Utilising such investments to stabilise the economy is a bit like offering a military base to another country
The Government of India, according to press reports, is considering approaching sovereign wealth funds (SWFs) to invest in India. This is an interesting idea that needs to be examined closely. In the recent financial crisis, SWFs are known to have played a stabilising role but that has not been their historical image. In fact, the threats posed by the SWFs and their intentions were characterised by the attempted purchase of US ports by a Dubai-based company in 2006 and expansion in Europe by Russia's Gazprom. These attempts alarmed policymakers in advanced countries.
SWFs have been attracting attention since their explosive growth from 2007 because of their increasing importance in the international monetary and financial system, though they have existed since the 1950s. There is lack of agreement on the number of SWFs and the size of their assets. According to some estimates, there were 83 SWFs of 54 countries, of which 13 are pension and pension-reserve SWFs in 2011 (Sovereign Wealth Funds: Threat or Salvation? by Edwin Truman, Peterson Institute, 2011). The total assets of these SWFs were $5.9 trillion, and were projected to reach $12 trillion by 2015.
In many countries, SWFs have been carved out from the official holdings of international reserves. The rise of SWFs is closely linked to the general increase in international reserves, especially after the South East Asian financial crisis of 1997. In some countries, such as Russia, official estimates of international reserves include foreign assets held by SWFs, while in Singapore an SWF manages the country's foreign exchange reserves.
An SWF can be defined as an entity that manages state-owned financial assets, and is legally structured as a separate fund owned by the state. According to International Working Group (IWG) of SWFs, SWFs are special purpose investment funds or arrangements that are owned by the government. SWFs hold, manage or administer assets to achieve financial objectives, and employ a set of investment strategies that include investing in foreign financial assets. In their investment activities, SWFs reflect increased financial globalisation as well as shifts in economics and financial power relationships in the global economy, according to Truman, a former US assistant secretary in the US Treasury.
SWFs were established with one or more objectives, which could be to insulate the Budget and the economy from excess volatility in revenues; help monetary authorities sterilise unwanted liquidity; build up savings for future generations; or use the money for economic and social development. In the case of countries that are commodity-rich, depletion of non-renewable resources and volatile commodity prices lead them to transform non-renewable resources into sustainable and more stable future income. In the case of countries with large foreign exchange reserves, SWFs allow for greater portfolio diversification with the key focus on providing higher returns than would traditionally be possible for central bank-managed assets.
In May 2008, the International Monetary Fund-facilitated IWG of SWFs was formed to develop a set of principles that transparently reflect the investment objectives and practices of SWFs. In September 2008, a preliminary agreement was reached in Santiago, Chile, on a set of 24 principles, also known as the Santiago Principles emphasising the need for transparency in purpose, objectives, investment policies, strategy, and accounting practices underpinning the performance of SWFs. Some success has been achieved but, as should be logically expected, the investments, objectives, strategy and operations of SWFs would never be transparent, as many of the host countries, such as China, have not even declared the currency composition of their reserves to the IMF.
SWFs typically have medium- to long-term investment horizons, suggesting that they are less likely to make abrupt portfolio shifts that could affect market stability. So, to some extent, investments made by SWFs can be expected to be stable. But as SWFs are mainly an extension of the government, utilising the investment of SWFs to build reserves or stabilise the economy is potentially hazardous. To illustrate, among the larger SWFs operating in the global financial markets are China, Singapore, Abu Dhabi, Saudi Arabia, and Kuwait. These SWFs have been set up with an explicit objective of pursuing higher returns on their investment. If India is negotiating with them to continue to invest in the country even when the global interest rate cycle reverses, this would imply that a proposal is commercially unviable and would require a sweetener or a quid pro quo.
SWFs, given their size, cross-border operations, and often non-transparent objectives and strategies, have the potential to cause disturbances in the market. Most importantly, seeking investment from SWFs would remind many an Indian of the unpleasant history associated with the East India Company. In the modern parlance, it would be the equivalent of offering a military base (in this case financial space) to another country. On the whole, it would be better to face hardships within the country than invite the proverbial camel's head in the tent.
Securing the global financial system requires a systemic approach