Democracy, Veto Player, and Institutionalization of Sovereign Wealth Funds

ABSTRACT

Sovereign Wealth Funds (SWFs) have become important and controversial in global economy. We analyze why some SWFs have more encompassing and clearly specified governance rules than others. We argue that SWF institutionalization is structurally rooted in a country’s regime type and number of veto players in public policymaking. Democracy promotes SWF institutionalization by its need for strong rule of law, voters trying to constrain opportunistic behaviors of politicians, and the free flow of information. In contrast, the number of veto players has a curvilinear effect. When the number of veto players is very small, institutionalization is too rigid, constraining, and not preferred; when the number of veto players is moderate, it is optimal for veto players to manage their conflict over SWF governance in a more routine and institutionalized fashion; and when the number of veto players grows above a threshold, it becomes too costly to coordinate and produce mutually agreeable institutional rules. Our empirical analysis of 46 SWFs in 30 countries from 2007 to 2009 provides robust confirming evidence. SWF governance is more institutionalized and transparent in democracies and in countries with four veto players. Our research has important theoretical and policy implications for the ongoing debate over SWF.

KEYWORDS:

• Democracy
• governance rules
• institutionalization
• veto player
• quantitative analysis
• sovereign wealth fund

Acknowledgment

Authorship shared equally. An earlier version of this article was presented at the 2011 American Political Science Association annual meeting and the 2012 Southern Political Science Association annual meeting. We thank Maya Hadar, Xiaobo Lu, Ken Meier, Jon Pevehouse, Gerald Schneider, Dale Smith, Joe Staats, Michelle Taylor-Robinson, Edwin Truman, and two anonymous reviewers for helpful comments and suggestions.

Supplemental Material

Supplemental data for this article can be accessed on the publisher’s website.

Notes

¹ Here we refer to the clarity of governance rules from the perspective of outside observers. Some SWFs may have rigorous and detailed rules known to their sponsors only but not to the general public. The focus of the current study is the transparency of governance rules to outside observers, since it enables the public to monitor fund behaviors. In addition, we are interested in explaining why wide variations exist from an outside observer’s perspective.

² Most of the other elements that Truman coded and were excluded from our analysis concern fund operations or reporting activities, which are beyond the scope of our study. Yet three of those elements might be relevant to the SWF governance structure. They include (1) Objective: Is the SWF’s objective clearly communicated? (2) Guidelines for corporate responsibility: Does the SWF have in place and publicly available guidelines for corporate responsibility that it follows? (3) Ethnical guidelines: Does the SWF have ethnical guidelines that it follows? The objective element is not included in the analysis because all of the SWFs in our sample have clearly stated objectives, exhibiting no variation. The corporate responsibility and ethics elements are conceptually distinct from the other five elements we study. They emphasize “socially responsible investing,” which is a narrow issue and of interest primarily to nongovernmental organizations and a small number of OECD countries. In a robustness analysis reported in the online appendix at the journal website, we construct an SWF institutionalization index based on seven instead of the first five elements. As expected, factor analysis shows that the seven elements represent two distinct latent variables: long-run structural governance and corporate ethical considerations. Our index correlates with the first factor at 0.94 and with the second factor at 0.32. When we estimate our baseline model using the two seven-element-based factors as dependent variables, the effects of democracy and veto player on structural governance are largely consistent with those in Table 1 reported later. In addition, democracy and veto player do not affect the second factor indicating corporate ethical considerations.

³ For each rule, its presence and greater clarity receives a score of 1, its absence receives a score of 0, and a partial score of 0.50 is occasionally applied when the rule is partially in place.

⁴ For the latter four countries, different levels of institutionalization among different funds may be attributable to fund-level characteristics. Due to data limitation, we cannot account for other fund-level characteristics than those controlled for in following our empirical analysis. We acknowledge this limitation and stress the need for future research.

⁵ For example, in many oil-producer countries and Asian exporters that accumulated massive reserves such as Brazil and Taiwan, key political actors debate over whether to immediately use those massive reserves or to “park” those revenues in long-term investment vehicles and over whether to pursue aggressive or conservative investment strategies (Clark and Knight 2010; Wheatley 2010). In Australia, competition between the Treasurer and the Prime Minister for power within the governing coalition affects the Future Fund, the country’s pension fund (Clark and Knight 2010).

⁶ In a case study of China and Singapore, Shih (2009) shows that a highly unified government is more likely to direct its SWF to maximize long-term profit, whereas an SWF in a politically fragmented environment suffers from domestic political and bureaucratic infighting.

⁷ The case of Ireland’s National Pension Reserve Fund (NPRF) is a good example. When the legislation establishing the NPRF was brought to Parliament, opposition parties were invited to agree or disagree section by section regarding the legislation (Clark and Monk 2011).

⁸ The sample covers 24 SWFs in 22 countries for 2007, 35 funds in 26 countries for 2008, and 42 funds in 28 countries for 2009. Countries included in estimation are Algeria, Australia, Azerbaijan, Bahrain, Botswana, Brunei, Canada, Chile, China, France, Iran, Ireland, Japan, Kazakhstan, Kuwait, Malaysia, Mexico, Netherlands, New Zealand, Nigeria, Norway, Oman, Qatar, Russia, Singapore, South Korea, Sudan, Thailand, Trinidad and Tobago, United Arab Emirates, the United States, and Venezuela.

⁹ The log transformation helps to reduce the skewness of the variable. Our key results do not change if we do not log the variable.

¹⁰ See Bueno de Mesquita, Smith, Siverson, and Morrow 2003; Mansfield, Milner and Pevehouse 2007; and North and Weingast 1989.

¹¹ In order to employ the panel setup, SWF institutionalization ought to vary enough within each country. This is indeed the case, where Figure 1 clearly shows that many countries’ institutionalization scores are not constant over the three-year period. In addition, the within-panel standard deviation (.281) is over double the size of the overall mean (.123), indicating the presence of sufficient variations within country-SWFs.