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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 The Emergence of Sovereign Wealth Funds as Contributors of Foreign Direct Investment Ruth Rios-Morales1 and Louis Brennan2 Abstract In the current world economy, sovereign wealth funds (SWFs) are hastily attaining significance as global financial players. SWFs embody the largest concentration of capital that the world has ever known (Redicker & Crebo-Redicker). We argue that by engaging in foreign direct investment (FDI), SWFs can play a role in sustaining the global economy. This paper examines the potential impact that SWFs encompass as tools for economic growth. It is widely acknowledged that FDI has the potential to sustain long-term economic development through job generation and enhancement of exports. The paper also examines the role of national governments in the management of these colossal funds and the recently established Santiago Principles related to issues of transparency and best practice code of conduct. 1 Ruth Rios-Morales (PhD), Lecturer at LRG, University of Applied Sciences Switzerland, CH 1630 Bulle, Switzerland. Tel. 00 41 26 919 7878, Fax 00 41 26 919 7878, e-mail: [email protected] 2 Louis Brennan (PhD), Associate Professor at the School of Business, Trinity College, Dublin 2, Ireland. Tel. 00 35 31 896 1993, Fax 00 35 31 679 95 03, e-mail: [email protected] June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 1 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 1. INTRODUCTION Amidst the economic and financial turmoil, sovereign wealth funds (SWFs) have emerged as significant financial players. SWFs have delivered some support in the initial stages of the global financial crisis triggered by the subprime mortgage meltdown by providing some element of financial relief to a number of financial institutions. Although these capital injections were welcome by market players, SWFs have garnered the concerns of policymakers. Two main reasons account for such concerns: the large magnitude that these funds represent and the role of national governments in the management of these large funds (Rios-Morales & Brennan, 2008). SWFs represent the largest concentration of capital that the world has ever known (Redicker & Crebo-Redicker, 2007). At present, these funds surpass the amount of five trillion dollars (UNCTAD, 2008); this figure is nine times larger than what private equity funds represent. However, trends also reveal that SWFs are growing faster than private equity funds. It is expected that by 2015 SWFs will have attained the level of 12 trillion dollars (UNCTAD, 2008). The second concern of policy makers highlighted above, is related to the issue of transparency and accountability. The lack of transparency of nations with surpluses has propelled a debate about the potential risks and opportunities for host nations (Johnson, 2007). Parallel to this debate, strong feelings of protectionism in some western countries had emerged to defend national sovereignty (Siebert, 2007). In response, the International Working Group of Sovereign Wealth Funds launched the Santiago Principles in October 2008. These principles aim to address such apprehensions. June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 2 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 The aim of the Santiago Principles is to provide a clear understanding of the management of SWFs so that policymakers and market players can welcome these funds and use them as tools of economic growth. FDI by SWFs can become the avantgarde of the global economy. It has been widely accepted that foreign direct investment is an important element of economic development in the new global economy (Blomstrom, 2001; Addison & Heshmati, 2003; World Bank, 2004; Lall, 2005). In the present global system, states are playing a central role in the determinants of international business activities (Dunning, 2006) and emerging and developing economies are becoming important investors increasing their role in the global economy. A large number of SWFs have their origins in emerging and developing countries (UNCTAD, 2008). The remainder of this paper is organized as follows: The next section presents a review of exiting literature on the topic of SWFs integrated with scholarly research on the topic of FDI. Section 3 focuses on the emergence of SWFs and the establishment of the ‘Santiago Principles’. Section 4 analyses the data on FDI and the potential role for SWFs in sustaining FDI. The implications of the emergence of SWFs are presented in section 5. Finally some conclusions are drawn in section 6 of the paper. 2. RELATED LITERATURE The unprecedented emergence of SWFs as financial players has impelled a debate among policymakers, market players and scholars regarding the potential risks and benefits that these funds can convey to the global economy (Johnson, 2007). While the June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 3 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 role of SWFs has been widely acknowledged in this highly volatile global financial system dominated by risk aversion, liquidity pressures and asset write-downs (RiosMorales & Brennan, 2008), the extant literature has tended to focus on the concerns highlighted above. In the debate around the potential risks and benefits of SWFs, the main concern has been the lack of transparency in the administration and investment strategies of these colossal funds. A