Economics of Sovereign Wealth Funds

Chapter 6 Legal Underpinnings of Capital Account Liberalization for Sovereign Wealth Funds

Udaibir Das, Adnan Mazarei, and Han Hoorn
Published Date:
December 2010
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The opening up of economies to international capital flows has been a key factor supporting the investment activities of sovereign wealth funds (SWFs), as well as the activities of other international investors. For SWFs to obtain their desired returns through investing abroad, they need broad access to foreign financial and fixed assets. Greater openness of regimes to capital flows would offer SWFs greater opportunity to diversify their investment portfolios. Portfolio diversification would reduce the potential risks—both for SWFs and recipient countries—that might otherwise arise as a result of the concentration of investments in certain asset classes or locales.

In the 1990s, proposals were considered to extend the regulatory authority of the IMF into international capital movements (IMF, 1997). Although the proposals to amend the IMF’s Articles of Agreement were not adopted, capital account liberalization has generally continued at other levels. The concept of capital account liberalization generally refers to measures that (1) allow foreigners to acquire and divest domestic financial and fixed assets, including foreign direct investment (FDI; inward liberalization); (2) authorize residents to acquire and divest foreign financial and fixed assets (outward liberalization); and (3) remove restrictions on payments and transfers related to those assets. Countries can achieve capital account liberalization by unilaterally eliminating restrictions under domestic law or pursuant to obligations assumed under international law. Furthermore, in contrast to these two formal “hard law” approaches, “soft law” techniques, entailing adoption and adherence to practice guidelines, also have a place in the capital account liberalization sphere.1

This chapter first addresses the domestic law and international law approaches to capital account liberalization relevant to SWF activities. Next, it considers the mandate of the IMF under its Articles of Agreement, which is part of the international legal order. Finally, it considers the Santiago Principles (IWG, 2008) as an illustration of soft-law techniques that complement (or obviate) hard-law regulation of capital flows.


Several countries have unilaterally taken measures within their domestic legal systems to liberalize their capital accounts, such as removing restrictions on access to local assets and on the repatriation of capital and profits for foreign investors, including SWFs. As an example, in the early 1990s Brazil reduced the tax on remittances abroad of profits and dividends of foreign institutional investors and established foreign capital investment companies.2 Since the mid-2000s, the Brazilian central bank’s prior approval for a foreign investment is no longer required for the registered investor to benefit from the right of repatriation. As another example, India has liberalized its capital account by gradually opening up to FDI and portfolio flows, raising the FDI limit in private sector banks, introducing full convertibility of nonresident deposits, and liberalizing outward FDI.

From the perspective of the recipient country, the advantages of unilateral liberalization are twofold. First, the country retains control over the process, allowing it to set the pace of gradual liberalization, taking into account its overall economic and institutional development (such as the strength of prudential supervision and sophistication of currency markets). Second, as a legal matter, the country remains free at any moment to impose capital controls, which may, for example, be warranted in extreme crisis situations or to protect national security interests. The principal disadvantage of the unilateral approach is that it cannot be levered to obtain similar liberalization in other countries. In addition, compared with liberalization through international law, which may be relatively harder to reverse, the unilateral domestic law approach may pose a higher residual risk for foreign investors that the liberalization might be undone.


Many countries have entered into international agreements facilitating investments and encouraging capital flows into and out of their territories. These agreements include bilateral investment treaties (BITs) and regional treaties relating to trade and investments. The coverage of many of these international agreements is sufficiently broad to protect the investments of SWFs.3

Bilateral Investment Treaties

BITs are agreements between two countries for the promotion and protection of mutual cross-border investments. BITs typically include obligations relating to the protection and fair and equitable treatment of foreign investments and, particularly relevant for SWFs, the guarantee of unrestricted repatriation of funds related to covered investments. This obligation to allow unrestricted transfer of funds aims specifically at liberalizing capital movements related to already-admitted investments. In most BITs, the right to repatriate the proceeds of investments applies with respect to profits, loans, interest, dividends, capital gains, returns in kind, and management fees.

