Sovereign wealth funds are government-controlled pools of assets that are making increasingly prominent investments in the economies of the Anglosphere. The combined heft of SWFs is estimated at approximately $3.3 trillion and growing rapidly. In 2007, Russia and China created new SWFs; press reports indicate that Saudi Arabia and Japan will create their own SWFs in 2008. These funds have been involved in high-profile equity purchases of Blackstone, UBS, Merrill Lynch, Morgan Stanley, and Citi. Morgan Stanley economist Stephen Jen projects SWFs to amass $12 trillion in assets by 2015—similar to the current gross domestic product of the United States. Their growth, unfortunately, feeds into two trends known to unnerve Americans: foreign investors and financial turbulence. 

Over the past 30 years, the United States has experienced periodic waves of investor protectionism. In the 1980s, the specter of Japan Inc. gobbling up prestigious pieces of property led to such absurdities as members of Congress holding a press conference to bash Toshiba products. In 2006, public hysteria helped to block United Arab Emirates–owned DP World’s acquisition of six port facilities in the United States. Congressional resistance thwarted China National Offshore Oil Corporation’s attempt to acquire Unocal. Public opinion polling shows unremitting hostility among a majority of Americans toward the prospect of foreign “ownership” of American firms (they’re more receptive to “investment”). SWFs exacerbate these suspicions. If Americans reacted negatively to faceless Japanese salarymen, imagine the reaction when the foreign purchasers are Arab governments or the Chinese Communist Party. 

At the same time, a series of financial disruptions have buffeted and confused Americans over the past decade. Americans have had to cope with the vicissitudes of the dot-com bust, Enron and its aftermath, financial derivatives, hedge funds, private equity, subprime mortgages, and structured investment vehicles. Given the uncertain effects of many of these financial shocks, one could excuse the average American for looking at SWFs with more than a whiff of distrust. 

In an admittedly hostile political climate, the SWFs have not done themselves many favors. At a Davos World Economic Forum session in January, Norway’s finance minister Kristin Halvorsen responded to gentle criticism of her country’s sovereign wealth fund by responding, “It seems you don’t like us, but you need our money.” 

The biggest risk posed by sovereign wealth funds to date has not been their actions, but the possibility of protectionist overreaction in Washington, D.C.

Compared to Norway, the transparency of other SWFs ranges from bad to worse. In terms of U.S. foreign policy, an obvious concern is that SWFs are sprouting up primarily in countries not commonly thought of as reliable U.S. allies. 

Testifying before the U.S.-China Economic and Security Review Commission in February, Alan Tonelson of the U.S. Business and Industry Council voiced the obvious concern: “If, for example, the Chinese government held significant stakes in a large number of big American financial institutions, especially marketmakers, and if our nation’s current period of financial weakness persists, how willing would Washington be to stand up to Beijing in a Taiwan Straits crisis?” 

No question, the growth of SWFs puts advocates of open capital markets in a quandary. During debates over what to do with the Social Security trust fund a few years ago, there was deep resistance to the idea of having a U.S. government fund pick winners in the stock market. Why should foreign governments get to play? 

Sovereign wealth funds do present concerns on the near and far horizons, but the predominant reaction at this point should be what is emblazoned on the cover of The Hitchhiker’s Guide to the Galaxy: “DON’T PANIC.” To date, SWFs have acted responsibly, and there is no sign that their behavior will change soon. 

A mixture of voluntary standards and additional surveillance by the salient authorities should deal with current concerns. With luck, they will also cause policymakers to focus on the bigger picture. SWFs are merely a small symptom of two bigger problems: the absence of proactive energy and exchange rate policies in this country. 

Sovereign wealth funds are not a recent invention—Kuwait created the first one in 1953. Nor are they un-American: the state governments of Alaska and Texas both have SWFs designed to prudently and properly manage the revenues from their energy booms. In many ways, these funds do not differ substantially from state-level pension funds like CalPERS. 

What is new is the size and scope of recently created and expanded funds. Two kinds of governments are pumping money into SWFs: energy exporters and Pacific Rim economies with undervalued currencies. For the oil exporters, the incentive to create an SWF is twofold. First, these economies want to create assets that ensure a long-term stream of revenue to aid in economic development. As many economists have observed, these countries are simply converting assets extracted from the earth into a more liquid form. 

A shift by opaque SWFs into more volatile investments could contribute to greater instability in financial markets.

Second, by focusing on foreign direct investment, these governments are attempting to forestall the so-called “Dutch disease” of rapidly appreciating currencies. Overseas investment via SWFs can accomplish both tasks simultaneously. 

Export engines like China are also using SWFs to keep their currencies from appreciating. As of 2007, China had accumulated more than $1.8 trillion in foreign assets in order to prevent the yuan from rising, thereby keeping Chinese exports competitive in the United States. More than 80 percent of these assets exist in the form of foreign exchange reserves—safe investments with very low rates of return. As these reserves have accumulated, the Chinese government has been willing to diversify its holdings into higher-risk investments—hence the creation of the China Investment Corporation. 

The effects of SWF investment in the United States to date have been completely benign. Although information remains patchy, the general consensus among financial analysts is that SWFs have taken a long-term, passive approach to their American investments. Indeed, the high-profile purchases of equity stakes have permitted firms like Citi to recapitalize in the wake of the crisis in mortgage-backed assets. The specter of China has also been exaggerated. To date, the China Investment Corporation has invested the bulk of its assets domestically; overseas investment totals a paltry $17 billion. 

