Game theory and sovereign wealth funds

Author:Harry McVea
Position:School of Law, University of Bristol, Bristol, UK Institute of Advanced Legal Studies, London, UK

Purpose – The purpose of this article is to assess strategies available to recipient states for managing the putative risks posed by sovereign wealth funds (SWFs) in the context of global, liberalized, and capital markets. Design/methodology/approach – The paper employs a game theory analysis in assessing these risks. Four basic scenarios are outlined whereby recipient states may... (see full summary)

1 Introduction

Although there is currently no agreed definition of the term “sovereign wealth fund” (SWF), the International Working Group of Sovereign Wealth Funds (IWG) has defined such entities as ( IWG, 2008, p. 3 ):

[…] [s]pecial purpose investment funds or arrangements, owned by the general government […] for macroeconomic purposes[.] SWFs hold, manage or administer assets to achieve financial objectives, and employ a set of investment strategies which include investing in foreign financial assets […] SWFs are commonly established out of balance of payments, surpluses, official foreign currency operations, the proceeds of privatisations, fiscal surpluses, and/or receipts resulting from commodity exports (footnotes omitted).

As investment vehicles which are, in effect, owned, funded and operated by sovereign states, SWFs provoke a variety of reactions. For some, they are “saviours” in straightened economic times ( McCreevy, 2008 ); for others, they are the “new barbarians at the gate” ( Kleinman, 2007 ) – little more than a modern form of “Trojan horse” ( Fleisher, 2008, p. 96 ). For most, however, SWFs are actors – if increasingly important ones – in a broader story about the liberalization of international capital flows. Set within this context, SWFs offer the prospect of unlocking latent economic wealth in ways that are mutually beneficial to donor and donee states, albeit that they simultaneously pose potential, if diffuse, dangers to the longer term economic interests of recipient states. Characterised in these more moderate though nonetheless problematic terms, there has existed for some time widespread recognition – both nationally and in global for a – of the need for some form of reasonable accommodation of the interests of donor and donee/recipient states.

In addressing the broader question of how best to approach the regulation of SWFs, this article considers the issue from the perspective of recipient states. Such states have much to gain from the injection of SWF capital, but also potentially much to lose from the operation of these funds within their territorial borders. By employing a version of game theory, which allows for an analysis of the choices made by competing “players” (here recipient states and SWFs), the article seeks to identify and assess strategies available to recipient states for managing the perceived risks posed by SWFs in the context of global, liberalized, capital markets. Four basic scenarios are outlined whereby recipient states may interact with SWFs: “unselfish recipient state – unselfish SWF” (Option 1); “unselfish recipient state – selfish SWF” (Option 2); “selfish recipient state – unselfish SWF” (Option 3); and “selfish recipient state – selfish SWF” (Option 4).

In the light of this analysis, and the balance of risks as we perceive them in practice, we argue that a form of selfish recipient state regulation should be employed when responding to SWF activity within their borders. Simply put, we suggest that recipient states ought actively to manage the potential risks associated with SWF investments, and that undue reliance on international “soft law” efforts to regulate SWFs represent at best an unreliable and at worst an irresponsible policy choice. This argument does not, however, deny the importance of international initiatives – such as the Santiago principles – to improve levels of transparency and accountability in SWF management, since such efforts are likely to contribute to higher levels of certainty, particularly in the context of SWF investment in the financial sector – an area which has been a major focus of recent SWF investment and one which remains susceptible to systemic risk. Rather, the point we seek to make is that according to a game theory analysis and an application of that analysis in practice, over reliance on such international “soft law” initiatives is strategically unwise.

