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I N T E R N A T I O N A L M O N E T A R Y F U N D
EDITORS
Udaibir S. Das, Adnan Mazarei, and Han van der Hoorn
Economics of Sovereign Wealth Funds
Issues for Policymakers
©International Monetary Fund. Not for Redistribution
© 2010 International Monetary Fund
Cataloging-in-Publication Data
Economics of sovereign wealth funds: issues for policymakers/edited by Udaibir S. Das, Adnan Mazarei, and Han van der Hoorn.—Washington, D.C.: International Monetary Fund, 2010. p. ; cm.
Includes bibliographical references. ISBN 978-1-58906-927-5 1. Sovereign wealth funds. I. Das, Udaibir S. II. Mazarei, Adnan. III. Hoorn, Han van der.
IV. International Monetary Fund. HJ3801.E26 2010
Disclaimer: The views expressed in this book are those of the authors and should not be reported as or attributed to the International Monetary Fund, its Executive Board, or the governments of any of its members.
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iii
Foreword xi
Acknowledgments xiii
Introduction xv
Abbreviations and Acronyms xxi
SECTION I ROLE AND MACROFINANCIAL RELEVANCE ..............................1
1 Demystifying Sovereign Wealth Funds ................................................................. 3Espen Klitzing, Diaan-Yi Lin, Susan Lund, and Laurent Nordin Understanding the Rise of SWFs ..............................................................................................................................................................4
The Diverse Aims and Investment Strategies of SWFs...............................................................................................................6
SWFs Remain Powerful, Despite the Financial Crisis ...................................................................................................................8
SWFs Will Remain Long-Term Investors, but the Crisis Has Prompted Some Shifts ................................................9
SWFs Will Continue to Grow .................................................................................................................................................................... 11
References ........................................................................................................................................................................................................... 13
2 From Reserves Accumulation to Sovereign Wealth Fund: Policy and Macrofinancial Considerations ............................................................................... 15Yinqiu Lu, Christian Mulder, and Michael Papaioannou Adequate Level of Foreign Reserves .................................................................................................................................................. 16
Options for Ample Reserves .................................................................................................................................................................... 18
Support from the SWF in a Financial Crisis .................................................................................................................................... 19
Macrofinancial Linkages Associated with Management of an SWF............................................................................... 20
Conclusion .......................................................................................................................................................................................................... 22
References ........................................................................................................................................................................................................... 23
3 Sovereign Wealth Funds: New Economic Realities and the Political Responses .......................................................................................................................25Steffen Kern Cross-Border Investments: Toward a Global Diffusion of Corporate Ownership? ................................................. 26
SWFs as Foreign Investors in the United States and the EU: The Policy Issues ....................................................... 31
Policy Responses: A Danger of Protectionist Reflexes?........................................................................................................... 33
The International Dimension: Ensuring Open Markets in a Fragmented Regulatory Environment .......... 36
Good Conduct by SWFs: The Key to Greater Acceptance in Recipient Countries ................................................ 38
Conclusion: The Global Perspective .................................................................................................................................................... 39
References ........................................................................................................................................................................................................... 40
4 Sovereign Wealth Funds and Economic Policy at Home ..............................43Jon Shields and Mauricio Villafuerte The Role of an SWF Within the Overall Macroeconomic Policy Framework ............................................................ 44
Accountability ................................................................................................................................................................................................... 53
Conclusion .......................................................................................................................................................................................................... 55
References ........................................................................................................................................................................................................... 56
Contents
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iv Contents
SECTION II INSTITUTIONAL FACTORS ......................................................... 57
5 Sovereign Wealth Funds and the Santiago Principles ...................................59Udaibir S. Das, Adnan Mazarei, and Alison Stuart SWFs: Objectives and Taxonomy .......................................................................................................................................................... 60
Issues Surrounding SWFs ........................................................................................................................................................................... 61
The IWG and the Development of the Santiago Principles................................................................................................. 63
The Key Features of the Santiago Principles.................................................................................................................................. 65
Concluding Observations and the Road Ahead ......................................................................................................................... 70
References ........................................................................................................................................................................................................... 73
6 Legal Underpinnings of Capital Account Liberalization for Sovereign Wealth Funds ...........................................................................................75Wouter Bossu, Obianuju Ezejiofor, Thomas Laryea, and Yan Liu Domestic Law ................................................................................................................................................................................................... 76
International Law ............................................................................................................................................................................................ 76
International Law Under the IMF’s Articles of Agreement ................................................................................................... 78
IMF Jurisdiction over Restrictions on Current Payments ....................................................................................................... 79
Soft Law Through the Santiago Principles ...................................................................................................................................... 81
Looking Forward ............................................................................................................................................................................................. 83
References ........................................................................................................................................................................................................... 83
7 Sovereign Wealth Funds: Investment Flows and the Role of Transparency ............................................................................................................85Robert Heath and Antonio Galicia-Escotto Cross-Border Data ........................................................................................................................................................................................... 86
Domestic Statistics ......................................................................................................................................................................................... 89
How Do SWFs Fit into External Sector Statistics? ....................................................................................................................... 90
Statistical Data Reporting Practices of SWFs ................................................................................................................................. 91
Conclusion .......................................................................................................................................................................................................... 92
References ........................................................................................................................................................................................................... 92
8 Regulating a Sovereign Wealth Fund Through an External Fund Manager...............................................................................................................95André de Palma, Luc Leruth, and Adnan Mazarei Regulating the SWF Operating Overseas Through an External Fund Manager ..................................................... 97
A Simple Model ............................................................................................................................................................................................... 99
Results, Interpretations, and Policy Implications ......................................................................................................................103
P-A Players with Multiple Objectives ................................................................................................................................................106
Conclusion ........................................................................................................................................................................................................110
References .........................................................................................................................................................................................................110
Annex: A Dynamic Model of Learning by Investing ...............................................................................................................111
9 Sovereign Wealth Funds and Recipient-Country Investment Policies: OECD Perspectives ................................................................................................... 113Kathryn Gordon Reaffirmation of the Relevance of OECD Investment Principles for Fair Treatment of SWFs .......................114
National Security Is a Legitimate Concern but Should Not Be Used to Disguise Protectionism...............115
OECD Guidelines for Recipient Country Policies Relating to National Security....................................................117
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Follow-Up Through the FOI Process Hosted at the OECD .................................................................................................117
Background Documents by the OECD Secretariat ..................................................................................................................120
OECD Investment Instruments ............................................................................................................................................................121
SECTION III INVESTMENT APPROACHES AND FINANCIAL MARKETS 123
10 Sovereign Wealth Fund Investment Strategies: Complementing Central Bank Investment Strategies .................................................................. 125Stephen L. Jen SWFs’ Growth Tempered by the Financial Crisis: US$11 Trillion by 2015 ...................................................................126
SWFs Are Likely to Continue to Seek Higher Returns with Higher Risk .....................................................................127
Sources of Capital Matter for SWFs’ Risk Tolerance ..................................................................................................................129
A 25:45:30 Long-Term Model Portfolio for SWFs ......................................................................................................................131
Less “Sibling Rivalry” Between Central Banks and SWFs? .....................................................................................................132
Sovereign Pension Funds.........................................................................................................................................................................134
Conclusion ........................................................................................................................................................................................................135
Reference ...........................................................................................................................................................................................................136
11 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm ................................................................................................. 137Peter Kunzel, Yinqiu Lu, Iva Petrova, and Jukka Pihlman Classification of SWFs and Its Implications ...................................................................................................................................137
Theoretical Considerations Behind SWFs’ Strategic Asset Allocations ........................................................................140
Comparison of SWFs’ Observed Asset Allocations ..................................................................................................................141
Unraveling of the Crisis .............................................................................................................................................................................142
Implications of the Crisis for Strategic Asset Allocations .....................................................................................................146
Policy Challenges Ahead..........................................................................................................................................................................148
Conclusion ........................................................................................................................................................................................................149
References .........................................................................................................................................................................................................150
12 Managing a Sovereign Wealth Fund: A View from Practitioners ............ 151Didier Darcet, Michael du Jeu, and Thomas S. Coleman Risk-Return Perception of a Long-Term Investor ......................................................................................................................152
The Utility Function of SWFs..................................................................................................................................................................157
SWFs: Investment Strategy and Risk Management in Practice .......................................................................................163
Conclusion ........................................................................................................................................................................................................171
References .........................................................................................................................................................................................................171
13 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis ........................................................................................ 173Tao Sun and Heiko Hesse Literature Review ..........................................................................................................................................................................................174
Data and Methodology ............................................................................................................................................................................176
Empirical Results............................................................................................................................................................................................180
Conclusion ........................................................................................................................................................................................................185
References .........................................................................................................................................................................................................185
14 The Macroeconomic Impact of Sovereign Wealth Funds .......................... 187Julie Kozack, Doug Laxton, and Krishna Srinivasan Current and Future Size of SWFs .........................................................................................................................................................189
How Have SWFs Coped with the 2007–09 Global Financial Crisis? .............................................................................192
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Implications for Global Capital Flows and Asset Prices ........................................................................................................194
Conclusion ........................................................................................................................................................................................................204
References .........................................................................................................................................................................................................204
15 A Market View on the Impact of Sovereign Wealth Funds on Global Financial Markets ...................................................................................................... 205Jens Nystedt Absolute and Relative Size of SWFs in Context .........................................................................................................................206
How Do SWFs’ Publicly Announced Equity Investments Affect Markets? ..............................................................209
Where Do SWFs Invest? ............................................................................................................................................................................210
Market and Macro Implications of the Shift Toward SWFs from Official Reserves ..............................................212
How Do Market Participants React to SWF Investments? ..................................................................................................215
Market Impact and Transparency .......................................................................................................................................................217
Conclusion ........................................................................................................................................................................................................218
References .........................................................................................................................................................................................................220
SECTION IV POSTCRISIS OUTLOOK ................................................................... 223
16 Sovereign Wealth Funds in the New Normal ................................................. 225Mohamed A. El-Erian SWFs and the Global Financial Crisis ................................................................................................................................................226
Aftermath of the Financial Crisis: A New Normal .....................................................................................................................228
Implications for SWFs .................................................................................................................................................................................230
Conclusion ........................................................................................................................................................................................................233
References .........................................................................................................................................................................................................233
17 The Future of Sovereign Wealth Funds ............................................................ 235Edwin M. Truman The Past: Prologue to the Future.........................................................................................................................................................235
The Future .........................................................................................................................................................................................................239
Conclusion ........................................................................................................................................................................................................242
References .........................................................................................................................................................................................................242
18 Long-Term Implications of the Global Financial Crisis for Sovereign Wealth Funds ........................................................................................ 245Andrew Rozanov Sovereign Assets and Liabilities: A Broader Perspective ......................................................................................................248
Domestic Sovereign Investments: Toward a New Washington Consensus ............................................................252
References .........................................................................................................................................................................................................255
Annex ...................................................................................................................................................................................................................257
19 A Final Word: Views of the Sovereigns .............................................................. 259A. Alberta Heritage Savings Trust Fund: Looking Forward ....................... 259 Aaron Brown and Rod MathesonB. Managing Chile’s SWFs Beyond the Global Financial Crisis ................. 262 Eric Parrado
C. SWFS and Recipient Countries: Toward a Win-Win Situation ............. 270
Jin Liqun
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D. The New Zealand Superannuation Fund: Surviving Through and
Seeing Beyond the Global Financial Crisis ...................................................... 273
Adrian Orr
E. Norway: Dealing with Risk in an Uncertain World ................................ 276
Thomas Ekeli and Martin Skancke
F. The Russian Federation: Challenges for a Rainy Day ............................. 277
Peter Kazakevitch and Alexandra Trishkina
APPENDICES ........................................................................................................................... 281
1 The Santiago Principles .......................................................................................... 281
2 The International Forum of Sovereign Wealth Funds ................................. 285
Contributors .............................................................................................................................287
Index ...........................................................................................................................................299
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Figures Figure 1.1. Petrodollar and Asian SWFs Rank Among the Largest .......................................................................5
Figure 1.2. Foreign Reserves in Central Banks Account for 90 Percent of Asian Sovereign
Foreign Assets ...............................................................................................................................................................6
Figure 1.3. SWF Investment Strategies Vary Widely .......................................................................................................8
Figure 1.4. SWF Assets Held Steady in 2008 .......................................................................................................................9
Figure 1.5. SWF Assets Could Reach US$4.3 Trillion by 2013 ................................................................................12
Figure 3.1. Regional Distribution of Assets Held by Sovereign Investors, Percentage of Total,
May 2010 .......................................................................................................................................................................26
Figure 3.2. Financial Assets and Markets Worldwide, by Volume ......................................................................27
Figure 3.3. Sovereign Investments and Asset Sales, 1995–2009 ........................................................................28
Figure 3.4. Sovereign Investments by Size of Acquired Stakes ..........................................................................29
Figure 3.5. Projected Growth in SWF Assets through 2020 ...................................................................................30
Figure 3.6. Effects of SWF Investments on Bank Share Prices ..............................................................................32
Figure 7.1. Statistical Data Provided by SWFs to Compiling Agencies (Percentage of
Respondents) .............................................................................................................................................................91
Figure 7.2. Primary Sources of Funds for SWFs (Percentage of Respondents) ..........................................92
Figure 8.1. An SWF Invests through a Recipient-Country Fund Manager................................................. 100
Figure 8.2. Additional P-A Relationships ......................................................................................................................... 101
Figure 10.1. AUM of the World's SWFs Could Reach US$22 Trillion by 2020 ............................................. 127
Figure 10.2. Relative Buy-and-Hold Returns of Various Asset Classes ............................................................. 128
Figure 10.3. Risk-Return Profiles of Different Asset Classes .................................................................................... 128
Figure 10.4. How SWFs Affect Financial Risk-Return Balance ............................................................................... 130
Figure 10.5. Central Banks to Invest in Equities and Corporate Bonds .......................................................... 133
Figure 11.1. Precrisis SWF Asset Allocation (Percentages) ...................................................................................... 143
Figure 11.2. SWF Returns (Percent), 2008.......................................................................................................................... 144
Figure 11.3. SWF Returns (Percent), 2009.......................................................................................................................... 145
Figure 11.4. SWF Assets Under Management, December 2007–December 2009 ................................. 145
Figure 11.5. Postcrisis SWF Asset Allocation (Percentages) ................................................................................... 147
Figure 12.1. Distribution of Returns ...................................................................................................................................... 154
Figure 12.2. Diagrammatic Representation of VaR for Higher-Volatility Equities Shifting
Below VaR for Lower-Volatility Bonds ...................................................................................................... 154
Figure 12.3. Empirical Distribution of Losses Based on Historical Returns, 1907–2008 ....................... 155
Figure 12.4. SWF Utility Function Components ............................................................................................................ 158
Figure 12.5. Financial Utility Function for an SWF ....................................................................................................... 158
Figure 12.6. Drawdown Risk as a Function of Past Drawdown ........................................................................... 160
Figure 12.7. Correlation of Asset Classes with Inflation, 1900–2009 ................................................................ 162
Figure 12.8. Return-to-Risk Ratio Across the Economic Cycle, Equities (S&P 500) and
Debt (U.S. Treasury Bond, 10-Year), Annualized Real Returns and
Volatilities, 1900–2009 ....................................................................................................................................... 163
Figure 12.9. Returns to Asset Classes over the Economic Cycle, 1900–2009 ............................................. 165
Figure 12.10. Returns to S&P 500 in Various Market Phases as a Function of P/E Ratio ......................... 166
Figure 12.11. Annualized Earnings Growth in the United States, 1985–2007 .............................................. 167
Figure 13.1. Ratios of SWF Investments and Divestments ..................................................................................... 179
Figure 14.1. Emerging-Economy Reserves ....................................................................................................................... 187
Figure 14.2. SWF Formation ....................................................................................................................................................... 188
Figure 14.3. SWFs by Region .................................................................................................................................................... 191
Figure 14.4. SWFs by Type .......................................................................................................................................................... 191
Figure 14.5. SWF Projections by Region, 2014 ............................................................................................................... 192
Figure 14.6. Currency Composition of Stylized Portfolios ...................................................................................... 197
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Figure 14.7. Change in Pattern of Capital Flows, by Currency ............................................................................. 198
Figure 14.8. Model Simulations, Deviations from Baseline .................................................................................... 200
Figure 15.1. Emerging-Market SWFs Tend to Invest Locally .................................................................................. 211
Figure 15.2. Value of SWFs’ Investments by Target Sector ...................................................................................... 214
Figure 15.3. Large Potential for Emerging-Market Central Bank Reserves Diversification ................. 215
Figure 19B.1. Fiscal Savings Rule ............................................................................................................................................... 263
Figure 19B.2. Governance Structure........................................................................................................................................ 264
Figure 19B.3. Asset Allocation ..................................................................................................................................................... 264
Figure 19B.4. ESSF Market Value ................................................................................................................................................ 267
Figure 19B.5. PRF Market Value .................................................................................................................................................. 268
Figure 19B.6. Fiscal and Monetary Stimulus ....................................................................................................................... 268
Figure 19B.7. Current Investment Policy vs. Financial Committee Recommendation ............................ 270
TablesTable 7.1. Statistical Initiatives to Improve Transparency on Cross-Border Flows .................................87
Table 10.1. Sovereign Pension Funds ................................................................................................................................ 135
Table 11.1. Sovereign Wealth Fund Classification ...................................................................................................... 138
Table 12.1. Real Returns Across U.S. Asset Classes, 1928–2008 ......................................................................... 153
Table 12.2. Real U.S. Equity Returns by Category, 1925–2008 ........................................................................... 153
Table 12.3. U.S. Assets’ Returns in Early Recession and Expansion Phases, 1928–2008 ..................... 156
Table 12.4. Drawdowns by Asset Class, 1928–2008 ................................................................................................. 157
Table 12.5. Return Correlation Matrix, Real U.S. Assets, 1945–2008 ............................................................... 161
Table 12.6. Total Returns to Equities, S&P 500, 1901–2009 .................................................................................. 167
Table 13.1. Country of Target Firms .................................................................................................................................... 178
Table 13.2. Events by Acquiring SWF ................................................................................................................................. 178
Table 13.3. Stock Market Reactions to Announcements of SWF Investments and
Divestments (Total Returns in Percent) .................................................................................................. 181
Table 13.4. Stock Market Reactions to Announcements of SWF Investments and
Divestments (Using Price Indices, Returns in Percent) ................................................................. 183
Table 14.1. Estimated SWF Assets Under Management, End-2008 ................................................................ 190
Table 14.2. Gross Value of SWF Transactions (US$ billion) .................................................................................... 194
BoxesBox 4.1. SWFs’ Objectives: Selected Examples ........................................................................................................47
Box 4.2. SWFs and the Global Financial Crisis .........................................................................................................49
Box 5.1. The Santiago Principles: Elements Addressing Issues Raised ....................................................66
Box 9.1. Investment Policy Principles Established in the OECD Acquis ............................................... 115
Box 9.2. Guidelines for Recipient Country Investment Policies Relating to
National Security. .................................................................................................................................................. 118
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Foreword
This volume is focused on the economics of sovereign wealth funds (SWFs). It is intended to increase the understanding of SWFs and to help guide informed discussions about them. The book features contributions by leading experts and reflects the IMF’s ongoing commitment to these important participants in the international monetary and financial system.
The global financial crisis that erupted in 2007 replaced SWFs as the center of financial policy debates. Previously, much attention had been focused on the objectives of SWFs and the potential implications of their investment decisions. Interest in SWFs likely will increase again in the coming quarters—many of the factors that boosted their importance will persist, especially the large foreign exchange earnings of commodity producers. Moreover, international capital flows are expanding again as the financial crisis recedes and the global economy mends. Proposals now under consideration for avoiding future crises likely will affect SWFs, either directly or indirectly.
The recent crisis created many serious challenges, but it also provided impor-tant lessons about the need for stronger risk management, greater transparency, and stronger supervision of all financial institutions. With regard to SWFs spe-cifically, a few issues are particularly relevant. Recent events underscored that SWFs work best when they are integrated into their sponsoring government’s overall policy framework. In this context, it is important that adequate informa-tion is provided to stakeholders and that SWF operations are reflected in national accounts. The funding and withdrawal rules for SWFs should be con-sistent with their objectives, underpinned by well-framed corporate governance arrangements.
In general, sponsoring governments set SWFs’ objectives and governance structures, including well-defined accountability frameworks. These measures are intended to create clear roles and responsibilities for, and interrelationships between, the different entities involved in SWF administration and management. An important element in determining an SWF’s effectiveness is its operational independence in making investment decisions. Thus, SWFs need investment management that is consistent with their policy objectives and that covers their asset choices as well as their risk-management practices.
These key considerations are reflected in the Santiago Principles that were agreed to by the SWFs in 2008, following extensive consultations. The principles have contributed to greater understanding of SWFs and have enhanced their overall credibility. Implementation of the principles continues to advance. For example, more SWFs are publishing annual reports. Moreover, SWFs have estab-lished an International Forum to share views on the application of the principles, among other things. Ongoing implementation of the Santiago Principles under-scores the positive impact that SWFs can make to global prosperity and stability.
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I would like to extend my thanks to all those responsible for the volume’s creation, and to my colleagues, and I hope that this volume provides a valuable resource to everyone interested in the role and operation of SWFs.
John LipskyFirst Deputy Managing Director
International Monetary Fund
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This book is the culmination of the efforts of many policy makers, asset managers, financial market analysts, academics, and IMF staff. It also reflects the work and efforts of sovereign wealth funds (SWFs). Their coming together has been instru-mental in improving the understanding of SWFs and their activities, and in help-ing strengthen international cooperation. We would like to thank Joanne Blake and Michael Harrup of the IMF’s External Relations Department for coordinating the production of the book. A special word of thanks goes to Sherrie Brown who as our copyeditor provided many excellent suggestions for improving the style and content of the chapters.
This book would not have been possible without the support and encourage-ment of Masood Ahmed, director of the Middle East and Central Asia Department, and José Viñals, financial counsellor and director of the Monetary and Capital Markets Department of the IMF. We would like to pay a special tribute to Jaime Caruana, the former director of the Monetary and Capital Markets Department, and now the general manager of the Bank for International Settlements, who contributed in several different ways in bringing together the SWFs and in ensuring the successful completion of the Santiago Principles. Last, but not least, we would like to thank a large number of colleagues at the IMF and at the International Forum of SWFs for their support.
Udaibir S. Das, Adnan Mazarei, and Han van der Hoorn
Acknowledgments
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Introduction
This book is about understanding sovereign wealth funds (SWFs) from an economic policy perspective and how they fit into the changing global financial landscape. It aims to contribute toward allaying concerns about the economic and financial roles SWFs fulfill in their home countries and in the countries in which they invest.
SWFs have existed for many decades. Yet, for a long time, they remained largely unknown to the public and out of the policy limelight. This relative obscurity changed abruptly in 2006 with the controversy surrounding the attempted purchase by Dubai Ports World of port management operations at six major U.S. seaport terminals. The proposed takeover fueled national security concerns in the United States that quickly led to a wider debate about the roles, rights, and responsibilities of sovereign investors. At the same time, several sovereigns had begun accumulating foreign currency and fiscal surpluses and deploying them actively in foreign financial assets. Suddenly, the sovereigns had emerged as a major class of cross-border institutional investors. These developments attracted considerable policy and commercial interest. They also gener-ated controversies that became so widespread and politically intense that in October 2007 the international community asked the IMF and other international organiza-tions to analyze the key issues surrounding SWFs and start a dialogue with the SWFs and countries receiving SWF investments. The key outcome of this effort was the development of the Generally Accepted Principles and Practices (Santiago Principles) by the SWFs, with support from the IMF. The aim of the process that resulted in the Santiago Principles was to identify a set of practices that would lead to greater clarity about the operations of SWFs and at the same time fortify SWFs’ operations. These steps were intended to contribute to a more stable environment for cross-border investment flows and also stave off protectionist sentiments against SWFs, a task that is now being carried forward by the International Forum of Sovereign Wealth Funds (IFSWF), established by the SWFs that developed the Santiago Principles.
The global economic and financial crisis that began in 2007 changed the char-acter of the focus that had been put on SWFs. Thanks to their fairly stable sources of funding—oil and commodity revenues in many cases—SWFs were a welcome source of fresh capital, particularly to the financial industry, during the crisis. SWFs identified attractive long-term investment opportunities as market prices dropped dramatically. Through their actions and communications, many SWFs managed to reassure country authorities and financial markets that their investment decisions were driven by financial risk-return considerations. Additionally, since 2006 the Organisation for Economic Co-operation and Development (OECD) has hosted the Freedom of Investment process, which led to guidance for recipient countries on policies toward SWFs to minimize the risk of the return of protectionism.
With the adoption and publication of the Santiago Principles in October 2008, much more is known and understood about SWFs today than, say, five years ago. Yet, much remains to be better explained, especially from an economic and policy
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angle, about how the funds are evolving as a result of both their greater experience and the important lessons learned from the recent crisis.1 Several countries are meanwhile contemplating establishing new SWFs. It is for these reasons that we decided to publish this book, in which renowned experts explain the SWF phenom-enon and discuss the role of SWFs, both domestically and internationally. Some new insights are also provided on the strategic asset allocation choices pursued by the SWFs and their impact on financial markets and macroeconomic stability.
ROLE AND MACROFINANCIAL RELEVANCE
The book starts by describing and explaining SWFs. In Chapter 1, Klitzing, Lin, Lund, and Nordin explain why SWFs exist and what they do, and clarify some important distinctions between different types of SWFs. The chapter compares SWFs with other institutional investors, notably central banks, and argues that in many cases the focus on SWFs is too narrow, particularly when most foreign assets are held by a country’s central bank and that often the central bank has an investment strategy very similar to that of an SWF.
In Chapter 2, Lu, Mulder, and Papaioannou analyze the policy and structural questions associated with the creation of SWFs. Specifically, they discuss the con-ditions under which it would be appropriate for countries to set up an SWF. They consider alternatives to an SWF as a mechanism for managing public savings, as well as policy options when liquidity or stabilization support is needed from an SWF in a balance of payments crisis. The chapter explains how countries have benefited from having SWFs during the global economic and financial crisis, yet are also exposed to additional risks.
In Chapter 3, Kern discusses the political responses in recipient countries to foreign state investments. He views SWFs and their investments as just one facet of a new phase of globalization, one that will be defined by the global ownership of assets and the participation of emerging markets in the global economy. A better dialogue between SWFs and recipient countries increases the chances of achieving mutually acceptable policy outcomes.
With public attention focused on recipient countries’ responses to a number of high-profile investments, it is easy to forget that the design and operations of SWFs have important domestic macroeconomic consequences. After all, SWFs manage public money that could have been spent domestically rather than invested abroad. A poorly designed SWF can be a source of instability in the home country. In Chapter 4, Shields and Villafuerte explore the ways SWFs could be structured and operated to further their governments’ broader macroeconomic objectives.
1 At its second meeting, in Sydney (May 6–8, 2010), the IFSWF acknowledged the continuing impor-tance and value of the Santiago Principles in strengthening their operations as reliable and responsible sovereign investors. The forum also felt that a lot more work was needed on improving public under-standing of the principles. The SWFs were of the view that they remain important actors in their home and host countries, and that while not escaping the effects of the 2007–09 global financial crisis, the assets under management of the forum members are expected to continue growing as the global eco-nomic recovery takes place.
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INSTITUTIONAL FACTORS
The second part of the book starts with a discussion of the Santiago Principles and the process that led to these principles by Das, Mazarei, and Stuart (Chapter 5). The chapter explains the role and mandate of the IFSWF as the successor to the International Working Group of SWFs, which formulated the Santiago Principles. A topical issue is how the principles affect the behavior of SWFs and the attitude of the recipient countries toward SWFs. The road for implementation of the prin-ciples is evolving, and there are signs that SWFs are becoming more open and responsive to public policy concerns about their activities.
In Chapter 6, Bossu, Ezejiofor, Laryea, and Liu address the domestic and international law approaches to capital account liberalization relevant to SWF activities, and consider the mandate of the IMF in these areas under its Articles of Agreement. They view the Santiago Principles as a “soft law” technique that complements (or obviates) “hard law” regulation of capital flows.
Chapter 7, by Heath and Galicia-Escotto, sets out the coherent reporting framework and multilateral surveys set up by the international community to support a stable global financial system and the free flow of capital and invest-ment. Information on data reporting by SWFs is also provided in this chapter.
Some observers have suggested that SWFs could partly allay the concerns about possible political motivations behind their activities by investing through fund managers located in the recipient countries. De Palma, Leruth, and Mazarei, in Chapter 8, examine the usefulness of this proposal by using agency theory. Their results show that, under reasonable assumptions, the use of fund managers may not necessarily address these concerns. This result could, unfortunately, induce recipient countries to address their concerns through more direct and excessive regulation, which could add to the protectionist trends seen in many countries. Therefore, to avoid protectionism, SWFs and recipient countries need to work toward greater organizational and operational transparency.
In Chapter 9, Gordon describes the OECD guidance for recipient countries toward SWFs and the follow-up on this guidance. The guidance reaffirms the rele-vance of long-standing OECD investment principles, but also indicates ways in which national security concerns should be handled. Of particular relevance is peer monitor-ing of countries’ adherence to the guidance, which the chapter covers in detail.
INVESTMENT APPROACHES AND FINANCIAL MARKETS
Knowledge of the investment strategies of SWFs is still incomplete. While some disclose full details of the composition of their portfolios—sometimes down to the individual asset level—and explain risks and returns at length, others are more reserved in disclosure. Jen, in Chapter 10, examines some of the traits of SWFs’ long-term investment strategies and how these strategies may be affected by their sources of funding. He also explains how the 2007–09 global financial crisis may lead to changes in the governance and investment strategies of both
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xviii Introduction
SWFs and central banks. One possibility is that the similar investment strategies used by central banks, SWFs, and sovereign pension funds will be replaced by complementary, specialized strategies.
A similar perspective is offered by Kunzel, Lu, Petrova, and Pihlman in Chapter 11, which focuses on the investment objectives of different types of SWFs. They explain why factors such as macro-stabilization and asset-liability management considerations, as well as forthcoming adjustments to the global financial regulatory environment, may need to factor more prominently in SWFs’ investment strategies.
In Chapter 12, Darcet, du Jeu, and Coleman offer a more hands-on perspective on SWF strategic asset allocation issues, describing the steps from determination of objec-tives to investment decisions, while offering a long-term view of various asset classes.
The next three chapters study, from different perspectives and using different methodologies, the concern that SWFs may destabilize international capital markets.
Using an event-study approach, Sun and Hesse (Chapter 13) examine financial stability issues that arise from the increased presence of SWFs in global financial markets by assessing whether and how stock markets react to the announcements of investments and divestments in firms by SWFs. Consistent with anecdotal evi-dence, the results show no significant destabilizing effects of SWFs on equity markets in a variety of market segments.
In Chapter 14, Kozack, Laxton, and Srinivasan explore the implications of shifts in SWFs’ risk appetites and investment portfolios for global capital flows and asset prices, using illustrative scenario analysis and model-based simulations. The results suggest that the pattern of global capital flows could change significantly if SWFs shift away from U.S.-dollar assets, leading to higher U.S. interest rates and a more depreciated dollar. These findings are consistent with views prevailing before the crisis and may yet come to pass as the global economy gradually recovers and risk appetite returns.
In Chapter 15, Nystedt compares SWFs with other institutional and com-mercial investors. He notes that market concerns could arise as a result of sectoral, geographic, or asset concentration by SWFs. Although growing, SWFs as a group, as well as individually, are by no means unusual in size; hence, in his view, con-cerns about their investment activities are likely to remain more politically moti-vated than market based, reinforcing the importance of transparency.
POSTCRISIS OUTLOOK
The global financial crisis did not bypass SWFs. Not only did they suffer paper losses on their investments, but some SWFs had to realize those losses because their assets were needed to finance domestic support measures during the crisis. Commodity-based funds saw their revenue streams decline substantially as the prices of oil and other commodities fell. Therefore, the crisis has forced SWFs to review their strategies, models, parameter assumptions, and risk tolerance. Three chapters focus in more detail on the long-term implications of the crisis.
El-Erian (Chapter 16) discusses the opportunities and risks that SWFs face in a world changed by the global financial crisis. He argues that the postcrisis world will
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be characterized by lower growth and different markets and risks—collectively coined the “new normal.” The chapter outlines the potential components of this new normal that are directly relevant to SWFs and argues that SWFs are well posi-tioned for the new reality as a result of their long investment horizons. There is a need, however, for continuous improvements in the institutional responsiveness of SWFs with regard to their governance, investment processes, and communication.
The on-balance positive outlook is reaffirmed in Chapters 17 and 18, which concentrate more on the risks faced by SWFs. In Chapter 17, Truman argues that SWFs need to build on the successes of the Santiago Principles, both through the IFSWF and individually, and establish a basis for greater accountability of SWFs in home and host countries. Recipient countries need to resist financial protectionism. Clearly, these difficult processes require trade-offs between national interests, accountability, and transparency.
Rozanov (Chapter 18) discusses the importance of analyzing and managing SWF assets in the context of broader national assets and liabilities, and the need to recognize and mitigate the risks that come with an increased role for the state in the local economy. This involves, among other things, reassessing reserves needs, quantifying contingent liabilities, understanding the investment horizon, realign-ing the risk tolerance of all stakeholders, and educating politicians and the public.
The book concludes in Chapter 19 with a variety of perspectives from the SWFs. Contributors from Canada, Chile, China, New Zealand, Norway, and the Russian Federation provide insiders’ views on SWFs’ roles, objectives, responses to the crisis, and challenges for the future. Although reflecting unique national objectives and facing different issues, many aspects of their SWFs’ operations are similar, including strong support from the owners, the importance of dealing with risk from an asset-liability management perspective, taking into account the con-tingent liabilities of the government, and the importance of transparency.
***
We hope that this book helps improve policymakers’ and regulators’ under-standing of SWFs. It aims at adding to the tremendous body of recent work from academia and analysts, and contributing to the debate about how to better inte-grate SWFs into the global financial system and into their own countries’ policy frameworks. We also hope that the benefit will accrue equally to the functionaries in the international capital markets who deal with the SWFs, and to those actively researching SWF behavior.
Introduction xix
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Abbreviations and Acronyms
AUM assets under managementBIT bilateral investment treatyBPM6 Balance of Payments and International Investment Position
Manual, 6th editionCBC Central Bank of ChileCDIS Coordinated Direct Investment SurveyCFIUS Committee on Foreign Investments in the United StatesCIC China Investment CorporationCIS Commonwealth of Independent StatesCPIS Coordinated Portfolio Investment SurveyESSF Economic and Social Stabilization Fund (Chile)EU European UnionFDI foreign direct investmentFOI Freedom of InvestmentGAPP Generally Accepted Principles and PracticesICAPM intertemporal capital asset pricing modelIFSWF International Forum of Sovereign Wealth FundsIWG International Working Group of Sovereign Wealth FundsMOF Ministry of FinanceNBIM Norges Bank Investment ManagementNWF National Welfare Fund (the Russian Federation)OECD Organisation for Economic Co-operation and DevelopmentP-A principal-agentP/E price-earnings ratioP&L profit and loss accountPRF Pension Reserve Fund (Chile)RF Reserve Fund (the Russian Federation)SAA strategic asset allocationSAFE State Administration of Foreign Exchange (China)SAMA Saudi Arabian Monetary AgencySWF sovereign wealth fundVaR value-at-risk
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SECTION I
Role and Macrofinancial Relevance
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3
CHAPTER 1
Demystifying Sovereign Wealth Funds
ESPEN KLITZING, DIAAN-YI LIN, SUSAN LUND, AND LAURENT NORDIN
Sovereign wealth funds (SWFs) have grown rapidly in recent years in both num-ber and assets, emerging as significant and sometimes controversial players in global capital markets. Before 2000, almost two dozen SWFs existed around the world, investing state-owned profits from fiscal surpluses; official foreign cur-rency operations; the proceeds of privatizations; or receipts resulting from exports of commodities such as oil, diamonds, and copper. Estimates in 2009 indicated that more than 50 SWFs are in operation, representing 35 nations from Brunei to Botswana, from Kuwait to Kiribati, and from the United Arab Emirates to the United States. Together, they held US$3.2 trillion in financial assets at the end of 2008—an amount that will increase over the next five years in almost any sce-nario for the global economy.1
SWFs are, therefore, not a temporary feature of the global financial landscape. On the contrary, they will likely continue to proliferate and grow wealthier because of the continuing source of their capital inflows: trade surpluses. The five years beginning with 2005 mark the take-off point for this major emerging investment industry, much as the 1980s witnessed the birth of the mutual fund industry.
As SWFs have generated headlines, so have they stirred debate. Critics have raised concerns about their potential influence in financial markets and their pos-sible political motives. Defenders view them as responsible and sophisticated investors, bringing a variety of benefits to financial markets. Much of the discus-sion, however, has been clouded by confusion because the term “sovereign wealth fund” is used to refer to a widely diverse group of state investment vehicles.
This chapter seeks to provide clarity by outlining the origin and growth of SWFs, describing their differing goals and investment approaches, and projecting their size relative to other types of institutional investors under different eco-nomic scenarios.
1The value of SWF assets are subject to significant uncertainty because total assets under management are not publicly disclosed by many funds. The estimates in this chapter are based on official reports, press reports, and expert opinions.
