II. LITERATURE REVIEW
5. T HE MANAGEMENT AND REGULATION OF SWF S
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If the national security concerns cannot be eliminated, it is possible to cause protectionism triggered by recipient countries, especially developed countries. It also makes developed countries fall into a dilemma situation. For decades, the world economic rule is
“free market”, that is also what developed countries advocate extremely, but now, the situation reverses. If SWFs really trigger the next national financial protectionism wave, the effect they bring is the overall change of global economic rule in a dramatic way.
To make a simple conclusion from above, the impacts that SWFs bring can be
generalized as below:
Advantage Disadvantage Financial Stabilization Exacerbating market volatility
Increase global capital liquidity National security Abundant capital injection
SWFs can stabilize global financial markets due to their long term investment horizon;
increase global capital liquidity via their wide range of investment objectives; provide an abundant capital injection to those in need. However, they may also exacerbate the global financial market to become more volatile since they can change their investment activities without any reasons; trigger the national financial protectionism and national security concerns, as most big SWFs lack transparency about their operation.
5. The management and regulation of SWFs
There is no precise model to manage SWFs now, but there are two regular ways be seen.
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One way is to be managed by the central bank directly; the other way is to set up a new investment entity insulated from the central bank to take charge of SWFs. The advantage of setting up SWFs under the central bank is that it can strengthen the function of the central bank. Like HKMA (Hong Kong Monetary Authority), it sets up two different investment portfolios under the central bank; according to different purpose, risk, and horizon, to meet the needs of liquidity and higher investment returns purpose.
The advantage of setting up an independent investment entity for SWFs is that it can divide the different roles from the owner of SWFs and the owner of foreign exchange reserves strictly. This kind of management can be classified into two types. One is to make a special law to regulate SWFs, like what KIC (Koran Investment Corporation) did. Korean Congress promulgates Korean Investment Corporation Act to establish KIC aiming to manage their SWF. There are precise regulations in this Act to stipulate how KIC operate.
The other type is to manage SWFs by normal Company Law and be monitored by financial inspection authority, like GIC and Temasek Holdings in Singapore. These two institutions were established by Singapore Ministry of Finance, but their operation is insulated from the government. The government only has the rights to monitor the operation and receive the annual report, but no rights to intervene the companies’ business decisions.
Although lots of commentators and recipient countries fear that the national security may be threatened by SWFs’ home countries, there is no direct evidence to proof the SWFs
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home countries have the political investment strategy till now. At this moment, the most important thing is to find the balance between western calls for transparency and the funds’
insistence on fair treatment. Not only the recipient countries but also the home countries should step back since that- if SWF is really economically driven, both sides would benefit from the investment activities. Here are some responses and the relative regulations for SWFs.
5.1. Principles for both sides
Both SWFs themselves and the countries in which SWFs invest in have responsibility to resolve the dilemma. According to Kimmitt (2008), there are 4 principles for recipient countries and five principles for SWFs home countries to achieve this goal.
Principles for recipient country (1) Avoid protectionism
Countries should not raise counterproductive barriers for investments. No matter the investors have the controlling of national firms or not, erecting the investment obstacle is never a friendly behavior.
(2) Uphold fair and transparent investment frameworks
Investment policies, processes, and regulations should be public clearly, no vagueness, no discriminating, and should be predictable, especially the rules which relate to national
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security considerations.
(3) Respect investor decisions
Recipient countries should respect investors’ decisions. Do not ask investors or intervene how to do their SAA decisions, especially those decisions are relative to investor’s gains and losses. The rights how to allocate the investment objectives should belong to investors.
(4) Treat investors equally
Any relative regulations and laws for investors should not be discriminating, not only between domestic and foreign investors but also between different foreign investors.
Principles for home country
(1) Invest commercially, not politically
SWFs investment decisions should be purely based on economic consideration rather than political or foreign policy purpose. In order to eliminate recipient countries’ fear, investors should incorporate this principle into their basic investment management policies.
(2) Convey world-class institutional integrity
Because of SWFs’ huge size and state-owned characteristic, obscure investment policy would raise recipient countries’ worries. Therefore SWFs should be transparent about their investment policies, including their purpose, objectives, governance structure, and internal controls.
(3) Compete fairly with the private sector
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Since SWFs have more potential to get the competitive advantage information than private entities, they should be careful not to take advantage of this information to erect unfair competing environment.
(4) Promote international financial stability
As public-sector entities which can benefit from healthy global markets, SWFs have the responsibility to promote the international financial stability. Especially during times of financial crisis, SWFs should try to do something to sustain the regular operation of global economic market.
(5) Respect host-country rules
SWFs should comply with all regulation established by countries which invest in and co-operate what the host-country rules ask, such as disclosing required information.
5.2. Linaburg-Maduell Transparency Index27
The Linaburg-Maduell Transparency Index was developed by Carl Linaburg and Michael Maduell at the Sovereign Wealth Fund Institute. This index is a rating system for measuring transparency of sovereign wealth funds. SWFs, as a state-owned investment vehicle, will receive more unethical concerns and suspicions than private investors from public. Therefore, there are calls to make a regulation or rating system aiming at those SWFs with large opaque or non-transparency in order to show their investment intentions.
27 SWF institute, http://www.swfinstitute.org/research/transparencyindex.php
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The index is based on ten principles that illustrate SWFs transparency to the public.
