Sovereign Wealth Funds and the (In)security of Global Finance

By Drezner, Daniel W. | Journal of International Affairs, Fall-Winter 2008 | Go to article overview

Sovereign Wealth Funds and the (In)security of Global Finance


Drezner, Daniel W., Journal of International Affairs


Sovereign wealth funds (SWFs) sit at the intersection of high finance and high politics. Their net worth is currently estimated to exceed $3 trillion--more than the value of all private equity or hedge funds. SWFs were responsible for 35 percent of total mergers and acquisitions activity in 2007. Between March 2007 and June 2008, these actors injected $59 billion into Western financial institutions, including high-profile equity purchases of Barclays, Citigroup Inc., Credit Suisse, Merrill Lynch, Morgan Stanley and UBS. (1) In an echo of the Japanese foreign direct investment boom from two decades ago, SWFs have also moved into acquisitions of high-profile real estate. In July 2008, a sovereign wealth fund based in the United Arab Emirates purchased 90 percent of the Chrysler Building in New York.

The explosive growth of these funds raises regulatory and geopolitical concerns. The deputy secretary of the Treasury wrote in Foreign Affairs earlier this year that "SWFs are already large enough to be systematically significant ... [and] they are likely to grow larger over time, in both absolute and relative terms...." (2) Market analysts and regulators are concerned about the transparency of these funds. (3) Free market enthusiasts fret about the ideological implications of SWFs and the protectionist backlash they could create. (4) Politicians in the advanced industrialized states fret that SWFs now possess bargaining leverage over the economic and political futures of major economies. Many policy analysts argue that SWFs are symptomatic of shifts in the global distribution of power away from the advanced industrialized states and towards authoritarian, capitalist governments in the developing world. (5)

Are these fears of sovereign wealth funds justified? This paper examines the sovereign wealth funds phenomenon and the security concerns they provoke in the United States. In most respects, the growth of SWFs has marginal effects on American national security and foreign policy. Sovereign wealth funds are a symptom of other national ailments, like persistent macroeconomic imbalances and a failure to diversify America's energy supply. However, as symptoms go, SWFs are relatively benign in their foreign policy effects. If anything, these investments demonstrate the complex interdependence of the Pacific Rim and Middle East with the American economy. However, some negative policy externalities come with these funds. Their growth will significantly impair democracy promotion efforts in the developing world and increase the fragility of cooperation in global finance.

A PRIMER ON SOVEREIGN WEALTH FUNDS

I will define sovereign wealth funds as, "government investment vehicles that acquire international financial assets to earn a higher-than-risk-free rate of return." They are not a recent invention--Kuwait created the first modern fund in 1953. Nor are they alien to the advanced industrialized states. Norway's central bank controls the second largest SWF in existence. Several other economies within the Organization for Economic Co-operation and Development (OECD)--including Australia, New Zealand and the United States--house sovereign wealth funds as well.

What is new about sovereign wealth funds is their size, anticipated rate of growth, recent investment trends and countries of origin. The combined heft of SWFs is currently estimated to be between $3 trillion and $3.5 trillion--or between 1 and 1.5 percent of global asset markets. They have grown at an annual rate of 24 percent over the past five years. The inelastic demand and high price of oil, combined with the persistence of global macroeconomic imbalances, lead many analysts to predict an annual 20 percent growth rate over the next decade. By 2015, their total valuation could range in size from $9 trillion to $16 trillion--or close to 4 percent of global asset markets. (6)

To seek higher rates of return, sovereign wealth funds have shifted from bond and index funds to assets that carry greater risk.

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