As Libya's citizens rebuild their lives and economy, undoing the corruption in the Libyan Investment Authority (LIA), the sovereign wealth fund (SWF) in which Muammar Gadhafi's regime allegedly stashed and misused Libya's oil wealth, is becoming a priority. The National Transitional Council is debating who should take over Libya's Central Bank and the LIA's assets an especially important decision, given that oil production is not expected to return to pre-war levels for several years.

Regardless of how the Libyan government eventually handles the LIA, all sovereign wealth funds and their advisers and fundraisers can learn several important lessons. Of course, no one should infer from the Libyan case that other SWFs across the board are riddled with corruption and conflicts of interest. The LIA has always been exceptional; indeed, several indices that rank SWFs on transparency, accountability, and governance issues have traditionally given only Iran a lower ranking.

Yet, while hard cases tend to make bad law and it is too early to judge, the LIA should be a wake-up call for corporations and funds both in the Middle East and around the globe.

First, governments should better clarify the sources of funding behind each particular investment. Private funding that turns out to be public funding tied to the ruling family or government ministers presents different political and financial risks and should therefore be valued differently.

Second, the Libyan crisis has crystallized the problem of corporate shares owned by sovereign governments. When the United States and the European Union decided to impose sanctions on the Libyan regime, including freezing shares owned by the LIA in European and American companies, many executives at these companies were surprised by how dramatically their firms were affected by the ownership structure. Clearly, the liquidity of the shares and the perception of a lack of diligence on the part of corporate managers matter mightily.

Third, the LIA saga highlights SWFs' potential cumulative effect on the stability of global markets. All SWFs can respond to global political events by quickly withdrawing funds invested abroad. As one of the WikiLeaks documents revealed, American diplomats lobbied the Libyan government during the financial crisis to keep funds in US banks, and to invest directly in a troubled US financial institution.

In this case, the Libyans did not respond by withdrawing a large amount of funds, but that could happen in the future. Some argue that SWFs' home governments and host countries have too many mutual interests including the stability of the financial system and maintaining the US dollar as the world's reserve currency to threaten global markets. That is true, in normal times, but what happens if many SWFs, responding to sudden uncertainty and volatility, pull back at the same time for diplomatic or commercial reasons? Individually rational behavior is often collectively suicidal.

Finally, the Libyan case and the Dubai debt crisis of 2009 might increase suspicion in the developed world and lead to protectionism against SWFs, especially those from North Africa and the Gulf. The free flow of capital from these regions' SWFs to corporations in the advanced countries is crucial in order to balance the global economy and provide liquidity to financial markets, especially given the prospect of another recession in the West. Both home and host states will have to make sure that the current conflict over the LIA will not impede this important process.

But are people being fair by comparing the various regions' SWFs and expecting them to adhere to Western standards? The current efforts to restructure Libya's Central Bank and LIA will affect markets' perceptions of other sovereign players in the region. Bahrain and Dubai come to mind. Although recent reports of the International Working Group of sovereign funds have indicated the difficulties in applying uniform governance standards, several measures are needed in order to bring Libya back to global capital markets. Despite the unique status of Libya's economy and political system today, scrutinizing the process of investment in foreign companies, as well as defining the nature of the relationships between the Libyan regime and fund management, is necessary to ensure healthy commercial relations between sovereigns and their portfolio investments. Large allocations based on pragmatic political concerns, such as Libya-Italy relations, or cronyism should be reevaluated in the light of better and stronger governance practices.

Both governments and corporations should internalize the message and learn from the Libyan example. The alternative may be too expensive for shareholders and citizens alike.

The author is an international economic law scholar and adviser, and the founder of the Global Center for Economic Development and Security.

Project Syndicate

(China Daily 10/27/2011 page9)