Sovereign wealth funds and financial stability – guide

The European Commission has today adopted communications on sovereign wealth funds and on adapting European and global financial systems to better promote financial stability. These communications are the Commission contribution to EU leaders’ discussions on these subjects at the Spring European Council on March 13-14. On sovereign wealth funds (SWFs), the Commission is proposing that EU leaders endorse a common EU approach to increasing the transparency, predictability and accountability of SWFs. This common approach will strengthen Europe’s voice in international discussions aiming to establish a code of conduct including standards in areas of transparency and governance. On financial stability, the Commission wants the European Council to confirm the principles which will guide the EU’s efforts to improve financial market transparency and reinforce prudential control and risk management, and to set out the broad lines of the action to be taken.

Sovereign Wealth Funds (SWFs) are generally defined as state-controlled investment vehicles funded by foreign-exchange assets.

Traditionally, SWFs were the preserve of major commodity exporters, particularly oil-rich countries like Kuwait or Norway. Sovereign Wealth Funds have existed since the early 1950s. Since then, more than 30 countries have established SWFs, although their asset holdings are concentrated in a relatively small number of funds. The biggest funds are sponsored by the United Arab Emirates (two funds), Norway, Saudi Arabia, Kuwait, China and Singapore (two funds).

Recent years have seen a rapid growth in SWFs, and in particular their spread to countries with major strategic and political interests – such as Russia and China. Twenty new SWFs have been created in the past eight years, in which period the assets under management of SWFs have grown from several hundred billions to trillions of euros/US dollars. This expansion in SWFs has mirrored the emergence of historically large global financial imbalances, with many of the oil-producing and Asian countries running wide current account surpluses on a sustained basis. As the accumulated reserves in these countries are well beyond the requirements for exchange-rate management, some of them are increasingly channelled into SWFs. SWFs have also increasingly switched from neutral assets like US Treasury bonds to a more diversified investment portfolio, with a higher level of risk accepted in search of higher returns, mainly in the form of portfolio investments, besides real estate and alternative investments.

SWFs are today estimated to control assets of $1.5-2.5 trillion – more than all the world’s hedge funds. The rise in commodity prices and current account imbalances has fuelled the argument that SWFs will continue to grow – one estimate has put the possible scale of SWFs at $12 trillion by 2015.

The distinguishing feature of SWFs from other categories of investment vehicles, such as pension funds, investment funds and trusts, hedge or private equity funds, is that they are state-owned. In general, SWFs are funded from accumulated foreign-exchange reserves in their sponsor countries, but are managed separately from the official reserves.

Typically, SWFs have a diversified investment strategy, with a higher level of risk accepted in search of higher returns. SWF portfolios include a wider range of financial assets, including fixed-income securities but also equities, real estate and alternative investments. In their purpose and investment behaviour, SWFs are therefore not much different from other privately-owned investment vehicles.

Although SWFs have diverse investment objectives, most can be broadly classified as either stabilisation funds or savings funds. Stabilisation funds are typically established by commodity-producing countries to help counter the effects of volatile commodity prices. Savings funds focus on longer-term wealth creation and policy objectives. However, the investment behaviour of SWFs can vary significantly within these two broad categories.

Sovereign Wealth Funds have been operating in the internal market for almost fifty years and they have never created problems. During the recent financial turmoil, they have injected liquidity in the system at the time it was most needed, helping stabilise the markets. Their investments are often long-term and contribute to providing funds for European companies, contributing to growth and jobs. Another contribution of potential relevance for the EU is the importance of their investments for the international role of the euro.

As SWFs are foreign state-owned investment vehicles, their investments may raise concerns for the recipient State. Among the concerns most often aired is the preoccupation that SWFs’ investments may be driven by considerations other than maximisation of return. For example, investment targets may reflect a desire to obtain technology and expertise to benefit national strategic interests, rather than being driven by normal commercial interests in expansion to new products and markets. More generally, business and investment decisions could be influenced in the political interest of the SWFs’ owners. Concerns about SWFs’ operations are inevitably fuelled by the opaque way in which some of them operate.

The Commission is proposing a common EU approach to respond to concerns over SWFs and enhance the transparency, predictability and accountability of SWFs’ investments while maintaining an open investment environment.

It lays out principles which should shape that approach:

• commitment to an open investment environment both in the EU and elsewhere, including in third countries that operate SWFs;
• support of multilateral work, in international organisations such as the IMF and OECD;
• use of existing instruments at EU and Member State level;
• respect of EC Treaty obligations and international commitments, for example in the WTO framework;
• proportionality and transparency.

These elements should contribute both to arriving at a common EU approach on this issue and to discussions taking place at international level, such as in the IMF and the OECD.

Those discussions should result in a voluntary code of conduct prepared at international level The Commission asks the European Council to endorse this approach and make it the basis to encourage recipient countries and SWF owners to reach agreement on such a code of conduct, preferably by end 2008.