Qualifying the guarantee of unrestricted transfer of funds, many BITs allow contracting states to impose limitations under certain circumstances. Most BITs include more general exceptions to host state obligations, such as exceptions for national security reasons. Some BITs provide for the temporary and nondiscriminatory restriction of funds if there is a threat of balance of payments problems, or if such problems exist (see, e.g., Article 6 of the France-Uganda BIT), provided the restriction is consistent with the IMF’s Articles of Agreement.4 Similarly, some BITs allow contracting states to impose restrictions in circumstances in which they could otherwise restrict transfers under the World Trade Organization Agreement (see Article 14 (7) of the Canada Model BIT).

Regional Trade and Investment Treaties

Regional agreements are entered into between three or more countries for the purposes of regional economic integration and the promotion of cross-border investment and trade. As with BITs, the investment chapters of these agreements typically achieve substantial capital account liberalization by including provisions relating to the free movement of capital and the protection of the free transfer of funds related to investments. Thus, these agreements may support investments by SWFs from within the regional trade bloc, and possibly even beyond. However, as demonstrated by the following examples, though often far-reaching, this liberalization is seldom absolute.

  • North American Free Trade Agreement. NAFTA generally guarantees the freedom of inward and outward transfers related to investments, but permits governments to restrict transfers through equitable and nondiscriminatory means. Governments are also permitted to temporarily and by nondiscriminatory means restrict capital movements if they experience serious balance of payments difficulties, provided that the restrictions are consistent with the IMF’s Articles of Agreement. NAFTA also excludes certain sectors of the economy and certain activities from the nondiscrimination standard.5

  • Gulf Cooperation Council. The GCC generally allows its nationals to engage in economic activities in each other’s territories without limitation, and there are very few restrictions on the movement of capital within the GCC area.6 GCC nationals are thus allowed to own shares in stock companies, albeit with the exclusion of insurance companies and banks. Additionally, equal tax treatment is accorded all GCC nationals owning stock or forming corporations.7

  • Common Market for Eastern and Southern Africa. COMESA encourages member states to take measures—such as the deregulation of interest rates, the harmonization of tax policies with a view to removing tax distortions, and wider monetization of the region’s economies under a liberalized market economy—to facilitate capital movements. The treaty permits the free movement of capital within the common market, but member states may take safeguard measures to deal with the adverse effects of liberalization.8

The European Union (EU) provides the most comprehensive framework for regional capital account liberalization.9 Not only does the EU regime include clear rules promoting the free movement of capital similarly to other regional treaties, but two distinguishing features make it particularly relevant for international investors such as SWFs. First, the EU rules do not only safeguard free capital movements within the EU, but also between the EU member states and third countries.10 Second, the EU legal framework provides for enforcement of those safeguards through administrative action by the European Commission against EU national governments, and through adjudication by national courts within the EU and the European Court of Justice, which has resulted in an extensive set of case law in support of free capital flows.


The IMF’s Articles of Agreement constitute an international law treaty to which each of the IMF’s 187 member countries are a party.11 Under its Articles, the IMF has a distinctive legal mandate comprising elements that, taken together, promote international capital movements relevant for SWFs. The IMF promotes international capital flows through exercise of its jurisdiction with respect to exchange restrictions and surveillance and through provision of financial and technical assistance.


Under Article VIII, Section 2(a) of the IMF’s Articles of Agreement, member countries of the IMF are generally prohibited from imposing restrictions on the making of payments and transfers for current international transactions, absent IMF approval.12 Because of the relatively broad definition of current payments in the Articles, IMF jurisdiction extends to some investment-related payments, such as amortization of debt instruments and net income from investments (which are commonly treated as capital in other contexts). The IMF’s jurisdiction over such broadly defined current outflows is in contrast to the general right of member countries to exercise controls necessary to regulate international capital movements. As recognized under Article VI, Section 3, member countries may choose to permit, prohibit, or limit inward and outward capital movements.13 Although this provision establishes an important legal boundary in the respective authority of the IMF and its member countries over international capital flows, its implications need to be considered in light of the other ways in which the exercise of the IMF’s mandate supports capital account liberalization.