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4 Demystifying Sovereign Wealth Funds
UNDERSTANDING THE RISE OF SWFS
Although interest in SWFs has increased in recent years, they have existed for decades. The first such fund, the Kuwait Investment Authority, was created in 1953 to invest the Kuwaiti government’s oil revenues in behalf of its future gen-erations. Over time, many governments followed suit, establishing a variety of financial vehicles to manage state-owned financial assets. Most of the new capital flowing into SWFs comes from the countries’ trade surpluses, though funds can also come from budget surpluses, returns on investments, land leasing fees, and other sources. Several of the largest and best-known SWFs—such as those in the Middle East, Norway, and the Russian Federation—invest the proceeds from oil and natural gas exports. Many Asian funds derive their revenues from trade sur-pluses resulting from their economies being net exporters of goods. Others invest the profits from the sale of non-energy commodities: Botswana’s Pula Fund, for example, manages revenue from diamond mining; and Kiribati’s Revenue Equalisation Reserve Fund was created to invest the earnings from the island nation’s phosphate mines.
SWF growth accelerated after 2002 primarily because of soaring petroleum prices, growing Asian current account surpluses, and, more recently, rising prices for commodities of all kinds. Crude oil prices shot up from less than US$20 per barrel in the late 1990s to a record US$147 in July 2008, before sliding to about US$70 in the summer of 2009.2 Meanwhile, after the Asian financial crisis of 1997–98, many countries in that region pursued successful export-led growth strategies that produced sizable trade surpluses. Many of the countries that have profited from these trends have economies or financial systems that currently are too small to absorb so much capital, or have leaders committed to preparing for a time in the future when their surpluses may wane. So these states created SWFs to invest a share of their export revenues in foreign financial assets such as equi-ties; private and government debt; currencies; commodities; and stakes in hedge funds, private equity, and other asset classes. By the end of 2008, petrodollar3 and Asian funds together accounted for an estimated 88 percent of the financial assets held by all the world’s SWFs.
The biggest SWFs include those of the United Arab Emirates (Abu Dhabi), Saudi Arabia, Norway, Singapore, Kuwait, China, and the Russian Federation (Figure 1.1). Among the newest are the China Investment Corp., established in 2007, and the Fundo Soberano do Brasil, created in 2008.
Of course, the exact number of SWFs depends on the definition. In the public debate, “sovereign wealth fund” has been used to refer to many types of govern-ment-controlled investment vehicles with different revenue sources, goals, and investment approaches. The term is defined fairly broadly in this chapter, as an entity that manages state-owned financial assets, and is legally structured as a
2Weekly prices of Brent crude oil, as reported by Datastream.3 The term “petrodollar” in this chapter refers to profits from the sale of oil and natural gas.
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Klitzing, Lin, Lund, and Nordin 5
separate fund or fund manager owned by the state.4 This structure is intended to insulate the entity from short-term political pressures and enable it to recruit pro-fessional fund management personnel. This chapter includes only funds that have a sizable portion of their assets invested outside of their local economies. Thus, it includes reserve funds, stabilization funds, and some government holding compa-nies that have expanded internationally, such as Singapore’s Temasek Holdings and Malaysia’s Khazanah Nasional Berhad. The discussion does not include cen-tral banks, government finance ministries, or any entity whose primary function is to manage the government shares in domestic state-owned companies, such as China’s state-owned Assets Supervision and Administration Commission. One exception is the Saudi Arabian Monetary Agency, which is included as an SWF because it manages funds on behalf of Saudi Arabia’s pension fund and has a more diversified investment portfolio than do traditional central banks.
However, this effort to define SWFs also highlights that they are just one vehicle for managing sovereign wealth. State-owned companies are another increasingly important vehicle, particularly those active in making foreign acqui-sitions. And the distinctions between SWFs and other types of government inves-tors are blurring. Traditionally, central banks invested their reserve assets in highly liquid, safe instruments such as U.S. treasuries, while SWFs pursued a more diversified portfolio. But some SWFs, such as the Russian Federation’s Reserve Fund or Alaska’s Permanent Fund, also invest mainly in conservative, fixed-income securities. And some central banks are beginning to expand their
4This definition is similar to that adopted in the International Working Group of Sovereign Wealth Funds’ Generally Accepted Principles and Practices, also known as the “Santiago Principles.” A detailed discussion of these principles is provided in Chapter 5 of this volume.
Sources: Press releases; interviews; McKinsey Global Institute analysis.1 Estimates of ADIA’s assets vary widely. This figure shows the published range for 2007, and an estimated range for 2008 based on 2007 data.2 SAMA is a central bank, but is included here as a sovereign wealth fund because its portfolio is more diversified than that of a typical central bank and it invests funds on behalf of several state pension funds. Data for SAMA are marked-to-market estimates.3 The former Russian Oil Stabilization Fund was split into the Reserve Fund and the National Wealth Fund in February 2008.
Estimated assets of major sovereign wealth funds, 2007 and 2008US$ billion
23
25
88
80
137
210
240
300
326
390
15
18
32
108
125
200
250
330
371
350
Khazanah Nasional (Malaysia)
Korea Investment Corporation
Russian National Wealth Fund3
Singapore Temasek Holdings
Russian Reserve Fund3
Kuwait Investment Authority
Government of SingaporeInvestment Corporation
Norway Government Pension Fund–Global
Saudi Arabian Monetary Agency2
Abu Dhabi Investment Authority1500–875
470–740
China Investment Corporation
2008
2007
Figure 1.1 Petrodollar and Asian SWFs Rank Among the Largest
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6 Demystifying Sovereign Wealth Funds
investment strategies as well. China’s State Administration of Foreign Exchange, for instance, has invested in several foreign companies—investments closer to those of an SWF.
Therefore, in some discussions of state-managed wealth, a focus on SWFs is too narrow.5 This is particularly true in Asia, where the vast majority of sovereign assets are held in central banks rather than by diversified SWFs (Figure 1.2).
THE DIVERSE AIMS AND INVESTMENT STRATEGIES OF SWFS
SWFs are created with a variety of objectives that influence their investment approaches. Reserve funds, for example, manage state reserves in excess of those retained by the central bank for the execution of monetary policy. Usually, invest-ments are made exclusively in foreign assets to provide exposure away from the domestic economy and mitigate Dutch disease effects. Because no explicit near-term expenditures or liabilities are related to the assets, reserve SWFs typically have long-term investment horizons and higher risk-return aspirations than do other sovereign investors. Therefore, they invest in broadly diversified portfolios of assets, including equities, fixed-income instruments, and alternative asset classes such as hedge funds and private equity funds, similar to many pension funds and endowments.
Stabilization SWFs also receive state assets—usually the proceeds from the export of oil and other commodities. The primary purpose of a stabilization SWF
5For more detail on petrodollar and Asian sovereign investors generally, see McKinsey Global Institute, 2009.
Breakdown of sovereign assets1 by country, 2008Percent, US$ billion
Total assets,1 2008US$ billion
95 100
33
100 10089
100 99
100%2 =
Foreignreserves
Sovereignwealthfunds
Other3
2511
Hong Kong SAR
1820
Repu-blic of Korea
229
11
India
2520
Taiwan
2920
Singa-pore
525
67
Japan
1,0120
China
2,0465
Share of Asian sovereign wealthPercent
43 21 11 6 5 5 3 5
4,793482
4,278
Sources: Global Insight; People’s Bank of China; McKinsey Global Institute analysis.1 Includes central bank reserve assets and sovereign wealth funds’ foreign assets.2 Some figures do not sum because of rounding.3 Other: Bangladesh, Cambodia, Malaysia, Pakistan, the Philippines, Sri Lanka, Thailand, and Vietnam.
Figure 1.2 Foreign Reserves in Central Banks Account for 90 Percent of Asian Sovereign Foreign Assets
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Klitzing, Lin, Lund, and Nordin 7
is to provide a source of funds that can be used to cushion the impact of com-modity-price volatility on the exporting nation’s economy and budget. As a result, these SWFs usually have a lower risk-return profile, shorter time horizon, and higher appetite for liquidity than do reserve SWFs.
Government holding companies are created to provide oversight of a country’s assets by acting as a shareholder in state-owned enterprises. However, some of these companies, most notably Singapore’s Temasek Holdings, also reinvest pro-ceeds from asset sales and dividend income into foreign assets. Given their ori-gins, such funds typically take direct stakes in foreign companies and, in some cases, even majority control. In this regard, they are more like private equity funds than broadly diversified passive investors.
Some countries have multiple SWFs with distinct mandates. For example, in 2008, the Russian Federation split its former petrodollar stabilization fund into two entities—the Reserve Fund, which is actually a stabilization fund intended to cover budget deficits arising from drops in oil prices, and the National Wealth Fund, which seeks long-term returns.6
Meanwhile, some individual SWFs operate with multiple mandates. In the Middle East, for example, more SWFs are pursuing strategic foreign investments in specific companies that are not only commercially attractive but also can gener-ate benefits for the local economy by bringing new skills, technologies, or busi-ness opportunities (McKinsey Global Institute, 2008). These investments may take the form of setting up a joint venture with a foreign company, establishing a more loosely defined partnership, or taking a sizable equity stake in a company. For example, Abu Dhabi’s Mubadala Development Company invested US$1.35 billion in the U.S. private equity firm Carlyle in 2007, aiming in part to expand private equity investments in the Middle East and North Africa region (Kennedy, 2007); Carlyle recently closed a new fund targeted at investments in that region. A key reason for Mumtalakat Holdings’ 30 percent stake in McLaren Group is to develop Bahrain’s aluminum industry.
Although each SWF’s investment strategy is unique, they are grouped here into three broad categories (Figure 1.3):
• Conservative, passive investors. These SWFs employ a conservative strategy, focused primarily on fixed-income assets. They seek principal preservation and liquidity more than capital appreciation, and are therefore passive, minority investors with diversified portfolios. Funds in this category include the Saudi Arabian Monetary Agency, the Russian Reserve Fund and National Wealth Fund, and the Kuwait Investment Authority’s General Reserve Fund.
• Yield-seeking, passive investors. These investors hold more diversified portfolios of assets with higher expected returns and risk. Many funds in this category
6The former Russian Oil Stabilization Fund was split into the Reserve Fund and the National Wealth Fund in February 2008. The National Wealth Fund, as it is called on the Ministry of Finance’s English Web site, is sometimes referred to elsewhere as the National Welfare Fund or the National Wellbeing Fund.
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8 Demystifying Sovereign Wealth Funds
are believed to hold a large portion of their assets in equities, with the remain-der split between safer, fixed-income assets and higher-risk alternative invest-ments, including hedge funds, leveraged buyout funds, and real estate. This group includes some of the largest SWFs, such as the Abu Dhabi Investment Authority (ADIA) and Norway’s Government Pension Fund–Global.
• Strategic, active investors. The third category of investors is smaller than the first two and itself includes diverse SWFs with different investment strategies. The common element among these funds is that they have narrower invest-ment mandates than do the passive portfolio investors, and many take much larger stakes in individual companies. For example, Dubai’s Istithmar World has real estate investments in New York and London and several significant private equity investments, including a stake in the U.S. luxury retailer Barneys and in Standard Chartered Bank. Other investors in this group, such as Mubadala, seek to promote national strategic and economic interests by investing in international corporate assets that may also yield local economic development benefits. Many funds in this category take an active approach to generating investment returns, for example, by being represented on the boards of directors of the companies in which they invest. Singapore’s Temasek and the Qatar Investment Authority are examples.
SWFS REMAIN POWERFUL, DESPITE THE FINANCIAL CRISIS
The escalation of the global financial crisis in late 2008 caused deep losses for global investors—including SWFs—that were exposed to equities, mortgage-
Estimated asset allocations of sovereign investorsPercent
Strategic active and other
0 030–35
50–60
10
Yield-seeking, passive
5–1010–20
50–60
5–1010–20
Conservative,passive
20–30
50–70
0–250 Cash and deposits
Fixed income
Equity
Private equity1
Real estate and other
Examples • Saudi Arabian Monetary Agency
• Russian Reserve Fund and National Welfare Fund
• Kuwait Investment Authority–General Reserve Fund
• Abu Dhabi Investment Authority
• Kuwait Investment Authority–Future Generation Fund
• Norway Government Pension Fund–Global
• Government of Singapore Investment Corporation
• Qatar Investment Authority
• Istithmar World• Temasek Holdings• Mubadala
Sources: Interviews; Setser and Ziemba, 2007; Morgan Stanley; Capgemini/Merrill Lynch; McKinsey Global Institute analysis.1 Includes direct stakes in companies, not through a private equity fund.
Figure 1.3 SWF Investment Strategies Vary Widely
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Klitzing, Lin, Lund, and Nordin 9
backed securities, currencies, commodities, and other assets. The authors estimate that some SWFs, such as Norway’s, saw their losses exceed their governments’ new capital injections in 2008. But SWFs have long-term investment horizons, so it is not known if all those paper losses will be realized. For many SWFs, much of the paper losses were indeed reversed in 2009. Moreover, some investments—such as those in western financial institutions in late 2007 and early 2008—took a variety of complex forms whose returns may differ substantially from equity market performance.
Meanwhile, SWFs, including those of Saudi Arabia and the Russian Federation, that had invested more conservatively in government bonds and other fixed-income securities enjoyed investment gains in 2008. Moreover, petrodollar and Asian SWFs continue to receive large capital inflows from their nations’ trade surpluses. The estimated net result is that, collectively, global SWF assets held roughly steady through the crisis, totaling US$3.2 trillion at the end of 2008, about the same as a year earlier—a much better performance than the losses posted by global pension funds, mutual funds, insurers, and other traditional institutional investors (Figure 1.4).
SWFS WILL REMAIN LONG-TERM INVESTORS, BUT THE CRISIS HAS PROMPTED SOME SHIFTS
Since the worsening of the global financial crisis in September 2008, many SWFs have moved to the sidelines, conserved cash, and focused on supporting domestic companies and banks. Most will retain their long-term investment horizons and focus on foreign assets, although some have indicated that they are reviewing their
0.9
1.9
4.4
18.9
26.2
30.4
5.1
0.9
1.4
4.8
5.0
16.2
18.8
25.0
Private equity, buyout2
Hedge funds
Asian sovereigninvestors1
Petrodollar foreignassets
Insurance assets
Mutual funds
Pension funds
Assets under management, 2008EUS$ trillions
Change 2007–2008EPercent
-18
-24
-14
-2
8
-25
0
2008
2007
Sources: International Financial Services, London; Hedge Fund Research; Investment Company Institute; Preqin;McKinsey Global Institute analysis.1 Includes Asian central banks (US$4.3 trillion) and foreign holdings of Asian sovereign wealth funds (US$490 billion).2 Reflects estimated marked-to-market values of portfolio companies. Measuring only cumulative fundraising, assets would have grown to US$1.2 trillion.
Figure 1.4 SWF Assets Held Steady in 2008
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10 Demystifying Sovereign Wealth Funds
specific investment strategies (Irish and Saadi, 2009; Moskwa and Stoltz, 2009). As the financial crisis subsides and recovery begins, they will be ready to jump at new opportunities. Some shifts in investment approaches are already being detected.
More Diversification into Nontraditional Asset Classes
In 2009, managers of several SWFs had discussed plans to broaden their invest-ment strategies to include more nontraditional asset classes, such as real estate, commodities, and hedge funds. This direction may reflect a structural shift to seek opportunities outside of public equity and fixed-income markets, particu-larly in light of investment losses in 2008. Such a shift may serve several goals. The focus on real estate, for instance, reflects unique opportunities to snap up many properties at depressed prices. And real estate can also be a good hedge against inflation, which is a growing worry in the face of large government stimulus packages in the United States and other countries. For example, the Abu Dhabi Investment Company, which is owned by the Abu Dhabi Investment Council, stated in April 2009 that it plans to launch an international real estate investment fund (Carvalho, 2009). The Kuwait Investment Authority reportedly planned to take advantage of opportunities in global real estate and in equities.
With soaring commodity prices, some SWFs are also pursuing investments in commodity producers as a hedge against the risk of higher global inflation and an indirect way to secure future supplies of raw materials. The executive director of the Qatar Investment Authority, for example, said in March 2009 that the fund would turn its focus to commodities—particularly food and energy—in the sec-ond half of that year (England and Blas, 2009). But commodities are one area in which the investments of SWFs pale in comparison with foreign acquisitions by state-owned companies, with China’s bids for foreign energy producers as a notable example.
Meanwhile, the SWF appetite for hedge funds and other alternative invest-ment vehicles appears undiminished by the crisis. The China Investment Corporation, for instance, recently announced new mandates for investments in hedge funds, channeling these investments through Blackstone and Morgan Stanley, with whom it had previous relationships.
More Focus on Emerging Markets
SWFs are looking more than ever to emerging markets for long-term growth opportunities. This trend is not new, but has been accelerated by the crisis. In 2007, research by the McKinsey Global Institute found that SWFs as a group were weighted more heavily toward emerging markets than were pension funds (McKinsey Global Institute, 2007). As the head of the Kuwait Investment Authority noted at the start of the global financial crisis in 2007, “Why invest in 2 percent-growth economies when you can invest in 8 percent-growth econo-mies?” (Sender 2007).
Going forward, more focus on investments in emerging markets is expected. The Qatar Investment Authority, for example, plans to invest US$400 million in
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Klitzing, Lin, Lund, and Nordin 11
infrastructure in Africa, particularly in South Africa, focusing on transportation, communications, and energy. It also has set up a joint venture with the Indonesian government to invest US$850 million in that country and plans to establish a US$1 billion fund to invest in agriculture, natural resources, and tourism in Vietnam. Kuwait has reported plans to raise its stake in the Industrial and Commercial Bank of China and to invest in China’s energy and industrial sectors (Irish and Drees, 2009).
Hiring New Talent
The crisis has caused financial institutions to lose thousands of employees in the United States and Europe, and SWFs are taking advantage of this outflow of tal-ent. In 2009, for instance, the ADIA hired a managing director from JP Morgan to guide ADIA’s global real estate investment strategy and a senior investment banker from Rothschild to advise on cross-border mergers and acquisitions. The China Investment Corporation is hiring more than 20 senior professionals from around the globe and has named a former UBS executive to oversee its Special Investments Department, which will take large, long-term positions in publicly traded companies. The Korea Investment Corporation recently picked a U.S. hedge fund manager as its chief investment officer.
This hiring spree will expand the SWFs’ financial and investment expertise, allowing better selection and monitoring of external investment managers. Such hires may also be part of another trend—SWFs’ moves to manage a larger portion of their portfolios directly rather than through outside money managers.
New Funds with More Targeted Goals
Some of the newest SWFs are being created with more targeted investment goals. In 2006, for example, Abu Dhabi spun off the Abu Dhabi Investment Council from the larger ADIA to focus on local and regional investments. In 2008, Abu Dhabi created the state-owned Advanced Technology Investment Company to invest in high technology locally and internationally; its first major deal was a joint venture with chip-maker Advanced Micro Devices to create The Foundry Company, a semiconductor manufacturer. Also in 2008, Mubadala formed a joint venture with Rolls Royce to provide aviation services in the Middle East.
This proliferation of SWFs serves two purposes. First, it allows policymakers to create better-defined investment goals for each entity. Second, it creates com-petition among sovereign investment vehicles and may therefore spur better per-formance, given that the better-performing funds could get larger capital injec-tions in the future.
SWFS WILL CONTINUE TO GROW
The recent global financial crisis and economic downturn has altered the dynam-ics that had fueled rapid growth in SWFs since 2000. At this writing, commod-ity prices, trade, and equities all remain far below their recent peaks. Nonetheless,
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12 Demystifying Sovereign Wealth Funds
oil exporters and several Asian countries continue to run trade surpluses, and continue to allocate some portion of their surplus capital to SWFs. Research sug-gests that this process will continue in coming years, regardless of whether the world economy recovers relatively quickly or much more slowly. Thus, this chap-ter projects that total SWF financial assets will grow from US$3.2 trillion in 2008 to between US$3.4 trillion and US$5.8 trillion in 2013 (Figure 1.5).
Because the economic outlook remains so uncertain, SWF financial asset growth is modeled, in this chapter, according to different proprietary macroeco-nomic scenarios developed by McKinsey & Company and Oxford Economics. These scenarios each depict different trajectories for GDP growth, oil prices, Asian trade surpluses, financial market recovery, and other key variables.
In the conservative, base-case scenario, global GDP does not resume growth until mid-2010, depressing commodity prices and trade. Oil prices start rising slowly as the economy recovers, surpassing US$70 per barrel by 2013, and Asian current account surpluses decline. This scenario projects SWF assets to climb to about US$4.3 trillion by 2013.
As would be expected, SWF assets rise much higher, to US$5.8 trillion in 2013, in the best-case optimistic scenario, which envisions a more rapid recovery in global GDP, oil prices, and trade. But it is striking that SWF assets increase a bit even in the worst case. In this pessimistic scenario, global GDP does not start growing until 2011; crude prices linger below US$50 per barrel for several years before rising to just US$60 per barrel in 2013; and global trade remains well below its peak. Sluggish economic growth dampens global equities and fixed-income markets, limiting returns on investments. Nonetheless, appreciation of the current portfolio of assets would still be significant, and could offset govern-ments’ drawing on SWF assets for other purposes. In such a scenario, SWF assets would remain essentially flat, at US$3.4 trillion, in 2013.
2.8
5.4
2013E
3.4–5.8
2008
3.2
3.0
3.9
Sovereign wealth fund assets, 2008 and 2013US$ trillions
OtherNet oil exporters and Asian SWFs1
Compound annual growth rate, 2008–13Percent
14
7
1
Historical
Optimistic
Base case
Pessimistic
Base
0.4
0.4
Sources: International Monetary Fund; Sovereign Wealth Fund Institute; McKinsey Global Institute analysis.1 Includes sovereign wealth funds in Algeria, Bahrain, China, Indonesia, the Islamic Republic of Iran, Kuwait, Libya, Malaysia, Nigeria, Norway, Oman, Qatar, the Russian Federation, Saudi Arabia (including the Saudi Arabian Monetary Authority), Singapore, the Republic of Korea, United Arab Emirates, and República Bolivariana de Venezuela.
Figure 1.5 SWF Assets Could Reach US$4.3 Trillion by 2013
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Klitzing, Lin, Lund, and Nordin 13
SWFs, along with other global investors, will continue to be buffeted by unforeseeable market forces in coming years. How the recent global financial crisis will be resolved, whether world GDP growth will return to precrisis levels, and how the economic landscape may be changed in the process remain uncer-tain. Even so, the financial assets controlled by governments around the world will continue to grow in all macroeconomic scenarios considered, meaning that SWFs will continue to be important players in global capital markets, and may even gain influence. Thus, they will also continue to command the attention and scrutiny of business leaders and policymakers for years to come.
REFERENCES
Carvalho, Stanley, 2009, “Abu Dhabi Investor Plans Global Property Fund,” Reuters News, April 21.
England, Andrew, and Javier Blas, 2009, “Qatar to Target Food and Energy,” Financial Times, March 13.
Irish, John, and Caroline Drees, 2009, “Kuwait Looks to Raise Stake in China’s ICBC,” Reuters News, May 15.
Irish, John, and Dania Saadi, 2009, “Qatar Fund Plans 6-Month Pause, Then Strategy Switch,” Reuters News, March 12.
Kennedy, Siobhan, 2007, “Abu Dhabi Takes $1.35 Billion Stake in Carlyle Group,” The Times, September 21.
McKinsey Global Institute, 2007, The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity Are Shaping Global Capital Markets. Available via the Internet: http://www.mckinsey.com/mgi/publications/The_New_Power_Brokers/.
———, 2008, The Coming Oil Windfall in the Gulf. Available via the Internet: http://www.mckinsey.com/mgi/publications/The_Coming_Oil_Windfall/index.asp.
———, 2009, The New Power Brokers: How Oil, Asia, Hedge Funds, and Private Equity Are Faring in the Financial Crisis. Available via the Internet: http://www.mckinsey.com/mgi/publications/the_new_power_brokers_financial_crisis/.
Moskwa, Wojciech, and Aasa Christine Stoltz, 2009, “Norway to Review Oil Fund Strategy after 2008 Losses,” Reuters News, April 3.
Sender, Henny, 2007, “Deep Well: How a Gulf Petro-State Invests Its Oil Riches—Kuwait’s Mr. Al-Sa’ad Likes Asian Real Estate but Is Cool to Treasuries,” Wall Street Journal, August 24.
Setser, Brad, and Rachel Ziemba, 2007, “What Do We Know About the Size and Composition of Oil Investment Funds?” RGE Monitor, April.
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CHAPTER 2
From Reserves Accumulation to Sovereign Wealth Fund: Policy and Macrofinancial Considerations
YINQIU LU, CHRISTIAN MULDER, AND MICHAEL PAPAIOANNOU
Sovereign wealth funds (SWFs) are attracting increasing attention. SWFs are not new, and some of the longer-established funds—for example, those of Kuwait, Abu Dhabi, and Singapore—have existed for decades. The growing prominence of SWFs is one of the results of the profound transformation of the global econ-omy. Following the 1997–98 Asian financial crisis, emerging-market countries built high international reserves cushions; this trend was strengthened by high commodity prices, high demand from the United States, and large global imbal-ances. Rather than capital importers, emerging-market countries are now capital exporters. Gradually, they have emerged as savers to finance richer economies, a reversal of history.
However, the objectives of SWFs or SWF-type arrangements in meeting domestic policy goals, as outlined in this chapter, is a fundamental issue that must not be lost sight of in any SWF discussion.1 Those objectives can be multiple and overlapping, and are certainly changing over time.
Depletion of nonrenewable resources and volatile commodity prices lead to the first objective: countries need to transform nonrenewable resources into sus-tainable and more stable future income. Saving commodity revenue can spread the wealth across generations; it can help mitigate the boom and bust cycles com-modity exporters experienced following the oil surge of the 1970s; and it can help prevent Dutch disease2 effects on the noncommodity side of the economy. Indeed, most SWFs, as measured by assets, reflect such motives.
Second, significant accumulation of reserves puts pressure on some surplus countries’ balance sheets as a result of carry costs and currency mismatches, prompting those countries to seek prudent and effective management of this type
1See IMF taxonomy of SWFs in IMF, 2007. 2“Dutch disease” arises when foreign currency inflows caused by commodity exports cause an increase in the affected country’s real exchange rate. The effect of Dutch disease is to reduce external com-petitiveness, which weakens net noncommodity exports, contributing to the loss of jobs in the rele-vant industries. The end result is that nonresource industries are hurt by the increase in wealth gener-ated by the resource-based industries.
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16 From Reserves Accumulation to Sovereign Wealth Fund
of foreign currency accumulation via SWFs. This situation affects a number of Asian countries in particular.
Third, aging populations in many countries create a need to secure future welfare or meet future superannuation obligations. An aging population leads to future economic vulnerability and expenditures, often related to entitlements that were funded by pay-as-you-go systems resulting in high economic and social costs. A prudent response to such challenges is to accumulate assets in the present to offset the projected higher liability related to sustaining pensions and social welfare in the future.
Along with such specific goals, an SWF’s policy objective and activities also should be consistent with the country’s overall macroeconomic framework. The SWF’s assets, and the returns they generate, affect a country’s public finances, monetary condition, balance of payments, and overall balance sheet. They may also affect public sector wealth and influence private sector behavior. Therefore, appropriate coordination between the SWF and the fiscal and monetary authori-ties is critical to achieving a country’s overall policy objectives in the context of which an SWF is established.
The global financial crisis of the late 2000s has provided an important reflec-tion point to examine the domestic policy angle of SWFs. The first issue is the level of reserves and foreign assets a country could consider sufficient to contem-plate setting up an SWF (examined in the first section of this chapter). The sec-ond issue, assuming a country’s foreign reserves are adequate, is what options, other than creating an SWF, should be explored (second section). Given the roles played by some SWFs in cushioning domestic banking systems and insulating budgets from the global financial crisis, the third section examines issues and concerns about domestic support from SWFs. A close examination of the link between management of the SWF and the resulting macrofinancial impacts is presented in the fourth section.
ADEQUATE LEVEL OF FOREIGN RESERVES
Typically, ample official reserves are a signal to authorities to assess whether the excess reserves should be managed and invested differently and to what alternate uses the reserves could be put. The possibility of calling for liquidity support in a crisis could potentially prevent excess reserves from being used to pursue a long-term investment horizon with less liquid assets in a quest to earn higher returns than reserve assets earn.
Reserves play an important role in reducing the risk of crises and lessening their impact when they occur. Though not a substitute for sound macroeco-nomic policies, adequacy in reserves can buy time. When trouble appears on the horizon, an adequate reserve position can give countries enough breathing space to implement reforms and so reduce the risk of a full-blown crisis. An adequate level of reserves can increase market confidence that a country can meet its exter-nal obligations.
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Lu, Mulder, and Papaioannou 17
Because reserves provide significant benefits, especially in reducing external vulnerability and providing country insurance, reserve levels need to be carefully assessed. Thus, the “adequate” level of reserves should be established and agreed on between the central bank and the government before establishing an SWF.
The debate about the adequate level of reserves has developed in conjunction with the evolution of balance of payments needs. After the demise of the gold standard in the early 1970s, the focus of reserve adequacy assessment shifted to the current account. Thus, reserves should first be compared with a country’s trade figures, especially import coverage.
The emerging-market crises of the 1990s made clear that for many countries that had been able to tap the capital markets, exposure was in the capital account. With this realization, the emphasis on risk in the balance of payments switched from the current account to the capital account. As a result, and supported by empirical analysis, the Greenspan-Guidotti rule of 100 percent coverage of short-term external debt emerged as the most useful rule of thumb for reserve adequacy for emerging-market countries with access to private capital markets.3 This indi-cator has become widely used as a measure of reserve adequacy. Other factors have an impact on the level as well. Higher levels of reserves would be preferable in countries with large external current account deficits, overvalued exchange rates, high levels of short-term public domestic debt, derivatives exposures of the public sector, and weak banking systems.
The lessons from the global financial crisis have led to proposed adjustments to or augmentation of these indicators. First, although still a relevant indicator for reserve adequacy, the Greenspan-Guidotti rule focuses entirely on an “external drain” on a country’s reserves. But an “internal drain” on reserves is also possible, reflecting capital flight by residents. Residents may not be willing to roll over gov-ernment debt, or a run on banks could occur, with residents withdrawing their deposits. If residents seek foreign currency as a safe haven, foreign exchange reserves will be drawn down. Such drains are likely if the central bank stands ready to provide the foreign exchange under a fixed exchange rate regime. Internal drains involving runs on foreign currency deposits are even harder to thwart under a floating regime with a more open capital account; therefore, foreign currency maturity mismatches in banks typically require an additional reserve cushion.
Second, in addition to short-term debt drains, other forms of external drains could materialize in a crisis. For example, other types of capital inflows that are usually considered to be immune from crises could also put pressure on reserves if inflows stop or are reversed. Nonresident holders of the country’s local bonds, who may not be willing to liquidate their positions, can build up derivative posi-tions to hedge against a domestic currency depreciation, putting pressure on reserves. Equity flows have become an important source of finance in emerging-market countries, but during the global financial crisis of the late 2000s the trend has been for investors to pull back some of the equity investments. Experience in
3See IMF (2000, 2001) and Bussière and Mulder (1999, 2001).
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18 From Reserves Accumulation to Sovereign Wealth Fund
previous crises suggests that such outflows are halted quickly by declining stock prices, making such withdrawals no longer attractive.
Third, in a crisis, a large drop in private demand can be offset by fiscal stimu-lus measures. However, the global financial crisis has actually made the borrowing environment for emerging-market countries more challenging and is, in a num-ber of cases, forcing fiscal contraction. An ample reserve cushion provides some leeway to pursue fiscal stimulus and avoid contraction.
Fourth, a worrisome aspect of the global financial crisis is that its core is a banking crisis, and banking crises tend to be prolonged. Moreover, given low demand, current accounts may not adjust as quickly as during previous crises to offset the drought in capital flows. Thus, the question becomes whether reserve coverage of just one year of short-term debt is sufficient.
OPTIONS FOR AMPLE RESERVES
The next step in deciding to set up an SWF is to review the origins of the ample reserves, the longevity of the sources of the reserves, and the other assets and lia-bilities of the sovereign to judge whether there are better alternatives to setting up an SWF.
Sovereign foreign asset accumulation typically comes from a few main sources. The first source is capital inflows, mopped up through the issuance of central bank liabilities, and sometimes through issuance of government paper. In such a case, the central bank or the ministry of finance (or both) has to assess the longev-ity of these inflows in deciding whether the stream of inflows is sufficient to permit assets to be invested over a longer term and with greater risk to reduce the cost of carry.
A second source of the accumulation could reflect the government balance sheet—general fiscal budget surpluses, privatization receipts, or surpluses related to revenues from booming commodity exports—in which case the initial or anticipated reserve buildup will, typically, have a counterpart in government deposits with the central bank.4 Whether these are one-off and small or likely to continue over time can be determined based on these individual sources of flows.
A first option for the use of these reserves, applicable in the first case, where the objective is to reduce the cost of carry when mopping up excess liquidity, is to increase the reserve requirement ratio on banks’ foreign deposits. If a need arises to inject foreign liquidity, the central bank can reduce this ratio. In Peru’s experience, reducing this ratio was more effective than the direct sale of foreign currency in the exchange market because the reduction in the reserve requirement ratio allowed banks to increase liquidity in foreign currency without reducing their liquidity in domestic currency (Bardález and Rondán, 2009).
A second option, again applicable in the first case, is to relax foreign exchange regulations on residents’ investments abroad and accommodate the outflows
4SWFs funded from public savings and privatization are more akin to nonrenewable resource funds because they represent an increase in net financial wealth.
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Lu, Mulder, and Papaioannou 19
through central bank intervention in the foreign exchange market. This approach could slow the net inflows of capital and reduce the cost of carry of mopping up excess liquidity, although relaxing foreign regulation and opening capital markets cannot be done overnight.
A third option, applicable in either case, is to reduce external debt obligations, which is a straightforward way of using ample reserves and reducing currency mismatches and carry costs. For instance, Banco Central de Chile and Banco de Mexico have used excess reserves to reduce external foreign currency debt, in essence shrinking the overall balance sheet (Ortiz, 2007).
A fourth option is to start managing reserves on the central bank balance sheet with a long-term perspective. Often reserves are split into tranches, such as a liquidity tranche and an investment tranche, and the latter could be amplified and its mandate expanded to a longer horizon. For instance, the Hong Kong Monetary Authority separates foreign reserves into two portfolios, the Backing Portfolio and the Investment Portfolio (IMF, 2005). Assets in the Backing Portfolio are invested in highly liquid and short-term U.S. dollar-denominated fixed-income securities, while assets in the Investment Portfolio are invested more dynamically, including investments in equities. Typically, however, a limited tol-erance for reporting losses, combined with marked-to-market accounting stan-dards, may limit the risk and size of the investment portfolio, unless the risks (and rewards) are explicitly borne by the ministry of finance.5
A fifth option is to set up an SWF, be it in the central bank or as a separate institution. The SWF option is usually chosen when there is a clear objective for the increased reserves. For example, a net commodity-exporting country facing a large and prolonged commodity price boom may have few sound options other than to set up an SWF; net commodity-exporting countries typically have limited remaining external government debt. An important macro aim is to reduce the volatility of government revenue and limit the Dutch disease effects that arise from crowding out the private sector if commodity revenue is rapidly spent.
SUPPORT FROM THE SWF IN A FINANCIAL CRISIS
The global financial crisis has compelled SWFs to take more prominent and direct roles in their home countries.6 These roles include providing liquidity sup-port to domestic banks or to companies, recapitalizing domestic banks, investing in domestic stocks, and financing the budget deficit or fiscal stimulus packages.
Several of these roles are supported by the objectives of some SWFs. For example, financing the budget is the objective of SWFs mandated to stabilize the budget, and assets are intended to be drawn down in periods of recession. Several SWFs have investment policies to invest a part of their assets domestically (for example, Australia’s Future Fund and the Alaska Permanent Fund Corporation).
5 We abstract from the option to reduce excess reserves through an appreciating currency and assume that the exchange rate is already optimally managed.6See Chapter 11 for further discussion.
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20 From Reserves Accumulation to Sovereign Wealth Fund
As long as their domestic asset allocation is within the strategic asset allocation (SAA), investing domestically in the current environment is likely to boost SWFs’ long-term returns when asset prices rebound.
If an SWF does not have a mandate to invest domestically but is compelled to do so in the wake of the crisis, there could be implications for domestic macroeco-nomic policy. One result could be that foreign exchange management becomes difficult as the swap of foreign currency into domestic currency brings foreign cur-rency into the domestic monetary system. If spending is allowed to take place outside the budget, issues of fiscal accounting and transparency could emerge, which could undermine budgetary control, imply unequal treatment of different types of spending, and possibly lead to mismanagement of funds and to waste.
Moreover, the role of providing liquidity, especially foreign currency liquidity, is the objective of a country’s official foreign currency reserves, and not that of a typical SWF. Contingent calls for liquidity support could prevent the SWF from pursuing a long-term investment horizon and holding less liquid assets. Therefore, if the SWF needs to provide liquidity support, a clear investment policy and sup-porting rules and procedures should be established consistent with that purpose, thus promoting transparency and accountability of the SWF and safeguarding the value of the SWF’s assets.
MACROFINANCIAL LINKAGES ASSOCIATED WITH MANAGEMENT OF AN SWF
An SWF is often designed as an integral part of the owner country’s policy frame-work, with purposes such as minimizing the distortions that large and volatile commodity flows might cause to the fiscal accounts, inflation, and the exchange rate. While the objective of an SWF could be to further reduce fiscal cyclicality, provide for future government contingent liabilities, or reduce the cost of carry, the ways in which SWFs manage their assets have other significant effects on policy, specifically fiscal, monetary, and exchange rate policies (Brown, Papaioannou, and Petrova, 2010).
Fiscal Policy
This discussion of the linkages between SWF management and fiscal policy focuses on stabilization SWFs and pension reserve SWFs, given that they are set up with the mandate to ensure a country’s fiscal viability.