2 The rise and rise of SWFs

SWFs have existed for over half a century. For example, the Kuwait Investment Authority has existed since 1953 and the Kiribati Revenue Equalization Reserve Fund since 1956. Nevertheless, around 60 percent of the SWFs active today have been set-up in the past decade or so1. Many of these funds are associated with Middle Eastern countries which have experienced windfall oil revenues, such as the Abu Dhabi Investment Authority (ADIA) in the United Arab Emirates – the world's largest SWF – or the Future Generations Fund located in Kuwait. Also popular as a place of origin for SWFs are a number of developing Asian nations experiencing high surpluses in trade over the last ten years or so – such as the China Investment Corporation of China and Temasek Holdings of Singapore. That said, SWFs are also located in many other jurisdictions experiencing similar oil or trade surpluses, such as in Norway, Russia or Alberta, Canada ( Truman, 2007, pp. 3-4 ) and there have even been calls for some EU states to establish their own funds ( Bloomberg Business Week, 2008 ).

In view of an acknowledged lack of transparency associated with SWF activities it is notoriously difficult to ascertain with any great degree of precision total assets under management. Nevertheless, according to recent estimates, SWFs manage funds totalling around $4.62 trillion, up over half a trillion dollars in the last year ( Preqin Sovereign Wealth Fund Review, 2012 )2 – a sum which is widely expected to more than double by 20153. These figures are over twice the size of total hedge fund assets under management, albeit significantly less than the total amount of funds managed by traditional investment vehicles, such as insurance companies, pension funds, and mutual funds ( Balin, 2008, p. 3 ). However, as extensions of sovereign states, and as global actors operating with uncertain financial objectives and governed by opaque management structures, the burgeoning economic muscle and heightened profile of SWFs has now begun to be matched by an explosion of interest in their operations and activities – and more recently with repeated calls for tighter regulation.

Four different categories of SWF can be identified ( Kunzel, 2001, p. 3 ):

  • savings funds (designed to secure wealth for future generations);
  • fiscal stabilization funds (designed to mitigate volatility in international market prices for natural resources and commodities);
  • pension reserve funds (aimed at producing income for an aging population); and
  • investment reserve corporations (designed to pursue investment policies with higher returns).
  • Although some funds have multiple objectives (and some countries even have more than one fund), typically it is the type of SWF that determines the investment objectives and behaviour of the fund ( Kunzel, 2001, p. 3 ). Research indicates that the majority of established SWFs are, in fact, either savings funds or fiscal stabilization funds, with only a handful of pension funds, and even fewer investment reserve corporations ( Kunzel, 2001, p. 3 ). More generally, while early SWFs favoured relatively secure investments, such as international bonds, in more recent years they have begun to search out higher yields by investing in equity markets as well as in more illiquid assets, including real estate. This reflects the fact that, in contrast to more traditional investment funds, SWFs tend to be relatively immune from short-termist market pressures, and thus often have a higher tolerance for risk, with an emphasis on absolute returns over liquidity.

    While the legal form adopted by SWFs varies, they are normally constituted as one of three basic forms ( IWG, 2008, p. 12 ). First, some SWFs take the form of “pools of assets” without a separate legal identity, which are owned and managed by a country's Ministry of Finance (and often operationally managed by its Central Bank or by a statutory management agency)4. In such cases, specific legislation typically specifies the rules which govern the asset pool. Second, some SWFs are established as separate legal entities which have full capacity to act and are governed by specific constitutive laws (e.g. Kuwait, Korea, Qatar, and United Arab Emirates (ADIA). As such, these funds are afforded explicit public law recognition under their respective legal jurisdictions. Finally, some SWFs take the form of state-owned corporations (e.g. Singapore's Temasek and Government of Singapore Investment Corporation (GIC), or Korea's “Korea Investment Corporation”). Although SWF constituted as corporations are typically governed by their states' general company law provisions5, other SWF-specific laws usually also apply.

    3 Concerns associated with SWF investments and international “soft law” consensus

    In principle, as long-term investors, SWFs have the potential to act as important stablising influences on economic activity, capable of injecting low cost capital into relatively capital starved economies and acting as a spur to innovation and as an engine for growth. Nevertheless, despite having their assets managed separately from official reserves, SWFs are of and for the countries that fund them (i.e. donor states). It is within this context that a number of serious concerns have surfaced with regard to their operations in recipient states. Notwithstanding the fact that these concerns are typically expressed in relation to the operation of SWFs as a monolithic investor class, it would seem that in reality (and to the extent these perceived risks are, in fact...

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