However – and I think this is the more critical point and why it's necessary to put sovereign wealth funds in the proper context – the forces that give rise to sovereign wealth funds have, in fact, begun to influence the balance of power in a global context. I think of sovereign wealth funds as organizational constructs that have certain purposes. There are funds that are targeted for development, of course. There are those designed to affect trans-generational wealth transfers, and those designed to enable economic stability as a result of changes in global production forces. And certainly, there are resource-based funds designed to transform physical wealth into financial wealth.
I want to talk more about the factors that give rise to sovereign wealth funds. Think about, for example, the mobilization of capital for rapid economic growth. Many governments are focused on not only promoting economic growth, but also sustainability. Think about shifts in demographics, in both the scale of populations, but also, importantly, the distribution of populations in places like China and India. We know the prospects for economic growth in India over the next 20 to 30 years are very different compared to those in a country like Japan where the demographic distribution is very different. There is a conscious effort to leverage shifts in capital flows and momentum for economic development into a degree of political power globally, whether they are in the form of blocks or even as individual entities. Those global economic forces are tilting or, as I like to say, reorienting – and the pun is absolutely intended – the balance of power.
So where do sovereign wealth funds play in that? In some ways they're facilitators, because they're enablers. They allow governments to use the capital that flows in – whether that is in the form of foreign exchange reserves, through sales of state assets, or natural resources – in ways that result in a degree of sustainability for that model. There has been a very rapid pickup in the pace of the introduction of new funds. These have been primarily among emerging market countries and they are of a variety of shades. Temasek in Singapore is a strategic development fund that has been around for 20 years. It has been quite successful in the privatization of state assets in Singapore, and is functioning now as a large global private equity investor. On the other hand, the government of Vietnam established in 2006 is something that's very similar in style, structure, orientation and mandate.
BC: You modified the question in your response by saying that sovereign wealth funds are facilitators as opposed to directly causing the tilting of power. But if the facilitator is armed with billions of dollars, then do you actually step outside the bounds of being a pure facilitator? After all with economic power comes political power. Historically, political power was created by military power. And now the question is, instead of armaments, if I'm bringing investable dollars, does that actually play the role that nuclear warheads used to play in an earlier geopolitical era?
PS: I would address it in this way. We had been struggling in the immediate post-financial crisis with concerns about sovereign wealth funds being nontransparent and investing globally for political or strategic purposes. I'm not going to argue that this outlook is not warranted, but I think we've begun increasingly to step away from that as a focal point.
Now, there are wealth funds that invest simply for domestic purposes. Mumtalakat, for example, in Bahrain is right now very domestically focused, as is Khazanah in Malaysia. Then again, there are funds, about whom, when combined with a perceived motivation of using sovereign wealth for strategic purposes - such as in China – there have been those suspicions. So again, I don't think it's the wealth fund itself that is driving the tilt. I think if a government looks to position the wealth fund as one of several arrows in its quiver, then conceivably it could and would use it in that respect.
There's an increased focus on global governance of wealth funds through the introduction of the Santiago principles, for example. It begs the question of whether sovereign wealth funds will begin to take on the stature of a central bank. Some are subsidiaries of central banks, and interestingly enough, some of them are embedded within central banks. The Hong Kong Monetary Authority doesn't have a separately-defined wealth fund, but it has an excess reserve fund that is managed by the Monetary Authority.
Central banks have become increasingly independent of governments, but with the objective of trying to promote specific government economic outcomes like economic stability. I think it begs the question from a governmental standpoint: What is the mandate of a sovereign wealth fund? If a government’s objective is to create jobs domestically and promote economic stability, a fund might hire the best financial technocrats and focus them on that mandate. So the question is whether governments seek to use them, either directly or indirectly, for strategic purposes.
This is linked to another question you are considering: Are the U.S. and Europe are becoming the new BRICs?. In the context of sovereign wealth funds, this comes back to the idea of motivation. In 2008, France, and then more recently Italy, announced they were setting up funds. In this one sense, it feels like European governments are starting to draw from the emerging market playbook. In the past there were other ways for governments to stimulate economic growth. Here they are now, using this construct to influence specific economic outcomes namely to protect and promote domestic industry.
Interestingly, the mandate for each of them – and we'll take this in good faith – is not only to protect, but to actually encourage good governance, productive efficiency, and operational excellence in order that domestic firms be globally competitive and strengthen the base of the local economy. A second goal is also to ensure they are not the targets of foreign acquisition and result in a loss of national control.
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- On the ability of sovereign wealth funds to affect the balance of power
BC: I think you agree that there is a potential for the funds to be an instrument in the shift of balance of power – even though they are not the instigator, but they are facilitating such shifts.
PS: In two ways, I would agree. The first is that if funds succeed in their base missions for example to enable the diversification of foreign exchange or the sustainability of economic development, they're supporting the growth agenda of their economies. They are strengthening the economic foundations that ultimately are the real sources of power. To the extent that they're succeeding in that mission, I would agree they can change the power dynamic.
