This post originally appeared in the Financial Times.
In recent weeks, rising trade tensions between the US and China and around the world have increased the likelihood that investment protectionism — blocking the free flow of capital across borders — is the next policy shoe to drop. Coupled with what some see as a growing probability of recession, this development poses added risk to the health of the global financial system and economy.
We experienced similar risks of investment protectionism a decade ago, leveled predominantly against sovereign wealth funds. A resurgence of investment protectionism blocking capital flows and targeting public megafunds would be even more perilous today because of the elevated role they play in capital markets.
Megafunds, what we call the largest sovereign wealth funds, national pension funds, and other massive public pools of capital, represent a relatively new phenomenon and the rapidity of their growth is noteworthy.
Over the past two decades, their wealth increased faster than most countries. Today, just 40 of these funds command approximately $12tn in assets, holding an estimated 5-10 per cent of the investible assets and representing nearly the amount of wealth held by the UK.
As a function of their size, influence, and investment approach, megafunds have meaningful impact on the flow and formation of capital, and are providers of liquidity to financial markets. Policymakers should take heed of the role they play in the global economy.
First, as investors, these funds deploy capital where others can’t or won’t, pushing the frontiers of capital markets. They have large balance sheets, sophisticated investment teams, few constraints, global portfolios and high risk tolerance.
We see this through the implementation of their asset allocations, which tend to skew more heavily towards riskier equity and equity-like instruments and more illiquid and alternative instruments — such as private equity, real estate, infrastructure, private credit.
This approach drives the expansion of capital formation by investing where liquidity is limited. For example, megafunds have played a large role in the growth and development of private capital markets, driving hundreds of billions of dollars of capital into private companies and public infrastructure.
Second, they can play a stabilizing force in capital markets. Megafunds typically have long-dated or open-ended liabilities, target long-term strategic asset allocations and limit their use of financial leverage. They provide stability to borrowers by providing long-term, stable capital and are less likely than many other investors to be squeezed by short-term liquidity needs.
As a result, they can be a source of needed liquidity for borrowers, especially in times of duress. During the last financial crisis for example, sovereign investors injected more than $100bn of extremely scarce capital into western financial institutions, in many cases ensuring their solvency.
They also provide systemic stability to capital markets by “rebalancing” their liquid portfolios to their asset allocation targets, which has a volatility damping effect on markets because it requires selling assets that have rallied in price and buying assets that have sold off.
And what about concerns that these state-funded investors, in particular sovereign wealth funds, would wield their capital in pursuit of political aims, rather than in support of free markets?
Over a decade ago, in response to rising investment protectionism, investors and policymakers came together to create a series of policy principles outlining best practices for sovereign investors to promote commercially motivated investing, the Santiago Principles, and for recipient countries to guard against protectionist barriers to foreign investment.
In reviewing trillions of dollars of megafund investment activity since then, with a few headline-catching exceptions, these investors appear to have for the most part acted responsibly with free market economic motivations.
Of course those investments that have national security implications must be carefully reviewed and controlled, and we must be vigilant about ensuring appropriately high standards regarding behavior for public investment. But as policymakers seek to simultaneously navigate growing conflict around trade and investment, they must recognize that the evolution in size and composition of capital markets increases the risks posed by investment protectionism.
Today, megafunds are an important source of capital and financial market stability. Policy actions that affect their behavior should be undertaken with great care.