large number of publications have underlined the danger that SWFs may cause if they remain unregulated (Truman, 2007a; Green & Torgerson, 2007; Redicker & Crebo-Redicker, 2007), suggesting that SWFs can act as vehicles of future global instability (Redicker & Crebo-Redicker, 2007). A number of publications have emphasised the need to establish an international code of conduct in order to avoid protectionism that would be detrimental to the globalization process (Truman 2007a, 200b). In contrast to the above perspective, Jen (2007a) and Kern (2007) have underlined the variety of economic and financial benefits that SWFs present. Beside the benefits that SWFs encompass as investors, the IMF (2008) argues further that SWFs can help to avoid extreme economic cycles, transfer across generations surpluses of current accounts and enhance revenues of investors’ nations (IMF, 2008). Nonetheless; this international institution has being prominent in raising the importance of establishing an international code of conduct (IMF, 2008). The potential risks that have been attributed to SWFs, have been addressed by the launch of the Santiago Principles in October 2008. Thus, there is a need to focus on the potential benefits that SWFs can bring to the global economy. Although much has been June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 4 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 written about SWFs in recent times, the body of scholarly research on this topic is rather scant. In assessing the role of SWFs as important contributors of FDI in the global economy, the existing substantial body of literature on FDI provides evidence for the significance of FDI as a method of economic growth. However, research on the topic of SWFs as contributors of FDI is limited. Nonetheless, the work of Green & Torgerson (2007), Jen (2007b), Siebert (2007), UNCTAD (2008) and Plotkin & Fagan (2009) offer a basis for seminal work to support our argument that by engaging in FDI, SWFs can sustain the global economic growth. According to the World Investment Report 2008 SWFs have only invested 0.2 percent of their total assets in FDI. About 80 percent of this investment has taken place during the period 2005-2007. The report also reveals that 73 percent was invested in the developed world mainly in the United Kingdom, the United States and Germany (UNCTAD 2008). Since these funds already represent five trillion dollars (UNCTAD, 2008) and are estimated to reach the sum of 12 trillion dollars by 2015, (Redicker & Crebo-Redicker, 2007), SWFs have the potential to serve as major funding sources in the global financial system (Fernadez & Bris, 2009). Important research has been conducted on the topic of FDI as a contributor of economic growth. The large body of literature is not unanimous in acknowledging that FDI is a direct contributor of economic growth. However, research shows that FDI has the potential to contribute to long-term economic development (Blomström, 2001; Addison and Heshmati, 2003; World Bank, 2005; Lall, 2005; Dunning, 2006). Researchers also acknowledge the fact that FDI will have a positive impact in the economy of a country when the infrastructure of the host country is ready to receive the so-called spillovers of June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 5 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 FDI (Borensztein et al., 1998, Willem te Velde, 2001). Spillovers of FDI can benefit the domestic economy by bringing technology, know-how, managerial skills and production networks (Blomström, 2001). Hermes & Lensink (2003) found that FDI has a particularly positive impact in economies with well-developed financial markets. The participation of SWF in FDI is novel and to date no theories have been developed to analyse and forecast the impact of these new financial players on FDI. However, the Investment Development Path Theory (IDP) of Dunning (1998) offers a basis for examination. The IDP suggests that the magnitude of countries investment is correlated positively with the rate of economic growth. The IDP hypothesizes that with increasing economic development measured by GDP per capita, conditions for inward and outward investment in a country change. This is reflected in the country’s NOIP (Net Outward Investment Position) defined as the difference between outward and inward investments, which is hypothesized to evolve from being highly negative in the early stages of development to becoming positive and eventually fluctuating around zero once the country is fully developed and industrialized. Dunning divides the economic development of countries into five stages. At the first stage, a country’s outward FDI (OFDI) is negligible or non-existent but attracts a small amount of inward FDI (IFDI). In the second stage, the rate of economic growth continues to increase, while the rate of IFDI is higher than that of OFDI. At the third stage, countries exhibit a growing NOIP, due to an increased rate of growth of OFDI and a gradual slowdown in IFDI while GDP continue to grow. At the forth stage, the GDP rate increases from the pervious stage and outward FDI continues to grow rapidly. In the final stage, NOIP tends to fluctuate around zero reflecting high levels of IFDI and OFDI. This is explained by the June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 6 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 neutralisation of the asymmetries among positive and negative balances, given