The objective of a stabilization SWF is to finance future potential deficits through resources of the SWF and, thus, to smooth fiscal spending, or to finance regular or extraordinary public debt amortization. If a commodity-rich country has a fiscal rule such that government expenditures must be equivalent to long-term revenues minus a structural surplus, as a certain percentage of GDP, every year, then the actual government balance depends upon the cyclicality of govern-ment revenues. As shown in the formula below, this cyclicality is reflected in the revenue shortfall relative to the long-term revenues.
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Lu, Mulder, and Papaioannou 21
Budget Balance = Revenues – Expenditures = Revenues – (Long-Term Revenues – Structural Surplus)= Revenues – (Long-Term Revenues – k × GDP)= Revenue Gap + k × GDP
where k = Structural Surplus/GDP= Annual Surplus Savings Rate.
The stabilization features of the SWF are then determined by the parameters of the fiscal rule and the amplitude of the revenue gap. A greater structural surplus requirement would mean that the SWF would have to be tapped only in very extreme cases, that is, to offset very large revenue shortfalls. In such cases, the SWF would serve as an additional source of stabilization to the surplus savings rule. A small surplus savings requirement or an allowance for a structural deficit would place great pressure on the SWF as a stabilization fund because it would have to be used more often. Therefore, while the stabilization function of the SWF is to counteract the revenue gap, the surplus savings requirement determines the threshold that triggers use of the SWF’s resources.
The revenue gap has two main components: a cyclical effect resulting from the commodity price and a cyclical effect resulting from tax revenues. Because the commodity price effect often dominates and the two effects are highly correlated, the SWF will, as a stabilization fund, be used primarily to neutralize the effects from movements in the commodity’s price.7 The SAA of the SWF should, there-fore, contain assets that are negatively correlated with the commodity price.
If an SWF is intended to cover the government’s future pension liabilities, the structure of the pension payments should be well defined to appropriately specify the SWF’s withdrawal rules. Alternatively, a law may lay out how the SWF’s resources can be spent to support pensions. For example, spending may not exceed the return generated by the fund in the previous year. Hence, spending rules set for an SWF are intended to relieve pension-related budgetary spending pressures. From a sovereign balance sheet perspective, the macrofinancial linkages from the pension-system liability to the SWF have implications for the SWF’s asset alloca-tion. In particular, the SWF’s SAA will have to be concentrated in assets of coun-tries whose currencies exhibit high positive correlations with the domestic currency so as to reduce exchange rate risk.
Monetary Policy
The country’s monetary policy could be affected by the way in which the SWF is managed. The volatility of fiscal revenues—specifically commodity revenues— presents a challenge for monetary authorities because that volatility affects the vola-tility of aggregate demand, either through the channel of government spending or
7The cyclical deterioration of factors that are not correlated with the commodity price must be dra-matic to have any negative effect on the revenue gap.
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22 From Reserves Accumulation to Sovereign Wealth Fund
through the additional private-sector lending enabled by government deposits, lead-ing to excessive inflation and real exchange rate fluctuation.
The funding and withdrawal rules of a stabilization SWF, in combination with a fiscal rule, should seek to minimize such effects on domestic demand. Use of the stabilization SWF to cover fiscal liabilities during cyclical downturns ensures that these resources will enter the economy during periods when private demand is relatively weak, and the absorption capacity for additional public resources is correspondingly strong. Because the stabilization SWF may reduce the amplitude of budget balances, the transmission mechanism of monetary policy is likely to be enhanced.
Exchange Rate Issues
Investing SWF resources abroad reduces the exchange rate impacts of the export-ed commodity. If the SWF’s resources are saved abroad and commodity-extrac-tion companies and exporters are allowed to pay tax liabilities in foreign curren-cies, the export-related revenue can be prevented from affecting the value of the exchange rate. In particular, this policy may reduce the real appreciation associ-ated with increases in GDP growth and commodity prices, as well as reduce the impact of later exchange rate reversals.
Under a flexible exchange rate regime, the (nominal) exchange rate of the local currency vis-à-vis the foreign currency mitigates negative terms-of-trade shocks related to the (nominal) price of the endowed commodity, which could have direct implications for the objective, use, and SAA of an economic stabilization SWF. In most commodity-exporting countries, the local currency tends to depre-ciate when the commodity price falls. The SWF’s interest returns measured in domestic currency are then boosted by the domestic currency depreciation, pro-viding an additional cushion to the budget.
However, if the authorities decide to prevent a substantial depreciation of the exchange rate stemming from a sharp drop in commodity prices, the resulting fiscal deficit may have to be financed with SWF resources. Although this advanc-es the argument for investing the SWF in assets that are negatively correlated with domestic economic growth, such correlation—and the asset choice—will be affected by the authorities’ tolerance for exchange rate adjustment.
CONCLUSION
Although SWFs have provided greater portfolio diversification and their eco-nomic and financial benefits in the global financial crisis of the late 2000s have been proven, they clearly have an important role in meeting domestic policy objectives. This positive role of SWFs, however, also poses challenges that SWF-owner countries face, especially in the context of an increasingly globalized financial and monetary system. From the macroeconomic perspective, it is important to assess whether SWFs help or hinder broader economic policy objectives, and whether they pose potential sovereign balance sheet risks. Equally
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Lu, Mulder, and Papaioannou 23
important is ensuring that the management processes for these funds have a relatively high degree of accountability to ensure that SWFs are well governed and prudently managed.
REFERENCES
Bardález, Paul Castillo, and Daniel Barco Rondán, 2009, “Peru: A Successful Story of Reserves Management,” in Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin America, ed. by E. Cavallo and A. Izquierdo (Washington: Inter-American Development Bank).
Brown, Aaron, Michael G. Papaioannou, and Iva Petrova, 2010, “Macrofinancial Linkages of the Strategic Asset Allocation of Commodity-Based Sovereign Wealth Funds,” IMF Working Paper 10/9 (Washington: International Monetary Fund).
Bussière, Matthieu, and Christian Mulder, 1999, “External Vulnerability in Emerging Market Economies: How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion,” IMF Working Paper 99/88 (Washington: International Monetary Fund).
———, 2001, “Which Short-Term Debt over Reserves Ratio Works Best? Operationalising the Greenspan Guidotti Rule,” in Capital Flows Without Crisis? Reconciling Capital Mobility and Economic Stability, ed. by D. Dasgupta, M. Uzan, and D. Wilson (New York: Routledge).
International Monetary Fund, 2000, “Debt- and Reserve-Related Indicators of External Vulnerability,” IMF Board paper (Washington).
———, 2001, “Issues in Reserves Adequacy and Management,” IMF Board paper (Washington).———, 2005, Guidelines for Foreign Exchange Reserve Management: Accompanying Document
and Case Studies (Washington).———, 2007, Global Financial Stability Report (Washington, October).Ortiz, Guillermo, 2007, “A Coordinated Strategy for Assets and Liabilities: The Mexican
Experience,” in Sovereign Wealth Management, ed. by J. Johnson-Calari and M. Rietveld (London: Central Banking Publications).
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CHAPTER 3
Sovereign Wealth Funds: New Economic Realities and the Political Responses
STEFFEN KERN
Sovereign wealth funds (SWFs) are on their way to a new normal. Having oper-ated for many decades in quiet niches of global financial markets, SWFs became the subject of considerable political controversy in the years preceding the recent global financial crisis. During that time, the public discourse in many recipient countries metamorphosed from unawareness to reservations, and in a few cases to outright rejection. When financial markets slipped into the crisis, concerns gave way to busy courting of the SWFs for their capital, while the value of their assets under management was under pressure in light of the general market downturn. Despite the previous controversies, policy toward SWFs has not resulted in pro-tectionist stances in most countries. The initiative taken by the SWFs themselves leading to the Santiago Principles, and the Organisation for Economic Co-operation and Development’s (OECD’s) efforts at constructing guidelines for good policy responses, have helped to attenuate concerns in recipient countries, and encouraged reasonable policy measures.
With a view to the long term, the key question is whether these measures suf-fice to ensure a stable equilibrium of interests between state investors and recipi-ent economies. After all, sovereign investments have strong potential to grow, and to become a symbol of the increasing wealth of emerging economies and their increasing participation in and ownership of financial assets at the global level.1 To that end, policymakers and market participants will find it beneficial to tran-scend this fragile equilibrium between competing interests. SWFs and recipient economies will need to translate voluntary commitments into concrete policy measures, and avoid, on the one hand, politically sensitive transactions, and, on the other hand, protectionist measures against foreign private or public investors.
This chapter discusses the prospects for a political environment that encour-ages efficient capital allocation in the long run, against the background of recent policy initiatives, and based on a review of underlying economic forces and political rationale.
1The potential benefits of SWFs to their home economies are described in Kern, 2007. A discussion of the sovereign investments relative to other uses of government revenues is provided in Blackburn, 2008.
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26 Sovereign Wealth Funds: New Economic Realities and the Political Responses
CROSS-BORDER INVESTMENTS: TOWARD A GLOBAL DIFFUSION OF CORPORATE OWNERSHIP?
The political controversy around SWFs has been sparked by their fast and strong rise as government-owned investment vehicles funded by the transfer of state-owned assets that are set up to serve the objectives of economic stabilization, saving for future generations, investment and development, or the funding of contingent pensions through investing the assets on a long-term basis, often overseas.
Globally, this class of institutional investors—comprising more than 60 entities—was estimated to have well over US$3.7 trillion of assets under management in 2010 and has grown impressively, driven by high incomes from commodity sales and reserves accumulation for existing SWFs, as well as the establishment of new entities. The assets are concentrated in the top SWFs, 10 of which are believed to manage more than US$100 billion each, and totaling more than three-quarters of all sovereign assets. In addition, SWF assets are concentrated in geographic terms: They are predominantly found in emerging and developing countries, as shown in Figure 3.1,2 especially in Asia and the Middle East, together home to more than two-thirds of all SWF assets.
2Figures on SWF investments presented in this chapter are based on completed and reported equity transactions by state-sponsored investment vehicles. The total volume of investments flows, including nonreported equity transactions and investments in other asset classes, is substantially higher.
Figure 3.1 Regional Distribution of Assets Held by Sovereign Investors, Percentage of Total, May 2010
Middle East
Source: Deutsche Bank Research.
34
EuropeanUnion
18
Australia2Africa
4
Americas3
Asia39
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Kern 27
The size of the state-owned funds, their concentration, and their growth have greatly influenced the public debate, in the course of which SWFs were at times characterized as state funds of disquieting size and opaque intentions. This per-ception was particularly pronounced in the United States and Europe, the major recipients of SWF investments, absorbing half of all reported capital contribu-tions by state-sponsored investment vehicles worldwide, followed by Asian economies absorbing one-third of the investments, and the Middle East, in which less than one-tenth of assets have been invested (Kern, 2009).
This perception has changed. Most important, growing awareness about the relative size of sovereign investors has helped calm the debate. SWFs are—albeit large and growing—a relatively small group of institutional investors, whose total assets under management amount to merely one-sixth of the investment-fund industry, and to less than 4 percent of bank assets worldwide (Figure 3.2). In aggregate, the reported and completed direct equity investments by SWFs world-wide amounted to US$215 billion between 1995 and 2009 (Figure 3.3). This figure is dwarfed by private capital flows, for example, the US$700 billion of private capital expected to be invested in emerging markets in 2010 alone (Institute of International Finance, 2010). In addition, SWF investments are only one part of a broader trend in the course of which foreign direct investments from emerging markets—whether from public or private sources—have accelerated substantially since the 1990s. With US$290 billion of foreign direct investments, emerging economies have multiplied their participation in global corporate own-ership from its past levels (UNCTAD, 2010). But again, it is useful to recall that this compares with a total of nearly US$2 trillion in foreign direct investment
Sources: Deutsche Bank Research; Hedge Fund Research, Inc.; IMF; International Financial Services, London; WorldFederation of Exchanges.Note: In US$ trillions, actual or estimates for mid-2010.
1.7
3.7
3.7
4.2
6.0
21
25
32
41
0 30 60
Hedge funds
Private equity
Others
Pension funds
HNWI assets
12
25
41
47
102
108
0 50 100 150
Securitizedassets
Commercial realestate
Residentialproperty
Stock marketcapitalization
Debt securities
Bank assets
Investment funds
Insurance companies
Reserves, excl. gold
Sovereign wealth funds
Figure 3.2 Financial Assets and Markets Worldwide, by Volume
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28 Sovereign Wealth Funds: New Economic Realities and the Political Responses
globally, almost half of which originates in the European Union (UNCTAD, 2010).3 (See also Chapter 15 of this book for a further discussion on the relative size of SWFs.)
In addition, some of the concerns in the recipient countries have been dis-pelled by the approach SWFs have taken to their investments for the time being. A considerable share of SWF assets is understood to be invested in company equities, listed or unlisted, worldwide. Although real estate, debt securities, derivatives, and cash are also part of SWFs’ portfolios, public policy issues have clearly centered on the question of corporate ownership on the part of state investors. Concrete substantiation of investment strategies has remained sparse so far.4
Anecdotal market evidence suggests that SWFs generally prefer to acquire small minority stakes in target companies. Other investment strategies notwithstanding, an oft-cited example is Norway’s Government Pension Fund–Global, whose holdings—as one of the largest state-sponsored funds—averaged 1 percent of the world’s listed companies at the end of 2009. The vast majority of the fund’s equity investments are understood to be stakes of less than 2 percent. For publicly reported equity purchases by SWFs, however, the stakes in individual companies are substantially higher (Figure 3.4): Almost two-thirds of all reported transactions result in stakes of 20 percent or higher, and one-quarter of the deals represent outright takeovers (Kern, 2009).
3On the relative economic importance of SWFs, see also Balding, 2008.4For a review of sovereign investment strategies, see, for example, Bernstein, Lerner, and Schoar, 2009; and Chhaochharia and Laeven, 2008.
Source: Deutsche Bank Research.Note: Completed and reported equity investments and sales by state-sponsored investment vehicles globally.
0
10
20
30
40
50
60
70
200920082007200620052004200320022001200019991998199719961995
Investments Sales
US
$ bi
llion
Figure 3.3 Sovereign Investments and Asset Sales, 1995–2009
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Publicly reported stakes, however, make up only a fraction, approximately one-fifth, of total SWF equity holdings.
A further calming factor in the public debate has been the long-term approach most SWFs are understood to pursue regarding their equity holdings. Although no specific evidence is available on this subject, SWFs’ low 1:4 rela-tionship of asset sales to purchases since 1995 suggests that most assets are held for relatively long periods.5 When SWFs divested assets in the past, they sold them directly to private investors in two-thirds of all cases, and in nearly 90 per-cent of these cases to foreign investors outside the SWF’s home jurisdiction. In only 15 percent of all cases were assets sold directly to another state-sponsored investor—half of this 15 percent went to domestic state-investment vehicles and the other half to foreign state investors. The remaining 20 percent of SWF asset sales were executed through secondary market sales (Kern, 2009).6 SWFs’ claim of being similar to conventional institutional investors is further supported by the fact that the majority of equity assets sold to the private sector are sold through private placements or market sales.
Finally, a key factor in rationalizing the debate has been the observation that none of the transactions reported so far has proved harmful to the security and broader economic interests of the recipient economies. In fact, foreign state
5The long-term ratio of asset sales to investments is likely to be altered by the pickup in asset sales in the wake of the crisis, albeit only temporarily.6Reference period is 1995 through mid-2009.
100% stake23%
50–99% stake21%
20–49% stake14%
5–19% stake28%
<5% stake14%
Source: Deutsche Bank Research.Note: Completed investment transactions by state-sponsored investment vehicles, by size of final stake acquired inindividual enterprises, percent of total investment volumes, 1995–2009.
Figure 3.4 Sovereign Investments by Size of Acquired Stakes
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30 Sovereign Wealth Funds: New Economic Realities and the Political Responses
investments in defense-related companies—one of the most critical issues in political debates in the United States and the EU—have played an insignificant role in past years, at 1 percent of the invested total. More important, SWF invest-ments have focused on enterprises in the technology, commodities, real estate, and services sectors, and manufacturing industries, with a share between 10 percent and 15 percent each. The most significant development, however, has been the participation of state-sponsored investors in the financial industry between 2006 and 2009. Spurred by falling equity prices for financial firms in the course of the crisis, the share of investments in the financial sector in completed and reported investment transactions by SWFs between 1995 and mid-2009 amounted to 42 percent, or US$78 billion. Overall, the figures suggest not only that the con-cerns about security issues in recipient economies, especially in the United States and Europe, may have been overestimated, but also that SWFs were broadly per-ceived as beneficial investors in normal as well as crisis conditions.7 This new rationality in dealing with SWFs represents a good basis for building mutually beneficial and productive business relations between foreign state investors and recipient countries in the longer run.
At the same time, policy issues may reemerge, depending on a number of economic and political factors. Realistically, SWFs will continue to grow in busi-ness size and economic and political weight. Even taking into account the setback from the crisis, which resulted in sizable imputed losses on SWFs’ asset portfolios and weakened inflows of new funds from parent governments, SWFs’ assets can be expected to double over the next decade. See Figure 3.5. Given their poten-tially rising financial weight, and with it their growing economic and political influence, SWFs are set to remain under close, if not intensifying, scrutiny by market participants and policymakers.
7Further evidence on the portfolio composition of SWFs has been provided by Balding, 2008; Fernandes, 2009; and Fisher, 2008. Evidence on the role of third-party asset managers has been pre-sented by Clark and Monk, 2009.
0
2
4
6
8
10
2006
Source: Deutsche Bank Research.Note: Scenarios for the development of assets managed by SWFs, based on past 5-, 10-, and 30-year compound averagegrowth rates (CAGR) of foreign exchange reserves, main forecast based on varying scenario probabilities.
2007 2019 20202017 20182015 20162013 201420122010 20112008 2009
Estimated asset volumeMain forecast
US
$tri
llion
Figure 3.5 Projected Growth in SWF Assets through 2020
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SWFS AS FOREIGN INVESTORS IN THE UNITED STATES AND THE EU: THE POLICY ISSUES
The size, growth, and investment activities of SWFs have made them the subject of economic and political concerns in recipient countries, especially the United States and the EU. These fundamental concerns were the background against which a number of measures were targeted at state investors, and they explain the political dynamics behind investment policies in many countries worldwide.8
Financial Market Stability
The SWF industry as a whole represents an economically influential part of the global financial sector. Equally important, individual SWFs have grown to sub-stantial size, bringing them in the league of the largest institutional investors worldwide. This, and the size of many of their individual investment transactions, has given rise to questions regarding the potential impact of SWF transactions on financial market stability. Thus, it is conceivable that an individual transaction undertaken by one SWF might lead to herd behavior by other market partici-pants, resulting in excessive capital movement and price and rate changes for the subject asset as well as—if spillover effects occur—for correlated assets. At the extreme, such herd behavior can exert a destabilizing effect on financial markets. The probability of herd behavior and spillover effects may be aggravated by SWFs’ comparative opacity, and may be further complicated if markets react sensitively to unverifiable market rumors.
Empirically, however, SWF investments have had no detectable impact on financial stability. An analysis of the effects of the equity purchases made by sovereign investors in 2007 and 2008 suggests that no strong or lasting impact on bank share prices existed (Kern, 2008). Although all indicators—including share price, share-price volatility, and abnormal returns—showed aberrations in selected cases, none of them was extraordinarily strong or sustained (Figure 3.6). Even in cases for which the events’ impacts could be identified, the direction of the impacts was not homogeneous. In some cases the investments were likely critically important to stabilizing the capital conditions at the invested institu-tion; however, it would be premature to regard SWF commitments as funda-mentally altering market sentiments in a fragile market environment.9
State Funding
Drawing on budgetary revenues or official reserves, SWFs are state-funded investment vehicles, open to the charge that their activities stand in contrast to the concept of a free-market economy with minimum state intervention and that they distort market activities because their funds are not refinanced under
8An overview of the political issues discussed in the context of the SWFs can be found in Greene, 2008; and Rose, 2009. 9For further evidence, see, for example, Beck and Fidora, 2008; Kotter and Lel, 2008; and Sun and Hesse, 2009.
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32 Sovereign Wealth Funds: New Economic Realities and the Political Responses
market conditions or do not originate from market activity. With states having provided support to the financial sector in industrial economies in response to the financial crisis, and the critical importance of that support for restoring well-functioning markets, this argument has receded to the background in the current debate. The practical impact of foreign state investments on enterprises, however, remains subject to scientific scrutiny, suggesting that a negative impact on the long-run performance of enterprises with shares owned by SWFs cannot be excluded.10
Sale of Strategic Assets and Know-How
Although SWFs emphasize their commercial objectives, much of the public debate in recipient countries has centered on the concern that foreign investors with non-financial motivations could seek control of companies and assets. Such control, it was conjectured, could pose a threat to national security and public order, espe-cially in the defense industry, public and private infrastructure, high technology, and financial markets, but also with respect to access to natural resources world-wide. This issue was seriously considered in many recipient countries, even though it is certainly not specific to SWFs. In fact, states have a number of means and institutions at their disposal through which investments can be pursued. These include public pension funds, development banks, state-owned enterprises, and other public entities. Of these institutions, SWFs are the least suspicious with
10Evidence on a negative impact has been provided by Bortolotti, 2010. A competing view has been presented by Fernandes, 2009.
-1.0
-0.8
-0.6
-0.4
-0.2
0
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-30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30
Barclays, Jun 25, 2008
Credit Suisse, Feb 18, 2008
Merrill Lynch, Jan 15, 2008
Citigroup, Jan 15, 2008
Merrill Lynch, Dec 21, 2007
Morgan Stanley, Dec 19, 2007
UBS, Dec 10, 2007
Citigroup, Nov 26, 2007
Deutsche Bank, May 15, 2007
Ret
urn
(%)
Days
Source: Deutsche Bank Research.Note: Cumulative abnormal returns on share prices within 30 days prior to and after SWF investments in those banks.
Figure 3.6 Effects of SWF Investments on Bank Share Prices
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regard to political investment objectives, given their commitment as long-term-oriented financial investors, mainly seeking small minority stakes. Many of the SWFs also have proven and long-standing track records as reliable partners of the companies in which they have invested. Although no significant cases of security issues involving SWFs have been observed in practice,11 the political concerns have remained the single most critical issue in political and public perception.
Corporate Governance
Finally, critics of foreign state fund investments have argued that SWFs—especially if domiciled in emerging economies—may not be able to live up to corporate governance requirements as established in many traditional indus-trial economies.12 In particular, whether SWFs would be able to meet stan-dards of corporate governance and the responsibilities associated with seats on governing or supervisory boards has been at question.
POLICY RESPONSES: A DANGER OF PROTECTIONIST REFLEXES?
As these concerns were increasingly articulated, governments in many countries13 were quick to review their domestic rules governing incoming investments. In the end, legislative or regulatory initiatives were limited, with concrete changes in market-entry conditions in Australia, Germany, the Russian Federation, and the United States, while the European Union has announced that it will explore the need for EU-wide policy adjustments. The outcomes vary considerably, from the establishment or refinement of reasonable review mechanisms for inward invest-ments to the establishment or heightening of outright protectionist barriers to entry of foreign capital.
Australia
Australia has maintained a foreign investment screening process since 1975, as introduced by the Foreign Acquisitions and Takeovers Act. The process is designed to ensure that foreign investment in Australia is consistent with the national interest. The process requires that significant foreign investment propos-als be notified to the government and examined by the Foreign Investment Review Board (FIRB), which advises the Treasurer, who can reject proposals deemed contrary to the national interest or can impose conditions. The FIRB examines whether foreign investments might have adverse implications for national security, economic development, or government policies. In 2008, the government issued additional principles applicable to foreign state investors, including the operational independence of investors from the government, clear
11For evidence on SWF investment practices, see Avendaño and Santiso, 2009.12For a review of associated issues, see Backer, 2008; Gilson and Milhaupt, 2008; and Monk, 2008.13Extensive comparative accounts can be found in US GAO, 2008; and Kern, 2008.
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34 Sovereign Wealth Funds: New Economic Realities and the Political Responses
commercial objectives, the adherence to adequate and transparent regulation and supervision, and the economic impact of foreign state investments on Australian business. Even though none of these principles establishes qualitatively new crite-ria, the intervention clearly set the tone for investment policies at a time when the Australian public was particularly concerned about the entry of foreign state investors in the areas of natural resources, commodities, ownership and explora-tion rights, and processing. Unlike the policy measures in the United States and Germany (discussed below), the Australian approach explicitly includes broader economic and societal interests in its review criteria, and does not confine itself to questions of national security in a strict sense.14
Germany
Germany’s response to foreign state investments15 was one of the most carefully watched developments in this policy area; nonetheless, the law that emerged from the debate turned out to be a very balanced solution and not nearly as restrictive as expected by some. The law envisages the establishment of a review process, under the auspices of the Federal Ministry of Economics, for foreign investments originating outside the EU or the European Free Trade Association and leading to a stake in a listed or unlisted German company of more than 25 percent of its capital. The federal government can prohibit or approve with conditions a trans-action found to be in violation of the country’s security or public order. The law largely resembles the basic functioning of the Committee on Foreign Investments in the United States review process, but with its high trigger value, a generally lean review process, and its transparent structure, the German investment law is one of the less restrictive in an international comparison. In the final analysis, the quality of the new law can only be judged by the way it is applied in practice. Optimally, the process would and should be invoked in as few cases as possible, and certainly only in circumstances where a material threat to public order or security can be detected (Deutsche Bank, 2009; Kern, 2008).
The Russian Federation
In 2008, the Russian Federation introduced a federal law on foreign investments in companies having strategic importance for state security and defense,16 establishing a process of approval of foreign investments in strategic sectors in the Russian Federation. The process features the specification of 42 strategic sectors in which foreign investments are outlawed or can be prohibited by the government. Furthermore, it sets threshold values for foreign shares in Russian companies trig-gering the review process and establishes notification requirements and sanctions. The law marked a substantial tightening of conditions for foreign investments in
14For details, see Australia, Treasurer of the Commonwealth, 2008. Also Kern, 2008.15Dreizehntes Gesetz zur Änderung des Außenwirtschaftsgesetzes und der Außenwirtschaftsverordnung, Drucksache 16/10730.16Federal Law “On Procedures for Making Foreign Investments in Russian Commercial Entities of Strategic Importance for the National Security of the Russian Federation,” No. 455348-4. Also Kern, 2008.
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the Russian Federation, especially in the strategic sectors identified by the new rules. In addition, investments in areas outside the realm of the strategic sectors ring-fenced by the new laws are regulated by a number of existing general or sectoral rules, which are tight by international standards. As a result, the Russian investment framework is one of the most restrictive regimes worldwide, as reflected in the OECD’s measures for market openness, in which the Russian Federation—before the additional restrictions in the new law—ranked third to last.
The United States
Since 1988 the United States has operated a review process for foreign invest-ments, undertaken by the Committee on Foreign Investments in the United States (CFIUS),17 on the basis of which the U.S. president can prohibit incoming invest-ments. Existing rules were strengthened in 2007 and 2008 to extend the range of transactions open to CFIUS review and to broaden the definition of the review crite-ria of national security to encompass transactions involving critical infrastructure, energy assets, and critical technologies. Further implementing regulations substan-tially lowered the trigger value for setting off the CFIUS process and increased the reporting requirements for the companies involved. The Foreign Investment and National Security Act reform clearly sharpened CFIUS as a policy instrument, raising the complexity of the review and making it one of the most demanding foreign invest-ment processes among the industrial economies—not least for sovereign investors.18
The European Union
With the entry into force of the Lisbon Treaty, the EU has assumed exclusive competence on foreign direct investment policy as part of its common commercial policy. In the long term, this new competence may substantially change the frame-work conditions of foreign investment flows into the EU. Foreign investment policy until 2009 used to be an exclusive prerogative of the member states, leading to a total of almost 1,200 bilateral investment agreements, which account today for almost half of the investment agreements currently in force around the world.
In response to these new EU-level powers, the EU Commission has decided to explore the feasibility of developing an international investment policy for the EU. In a first Communication, the Commission announced that it intends to enable the EU to enlarge, and better define and protect, the competitive space that is available to all EU investors, building on the body and substance of the bilateral arrangements that already exist. In the long term, the Commission is planning to achieve a situation where investors from the EU and from third countries will not need to rely on bilateral investment treaties entered into by the member state for an effective protection of its investments.
17For details on the U.S. CFIUS process see, for example, Jackson, 2006a, 2006b, 2008. A detailed account of the economic and political arguments in the United States has been provided by Truman, 2008.18For details on the U.S. CFIUS legislation and its implementation, see US GAO, 2008. A detailed account of the political debate has been provided by Epstein, 2009.
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36 Sovereign Wealth Funds: New Economic Realities and the Political Responses
In the interim, the Commission has issued a Proposal for a Regulation estab-lishing transitional arrangements for existing bilateral investment agreements between the member states and third countries. The act is aimed at maintaining the status quo by authorizing the continued existence and application of bilateral agreements between the member states and third countries, and avoiding the ero-sion of rights and benefits available to investors and investments under interna-tional investment agreements.
The transfer of exclusive powers in investment policy to the EU represents an historic opportunity for the EU to greatly simplify and encourage investments across the Union. In the end, the EU can only succeed in completing the single market if it manages to establish a joint EU-level investment policy. With the transitional act and its Communication, the Commission has laid the basis for the conceptual debate that will be important to arrive at such a single policy.
THE INTERNATIONAL DIMENSION: ENSURING OPEN MARKETS IN A FRAGMENTED REGULATORY ENVIRONMENT
Rules to govern foreign investments have remained a national prerogative. In practice, most economies worldwide impose substantial regulatory barriers in the form of direct and indirect hurdles on foreign investment. This discourages important investments, or—if they are undertaken notwithstanding—substan-tially raises the cost, especially considering that the barriers differ widely from country to country, with no general patterns.
From an international perspective, no global agreements exist that provide national governments with guidelines, let alone binding rules, to encourage the liberalization of investment regimes or at least their standardization. In addition, a growing number of international and bilateral agreements, although useful for facilitating cross-border capital flows, further fragment the operational environ-ment for international investments. As of end-2008, almost 5,800 international investment agreements (IIAs), including almost 2,700 bilateral investment trea-ties, more than 2,800 double taxation treaties, and more than 270 free trade agreements, were in place (Kern, 2008).
The severity of investment barriers has been measured across various catego-ries of direct and indirect hurdles as well as sectors. The EU and its member states are, on average, the most open and liberal economies in the world, with the Netherlands, Portugal, Romania, Slovenia, Belgium, Spain, and Germany leading the field. Japan, the United States, and other industrial and emerging economies follow. China, the Russian Federation, and India, in contrast, are among the most restrictive countries (Kalinova, Palerm, and Thomsen, 2010). Paradoxically, a comparison of the degree of restrictiveness on foreign direct investment to the volumes of sovereign assets at issue suggests that it is, in par-ticular, countries with extensive state-owned funds at their disposal that cur-rently maintain the strictest regimes for preventing foreign investments from entering their domestic markets.
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With protectionist reflexes against foreign state investors in potential recipient countries looming, the finance ministers of the Group of Seven19 asked the OECD to examine possibilities to provide principles for foreign investment poli-cies. In response to this mandate, the OECD issued its Declaration on Sovereign Wealth Funds and Recipient Country Policies (OECD, 2008b), calling for
• no protectionist barriers to foreign investment in recipient countries;• no discrimination among investors in like circumstances;• investment restrictions only to address legitimate national security concerns,
and subject to the principles of transparency, predictability, proportionality to clearly identified national security risks, and accountability; and
• adherence to OECD General Investment Policy Principles (OECD, 2008b), including, in addition to the above, progressive liberalization, commitment to not introducing new restrictions, and unilateral liberalization.
These principles and the detailed guidance the OECD provides are important yardsticks for national investment policies. The extent to which this guidance will lead to more open and harmonized investment regimes is a different question, critically hinging on four factors (OECD, 2009):
1. Political climate. Following the benign international conditions in the 1990s, further market opening faced increasing opposition through the first decade of the 2000s. General concerns about the impact of globaliza-tion and concrete national and sectoral protectionist interests in many economies have considerably weakened the political momentum for further liberalization of capital movements.
2. Application of the guidelines. The OECD guidelines are nonbinding stan-dards, leaving political application to national governments, so the degrees of commitment and the methods of implementation and enforcement necessarily vary. On the one hand, the OECD has used its peer review process to promote adherence to the standards. On the other hand, the recent dramatic rise in the economic importance and volumes of foreign investments warrants a much stronger commitment to these guidelines by national governments that should result in binding rules along the lines of trade agreements under the World Trade Organization.
3. Symmetry of market access. Cross-border investments not only suffer from high regulatory barriers, but also from the asymmetric way in which many economies pursue foreign investments and benefit from open markets else-where while maintaining restrictive rules on inward investment. These asymmetries are counterproductive, and policymakers should work toward reducing them.
4. Scope of the guidelines. OECD guidelines have only a limited geographical reach, and primarily address the traditional industrial countries. It is
19The Group of Seven comprises Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
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38 Sovereign Wealth Funds: New Economic Realities and the Political Responses
encouraging that the OECD has made special efforts in its SWF-related work to include some 20 non-OECD countries in its discussions, and intends to maintain and enhance this dialogue.
GOOD CONDUCT BY SWFS: THE KEY TO GREATER ACCEPTANCE IN RECIPIENT COUNTRIES
Another important political development in response to the rise of SWFs has been the call for rules for the good conduct of these funds, resulting in the Group of Seven’s request to the IMF to explore ways of reaching international standards (IMF 2008b). In October 2008, the International Working Group of Sovereign Wealth Funds (IWG) issued the results of this process, presenting a set of 24 Generally Accepted Principles and Practices (GAPP), also known as the Santiago Principles (IWG, 2008b).
The GAPP are designed as a voluntary framework that is subject to home-country laws, regulations, requirements, and obligations. They provide guidance for appropriate governance and accountability arrangements,20 as well as guide the conduct of appropriate investment practices on the part of SWFs. With the GAPP, the IWG aims to further develop the level of transparency and quality of governance of SWFs worldwide, including a commitment to financial, nonpo-litical objectives. With regard to transparency, the GAPP seek to improve knowl-edge of investment strategies, including details on the intended use of voting rights, risk management, and the use of financial leverage. Regarding governance, the GAPP aim at better information about organizational structures and pro-cesses, most importantly featuring a commitment to a separation of SWF asset management from government (Kern, 2008).
Despite the breadth of the GAPP and their voluntary nature, their adoption in 2008 signaled a remarkable achievement on the part of the IMF and the mem-bers of the IWG, especially considering the political challenges along the way. Reaching agreement on the GAPP marks an important step. Their success in practice will depend on three critical questions:
• Fulfilling expectations of key stakeholders. Can the GAPP satisfy the expecta-tions of the various stakeholders—policymakers in SWF home countries and in recipient economies, market participants, and the wider public? If the GAPP fail to address the key concerns of the main parties to future investment transactions, there is a risk that they will become ineffective and SWFs will continue to face difficulties accessing certain economies and gaining acceptance as reliable institutional investors.
• Securing broad support and adherence. Will SWFs and the states that run them—participating in the IWG process or not—subscribe and adhere to these principles in practice? If an SWF decides not to embrace the GAPP, whether that SWF will in practice be confronted with heightened political
20For first evidence on institutional and operational practices of SWFs, see IWG, 2008a.
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scrutiny or even resistance in the recipient economies, remains to be seen. Subscribing to the GAPP could lend a cachet to SWFs, signaling to recipient economies that those entities are committed to financially motivated invest-ments and fulfilling minimum standards of transparency and governance.
• Ensuring oversight and implementation. Will SWFs and the IMF succeed in overseeing and ensuring implementation of the GAPP, or is there a risk that these voluntary commitments will remain unobserved in the countries to which they are particularly addressed? If committing to the GAPP were to develop into a seal of quality, SWFs would need to back up their commit-ments with actions. They should adhere to financial objectives and imple-ment and apply transparency and governance standards in a way that can actually be monitored by all stakeholders.
The establishment of the International Forum of Sovereign Wealth Funds (IFSWF) in 2009 as a voluntary standing group of SWFs to discuss issues of common interest and facilitate an understanding of the Santiago Principles and SWF activities has been an important measure toward the implementation of the GAPP. Similarly, the efforts by a number of SWFs to enhance their public reporting in the wake of the adoption of the Santiago Principles can be seen as progress in the spirit of the principles. These first steps, it is hoped, will inspire more far-reaching efforts at meeting requirements and expectations set by the Santiago process.
CONCLUSION: THE GLOBAL PERSPECTIVE
SWFs and their investments are one facet of a new phase of globalization that will lead to ownership of assets globally and a new quality of the participation of emerging markets in the global economy. Because many emerging markets have made tremendous economic progress in recent years and are becoming wealthier, private individuals and public institutions in these economies are increasingly engaging in international investments. This engagement has boosted capital flows from the emerging economies to the traditional industrial economies and resulted in greater and more active participation in global capital markets.
Both are positive and highly welcome developments, considering that—owing to the economic realities in earlier phases of globalization—capital had tradition-ally flowed from industrial countries into emerging markets. The growing inter-national investments by emerging markets are likely to help them achieve a more established role in world finance commensurate with their increasing importance in the global economy.
Foreseeable economic developments of this kind, and their growing magni-tudes, call for early and coordinated policy approaches. The IMF’s coordinating strategy on SWF transparency and governance is a positive example of how a swift and targeted policy response brought emerging markets to the negotiating table, actually making them the drivers of the process.
If SWFs can be regarded as harbingers of the escalating international involve-ment of emerging markets in global economics and finance, their case illustrates
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40 Sovereign Wealth Funds: New Economic Realities and the Political Responses
that intensification of the dialogue increases the chances of achieving mutually acceptable policy outcomes. Ultimately, stronger participation of the emerging markets in international economic and financial policymaking and diplomacy will be needed. Their participation will be an important element for reaching joint rules in globalized capital markets.
