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Sovereign Wealth Funds: Form and Functions in the 21st Century

Journal 33: Technical Finance

Gordon L. Clark, Ashby H. B. Monk

As representatives of nation-states in global financial markets, sovereign wealth funds (SWFs) share a common form and many functions. Arguably their form and functions owe as much to a shared (global) moment of institutional formation as they owe their form and functions to the hegemony of Anglo-American finance over the late 20th and early 21st centuries.

We distinguish between the immediate future for SWFs in the aftermath of the global financial crisis, and two possible long-term scenarios; one of which sees SWFs becoming financial goliaths dominating global markets, while the other sees SWFs morphing into nation-state development institutions that intermediate between financial markets and the long-term commitments of the nation-state sponsors. If the former scenario dominates, global financial integration will accelerate with attendant costs and benefits. If the latter scenario dominates, SWFs are likely to differentiate and evolve, returning, perhaps, to their national traditions and their respective places in a world of contested power and influence. Here, we clarify the assumptions underpinning the formation of sovereign wealth funds over the past twenty years in the face of the “new” realities of global finance.

The global financial crisis challenged those who believe in the integrity of financial markets, those who hold the commonplace presumption in favor of “light-touch” regulation, and those who believe that markets are essential mechanisms for managing and distributing risk. Greenspan’s recanting of his hitherto unquestioned belief in the rationality of market agents is emblematic of the re-regulation of banking institutions and the compensation practices of the global financial industry. Notwithstanding the scope and depth of the global financial crisis, and the debate over its causes and consequences, recent years have also seen the continued growth of sovereign wealth funds (SWFs). As these funds indicate, nation-state sponsors have not lost faith with financial markets. In fact, some would say the appeal of these financial institutions has risen over the past few years. For example, Merton (2009) suggested that the U.S. should establish a SWF to “hold and manage” assets acquired through the crisis, eschewing government management in favor of “autonomous investment” so as to realize the value of those assets as markets recover.

Underpinning Merton’s recommendation is a firmly held belief that there are pitfalls associated with public investment. For Merton, the recent experience of the U.S. Pension Benefit Guarantee Corporation (PBGC) is a salutary lesson in how not to govern investment strategy, noting that approval by the PBGC Board and the Secretaries of Commerce, Labor, and the Treasury for increased equity exposure came in February 2008 [nine months short of the notional trough of the crisis; see French et al. (2010)]. By implication, and by reference to the logic justifying the establishment of SWFs around the world, there is something special about the form and functions of SWFs that distinguish this type of institution from its close “cousins” within government, including the currency reserve funds of central banks. As we have noted elsewhere, one claimed virtue of SWFs is to be found in their relative insulation from political influence [Monk (2009)]. Moreover, the quasi-government status of these institutions facilitates a level of sophistication in investment and operations typically not found within government, thanks to SWFs’ claimed commitment to best-practice standards of governance and transparency.

Sovereign sponsors often have a specific purpose (or purposes) when establishing a SWF [Clark and Monk (2012)]. For example, the Singapore government established the GIC so as to insure the welfare of its citizens against global economic and financial instability and regional political instability. The Norwegians created the NBIM so as to manage resource wealth and underwrite government pension obligations on behalf of future generations. Similarly, Australia established the Future Fund so as to promote inter-generational equity while ensuring macroeconomic stability in the face of burgeoning public and private wealth. For the Gulf States, SWFs were established, in part, to preserve their resource wealth given past experience of “windfalls” lost to corruption, poor investment, and arbitrary decision-making. China has sought to realize value from its U.S. dollar holdings through the China Investment Corporation, while maintaining a modicum of domestic economic stability. Sovereign sponsors have sought rates of return above the notional risk-free rate of return on government-backed securities or, more precisely, a real rate of return on financial assets higher than the rate of national economic growth.

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