Now, let's also think about it in the way you want to talk about it, which is in a geopolitical sense. Can they be effectively used as tools to influence shifts in geostrategic balance? I think the possibility is there. Why? Because you have a means by which to take wealth and, based on a concerted strategy, influence very specific geopolitical outcomes. And so the potential is there to do that with an institution staffed by technocrats that have the financial wherewithal and the engineering skills to execute.
BC: Is there enough money concentrated in the funds to do that?
PS: Excellent point. Many funds are in fact well-diversified and also intermediated through managers. You seek to invest globally, but don't have the skills or the base knowledge to invest across countries in local currencies. You hire the best local managers and give them a certain degree of investment discretion. Under such circumstances it's difficult to have a significant politico-strategic impact. It leaves you to otherwise consider the impact of direct investments. Empirically we could study volumes and flows. However, even in the case of CIC, for example, those numbers are relatively small.
So at the moment, I do not believe that the volumes are enough to tilt the balance of power.
BC: How does that work if the fund manager has a political mandate and a financial strategy? Do they actually face a bit of a tension in terms of the framework that they have to use to make the investments?
PS: Absolutely. When you think about the ways that many funds are structured, they will have at the highest level a CEO or chairman, who is often a political appointee. That is quite true in Singapore, for example. Below that level, there are technocrats. Therein lays the struggle. Professional staff members come from the financial industry and are incented based on financial considerations. A political requirement to do a deal, even though there are sound financial reasons not to, would inevitably present real challenges and lead to organizational tensions as the senior leadership serves two masters.
- Sovereign wealth funds as tools of diplomacy
BC: Can these funds potentially be an instrument for diplomacy? I know it's not explicitly out there in terms of the fund charters. But why shouldn't the administrators of these funds and the authorities that back them think about the funds as instruments for putting the chess pieces in play to have leverage in international negotiations? These could be negotiations that historically have involved diplomats sitting across the table from each other. So if I am a diplomat, for instance, and I know that it's my money that's building your highways, then I have some additional leverage over you.
PS: It's a good point. What I come back to is: Why is it that the sovereign wealth fund is making the difference? For example, consider the financing of railways in China at the turn of the 19th century. They were largely financed, as you probably are aware, by foreign investment, because there were many significant challenges to mobilizing domestic capital. That could be analogous to a sovereign wealth fund making a direct investment. Ultimately this was about very large inflows of capital, and it was the power of the capital itself that allowed those foreign investors to gain concessions, like extraterritorial rights. Even without the institution itself, there was a degree of direct influence. We can find many more examples where the influence of that capital base has had ramifications diplomatically and politically, like China's alignment with Western Europe during World War I.
One of the questions I continue to challenge myself with is: Where is the base of the power? Is it in the structure, i.e. the institution? Or is it in what gives life to the institution itself? Take, for example, a fund like Norway’s, which arguably is very transparent. The Norwegian government perhaps is not motivated to exploit that structure. It is invested in a portfolio that’s broadly diversified, and there are third party managers in between. It's very difficult, then, to draw a link between Norwegian capital flowing into the U.S. and this being a function of the Norwegian fund directly. So there are cases where a fund invests, but one cannot trace a direct connection; then there are cases where that connection is obvious, such as the fund investments in U.S. financial institutions during the recent crisis.
This brings us to another question: Do we need to be discerning of these institutions as, in fact, an extension of the state? And the short answer to that is, absolutely, of course we do. Think about these funds as state-owned entities. Can we devise, through international law or international organization, some mechanism to allow them to grow, but yet ensure that geopolitical externalities don't ultimately become disruptive? Can we do this as we would have treaties to control armaments, for example? How do we address the externalities that would be otherwise associated with the funds? Here the debate around global governance associated with sovereign wealth funds is, I think, well-placed.
If we think about how the funds have reacted over the last several years to initiatives like the Santiago Principles, there's some hope. Increasingly, the funds themselves – despite being cajoled by the IMF and others – seem to be developing independent structures, including potentially a secretariat for the International Forum of Sovereign Wealth Funds. This would create permanency and perhaps more widespread transparency.
- The movement towards transparency
BC: Transparency is of one of the more contentious aspects of sovereign wealth funds. Despite the progress, they continue to be rather opaque institutions. What's your prognosis over the long term? Are these going to be institutions that follow a reasonably acceptable set of principles and guidelines that publish financials in a way that the international community will feel comfortable with?
PS: I think inevitably there will be a degree of differentiation. I don’t see an international forum saying, “We're going to lay down the law with respect to transparency.” There must be a consensus among funds, an opting in. Certainly what we see today is a broad disparity. Part of the challenge, as with any other large institutional investor, there's a certain degree of transparency that may be beyond what is commercially prudent.
Also what is really required from a transparency standpoint? Is it detail around portfolio accounting information or is it detail around financial accounting information? There is a significant difference. There's probably no practical reason to withhold financial accounting information. To a very large extent, not only government sponsors, but also the general populace should have that information. At the portfolio level, the managers of the funds might very well argue that they could be placed at a competitive disadvantage, and therefore the beneficiaries could be at a competitive disadvantage if they are completely open as to investment strategy.