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Kern, Steffen, 2007, “Sovereign Wealth Funds—State Investments on the Rise,” Current Issues, September 10 (Frankfurt: Deutsche Bank Research).
———, 2008, “SWFs and Foreign Investment Policies—An Update,” Current Issues, October 22 (Frankfurt: Deutsche Bank Research).
———, 2009, “Sovereign Wealth Funds—State Investments during the Financial Crisis” (Frankfurt: Deutsche Bank Research).
Kotter, Jason, and Ugur Lel, 2008, “Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the Price of Keeping Secrets,” International Finance Discussion Papers No. 940 (Washington: Board of Governors of the Federal Reserve System).
Miracky, W., and B. Bortolotti, eds., 2009, “Weathering the Storm: Sovereign Wealth Funds in the Global Economic Crisis of 2008” (Monitor Group and Fondazione Eni Enrico Mattei).
Monk, Ashby H. B., 2008, “Recasting the Sovereign Wealth Fund Debate: Organizational Legitimacy, Institutional Governance and Geopolitics,” School of Geography and Environment Working Paper WPG08-14 (Oxford, UK: Oxford University).
OECD (Organisation for Economic Co-operation and Development), 2008a, OECD Declaration on Sovereign Wealth Funds and Recipient Country Policies (Paris).
———, 2008b, OECD General Investment Policy Principles (Paris).———, 2009, OECD Guidelines for Recipient Country Investment Policies Relating to National
Security (Paris). Rose, Paul, 2009, “Sovereign Wealth Fund Investment in the Shadow of Regulation and
Politics,” Georgetown Journal of International Law, Vol. 40, No. 4, pp. 1–33. Sun, Tao, and Heiko Hesse, 2009, “Sovereign Wealth Funds and Financial Stability—An Event
Study Analysis,” IMF Working Paper No. 09/239 (Washington: International Monetary Fund).Truman, Edwin M., 2008, The Rise of Sovereign Wealth Funds: Impact on US Foreign Policy and
Economic Interests, Testimony before the Committee on Foreign Affairs, US House of Representatives, Washington, May 21.
UNCTAD (United Nations Conference on Trade and Development), various years, World Investment Report (New York).
US GAO (United States Government Accountability Office), 2008, Foreign Investment, U.S. Senate, Report GAO-08-320 (Washington).
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CHAPTER 4
Sovereign Wealth Funds and Economic Policy at Home
JON SHIELDS AND MAURICIO VILLAFUERTE
This chapter explores the macroeconomic objectives and consequences of sover-eign wealth funds (SWFs). It looks at what governments should ask SWFs to achieve, and at what might result if they are not properly tasked and coordinated. The discussion highlights in particular how the macroeconomic implications of an SWF’s actions affect the ways in which it should be structured, operated, and reported upon.
For any government, few decisions can be more significant—politically or economically—than to choose to accumulate financial assets when its citizens still have large unmet needs. Every dollar that a government saves is money that some may believe would have been better spent on social welfare or infrastructure, or taxes that need not have been levied. The government must be able to show both that the money it sets aside will be well managed, and that the economy will benefit directly from increasing public savings. Economic benefits may range from the immediate avoidance of undesirable pressures on the exchange rate or the inflation rate to providing insurance against bad times. The objectives of an SWF may also need to change over time, particularly if the conditions that gave rise to the SWF in the first place change, as witnessed during the recent global financial crisis. In all cases, however, the government needs to be clear to the public not only about the intertemporal objectives of any SWF that is created, but also about its direct consequences in the present.1
This chapter places SWFs within the broad context of their home economies. It analyzes the impact of SWFs in both the short and the long term and discusses how countries that choose to establish SWFs to help manage government savings can ensure that the SWFs also help them achieve their broader macroeconomic objectives. The chapter reviews relevant aspects of SWFs’ governance, transparency, relationship to other parts of the public and private sectors, and actual conduct. A key message is that the rules and provisions governing SWFs can be critical in determining their ability to make a positive impact on their home economies.
1Many of these issues are covered in depth in the IMF “Guide on Resource Revenue Transparency” (IMF, 2007a).
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THE ROLE OF AN SWF WITHIN THE OVERALL MACROECONOMIC POLICY FRAMEWORK
Objectives
In practice, SWFs have been established for a variety of reasons and in a variety of circumstances. Many were initially created for fiscal stabilization, that is, to help smooth the impact on government spending of revenues that were large and volatile, particularly revenue from the export of natural resources. Safety buffers were built up when revenues were high so that spending could be protected when times turned bad. Other SWFs were focused more specifically on protecting high revenues from being raided through populist pressures for sharp increases in spending that might prove unsustainable. But behind these motivations were often broader concerns about management of the economy as a whole. The inten-tion was then more specifically one of macroeconomic stabilization, and in par-ticular, of avoiding excessive pressures on the productive capacity of the economy and hence on inflation.
Another objective for the creation of SWFs was longer term: to set aside funds for the future needs of the economy, or of specific groups such as pensioners, or for future generations—a consideration particularly relevant in the case of reve-nues derived from exhaustible natural resources.
In addition, in many instances, a prime reason for establishing an SWF was to improve the potential return on a government’s financial investments, specifically by investing in riskier assets.2 If the foreign reserves were accrued by sterilized foreign exchange interventions, this objective amounted to reducing the carry costs of those reserves.
Many SWFs were set up with several of these objectives in mind, which tended to complicate their design and operation. For instance, for an SWF with both macroeconomic stabilization and long-term saving objectives, questions arise about the portion of its assets that can in practice be used for short-term purposes. With regard to an SWF’s asset management, short-term macroeco-nomic factors might require a highly liquid portfolio, while savings objectives might point to a longer-term investment strategy focusing on financial returns. Furthermore, some SWFs have been given the authority to spend directly, bypassing the budgetary process and leading to fragmentation of policy deci-sions regarding public expenditures.
Impact on the Domestic Economy
Regardless of the initial objectives specified for an SWF, governments need to recognize that the actions of SWFs can influence other dimensions of their
2The contention that setting aside financial savings in an SWF will necessarily enhance or maximize returns to the government (and the economy at large) is, nevertheless, often disputed. In countries where governments are liquidity constrained, and social and infrastructure needs are sizable, net returns to the economy from social spending and public investment may exceed those of (foreign currency) financial assets.
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economies—and sometimes even in troublesome directions. Depending on the size of assets that the SWF has under management, the economic characteristics of its owner country, and the country’s overall institutional framework, changes in an SWF’s assets, investment strategies, and operations may have substantial implications not only on public finances, but also on monetary conditions, the balance of payments, the exchange rate, domestic financial markets, and private sector balance sheets and behavior.
Because of these potentially profound implications, the government needs to specify carefully the setup and operations of the SWF and the coordination of the SWF’s policies with those of the country’s fiscal and monetary authorities, and explain these fully to the public. Among the more important aspects of the economy that can be affected by the activities of an SWF are the following:
• The path of public spending. Use of an SWF’s financial assets can help insulate public expenditure from year-to-year volatility in commodity-related revenue, particularly in the presence of liquidity or borrowing constraints. However, if an SWF operates under rigid rules that, for example, require revenues to be set aside from the budget irrespective of economic conditions, the government’s ability to sustain its spending plans can be severely limited.
• Aggregate demand and economic activity. By using SWF-managed assets to increase spending, or alternatively increasing SWF assets through govern-ment savings, the authorities can affect aggregate demand (that is, the over-all level of spending in the economy) with a view to smoothing economic cycles. This capability can be especially important when there are large shocks to the economy and the country has few alternative sources of financing, a situation faced by many resource-revenue-dependent countries in the global financial crisis. However, rigid rules governing the rate of accu-mulation of assets in the SWF, or of withdrawals from it, can themselves induce substantial cyclical volatility. Domestic spending or investment in domestic assets by SWFs can also affect aggregate demand.
• Monetary conditions and the exchange rate. SWF operations can have an impact on the conduct of monetary policy and on the levels of interest rates and the exchange rate. For instance, injecting liquidity into the domestic economy by using an SWF’s assets to increase public spending or invest in domestic capital markets can lead to pressures on inflation and the real exchange rate. But if the existence of an SWF means that foreign currency revenues are used to purchase foreign currency assets rather than being spent at home, the real exchange rate will appreciate less than it would otherwise, alleviating upward pressure on the nominal exchange rate, on inflation, or on both. Using an SWF to reduce the carry cost of foreign reserves may prolong the use of sterilized intervention to avoid exchange rate adjustments.
• Private sector behavior. The accumulation of financial assets by the govern-ment may trigger offsetting reactions by the private sector. For instance, the private sector, observing that the wealth of the public sector is rising (and
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sensing that the future tax burden may be lower), may feel more confident about increasing its consumption, investment, and even risk-taking. This latter effect is even more likely if the buildup of public sector financial assets results in lower sovereign premiums in international financial markets.
• The returns from public resources over time. By increasing the returns on pub-lic financial assets, SWFs may create fiscal space—room for higher spending or lower taxes—or improve the sustainability of the public finances. At the same time, however, because higher risk-taking can translate into financial losses, such investments may pose higher fiscal risks.
• The vulnerability of the economy. The assets and liabilities of an SWF can have a bearing on the soundness of the balance sheet of the public sector and its solvency and debt sustainability. This is not just a question of the total net worth of the SWF, but also the composition and liquidity of its portfo-lio. For instance, an SWF may be required to hold assets whose value tends to move in the opposite direction from the country’s major exports to pro-vide a hedge against country-specific risks. Conversely, SWFs based on the issuance of domestic securities to purchase foreign exchange surpluses from the private sector might cause mismatches in the overall public sector port-folio and lead to balance sheet risks.
The extent and variety of the impacts that an SWF may have on its home economy suggest the need for its owners and managers to adopt a holistic per-spective on its role and how it should fit into the overall economic policy frame-work. The following subsection provides a systematic approach to this issue.
Types of SWFs and Overall Policy Objectives
Four principal categories of SWFs can be discerned, based on their underlying objectives. In addition to stabilization funds and long-term savings funds, there are also pension reserve funds, which are designed to explicitly provide for contin-gent unspecified pension liabilities from sources other than individual pension contributions, and reserve investment corporations, which are established to reduce the carry cost of foreign reserves. Somewhat different conceptually, and in the composition of their assets and behavior, are so-called development funds, which have been created to direct spending and investment toward the home economy. Of course, to complicate the picture, some SWFs have multiple objectives. Box 4.1 provides some examples of SWFs that have been established with clear single or multiple objectives.
Operational Framework
The day-to-day functioning of an SWF is determined by its operational rules, which cover specific principles for the accumulation and withdrawal of resources (that is, when and under what conditions to make deposits or use its money); the manage-ment of its assets (for example, in which asset classes to invest and in what propor-tions); and provisions for the SWF’s governance, transparency, and accountability.
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Devising operational rules for SWFs that help to achieve their objectives—without complicating the country’s economic management—is not straightfor-ward. For a start, although SWFs are set up to make the best use of government savings, they are not the only players. Governments that are able to borrow from other sources while also accumulating funds in an SWF can determine the level of their net savings independently of any rules set for the SWF. This simple fact has undermined the effectiveness of many commodity-based SWFs. One mistake has been to set rigid rules for the accumulation and withdrawal of funds by the SWFs in the expectation that siphoning off some large and volatile government revenues into the SWF, and refusing to allow them to be spent in the short term, would help reduce fiscal policy discretion and moderate government expenditure. The reality has often been either that governments have simply found other ways to finance their spending—particularly because their ability to borrow may have been strengthened by the buildup of assets in the SWF—or have resorted to changing or circumventing the rules of the SWF to give themselves the flexibility
SWFs’ Objectives: Selected Examples
Chile. Chile’s 2006 Fiscal Responsibility Law established two SWFs with clearly distinct objectives to invest the fiscal surpluses resulting from the application of Chile’s struc-tural balance rule. The Fund for Economic and Social Stabilization was set up as a stabi-
lization fund. The Pension Reserve Fund was created to provision for future pension lia-
bilities of the government; the intention was to lock in its resources for 10 years so that they could subsequently help to cover a specific fraction of the increases in pension-related outlays.
Azerbaijan. The State Oil Fund of the Republic of Azerbaijan has multiple objectives: savings, stabilization, and development. A cornerstone of the SWF is to provide for inter-generational equality with regard to benefit from the country’s oil wealth. But the SWF is also charged with improving the economic well-being of the current population, including assisting in economic management. The SWF’s assets may also be used for undertaking domestic projects, including construction or reconstruction of infrastruc-ture or projects considered strategically important.
The Republic of Korea. Korea Investment Corporation has a single objective in managing the nation’s assets, but it is also expected to contribute to the development of the local asset-management industry. It was created as a reserve investment corporation, a spe-cialized investment management company to manage part of the country’s foreign exchange reserves and other public funds.
Norway. Renamed the Government Pension Fund–Global in 2006, Norway’s long-term
savings fund was established in 1990 as a fiscal policy tool to support long-term man-agement of petroleum revenues. While its assets are not specifically earmarked for pension expenditures, its current title reflects the need to facilitate government savings to meet the rapid rise in public pension expenditures in the coming years. The clarity of its savings objective was underlined by the decision not to use its assets for stabilization spending when Norway adopted a large fiscal stimulus package in late 2008. However, inflows into the SWF were reduced by changes in the overall fiscal stance.
BOX 4.1
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to conduct short-term fiscal management. These considerations highlight the problems of conceiving the SWF as an independent instrument of fiscal policy rather than simply as a medium to manage part of the government’s net worth.
An SWF’s operational rules need to allow it to function effectively within an appropriate overall government-wide framework for economic management. Therefore, clear and stable functional guidelines for an SWF should allow it both flexibility in its conduct and assured coordination with the economic authorities. One way of harnessing these principles is for the SWF to link its operational rules explicitly and transparently with the government’s broader fiscal policy framework. In Norway and Timor-Leste, for example, flows in and out of the oil SWFs depend on oil revenue and policy decisions embodied in each country’s non-oil fiscal stance. Thus, changes in the net assets held by the SWFs correspond to changes in the overall net financial asset position of the government. For such “financing funds,” assets are accumulated as long as surpluses in government finances continue.
No operational framework for an SWF can effectively overcome fundamental flaws in a government’s overall economic policy framework. Indeed, weak policy and institutional frameworks or a defective political process can actually impede the proper functioning of an SWF. Although in a few cases it has been argued that the creation of an SWF with separate procedures and controls might yield better results than a weak public financial management system, little tangible evidence indicates that such “islands of excellence” work in practice. (See discussion in Ossowski and others, 2008.) Moreover, scarce resources may simply be diverted from improving the national public financial management system. Similarly, the argument that an SWF can be useful in resisting spending pressures relies more on the notion of “putting sand in the wheels” than on raising the standard of public financial management.
Rigid operational rules can also become outdated if underlying conditions change, particularly for commodity-based SWFs, because the volatility of com-modity prices and revenues may change the relative importance of the SWF to the economy over time. Indeed, international experience shows that many oil SWFs with relatively rigid operational rules have had to change, bypass, or eliminate them in response to significant exogenous changes, shifting policy pri-orities, or increased spending pressures, or because of broader asset and liability management objectives.3
3Many oil stabilization funds have or have had price- or revenue-contingent deposit or withdrawal rules (e.g., Algeria, the Islamic Republic of Iran, Libya, Mexico, the Russian Federation, Trinidad and Tobago, and República Bolivariana de Venezuela). Most savings funds are revenue-share funds, in which a predetermined share of oil or total revenues is deposited in the SWF (e.g., Equatorial Guinea, Gabon, and Kuwait). Ossowski and others (2008) provide examples of SWFs for which rules were changed. The SWFs in the U.S. state of Alaska, the Canadian province of Alberta, and Papua New Guinea in the 1980s and 1990s, and more recently, the SWFs in Kazakhstan, the Russian Federation, and Trinidad and Tobago, are cited as examples of frequent changes in operational rules in response to changes in oil prices. In addition, Chad, Ecuador, and Papua New Guinea are highlighted as cases in which SWFs were abolished because they were found to be operationally or politically unworkable.
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The 2007–09 global financial crisis offers a clear example of sharp changes in economic policy objectives requiring a flexible framework for the management of SWFs. In response to the need for additional finance for public schemes to bolster their economies and support financial institutions, many governments turned to their SWFs. This resulted in a change in the focus of some SWFs (see Box 4.2) and a consequent blurring of institutional roles. By undertaking activities that would previously have been the responsibility of the government or other public sector entities, these SWFs were deflected from pursuing the financial objectives originally set for them. Changing objectives can also affect the governance arrangements for SWFs and complicate their accountability to their owner governments.
These events highlight the challenge of designing frameworks and rules that can withstand time and changes in situations and the importance of ensuring consistency between broader economic policy objectives and SWFs’ opera-tional objectives. They provide a strong argument in favor of “financing SWFs,” for which changes in asset accumulation are explicitly driven by the conduct of fiscal policy.
An SWF’s operational rules can also be critically important for macroeco-nomic policy if the SWF is permitted to spend its resources directly. This is especially true for SWFs that describe themselves as development funds. Direct spending by such an SWF may, for example, provide welfare services, finance public prestige projects, help local communities, or be used to invest in private development activities. One motivation for involving the SWF in these actions
SWFs and the Global Financial Crisis
The involvement of SWFs in government initiatives to tackle the global financial crisis has been quite varied:
• In the Russian Federation and Kazakhstan, resources from SWFs were used to sup-port domestic financial systems through third parties (a development bank and a distressed asset fund, respectively) tasked to deal with domestic institutions direct-ly. For that purpose, the investment rules of SWFs were changed to allow them to acquire sizable long-term deposits and bonds of those government entities. Although helping to address critical policy needs, those investments directly exposed the balance sheets of SWFs to the risks of the governments’ intervention and potential quasi-fiscal losses.
• In Kuwait and Qatar, the Kuwait Investment Authority and Qatar Investment Authority are allowed to, and have been, directly investing in domestic financial institutions as part of their governments’ strategies to support their financial sys-tems in light of the global financial crisis.
• By contrast, in Norway, the Government Pension Fund–Global has not had a role in financing government measures explicitly aimed at assisting the financial system.
BOX 4.2
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may be to satisfy a political requirement to show how the revenue from natural resources is being spent. However, if such direct spending is not coordinated with regular budgetary institutions, it can seriously affect the integrity of the budget process and lead to fragmentation of policymaking. In these circumstances, gov-ernments may lose effective control over public sector expenditure, and the effi-cient allocation of resources may be impeded because of a decline in prioritization of resources among different needs.
Relationship to the National Budget
In principle, the national budget should be the key institution for setting and implementing public policies and priorities. Therefore, the growing practice among countries with SWFs has been to limit the ability of the SWFs to spend their resources outside the government’s budget framework. In Chile, Norway, and Timor-Leste, the resources of the oil SWFs can only be used through the budget. In other countries, such as Azerbaijan, the budget of the oil SWF is pre-pared in consultation with the Ministry of Finance and, to encourage the trans-parent and efficient allocation of public resources, the documentation submitted to parliament at the time of the annual budget records all direct SWF spending.
However, fiscal policy management can be complicated if transfers from SWFs to the budget are earmarked for specific purposes, such as spending in priority areas.4 Such provisions generally reduce the flexibility of public finances to adjust to changing conditions or priorities, complicate liquidity management, and affect the efficiency of government spending. They can also result in offsetting actions being taken by the government, such as borrowing to finance other spending.
Monetary and Exchange Rate Policies
The monitoring of SWFs’ operations by monetary authorities can be critical because SWFs can have an impact on the conduct of monetary policy and on the levels of interest rates and the effective exchange rate through the injection or withdrawal of liquidity in the domestic economy. Operations by reserve invest-ment corporations (or any SWF that has some counterpart sovereign debt) deserve special emphasis because they bring to the surface more strategic policy considerations. By improving the likely financial returns on foreign exchange reserves, reserve investment corporations reduce the expected carry costs of steril-ized foreign exchange interventions. This may tempt the authorities to prolong the use of such interventions to delay adjustment in the real exchange rate. A further twist may be added to this spiral by the growing currency mismatch it produces (short domestic and long foreign currency), which will make future currency appreciation increasingly costly.
4In some cases, such earmarking provisions have derived from political economy considerations, such as creating a constituency supportive of the oil SWF (e.g., Alaska). This can make it easier to resist political pressures to use oil revenues inappropriately, or (as in Azerbaijan, Chad, and Ecuador) to prioritize resources for special purposes, such as poverty reduction or debt service.
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Economic Policy Coordination
Depending on the type of institutional arrangement chosen for the SWF, mecha-nisms may need to be established to ensure appropriate coordination with the fiscal and monetary authorities. For SWFs established simply as central govern-ment accounts managed by the central bank (as in Norway and Kazakhstan), or as agencies managing international reserves under the government’s direction (Government of Singapore Investment Corporation, Korea Investment Corporation), the SWFs themselves may have little independent impact on fiscal and economic management. However, SWFs set up as separate public entities (Temasek in Singapore, Kuwait Investment Authority), with or without authority to undertake off-budget expenditure and maintain their own sources of revenue, are likely to need specific coordination mechanisms. At a broad level, the SWF’s legal framework and corporate governance arrangements can help to frame the institutional relationships between the SWF, the government, and the central bank. But clear guidelines should also direct any large operations of the SWF involving intervention in foreign exchange markets or domestic market opera-tions, including coordination with the monetary authorities.
Economic policy coordination can also be complicated by blurred institu-tional roles for an SWF. If, for example, an SWF provides subsidies, or under-takes other quasi-fiscal activities, it can obscure the impact and extent of government operations.
Use of SWF resources to invest in domestic markets raises a range of addi-tional economic and governance issues. With regard to potential macroeconomic impact, particularly if SWFs are funded from foreign exchange sources, such operations may have an impact on interest rates, the real exchange rate, and the relative prices of securities. From a market perspective, a critical question is whether the SWF is able to invest purely on commercial grounds, or whether it will be much more susceptible to political or ethical pressures than when invest-ing overseas. Considerations of portfolio diversification, or helping to develop deeper domestic capital markets, may also motivate investment in home markets. From a fiscal perspective, a more complex issue is whether some domestic transac-tions by SWFs should be considered government spending rather than financial investment. Some transactions clearly fall in this category, including transfers, subsidies, and investment in physical capital. But others may be more difficult to identify. For example, some investments may turn out to be profitable, but may have been undertaken initially because of a strong policy motive. Ideally, the quasi-fiscal activities inherent in such investments should be quantified and reflected separately in budget documentation and fiscal accounts.
Fiscal Risks and the Public Sector’s Balance Sheet
In assessing the sustainability of a government’s fiscal plans, not only must realis-tic central projections of spending, revenues, and deficits be considered, but also the probability and size of potential deviations from these projections. Given the inherent uncertainties about the likely returns from an SWF, and any potential
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liabilities held on the SWF’s balance sheet, it is crucial that risks associated with an SWF be taken into account when assessing the net worth of the public sector’s balance sheet.
Of course, SWFs are generally created to reduce the potential impact on the economy of fiscal risks. For example, commodity-related SWFs are designed to help manage revenue volatility and protect the value of financial savings for future needs (e.g., depletion of oil reserves or pension liabilities). But SWFs can be sources of risks, too. Judging by the experiences of some small Pacific Island countries, SWFs can easily create fiscal risks if they accumulate riskier and more volatile investments in a drive for increased financial returns (see Le Borgne and Medas, 2007).
Specific financial risks such as currency, interest rate, and maturity risks become relevant if SWFs undertake leveraged operations, invest in derivatives, or finance foreign currency assets through domestic sterilization operations. Currency mismatches (short domestic and long foreign currency positions) can have sizable costs if the underlying exchange rate policy proves unsustainable.
One particular element that became more critical in the recent global financial crisis was the degree of liquidity of SWFs’ financial assets. Given the extent and speed of the crisis, governments were faced with the prospect of requiring SWFs to realize short-term capital losses to compensate for large government revenue shortfalls or to support the domestic financial system. This focused attention on the underlying tensions between an SWF’s liquidity and its potential returns, and between protecting its assets and supporting the domestic economy. As a result, more countries are accepting the need to approach SWFs from a holistic perspec-tive, which may lead to a reconsideration of the objectives of some SWFs. In such circumstances, their degrees of liquidity and risk-taking are likely to change, with direct consequences for their original investment strategies and policies.
Implications for Asset-Liability Management
Both the underlying objectives of an SWF and the various risks mentioned above need to be considered when designing the SWF’s asset-liability management framework and its strategic asset allocation (SAA). Some basic principles are stressed here (and discussed extensively in Chapters 10–12 of this book):
• Different objectives generally require different SAAs. Stabilization SWFs should generally have conservative SAAs, using shorter investment hori-zons and low risk-return profiles, or other instruments that vary inversely with the risk the SWF is meant to cover. The same rationale could apply in a country that is highly dependent on the returns on SWF assets.5 By contrast, SWFs with long-term objectives, such as savings funds, may seek to maximize returns while also aiming to preserve a certain amount of
5This is a critical lesson from the study by Le Borgne and Medas (2007) on the operation of SWFs in Pacific Island countries, where weak asset management led to substantial financial losses and severely jeopardized fiscal sustainability.
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capital, in real terms, so that the purchasing power of the SWFs is guar-anteed. Therefore, they may have longer investment horizons and riskier investment strategies.
• Risks from reversal of the original conditions leading to the accumulation of assets in an SWF need to be considered in defining appropriate investment hori-zons and risk tolerance. For instance, many SWFs are funded by volatile, and in some cases exhaustible, commodity revenue, making the SWFs only temporary vehicles.
• SWFs with explicit (or even implicit) liabilities should develop SAAs and invest-ment guidelines aimed at preserving the soundness of their balance sheets in the face of portfolio mismatches. Inappropriate asset-liability management in this context could result in losses with macroeconomic implications, particu-larly for reserve investment corporations with large currency mismatches associated with sterilized foreign exchange interventions.
ACCOUNTABILITY
Accounting for an SWF
Regardless of its legal form, an SWF is first and foremost a guardian of public financial assets. SWFs can also provide the scope and means through which fiscal action can be taken. So no representation of a sovereign’s balance sheet, income, or expenses is complete without full recognition of the size and performance of the assets (and liabilities) being managed or controlled by the SWF and the sources and uses of its funds. Such disclosure does not in any way compromise the institutional independence of an SWF.
In many cases, consolidating the activities of an SWF within the sovereign’s balance sheet and income and expenditure statements is fairly straightforward. No complications are likely if the SWF is an account managed by the central bank, or is permitted only to receive funding or make transfers through the national budget. However, consolidation can be more complex if an SWF receives inflows directly from revenue sources (e.g., a company’s payments of oil royalties) or makes payments for goods and services outside the national budget. Such transactions need to be fully and separately identified so that they can be assigned to the appropriate components of the government’s accounts. The same consid-erations apply to interest and dividends earned by an SWF, regardless of whether they are in practice retained and reinvested by the SWF. Even for an SWF that functions legally as a public corporation, a strong case can be made for it to pro-duce accounts that consolidate its activities within the government because of its custodial role.
At the same time, it is also important to report separately an SWF’s individu-al contributions to aggregate demand, national savings, and investment to high-light its importance to economic management and to improve the quality of fiscal analysis and coordination of economic policy. An SWF’s own financial statements and accounts, which should be independently audited and published, needs to
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clearly disclose all sources and beneficiaries of income and spending, including other parts of the public sector.
Transparency
To be an effective instrument for economic management, an SWF needs to be perceived by the public as responsible and relevant. Transparency often provides the key to developing this perception. For example, being open and clear about its operations shows that an SWF is fully answerable for the government savings that it handles. Published reports on its performance demonstrate accountability for the objectives set by its owner government. And disclosure of its governance structure and integrity standards provides assurance that political or personal motivations are not undermining its effectiveness.
It is occasionally argued that disclosure of an SWF’s assets and operations could generate excessive public pressure to spend some of the resources, or focus attention too much on the SWF’s short-term performance. But these are minor risks compared with the problems that can be created by hiding such information. Ignorance about a country’s financial wealth or the governance of its assets can undermine public confidence in its economic policies by generating unrealistic expectations about the country’s capacity to support its citizens or suspicions about the honesty and effectiveness of its wealth management.
In many respects, the transparency requirements for an SWF are similar to those for other entities responsible for government functions, which are summa-rized in guidelines published by the IMF and the Organisation for Economic Co-operation and Development.6 Particularly relevant to SWFs are provisions dealing with holdings of government assets and the reporting of revenues and expenditures. The need for comprehensive disclosure of information about the size and types of financial assets and the gross flows of revenue and spending is especially stressed.
The IMF “Code of Good Practices on Fiscal Transparency” also emphasizes the need to clearly specify roles and responsibilities for the holding of financial assets, implying the need for legal frameworks and regulatory documents that include an unambiguous statement of an SWF’s objectives and mechanisms for ensuring accountability (IMF, 2007b). Equally important is to have clear and publicly accessible corporate governance arrangements that frame the SWF’s rela-tionships with other institutions, including coordination of fiscal, monetary, and exchange rate policy, and asset-liability management. Operational rules and the asset management strategy should be made public.
Accessibility and timeliness of information are important aspects of fiscal accountability. For an SWF, this entails regular publication of audited balance sheets and operations and performance statements. Details of the SWF’s revenue, borrowing, spending, and performance should also be provided in the govern-ment’s budget documentation.
6 See IMF, 2007b; and OECD, 2002.
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CONCLUSION
This chapter concludes with some lessons for the proper design of an SWF. As discussed, the operations of SWFs can be wide-reaching, influencing many dimen-sions of an SWF’s own economy. Public finances, monetary conditions, the balance of payments, the exchange rate, domestic financial markets, and private sector bal-ance sheets and behavior can all be affected by an SWF. So, while a well-designed SWF operating under clear and flexible rules in good coordination with the macro-economic authorities can be a valuable instrument in helping to maintain eco-nomic stability, a poorly designed one can be a source of disruption and instability.
• Operational rules for SWFs need to be consistent with the overall macrofiscal policy framework and permit flexibility in the face of changes in underlying conditions. International experience shows that many oil SWFs with rela-tively rigid operational rules have had to change, bypass, or eliminate those rules in response to significant exogenous changes, shifting policy priorities, or increased spending pressures, or because of broader asset and liability management objectives. This argues for a better balance in operational rules between sufficient firmness to prevent the SWF being raided for short-term political considerations and sufficient flexibility to accommodate the requirements of macroeconomic management. Financing funds largely avoid these problems because the government’s fiscal position (the overall fiscal balance) itself determines net flows into the fund.
• SWFs should have no or minimal ability to spend their resources directly. Ensuring that all spending of an SWF’s resources is conducted transpar-ently through the budget prevents fragmented fiscal policymaking and allows for a more efficient allocation of resources. This also applies to any intervention by an SWF in the domestic economy: to the extent that such intervention entails a subsidy or other form of quasi-fiscal activity by the SWF, it would be better for it to make an explicit transfer to the relevant government entity. By the same token, earmarking withdrawals from SWFs should be discouraged because such earmarking generally reduces the flexi-bility of the public finances to adjust to changing conditions or priorities and complicates liquidity management.
• Using SWF resources to invest in domestic markets raises complex economic and governance issues. From a macroeconomic perspective, particularly if an SWF obtains funds from foreign exchange sources, buying domestic financial assets could have an impact on interest rates, the real exchange rate, and the prices of securities. The investments might also be more susceptible to political or ethical pressures.
• Mechanisms may need to be established to ensure appropriate economic policy coordination. An SWF should work closely with—under clear operational guidelines—government entities charged with implementing fiscal, monetary, and exchange rate policies. The precise arrangements for that working relation-ship will depend on the type of institutional arrangement chosen for the SWF.
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56 Sovereign Wealth Funds and Economic Policy at Home
• The underlying objectives of an SWF, as well as potential fiscal risks, need to be taken into account in determining its asset-liability management framework and its SAA; and these objectives and risks should be clearly disclosed. Basic principles in this regard include the need to adapt the SAAs to different objectives, robustly define investment horizons and risk tolerance, and ensure that SAAs and investment guidelines for SWFs protect balance sheet soundness in the face of explicit (or even implicit) liabilities. This is particu-larly applicable to reserve investment corporations with large currency mis-matches associated with sterilized foreign exchange interventions.
• Transparency is a key factor in ensuring that an SWF supports the objectives of its owner government. Transparency underpins accountability and public trust. A nation’s balance sheets, and its income and expenses, need to fully recognize the size and performance of the assets (and liabilities) being man-aged or controlled by the SWF, and the sources and uses of its funds. The identification of an SWF’s contributions to aggregate demand, national sav-ings, and investment will help to highlight its importance to economic management and to improving the quality of fiscal analysis and coordina-tion of economic policy.
REFERENCES
Davis, J., and others, 2001, “Stabilization and Savings Funds for Nonrenewable Resources: Experiences and Fiscal Policy Implications,” IMF Occasional Paper 205 (Washington: International Monetary Fund).
International Monetary Fund, 2007a, Guide on Resource Revenue Transparency (Washington). Available via the Internet: http://www.imf.org/external/np/fad/trans/guide.htm.
———, 2007b, Manual on Fiscal Transparency (Washington). Available via the Internet: http://www.imf.org/external/np/fad/trans/manual.htm.
Le Borgne, Eric, and Paulo Medas, 2007, “Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages,” IMF Working Paper 07/297 (Washington: International Monetary Fund).
Organisation for Economic Co-operation and Development, 2002, “OECD Best Practices for Budget Transparency” (Paris: OECD). Available via the Internet: http://www.oecd.org/dataoecd/33/13/1905258.pdf.
Ossowski, R., and others, 2008, “The Role of Fiscal Institutions in Managing the Oil Boom,” IMF Occasional Paper 260 (Washington: International Monetary Fund).
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SECTION II
Institutional Factors
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CHAPTER 5
Sovereign Wealth Funds and the Santiago Principles1
UDAIBIR S. DAS, ADNAN MAZAREI, AND ALISON STUART
The public policy focus on sovereign wealth funds (SWFs) during 2007–08 raised several important issues relevant for the functioning of the international mone-tary system. These issues encompassed the manner of funding and growth of SWFs, the purposes underlying SWF investments and their governance and transparency, discriminatory regulatory treatment, and protectionism against sovereign investments.
The IMF took the view that some of the public policy concerns relating to SWFs could be addressed by facilitating a structured dialogue between SWFs and recipient countries, and by developing a set of voluntary principles for SWFs. At the same time, the IMF became more aware of the need to integrate the operations of the SWFs more firmly within the macroeconomic policy frameworks of their home countries and within the structures for multilateral monitoring. Both objectives were consistent with the core mandate of the IMF to work toward ensuring that cross-border investment flows are conducted in a fair and open manner.
An IMF-facilitated International Working Group of Sovereign Wealth Funds (IWG) was formed in May 2008 to develop a set of principles that properly reflect the investment objectives and practices of SWFs. The IMF was tasked to provide a secretariat and to support the work of the IWG. Over the subsequent four months, the IWG went about its work, drawing upon SWF good practices and relevant international guidelines, standards, and codes. IMF staff provided back-ground material and technical inputs and helped facilitate negotiation and con-sensus building among the IWG members.
In September 2008, a preliminary agreement was reached in Santiago, Chile, on a set of 24 Generally Accepted Principles and Practices, also known as the “Santiago Principles” (the principles).2 The IWG presented these principles to the IMF’s policy-guiding committee, the International Monetary and Financial Committee, on October 11, 2008.
This marked the first time that the SWFs, along with their owner countries, had set out a comprehensive framework for their legal, governance, and institu-
1An earlier version of this chapter will be appearing in Sauvant, Sachs, and Schmit Jongbloed (forthcoming).2See IWG, 2008; and Appendix 1 in this volume.
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tional structures, and their investment policies. The output was a good example of multilateral collaboration, with the IMF acting as broker to facilitate develop-ment of consensus among the SWFs. Also, from the start, the IWG benefited from direct feedback and inputs from recipient countries and agencies such as the Organisation for Economic Co-operation and Development (OECD).
This chapter discusses the development of the Santiago Principles and the role of the IMF in that process. The first section defines SWFs and their role while the second section outlines key issues surrounding SWFs. The role of the IWG and the process that led to the development of the Santiago Principles are explained in the third section, which is followed by a discussion of the key fea-tures of the principles. The final section provides concluding thoughts on the progress thus far and some of the key challenges.
SWFS: OBJECTIVES AND TAXONOMY
SWFs are loosely defined as government-owned investment funds with invest-ments in foreign financial assets. The IWG developed a more precise definition of SWFs3 that excludes, among other things, foreign currency reserve assets held by monetary authorities for traditional balance of payments or monetary policy purposes, traditional state-owned enterprises, government-employee pension funds, and assets managed for the benefit of individuals.
SWFs are a heterogeneous group funded from different sources and with a vari-ety of purposes. Based on their dominant objectives, the IMF categorizes SWFs broadly into five types: (1) stabilization funds, the primary objective of which is to insulate the budget and the economy against commodity (usually oil) price swings; (2) savings funds for future generations, which aim to convert nonrenewable assets into more diversified portfolios of assets and mitigate the effects of Dutch disease;4 (3) reserve investment corporations, whose assets are often still counted as reserve assets, and are established to increase the return on reserves; (4) development funds, which typically help fund socioeconomic projects or promote industrial policies that might raise a country’s potential output growth; and (5) contingent pension reserve funds (from sources other than individual pension contributions) for con-tingent unspecified pension liabilities on the government’s balance sheet.