that inward and outward FDI have gone through a vast growth in previous stages (Buckley & Castro, 1998). At this stage, the relationship between the NOIP of an economy and its level of development becomes less stable (Dunning & Narula, 1998). The IDP model gives special attention to the government role in FDI (Dunning & Narula, 1998). This theory focuses on the role of government and economic development in determining the pattern of competitive advantages of foreign investors relative to those of local firms (ownership advantages), relative competitiveness of location-bound resources and capability of the country (locational advantages), and the propensity of foreign and local firms to utilize the ownership advantages internally rather than through markets (internalization advantages). With a country’s development and government interventions the configuration of these advantages changes and reflects on the NOIP of the country (Dunning & Narula, 1996). While Dunning suggests that the IDP of countries differ with each other mainly due to the pattern and efficacy of government interventions, the theory should take this into account (Dunning & Narula, 1996). Since the establishment of SWFs, and in many cases their operation, represent a government intervention, they may impact on the IDP of their countries of origin. 3. THE EMERGENCE OF SWFs AND THE SANTIAGO PRINCIPLES Sovereign wealth funds are special-purpose government-owned investments, accumulated from surpluses of current accounts and reserves (IWG, 2008). A number of these most important funds were established over the second half of the last century. Kuwait pioneered the establishment of SWFs, launching its SWF in 1953 (Roy, 2007). June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 7 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 Among the older and largest is Singapore’s Temasak Holding which was created in 1974. Alaska established its SWF in 1976 while Abu Dhabi investment Authority, the largest SWF, was also launched in 1976 (see Table 1). In Table 1 we can observe that a larger proportion of SWFs were established in recent years. This extraordinary growth in the number of SWFs has been the result of the rapid accumulation of foreign assets in some countries (IWG, 2008). Among some of the largest SWFs is the China Investment Corporation (CIC) which was established in 2007 and holds US$200 billion. China has accumulated surpluses from exports sales revenue. Given that China has reserves of US$1.5trillion (Jen, 2007b), it is likely that the CIC will increase its assets. Table 1: The 20 Largest Sovereign Wealth Funds Name of Funds Year founded Source Billion US$ Abu Dhabi Investment Authority 1976 Oil 875 Singapore Investment Corporation 1981 Non-commodity 330 Norway Government Pension Fund-Global 1990 Oil 322 Saudi Arabia Various Funds n/a Oil 300 Kuwait Invetsment Authority 1953 Oil 250 China Investment Corporation 2007 Non-commodity 200 Hong Kong Monetary Authority Investment Portafolio 1998 Non-commodity 140 Stabilisation Fund of the Russian Federation 2003 Oil 127 China Investment Company 2003 Non-commodity 100 Singapore Temasek Holdings 1974 Non-commodity 108 Australia Government Future Fund 2004 Non-commodity 50 Libya Reserve Fund n/a Oil 50 Qatar Investment Authority 2000 Oil 40 US Alaska Permanent Fund 1976 Oil 40 Brunei Investment Agency 1983 Oil 35 Ireland National Pension Funds 2001 Non-commodity 29 Algeria Revenue Regulation Fund n/a Oil 43 South Korea Investment Corporation 2006 Non-commodity 20 Malaysia Khazanah Nasional 1993 Non-commodity 18 Kazakhstan National Oil Fund 2000 Oil, gas and metals 18 Source: Deutsche Bank Research, "Sovereign Wealth Funds, State Investment on the Rise", September, 2007 June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 8 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 Currently, there are about 70 SWFs held by 44 countries with assets that range from US$20 million to US$875 billion (Beck & Fidora, 2008). About 30 percent of total SWFs have originated from accumulated current accounts surpluses of non-commodity sources (Rios-Morales & Brennan, 2008) and about the same percentage are held by Asian and Pacific countries (Johnson, 2007). However, oil producing countries remain the largest holders of SWFs (see Table 1). The accumulation of large current accounts surpluses has been a trend observed in a number of countries; remarkably the majority of these countries are emerging and developing nations (Rios-Morales & Brennan, 2008). The rapid growth in the number of SWFs and the establishment of large SWFs by China and Russia has provoked concern and anxiety in some western countries (Betts, 2008). Although the Anglo-Saxon governments were receptive of SWF investment (Jen, 2007b), other western countries voiced strong apprehension based on the prospect that SWFs could be used to seize control of strategic companies in sensitive sectors for their own political purposes (Siebert, 2007; Betts, 2008). The argument of financial protectionism became an issue for the International Financial Institutions (Thompson Financial, 2007). Given the significance of the possible impact that protectionism could have in the global economy, the International Monetary Fund (IMF) called states to a dialogue in October 2007 (IMF, 2008). Twenty-six countries that hold SWFs voluntarily played a role in the creation of an institutional framework around the governance and investment operations of these funds. A