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Sovereign wealth funds: China's potent economic weapon

SWFs can act as a nation's fiscal stabilizer, but can also be used to achievemore nefarious economic goals.

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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.

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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.