In practice, this system of categorization needs to be used flexibly because the objectives of the SWFs may be multiple, overlap, or change over time. For example, some countries’ stabilization funds have evolved into funds with savings objectives because accumulated reserves increasingly exceeded the amounts needed for short-
3SWFs “are special purpose investment funds or arrangements that are owned by the general govern-ment. Created by the general government for macro-economic purposes, the SWFs hold, manage or administer assets to achieve financial objectives, and employ a set of investment strategies that include investing in foreign financial assets” (IWG, 2008, p. 3).4Dutch disease arises when foreign currency inflows cause an increase in the affected country’s real exchange rate. The effect of Dutch disease is to reduce external competitiveness, which weakens net exports, contributing to the loss of jobs in the relevant industries. The end result is that nonresource industries are hurt by the increase in wealth generated by the resource-based industries.
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term fiscal stabilization or to sterilize foreign exchange inflows. The various objec-tives of SWFs imply different investment horizons and trade-offs between risk and return, which have led to different approaches in managing these funds. SWFs with stabilization objectives place more emphasis on liquidity and have shorter invest-ment horizons than do SWFs with savings objectives, for which liquidity needs are lower. Several countries have revisited the objectives and redesigned the structures of their SWFs to broaden their policy roles and investment goal.5
ISSUES SURROUNDING SWFS
Commentaries and studies on SWFs have mainly focused on (1) the transparency of SWFs, including their size, approaches to risk management, investment strate-gies, and the possible influence of political objectives on SWF investments; (2) the integration of SWF activities into external and government accounts; (3) the impact of funds’ asset allocations on international capital movements and asset prices; (4) protectionist restrictions on SWFs; and (5) the transparency and pre-dictability of capital-importing countries’ investment regimes.
The IMF’s interest in SWFs stems from two of its key functions: (1) macro-economic and financial stability surveillance, and (2) ensuring the effective func-tioning of the international monetary system. Coverage by the IMF of SWF-type arrangements and their operations becomes important both for the domestic economies of countries with SWFs, as well as from the international perspective of financial stability and capital market spillovers. From the IMF’s standpoint, the following key issues have been raised with regard to SWFs:6
• First, the way in which SWFs fit within the domestic policy framework and in policy coordination is important. An SWF’s assets—and the returns they gen-erate—have a significant impact on a country’s public finances, monetary condition, balance of payments, and balance sheet links.7 Well-designed SWFs can support fiscal and monetary policies and liquidity management. However, SWFs may also create macroeconomic policy challenges, so good coordination between the SWF and the fiscal and monetary authorities is necessary to ensure that overall policy objectives are met. The interrelations between SWFs and their home governments became even more complicated during the 2007–09 global financial crisis (IMF, 2009).
• Second, the operations of SWFs may affect global financial markets’ flows and prices. SWFs are generally long-term investors that are usually not leveraged, meaning
5This has also occurred in the context of the recent global financial crisis, in which some SWFs have been tasked to play an active role in stabilizing domestic financial systems. The severity of the crisis prompted governments to turn to their SWFs to support troubled local firms, reduce government deficits, or fund economic stimulus programs. The role SWFs played in crisis management may prompt changes to the legislative framework of some SWFs.6 For a more detailed discussion, see IMF, 2008b.7 For a discussion of policy and operational considerations and factors that determine investment policies, see Das and others, 2009.
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they can sit out longer during market downturns or invest against market trends. Thus, SWFs may tend to provide a stabilizing influence in financial markets. However, circumstances could also arise in which they could cause volatility in markets—for example, if they are operating in shallower markets or where rumored transactions affect relative valuations in particular sectors and lead to herd behavior, further adding to volatility (e.g., Corsetti and others, 2001). Looking ahead, it will be interesting to see if SWFs maintain diversified portfo-lios or whether they retrench toward U.S. dollar assets as global growth slows. Shifts in asset allocations are likely to contribute to changes in equity prices, interest rates, and exchange rates, raising the IMF’s interest in SWFs as it con-ducts multilateral surveillance, and more broadly, in its analysis of global finan-cial stability and capital markets (IMF, 2007b, 2008a).
• Third, good corporate governance of SWFs is a critical issue for domestic stake-holders. Many aspects of good corporate governance are universally appli-cable. General principles regarding key ownership functions, the role of stakeholders, disclosure and transparency, the flow of information between management and the governing board, and the composition and responsi-bilities of the board are all relevant for SWFs. SWFs also need to ensure that adequate risk-management processes and human and system resources are present to correctly monitor and manage financial and operational risks, including those arising from the use of external fund managers.
• Fourth, recipients of SWF investments have raised concerns about SWFs’ objec-tives and investment practices. The key concern is whether SWFs follow commercial objectives or whether they might invest with political or strate-gic objectives in mind. A related concern is whether SWFs might be too active or passive in their approach to corporate governance in the companies in which they invest. A perception that SWFs could invest for noncommer-cial motives could fuel protectionism.
Various suggestions have been made about addressing these issues, including standards that could cover SWFs’ objectives and investment strategies, gover-nance, accountability, and transparency.8 Observers have also suggested specific changes to SWFs’ investment behavior and the exercise of their voting rights to reduce perceptions of political influence.9 One proposal is that SWFs should invest at arm’s length solely through intermediary asset managers, as is the case for some endowment funds. However, others do not think that the use of mandates and outside managers would be sufficient to eliminate potential conflicts of inter-
8For example, Truman (2007) argues that a standard should cover all international investment activi-ties of governments. He suggests that a standard should cover their (1) objectives and investment strategy; (2) governance; (3) transparency; and (4) behavior (the scale and speed at which portfolio adjustments are made). Mervyn Davies has called for SWFs to adopt minimum standards on transpar-ency and governance (Larsen, 2008).9See, for example, Summers, 2007; Gilson and Milhaupt, 2008. Hildebrand (2007) suggested that SWFs be given independence from governments along the lines of independent central banks to reduce perceptions of political interference.
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est because the SWF would still provide guidance to the asset manager. Other proposals include upper limits on the ownership or voting rights of SWFs in foreign private sector corporations, with the limits set below the typical threshold for a controlling minority in a firm. A less onerous suggestion is that SWFs should publish a voting list on a regular basis.10 Discussions have also considered a “negative list” of strategic and sensitive areas in which SWFs should not invest.
Some aspects of SWFs have been dealt with by other regulators, agencies, and country authorities directly. One example is market integrity issues, which are in the domain of domestic market regulators such as the Securities and Exchange Commission in the United States; market regulators’ activities are harmonized through the International Organization of Securities Commissions.11,12 National security issues are primarily in the domain of national safeguard procedures (e.g., the Committee on Foreign Investment in the United States). The OECD, which focuses its work on recipient countries, has formulated practices relating to the treatment of foreign investors with adequate safeguards for national security.13
THE IWG AND THE DEVELOPMENT OF THE SANTIAGO PRINCIPLES
The IWG comprised 23 IMF member countries, with three additional countries, the OECD, and the World Bank acting as permanent observers.14 A subgroup of
10 Some institutional investors disclose their voting policies. In the United States, mutual funds are required to disclose their proxy voting policies and records and these are published on the Securities and Exchange Commission Web site. A number of U.K. institutional investors have voluntarily published their voting records (e.g., co-operative insurance, Friends Provident, and the Universities Superannuation Scheme). The 2006 U.K. Companies Act (Sections 1277–1280) gives the government a reserve power to issue regulations, which would require institutional investors to report publicly on how they vote their shares. The institutions to which these provisions apply are unit trust schemes, open-ended investment companies, investment trusts, pension schemes, insurance businesses, and collective investment schemes. 11See, for example, “Capital Movements—Legal Aspects of Fund Jurisdiction under the Articles,” SM/97/32, Supplement 3 (02/21/1997). Article VI, Section 3 generally preserves the members’ rights to impose capital controls to regulate international capital movements, including by limiting or pro-hibiting inward and outward capital transfers.12However, where such issues have an impact on the member’s domestic or external economic stabil-ity, or on international financial stability, they would fall under the IMF’s surveillance authority.13OECD Guidance on Sovereign Wealth Funds is available at http://www.oecd.org/document/19/0,3343,en_2649_34887_41807059_1_1_1_1,00.html. The final “tranche” of OECD guidance on recipient country policies toward SWFs was adopted by OECD members October 8, 2008, and presented to the International Monetary and Financial Committee meeting in Washington, DC, October 11, 2008. The guidance was developed by the OECD Investment Committee as part of its project on Freedom of Investment, National Security and “Strategic Industries.” The Investment Committee is treating the issue of recipient-country policies toward SWFs and other government-controlled investment entities as an integral part of the Freedom of Investment project.14 The IWG member countries were Australia, Azerbaijan, Bahrain, Botswana, Canada, Chile, China, Equatorial Guinea, the Islamic Republic of Iran, Ireland, the Republic of Korea, Kuwait, Libya, Mexico, New Zealand, Norway, Qatar, the Russian Federation, Singapore, Timor-Leste, Trinidad and Tobago, the United Arab Emirates, and the United States. Oman, Saudi Arabia, Vietnam, the OECD, and the World Bank were permanent observers. The IWG was co-chaired by Hamad Al Hurr
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64 Sovereign Wealth Funds and the Santiago Principles
the IWG was formed to undertake the technical drafting work; that subgroup was supported by IMF staff. The IWG met three times and the drafting subcommit-tee also met on three occasions.15 Throughout its discussions, the IWG main-tained an active dialogue with a number of recipient countries and the European Commission. In developing the principles for SWFs, the IWG considered the following objectives as its guiding tenets:
• to help maintain a stable global financial system and the free flow of capital and investment;
• to comply with all applicable regulatory and disclosure requirements in the countries in which SWFs invest;
• to ensure SWFs invest on the basis of economic and financial risk- and return-related considerations;
• to encourage SWFs to have in place transparent and sound governance structures that provide for adequate operational controls, risk management, and accountability.
The IWG also reviewed the practices followed by its members and drew upon the existing body of international standards and codes.16 These included relevant IMF guidelines and standards,17 the OECD guidelines on corporate governance (OECD, 2005b), and voluntary guidelines developed by large institutional inves-tors in the private sector.18 Many of these guidelines focus on governance, trans-parency and accountability issues, and risk-management frameworks. A common objective of these standards and guidelines is to provide confidence to the public that institutions are properly run, with clear lines of responsibility and levels of transparency that facilitate accountability—which is especially important for SWFs because government ownership brings with it the need for high standards of accountability.
Al Suwaidi, Undersecretary of the Abu Dhabi Department of Finance and a Director of the Abu Dhabi Investment Authority, and Jaime Caruana, Director of the IMF’s Monetary and Capital Markets Department.15The IWG meetings were held in Washington, DC; Singapore; and Santiago. The drafting subcom-mittee met in Oslo, Singapore, and Santiago. A large part of the IWG work was conducted in a vir-tual mode, via the Internet and conference calls.16 The IMF undertook a survey of SWFs and their operations (Hammer, Kunzel, and Petrova, 2008).17Relevant IMF standards and guidelines include the Code of Good Practices on Fiscal Transparency (IMF, 2007a), Special Data Dissemination Standard (established in 1996), General Data Dissemination System (established in 1997), Data Quality Assessment Framework (established in 2003), and the Code of Good Practices on Transparency in Monetary and Financial Policies (IMF, 1999), Guidelines for Foreign Exchange Reserve Management (IMF, 2005), and Guidelines for Public Debt Management (IMF, 2003).18For example, the UK’s Hedge Fund Standards Board, the Guidelines for Disclosure and Transparency in Private Equity (Walker, 2007), and the Agreement Among the President’s Working Group and US Agency Principals on Principles and Guidelines Regarding Private Pools of Capital (PWG, 2007) were also considered.
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THE KEY FEATURES OF THE SANTIAGO PRINCIPLES
The Santiago Principles cover three main areas: (1) legal framework, objectives, and coordination with macroeconomic policies; (2) institutional framework and governance structure; and (3) investment and risk-management framework. The principles are, of course, subject to home country laws, regulations, and require-ments. Elements of transparency and disclosure are integrated in all sections of the Santiago Principles to ensure accountability. This structure is broadly similar to those of a number of other relevant guidelines, codes, and standards (e.g., OECD, 2005). References in the Santiago Principles to transparency and disclo-sure are embedded in its three sections rather than constituting a separate section.
The key features of the principles and practices are analyzed below. Box 5.1 illustrates how the principles seek to address the major issues surrounding SWFs.
Legal Framework, Objectives, and Coordination with Macroeconomic Policies
The IWG recognized that clear and sound legal frameworks are important because they underpin governance structures, provide the construct for clear lines of responsibility, and help an SWF to operate effectively. Coordination with domestic macroeconomic policy matters, because the scale of assets, returns, and operations of SWFs can significantly influence public finances, monetary condi-tions, and the balance of payments. The principles cover a number of important elements in this area:
• The need for sound and clear legal frameworks that are publicly disclosed and that clarify the SWF’s relationships with other state bodies is set out in Principle 1. Principle 2 states that the policy purpose of the SWF should be clearly defined and publicly disclosed. Together, these elements contribute to good governance and transparency as reflected in a number of IMF and other standards and guidelines. Clarity about the policy purpose of the SWF, and importantly, its disclosure, guard against political interference in investment decisions and support public understanding of the SWF’s goals and its performance.19
• The need for close coordination between the SWF’s activities and macroeco-nomic policy formulation is provided for in Principle 3. The principles also highlight that the SWF’s activities with significant direct domestic macro-economic implications should be closely coordinated with domestic fiscal and monetary authorities. This helps to ensure that the SWF supports, and does not work against, the macroeconomic policy framework.
19Similar principles are covered in the Code of Good Practices on Fiscal Transparency (IMF, 2007a) and related Manual on Fiscal Transparency (IMF, 2007d), Guide on Resource Revenue Transparency (IMF, 2007c), OECD Guidelines on Corporate Governance of State-Owned Enterprises (OECD, 2005b), OECD Guidelines for Pension Fund Governance (OECD 2009), OECD Guidelines for Insurers’ Governance (OECD, 2005a), ISSA Guidelines for the Investment of Social Security Funds (ISSA, 2004), and Guidelines for Foreign Exchange Reserve Management (IMF, 2005).
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The Santiago Principles: Elements Addressing Issues Raised
Main issues Elements of the principles addressing
the main issues
Governance and Accountability
Checks and balances are important to ensuring that an SWF is run effi-ciently and in accordance with the policy objectives of its owners.
Efficient management of the SWF is promoted by
• A clear policy objective for the SWF (Principle 2);• A sound legal framework underpinning a robust
institutional and governance structure, which sets out a clear allocation and separation of responsibil-ities (Principles 1 and 6–9);
• Adequate reporting systems—including audited annual reports and financial statements—allowing monitoring of performance and ensuring that the SWF’s operations are consistent with its stated objectives (Principles 7, 10–12, and 23);
• Professional and ethical standards, and clear rules and procedures for dealing with third parties to ensure the integrity of the SWF’s operations (Principles 13–14);
• Public disclosure of the SWF’s policy objective, and legal and governance framework to enhance checks and balances and promote a clear under-standing of the SWF (Principles 1–2 and 16).
Macroeconomic Policy Challenges
SWFs’ assets, returns, and operations are likely to have a significant impact on an owner country’s macroeconomic framework.
Consistency of the SWF’s operations with the govern-ment’s overall macroeconomic policies is furthered by
• Appropriate coordination between the SWF’s oper-ations and the macroeconomic authorities (Principle 3);
• Clear rules on the SWF’s general approach to fund-ing and withdrawal that are consistent with its pol-icy objective (Principle 4);
• Macroeconomic data sets incorporating SWF data to facilitate economic policy analysis (Principle 5).
Management of the Nation’s Wealth
Robust investment strate-gies and risk-manage-ment frameworks guard against the mismanage-ment of funds and poor portfolio performance.
The SWF’s performance is enhanced by
• A clear investment policy showing commitment to a disciplined investment plan (Principle 18);
• Care, skill, prudence, and diligence in the SWF’s investment practices (Principle 19);
• Execution of ownership rights in a manner consis-tent with the SWF’s investment policy (Principle 21);
• A robust framework to identify, assess, and man-age the risks of the SWF’s operations (Principle 22);
• Public disclosure of a description of the SWF’s investment policies, and of its general approach to the risk-management framework and to executing ownership rights (ex ante) to promote accountabil-ity (Principles 18 and 21–22).
BOX 5.1
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• Clear rules on the SWF’s general approach to funding, withdrawal and spending rules, and their public disclosure are covered by Principle 4. This principle helps ensure consistency of the SWF’s activities with budgetary processes and objectives. A predictable framework is helpful for investment
Main issues Elements of the principles addressing
the main issues
Commercial Behavior
Recipient countries want reassurance that SWFs invest on a commercial basis and are not aimed at political objectives or investments in areas per-ceived to be a threat to national security.
The SWF aims to reassure recipient countries of its commercial orientation through
• Public disclosure of its policy purpose and gover-nance framework, and of relevant financial infor-mation to demonstrate that its investments are based on economic and financial considerations (Principles 2 and 16);
• Refraining from pursuit of objectives other than maximization of risk-adjusted financial returns (Principles 4 and 19);
• Public disclosure of its general approach to voting and representation on the boards of the public companies it invests in to ensure that its influence over the strategic direction of such companies does not undermine their corporate governance (Principle 21).
Fair Competition in Markets
Other investors are inter-ested in ensuring that SWFs do not have an unfair advantage, for example, from a lower cost of capital resulting from government guaran-tees, or from privileged access to information.
The SWF commits to not gaining unfair market advan-tage by
• Respecting and complying with all applicable host country rules, laws, and regulations (Principle 15);
• Not seeking advantages of privileged information or the government’s inappropriate influence (Principle 20).
Financial Market Stability
SWFs have recently con-tributed to financial sta-bility through their injec-tions of capital into sys-temically important finan-cial institutions. However, actual or rumored shifts in asset allocations of large, and unclear, positions of SWFs could cause volatili-ty in certain markets and asset classes.
The SWF promotes financial market stability by
• Disclosing relevant financial information and key elements of its investment policy to give an indica-tion of its risk appetite, exposure, and directions of asset allocation (Principles 17 and 18);
• Describing the use of leverage or disclosing other measures of financial risk exposures (Principle 18);
• Exercising its voting rights in a manner consistent with its investment policy and protecting the financial value of investments (Principle 21);
• Having in place a transparent and sound opera-tional control and risk-management system (Principle 22).
BOX 5.1 (cont.)
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managers, allowing them to think long term and invest over long horizons. Publication of these rules also strengthens accountability. The principles note that SWFs will publicly disclose policies or rules regarding their general approach to funding, withdrawal, and spending operations. Although use-ful, for overall fiscal transparency of a country, as suggested in the IMF codes on fiscal transparency, the government owners of SWFs should also provide clarity about the links between the SWF and the medium-term budget framework, and publish data relating to the SWF’s transactions with the government.20
• The provision of data to national statistics agencies for inclusion in macro-economic data sets is important so that policymakers and other users have access to complete data that include SWFs’ operations (Principle 5). Such access will ensure that the information about a country’s economic perfor-mance is accurate. To date it has not always been clear whether information on SWFs has been accurately reflected in macroeconomic data sets. The principles unambiguously state that statistical agencies should be provided with the relevant data.21 The IMF intends to encourage, and work with, statistics agencies to ensure that these data are included in the macroeco-nomic data sets.
Institutional Framework and Governance Structure
Clear and sound governance structures, the division of roles and responsibilities, and high-quality accounting and auditing standards support good corporate gov-ernance by providing the checks and balances that enable and promote opera-tional independence in the management of an SWF’s operations. The provision of regular financial information presents a reliable picture of an SWF’s perfor-mance, strengthens accountability, and could help to reduce uncertainty in finan-cial markets and enhance trust in recipient countries. The principles in this area include key elements essential for good corporate governance; they establish the framework for information provision to the owner and regulators of SWFs but provide for public disclosure of only a limited set of financial information.
• The allocation and separation of responsibilities is set out in Principles 6–9 and 16. A number of these principles are derived from the OECD Guidelines on Corporate Governance of State-Owned Enterprises, which promote opera-tional independence. The principles set out clear distinctions and division of responsibilities among the owner of the SWF, the governing bodies, and management. The principles are also sufficiently flexible to take into account the different institutional structures of SWFs; for example, some
20For example, the IMF’s Code of Good Practices on Fiscal Transparency (IMF, 2007a) identifies the need for receipts from all major revenue sources to be separately identified in the annual budget presenta-tion. The IMF’s Guide on Resource Revenue Transparency (IMF, 2007c) elaborates on these require-ments in relation to resource funds.21The extent to which SWFs are classified as international reserves is also set out in the commentary accompanying Principle 4.1.
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SWFs are established as separate legal entities and others are established as pools of assets without a separate legal personality. These differences are reflected in the commentary accompanying the principles.
• Accounting and auditing in line with recognized international or national accounting standards is covered, and an annual report is required, although there is no requirement that it be published. The principles rec-ognize the need for rigorous internal auditing procedures and standards and an independent external audit (Principle 12), and an annual report and accompanying financial statements (Principle 11). However, the prin-ciples do not promote the publication of an annual report even though publication is universally accepted as an important part of transparency and accountabil ity.22
• The principles provide for disclosure of an SWF’s financial information to its owners (Principle 23) and to regulators in recipient countries (Principle 15), but greater public disclosure would also be desirable. According to the principles, SWFs should publicly disclose relevant financial information, including asset allocation, benchmarks, and where relevant, rates of return over appropriate historical periods (Principle 17). But other areas of finan-cial information about an SWF, such as audited financial statements, infor-mation on the size of assets under management, the use of derivatives, and leverage, are not covered in the principles, and will only be publicly pro-vided at the discretion of the SWF or in confidence to regulators upon request. It is also recognized that some newly established SWFs may require time to be able to disclose the relevant information indicated in Principle 17. The IWG discussed what additional public disclosure of financial infor-mation should be required by the principles. Although views varied widely, the group eventually decided that public disclosure need not go beyond provision of relevant financial information sufficient to demonstrate an SWF’s economic and financial orientation.
Investment and Risk-Management Framework
Sound, well-defined investment policies and risk-management frameworks are imperative to ensure that an SWF’s decisions are consistent with its purpose and investment objectives, and to ensure that risks are well managed. In particular, transparency with respect to an SWF’s voting behavior would provide assurance to other stakeholders, including those in recipient countries, that its actions are consistent with its stated objectives.
22The OECD Guidelines on Corporate Governance of State-Owned Enterprises (OECD, 2005b) empha-size that in the interest of the general public, state-owned enterprises should be as transparent as publicly traded companies. The OECD Principles of Corporate Governance (OECD, 2004) include disclosure of the financial and operating results of the company. In addition, the Guide on Resource Revenue Transparency (IMF, 2007c) states that operations of resource funds should be clearly identi-fied, described, and reported in the budget process and final accounts documents.
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• The principles in this area aim to achieve greater clarity about SWFs’ invest-ment policies and risk-management frameworks, as well as about their poli-cies on exercising ownership rights. The principles provide for the presence of a sound investment policy, and the publication of a description of this policy (Principle 18). This principle also sets out that the SWF’s investment policy should be clear and consistent with its defined objectives and risk tolerance, as set by the owner or the governing body or bodies, and be based on sound portfolio management principles. By defining its investment policy, an SWF commits to accountability for a disciplined and appropriate investment plan. The investment policy should also guide the SWF’s finan-cial risk exposures and its possible use of leverage.
• Principle 19 firmly esta blishes that SWFs should operate on economic and financial grounds. According to the principles, an SWF’s investment deci-sions should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy. This key commitment aims to allay concerns in recipient countries.
• The principles also address the critical issue of public disclosure of SWF voting policies. The principles call on SWFs to publicly disclose, before-hand, their approaches to voting, including the key factors guiding their exercise of ownership rights, but any after-the-fact disclosure of actual vot-ing behavior is left to the discretion of the SWF. Although the disclosure of voting records could help to verify whether SWF voting behavior is consis-tent with stated intentions, a number of IWG members felt that a commit-ment to publicly disclose voting records would be more than they under-stood to be required for other institutional investors (e.g., hedge funds and private equity funds). IWG members, however, agreed that the disclosure of voting policies should be sufficiently transparent to demonstrate that the policies are based on economic and financial criteria.
• SWFs are encouraged to review their existing arrangements, and assess the implementation of the principles on an ongoing basis (Principle 24). Options for this review include self-assessment and third-party verification. Follow-up work on this issue is needed.
CONCLUDING OBSERVATIONS AND THE ROAD AHEAD
The Santiago Principles set out a broad and comprehensive framework, and reflect a strong unanimity of views among the SWFs and their governments. The principles provide a clearer understanding of the institutional framework, gover-nance, and investment operations of SWFs. They also provide greater clarity about the provision of information to the owners of the funds and to regulators in recipient countries. It is impressive that such a diverse group of SWFs was able to reach a consensus on many issues in such a short time frame.
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However, as recognized by the IWG, certain areas could benefit from further study and work, such as those relating to reliable information about SWFs’ operations. From macroeconomic and financial-stability perspectives, SWFs should continue to strive toward clearer explanations of their activities and per-formance, and policymakers in their home countries should strengthen clarity about the role of SWFs in their domestic policy framework. Since the publication of the Santiago Principles, some SWFs have begun to clarify and explain their structures and governance arrangements. However, the 2007 –09 global financial crisis has emphasized the need for greater institutional clarity, stronger risk-management practices, and proper oversight across all types of firms involved in financial intermediation functions.
The work with the IWG marked a departure from the IMF’s usual mode of operation. The IMF was not the protagonist in the negotiations. Instead, it pro-vided a secretariat for the work, technical expertise, and background analysis, and helped to facilitate the negotiations of the IWG. The process worked well, and the SWFs recognized the benefits of this multilateral format to meet and address issues of common interest. The experience gained by the IMF in these negotia-tions also suggests that the involvement of IMF staff can be helpful in bringing together different types of institutions (or officials from different regions and countries), discussing issues of common importance, facilitating negotiations, and helping push forward work programs that can be of widespread relevance to the international community. The IMF’s work with SWFs could be a model for future work, possibly with regard to financial system surveillance, and on issues where international common ground needs to be reached.23
The recent global financial crisis has drawn attention to new and important challenges for SWFs in managing their wealth and the markets in which they operate. The Santiago Principles demonstrate a firm commitment on the part of the IWG member governments and the SWFs to keep the principles under review, facilitate their dissemination, and provide a forum for an exchange of ideas with recipient countries. Future work could also examine ways in which aggregated information on SWF operations could be periodically collected, made available, and explained. Continued efforts are thus needed to adjust the Santiago Principles as the postcrisis financial landscape evolves and SWFs adjust to domes-tic, external, and capital market developments.
Since late 2009, the financial media have again been filled with news of high-profile acquisitions and divestitures by many SWFs. As the crisis phase unwinds, global merger and acquisitions activity is increasing, as is participation in that activity by SWFs, whereas many SWFs had a more domestic focus during the crisis. The severity of the crisis prompted governments to turn to their SWFs to
23 The IMF is, in fact, playing a similar role in the context of the Group of 20 (G-20) Mutual Assessment Process. The IMF has been asked by the G-20 to help it with its new process of mutual assessment aimed at achieving strong, sustainable, and balanced growth. The IMF’s job will be to assist the G-20 countries achieve this goal by providing analysis of how their policy frameworks and eco-nomic projections fit together. The IMF’s role will be that of a “trusted advisor,” with the G-20 countries firmly in the driver’s seat.
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bail out troubled local firms, reduce government deficits, or fund economic stimulus programs. The crisis and SWFs’ role in their domestic economies have prompted many of them to review their investment frameworks, including their strategic asset allocations.
A number of SWFs have started to make use of the Santiago Principles as a framework to strengthen and review their internal processes, governance, and accountability. The successor to the IWG, the International Forum of Sovereign Wealth Funds (IFSWF), established in April 2009, is actively engaged in shar-ing experiences about the emergence of good implementation practices.24 However, little feedback has been received thus far on the implementation of the Santiago Principles from countries that are recipients of SWF investments. Priorities in recipient countries have shifted to coping with the aftermath of the crisis, and a question remains about how or whether these countries will make formal use of the principles and follow up with SWFs on their implementation. While private sector analysts have provided much positive commentary on the principles, little feedback has been forthcoming from those in the private sector who are directly affected by the investment operations of SWFs. It is too early to judge whether capital markets will reward good implementation of the Santiago Principles.
The role of SWFs as providers of significant cross-border long-term capital is here to stay. Given the international profile SWFs assumed in the late 2000s, their investment objectives and operations, and how they are adhering to the spirit of the Santiago Principles will continue to make news. The IMF suc-ceeded in partnering with the SWFs and their governments to provide a balance in the international debate on the role of SWFs. The ball is now in the court of the SWFs. The establishment of the IFSWF is a commendable step, and an important contribution to the architecture of the international financial system. The IFSWF has already begun to play an important role in clarifying the objec-tives and functions of SWFs, as well as in improving their transparency. The SWFs themselves have also become more active in participating in this debate, either through the IFSWF or individually through public statements. Their main message seems to be unified: “Borders need to remain open for foreign investments, including those of SWFs.” It is encouraging that collaboration and partnership with recipient countries and other parties, which has been a key feature of the IWG’s work so far, will continue and that the IFSWF will operate in an inclusive manner.
The IFSWF is placing a high premium on active and continuing engage-ment with the private sector to improve the private sector’s understanding and interpretation of SWF activities. It would be helpful for representatives of
24The IFSWF is a voluntary standing group of SWFs that was established by the IWG in Kuwait City in April 2009 (IWG, 2009). Its purpose is to meet, exchange views on issues of common interest, and facilitate an understanding of the Santiago Principles and SWF activities. The forum is not a formal supranational authority and its work does not carry any legal force. The forum has a professional secretariat to facilitate its activities and those of its subgroups, and to enable efficient cooperation and communication among its members and with other relevant parties.
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recipient countries and the private sector to work together with the IFSWF, to discuss issues of common concern (while maintaining strategic and commercial confidentiality), and to provide feedback. This dialogue could promote an investment regime that operates on a more collaborative basis. In a world in which capital, especially long-term investment capital, is scarce and wealth has eroded, responsible and mutually reinforcing arrangements for cross-border investments are important.
REFERENCES
Corsetti, Giancarlo, and others, 2001, “Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders,” Financial Markets Group Discussion Paper No. 372 (London).
Das, Udaibir S., Yinqiu Lu, Christian Mulder, and Amadou Sy, 2009, “Setting Up a Sovereign Wealth Fund: Some Policy and Operational Considerations,” IMF Working Paper 09/179 (Washington: International Monetary Fund).
Gilson, Ronald J., and Curtis J. Milhaupt, 2008, “Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to the New Mercantilism,” 60 Stanford Law Review 1345.
Hammer, Cornelia, Peter Kunzel, and Iva Petrova, 2008, “Sovereign Wealth Funds: Current Institutional and Operational Practices,” IMF Working Paper WP/08/254 (Washington: International Monetary Fund).
Hildebrand, Philipp, 2007, “The Challenge of Sovereign Wealth Funds,” speech at the International Center for Monetary and Banking Studies, Geneva, December 18.
International Monetary Fund, 1999, Code of Good Practices on Transparency in Monetary and Financial Policies (Washington).
———, 2003, Guidelines for Public Debt Management (Washington).———, 2005, Guidelines for Foreign Exchange Reserve Management (Washington).———, 2007a, Code of Good Practices on Fiscal Transparency (Washington).———, 2007b, Global Financial Stability Report, Financial Market Turbulence: Causes,
Consequences, and Policies (Washington).———, 2007c, Guide on Resource Revenue Transparency (Washington). ———, 2007d, Manual on Fiscal Transparency (Washington).———, 2008a, Global Financial Stability Report: Containing Systemic Risks and Restoring
Financial Soundness (Washington).———, 2008b, Sovereign Wealth Funds—A Work Agenda (Washington).———, 2009, Crisis-Related Measures in the Financial System and Sovereign Balance Sheet Risks
(Washington).ISSA (International Social Security Association), 2004, “Guidelines for the Investment of Social
Security Funds,” Technical Report No. 13 (Geneva).IWG (International Working Group of Sovereign Wealth Funds), 2008, Sovereign Wealth
Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
———, 2009, “Kuwait Declaration.” Available via the Internet: http://www.iwg-swf.org/mis/kuwaitdec.htm
Larsen, Peter T., 2008, “SWFs Warned to Adopt Code,” Financial Times, January 23.OECD (Organisation for Economic Co-operation and Development), 2004, OECD Principles
of Corporate Governance (Paris).———, 2005a, OECD Guidelines for Insurers’ Governance (Paris).———, 2005b, OECD Guidelines on Corporate Governance of State-Owned Enterprises (Paris).———, 2009, OECD Guidelines for Pension Fund Governance (Paris).
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PWG (President’s Working Group), 2007, Agreement Among the President’s Working Group and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital (Washington).
Sauvant, Karl, Lisa E. Sachs, and Wouter P. F. Schmit Jongbloed, eds., Forthcoming, Sovereign Investment: Concerns & Policy Reactions (New York: Oxford University Press).
Summers, Lawrence, 2007, “Funds that Shake Capitalist Logic,” Financial Times, July 29.Truman, Edwin M., 2007, “Sovereign Wealth Funds: The Need for Greater Transparency and
Accountability,” Policy Brief (Washington: Peterson Institute).Walker, David, 2007, Guidelines for Disclosure and Transparency in Private Equity (London:
Jeffrey Pellin Consultancy).
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CHAPTER 6
Legal Underpinnings of Capital Account Liberalization for Sovereign Wealth Funds
WOUTER BOSSU, OBIANUJU EZEJIOFOR, THOMAS LARYEA, AND YAN LIU
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 diversifica-tion would reduce the potential risks—both for SWFs and recipient countries—that might otherwise arise as a result of the concentration of investments in cer-tain 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 pro-posals 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 inter-national legal order. Finally, it considers the Santiago Principles (IWG, 2008) as
1Soft law includes “general principles which might contribute to the interpretation of related legally binding rules of ‘hard law’” (Giovanoli, 2002, p. 7).
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an illustration of soft-law techniques that complement (or obviate) hard-law regulation of capital flows.
DOMESTIC LAW
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, intro-ducing 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, com-pared with liberalization through international law, which may be relatively harder to reverse, the unilateral domestic law approach may pose a higher residu-al risk for foreign investors that the liberalization might be undone.
INTERNATIONAL LAW
Many countries have entered into international agreements facilitating invest-ments and encouraging capital flows into and out of their territories. These agree-ments 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
2With the reintroduction of the tax on foreign exchange inflow transactions in October 2009, one of these measures was reversed.3While 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.
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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, par-ticularly 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-admit-ted 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 nondis-criminatory restriction of funds if there is a threat of balance of payments prob-lems, 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 circum-stances 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 liber-alization 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 nondis-criminatory 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
4A discussion of the relevant requirements under the IMF’s Articles of Agreement occurs later in this chapter.5Article 1109 NAFTA.
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• 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 com-panies, 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 interna-tional 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 exten-sive set of case law in support of free capital flows.
INTERNATIONAL LAW UNDER THE IMF’S ARTICLES OF AGREEMENT
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,
6The 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.7Article 8(4) GCC Charter. 8Article 81 COMESA Treaty.9Note that the EU rules do not exclude foreign states or state-owned entities from the benefit of the provisions on freedom of capital movement.10In 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. 11The 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.
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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.
IMF JURISDICTION OVER RESTRICTIONS ON CURRENT PAYMENTS
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 move-ments. 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 implica-tions 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 eco-nomic 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 opera-tions, and the response by recipient countries can be relevant in the IMF’s assess-
12Similarly, the IMF’s Articles require that members not impose multiple currency practices or discriminatory currency arrangements. Default by a government on its external payment obliga-tions 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. 13Notably, 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.
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ment 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 obliga-tions on each member to provide specified information to the IMF. Such infor-mation, 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 adjust-ment programs supported by IMF financing would tend to facilitate interna-tional 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 pay-ments 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 circum-stances 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 con-dition 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 invest-ment and exit decisions of SWFs.
14 Accordingly, SWFs have been discussed in a number of IMF surveillance reports. See, for example, IMF, 2008, 2009b. 15 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. 16 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.17Article VI, Section 1(a) of the IMF’s Articles.
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Technical Assistance
The IMF’s technical assistance mandate also contributes to the legal and regula-tory 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 man-agement 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.
SOFT LAW THROUGH THE SANTIAGO PRINCIPLES
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 pro-mote 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 under-standing 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
18Article 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.”19The 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. 20These 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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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 preserva-tion of the free flow of cross-border investment by promoting operational inde-pendence 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 delin-eation 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 dem-onstrate 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 opera-tional independence in the management of SWFs, free of political interfer-ence or influence. The governance structure should clearly separate the functions of the owner, governing bodies, and management. Such a struc-ture 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 prin-ciples 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 circum-
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stances. 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 govern-ment 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.
LOOKING FORWARD
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 atten-tion. 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.
REFERENCES
Evens, Owen, and Peter Quirk, 1995, Capital Account Convertibility: Review of Experience and Implications for IMF Policies (Washington: International Monetary Fund).
Giovanoli, Mario, 2002, “Reflections on International Financial Standards as ‘Soft Law’,” Essays in International Financial and Economic Law, No. 37 (London: London Institute of International Banking, Finance, and Development Law).
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84 Legal Underpinnings of Capital Account Liberalization for Sovereign Wealth Funds
International Monetary Fund, 1997a, “Capital Movements: Legal Aspects of Fund Jurisdiction under the Articles,” Staff Report No. 97/32 (Washington).
———, 1997b, “Communiqué of the Interim Committee of the Board of Governors of the IMF,” Press Release No. 97/22, April 28 (Washington).
———, 2008, “Singapore: 2008 Article IV Consultation—Staff Report,” IMF Country Report No. 08/280 (Washington).
———, 2009a, “Committee on IMF Governance Reform, Final Report,” March 24 (Washington).
———, 2009b, “United Arab Emirates: 2008 Article IV Consultation—Staff Report,” IMF Country Report No. 09/124 (Washington).
