How can we preempt investment protectionism?

The slowdown of the global economy experienced since late 2007 has provided fertile ground for trade protectionism. The threat has been made worse by this summer’s collapse (once again) of the WTO Doha Round negotiations. However, affording some much-needed relief is the fact that the other protectionist threat floating around — that of investment protectionism — could be mitigated by the adoption of a voluntary code of conduct for sovereign wealth funds negotiated between the IMF and the 26 countries that hold this kind of instrument. Final negotiations took place in Santiago, Chile, on September 1–2, 2008. The principles of the code aren’t yet known because, before being made public, they must undergo a process of review by the 26 governments involved and be presented to the IMF’s policy setting committee on October 11, 2008. Yet, the parties to this deal claim that the set of Generally Accepted Principles and Practices (GAPP) agreed upon will be good enough, as far as the SWFs pertain, to help maintain the free flow of cross-border investment and sustain open and stable financial systems. To validate this claim, we will have to wait for the publication of the GAPP and, more importantly, the results of their implementation by the SWFs as well as the reactions of the recipients of their investments.

For the time being, it is good news that, at last, a collective action undertaking — one of many that are urgently needed to better manage globalization — has resulted in agreement among the parties involved. This move to address concerns about the SWFs quickly is not a minor event. Consider the reactions, some bordering on outright paranoia, to these funds’ mushrooming resources and large investments in highly visible enterprises, particularly since China launched its own fund last year. Typical of those reactions is the statement that “the rise of sovereign wealth funds represents a shift in power from the U.S. to a group of countries that aren’t transparent, aren’t democracies, and aren’t necessarily U.S. allies.”

The most common fears are that the SWFs, being government-owned, may be used not only for the purpose of receiving attractive returns on their investments but also for pursuing geopolitical objectives, gaining control of strategic natural resources or extracting sensitive technologies; that they could undermine the corporate governance of companies in which they invest; and that they could pose a threat to the stability of global financial markets. These anxieties have been made worse by the funds’ sheer size, lack of transparency, and virtually complete lack of clarity of objectives, not to speak of their appetite for risk.

True, SWFs now control significant resources — by some estimates up to $3 trillion — and if present trends hold, they will control at least three times that amount in five years’ time. But the argument that they may prove to be a destabilizing force for global capital markets simply does not hold water, at least so far. On the contrary, SWFs have been supportive of global financial stability during the recent turmoil. They are providing massive infusions of fresh capital to large banks under stress, helping to recover normalcy in the credit markets. The assertion that SWFs could be disruptive of global capital markets is also doubtful considering that that their size relative to the entire market is still very small. The IMF estimates the size of global capital markets to be in the vicinity of $190 trillion, which is more than 60 times the value of the assets held by SWFs. It should also be taken into account that these funds have typically gone only for long positions with nil borrowing or lending. Available, though fragmented, information suggests that SWFs don’t seem inclined to acquire assets only to see their value reduced for the sake of non-economic objectives. They seem to have long horizons and are willing to step in when asset prices fall, a behavior that constitutes, if anything, a stabilizing force on the world’s financial system.

In addition to the fundamental questions of international regulation and supervision, serious concerns about the stability of financial markets should rather focus on the persistence of the so-called global imbalances that have been caused by the combination of some countries — mainly the U.S. — running large current account deficits while others — most conspicuously China — have large surpluses. Actually, these imbalances are part of the explanation of the SWFs’ growing importance. Large current account surpluses have led to huge foreign exchange reserves, which for a while were mostly invested in Treasury bills. These instruments, by any historical standard, have provided low yields in recent years, a situation further aggravated by the depreciation of the U.S. dollar against most other major currencies. It was therefore only a matter of time before the holders of these reserves started looking for higher returns by means of their own SWFs. Not even the country with the world’s largest economy can expect its creditors to keep providing cheap financing forever. What is needed are sounder macroeconomic policies both in countries with large current account deficits — which should find ways to increase their domestic savings rates — and in countries with large surpluses — which should allow more flexibility in their exchange rates and implement policies to foster domestic consumption.

As for security and strategic concerns, most countries — and certainly the U.S. with the recent Foreign Investment and National Security Act of 2007 (P.L. 110-49) — already have legal mechanisms in place to deal with legitimate caveats of that nature regarding foreign investment. Instituting special, and therefore discriminatory, rules for SWFs would be redundant and costly.

Even though the available evidence does not in any way validate the most serious concerns voiced about SWFs, it would be prudent to address them, even if only to eliminate the excuses countries might use to adopt protectionist investment policies. Investment protectionism against SWFs would surely lead to other forms of protectionism; furthermore, erecting arbitrary barriers to investing by sovereign funds would undoubtedly be counterproductive for the host economies and damaging to the world economy at large, hence the importance of relieving the mounting pressures against SWFs. This can certainly be achieved by the SWFs effectively adopting a code of conduct that encompasses truly best ethical and financial practices. Let’s hope that this is the case for the principles negotiated at Santiago. At this point, a paramount reservation about the deal achieved would be the “voluntary” nature of the code. Thus, a necessary next step to prevent suspicion and investment protectionism should be the mandatory reporting by the SWFs on their activities and finances to the IMF. These steps would prove to be the best antidote against this new face of the globalization backslash.