IMF Surveillance

Under Article IV, Section 1 of the Articles of Agreement, the IMF is charged with the responsibility to oversee the functioning of the international monetary system and to exercise surveillance over members’ exchange rate (and underlying economic and financial) policies. The macroeconomic implications of SWFs’ and other large agents of capital’s flows fall within the purview of IMF surveillance. Specifically, the establishment of SWFs, their domestic and cross-border operations, and the response by recipient countries can be relevant in the IMF’s assessment of whether countries are adhering to their obligations under the Articles of Agreement with respect to domestic and external stability.14 Furthermore, for the IMF to carry out its surveillance mandate effectively, the Articles impose obligations on each member to provide specified information to the IMF. Such information, in a number of respects, covers capital flows occasioned by SWFs and other actors. For example, each member country is required to provide the IMF information on the “international investment position; i.e. investments within the territories of the member owned abroad and investments abroad owned by persons in its territories.”15

IMF Financing

Capital flows—including those of SWFs—are germane to the exercise of the IMF’s mandate to financially assist members in resolving balance of payments problems. First, the macroeconomic and financial stability objectives of adjustment programs supported by IMF financing would tend to facilitate international capital flows from SWFs and others. Second, because both the capital and current accounts are part of the assessment of a member country’s balance of payments needs, the openness of the capital account is a factor affecting a member’s potential level of access to IMF financing.16 Third, however, the Articles preclude a member from using IMF financing to meet “a large or sustained outflow of capital” and specifically authorize the IMF to request a member to adopt capital controls to prevent such result.17 One way of cohering these provisions is that they recognize the limited size of financing available from the IMF, especially relative to the volume of international capital movements; accordingly, these provisions seek to ensure that IMF financing would not be wasted in circumstances in which the tool of capital controls is open to members. Finally, the delicate balance of authority with respect to capital movements has established the position that the IMF will not require capital account liberalization as a condition for a member country’s access to IMF financing (Evens and Quirk, 1995). In sum, the legal parameters of IMF balance of payments financing to member countries represent a component of the international environment for the investment and exit decisions of SWFs.

Technical Assistance

The IMF’s technical assistance mandate also contributes to the legal and regulatory framework for capital movements in which SWFs and other actors operate.18 Over the years, the IMF has provided extensive advice on the infrastructure, regulatory tools, and sequencing of measures to support capital flows. Technical assistance has more broadly covered monetary, fiscal, and balance sheet risk management and statistical issues, including their legal dimensions. Notably, the involvement of the IMF in facilitating the process leading to the Santiago Principles emanated principally from its technical assistance mandate.


The Santiago Principles resulted from a collaborative effort of SWFs to reflect appropriate governance and accountability arrangements in addition to sound investment practices. As a voluntary code of conduct among SWFs, the Santiago Principles do not alter the legal frameworks in SWF home countries. Rather, through guiding the practices of SWFs and thereby making them more effective exporters of capital, the Santiago Principles can be seen as a soft-law instrument for capital account liberalization. Furthermore, this soft-law approach on the part of SWF countries has the benefit of alleviating concerns of recipient countries, and thus mitigating the risk of hard-law regulation that could restrict SWF capital flows.