———, 2010, “Capital Inflows: The Role of Controls,” IMF Staff Position Note, SPN/10/04 (Washington).
IWG (International Working Group of Sovereign Wealth Funds), 2008, Sovereign Wealth Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
OECD (Organisation for Economic Co-operation and Development), 2008, Declaration on Sovereign Wealth Funds and Recipient Country Policies (Paris).
———, 2009, “Guidelines for Recipient Country Investment Policies Relating to National Security” (Paris). Available via the Internet: http://www.oecd.org/dataoecd/11/35/43384486.pdf.
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CHAPTER 7
Sovereign Wealth Funds: Investment Flows and the Role of Transparency
ROBERT HEATH AND ANTONIO GALICIA-ESCOTTO
Over the past 10–15 years, international recognition that macroeconomic statis-tics are an essential prerequisite for the formulation of appropriate economic and financial policies has grown, as has recognition of the importance of transparency for the efficient functioning of markets. The recent global financial crisis has reinforced these messages.
Although sovereign wealth funds (SWFs) are not a new phenomenon, more than half of the existing funds were established since 2000, often to help manage foreign currency accumulation prudently and effectively. Although no firm fig-ures are available on the total size of SWFs worldwide, market participants were estimating the total size at about US$2 trillion to US$3 trillion in 2008, com-pared with total official foreign exchange reserves of around US$7 trillion.
The growing importance of SWFs within financial markets compels coverage of their activities in the macroeconomic data sets upon which policymakers, mar-kets, and users in general rely. The absence of SWF data can hinder economic analysis and potentially mislead data users, most important among them policy-makers, market participants, and other commentators on a country’s economic performance. The importance of accurate data was recognized in the fifth prin-ciple of the Santiago Principles of the International Working Group of Sovereign Wealth Funds (IWG, 2008, p. 14), which states: “the relevant statistical data pertaining to the SWF should be reported on a timely basis to the owner, or as otherwise required, for inclusion where appropriate in macroeconomic data sets.”
More specifically, the flows and positions of SWFs should be covered in the national accounts data; and in fiscal, monetary and financial, and external statis-tics. Participation in the internationally coordinated statistical exercises (described later in this chapter) also facilitates monitoring and analysis of international capital flows. Thus, from the perspective of IMF policymakers and other users, including the IMF, it is critical that adequate data are reported to support surveil-lance of countries’ economic policies.
This chapter (1) sets out some of the important initiatives that have been undertaken since the mid-1990s to improve transparency of cross-border activity, (2) undertakes a brief discussion of domestic statistics, (3) explains the framework
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created to capture information on SWFs, (4) discusses SWF statistical data reporting practices, and (5) offers some brief conclusions.
CROSS-BORDER DATA
Because SWFs have become more prominent owners of foreign assets, analysis of both a country’s external stability and its capital flows in international financial markets requires that SWF activities be covered in external sector data.
First, SWFs often own a significant part of a country’s external wealth. If these external assets are not captured in the balance of payments and international investment position data, external sector data can be misleading. Reliable external sector data are critical to analyzing the country’s external stability.
For instance, a reported net liability in international investment position may in fact be a net asset position once SWF assets are included. Furthermore, the currency risk facing the economy as a whole might be misunderstood without information on SWF assets—an increasingly relevant risk as exchange rates become more flexible.1
Second, the growing financial links among economies, and the resulting potential external financial vulnerabilities, have focused attention on the impor-tance of capturing financial exposures to partner countries in a consistent manner. Omission of the recent growth in the volume of SWFs’ cross-border assets would detrimentally affect the analysis of the international flow of funds and issues such as the common creditors and debtors of economies.2
The international and cross-border links aspects of statistical collection and analysis has special resonance for the IMF, which has made significant efforts to improve data collection for the purpose of analyzing the systemic implications of international financial flows. A summary of statistical initiatives to improve trans-parency of cross-border flows is provided in Table 7.1.
In the early 1990s, as the progressive deterioration of the quality of informa-tion about international financial flows began to undermine the conduct of national economic policy and international policy coordination in several ways, the IMF published the principal findings and recommendations of a working group on the measurement of international capital flows (IMF, 1992).3 The rec-ommendations included the creation of the IMF Committee on Balance of Payments Statistics (Committee) to advise on developments in international financial markets and to work with the IMF to better capture these activities.
One of the first initiatives of the Committee was an internationally coordinated survey of portfolio investment, which became the Coordinated Portfolio Investment Survey (CPIS). The CPIS is now an annual voluntary exercise involving more than
1The currency composition of the international investment position is introduced in the sixth edition of the IMF’s Balance of Payments and International Investment Position Manual (BPM6) (IMF, 2009).2For example, the April 2007 edition of the IMF’s Global Financial Stability Report included an article on “Changes in the International Investor Base and Implications for Financial Stability” (IMF, 2007).3Also well known as the “Godeaux Report.”
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TABLE 7.1
Statistical Initiatives to Improve Transparency on Cross-Border Flows
Initiative Description Impact on cross-border flows
Standards
Special Data Dissemination Standard (SDDS)
The SDDS, established in March 1996, aims to guide members that have, or that seek, access to international capital markets in providing their economic data to the public.
Enhances data transparency, including external sector statistics.
General Data Dissemination System (GDDS)
The GDDS is a structured pro-cess through which IMF member countries commit voluntarily to improving the quality of the data compiled and disseminated by the statistical systems over the long run to meet the needs of macroeconomic analysis.
A framework for a national sta-tistical development strategy. Comprehensive metadata and description of methodologies used to compile and dissemi-nate external sector statistics.
Data quality
Data Quality Assessment Framework (DQAF)
The DQAF brings together a structure and common lan-guage for good practices and internationally accepted con-cepts and definitions in statis-tics, including those of the United Nations Fundamental
Principles of Official Statistics and the SDDS/GDDS.
Main instrument of analysis of the data module of the report on the observance of standards and codes (ROSC). Its coverage includes external sector statistics.
Methodologies
Balance of Payments and
International Investment Position
Manual (BPM6)
Internationally accepted stan-dard to compile and disseminate balance of payments and International Investment Position statistics.
BPM6 provides advice on how to determine whether SWF assets should be included in reserves or not under different institu-tional arrangements.
External sector statistics
Assistance to a set of countries in compiling International Investment Position (IIP) Statistics
The IIP is a statistical statement that shows at a specific time the value and composition of finan-cial assets of residents that are claims on nonresidents, and lia-bilities of residents of an econo-my to nonresidents.
An SWF’s external assets are classified on the asset side of a country’s IIP.
Reserve Assets and the Data Template on International Reserves and Foreign Currency Liquidity (Data Template).
Internationally accepted stan-dard to analyze foreign currency liquidity, which allows the com-pilation and dissemination of official reserves, other foreign currency liquidity, and predeter-mined and contingent net drains in a single framework.
SWF assets held as official reserve assets are covered.
(continued)
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88 Sovereign Wealth Funds: Investment Flows and the Role of Transparency
70 large economies that are investing abroad in securities.4 This survey provides position data by country of issuer and holder of portfolio investments, such as debt and equity securities, from a creditor perspective, thus potentially including SWFs. Indeed, some countries with SWFs do undertake the CPIS and provide data to the IMF. When these countries provide a sectoral breakdown by holder, an indication of the geographic distribution of SWF assets can be gauged.
In 2007, the Committee promoted an internationally coordinated survey of foreign direct investment positions—the Coordinated Direct Investment Survey (CDIS). This voluntary survey was launched in 2010 to collect data for end-2009 with a focus on position data attributed by counterpart country. SWFs’ invest-ments are potentially captured by the outward survey of investment. Because of the nature of SWFs, inward investment in domestic SWFs is unlikely (unless the SWF is established offshore), but inward surveys of recipient countries will cap-ture SWF investment into the economy, from a counterpart perspective.
4The results of the CPIS are available on the IMF Web site at “Portfolio Investment: CPIS Data—Database Contents,” http://www.imf.org/external/np/sta/pi/datarsl.htm.
Initiative Description Impact on cross-border flows
External sector statistics (cont.)
Currency Composition of Foreign Exchange Reserves (COFER)
Confidential database main-tained by the IMF on the volun-tary reporting of currency com-position of official foreign exchange reserves.
COFER is published quarterly on a strict multicountry aggregated data basis only.
Coordinated Portfolio Investment Survey (CPIS)
The CPIS collects information on a voluntary basis on individual economy holdings of portfolio investment securities—valued at market prices at the end of each year, cross-classified by the country of the issuer.
Available data by country of issuer and holder of portfolio investment, such as debt and equity securities from a creditor perspective. SWF coverage depends upon country partici-pation in the CPIS.
Coordinated Direct Investment Survey (CDIS)
To be launched with a reference date of end-2009. The objective of the CDIS is to improve the quality of foreign direct invest-ment data at global and bilater-al levels. The CDIS will result in the assemblage of a compre-hensive database of direct investment positions data, dis-aggregated by instrument—equity and debt—and by coun-terpart economy of immediate investor. Country participation is on a voluntary basis.
An SWF’s investments are poten-tially captured by the outward survey of investment. Inward sur-veys will capture SWF investment into the recipient economies.
Source: Authors’ compilation.
TABLE 7.1
Statistical Initiatives to Improve Transparency on Cross-Border Flows (cont.)
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Both the CPIS and CDIS capture financial positions between member coun-tries and complement the Bank for International Settlements’ international bank-ing statistics, which is the oldest of the internationally coordinated surveys and covers cross-border banking business. Information from the Bank for International Settlements on SWF activity is gathered as if SWFs are customers of banks—that is, from a counterpart perspective.
A number of international initiatives collect data on SWF assets held as official reserves. In the late 1990s, the IMF introduced a framework to disseminate com-prehensive information on countries’ international reserves and foreign currency liquidity on a timely basis, known as the data template. The IMF also established a database for storing and disseminating countries’ template data.5 For subscribers to the IMF’s Special Data Dissemination Standards, SWF assets held as official reserves are covered by the data template.
Since December 2005 the IMF has published, on a quarterly basis, aggregate data from the Currency Composition of Foreign Exchange Reserves, another voluntary initiative. The securities held within official reserves are collected through the voluntary Securities held as Foreign Exchange Reserves (SEFER) exercise and presented along with the results of the CPIS on a country-of-issuer basis. These two initiatives provide, for analysis purposes, the currency of denom-ination and cross-border holdings of all securities held as official reserves, making no distinction between SWF assets held as official reserves and other securities held as official reserve assets.
These endeavors have been collaborative efforts, involving IMF staff, IMF member countries, and staff of other international agencies, to improve the avail-ability of cross-border financial data to support policymaking and market analy-sis. Coverage of SWFs’ investments has become increasingly important as their significance in international markets has grown.
DOMESTIC STATISTICS
The system of national accounts provides a comprehensive and systematic frame-work for the collection and presentation of the economic statistics of an economy. SWFs’ activities could significantly affect the generation and distribution of income, consumption behavior, and accumulation activities of the economy, and so need to be included in the national accounts.
SWFs’ activities should be covered in government finance statistics to allow the asset and liability position and the fiscal risks of the public sector to be assessed,6 and the way in which SWF operations are integrated with the overall
5The data template framework integrates data on on-balance-sheet and off-balance-sheet interna-tional financial activities of countries’ authorities and supplementary information, including data on predetermined future foreign exchange flows. More information is available on the IMF Web site at “Data Template on International Reserves and Foreign Currency Liquidity,” http://www.imf.org/external/np/sta/ir/colist.htm.6For instance, SWFs with explicit liabilities will need to take into account the portfolio mismatches and risks to balance sheet soundness.
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fiscal accounts and macroeconomic policy objectives to be evaluated. Regardless of whether the assets of SWFs are held by the general government, on the balance sheet of the central bank, or by a separate public entity, the net assets of SWFs should be encompassed in the general government’s net worth.
Furthermore, transactions, including income transactions, should be captured in the appropriate government accounts, not least because the revenues associated with an SWF’s assets may have an important impact on the government’s fiscal performance (and thereby the country’s domestic and external stability).
Likewise, SWFs’ activities are important for monetary and financial statistics given that they may affect monetary policy formulation and financial analysis. SWF assets may be included in the balance sheets of the country’s central bank, which affects the measures of the central bank’s net foreign assets and, possibly, net claims on the government. Or an SWF may be a separate institutional unit classified as a financial corporation. SWFs may borrow from domestic financial institutions. Understanding the impact of SWFs on these aggregates is also neces-sary for determining consistency of monetary statistics with other macroeco-nomic data sets.
In the context of the balance sheet approach used for assessing sectoral finan-cial positions, SWF data are needed to complete the coverage of the institutional sector in which these funds need to be classified.7 Data inconsistencies may be identified in the balance sheet approach framework if an SWF’s data are reported for, say, external statistics but not for government and financial statistics.
HOW DO SWFS FIT INTO EXTERNAL SECTOR STATISTICS?
The Balance of Payments and International Investment Position Manual (BPM6; IMF, 2009) provides explicit guidance for the reporting of economic and financial data by SWFs. There is no special treatment for SWFs and their assets in the international statistical standards, but the explicit discussion of SWFs in BPM6 brings clarity to the appropriate treatment.
Based on discussions with reserve asset and balance of payments experts, and a worldwide consultation period, BPM6 includes a definition of SWFs taken directly from the Santiago Principles (IWG, 2008), as well as advice on the com-pilation and dissemination of external sector data on special purpose government funds, usually known as SWFs, particularly in relation to official reserve assets. Indeed, BPM6 provides advice on determining whether SWF assets should be included in official reserve assets under differing institutional arrangements.
BPM6 does not call for the separate identification of SWF assets within the external data, but allows for the voluntary disclosure of SWF assets not included
7 The balance sheet approach presents a matrix of data by institutional sector—general government, deposit-takers, other financial corporations, and so forth—to permit the identification of balance sheet vulnerabilities. For more information on the balance sheet approach, see Mathisen and Pellechio, 2007.
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in official reserves. Although assets in SWFs that are not readily available for use to meet a balance of payments need do not meet the definition of official reserve assets, such assets are an indication of the external financial wealth of an economy, and so can be provided as information additional to that on official reserve assets. Thus, if official reserves decline as the result of a transfer of assets from official reserves to an SWF, a separate item can show that this decline is not due to adverse circumstances but instead is a sign of strength in the future. This signal may be particularly important if there are significant transfers of funds from offi-cial reserves to the SWF.
BPM6 also advises on the sectoral classification of SWFs as institutional units, consistent with the principles of government finance and monetary statistics and the system of national accounts, and the functional classification of their assets, such as portfolio or direct investment, if not held as official reserve assets.
STATISTICAL DATA REPORTING PRACTICES OF SWFS
In 2008, a survey of current institutional and operational practices was prepared by the IWG Secretariat, based on information provided by the IWG members, for use by the IWG in drafting the Santiago Principles (Hammer, Kunzel, and Petrova, 2008). The survey included a section on statistical data reporting.
In the survey, respondents indicated that they produce economic and financial data on a regular basis. While some SWFs make information available to the public, others provide statistical data to only relevant national agencies. A major-ity of SWFs surveyed mentioned that they make their data available to compilers of macroeconomic statistics (Figure 7.1).
Although a majority of the SWFs surveyed indicated that relevant data are included in balance of payments and international investment statistics, or government finance statistics, in most cases SWF-specific data cannot be sepa-rately discerned because of consolidation with other items. This is in line with the current statistical standards, which do not provide for separate reporting of SWF assets.
Not in Balance of Payments Statistics or International
Investment Position14%
Included in Balance of Payments Statistics or
International Investment Position
62%
Not Specific24%
Source: Hammer, Kunzel, and Petrova, 2008.
Figure 7.1 Statistical Data Provided by SWFs to Compiling Agencies (Percentage of Respondents)
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92 Sovereign Wealth Funds: Investment Flows and the Role of Transparency
The majority of responding SWFs reported they were funded from mineral royalties (principally oil), while the remainder are funded from fiscal surpluses or other sources, including official reserve assets and returns on fund invest-ments. In a few cases, divestment proceeds and borrowing from markets also contributed to asset accumulation. The identification of all these sources of financing is important for the proper coverage of macroeconomic statistics of the reporting economy.
CONCLUSION
For policymakers and other users it is important that data on SWFs’ activities are consistently captured in the macroeconomic statistics—national accounts data; and fiscal, monetary and financial, and external statistics. Furthermore, to help support analysis of international markets, at both the international and national levels, the participation of countries with SWFs in the internationally coordi-nated statistical exercises, such as the CPIS and the CDIS, is also important. As recognized in the Santiago Principles, the absence of SWF data can hinder eco-nomic analysis and potentially mislead policymakers, market participants, and other commentators about a country’s economic performance.
REFERENCES
Hammer, Cornelia, Peter Kunzel, and Iva Petrova, 2008, “Sovereign Wealth Funds: Current Institutional and Operational Practices,” IMF Working Paper WP/08/254 (Washington: International Monetary Fund).
International Monetary Fund, 1992, Report on the Measurement of International Capital Flows (Washington).
———, 2007, “Changes in the International Investor Base and Implications for Financial Stability,” Global Financial Stability Report: Market Developments and Issues (Washington).
———, 2009, Balance of Payments and International Investment Position Manual (Washington; 6th ed.).
Various19%
Budget Transfers
14%
Mineral Royalties
67%
Source: Hammer, Kunzel, and Petrova, 2008.
Figure 7.2 Primary Sources of Funds for SWFs (Percentage of Respondents)
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Heath and Galicia-Escotto 93
IWG (International Working Group of Sovereign Wealth Funds), 2008, Sovereign Wealth Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
Mathisen, Johan, and Anthony Pellechio, 2007, Using the Balance Sheet Approach in Surveillance: Framework and Data Sources and Availability (Washington: International Monetary Fund).
United Nations Statistics Division, 1994, “Fundamental Principles of Official Statistics” (New York).
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CHAPTER 8
Regulating a Sovereign Wealth Fund Through an External Fund Manager
ANDRÉ DE PALMA, LUC LERUTH, AND ADNAN MAZAREI1
Only a short while ago, sovereign wealth funds (SWFs) were seen by many as the newest malignant instrument of state-sponsored capitalism on the global financial stage. SWFs, with large amounts of assets projected to rise rapidly on the backs of rising commodity prices and widening global imbalances, were expected to invade and occupy financial markets and hold them hostage for the unfriendly objectives of their home governments. Little empirical evidence sup-ports these concerns and, in fact, SWFs have generally behaved noncontrover-sially. In international forums where these issues are debated, many observers were not surprised by SWFs’ benign behavior and expressed serious doubts when others feared that SWFs would pursue objective functions vastly at odds with the objectives of other economic actors operating in the host country, and in particular, that profit maximization would not be at the core of their strate-gies.2 Yet, the concerns were sufficiently strong to have led to calls from many quarters for more regulation of SWF operations through a number of means (e.g., Kimmit, 2008).
Fortunately, with improved information, persistent communication efforts by SWFs explaining their activities, the preparation of a voluntary set of best prac-tices (known as the Santiago Principles; IWG, 2008), and efforts by various international organizations (principally the IMF and the Organisation for Economic Co-operation and Development) to clarify the rules and regulations governing SWFs’ investments, tempers have cooled. Perhaps more important, with the global financial crisis unfolding, other issues have taken center stage. Also, SWFs have lost a portion of their portfolio value as a result of the global decline in asset prices, and many have turned inward in an attempt to save their domestic economies through increased support for local banks or purchases of domestic assets.
1The authors have benefited from comments from E. Barot, M. El-Gamal, A. Ferrière, and J. Pihlman.2Others have also argued that, far from being sophisticated, SWF managers were actually not aware of their potential impact, or were reluctant, for reasons of “image,” to activate all the tools of leverage at their disposal.
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96 Regulating a Sovereign Wealth Fund Through an External Fund Manager
So, was the debate about SWFs all about nothing? The authors of this chapter do not think so. Although many of the fears about sovereign funds have been exaggerated, SWFs do pose important issues for regulation, as foreign investors and as key players in the economies in which they operate, and also, more simply and irrespective of the location of their activities, as players whose characteristics are not fully known to other economic actors. That many SWFs turned inward during the crisis is certainly not an argument against looking into these issues more deeply. In parallel, the recent crisis has heightened global concerns about risk management of all financial institutions, especially systemically important ones. Some SWFs have already started to make their comebacks and, as the crisis recedes, their operations in foreign markets are likely to accelerate quickly, which will tend to revive concerns and misgivings in recipient countries.
Before moving further, this section details some of the key issues surrounding SWFs’ operations.3 Concerns in recipient countries about SWFs have generally involved three broad issues. First is ownership of SWFs by foreign sovereigns, which may have noncommercial, perhaps strategic, motives for investment. Sovereign ownership generally raises the role of governments in economic activity, with a concomitant distortionary impact on business decisions. Second is their size, which may unduly affect asset prices and financial stability in host countries. Third is the transparency of their operations. Notwithstanding the decline in SWFs’ foreign-based operations during the recent global financial crisis, clearly the issue of governance by the SWF of its operations in countries receiving SWF investments will remain relevant for a long time, if only because some key SWF operations are locked in.
SWFs have also raised important issues in their home countries although these concerns differ substantially from those in recipient countries. Irrespective of its location, an SWF can be of one or a combination of the following types: stabiliza-tion fund, savings fund, reserve management corporation, development fund, or contingent pension reserve fund (IMF, 2008). Accordingly, even when they oper-ate at home, SWFs raise a number of concerns for their sovereign owners.4 Unfortunately, the principal-agent (P-A) model is not well suited to analysis of an
3Das, Mazarei, and Stuart (Chapter 5, this volume) discuss this and many other concerns raised by SWFs’ operations. They also elaborate on the rationale for the Santiago Principles and how the prin-ciples seek to allay those concerns.4First, as public investors, SWFs must properly invest public funds and secure adequate risk-adjusted returns. Second, SWFs need to make sure their investments are immune from undue domestic political interference. Third, because of their size, their activities need to be well coordinated with the country’s overall macroeconomic policies, particularly with the activities of other actors tasked with the implementation of macroeconomic objectives (e.g., the central bank). And fourth, as mentioned in the case of an SWF operating overseas, there is the possibility that some of the multiple objectives pursued by the manager of the SWF may not be compatible with those of the other domestic eco-nomic actors. For example, the finance minister of a centralized economy may have misgivings about the profit-maximizing instincts of the SWF manager. As mentioned, these issues became more rele-vant during the 2008–09 financial crisis as SWFs were asked by their governments to shift some of their focus to their domestic economies.
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SWF’s operations at home and, while there may be some lessons to be drawn, they are not the focus of this chapter.
Rather, this chapter concentrates on the concern that SWFs’ operations may distort the decision-making processes and governance of the foreign firms they invest in (though not unique to SWFs), thereby harming the national interest of the recipient country—even leaving security-related concerns aside. At the root of this concern is the lack of trust among all parties in the objectives (the utility functions) pursued by the others. This concern implies that perceptions and the difficulty in interpreting the actions of any party will affect the interactions between the SWF and the recipient country, which may lead to a lack of trust that is not necessarily justified. This chapter thus looks in detail at the possibility that SWFs invest in recipient countries with legitimate (i.e., not related to strategic or “unfriendly” motives) objectives that are hard to interpret because they are not necessarily associated with short-term profit maximization. For example, an SWF could invest to learn more about a certain business. In that case, it is difficult for authorities in the recipient country to accurately interpret the signals sent by the SWF through its actions.
This chapter examines the relationships between SWFs and their recipient countries, concentrating on the dependence of that relationship on the nature of the objectives pursued by the SWFs, using a P-A framework. In particular, when an SWF has multiple objectives, signals can be misinterpreted, leading to mis-guided reactions by authorities in the recipient country. Thus, hard-to-interpret signals do not provide a sufficient case for the imposition of constraints on the SWF. However, the chapter shows and discusses later that requiring the SWF to invest through intermediary asset managers may foster cooperation, especially when the objectives of the SWF and of the authorities are closely aligned. An SWF may also alleviate concerns in a recipient country by acting as an investor for (and accepting the funds of ) other SWF and non-SWF investors.
The next section of this chapter discusses the foreign operations of SWFs that may create the need for regulation through an external fund manager. The subse-quent section provides the outlines of an analytical framework, and is followed by a section discussing the scope for regulation under different assumptions about the information set of the agents involved. The penultimate section complicates the basic model set out earlier by introducing agents with multiple objectives, thus increasing the risks that signals are misinterpreted by recipient countries. The final section concludes.
REGULATING THE SWF OPERATING OVERSEAS THROUGH AN EXTERNAL FUND MANAGER
For a variety of reasons, countries regulate financial domestic companies. Upon becoming active in a foreign country, some or all of the activities of an SWF also become subject to regulations imposed by the recipient government. Although generally encouraging foreign investment, many recipient countries tend to be more suspicious of SWF activities than they are of domestic firms, because they
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fear that the SWF may somehow find a way to circumvent the regulatory process, even if not actively trying to avoid scrutiny.
Hence, various propositions have been made to regulate SWFs, including imposing upper limits on ownership or voting rights, prohibiting SWFs’ invest-ments in sensitive areas, and subjecting SWF operations to a specific set of procedures. The recipient country experiences a clear trade-off, however. If an SWF brings economic benefits to the recipient country (as most have argued), limiting its room for maneuver through more regulations than typically applied to domestic firms engaged in similar activities may not be wise—in addition to the extra costs to the regulatory authority (and the compliance costs to the SWF), the SWF will face additional constraints (some arguably not necessary) and, if there are too many hurdles, it could even forego the opportunity of oper-ating in that country altogether.
A more subtle idea that has received support is to ask an SWF to invest through a fund manager in the recipient country (Gibson and Milhaupt, 2008). By introducing an additional layer between the SWF and the companies in which the SWF’s money is to be invested, the hope is that the probability of detrimental activities (be it to the companies or, more generally, to the country) would be reduced for two reasons: the scope for collusion between the SWF and the target company, or undue influence by the SWF on that company, would be more lim-ited; and investment funds tend to be more tightly regulated than other com-mercial activities. Another approach for allaying the concerns of recipient coun-tries about the possible noncommercial motivations of SWFs has been initiated by Temasek of Singapore. Temasek has taken steps to establish a more general fund that would also take investments from other SWFs and non-SWF investors. Through this approach, Temasek and a few of its non-SWF partners could signal to recipient countries that their investments involve resources from diverse inves-tors with different political interests, thus tamping down concerns about any noncommercial objectives of their investments.5
The next subsections look at the proposal to use an external manager by considering the case of an intermediary fund in the recipient country. P-A theory is used for this analysis. Broadly speaking, both the regulatory authority (or a trusted domestic investor) and the SWF become the principals of the recipient-country fund manager (the agent). As is standard in contract theory, the strategy of each principal is to induce the agent to act in such a way that the resulting output maximizes the principal’s utility. In doing so, the principals interact with and learn more about each other. Thus, the principals compete in trying to influence the actions of the agent in a way that could protect the interests of the recipient country (the principal represented by the regulatory authority or a domestic investor) and of the sovereign owner (the principal represented by the SWF). The analysis demonstrates that a critical consider-ation in determining whether the approach is likely to have the desired results is the extent to which the objectives of the domestic regulator and an SWF can
5“Temasek to Launch $4bn Investment Division,” Financial Times, February 10, 2010.
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be accurately interpreted and, if they can, whether these objectives are comple-mentary or antagonistic.
A SIMPLE MODEL
Theoretical Considerations
The discussion now turns to a simple description of the model used to develop the ideas and the policy arguments. The model, inspired by Martimort (2006), will not be solved here. The framework is a simple way to sketch the case of one agent being supervised by several principals (the model is limited here to two principals) and is consistent with the typical model used in the field.
Let us assume that two principals (Pi, i = 1,2) have an objective function Si(q), where q = q(q1,q2) is the output of the agent. In return for the agent’s output, each principal makes a transfer ti to the agent. The utility Vi of each principal is given by
Vi = Si(q) – ti; (i = 1,2).
The utility U of the agent is given by the transfers received from both princi-pals minus the effort it makes to produce q. It is further assumed that the agent is efficient with an intensity θ, so that the cost C(q) of producing q affects the agent’s utility as follows:
U = t1 + t2 – θC(q),
where the term θC(q) can be interpreted as the opportunity cost to the agent of producing q—or in managing a company F on behalf of its principals in such a way that F produces q. The term θ can be interpreted as the agent’s type (e.g., efficient or not) and this parameter may or may not be known to the principals. As detailed below, the analysis can then refer to cases of perfect or imperfect information, respectively. The model appears in Figure 8.1 (which does not include company F). The cost function C(q) is supposed to be known to the principals.
This formulation of the utility function of the agent is very general. In fact, the analysis allows for the possibility that each principal Pi enters into a contract with the agent on a specific component of the output that matters to that principal. This quantity is called qi (i = 1,2) with q = q(q1,q2). A further assumption that principal P1 (resp. P2) can only observe q1 (resp. q2), and is not able to observe q2 (resp. q1) (the output going to the other principal), yields the case of private agency. If the contract is on the entire output q = q(q1, q2), it is public agency. In both cases, as discussed in the next subsection, the principals interact with each other via the contracts they offer to their common agent. The analysis shows that the ability of the regulatory body (or the recipient-country fund manager) to constrain the SWF depends on whether the agency is private or public. For the cost function, this distinction is not necessary because the agent is assumed to have perfect informa-tion about it. Yet, C(q) can play a role in the results, as discussed later.
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Considerations on the Basic Assumptions
The main elements of the model relevant for the purpose of this chapter’s thesis follow:
• First, who are the principals? Because the P-A model with two principals assumes a transfer to the agent, the regulatory authority cannot technically be associated to a principal. Instead, it should be assumed that the “domes-tic” principal is a recipient-country financial institution in which the authorities have full trust while the other principal is the SWF. This sim-plification could affect the results, because a P-A relationship would also exist between the regulatory authority (which would become an additional, main principal as shown in Figure 8.2) and the recipient-country fund manager (the domestic principal); the recipient-country fund manager is, in fact, an agent of the regulatory authority. Similarly, there would be a P-A relationship between the recipient-country fund manager (the agent in Figure 8.1) and the domestic company F in which money is ultimately invested. Just as in the other case, the recipient-country fund manager—agent of principals 1 and 2—would itself become one of the principals of company F. Yet another realistic complication would be to take into account the P-A relationship that necessarily exists between the SWF and its sovereign owner (not included in Figure 8.2). Hence, the domestic principal is associated to the “government,” or to the “recipient-country fund manager,” as the case may be. The simple situation presented in Figure 8.1 would then become as in Figure 8.2.6 Unfortunately, these com-plex features cannot be included in the model because cascade P-A relation-ships have not been studied (although Mookherjee [2006] provides a qualitative discussion of such models). The analysis also neglects firm F, the domestic company, as a player.
6Several other P-A relationships are ignored in this brief description, some of which can be very important, such as the relationship already mentioned between the foreign authority as a principal and the SWF as its agent.
Source: Authors.
Principal 1(recipient country)
Principal 2(foreign SWF)
Agent (recipient-country fund manager)(type θ known or not)
Figure 8.1 An SWF Invests through a Recipient-Country Fund Manager
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• Second, who knows what? With complete information (see “Perfect Information” section later in this chapter), the parameter θ is known to both principals (see Figures 8.1 and 8.2). Both principals knowing θ corresponds to a situation in which the regulatory authority feels confident that, through the recipient-country financial institution acting as domestic principal, it knows the characteristics of the agent or is in a position to monitor it closely enough to be well informed about its behavior. This may not always be the case because the relationship between the regulatory authority and the domestic principal is not as straightforward as has been assumed (as dis-cussed in the previous bullet) or because there is less than perfect informa-tion (as discussed in the next bullet). More important, and contrary to the simple assumption of perfect information, the SWF is unlikely to know an agent unilaterally selected by the regulatory authority as well as the eco-nomic actors of the recipient country know the agent, implying an asym-metry between principals, which, to the authors’ knowledge, has not been studied in the literature. However, it could be realistic to assume that the SWF is allowed to choose an agent from a list of candidates deemed accept-able by the regulatory authority of the recipient country (perhaps a fund manager with ties to the SWF’s country), which would restore some balance of information between the two principals. If the agent is sufficiently well known, the assumption of perfect information holds. In addition, there is an aspect of information that involves sending messages to and properly reading the intentions of the other players (which can be interpreted cor-rectly or incorrectly). This situation is discussed in detail in the section titled “P-A Players with Multiple Objectives.”
Main principal(recipient country)
Domestic company F
Principal 1(domestic agent of
main principal)
Principal 2(foreign SWF)
Agent (recipient-country fund manager)(type θ known or not)
Source: Authors.
Figure 8.2 Additional P-A Relationships
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102 Regulating a Sovereign Wealth Fund Through an External Fund Manager
• Third, situations of imperfect information present additional issues.7 With imperfect information, the agent is not well known to either principal and therefore will retain some advantage in its ability to extract surplus from both principals as they compete for the agent’s services. The regulatory authority will also face uncertainty about the characteristics of the SWF. This situation appears to be a more realistic assumption than q being known. For example, because q is an aggregate measure, it is reasonable to assume that a principal may be fully aware of some characteristics of the agent and ignorant of others, making the principal’s aggregate perception imperfect. In addition, as will be shown, this model allows a related issue to be explored, specifically, the extent to which antagonistic or complementary utility functions belonging to the principals can affect the outcome. It is important because an agent could be very good at certain tasks and not as good at others while the global output q = q(q1,q2) received by each principal is a combination of these tasks. This is also important because a key consid-eration in the debates about SWFs is precisely the extent to which their objectives conflict with those of domestic actors.
• Fourth, the interpretation of q should not be restricted to the notion of quantity. In fact, the output q, in the context of SWFs’ operations, corresponds to a portfolio that the principals ask the agent to manage for them. Martimort (2006), for example, considers the agent’s output to be a portfolio. An ambi-tious approach (not used in this chapter) would be to consider that the sovereign breaks up its SWF into a number of agents, each with a compara-tive advantage in dealing with various aspects of portfolio management, to maximize the sovereign’s overall utility with the combination of their out-puts (just as an investor strikes a balance between risks and returns). Such a model would provide useful insight into the optimal architecture of any organization; one obvious example would be to determine the share of for-eign reserves that the SWF would be allowed to manage while the central bank retains responsibility for the rest. This topic is discussed briefly later in this chapter, but the issue is not modeled.
• Fifth, the model is here restricted such that the agent has an obligation to work for both principals simultaneously. In the P-A literature, this is a special case because most models allow the agent to reject one contract and accept the other. However, doing so would not make sense in this context. Indeed, this analysis rules out the possibility that the SWF could be operating indepen-dently in the recipient country. Thus, if the agent rejects the possibility of working with the SWF (or the other way around), the SWF would simply not be allowed to operate.
7In the model considered here, imperfect information corresponds to adverse selection. Other varia-tions of the model could also have been investigated but, in the context of this chapter, the analysis would not yield substantially different conclusions.
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• Finally, the welfare aspects of multiprincipal models are generally not well defined because the objectives of the two principals may overlap with each other. This overlap means that utilities cannot easily be added up and the theo-retical literature has therefore neglected welfare analysis to instead focus on various notions of economic efficiency, but these notions are not discussed in the context of this chapter.
RESULTS, INTERPRETATIONS, AND POLICY IMPLICATIONS
Perfect Information
With perfect information, both principals in this model know the characteristics θ of the common agent. Let us first consider the case in which the common agent operates as a private agency (i.e., deals with each principal Pi individually and negotiates on the specific output qi that only the two parties involved can observe). Because the principals know θ, each principal is able to reduce its own transfer ti to the point at which the agent is indifferent between undertaking the task and rejecting the offer (although the rejection option is not allowed here, as discussed earlier). Each principal behaves in the same way, and an equilibrium is reached when none of the parties wants to deviate.
Even in this simple case, both principals interact with each other when they negotiate with the agent. This interaction occurs during the negotiations, as each principal offers a contract in the form of a set of options to the agent. Most of these options will not materialize, but they are nevertheless important because they act as strategic signals to the other principal.8 With both principals acting through the agent, the result may be inefficient outcomes, a somewhat unex-pected result since there is otherwise perfect information in the game (better information being often associated with more efficiency).
In a private agency, and from the point of view of the regulatory authority, the ability to monitor the activities of the SWF is limited by the fact that each prin-cipal negotiates directly with the agent and that the interactions between the principals are limited to sending signals to each other through a set of contracting options. Therefore, even with perfect information—and private agency—it is dif-ficult to see how forcing an SWF to go through an agent with which it would be able to contract on its specific output would limit the scope for undesirable behavior. In fact, although it is possible that the signals sent by the other principal somehow affect (in a socially positive manner) the SWF, it is also equally likely that the signals sent by the SWF to the domestic principal have a less desirable impact (if the SWF has undesirable objectives). This chapter argues below and in
8Parlour and Rajan (2001) provide a model of private agency where the principals lend money to a common agent who may default. In that case, however, the signaling between the principals is made through that possibility of default. This type of signaling may also lead to inefficient equilibriums.
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the subsection devoted to the case of imperfect information that this is, indeed, a risk for the recipient country.
When the agency is public (i.e., both principals can negotiate with the agent on the entire output), there is clearly more scope for interaction between the two principals (through the agent). However, although these interactions can lead to more coordination (and that is presumably what the regulatory authority would like to see), there is also potentially more room for failing to coordinate properly (a situation the regulatory authority would like to avoid). The latter is especially likely to happen if the SWF’s objectives diverge substantially from those of the recipient country. This is precisely the situation in which the recipient country would want to increase its control over the activities of the SWF, and the model suggests that the ensuing lack of coordination leads to inefficient equilibriums. If, however, the SWF has objectives that are broadly compatible with those of the recipient country, then using a common fund manager as a public agency is indeed likely to strengthen collaboration and therefore yield efficient equilibri-ums. Overall, if the room for coordination is limited, having an agent in com-mon is unlikely to help. If scope for coordination exists, having an agent in common may help reinforce that coordination.
