Related Stories CPI (Management)The Q DayThe M-dealWeak PM in waiting?Karat to carrot

 There’s this new test to check if you are a true believer in liberal economics: would you feel uncomfortable if an investment entity funded and controlled by, say, a Chinese or Russian or a Middle Eastern government buys a big stake in a big company in your country? These entities are called, in self-explanatory fashion, sovereign wealth funds (SWFs). Countries that sit on large piles of foreign exchange reserves — they can afford to spare a portion of reserves for purposes other than maintaining external economic security — set up SWFs. According to a widely quoted Morgan Stanley study, SWFs are likely to command around $12,000 billion by 2015. That’s a lot of money even by global financial standards.

SWFs rescued Wall Street investment banks when the credit crisis started in America. Merrill Lynch and Citigroup received SWF investment in January. Till now, SWF investment in global finance blue chips is nearly $70 billion. So Wall Street is rather happy about SWFs. The PMO isn’t. It recently asked the finance ministry to closely look at these funds. Governments in France and Germany aren’t happy either.

So that’s a no-brainer, right? Savings from savings-surplus countries have helped businesses in savings-deficient countries. Plus, if Wall Street is happy and governments that are not committed economic liberals are worried, SWFs must be good for the liberal economic order. Wrong.

If you are a liberal, you should admit to feeling uncomfortable about SWFs. Have no fear of being labelled an alarmist nationalist. You have nothing to lose but intellectual inconsistency if you argue that SWFs should be treated differently, indeed treated with a great deal of a priori suspicion. Because to argue that SWFs are just another investor in global capitalism is to attack the fundamental precept of capitalism.

The fundamental precept is that private investors are better than governments as investors. This was at the heart of the great intellectual post-War struggle that economic liberals won. This is equally at the heart of the current Indian economic policy discourse. Reforms are essentially about giving private capital the recognition and space it deserves. If liberals support privatisation and are appalled by nationalisation when it comes to domestic capital, why are they unable to see SWFs for what they are: across-the-border quasi-nationalisation?

To argue that government-controlled investment funds be treated at par with private investors simply because the governments happen to be foreign is being rank illogical. This is not about the phobia of things “phoren”. This is Liberal Economics 101.

Remembering this allows liberals to counter another argument, that SWFs are just like private foreign investors as they too want to make money, getting fatter returns on their foreign exchange reserves that otherwise earn small incomes from plain vanilla foreign government bonds. But governments are never about only wanting to make money. That’s the unalterable nature of the beast, and that’s how it should be for the wider business of governance. But for the narrower business of business, this means no matter what governments say, treat their business investments with suspicion.

This principle should end the theoretical debate on whether SWFs should be treated differently from private foreign investors — of course, they should be. But liberals also have an argument from practice.

Many, although not all, SWFs are creatures of patently illiberal states. China and Russia are good examples. This means suspicion of government intentions should intensify — that’s how liberals should view illiberal states. These states are not subject to the kind of internal scrutiny that a liberal political economic system demands. Therefore any investment decision backed by their money is ipso facto dodgier than, say, an investment by the Norwegian SWF. Norway’s is one of the few SWFs that publicises its intentions.

There’s an argument that SWFs will be okay if they increase disclosure. More information about their investment plan will make them look more like private foreign investors. The IMF is working on a set of guidelines about SWF disclosure standards. Much hope is riding on that. But it’s a fundamentally flawed logic.

It is not as if all private investors are models of transparency. Hedge funds are pretty secretive, for example. Indeed, one of the conclusions from the current financial crisis is that there must be more disclosure. If the argument is that SWFs are like other investors but only need to disclose more, it is unfair and illogical to ask only SWFs to open their books. On the other hand, if one explicitly recognises that SWFs are not at all like private investors, a special set of globally agreed upon rules seems more logical. The myth that SWFs are just another set of players needs to be abandoned to make intelligent policy.

And one intelligent policy that governments should consider is to mandate that SWFs, apart from increasing disclosure, can only invest in non-voting shares. The valid suspicion about SWFs is that being government creatures they can’t only be driven by the profit motive. That means if they have shares that offer control, or voting rights, they have the opportunity to act out non-commercial motives.

One more argument needs to be disposed of here. Those who a priori ascribe benign motives to SWFs argue that many SWF-running countries, including those with illiberal governments, also hold huge amounts of foreign government bonds. The classic example is Chinese holdings of US treasury bills. If SWFs are treated with suspicion, the argument goes, how come America isn’t panicking that China may dump US bonds? The reason is China will have to be prepared to take huge capital losses if it dumps US bonds because China’s dollar-denominated assets will fall in value. So both the US and China will suffer. That’s not the case in SWF investment in companies.

A government wanting to further non-commercial goals via a stake in a big company in another country need not fear immediate financial loss. And to say that there are already rules preventing foreign investors, private and foreign, from buying too much stake in critical sectors is not enough. Such negative lists are short in liberal countries, defence, media, civil aviation and a few more sectors. Peddling influence is possible even when SWF stakes are in other sectors. Oil and gas, for example. Increasing the negative list, indeed a negative list itself, is bad, illiberal policy. Much better to recognise SWFs for what they are and restrict their investment to non-voting shares.