In fact, the biggest risk posed by SWFs to date has not been their actions, but the possibility of protectionist overreaction in Washington, D.C. In a presidential debate this January, Senator Hillary Clinton seized on the funds as a source of concern, asserting: “We need to have a lot more control over what they do and how they do it.” Fortunately, to date SWFs have acted with heightened political antennae. For example, the bulk of recent SWF direct investment has been for nonvoting shares, defusing concerns about foreign state control of the U.S. financial sector. However, just because SWFs have behaved this way in the past does not guarantee that they will do so in the future. 

At Davos this past January, former Treasury Secretary Lawrence Summers articulated two cogent concerns about how SWFs could negatively affect the American economy. First, SWF bailouts of firms in financial distress could weaken corporate governance by protecting the management of poorly run companies. Second, if SWFs put politics over profit maximization, the distortion of market incentives could be severe. To alleviate these concerns, Summers has called for a voluntary code of conduct.

Other analysts have gone further: both the Peterson Institute for International Economics and the New America Foundation’s Global Strategic Finance Initiative have called for stricter regulatory standards. 

Sovereign wealth funds reject calls for greater supervision and regulation by pointing out that hedge funds and private equity concerns remain unregulated, but this comparison is disingenuous. As Alan Greenspan pointed out recently in The Age of Turbulence, the strongest constraint against financial misbehavior is “counterparty surveillance,” the incentive of investors to make sure that their investment funds are acting prudently and profitably. 

The trouble with SWFs is that, in most cases, there is no counterparty surveillance. In the best-case scenario—Norway’s Government Pension Fund—democratically elected parliaments must approve changes in investment strategies. This kind of oversight is consistent with the spirit of counterparty surveillance. In places like the United Arab Emirates, Russia, and China, however, the lack of transparency, oversight, and accountability is much more problematic. 

As of 2007, China had accumulated more than $1.8 trillion in foreign assets in order to prevent the yuan from rising.

In the main, the lack of counterparty surveillance is a bigger problem for the home country than the host country. As Kenneth Rogoff of Harvard University pointed out in congressional testimony last year, “Governments have a long tradition of losing massive amounts of money in financial markets. This tradition is not likely to end anytime soon…. Any attempt by a well-heeled foreign government to use its financial leverage to upset the U.S. economy will almost certainly backfire.” Over the long term, however, a shift by opaque SWFs into more volatile investments could contribute to greater instability in financial markets. 

The foreign policy ramifications of SWFs are more problematic. Sovereign wealth funds aid and abet in the persistence of “rentier states,” governments that do not need their citizens to raise revenue. Democratization is a much more difficult policy for the United States to pursue when the target government is sitting on trillions of dollars in assets to buy off discontented domestic groups. The geopolitical implications of China and Russia amassing sufficient financial clout to spook American asset markets should be obvious. 

Lest one think that these fears are irrational, consider that U.S. interest groups have been eager to use America’s financial muscle to alter the behavior of foreign actors. On the left, shareholder activists have delighted in watching how the investment decisions of CalPERS have forced firms to stop doing business in Sudan. On the right, the recent Divest Terror campaign has been designed to pressure companies to withdraw investment from state sponsors of terrorism (ironically, if China or the Persian Gulf emirates were to democratize, one could easily envisage nationalist parliaments using their SWFs to constrain U.S. actions). 

There are clearly reasons for concern, but they should not be overstated or misplaced. The interdependence created by SWFs cuts both ways. The United States needs the money to finance its large current account deficit. However, most other asset markets are neither big enough nor open enough to cater to large-scale sovereign wealth investments. Indeed, the very countries ginning up SWFs at the moment are the most protectionist when it comes to foreign direct investment. To paraphrase Norway’s finance minister, even though SWF nations might not like us, they need to invest their money in our market. 

To date, SWFs have acted responsibly, and there is no sign that their behavior will change soon.

Going forward, the U.S. government is already doing what it should do to insure against the uncertainties of sovereign wealth funds—not panicking. The process of the Committee on Foreign Investment in the United States, revamped in 2007, already requires heightened scrutiny when a foreign government-controlled entity acquires a controlling stake in a U.S. firm. 

Writing in Foreign Affairs, Deputy Treasury Secretary Robert Kimmitt recently urged SWFs to adopt a voluntary set of best practices to increase transparency and soothe politicians and markets. The International Monetary Fund is consulting with established SWFs based in Singapore, Norway, and the United Arab Emirates in order to develop such a code. As previously noted, SWFs are not politically tone-deaf—they should refrain from taking actions that invite a political backlash. 

Over the long term, SWFs are merely a symptom. One deeper problem is that U.S. energy consumption is keeping energy prices high. The other problem is that the U.S. government has failed to get Pacific Rim economies to revalue their currencies. 

Those are the macroeconomic forces that are causing foreign governments to expand their SWFs. Addressing those problems sooner, rather than later, will go a long way toward eliminating sovereign wealth funds as a political hot potato. 

Daniel Drezner is associate professor of international politics at The Fletcher School, Tufts University. He is the author of, most recently, “All Politics Is Global: Explaining International Regulatory Regimes” (Princeton University Press).

Illustrations by Brady Yeo.