Although this issue is explored in more detail in the section “P-A Players with Multiple Objectives,” it is worth noting that, in this game in which signaling plays an important role, the signals sent by one principal (e.g., the SWF) could be misread by the other principal (e.g., the regulatory authority). A misreading is likely to happen when two intrinsically different principals use their investments through their common agent as tools to learn about each other. As discussed in the next section, it seems that if signals are misread, the outcome is likely to be inefficient. Once again, an agent in common may help, but will be a more effi-cient instrument once some common ground in the form of compatible objec-tives has been established.
Imperfect Information
The previous subsection assumed that the principals operate with perfect infor-mation about the agent’s type (θ), which means that the recipient country feels confident enough about the behavior of the recipient-country fund manager to put it in charge of handling the SWF’s activities. That the SWF also knows the agent perfectly is clearly a restriction, but the theoretical models typically do not consider the case of asymmetry of information between principals. Despite its limitations, however, the concept of perfect information helps to provide insight into the communication channels between the two principals, even when the agent is “transparent” (i.e., when the agent’s type θ is known).
However, the analysis must also consider the case in which the agent retains an informational advantage. It may be reasonable to assume that the authority in the recipient country does not know the agent well. For example, the 2008–09 global financial crisis revealed that regulatory authorities, in spite of the time and resources spent, were taken by surprise by the types of financial products
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developed (and their valuation) by the most trusted firms they were supervising, even those operating domestically.
There is also another situation leading to imperfect information: the risk for an existing principal that the agent changes its type (θ) when a new and unknown principal—the SWF—enters. Such an argument is often made in clubs: the new member of a club could alter the nature of the club. A similar argument has also been used by some observers to argue that the inclusion of China in the World Trade Organization would not only affect China’s approach to trade, but could also fundamentally change the way the World Trade Organization operates.
One of the results obtained in multiprincipal models with imperfect informa-tion is that the agent can strategically use its informational advantage to play one principal against the other, especially if the principals have conflicting objectives (see Laffont and Pouyet [2004] for a formal approach). This is not surprising because this result was already obtained in perfect information, under both pub-lic and private agency, but the effect is amplified when the agent retains private information. Because the principals do not have perfect information, they have an incentive to monitor the agent to minimize its rent-seeking behavior. However, by monitoring the agent, each principal will interact, although involuntarily, with the other principal and will therefore send strategic messages. Khalil and Lawarée (2006) study that framework for principals asking a common fund manager (the agent) to manage their investments. As with perfect information, the results depend on whether the agency is private or public, although, even when the agency is private, the principals still interact with each other by performing some monitoring. That monitoring may reveal to the other principal some information about the characteristics of the agent. When the agency is public, each principal may want to use monitoring to convince the other principal that the agent is not really good for the other principal’s purpose. In that sense, although θ is a one-dimensional parameter not designed to capture the multidimensional aspects of the agent’s skills, it also serves as a blurring device that prevents principals from correctly assessing these skills (assumed given) in the different areas that each cares about. If each principal does the same, too much monitoring, from a societal perspective, may be occurring. Too little monitoring may occur when the agency is private.
This is an interesting conclusion for SWFs’ operations. The idea that there can be excessive monitoring is not always accepted (much like the idea that there can be excessive availability of information), and a recipient-country fund manager may resent becoming the object of increased scrutiny by the domestic regulators and possibly by the SWF. Therefore, although some monitoring is beneficial, the regulatory authority may fall into the trap of excessive monitor-ing. This may also occur with public agency in which the principals have more opportunities to collaborate—and compete—with each other, suggesting that forcing a public-agency approach would not be without pitfalls. Excessive monitoring could also be thought of by SWF home countries as a protectionist step by the recipient country, creating demands in the SWF’s home country for retaliatory steps against all foreign investment.
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After having explored the way in which imperfect information can affect the results obtained with perfect information, the analysis uses the model to look briefly into other areas that could be relevant to the activities of SWFs. To keep the argument simple, the discussion assumes a private-agency model in which the principals are concerned with two different aspects of the activities (the output) of the common agent.
From the social point of view, a crucial consideration is the extent to which the outputs q1 and q2 are complementary or are substitutes (or antagonistic, as termed earlier in this chapter). Let us look at the private-agency model again. The agent is tasked by both principals to produce the output that is relevant to each of them (q1 for P1 and q2 for P2). For example, the common agent could be asked by one principal to invest in a stock with certain return and variance characteris-tics, while the other principal favors another stock with different characteristics. In that situation, the principals requesting different stocks compete with each other (when their respective desired outputs are substitutes) and they support each other (when their desired outputs are complementary) for the agent’s time and to capture the output. Technically, the agent’s outputs (activities) are comple-ments when C12 < 0, and substitutes when C12 > 0, where Cij denotes the cross derivatives of the cost function introduced in the section titled “A Simple Model.” It is easy to show that an increase in output q1 triggers a decline in output q2 when activities are substitutes, while the reverse holds when they are complements. Complementarity could be interpreted as a situation in which the SWF has “friendly” objectives that do not conflict with those of the recipient country.
One general lesson can be drawn from such imperfect information models. Principal P1 always tries to induce the agent to do more for it (of q1) and less for the other principal (P2) by offering to the agent signals and incentives aimed at convincing P2 that the agent is not good at performing the task that P2 cares about (q2). When outputs are substitutes (or compete with each other), this sig-naling behavior leads to output distortions as both principals play the same game and successfully manage to reduce the output for the other. When outputs are complementary, the game does not lead to a substantial loss in overall output.
Therefore, the extent to which the objectives of the regulatory authority and the SWF conflict with (substitutes) or reinforce (complements) each other is an important consideration, as noted in the introduction to this chapter. Not sur-prisingly, fewer distortions will occur with complements and the recipient coun-try is correct to feel more comfortable with the arrival on its territory of an SWF with objectives that do not conflict with domestic objectives. Once again, how-ever, all these results depend on how each player interprets (correctly or incor-rectly) the signals sent by the others. The chapter now shows, using one example, how even good intentions can be misinterpreted, and lead to a loss of efficiency.
P-A PLAYERS WITH MULTIPLE OBJECTIVES
While formally assuming that players maximize some general utility function, P-A models are often limited to profit maximization, as already indicated. Yet,
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some of the key issues emerging from the debates on SWF activities suggest that there are suspicions (on the parts of authorities in recipient countries, think tanks, and even home-country authorities) about SWFs’ motives, even though achieving profits must clearly be an important component of a more complex utility func-tion. The discussion in this section will primarily be relevant to the SWF operat-ing in a recipient country, although some of the issues would also be relevant to the SWF operating domestically.
A review of the various objectives that an SWF could pursue indicates that some of these objectives could be characterized as “learning by investing.” By investing in a line of business, the SWF will learn about the business’s activities and can, in turn, provide its sovereign with useful information (irrespective of whether such learning is aimed at strategic, commercial, security, or simply devel-opment purposes). Learning by investing contrasts with the well-researched field of “learning by doing,” in which costs continue to decrease with the cumulative quantity of goods produced (e.g., Dasgupta and Stiglitz, 1980; Tirole, 1988). If one of the players (in general, it could be either the principal or the agent but this chapter focuses on the principal) is pursuing multiple objectives in the long run, these objectives would probably not be compatible with short-term financial objectives, but could well be compatible, in the long run, with standard (although enlarged) financial objectives. Thus, the SWF is “investing” in the short run for a long-run payoff that the recipient country may find difficult to define or even understand at the time of the investment. In such a framework, the signals received by the other players (i.e., information about the investor’s action) will be hard to interpret. When signals are not read correctly, any move could lead to suboptimal reactions by other players and therefore to suboptimal outcomes from the point of view of the other players (including the agent and the principal). Such situations could clearly occur when an SWF operates in a recipient country, but could also arise for an SWF operating domestically. This issue has been touched on in the context of a model with two principals and one agent. For tractability, the model in this section is restricted to one principal and one agent in the first instance, before briefly moving to the case of several principals.
One Principal
A simple example illustrates how learning by investing can take place. Assume that an SWF acts as a principal and wishes to invest in each period (time is discrete) in one of two funds, denoted by j, with j = A, B. The financial returns from investing in either fund are stochastic and denoted by Rj, j = A,B. It can also be assumed that the principal can acquire some private additional benefit Tj from investing in either of these funds (e.g., control or acquisition of infor-mation). Again, this information can be directly related to the profitability of the fund or to more general benefits that the principal wishes to acquire. It is further assumed that the principal is facing uncertainty; therefore, the benefit Γj is modeled as a latent variable (not observable directly by the principal) that can take two values normalized to 0 or 1, without loss of generality. The pos-sible realizations of Γj are denoted by Γj = 0 (referred to as “bad outcome”) or
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Γj = 1 (referred to as “good outcome”). The words “good” and “bad” are arbi-trary. It is assumed that the underlying process generating the good and bad outcomes is stationary and unknown.
The principal is assumed to be facing uncertainty because it does not know the probabilities of occurrence of the good and bad outcomes. The principal can reduce this uncertainty, but at a cost. The analysis denotes by pj, the probability that the outcome is unfavorable Prob{Γj = 0} = pj, with fP(pj), the prior belief, in other words the probability distribution for parameter pj. Without any extra prior information, it is reasonable to assume the simplest possible prior, that is, that the distribution is uniform ( fP(pm) = 1). One extreme case occurs when the random variables Rj and Γj are perfectly correlated; the other extreme case occurs when the random variables Rj and Γj are independent; at these extremes, neither a large nor a low return on investment j tells anything about the value of Γj.
If there is perfect correlation (between the financial benefits and the addi-tional benefits), acquisition of information by the principal is required to maxi-mize the principal’s long-term objectives. If the two benefits are independent, acquisition of information and profit maximization correspond to two different objectives held by the principal in a multicriteria problem.
The analysis has assumed that the investment occurs in a discrete time frame and, in each period, the principal decides where to allocate its assets (the choice is discrete, i.e., either fund A or fund B is chosen). The proposed model is dynamic and captures the time lag associated with the concept of learning by investing. It works as follows: after each period, the principal observes a realiza-tion of the random variable Γj, and adjusts its previous knowledge accordingly. Note that the observation of fund j is costly because the principal has to invest in this fund to be allowed to have access to a realization of Γj. After n observations of the realization of Γj, the distribution of prior knowledge has changed and is determined by the observed number of good and bad outcomes; this provides sufficient statistics for making the next decision. This problem is difficult and has no closed-form solution, but rigorous numerical solutions exist. Some of the computations related to this problem are provided in the Annex to this chapter.
Investing in a fund can therefore play a dual role for the SWF because it gets both some financial return and some private benefit. Some simple cases are easy to solve.
Assume, for example, that returns and private benefits are perfectly correlated. To fix ideas, assume that the value of pA for fund A is known; we then have a “one-armed bandit” problem.9 It can be shown that in this case, the best strategy is one of three: (1) the principal always invests in fund A and never changes; (2) the principal invests in fund B, and if there are too many bad outcomes, it stops and switches to fund A forever; or (3) the principal invests in fund B and never changes (note that it would be irrational to invest in A and then switch to B).
9A one-armed bandit is a process akin to a jackpot. The probabilities of success are unknown but could be determined more accurately as the machine is used, but using the machine is costly (see Gittins, 1979, 1989).
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Case 2 is the most interesting, and illustrates what is meant by learning by invest-ing. The choice of fund B can be interpreted as follows: the principal is ready to possibly lose some money to find out if fund B will be a good source of private information. After exploring that possibility for some time, the principal decides (in case 2) that fund B is probably not a good source of private information and switches to fund A. Stopping rules must be designed and computed on the basis of past observations so that the principal knows when to switch; although they are complex, such rules (known as the Gittins Indices after Gittins [1979, 1989]) can be computed analytically.10 In more complex cases, the quality of the private information provided by both funds is unknown. In that situation, shifts by the SWF from fund A to fund B (and vice versa) can always occur, that is, the SWF can switch back and forth several times because a sufficiently long series of bad outcomes can discourage the principal from continuing to invest in the fund originally selected and induce it to switch.
Several Principals
When several principals are willing to invest in the same funds, the situation is far more complex. The principals will observe each other, and the rational SWF behaving as just described sends a signal to the other principals when it decides to switch from one fund to another. Although these signals are hard to interpret, they cannot be ignored. Given that all these signals convey information, they should and will be interpreted by the other principals. However, the solution is not easy to compute—a point made earlier—because the acquisition of some share of a fund could be explained by several considerations that are hard to dis-entangle: a principal could select a fund in the short-run investment stage to acquire potential private information conveyed by this fund. Or the principal may just be interested in the financial return on this investment. Moreover, the correlation between the private information that two principals could extract also matters in the discussion.
The analysis thus far has assumed that the recipient-country fund manager (the agent) is not acting strategically. The situation becomes more complicated when the agent ceases to be a passive player that ignores that its choices convey information to the principals. As seen in the “Perfect Information” section, even with perfect information, the agent may be in a position to play one principal against the other. The assumption of a passive agent may be realistic in situations in which the number of principals is large, but will generally not be a good assumption if there are only a few. In addition, if the principals are few, they will be aware that their actions are observed and, in turn, may benefit from acting strategically. This is usually true (Martimort, 2006), and the discussion has already shown that signals outside equilibrium can play a critical role in the game with single objectives. This analysis suggests that, with multiple objectives, the
10Note that this problem, known as the “bandit problem,” evoked at the beginning of this section, has been treated in the literature only for risk-neutral players, with the exception of Chancelier, De Lara, and de Palma (2009), who consider the case of players who are risk averse.
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signals sent by any player (one of the principals or the agent) can be significantly blurred, reducing the ability of the other players to interpret them.
The fees charged by the agent will depend on the value of the private informa-tion it can provide, called θ earlier in the chapter. As is usually assumed, this parameter will remain unknown to the principals, but while the value of the information (Τ m) gathered by the principals is unknown to the agent, the agent can learn from the principals’ investment behavior (via a market study, for example). This problem is complex and has not been addressed in the literature. However, in simple cases, it can be shown that when principals have multicriteria objectives, the agent may be able to extract a positive rent (even under perfect information) that it would not be able to extract otherwise (a result similar to that obtained in Martimort [2006] with a single objective). This is worrisome from the policy standpoint because the outcome of forcing an SWF to operate through a recipient-country fund manager (when it is suspected that the objectives of the SWF depart strongly from those of the regulatory authority), could be to increase the profits of the common agent and make that common agent move to an inef-ficient outcome. Once again, channeling the investment activities of the SWF through a recipient-country agent may not always increase efficiency.
CONCLUSION
Some observers have suggested that SWFs could partly allay the concerns about possible political motivations behind their activities by investing through fund managers located in the recipient countries. This chapter examines the usefulness of this proposal by using agency theory. The results show that, under reasonable assumptions, the use of fund managers may not necessarily address these con-cerns. This result holds when an SWF pursues only its profit-maximization motives, but even more so when it pursues multiple objectives, including learning by investing. These results indicate that recipient countries may try to address their concerns through more direct regulation, which may add to the protection-ist trends observed in many countries. To avoid protectionism, SWFs and recipi-ent countries need to work toward greater organizational and operational trans-parency. The recent creation by Temasek of a new investment division that hopes to seek backing from institutional investors (and possibly the general public in the future) may prove to be a useful example of an innovation that would help dispel the concerns of recipient countries.
REFERENCES
Chancelier, J.-P., M. De Lara, and A. de Palma, 2009, “Risk Aversion in Expected Intertemporal Discounted Utilities Bandit Problems,” Theory and Decision, Vol. 67, No. 4, pp. 433–40.
Das, Udaibir S., Adnan Mazarei, and Alison Stuart, 2010, “Sovereign Wealth Funds and the Santiago Principles,” Chapter 5, this volume.
Dasgupta, P., and J. Stiglitz, 1998, “Learning by Doing, Market Structure and Industrial and Trade Policies,” Oxford Economic Papers, Vol. 40, No. 2, pp. 246–68.
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de Palma, Leruth, and Mazarei 111
Gittins, J. C., 1979, “Bandit Processes and Dynamic Allocation Indices,” Journal of the Royal Statistical Society, Series B, Vol. 41, No. 2, pp. 148–77.
———, 1989, Multi-Armed Bandit Allocation Indices (New York: John Wiley & Sons).Gibson, Ronald J., and Curtis J. Milhaupt, 2008, “Sovereign Wealth Funds and Corporate
Governance: A Minimalist Response to the New Mercantilism,” Stanford Law Review, Vol. 60, No. 5, pp. 1345–69.
Hammer, C., P. Kunzel, and I. Petrova, 2008, “Sovereign Wealth Funds: Current Institutional and Operational Practices,” IMF Working Paper WP/08/254 (Washington: International Monetary Fund).
International Monetary Fund, 2008, “Sovereign Wealth Funds—A Work Agenda” (Washington). Available via the Internet: http://www.imf.org/external/pubs/ft/survey/so/2008/new032108a.htm.
IWG (International Working Group of Sovereign Wealth Funds), 2008, Sovereign Wealth Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
Khalil, F., and J. Lawarée, 2006, “Incentives for Corruptible Auditors in the Absence of Commitment,” Journal of Industrial Economics, Vol. 54, No. 2, pp. 269–91.
Laffont, J.-J., and J. Pouyet, 2004, “The Subsidiarity Bias in Regulation,” Journal of Public Economics, Vol. 88, No. 1–2, pp. 255–83.
Martimort, D., 2006, “Multi-Contracting Mechanism Design,” in Advances in Economics and Econometrics, ed. by R. Blundell, W. Newey, and T. Persson (Cambridge, UK: Cambridge University Press).
Mookherjee, D., 2006, “Decentralization, Hierarchies, and Incentives: A Mechanism Design Perspective,” Journal of Economic Literature, Vol. 44, No. 2, pp. 367–90.
Parlour, C. A., and U. Rajan, 2001, “Competition in Loan Contracts,” American Economic Review, Vol. 91, No. 5, pp. 1311–28.
Tirole, J., 1988, The Theory of Industrial Organization (Cambridge, Massachusetts: MIT Press).
ANNEX: A DYNAMIC MODEL OF LEARNING BY INVESTING
Denote by Nb the number of periods a bad realization (tj = 0) is observed. Then, the a priori distribution of t, conditional on the observation of k = Nb bad out-comes for j over n observations of j, can be computed according to Bayes’ rule. Some standard computations show that
fp/k(p; Nb = k) = (n + 1)Cnk pk(1 – p)n–k.
The expectation of the probability Γj conditional on Nb = k is
k + 1E(pj; Nb = k) = —–—.
n + 1
Note that, as expected, this converges to k/n, as k and n tend to infinity.Denote the benefit (conditional on the realization tj) of the principal, during
one period by Tj(Γj) = U(rj + θ j; Γj), where U(.,�.), the utility function of the principal, is based on the return of fund j ( j = A or B) and on the private informa-tion provided by this fund. For example, if the principal is risk neutral, and if there is a constant trade-off between the two criteria (profitability and learning), then its utility is linear, and Tj(Γj) = rj + θ Γj. If the principal is risk averse, the
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112 Regulating a Sovereign Wealth Fund Through an External Fund Manager
utility function will have a nonlinear specification, such as constant relative risk aversion or constant absolute risk aversion. With risk-neutral principals, the unconditional benefit of the principal, after n investment periods (observations) is then
Tj(n) = ∫1
0 [pT(0) + (1 – p)T(1)] fp/k(p; Nb = k)dp
Bj(n) = ∫1
0 [pB(0) + (1 – p)B(1)] fp/k(p; Nb = k)dp
This expression is linear in the probability. It can therefore be simplified as follows:
T = E(pj; Nb = k)T(0) + [1 – E(pj; Nb = k)]T(1)
B = E(pj; Nb = k)B(0) + [1 – E(pj; Nb = k)]B(1)
The principal should then maximize the discounted value of the flows of benefits over the total investment period.
Note that if the principal has some perception biases of the unknown proba-bilities, the expression will be nonlinear in the probability:
T'j(n) = ∫1
0 [v(p)T(0) + w(1 – p)T(1)] fp/k(p; Nb = k)dp,
B'j(n) = ∫1
0 [v(p)B(0) + w(1 – p)B(1)] fp/k(p; Nb = k)dp,
where v(�) and w(�) denote the probability weighting functions. With no per-ception biases, v(�) and w(�) reduce to the identity. When v(�) and w(�) are nonlinear, a closed-form solution for T(n) does not necessarily exist. However, numerical computations could still determine the switching points in the invest-ment strategies.
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CHAPTER 9
Sovereign Wealth Funds and Recipient-Country Investment Policies: OECD Perspectives
KATHRYN GORDON1
Sovereign wealth funds (SWFs) have much to offer. They can contribute to the economic development of their home countries by, for example, helping to diver-sify income sources for commodity-dependent economies and improving the risk-return profile of government-controlled portfolios. In recipient countries, SWFs’ investments stimulate business activity and create jobs. So far, SWFs have shown themselves to be reliable, long-term investors.
As one of the world’s main proponents of an open investment system, the Organisation for Economic Co-operation and Development (OECD) wel-comes the increasing prominence of SWFs as visible, important international investors. Since its creation in 1961, the OECD has been a strong advocate of free capital movements and their long-term benefits. The OECD is the pri-mary multilateral forum for dialogue and the development of guidance on good practices in the field of investment. This guidance sometimes takes the form of authoritative, even legally binding, government-backed investment instruments.
Because of its unique role in the investment policy field, the OECD was asked by the October 2007 Group of Seven Finance Ministers meeting and by the OECD Council to develop guidance for recipient countries’ policies toward investments from SWFs. Responsibility for developing this guidance was given to the Freedom of Investment (FOI) Roundtables, hosted at the OECD. At the FOI Roundtables, OECD and non-OECD countries participate as equal part-ners in investment policy discussions.2 The project resulted in guidance on recipient-country investment policies toward SWFs, which is described in this chapter. The guidance complements the Santiago Principles, developed by SWFs with the support of the IMF, which provide guidance on transparency
1 The views expressed herein do not necessarily reflect those of the OECD or of its member countries.2 The nonmember countries participating in the FOI project include the 12 nonmember adherents to the OECD Declaration on International Investment and Multinational Enterprises (Argentina, Brazil, Chile, the Arab Republic of Egypt, Estonia, Israel, Latvia, Lithuania, Morocco, Peru, Romania, and Slovenia). In addition, the Russian Federation attended all the discussions, and other countries (China, India, Indonesia, and South Africa) attended one or more.
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and governance for SWFs. Taken together, the two sets of guidance provide a robust framework for improving trust and confidence, and for facilitating investment flows between SWFs and recipient countries for the benefit of both home and host societies.
This chapter describes the OECD guidance for recipient-country policies toward SWFs and also OECD-hosted follow-up on this guidance. The guid-ance has two parts: (1) a reaffirmation of the relevance of long-standing OECD investment principles (e.g., openness, nondiscrimination, and trans-parency) for treatment of SWFs; and (2) guidance on how national security concerns should be handled in an investment-policy context so as to ensure that these security-related policies are effective in their intended purpose and not a disguised form of protectionism. OECD-hosted follow-up includes peer monitoring of countries’ adherence to these principles and deeper discussions of special issues raised by SWF investments (e.g., whether foreign state immu-nity leaves gaps in legal accountability).
REAFFIRMATION OF THE RELEVANCE OF OECD INVESTMENT PRINCIPLES FOR FAIR TREATMENT OF SWFS
The OECD is uniquely well-positioned to contribute principles for recipient-country policies because its existing investment instruments already contain fundamental principles needed for the required guidance. Through their adher-ence to these instruments, members and nonmember adherents commit to trans-parency, nondiscrimination, and liberalization of investment policies. The first component of the OECD guidance for recipient-country investment policy reaf-firms the relevance of these long-standing investment principles for the treatment of SWFs. These principles, which apply to all categories of foreign investment, are summarized in Box 9.1.
The OECD investment instruments (1) express a common understanding regarding fair treatment of foreign investors, including SWFs; (2) commit adhering governments to build this fair treatment into their investment poli-cies; and (3) provide for notification of investment policy changes and peer review of adhering governments’ observance of these commitments. Nonmembers are also invited to subscribe to these principles (e.g., 12 non-members3 adhere to the OECD Declaration on International Investment and Multinational Enterprises) or are incorporated into OECD-based investment dialogue in other less formal ways.
3 As of February 2010, the 12 nonmembers are Argentina, Brazil, Chile, the Arab Republic of Egypt, Estonia, Israel, Latvia, Lithuania, Morocco, Peru, Romania, and Slovenia. Chile is, at present, a non-member adherent; however, on January 11, 2010, it signed an accession agreement to become the 31st member of the OECD.
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NATIONAL SECURITY IS A LEGITIMATE CONCERN BUT SHOULD NOT BE USED TO DISGUISE PROTECTIONISM
The OECD investment instruments recognize the right of countries to take actions they consider necessary to protect national security.4 Moreover, the instru-ments stipulate that security concerns are self-judging—the country determines its security concerns and its strategy for dealing with them in an investment con-text. However, although addressing genuine security concerns is a fundamental responsibility of governments, security-related investment policies might also be used to disguise protectionism. Participants at the FOI Roundtables carefully
4 Article 3 (Public Order and Security) of the OECD Codes of Liberalisation of Capital Movements and Current Invisible Transactions.
Investment Policy Principles Established in the OECD Acquis
The key OECD investment instruments are the OECD Code of Liberalisation of Capital Movements, adopted in 1961, and the OECD Declaration on International Investment and Multinational Enterprises of 1976, as revised in 2000. These instruments contain procedures for notification and multilateral surveillance under the broad oversight of the OECD’s governing Council to ensure their observance. The instruments embody the following principles:
• Transparency. Information on restrictions on foreign investment should be compre-hensive and accessible to everyone.
• Progressive liberalization. Members commit to the gradual elimination of restrictions on capital movements across their countries.
• Nondiscrimination. Foreign investors are to be treated not less favorably than domestic investors in like situations. While the OECD instruments directly protect the investment freedoms of those SWFs established in OECD member countries, they also commit members to using their best endeavors to extend the benefits of liberalization to all members of the IMF. Experience has shown that, in prac-tice, OECD governments nearly always adopt liberalization measures without discriminating against non-OECD countries—investors from nonmember coun-tries reap the same benefits of free market access as OECD residents. Outright discrimination against non-OECD-based investors would be a major departure from OECD tradition.
• Standstill. Members commit to not introducing new restrictions.
• Unilateral liberalization. Members also commit to allowing all other members to benefit from the liberalization measures they take and not to condition them on liberalization measures taken by other countries. Avoidance of reciprocity is an important OECD policy tradition. The OECD instruments are based on the philoso-phy that liberalization is beneficial to all, especially to the country that undertakes the liberalization.
BOX 9.1
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explored the role of security concerns in participating governments’ investment policies. This examination culminated in the development of the OECD Guidelines for Recipient Country Investment Policies Relating to National Security. These guidelines, which are described in the next section, are the second part of the OECD response to providing guidance for recipient-country invest-ment policies toward SWFs.
Surveys of FOI participants’ practices regarding security-related investment policies reveal two major developments. First, there is a trend toward shared prac-tice in the area of national security strategic planning, including the development of a widely shared and broad view of national security concerns. In particular, the tendency over several decades has been to expand the number of risks covered by national security plans. Earlier views of security risk were limited to preserving national boundaries and the integrity of the state against foreign attack. Now, national security plans tend to cover all major sources of threat to the security of a nation’s people and its way of life (e.g., attack by foreign governments, natural disasters, pandemics, large-scale terrorism, and human negligence leading to large-scale accidents or breakdowns in critical infrastructure).
The second trend is toward greater use of investment policy—defined as dis-criminatory policies that focus on foreign-controlled or nonresident investors—as a tool for the management of national security risks. However, this trend coexists with continued wide variation in countries’ uses of investment policy for this purpose. Many countries make no use of investment policy for security purposes. Key findings of the survey include the following:
• Of the 41 countries that responded to the survey, 12 report that they do not depart from national treatment5 of foreign investors on security grounds (among them, Belgium, the Czech Republic, Hungary, Ireland, Italy, and the Netherlands).
• Among the remaining 29 countries, several make what could be viewed as minor departures from national treatment (e.g., most Nordic countries have partial restrictions in a narrow range of defense industries; Egypt restricts inward investment in defense and radioactive material, and Portugal only in maritime cabotage).
• Several countries (e.g., Canada, France, Germany, Japan, the Republic of Korea, Mexico, and the United States) have in place extensive policy mech-anisms for restricting foreign investment on national security grounds. These may involve all three types of investment policy measures (reviews, bans, and sectoral measures).
Thus, national practice continues to vary widely in this area, but countries have generally shown growing interest in the use of investment policy to safeguard national security. Over the period 2005–09, Canada, China, France, Germany, Japan, the Republic of Korea, the Russian Federation, and the United States
5 National treatment means that foreign investors are accorded treatment that is not less favorable than the treatment accorded to domestic investors under like circumstances.
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revised their policies in this regard. In 2009, Canada introduced its first security-related investment review and Germany expanded the scope of its reviews.
OECD GUIDELINES FOR RECIPIENT COUNTRY POLICIES RELATING TO NATIONAL SECURITY
The growing recourse to investment policy as a tool for managing security risks attests to heightened concerns about security in a globalizing world, but also under-scores the risk that such policies might be abused for protectionist purposes. The culmination of the FOI Roundtable’s consideration of security-related investment policies was the issuance, in October 2008, of Guidelines for Recipient Country Investment Policies Relating to National Security (see Box 9.2 for the complete text6). The OECD guidelines were presented at the IMF and World Bank Fall 2008 meetings in conjunction with the adoption of the Santiago Principles.
The guidance seeks to help countries to meet their genuine security needs while preserving their reputation for fair treatment of foreign investors, including SWFs. The guidelines recommend that governments design their security-related policies to be
• Nondiscriminatory. Although the security exception may allow countries to violate the nondiscrimination principle, the guidelines emphasize that non-discrimination is still a value to be respected, even for policy measures taken under the security exception.
• Transparent and predictable. Rules should be codified, should be subject to prior notification, and should be enforced with attention to procedural fair-ness and predictability.
• Proportionate to the objective pursued. Measures should be tailored to the specific risks posed by specific investments, and enforcement should bring to bear appropriate national security expertise and rigorous risk-manage-ment practices. Investment policy measures should be used only as a last resort, when no other policy tool is available.
• Accountable in their application. Policymakers should be accountable to citi-zens of the country, to the international community, and to foreign investors.
In May 2009, the OECD governing Council raised the legal status of these guidelines by entering them into the OECD acquis, which makes them a more authoritative source for international law.
FOLLOW-UP THROUGH THE FOI PROCESS HOSTED AT THE OECD
Countries’ adherence to these principles as related to national security is being moni-tored using the OECD’s trademark peer review process in the context of the FOI
6 The text of the guidelines can also be found at http://www.oecd.org/dataoecd/11/35/43384486.pdf.
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Guidelines for Recipient Country Investment Policies Relating to National Security
Non-discrimination: Governments should be guided by the principle of non-discrimina-tion. In general governments should rely on measures of general application which treat similarly situated investors in a similar fashion. Where such measures are deemed inadequate to protect national security, specific measures taken with respect to indi-vidual investments should be based on the specific circumstances of the individual investment which pose a risk to national security.
Transparency/predictability – while it is in investors’ and governments’ interests to main-tain confidentiality of sensitive information, regulatory objectives and practices should be made as transparent as possible so as to increase the predictability of outcomes.
• Codification and publication. Primary and subordinate laws should be codified and made available to the public in a convenient form (e.g. in a public register; on inter-net). In particular, evaluation criteria used in the review should be codified and made available to the public.
• Prior notification. Governments should take steps to notify interested parties about plans to change investment policies.
• Consultation. Governments should seek the views of interested parties when they are considering changing investment policies.
• Procedural fairness and predictability. Time limits should be applied to review proce-dures for foreign investments (30 days for an initial review is a benchmark). Commercially-sensitive information provided by the investor should be protected. Where possible, rules providing for approval of transactions if action is not taken to restrict or condition a transaction within a specified time frame should be considered.
• Disclosure of investment policy actions is the first step in assuring accountability. Governments should ensure that they adequately disclose investment policy actions (e.g. through press releases, annual reports or reports to Parliament), while also protecting commercially-sensitive and classified information.
Regulatory proportionality – restrictions on investment, or conditions on transaction, should not be greater than needed to protect national security and they should gener-ally be avoided when other existing measures are adequate and appropriate to address a national security concern.
• Essential security concerns are self-judging. Each country has a right to determine what is necessary to protect its national security. This determination should be made using risk assessment techniques that are rigorous and that reflect the coun-try’s circumstances, institutions and resources. The relationship between invest-ment restrictions and the national security risks identified should be clear.
• Narrow focus. Investment restrictions should be narrowly focused on concerns related to national security.
• Appropriate expertise. Security-related investment measures should be designed so that they benefit from adequate national security expertise as well as expertise necessary to weigh the implications of actions with respect to the benefits of open investment policies and the impact of restrictions.
• Tailored responses. Restrictive investment measures should be tailored to the risks posed by proposed investments. This would include providing for policy measures (especially risk mitigation agreements) that address concerns, but fall short of blocking the investment.
BOX 9.2
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• Last resort. Restrictive investment measures should be used as a last resort when other policies (e.g. sectoral licensing, competition policy, financial market regula-tions) cannot be used to eliminate security-related concerns.
Accountability – procedures for internal government oversight, parliamentary oversight, judicial review, periodic regulatory impact assessments, and requirements that important decisions (including decisions to block an investment) should be taken at high government levels should be considered to ensure accountability of the implementing authorities.
• Accountability to citizens. Authorities responsible for restrictive investment policy measures should be accountable to the citizens on whose behalf these measures are taken. Countries use a mix of political and judicial oversight mechanisms to preserve the neutrality and objectivity of the investment review process while also assuring its political accountability. Measures to enhance the accountability of implementing authorities to Parliament should be considered (e.g. Parliamentary committee monitoring of policy implementation and answers or reports to Parliament that also protect sensitive commercial or security-related information).
• International accountability mechanisms. All countries share a collective interest in maintaining international investment policies that are open, legitimate and fair. Through various international standards, governments recognise this collective interest and agree to participate in related international accountability mechanisms (e.g. the OECD notification and peer review obligations in relation to restrictive investment policies). In particular, these help constrain domestic political pressures for restrictive and discriminatory policies. Recipient governments should partici-pate in and support these mechanisms.
• Recourse for foreign investors. The possibility for foreign investors to seek review of decisions to restrict foreign investments through administrative procedures or before judicial or administrative courts can enhance accountability. However, some national constitution’s allocation of authority with respect to national security may place limits on the scope of authority of the courts. Moreover, judicial and adminis-trative procedures can be costly and time-consuming for both recipient govern-ments and investors, it is important to have mechanisms in place to ensure the effectiveness, integrity and objectivity of decisions so that recourse to such proce-dures is rare. The possibility of seeking redress should not hinder the executive branch in fulfilling its responsibility to protect national security.
• The ultimate authority for important decisions (e.g. to block foreign investments) should
reside at a high political level. Such decisions require high-level involvement because they may restrict the free expression of property rights, a critical underpinning of market economies, and because they often require co-ordination among numerous government functions. The final decision to prohibit (or block) an investment should be taken at the level of heads of state or ministers.
• Effective public sector management. Broader public sector management systems help ensure that the political level officials and civil servants responsible for security-related investment policies face appropriate incentives and controls for ensuring that they exercise due care in carrying out their responsibilities and are free from corrup-tion, undue influence and conflict of interest.
BOX 9.2 (cont.)
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Roundtables. Peer reviews enhance international transparency by improving informa-tion about countries’ policies; they also provide a forum for experience sharing and for exerting peer pressure. As noted earlier, OECD and non-OECD countries participate as equal partners in these Roundtables. The Roundtables have routinely benefited from the participation of some 50 countries. All members of the International Forum of SWFs have a standing invitation to participate in the discussions.
In preparation for these discussions, the OECD Secretariat produces invento-ries of recent investment policy measures taken by participating countries. These inventories are made public and serve as the basis of Roundtable discussions about recent developments. They also serve as the basis of the investment parts of the quarterly reports on trade and investment policies made to the Group of Twenty Leaders by the World Trade Organization, the OECD, and the United Nations Conference on Trade and Development (UNCTAD).7
SWFs stand to benefit greatly from the general surveys of recent developments that are a central part of each Roundtable. These are question-and-answer sessions in which participants can review and eventually challenge each others’ investment policy measures against the principles of nondiscrimination and standstill and against the new OECD guidelines on national security. The OECD Secretariat makes public the summaries of these discussions under its own authority.
The Roundtables also explore emerging policy issues of interest to SWFs. For instance, recent FOI Roundtables have examined possible recipient-country con-cerns relating to foreign state immunity. Under the doctrine of foreign state immunity, one state is not subject to the full force of rules applicable in another state; the doctrine bars national courts from adjudicating or enforcing certain claims against foreign states. There are concerns in recipient countries that foreign state immunity could make it difficult for private parties to pursue legitimate claims against SWFs and other foreign government-controlled investors or could create regulatory enforcement gaps. The FOI Roundtables’ work in this area has focused on fact-finding; it seeks to document and clarify, from a comparative law perspective, national practices in the area of foreign state immunity. SWFs have been invited to participate in and comment on this work.
More generally, the FOI Roundtables aim to help build trust and confidence between recipient countries and foreign investors, including SWFs. They also aim to improve recipient-country investment policies with a view to facilitating the free flow of investment while effectively addressing genuine concerns that such investment might raise.
BACKGROUND DOCUMENTS BY THE OECD SECRETARIAT
Inventory of Investment Measures Taken Between 15 November 2008 and 31 August 2009, October 2009 (http://www.oecd.org/dataoecd/42/21/44067629.pdf ).