Table 5 presents the principles, and each principle adds one point of transparency when calculating the index rating. The minimum rating a fund can receive is a 1, but according to the recommends of Sovereign Wealth Fund Institute, the minimum rating to ensure SWFs have adequate transparency is 8. This index is still an ongoing project in Sovereign Wealth Fund Institute, and the ratings for each SWF may change as funds publish additional information.
Table 5. Principles of the Linaburg-Maduell Transparency Index28
Source: SWF Institute
The following figure (Figure 11) is the latest release (4st quarter in 2009) for LMTI ratings. From the figure, most of the SWFs home countries with grades over 8 are high quality legal system, or high democracy countries. Like Singapore, Ireland, USA, Norway, New Zealand, Canada, and Australian.
28 SWF institute, http://www.swfinstitute.org/research/transparencyindex.php
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Figure 11. 4Q09 Linaburg-Maduell Transparency Index ratings released29
5.3. Legislation by advanced economies
Because of the political fears brought by SWFs and no particular regulation until the publishing of GAPP (Generally Accepted Principles and Practices) in 2008, many advanced
29 SWF institute, http://www.swfinstitute.org/research/transparencyindex.php Source: SWF institute
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economies issued or revised their laws which are related to foreign investment activities. The most famous is the FINSA (Foreign Investment and National Security Act) promulgated by United States.
The United States Congress passed the FINSA in 2007 and its responsibility is to monitor the acquisitions by government-owned entities, mandate the involvement of high-level officials in CFIUS30 , and report to Congress.
The other developed countries also did some legislative actions to respond. Table 6 collects those legislations issued by France, Japan, Canada, Australia, Germany, and United States. Those legislations are established for recipient countries’ national security concerns and make precise ordinance for foreign investors.
Table 6. Legislation actions by developed countries31
Country Year Legislation Description
U.S.A Oct.2007 Passed FINSA to do the scrutiny of acquisitions by government-owned investments.
France Dec.2005 Published a new ordinance mandating prior authorization for foreign investments that may affect “national defense interests.”
Japan Aug.2007 Emended its inward investments regulation to address the words “changed security environment surrounding Japan and trends in international investment activity.”
Canada Dec.2007 Published “clarifications” of its rules on foreign investment for state-owned enterprises under the Investment Canada Act.
Australia Feb.2008 Announce six principles that govern reviews of foreign investments by SWFs and other government-linked entities.
Germany Apr.2008 Published new legislation authorizing policy makers to pre-examine selected foreign investments, especially those coming from SWFs.
30 CFIUS, an interagency body created in 1975, which was led by Treasury Department and its responsibility is to monitor and review incoming investments
31 Benjamin J. Cohen, ”Sovereign Wealth Funds And National Security: The Great Tradeoff”, Department of Political Science University of California, August 20,2008, p.9
Source: Department of Political Science
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5.4. International Regulation Institutes
Since there is no particular rule for SWFs actions, international organizations are asked to do something about SWFs regulation. IMF and OECD got a strong pressure from the finance ministers and central bank chiefs of G-7 to identify the “best practices” for all the SWFs players (including both sides). After the summit meeting of the Group of Eight in June 2007, IMF and OECD start trying to develop related guidelines. The IMF would take charge of the behavior of SWFs, and the OECD would manage guideline for recipient countries.
The International Working Group of Sovereign Wealth Funds (IWG) was established in a meeting with SWFs countries attended during April 30 to May 1st, 2008. IWG comprises representatives from 26 IMF member countries with SWFs, and it would be initiated, facilitated and coordinated by IMF. The aim for IWG is to develop a generally accepted principles and practices (GAPP) for SWFs home countries to reflect their investment practices and objectives properly. And finally, the GAPP was published in October 2008 and it became the main and formal principles about SWFs in the world.
At the beginning in PART II of GAPP, it indicates that the principles and practices are based on a voluntary code of conduct, and hope to alleviate recipient countries’ fears that SWFs might operate in political purpose. The followings are the simple introduction about the guidelines and purpose of GAPP32:
32 Source are all from “Sovereign Wealth Funds Generally Accepted Principles and Practices- Santiago Principles”
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Guiding principles of GAPP
(1) Help to maintain a stable global financial system and free flow of capital and investment.
(2) Comply with all applicable regulatory and disclosure requirements in the countries where the funds invest.
(3) Invest on the basic consideration of economic and financial risk and return.
(4) Create and maintain a transparent and sound governance structure that provides for adequate operational controls, risk management, and accountability.
Purposes of GAPP
(1) Identify the framework of generally accepted principles and practices that reflect proper governance, accountability arrangements, and the conduct of investment practices by SWFs on a prudent and sound basis.
(2) Help to improve both the recipient and home countries’ understanding of SWFs as economically oriented entities.
(3) Stabilize the global financial system, reduce the protectionism, and maintain a stable and open investment surrounding.
Summing up the management and regulation about SWFs; there are two common ways to manage SWFs: one is to set up SWFs under central bank; the other is to establish another independent institution to manage SWFs. The advantage of the prior way is to strengthen the
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function of central bank; the advantage of the latter one is to divide the different ownership of SWFs’ capital and foreign exchange reserves. With regard to the regulation aspects, there are lots of principles suggested by commentators, and those principles are based on respect, indiscriminate, commercial oriented criteria. Linaburg-Maduell Transparency Index was developed by SWF Institute, and the minimum rating to ensure SWFs have adequate transparency is recommended to be over 8. GAPP is the newest and most formal principle which is published by IWG. Its purpose is to identify the generally accepted principle about SWFs; improve the relationship between SWFs’ home countries and recipient countries, and stabilize the global financial system.
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