year later, the General Accepted Principles and Practices (GAPP) - June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 9 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 Santiago Principles were launched with the aim of fostering trust and confidence among recipient and investor countries. These principles aim to support a healthy global economy with a financial system based on free flows of capital that complies with applicable regulatory requirements and transparent management (IWG, 2008). The purpose of the GAPP is to reflect appropriate governance and accountability of investment. The GAPP consists of 24 principles that cover four key areas: 1) Legal and institutional framework 2) Objectives and coordination on macroeconomic principles 3) Governance structure and code of conduct 4) Risk management framework The launch of the GAPP is expected to dispel some of the prevailing apprehension about SWFs. It is expected that the Santiago Principles will support further investment by these well-established institutional investors and continue to contribute to the economy of recipient countries (IWG, 2008). SWFs are long-term investors (Gilson & Milhaupt, 2008; UNCTAD, 2008). It is widely acknowledge that long-term investment is one of the best methods of economic development. Long-term investments endure business cycles, convey diversity to the markets and provide support during economic volatility (IWG, 2008). The Santiago Principles therefore facilitate a platform for a more efficient flow of foreign direct investment. 4. FOREIGN DIRECT INVESTMENT AND SWFS There has been a vast increase in global inward foreign direct investment (IFDI) flows since 1970. Enhancing the investment climate has been a policy priority for many June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 10 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 governments. Particularly over the past two decades, there has been strong support from governments for foreign investment. A large number of countries have implemented industrial policies and macroeconomic measures of liberalisation, deregulation, and improved the availability of infrastructure and skilled labour force. These are essential policies to support making FDI an instrument of economic development (Rios-Morales & O’Donovan, 2006). After a steady expansion of IFDI over the 1990s, it reached a peak in 2000. FDI flows declined for the three subsequent years (see Figure 1). In 2004, world FDI increased slightly due to the increased flows to developing countries while FDI into developed countries continued to fall. The recovery in FDI has since continued and in 2007 FDI reached higher levels than those obtained in 2000 (sees Figure 1). Developed countries continue to be the dominant contributor group to FDI flows. Developed countries also continue to be the major destination of inward FDI. However, developing countries participation in FDI is increasing steadily. The contribution of emerging and developing countries to FDI has been noteworthy in recent years. These countries have also been important recipient of FDI. In fact, the strong performance of IFDI in 2007 mirrors the strong performance of multinational corporations particularly in developing countries (UNCTAD, 2008). June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 11 2009 Oxford Business & Economics Conference Program Figure 1 ISBN : 978-0-9742114-1-1 Global Inward FDI Flows (Millions of US dollars) 2 000 000 1 500 000 1 000 000 500 000 World Developed economies 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 - Developing economies Source: UNCTAD, 2008 The emerging and developing countries are surging as important contributors and recipients of FDI. In Table 2 we observe that emerging and developing countries have obtained higher levels of inward FDI as a percentage of GDP than the developed countries. During the period 1990-2007, inward FDI stocks as a percentage of the GDP in these countries were at an average level of 20.83 percent, while the developed countries obtained an average level of 14.71 percent. The average real economic growth rate has also been higher in emerging and developing countries than the rate obtained by the developed world. During the period 1990-2007, emerging and developing countries obtained an average rate of real GDP growth of 4.75 percent. Developed countries real GDP growth for the period 1990-2007 is 2.6 percent. However, the level of outward FDI stocks as a percentage of GDP from developed countries continues to be higher than the level from emerging and developing countries. The average level of outward FDI from developed countries is almost double that obtained by emerging and developing countries during the period 1990-2007 (see table 2). June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 12 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 Table 2: Inward and Outward FDI stock as a percentage of Gross Domestic Product and Real GDP Growth, 1990-2007 In the light of Dunning’s IDP model (1998), we first examine the correlation between inward FDI stocks as a percentage of GDP and the rate of real GDP growth. We also examine the correlation between outward FDI stocks as a percentage of GDP to the rate of real GDP growth. For developed countries, the correlation coefficient between inward FDI stocks as a percentage of GDP and the rate of real GDP Growth is close to zero (-0.0070). Outward FDI stocks as a percentage of GDP correlated to the rate