The writer is senior advisor to the International Forum of Sovereign Wealth Funds

Foreign direct investment (FDI) is a cornerstone of global growth, economic interconnectedness and macro-financial stability. State-owned funds such as sovereign wealth funds (SWF) are pivotal in driving these flows and contributing to the economic development of both host and recipient countries.

Since the early 1970s, sovereigns have emerged as a significant investor class, deploying domestic and international capital through various vehicles. These include not only SWFs, but also state-owned enterprises, national development funds, export credit agencies and public pension funds. 

However, a trio of three interconnected phenomena — fragmentation, uncertainty and geopolitics — carrying new and complex financial and non-financial risks, is significantly reshaping the investment landscape. This is particularly true for funds, such as SWFs, capable of assuming long-term risks, where investments are held for at least five years. 

The trio of risks is gradually forcing state-owned funds to reconsider their investment outlook. This is a shift from the past, when they relied solely on traditional asset allocation models, which are primarily driven by inflation, interest rates and growth considerations. 

The current investment environment is unprecedented for SWFs and other internationally active state-owned funds involved in FDI. In 2008, the industry formalised the Santiago Principles, establishing globally accepted SWF standards founded on principles of transparency, accountability, and governance to foster an open and supportive global trade and investment environment. However, today’s landscape starkly contrasts with those assumptions, in light of increased geopolitical considerations, shifting regulatory frameworks, sanctions, tariffs and tax changes.

Disturbing trends

With the global gap between demand for capital and available investible resources widening, four disturbing trends are emerging. These are influencing various types of FDI, including state-owned funds, and have potentially long-term consequences for economic growth.

One is the growth of FDI within blocs of geopolitically aligned countries. Policy-makers are increasingly favouring friend-shoring, nearshoring and reshoring to make supply chains more resilient and less vulnerable to geopolitical tensions. This shift incentivises state-owned funds to realign cross-border capital flows with countries prioritising investments in aligned economies.

Another is a decline in FDI into emerging markets. There are also sectoral shifts, as many traditional FDI sectors are now considered strategic by host governments and are closely scrutinised under national security screening. 

The final disturbing trend is the bearing of the trio of risks on the financial costs of FDI by sovereign-owned funds, which limits the scope for diversification and makes financial assets held by sovereigns more vulnerable to risks.

Three solutions

How must sovereign funds and the recipient countries adapt to this changing landscape? Three things could help.

First, recipient countries play a significant role in helping keep cross-border investment requirements safe and open. Building stronger, long-term relationships with countries from which they receive significant investment could help foster trust and co-operation.

Second, state-owned funds’ continued emphasis on diversifying their portfolios and expanding investments across regions and sectors is one way to mitigate the fallout from the troika of new risks. In this context, embracing climate-related factors in FDI investment decisions will help them foster a common ground with the growing number of recipient countries also focused on these goals.

Third, investing in the frontiers of innovation — such as space, marine, digital and technology-savvy infrastructure — would not only be a forward-thinking approach to state-owned investing, it will also help capture growth potential for both the host and recipient country.

The fragmented global landscape presents significant challenges for allocating state-owned investable capital. But by adopting innovative strategies, diversifying investments, and fostering partnerships, state-owned funds can navigate these complexities and continue to play a vital role in global economic growth and development. However, success will depend on how the recipient countries embrace the opportunities presented and pursue non-discriminatory, fair and equitable investment policies that offer complete protection and security to state investors.

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This article first appeared in the October/November 2024 print edition of fDi Intelligence