Yes. In line with the above principles, the Communication spells out some basic governance and transparency standards.

On governance these can be summarised as follows:

• clear allocation and separation of responsibilities;
• issuing of an investment policy that defines the overall objectives of SWF investment;
• operational autonomy for the entity to achieve those objectives;
• public disclosure of the general principles of an SWF’s relationship with government authorities;
• disclosure of general principles of internal governance that provide assurances of integrity;
• issuing of risk management policies.

And on transparency as follows:

• annual disclosure of investment positions and asset allocation;
• exercise of ownership rights;
• disclosure of the use of leverage and of the currency composition;
• size and source of an entity’s resources
• disclosure of the home country regulation and oversight governing the SWF

No, the Communication does not propose any legislative initiatives at this stage, though President Barroso has made clear that the Commission reserves the right to do so if it becomes necessary in the future.

Investments by SWFs are subject to the same rules and controls as other investments in the EU, based on the principles of free movement of capital. However, that freedom is not absolute. The Council may adopt by qualified majority measures on the movement of capital from third countries involving direct investment. Secondly, it is not excluded that the EU can introduce by a unanimous decision of the Council measures that restrict direct investments.

It is also important to note that the application of both European and national regulatory systems applying to all investors, including therefore sovereign wealth funds, can be amended to protect the public interest in the light of changes in financial markets.

Yes. Member States also have legislative and regulatory instruments available. The Merger Regulation allows them to take measures to protect legitimate interests other than competition. Public security, plurality of the media and prudential rules are regarded as legitimate interests, while others may be so considered on a case by case basis on notification to the Commission. Member States can also take other measures if specific needs arise, as long as those are compatible with the Treaty, proportionate and non-discriminatory and do not contradict international obligations. The European Court of Justice has stressed that purely economic grounds can never justify obstacles prohibited by the treaty.

No. The Commission does not envisage proposing any legislative instrument on investment from sovereign wealth funds. In addition, the Commission recalls that there is a predictable, transparent and reliable legal framework for investors from our Member states and from third countries in the internal market.

In Europe, between the EU and Member State level, there exists a comprehensive regime to regulate the establishment and the actions of foreign investors, which covers SWFs in the same way as any other investors. Member States, by and large, already possess adequate instruments to monitor foreign investment and react if considerations of public policy or public security raise.

However, the EU and Member States are not alone in facing the current questions raised by sovereign wealth fund investments. In this light, Europe must avoid any uncoordinated responses that give the wrong message about the EU stepping back from its commitment to be a welcoming environment for investment. Equally, it must avoid uncoordinated actions that could hamper the functioning of the single market and damage the EU economy.

That is why the approach proposed is to promote a cooperative effort between recipient countries and SWFs owners. This can best be done at international level and that is why the suggested approach is to consolidate a coordinated EU position, through which to influence the international debate and facilitate the establishment of a voluntary code of conduct guiding the SWFs operations.

In recent months, the issue of SWFs has climbed the political agenda. In particular:

• Several European leaders raised the issue during European Council preparations;
• The G7 Finance Ministers discussed SWFs at their meeting on 19 October 2007. The G7 invited the IMF and the OECD to launch a reflection on the role of SWFs and on mechanisms to address the challenges they pose. Meanwhile, the G7 called the IMF to develop guidelines or a code of conduct for SWFs, relating to governance/institutional structure, risk management, transparency/appropriate disclosure of information, and accountability. The G7 invited the OECD to discuss with recipient countries to identify best practice frameworks, building on principles of non-discrimination, transparency and predictability, and accountability.
• The IMF is currently preparing a paper on SWF issues. This paper will be presented for a discussion in the Board, possibly in March. Sponsor countries have indicated that it should be a voluntary choice for SWF to be transparent. The IMF announced recently that a first draft of voluntary best practice guidelines for SWFs is expected in October, ahead of the IMF annual meetings.
• The OECD Investment Committee is working on best practice guidelines for recipient countries, to ensure fair and transparent investment frameworks. Again the Commission and EU Member States are contributing to this work. A roundtable on SWFs is planned by the OECD and the City of London (with the possible participation of IMF) in London on 1 April 2008.

Improving transparency and disclosure by SWFs will benefit also developing countries in which they might be investing.

There are currently no comprehensive or accurate data on where those investments are taking place, either geographically or by sector. This is exactly why the Commission insists on further transparency from funds and their sponsor countries. From what we know today, it is not possible to say to what extent investment is flowing to Africa and other developing countries or goes to investment in extractive industries.

However, SWFs seem to invest their capital largely in their own economies, as well as in mature markets in Europe, US and Asia. Little investment seems to go to Africa and developing countries. Furthermore, investment plays also a critical role in fostering growth and development of developing countries. The Commission seeks to contribute to fostering investment flows to developing countries, including through its bilateral agreements, where they include investment chapters.