I can’t complain about yesterday’s game. Lots of fouls, but very entertaining, and the good guys won. How often do I root for the Red over the Blue?
That’s not what I’m here to discuss, however. I’m here to discuss “sovereign wealth funds,” the consequences of which I think have been seriously misread by most observers.
The rise of “sovereign wealth funds” has scared a lot of people over the past few years, myself included. At first glance, these things are scary. SWFs don’t just represent ownership by foreigners of your nation’s assets, they represent ownership by foreign governments of your nation’s assets. To paraphrase Joseph Stalin, sovereign wealth funds represent “socialism outside your country.”
Control of your domestic manufacturing firms and financial institutions by foreign socialists is not a comforting thought. Those socialists might be, as socialists often are, motivated by things other than profits. And that possibility opens the door to a wide range of potential abuses.
The flip side, however, is that the emergence of sovereign wealth funds provides the governments of the countries in which they invest a golden opportunity to protect their own overseas investors, insure access to overseas markets, and generally shape world economic policies.
In other words, the rise of sovereign wealth funds controlled by Beijing, Abu Dhabi, and Brasilia will, if handled correctly, reinforce Washington’s control over the world economy rather than weaken it.
“The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders,” wrote Larry Summers in 2007. What might those motivations be?
First, and most often cited, foreign governments might use control over domestic industries to transfer key technologies to foreign competitors. Why is this danger any different when the owner is a foreign government rather than a foreign company? Well, a foreign company is presumably limited in their ability to transfer key technologies to competitors by the need to preserve the value of its investment. After all, if Nissan transfers technologies from Renault at Renault’s expense, then the value of Nissan’s investment in Renault will fall. Nissan may nonetheless choose to share Renault’s technologies, but only inasmuch as such sharing increases the total profitability of both companies — what economists call Pareto optimality and businesspeople call synergy.
That logic might not apply to a foreign government, which is presumably motivated by many things other than the profitability of its investment portfolio. (In fact, for the sake of their citizens, one would hope that foreign governments are motivated by things other than the profitability of their investment portfolios!) Such a government might willingly choose to reduce the value of the foreign companies under its control by transferring technologies to companies headquartered within its boundaries and controlled by its own citizens.
In fact, foreign governments might go further than the simple transference of technology: they might bias strategic decision-making in the companies under their control order to favor their own nation’s companies. For example, a sovereign wealth fund might try to replace one CEO with another, influence plant location decisions, reject new product lines, demand increased dividend payouts, or engage in other sorts of subtle and not-so-subtle economic sabotage. A concrete example proposed by the Economist was a situation in which “Venezuela bought Alcoa and set about closing its aluminium smelters in the United States in order to move production to Latin America.”
Financial institutions provide particularly fertile places in which sovereign wealth funds could do mischief. Such funds would not need to fully control such institutions in order to engage in “directed lending,” in which the institutions would direct capital towards favored companies. In that way, a SWF could leverage its funds to use foreign capital to support domestic companies, although good financial market regulation would lessen this possibility.
Finally, of course, SWFs could potentially leverage their ownership into political influence. Kevin Hassett, a prominent conservative, suggested that “an enemy of the U.S. could, if it had sufficient control of our financial institutions, use that power to gain intelligence about the activities of private American citizens. It might even use its influence to attack the U.S. economy during a time of conflict. Imagine, to take it to the extreme, that the Chinese bought Citigroup, then shut it down during a conflict with Taiwan if the U.S. tried to interfere.”
It all sounds very frightening. But it’s not … for the United States. The rise of sovereign wealth funds should, in fact, be frightening for the countries that run them, not the countries that receive their capital.
Why? Simply put, because Kevin Hassett’s reasoning applies even more so to the governments investing their hard-earned funds outside their borders. Imagine, to take it to the extreme, that the Chinese bought Citigroup, and then the United States threatened to nationalize their investment during a conflict with Taiwan if the Chinese did not withdraw their forces.