Although it is generally recognized that SWF investments have helped promote economic development in both capital-exporting and -receiving countries, the size and rapid growth of SWFs have raised concerns in recipient countries about SWFs’ investment objectives and institutional governance structures. To address these concerns, SWFs formed the International Working Group (IWG) in May 2008 to develop a framework of principles that would enhance the understanding of SWFs as economically and financially oriented entities in both the home and recipient countries.19 Facilitated by IMF staff, the IWG in October 2008 published the Santiago Principles, comprising a set of 24 generally accepted principles and practices. In parallel to the process leading to the Santiago Principles, many recipient countries adopted in June 2008 the Organisation for Economic Co-operation and Development “Declaration on Sovereign Wealth Funds and Recipient Country Policies,” which sets out some soft-law principles for OECD member countries receiving SWF investments (OECD, 2008).20

The process of open dialogue among SWFs, recipient countries, and the international community has been a positive factor in promoting an environment open to capital flows. Furthermore, the Santiago Principles support the preservation of the free flow of cross-border investment by promoting operational independence in investment decisions, and transparency and accountability of SWFs to ensure that SWFs invest on the basis of economic and financial risk and return-related considerations. In particular,

  • Sound legal framework. The Santiago Principles (1–5) call for a sound legal framework to underpin the establishment of the SWF, its operations, and its dealings with third parties. The legal framework should provide a clear delineation of responsibilities between the SWF and other governmental entities. It should ensure legal soundness of the SWF and its transactions by clearly specifying the beneficial and legal owners of an SWF’s assets irrespective of the particular legal structure of the SWF (e.g., a state-owned corporation or a pool of assets without a separate legal identity). In addition, because the SWF’s policy purpose guides its investment policy and asset management strategy, that policy purpose should be clearly defined and publicly disclosed to demonstrate the economic and financial objectives of the SWF.

  • Sound governance. The Santiago Principles (6–9) promote a sound and transparent institutional and governance framework that provides for operational independence in the management of SWFs, free of political interference or influence. The governance structure should clearly separate the functions of the owner, governing bodies, and management. Such a structure helps make SWFs more effective and efficient in achieving their defined objectives, thereby contributing to stable capital flows.

  • Accountability. The Santiago Principles (10–17) support annual internal and external audits of the SWF’s operations and financial statements to bolster accountability. In addition, the objectives, investment policies, and financial information concerning an SWF should be publicly disclosed. These principles aim to facilitate a better understanding of how public monies are used in the home country, thereby promoting accountability, while at the same time demonstrating the economic and financial orientation of SWFs to recipient countries.

  • Reliable risk management. The Santiago Principles (22–23) help preserve capital flows by requiring SWFs to put in place reliable and transparent risk-management frameworks that enable effective and efficient management of financial, operational, regulatory, and reputational risks. This requirement also helps enhance confidence in recipient countries that SWFs adhere to high standards of risk management to ensure the soundness and integrity of their operations.

  • Legal and regulatory compliance. The Santiago Principles (15) reaffirm SWFs’ commitment to comply with applicable regulatory and disclosure requirements in recipient countries. SWFs thus expect to be treated in the same manner as other foreign or domestic investors in similar circumstances. These principles aspire to foster trust in recipient countries and dispel concerns about undue political influence over SWF operations.

  • Exercise of voting rights. The Santiago Principles (20–21) require an SWF to exercise its voting rights in a manner consistent with its investment policy by disclosing beforehand whether and how it exercises voting rights and its general approach to board representation. The principles aim to strike an appropriate balance between the need for SWFs, like other shareholders, to protect their financial interests and the need to alleviate concerns about noncommercial investment objectives and national security in recipient countries. In addition, the principles call for SWFs not to take advantage of privileged information or inappropriate influence by the broader government to promote fair competition with private entities by requiring SWFs to further demonstrate their economic and financial orientation.

While the Santiago Principles are intended to be achievable by SWFs at all levels of economic development, a transitional period is envisioned for some newly established SWFs. Each SWF is expected to engage in a regular review of its implementation of the Santiago Principles through self-assessment or other mechanisms. To further foster confidence by recipient countries, the IWG reached a consensus in April 2009 to establish the International Forum of Sovereign Wealth Funds, a standing group of SWFs charged with keeping the Santiago Principles under review and monitoring implementation. Thus, the process of dialogue and engagement is ongoing.

