Policy Innovations Digital Magazine (2006-2016): Briefings: Sovereign Wealth Funds under Scrutiny

Brazil's finance minister announced this month that his country is establishing a sovereign wealth fund with as much as $20 billion to invest in fixed-income securities abroad. They hope to have it operational by the end of June. Twenty new sovereign wealth funds have been created since 2000, and the governments of India, Taiwan, and Japan are also considering funds to make better use of foreign reserves.

Sovereign wealth funds (SWFs) are nothing new, but their dramatic growth in recent years has generated significant attention. These state-owned funds, largely made up of commodity export revenues or foreign exchange reserves, have grown at a rate of 24 percent per year over the last three years, according to research firm Global Insight. Collectively, SWFs are predicted to surpass the entire economic output of the United States by 2015, reaching a total volume of more than $12 trillion. More than $80 billion has already been injected into the U.S. banking industry by sovereign wealth funds, including China Investment Corp.'s nearly 10 percent stake in Morgan Stanley.

Despite providing needed stability to Wall Street and allowing host countries to diversify investments and improve risk-return profiles, these potent funds have not been welcomed with open arms. Concerns have been raised over how a government should spend wealth that in effect belongs to its citizens, and the extent to which SWFs exert financial leverage for political ends.

In some cases, the emergence of SWFs represents a shift in the global balance of power, but the line between political and financial clout is always blurred. Foreign interests have long used financial incentives in an attempt to swing U.S. policies in their favor, and vice versa. Dictators and questionable regimes have secured military assistance and foreign aid under various U.S. administrations through the use of hired lobbyists.

The Center for Investigative Reporting and ABC News revealed this year that 11 lobbyists involved in fund-raising activities for presidential candidates John McCain and Hillary Clinton had also been hired by foreign governments to influence U.S. legislation.

Hedge fund manager George Soros is perhaps best known for the millions of dollars he spent in support of opposition to the Soviet Union, or the more than $23 million he donated to tax-exempt groups dedicated to defeating George W. Bush in the 2004 election cycle.

Sovereign wealth represents a slightly greater share of global assets than hedge funds, and they have a history of low-risk, apolitical investment. Controversy exploded in 2006 when government-owned Dubai Ports World attempted to purchase six U.S. ports. Corrupt governance in Russia and China, owners of the world's two largest funds, has also raised concerns.

Perhaps the most salient political usage of a sovereign wealth fund is Norway's sale of its Wal-Mart holdings. The fund invests in more than 7,000 companies but excludes arms manufacturers and corporations guilty of egregious environmental activities and human rights violations. Poor labor rights enforcement was cited in relation to Wal-Mart.

Norway's Government Pension Fund was created in 1990 to ensure that future generations benefit from the country's petroleum wealth. The fund is thus managed in such a way as to generate long-term returns. According to the fund's Ethical Guidelines established in 2004, this is contingent upon "sustainable development in an economic, environmental and social sense."

Recognizing the opportunities presented by SWFs, World Bank President Robert Zoellick encouraged governments last month to invest their assets in African economic development. Jordan's Queen Rania has urged Arab countries to direct their investment funds toward social causes and environmental protection.

With great power sometimes comes great scrutiny, and right now sovereign wealth funds have their share of both. IMF officials met recently to draw up a set of best practices for SWFs as fears of protectionist backlash mount in some Western countries. According to a newly released report by accounting firm Ernst & Young, SWF investments could be hindered if the funds fail to allay widespread apprehension over transparency. Singapore announced earlier this year that its Government Investment Corp. was looking to clarify the processes, governance, and purposes of its investments, while China has expressed the need to negotiate with the West over issues of concern.

The rise of sovereign wealth funds may provoke an irrational reaction to the development of what has been called a "nonpolar" world order. But, in the long-term, such funds may also play a role in alleviating global tensions. In addition to the emerging IMF guidelines, sovereign wealth funds are bound by the laws of the countries in which they invest, and they are unlikely to risk the consequences of acting out of line.

SWF investments also give governments a stake in the sustained prosperity of foreign countries. Rather than politics interfering with business, engagement with SWFs could result in best business practices spilling over into better political relations.

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