In fact, the U.S. regularly freezes (or threaten to freeze) the assets of countries with which it has conflicts. The U.S. froze Japanese assets in the run-up to World War 2. It froze Iranian assets in 1979. And the U.S. isn’t alone in this. At America’s request, the E.U. agreed on June 16th that it would freeze the European assets of Iran’s largest bank.
Of course, there is no reason to take it to the extreme. The U.S. government could use the presence of foreign assets in the United States to increase the security of American investments overseas without taking any overt legislative or policy steps. There already exists an international institution intended to secure foreign investments against expropriation. Foreign-owned hostages located in U.S. territory strengthen that institution immensely, and give the U.S. government even more control over the terms under which capital crosses borders.
The institution is called the International Center for the Settlement of Investment Disputes — ICSID, pronounced “Ick-sid,” like a Klingon warrior. ICSID, a division of the World Bank (and thus part of the U.N. system), runs arbitration panels that decide investment disputes between nations that have signed a bilateral investment treaty. The New York Convention obliges all signatories to “enforce” ICSID rulings against third countries, unless it violates their public policy. That is to say, unlike the WTO, ICSID provides for collective enforcement of its rulings.
So far, only four ICSID rulings have been violated … but the system hasn’t been used much until recently. Between 1965 and 2000, only 66 cases came before it. Since then, however, 202 more cases have been brought, of which 128 are still pending. Argentina, Bolivia, and Venezuela have all declared their intention to withdraw from the convention … and they have also all declared that they will ignore unfavorable ICSID rulings.
But governments that own significant commercial assets in the United States ignore ICSID rulings at their own risk. In fact, they ignore any agreements with the U.S. to protect U.S. investors or U.S. market access at their own risk. Venezuela, for example, may have gone after Exxon, but its ownership of Citgo means that the Chávez is taking a huge (and probably stupid) risk if he defies whatever ICSID rules about his actions.
In fact, U.S. companies can already sue foreign governments in American courts without going through ICSID. The Foreign Sovereign Immunity Act of 1976 removed “sovereign immunity” from all government-owned property (or flows of funds) within the United States as long as they were for “commercial purposes.” The holdings of sovereign wealth funds are, by definition, for commerical purposes. In other words, the rise of sovereign wealth funds gives the U.S. even greater teeth with which to protect its own companies and businesspeople overseas, without needing to change the scope of international or American law.
That said, the U.S. will almost certainly change its law to obviate the potential adverse effects of sovereign purchases of American assets. The emergence of a code-of-conduct based on the codes under which American public pension funds operate is almost inevitable. Even if Congress doesn’t impose such a code, SWFs will probably voluntarily adopt one in order to pass CFIUS review. (CFIUS — pronounced “seefy-uhss,” like a Star Wars droid — is the Committee on Foreign Investment in the United States, a group of cabinet officials which reviews foreign investments and possesses the power to deny them on national security grounds.) CFIUS has become much more active in recent years, and given the current political climate it’s unlikely to become less so.
In addition, most of the dangers from SWF investment could be obviated by one simple reform proposed by the New America Foundation: limit (or prohibit) SWFs from exercising their voting rights when they purchase shares. Such a reform would allow sovereign ownership without sovereign control. There would be no more fear of technology transfer or strategic decision-making on behalf of foreign interests.
The rise of sovereign wealth funds, if handled correctly, will strengthen America’s ability to shape the global investment environment and global economic policy. Other countries are, in effect, voluntarily providing a hostage to the United States contingent on their agreement to follow the rules laid down by the United States and its allies. All Washington needs to do is make a few small legal changes to protect its companies from possible strategic interference by their new owners, and the end-result will be all good for America, its companies, and its citizens. American investments and contracts abroad will be effectively collaterized against bad behavior by host governments. Other governments will have great incentives to abide by the prescripts Washington lays down. Finally, in times of crisis, the power of American economic sanctions will be multiplied.
Far from weakening the American hegemony, the rise of sovereign wealth funds greatly strengthens it. I, for one, gladly welcome our new Chinese, Latin, and Arabian owners … because while they may have the ownership, our elected officials still have the control.
American democracy, in the form of domestic control over foreign assets, is in the end not only more powerful than globalization, but essential to it.