Within this ongoing process, the Santiago Principles represent a significant achievement by the SWFs and the wider international community. They illustrate that soft-law techniques can operate in tandem with domestic and international law instruments, including instruments of the IMF, to promote a more orderly international system of capital flows.


The global financial crisis has reignited and in some respects redirected debates on the legal tools and policy objectives of regulating international capital flows. In particular, the use of capital controls on inflows as a part of the toolkit of measures designed to forestall macroeconomic imbalances is receiving new attention. The continuing high profile of SWFs can be expected to influence the analysis and outcome of the broader debate on the relationship between public and private actors in the flow of international capital.


Soft law includes “general principles which might contribute to the interpretation of related legally binding rules of ‘hard law’” (Giovanoli, 2002, p. 7).

With the reintroduction of the tax on foreign exchange inflow transactions in October 2009, one of these measures was reversed.

While international investment treaties were historically designed to protect foreign private investors, some have been explicitly extended to cover investments of foreign state-owned enterprises or other public entities.

A discussion of the relevant requirements under the IMF’s Articles of Agreement occurs later in this chapter.

Article 1109 NAFTA.

The authors of this chapter are not aware of a settled interpretation of the GCC rules clarifying the extent to which investments of SWFs are covered under the regime.

Article 8(4) GCC Charter.

Article 81 COMESA Treaty.

Note that the EU rules do not exclude foreign states or state-owned entities from the benefit of the provisions on freedom of capital movement.

In limited circumstances, the EU rules allow the EU (Articles 57.2 and 59 of the Treaty Establishing the European Community, as amended by the Treaty of Amsterdam [EC Treaty]) and the member states (Articles 58 and 60.2 of the EC Treaty) to take certain measures that may restrict capital movements.

The Articles establish the IMF as an international institution and, among other things, define the objectives and instruments of the IMF and the respective rights and obligations of the IMF and its member countries.

Similarly, the IMF’s Articles require that members not impose multiple currency practices or discriminatory currency arrangements. Default by a government on its external payment obligations does not give rise to a “restriction” subject to IMF jurisdiction. Whether an external payment default by an SWF would amount to a government default–thus outside IMF jurisdiction–would depend on the legal and operational relationship between the SWF and the government, including whether the SWF is a legally separate entity. If a government through exercise of its ownership interest (rather than through regulations of general applicability) directs nonpayment of a legally separate entity’s external obligations, the action is treated as a government default by the IMF.

Notably, the March 2009 report of the Committee of Eminent Persons (established by the managing director of the IMF as part of the ongoing debate of reform of the IMF) advised that extension of the IMF’s mandate over international capital movements should be revisited. See IMF, 2009a.

Accordingly, SWFs have been discussed in a number of IMF surveillance reports. See, for example, IMF, 2008, 2009b.

Article VIII, Section 5(viii) of the IMF’s Articles. In furnishing this information, a member country is not required to disaggregate the data to identify the positions of particular actors, such as SWFs.

The concept of a member’s balance of payments needs includes the need to bolster foreign exchange reserves. Depending on how foreign assets of an SWF are managed, they could be part of the foreign exchange reserves. Moreover, international financing from SWFs are part of a country’s balance of payments.

Article VI, Section 1(a) of the IMF’s Articles.

Article V, Section 2(b) of the IMF’s Articles provides that, “if requested, the IMF may decide to perform financial and technical services … that are consistent with the purposes of the IMF.”

The creation of the IWG also responded to calls by the International Monetary and Financial Committee of the IMF in October 2007 and April 2008. The IWG comprised representatives from 23 IMF member countries.

These principles include no protectionist barriers to foreign investment, no discrimination among investors in like circumstances, and the imposition of investment safeguards only for legitimate national security concerns. In addition, the OECD in May 2009 adopted guidelines to avoid the protectionist use of security measures (OECD, 2009).

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