of real GDP growth is also around zero (-0.0045). Dunning (1998) suggest that when countries obtained such correlation figures close to zero, these countries have reached the final stage of the IDP. Buckley & Castro (1998) explained that such countries have gone through such a vast development in previous stages that at the final stage countries have June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 13 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 managed to neutralised asymmetries in balances. By contrast the correlation coefficient between inward FDI stocks and economic growth for emerging and developing countries is high as is the correlation coefficient for outward FDI stocks and economic growth (see Table 2). According to the IDP model, these results are consistent with the fact that emerging and developing countries are at earlier stages of the IDP. Since high correlation coefficients are found for emerging and developing countries, this suggests that inward and outward FDI may have an influence on the real economic growth of this group of countries. According to the World Investment Report 2008, inward FDI flows are set to decline, indicating that emerging and developing world would suffer the most. However, SWFs can play a role in sustaining FDI. In order to estimate the figure needed to sustain FDI, we used forecasts for FDI for 2008 from UNCTAD (2008). This indicates that in 2008, FDI would have declined by 31 percent or US$568 billion. On this basis, we can measure the proportion of SWFs assets needed in order to neutralize such a decline. Our estimation suggests that by allocating just over 11 percent of their total assets of US$5 trillion to FDI, SWFs could have averted the forecast decline in FDI. June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 14 2009 Oxford Business & Economics Conference Program Figure 2 ISBN : 978-0-9742114-1-1 World Inward FDI, 1990-2010 (Millions of US dollars) 2000000 Forecasted Period 1500000 1000000 500000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 -500000 Source: UNCTAD, 2008 5. IMPLICATIONS OF SWFs IN THE GLOBAL ECONOMY The emergence of SWFs has two main implications for the global economy. Firstly, SWFs are potentially significant sources of investment. Although investment figures from SWFs in FDI are modest thus far, the potential that these funds have as investors is enormous. In the present global economic scenario, with an expected decline in FDI flows, developing and emerging countries are in an especially vulnerable situation. Table 2 shows the high dependency that developing and emerging countries have on inward FDI. Over the period 1990-2007, the magnitude of inward FDI represented 20.4 percent of GDP. In Table 2 we also observe that developing and emerging countries have obtained nearly twice as high the rate of real GDP growth than their developed economy counterparts. Since FDI has had a positive influence on the higher rate of GDP growth for emerging and developing economies, a reversal of the growth trend in FDI is June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 15 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 likely to have an adverse impact on these economies. To avoid such an impact, SWFs have a role to play by contributing more prominently to FDI. Secondly, SWFs are changing the world economic order. Despite the fact that some SWFs have been established long ago, the surge of SWFs as investors is novel. In recent years, states have used surpluses of current accounts to invest in the global financial market. This new phenomenon has been label “New Mercantilism” since the public sector is gaining involvement in corporate activity (Gilson & Milhaupt, 2008). The widely promulgated notion that the public sector is not an efficient administrator of resources is being ignored by the countries of origin of SWFs. 6. CONCLUSIONS SWFs have gained significance in the present global economy, mainly due to the lack of confidence of investors in the financial markets. SWFs have been acknowledged as potential funding sources for the global financial system (Fernadez & Bris, 2009). This paper proposes that by engaging in FDI, SWFs can play a very important role in sustaining the global economy, especially to developing and emerging countries that are vulnerable to FDI decline. SWFs are large and tend to be long-term investors, characteristics that are compatible to FDI. The funds’ features can also facilitate better endurance to volatility and market pressures. Our findings suggest that only 11 percent of SWFs investment in FDI is needed in order to counteract the future decline of FDI. Although much political controversy has surrounded the topic of SWFs, the recently established Santiago Principles related to issues such as transparency and best practice code of conduct can provide a clear understanding of the managements of SWFs. June 24-26, 2009 St. Hugh’s College, Oxford University, Oxford, UK 16 2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 Policymakers and market player should therefore welcome these funds and use them as tools of economic growth. REFERENCES Addison T. and Heshmati A. (2003). The New Global Determinants of FDI Flows to Developing Countries. United Nations University, WIDER, Discussion Papers No. 2003/45. Aslund A. (2007). The Truth about Sovereign Funds. Foreign Policy - Current Issues, December 2007. Beck R and Fidora M (2008). 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