Sovereign wealth funds: China's potent economic weapon

Sovereign wealth funds are neither good nor bad, but governments make them so. While the SWF of a country such as Norway may be cheered, those of China and Russia should rightly be feared by the United States.

SWFs are government-run investments financed by excess foreign reserves fueled by chronic trade surpluses. A SWF often acts as a nation's fiscal stabilizer. But China uses its excess foreign reserves in other ways – as a "loss leader" to achieve more nefarious economic goals. A perfect example is China's currency manipulation to boost its exports and create jobs – at the expense of American workers.

To keep the Chinese yuan pegged and undervalued, China first "sterilizes" its export dollars by issuing bonds to Chinese citizens at high interest rates. China's central bank then maintains the dollar-yuan peg by buying US bonds at substantially lower interest rates. While China earns a negative return, its financial loss is more than offset by China's boost in exports and Gross Domestic Product.

China also uses its foreign reserves as a political weapon. Whenever pressure builds in the US to curb China's currency manipulation or other unfair trade practices, Chinese government officials threaten to dump their vast US dollar reserves and stop buying US bonds. This "financial nuclear strike," which would cause interest and mortgage rates to soar and probably trigger a US recession, has effectively cowed US politicians.

Because China has repeatedly demonstrated its willingness to use foreign reserves as an economic and political tool, America has much to lose from the rapidly growing ability of Chinese SWFs to acquire controlling interests in US corporations. One obvious strategic danger is that China may seek to gain control of critical sectors of the US economy – from ports and telecommunications to energy and defense.

Chinese SWFs with controlling interests in US corporations may also try to offshore jobs, managerial best practices, and research and development to China. Even worse, they may also seek to promote technology transfer while nabbing customers in the US. The effect of offshoring jobs and poaching markets hits America's economy immediately – just ask Michigan. Moving America's R&D, managerial elite, and technologies to China significantly reduces future American productivity and growth.

While China poses the most direct SWF threat, Russia and its growing SWF are no strangers to state capitalism and brass-knuckled trade policies either. Exhibit A is Russia's bullying of Europe and Ukraine over access to Russian natural gas reserves at reasonable prices.

Not all SWFs smack of foul play or abuse. As the poster child of a good SWF, Norway's petrodollar-financed fund provides countercyclical "fiscal stabilization." When oil prices are high, Norway adds to its SWF. If oil prices fall, they can draw down their SWF rather than slashing government expenditures.

Norway also knows that its declining oil reserves eventually will cease to be a major revenue source. By growing its SWF now, Norway generates wealth for future generations to continue living in the style that current oil revenues have made them accustomed to. For these reasons, Norway's SWF seeks to maximize its risk-adjusted financial returns – a primary requirement of efficient global markets.

However, the rapid emergence of SWFs calls for a coherent US policy. One major obstacle to swift action is the constructive role SWFs appear to be playing in the current global financial crisis in providing critical liquidity. This should not lull the US into a false sense of security.

SWFs are financed by long-term trade imbalances – petrodollars in the Middle East and trade dollars in Asia. That's why the US needs a comprehensive energy policy to dramatically cut its oil imports and an urgent crackdown on the flagrant array of unfair trading practices that have turned China into the world's biggest "beggar thy neighbor."

America also needs a targeted SWF policy. The US should demand full transparency for any SWF purchasing US assets. This means quarterly and annual reporting requirements that summarize financial returns, major holdings, and objectives.

A second option would limit the percentage of equity shares held in any given company. The level should be set low enough to prevent any SWF from gaining a controlling interest and thereby influencing managerial decisions related to offshoring, R&D, and tech transfer.

Another possible solution would simply limit SWFs to investments in broad-based index funds such as the S&P 500 and Russell 2000. SWFs should also be completely prohibited from investing in any sector, industry, or asset deemed to be strategic for US economic or military purposes.

Global capital markets efficiently allocate resources only if all participants seek to maximize their financial returns. Without regulation, SWFs are a Trojan horse for mercantilism and realpolitik.

• Peter Navarro is business professor at the University of California-Irvine and author of The Coming China Wars. This essay is based on testimony before the US-China Commission on Feb. 7, 2008.