7The second quarterly report, issued on March 8, 2010, can be found at http://www.oecd.org/dataoecd/21/21/44741862.pdf.
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Status Report: Inventory of Investment Measures Taken Between 15 November 2008 and 15 June 2009, June 2009 (http://www.oecd.org/dataoecd/42/23/43148063.pdf ).
Security-Related Terms in International Investment Law and in National Security Strategies, May 2009 (http://www.oecd.org/dataoecd/50/33/42701587.pdf ).
Investment Policies and Economic Crises: Lessons from the Past, April 2009 (http://www.oecd.org/dataoecd/27/23/42602587.pdf ).
Foreign Government-Controlled Investors and Recipient Country Investment Policies: A Scoping Paper, January 2009 (http://www.oecd.org/dataoecd/1/21/42022469.pdf ).
Competition Law and Foreign-Government Controlled Investors, January 2009 (http://www.oecd.org/dataoecd/30/42/41976200.pdf ).
Accountability for Security-Related Investment Policies, November 2008 (http://www.oecd.org/dataoecd/41/26/41772143.pdf ).
Protection of ‘Critical Infrastructure’ and Role of Investment Policies Relating to National Security, May 2008 (http://www.oecd.org/dataoecd/2/41/40700392.pdf ).
Transparency and Predictability for Investment Policies Addressing Essential Security Interests: A Survey of Practices, May 2008 (http://www.oecd.org/dataoecd/2/20/40700254.pdf ).
Proportionality of Security-Related Investment Instruments: A Survey of Practices, May 2008 (http://www.oecd.org/dataoecd/2/25/40699890.pdf ).
Governance and Investment of Public Pension Reserve Funds in Selected OECD Countries, May 2008 (http://www.oecd.org/dataoecd/27/48/40196093.pdf ).
Competition, International Investment and Energy Security, March 2008 (http://www.oecd.org/dataoecd/3/19/40699061.pdf ).
Economic and Other Impacts of Foreign Corporate Takeovers in OECD Countries, October 2007 (http://www.oecd.org/dataoecd/1/45/40476100.pdf ).
Essential Security Interests Under International Investment Law, October 2007 (http://www.oecd.org/dataoecd/59/50/40243411.pdf ).
OECD’s FDI Regulatory Restrictiveness Index: Revision and Extension to More Economies and Sectors, October 2007 (http://www.oecd.org/dataoecd/1/40/40476272.pdf ).
Identification of Ultimate Beneficiary Ownership and Control of a Cross-Border Investor, March 2007 (http://www.oecd.org/dataoecd/57/8/41481081.pdf ).
Foreign State Immunity and Foreign Government Controlled Investors, April 2010 (http://www.oecd.org/dataoecd/21/32/45036449.pdf ).
OECD INVESTMENT INSTRUMENTS
OECD Declaration and Decisions on International Investment and Multinational Enterprises (www.oecd.org/daf/investment/declaration).
National Treatment for Foreign-Controlled Enterprises (www.oecd.org/daf/investment/nti).OECD Codes of Liberalisation of Capital Movements and of Current Invisible Operations
(www.oecd.org/daf/investment/codes).
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SECTION III
Investment Approaches and Financial Markets
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125
CHAPTER 10
Sovereign Wealth Fund Investment Strategies: Complementing Central Bank Investment Strategies
STEPHEN L. JEN
The global financial crisis has two relatively obvious implications for sovereign wealth funds (SWFs). Not only will the compression in global imbalances depress the future growth trajectories of assets under management by SWFs, the sharp correction in global equities in 2008 may have undermined the appetite and political tolerance for risk-taking by some SWFs, at least in the short run. However, notwithstanding these shocks in the short run, SWFs’ general proclivity and capacity for risk-taking—in the long run—should not be significantly altered because the motivations for generating investment returns on sovereign wealth should still prove to be compelling, especially after the sharp recovery in equity prices in 2009 and in early 2010. Also, official reserves have continued to build in the world, and petrodollars have burgeoned again, providing a powerful boost to SWFs’ asset bases. This chapter highlights some of the traits of SWFs’ long-term investment strategies that should remain relatively unaltered.
The financial crisis has also reminded central banks of the importance of hav-ing adequate foreign reserves in liquid form, held in the intervention currency. Given that the U.S. dollar is the dominant intervention currency in the world, the decade-long trend of reserve diversification away from U.S. dollars by central banks may not necessarily continue. Indeed, the diversification out of U.S. dollars seems not to have taken place as dramatically as some may think. The lower share of U.S. dollars is partly a consequence of the dollar’s depreciation for much of the period since 2002, rather than of active dollar selling. At the same time, while the global financial crisis has few direct implications for the desirable currency com-position of SWFs’ portfolios, indirectly, to the extent that central banks stop diversifying away from the intervention currencies, SWFs may need to compen-sate by diversifying away from the U.S. dollar and the euro more rapidly than otherwise. Thus, governance of some SWFs and their investment strategies may not be as independent as they once were, and greater coordination with corre-sponding central banks may be the trend going forward. In other words, greater specialization by central banks and SWFs is likely, with less competition between them as they pursue distinct investment strategies, with central banks focusing on safety and liquidity while SWFs focus on investment returns.
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126 Sovereign Wealth Fund Investment Strategies
This chapter has six sections. First, an updated forecast of the likely growth path of the collective assets under management (AUM) by SWFs is presented. Second, the case is made that SWFs will likely continue to pursue higher risk–higher return strategies, despite the global financial crisis. Third, a distinction is made between SWFs’ different risk profiles based on the sources of their funds. Fourth, a collective model portfolio is suggested for SWFs. Fifth, the “sibling rivalry” between some central banks and SWFs that had been brewing before the global financial crisis is discussed. It is argued that the rivalry will likely abate as central banks and SWFs, coerced by the crisis, become more complementary as they specialize in different tasks. Sixth, the chapter draws attention to a closely related category of funds— sovereign pension funds (SPFs)—which in the aggregate have even larger AUM than do SWFs. SPFs should increasingly exhibit the same traits highlighted for SWFs.
SWFS’ GROWTH TEMPERED BY THE FINANCIAL CRISIS: US$11 TRILLION BY 2015
The volatility in the financial markets in 2008 and 2009 led to meaningful swings in the AUM of SWFs. Because of marked difference in the ways in which equi-ties, bonds, and alternative investments have performed since 2008, different investment portfolios should have led to big differences in performance between SWFs. This author has long argued and assumed that, in the aggregate, SWFs are likely to have a portfolio with a 45:25:30 split between equities, bonds, and alter-native investments (Jen, 2007). For the SWF community as a whole, therefore, the guesstimate is that the total loss since end-2007 may have been about 11.1 percent. While there should have been a wide range of performances, depending on actual portfolio weightings, most SWFs are likely to have suffered modest net investment losses during this period. SWFs with more aggressive profiles may have suffered double-digit investment losses (15 percent or more), while those with conservative profiles may have fared much better (5–6 percent losses or less).
How will the total AUM of SWFs evolve over time? This exercise first com-putes the likely trajectories of the current account balances of the world’s largest holders of foreign reserves.1 Assuming that the net financial flows are nil, it then projects the likely trajectories of the official reserves and the SWFs’ share of those reserves. A further assumption is made that central banks with large foreign reserves will increasingly allocate excess reserves to their respective SWFs or invest a bigger portion of their reserves in higher risk–higher return markets. The fore-casts are in Figure 10.1. By 2015, SWFs are likely to have about US$11 trillion in AUM, and the “crossover” point where the AUM of SWFs exceeds that of central banks’ reserves occurs in 2016.2
1The IMF’s World Economic Outlook forecast series for the period 2010–14 is extrapolated beyond 2015. 2Total official reserves are about US$9.3 trillion, and will likely exceed the US$10 trillion mark by the end of 2010. This analysis assumes that the total returns on official reserves will be about 3 percent a year, and those for SWFs will be 7 percent a year.
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SWFS ARE LIKELY TO CONTINUE TO SEEK HIGHER RETURNS WITH HIGHER RISK
Though the growth profile of the AUM of SWFs may be modestly tempered, SWFs will most likely remain an increasingly important group of investors—a major source of support for risky assets—over the coming years. Despite the recent balance of payments shock, many emerging-market economies still have sizeable excess reserves positions. The three-month import-coverage rule and the Greenspan-Guidotti Rule, combined, suggest emerging markets may have roughly US$2.0 trillion in excess reserves (about US$1.5 trillion in China).
SWFs’ preferences for equities over bonds reflects their essential makeup, seeing that they were created to move out on the risk-return curve. This part of the thesis will not change. Furthermore, SWFs’ greater capacity to express long-term views—resulting from their superior liquidity and lack of leverage—should continue to permit them to capitalize on opportunities that private institutional funds may find too illiquid. Moreover, the structural conversion of wealth by oil-based SWFs from underground real wealth (oil) to above-ground financial wealth will certainly continue.
Figure 10.2 shows the cumulative nominal investment returns on various assets. As can be seen, the performances of these asset classes had been extraordinarily diverse until the onset of the global financial crisis. While past performance does not guarantee future performance, this is still a useful figure. For most of the period since 1987, energy and emerging-market equities have been outperformers, while government bonds have been laggards, though over the entire period, the passive return on bonds has matched that on global equities. Even with the violent sell-off in global equities and real estate in recent quarters, the returns in these asset classes are only modestly lower than the return on global bonds, which have enjoyed an arguably unsustainable safe-haven bid. To be precise, US$100 invested in 1987 would have grown to, in March 2010, US$914 in emerging-market equities, US$725 in energy, US$495 in real estate, US$465 in bonds, and US$476 in global
5,000,000
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Source: Bluegold Capital LLP Research.
Crossover in2016
US$22.3 trillion by2020
US$13.2 trillion by2020
Figure 10.1 AUM of the World's SWFs Could Reach US$22 Trillion by 2020
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128 Sovereign Wealth Fund Investment Strategies
returns
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Figure 10.2 Relative Buy-and-Hold Returns of Various Asset Classes
Source: Bluegold Capital LLP Research.Note: Data compiled from December 1987 to December 2009. GSCI is a benchmark for investment in commodity markets.
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G10 cash rate
Figure 10.3 Risk-Return Profiles of Different Asset Classes
equities. Furthermore, with rising concerns about market risks of sovereign bonds, investing in equities and commodities remains a compelling proposition for SWFs.
That the performances of various asset classes can be so diverse should not be news. Investors are concerned not just with investment return, but also with the associated risk of various investments. Figure 10.3 shows a scatter chart of
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the risk-return profiles of various asset classes (covering the period 1987 to 2009). These points indicate the risk-return position if 100 percent of the port-folio was invested in one asset. In addition, the figure displays the efficient frontier of a long-only portfolio, given that most SWFs are constrained to long-only investments. Emerging-market equities and oil mark one end of the efficient frontier, that is, high return and high volatility, while sovereign bonds mark the other end. While the global financial crisis has forced a comprehensive re-think of how historical returns and volatility should be interpreted, and has taught us that a better risk concept is needed, the point of Figure 10.3 is how fundamentally different government bonds are when compared with other assets.
Thus, notwithstanding the global financial crisis, the motivations for diversify-ing national wealth from foreign sovereign bonds still appear compelling.
SOURCES OF CAPITAL MATTER FOR SWFS’ RISK TOLERANCE
Whether SWFs raise the world’s risk-return tolerance depends on the sources of the SWF’s assets. Oil-based SWFs should have the biggest impact on the world’s risky assets, followed by SWFs funded from surpluses derived from trade in goods. SWFs based on capital inflows should have minimal—and possibly even negative—effects on the world’s aggregate risk-taking preference. The net overall effect on the world’s risk-return profile depends on the relative size of these three types of SWFs.
Based on the sources of the accumulation of their assets, SWFs could be divided into those funded by oil and other commodities (Type 1), goods-trade surpluses (Type 2), and net capital inflows (Type 3). A similar classification can be made for countries with large reserve accumulations that do not (yet) have an SWF. As measured by AUM, some 46 percent of the largest reserve holders and SWFs (with total assets of US$6.0 trillion) are Type 1, 36 percent are Type 2, and 18 percent are Type 3. Type 1 SWFs should have the highest risk-return profile, because they essentially have no distinct liabilities. Type 2 SWFs should have a marginally lower appetite for risk than Type 1 SWFs because of their domestic bond liabilities. But the underlying savings-investment surpluses should still imply future consumption and the entitlement of the surplus countries to accumulate claims on foreign assets, including equities. Being net creditors, the SWF and reserve managers should not have tight liquidity constraints. This idea—that reserve holdings should be invested in foreign (higher-yielding) equities—applies particularly well to a country such as Japan.3
3Japan’s investment earnings on foreign asset holdings are now larger than its trade surplus: Japan’s official reserves easily generate US$30 billion to US$50 billion a year in investment returns. This feature of Japan’s external account makes it as much a Type 1 economy (with fiscal reserves from investment earnings) as it is a Type 2 economy (one that will see its trade surplus recover with the global economy).
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130 Sovereign Wealth Fund Investment Strategies
Type 3 SWFs should not be aggressive risk-takers, given the relatively fickle nature of capital inflows. Because Type 1 and Type 2 have much larger AUM than Type 3 SWFs, in the aggregate, SWFs should in theory raise the world’s risk-return profile.4 India is a good example of a Type 3 country. Its official reserves reached US$276 billion at end-June 2010, having risen sharply from US$137 billion at end-2005. However, more than all of the reserve increases have come from capital flows, because India has run persistent trade deficits. Brazil is another example of a Type 3 country. Thus, if India and Brazil establish their own SWFs, it is likely they will not have particularly high risk tolerances relative to the SWFs from the Middle East, for example. Of course, the overall risk tolerance of an SWF is not solely determined by the source of the assets; other considerations are also important for the portfolio construction, such as the desire to diversify risk (e.g., an oil-based SWF investing in risk assets with negative correlations to oil).
Figure 10.4 shows the efficient frontier and the single-asset returns over the period 1987 to 2007. Type 1 SWFs, as shown in this figure, should move from the 100 percent–oil point to somewhere along the market line (the line tangent to the efficient frontier and intersecting with the risk-free interest rate). Type 2 and Type 3 SWFs, however, should move to a point on the market line, but away from the 100 percent–government bond point. The three types of SWFs will end up at different points along the market line. Specifically, they should be in the order indicated in Figure 10.4.
4To properly answer the question of how global financial assets may be affected by SWFs, one needs to ask the counterfactual question of not only where the ultimate portfolios will end up, but also how the assets in question would have been deployed had they not flowed into the SWFs.
Source: Bluegold Capital LLP Research.Note: Data compiled from December 1987 to December 2009. GSCI = a benchmark for investment in commoditymarkets. G10 cash rate represented in this figure by US$3 million interbank rate.
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Oil
GSCI
Emerging-market equi�es
Government bonds
Real estate
Global equi�es
Gold
G10 cash rate
Type 2
TypeType 1
TypeType 3
Figure 10.4 How SWFs Affect Financial Risk-Return Balance
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Oil-based SWFs, therefore, should invest at a higher risk-return balance than the rest of the world, because, based on Figure 10.2, crude oil is a low-return, high-volatility investment. It makes sense, in theory, for oil exporters to convert their wealth from underground real assets (oil) to above-ground financial assets. The recent decline in oil prices may constrain the ability of the Gulf Cooperation Council SWFs to invest as aggressively as they could before the global financial crisis, but the motivation for them to take risk should be unaltered, as argued above. Whether Type 2 SWFs will take more or less risk as a result of the crisis is difficult to tell at this point. Type 3 SWFs, however, are likely to further reduce their appetites for risk, because the sudden halt of private capital inflows during this crisis has underscored the fickle nature of these flows.
A 25:45:30 LONG-TERM MODEL PORTFOLIO FOR SWFS
What could the model portfolio look like for SWFs in the aggregate? Although different SWFs have different preferences and mandates, it is useful to consider the portfolios of established pension fund SWFs to help envisage the likely evolution of SWFs’ portfolios in the coming years. Given current allocations and taking into account that SWFs are usually from countries that are already rich in reserves and have large exposures to sovereign bonds, it seems plausible that, on average, large SWFs may eventually have portfolios with about 25 percent of total assets in bonds, 45 percent in equities, and 30 percent in alter-native investments.
The investment portfolios of SWFs evolve over time. Norway’s Government Pension Fund–Global (GPF) is a good example. As it has matured, it has raised its exposure to equities and alternative investments. The growing size and the long-term nature of the GPF’s investments permitted Norges Bank Investment Management to try to capitalize on the liquidity premium by entering into less liquid but higher-return investments. Other SWFs will follow the same path, in the view of this chapter’s author.
But established large pension funds are further along in this maturation process. Established large pension funds such as Caisse de dépôt et place-ment du Québec (CDQ) of Canada (with US$191 billion in AUM) and ABP of the Netherlands (with US$325 billion in AUM) already have portfolio structures with significant and balanced exposures to bonds, equi-ties, and alternative investments—which include not only real estate, infra-structure, and private equity, but also commodities and hedge funds. The portfolio structure of SWFs in general will probably evolve toward that of large pension funds and beyond, in terms of risk-taking. Many of these large pension funds have roughly 35 percent in bonds and 35 percent in equities. Because countries that have SWFs are usually rich in official reserves, almost all of which are held in sovereign bonds, it is likely that SWFs have lower preferred exposure to bonds, compared with central bank reserves. Indeed, the Government of Singapore Investment Corporation announced on
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132 Sovereign Wealth Fund Investment Strategies
September 23, 2008, that its portfolio allocation consisted of 26 percent bonds, 44 percent equities, and 25 percent alternative investments—not too different from the 25:45:30 expectation.
LESS “SIBLING RIVALRY” BETWEEN CENTRAL BANKS AND SWFS?
Signs of more competition between reserve managers at central banks and SWFs within the same countries became increasingly apparent during much of 2007; the two types of entities had increasingly similar investment strategies and may have been competing over the management of foreign assets. Specifically, more and more central banks may have begun to invest in foreign equities and corpo-rate bonds to enhance their own investment returns, to prevent capital from being transferred to the SWFs.5 With central banks not wanting to part with their reserve holdings, large reserve holders in Asia were on their way to adopting port-folios similar to that of the Swiss National Bank, with exposures to equities and corporate bonds.6 As young SWFs try to establish themselves, there is a period during which central banks are in a more advantageous position (more skilled personnel and longer experience). Indeed, some central banks tried to exploit their advantages and invested more aggressively in risk assets to raise the hurdle that SWFs needed to overcome to justify further fund transfers from the central banks. Up to the onset of the financial crisis, Japan, China, and the Republic of Korea might have already been managing their reserves more aggressively than they had in the past.
The crisis, however, may fundamentally alter the investment strategy of central banks and SWFs. Instead of competing against one another—that is, having increasingly similar investment strategies—central banks and SWFs could have more complementary investment strategies going forward, with each specializing in different tasks: central banks concentrating more on preserving liquidity and security of their assets, and SWFs focusing more on enhancing investment returns. Four fundamental arguments support this notion.
First, when some emerging-market economies came under balance of pay-ments pressures (from a sudden stop in private capital inflows, a sharp decline in exports, and a fall in investment earnings from overseas assets), large-scale interventions were necessary. (The IMF has had to deploy unprecedented financial resources to stabilize parts of emerging-market economies.) Reserve
5Although this might have seemed unusual (most central banks only invest in sovereign bonds), it is not unorthodox. The IMF’s Balance of Payments Manual explicitly acknowledges foreign equities as legitimate reserve assets. Furthermore, the Swiss National Bank has been investing in equities and corporate bonds since 2004. 6 At end-2008, the Swiss National Bank had around 146 billion Swiss francs (Sw F) worth of foreign reserves, Sw F 47 billion of which was held in foreign exchange reserves, Sw F 31 billion in gold, and the rest in claims from Sw F transactions and other assets. While the bulk (64 percent) of the bank’s foreign exchange reserves were still held in government bonds at end-2008, its corporate bond and equity holdings were substantial—22 percent and 11 percent of the total, respectively.
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hemorrhaging, in practice, occurs primarily through a particular intervention currency, which in most cases is the U.S. dollar. The crisis highlighted the importance of central banks having adequate foreign reserves, not just in the intervention currency but also in the most liquid form of asset in that cur-rency. U.S. agency bonds and mortgage-backed securities, for example, were temporarily illiquid, and may have been a complication for some central banks that needed U.S. dollar cash. Another reserves-management problem exposed by the financial crisis is that many emerging-market central banks do not mark their assets to market. This created the situation whereby central banks avoided selling assets that had suffered market losses, thus avoiding realizing the losses that were never reported. The U.S. agency bonds and mortgage-backed securities were, again, a good example—central banks short of U.S. dollar cash resisted selling their non-U.S. treasury asset holdings, not because they were not liquid, but because of the valuation problem. In short, the crisis raises a serious question about the relative weights central banks should place on liquidity, security, and return in relationship to their objectives in reserves management.
Second, SWFs, in contrast to central banks, should have very distinct man-dates and not be constrained by the need to have adequate resources in the intervention currency. SWFs’ portfolio management decisions should attach different relative weights to liquidity, security, and returns, compared with those of central banks. To the extent that central banks need to stop diversifying out of U.S. dollars, the corresponding SWFs could diversify more aggressively out of dollar assets to achieve the desired overall currency exposure from the nation’s public-sector perspective. This observation indicates that central banks and SWFs should not have a competitive relationship. Figure 10.5 suggests
Source: Bluegold Capital LLP Research.Note: G5-G10 = Australia, Canada, Switzerland, New Zealand, Norway, Sweden.
Assets Other
Real estate SOVEREIGNWEALTH
Private equity FUNDS
Equities Path A
Corporate bonds
Path B
Sovereign bondsRESERVES
US$ Euro British £ Japanese G5-G10 Emerging-market sterling yen currencies
Currency denomination
Government agencies
Real estate SOVEREIGNWEALTHWEALTH
Private equity FUNDS
Equities Path A
Corporate bonds
Path BPath B
Sovereign bondsRESERVES
Government agencies
Figure 10.5 Central Banks to Invest in Equities and Corporate Bonds
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134 Sovereign Wealth Fund Investment Strategies
that, although reserve managers may be encouraged to retreat into primarily sovereign bonds as a result of the crisis, SWFs should continue to diversify their portfolios. To the extent that central banks halt, if not reverse, the process of U.S. dollar diversification, SWFs may follow Path B in Figure 10.5 more than Path A in their diversification processes.
Third, while central banks should have independence in devising monetary policy, the case for their having both independence and total freedom in manag-ing foreign reserves is weak. The years ahead will likely witness a clearer delinea-tion of responsibilities and objectives between central banks and SWFs, and rivalries between these two types of institutions, and thus overlapping invest-ments, will likely abate.
Fourth, the analysis for this chapter shows that, as SWFs gradually rebalance toward the model portfolio suggested above, there will likely be large sales of both U.S. dollar and euro assets, and purchases of yen and emerging-market assets. Based on the market capitalizations of various asset classes in different currencies, a benchmark currency basket was calculated that is consistent with the 25:45:30 model portfolio. This benchmark’s currency composition is 43 percent in U.S. dollars, 18 percent in euro, 13 percent in yen, 9 percent in pound sterling, and 17 percent in other currencies. For comparison, the currency exposures of devel-oping countries’ official allocated reserves is 58 percent in U.S. dollars, 31 percent in euro, 2 percent in yen, 6 percent in pound sterling, and 3 percent in other currencies.7
SOVEREIGN PENSION FUNDS
SWFs are important, but SPFs are at least as relevant. The AUM of SPFs is approaching US$5.3 trillion—about a third larger than that of SWFs. Also, starting from a position of a relatively low-risk portfolio and a high “home bias,” though there will be exceptions, SPFs as a group are likely going to raise their risk profiles (i.e., hold more equities and fewer bonds) and increase their foreign content (i.e., hold more foreign assets). The same demographic trends (declining fertility and mortality rates) that have fueled SWFs will also lead to an evolution in SPFs. These prospective trends will likely have meaningful implications for financial markets. The Republic of Korea’s National Pension Service has just acquired a share in London’s Gatwick Airport and real estate in Canary Wharf. China’s National Social Security Fund is expected to grow to US$300 billion in five years’ time. Australia’s Future Fund is doing well and will also grow as a result of the expected fiscal surpluses Australia will run in the coming years. Japan’s US$1.35 trillion Government Pension Investment Fund is dormant now, but could be revived if politics allow. Table 10.1 shows the top 16 SPFs in the world.
7 COFER database, composition as of end-2009.
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CONCLUSION
Although the global financial crisis may have somewhat moderated the pace of SWFs’ asset accumulation, total AUM of SWFs are still likely to approach US$11 trillion by 2015. Total AUM of SWFs is currently a little more than US$3.6 trillion; emerging economies have, in addition, US$2.0 trillion or so of excess reserves, part of which could potentially be transferred to SWFs. In the long run, SWFs’ investment strategies should not be significantly altered by the crisis—the arguments for seeking higher returns by accepting a bit more risk are
TABLE 10.1
Sovereign Pension Funds
Domestic-foreign
allocation Asset allocation
Assets Domestic Foreign Bonds Equities1 Others2
Country Fund name (US$ million) (%) (%) (%) (%) (%)
United States Social Security Trust Funds 2,419,000 100 0 100 0 0Japan Pension Bureau (GPIF) 1,345,687 80 20 78 21 2Netherlands ABP 325,000 n.a. n.a. 42 52 6Korea, Rep. of National Pension Service 240,000 90 10 77 20 3Australia Age Pension 237,000 16 84 n.a. n.a. n.a.China HK Monetary Authority 139,700 n.a. n.a. n.a. n.a. n.a.Canada Canadian Pension Plan 127,600 263 74 31 43 26China National Social Security Fund 114,000 93 7 n.a. n.a. n.a.Spain Fondo de Reserva de la Seg. Soc. 84,000 77 23 96 4 0Australia Future Fund (2006) 49,300 72 28 25 43 32France Fonds de reserve pour les retraites 43,000 67 33 50 40 10Switzerland AVS 36,000 63 37 63 37 0Canada Regie des Rentes du Quebec 32,000 82 18 82 18 0Ireland National Pension Reserve Fund 30,600 0 100 22 63 15Sweden PPM (Premium Pensions System) 25,700 39 62 38 56 6New Zealand New Zealand Superannuation 15,600 48 52 48 52 0 Average 329, 012 60 40 58 35 8 Median 99,000 70 30 50 40 10 Total 5,264,187
Sources: Various national pension Web sites; International Financial Services, London. Note: n.a. = not available.1Equities include private equity in some countries, when transparency of portfolio constituents are high.2Others include real estate, hedge funds, cash, inflation-linked assets, and alternative assets. 3Canadian Pension Plan (CPP) has 26% Canadian equities and the rest foreign (Financial Highlights on CPP Web site). We
assumed the same weights for fixed income.
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136 Sovereign Wealth Fund Investment Strategies
still compelling. Although the source of capital to a large extent dictates SWFs’ risk tolerance, in the aggregate, SWFs could move toward a model port-folio with 25 percent bonds, 45 percent equities, and 30 percent alternative investments. Furthermore, the crisis exposed shortcomings in the currency-diversification strategies of some central banks. A halt in U.S. dollar diversifica-tion by central banks is now a distinct possibility, with SWFs, in contrast, accelerating their U.S. dollar diversification. In general, central banks and SWFs will likely adopt more complementary investment strategies in the years ahead. Finally, a closely related category of funds—SPFs—is worth monitoring. Not only are their AUM larger than those of SWFs, they are likely to exhibit similar investment styles as SWFs.
REFERENCE
Jen, Stephen, 2007, “G10: A 25:45:30 Long-Term Model Portfolio for SWFs,” Morgan Stanley Fixed Income Research, October 11.
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CHAPTER 11
Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
PETER KUNZEL, YINQIU LU, IVA PETROVA, AND JUKKA PIHLMAN
Sovereign wealth funds (SWFs) were severely hit by the global financial crisis. With increased public scrutiny over hefty losses incurred during the crisis, many SWFs have reviewed existing investment practices. This chapter examines the ways in which different types of SWFs approach their investment objectives, describes the impact of the crisis on SWF performance, reviews the extent to which portfolios have been reallocated, and draws lessons about how and why the investment behavior of SWFs has changed. Looking forward, it also considers additional issues that may need to factor more prominently in SWFs’ investment strategies, including macro-stabilization and asset-liability management consider-ations, as well as forthcoming adjustments to the global regulatory environment.
CLASSIFICATION OF SWFS AND ITS IMPLICATIONS
SWFs are typically categorized as stabilization funds, savings funds, pension reserve funds, or reserve investment corporations (Table 11.1).1 The majority of established SWFs are either savings funds for future generations or fiscal stabiliza-tion funds, with only a handful of pension reserve funds (Australia’s Future Fund, Chile’s Pension Reserve Fund, Ireland’s National Pensions Reserve Fund, New Zealand’s Superannuation Fund, and the Russian Federation’s National Wealth Fund), and reserve investment corporations (China Investment Corporation, Korea Investment Corporation, and Government Investment Corporation of Singapore) operating today. Some SWFs have multiple objectives (e.g., State Oil Fund of Azerbaijan, Kuwait Investment Authority, and Norway’s Government Pension Fund–Global), and a number of countries also have more than one SWF with different objectives, including Chile, the Russian Federation, and Singapore.
The category into which an SWF falls has an important bearing on its invest-ment objectives and behavior. A reserve investment corporation, for example, will need to consider the possible repercussions of balance of payments risks, and will want to hold a portion of its portfolio in liquid assets. The SWF’s type and its
1See, for example, IMF, 2007, 2008; and Hammer, Kunzel, and Petrova, 2008.
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8
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ealth
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Shiftin
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igm
TABLE 11.1
Sovereign Wealth Fund Classification
Policy purpose
Source Year established Country Macro-stabilization Saving Pension reserve Reserve investment
Oil and natural gas
1953 Kuwait Kuwait Investment Authority, General Reserve Fund
Kuwait Investment Authority, Future Generations Fund
1976 Canada Alberta Heritage Savings Trust Fund
1976 United Arab Emirates Abu Dhabi Investment Authority
1976 United States Alaska Permanent Fund
1980 Oman State General Reserve Fund
1983 Brunei Darussalam Brunei Investment Agency
1996 Norway Government Pension Fund–Global
Government Pension Fund–Global
Government Pension Fund–Global
1999 Azerbaijan State Oil Fund State Oil Fund
2000 Iran, Islamic Republic of Oil Stabilization Fund
2000 Mexico Oil Revenues Stabilization Fund
2000 Qatar Qatar Investment Authority
2000 Trinidad and Tobago Heritage and Stabilization Fund
Heritage and Stabilization Fund
2001 Kazakhstan National Fund 2002 Equatorial Guinea Fund for Future
Generations of Equatorial Guinea
2004 São Tomé and Príncipe National Oil Account
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K
un
zel, Lu
, Petro
va, and
Pih
lman
1
39
2005 Timor-Leste Petroleum Fund Petroleum Fund
2006 Bahrain The Future Generations Reserve Fund
The Future Generations Reserve Fund
2006 Libya Libyan Investment Authority
2008 Russian Federation Reserve Fund National Wealth Fund
Other commodity
1956 Kiribati Kiribati, Revenue Equalization Fund
1996 Botswana Botswana, Pula Fund
2006 Chile Pension Reserve Fund
2007 Chile Economic and Social Stabilization Fund
Fiscal surpluses
1974 Singapore Singapore, Temasek
1981 Singapore Government of Singapore Investment Corporation
1993 Malaysia Khazanah Nasional BHD
2000 Ireland Ireland, National Pensions Reserve Fund
2001 New Zealand New Zealand Superannuation Fund
2004 Australia Australia, Future Fund
2005 Korea, Republic of Korea Investment Corporation
Foreign exchangereserves
1981 Singapore Government of Singapore Investment Corporation
2005 Korea, Republic of Korea Investment Corporation
2007 China China Investment Corporation
Source: Authors' compilation. ©International Monetary Fund. Not for Redistribution
140 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
objectives will also influence its investment horizon. For instance, savings SWFs are expected to have longer investment horizons than stabilization SWFs, whereas pension reserve funds can derive their investment horizons from the timing of the future anticipated liabilities falling due, which can be decades in the future. In addition to the type, SWFs’ investment objectives may also be influenced by the source of their funds and may take into consideration other assets and liabilities on the wider government balance sheet.
THEORETICAL CONSIDERATIONS BEHIND SWFS’ STRATEGIC ASSET ALLOCATIONS
The type of SWF, its investment horizon and funding source, and other balance sheet characteristics should all affect its strategic asset allocation (SAA). This sec-tion discusses some stylized theoretical underpinnings for SWFs’ SAAs. The sec-tion that follows compares the actual asset allocations of several SWFs with these underpinnings and discusses other factors that may be driving asset allocations.
Investment Horizon and SAA
The investment horizon is a critical factor for any investor in determining the SAA. A long investment horizon is traditionally associated with the ability to take more risk. Usually, risk is defined as the probability of a loss or underperformance relative to a reference asset, such as a T-bill or a government bond, over a given horizon. The traditional SAA literature suggests a larger share in equities for investors with long investment horizons because historical data suggest a fairly consistent equity return premium over longer horizons.2
Another factor associated with investors with long investment horizons is the ability to benefit from the illiquidity premium. For many asset classes, such as infrastructure, real estate, and private equity, it may take a long time and a lot of planning to exit the investment without unduly affecting that asset’s price. Therefore, only SWFs with truly long horizons (i.e., those that are very unlikely to have to divest in a hurry) would be expected to venture into these asset classes, which, for the purposes of this chapter, are classified as “alternative assets.”
Conversely, investors with short or very uncertain investment horizons, such as stabilization SWFs, would be expected to have a larger share of their investment port-folios in cash and relatively liquid bonds to be able to meet potential and sometimes unexpected outflows without incurring large losses in the process. In that sense, the SAAs of stabilization funds should be very similar to those of central bank reserve managers. Such SWFs could potentially have some allocation to equities—allowing a part of the portfolio to be longer term—but should acknowledge the associated risk of having to divest these assets at fire sale prices when the liquidity requirement kicks in.3
2There are also some contrarian views on whether stocks outperform over the long run. See, for example, Bodie, 1995; and Bernstein, 1996.3A few reserve managers also invest in equities (e.g., Hong Kong SAR, the Netherlands, and Switzerland), which may be a reflection of their multiple objectives (e.g., a savings objective, too).
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Funding Source and SAA
Whether the source of the funds should affect the SAA depends, to a certain extent, on the type of SWF. For instance, for stabilization and savings SWFs that derive their funds from a commodity, this question seems self-evident. If a coun-try’s income is dependent on one (or even a few) real assets, it would be natural, according to portfolio theory, to diversify this dependency by investing in finan-cial assets that have a negative or low correlation with the real asset. Thus, for instance, SWFs funded from oil resources would need to take oil-price risk, cycles, and assets in the ground into consideration when determining their SAAs.4 Alternatively, a small country could outright hedge the commodity-price risk.5
In general, if a stabilization SWF is sourced from fiscal surpluses, its invest-ment objectives are likely to be influenced by the dynamics of the government budget. SWFs sourced from international reserves may also be influenced by the dynamics of private capital flows and the composition of private external debt—just as international reserves are—depending on the institutional arrangement and the funding and withdrawal rules of the SWF.6 Finally, the original source of pension reserve funds is unlikely to enter into the SAA process, which is more likely to be driven by the investment horizon and the nature of the liabilities.
Additionally, the vulnerability of other assets and liabilities of the wider balance sheet may also need to be taken into consideration when determining an SWF’s SAA.
COMPARISON OF SWFS’ OBSERVED ASSET ALLOCATIONS
Given the scarcity of data on SWFs’ targeted SAAs, the analysis focuses on observed asset allocations. For this purpose, assets are categorized into four classes: cash, fixed income, equities, and alternative assets.7 However, the available data do not capture sectoral distributions within an asset class for the whole sample, precluding analysis of the funding source as a factor in the actual asset allocation.
4However, there is little evidence of countries explicitly taking into account the assets in the ground (and uncertainty about the amount, the timing of extraction, and other factors) in their optimization models when deriving their SAAs.5For example, in Mexico the hedging volume corresponds to the amount of revenue that the national oil company (PEMEX) transfers to the budget, and the option premiums are paid out of the stabiliza-tion SWF. This cushions the outlays that have to be made from the SWF in downturns, and reduces the windfall revenues in upturns, thereby smoothing the profile of the revenue flows over the cycle. 6For example, the Government of Singapore Investment Corporation states that its resources may be called upon during times of crisis (http://www.ifswf.org/members-info.htm#sin).7 Cash includes current accounts and other cash-equivalent instruments; debt securities include bills, notes, and bonds of the treasury, and corporate bonds; equities comprise domestic and global stocks, including those of both developed and emerging markets; all other assets are classified as “alternative assets,” including private equity, hedge funds, property, commodities, infrastructure, forests, and so forth. Although some potentially liquid asset classes are captured, the latter class could be seen as a proxy for illiquid assets.
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142 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
Some notable patterns in the asset allocations of different types of SWFs emerge, broadly along the lines discussed in the previous section (Figure 11.1). For instance, whereas savings funds have varying proportions of equities in their portfolios, fixed income and cash figure prominently in stabilization funds. Most pension reserve funds also have some equity exposure, as do reserve investment corporations.
At the same time, notable differences can be detected in observed asset allocations for SWFs with the same types of objectives. As discussed above, this may be due to idiosyncratic reasons, including the investment horizon, the funding source, or other asset or liability considerations of the broader sovereign balance sheet (including mul-tiple objectives of the SWFs or the interaction of multiple SWFs of the same country).
Other practical considerations are at play, too. Varying views on relative perfor-mance of asset classes over different horizons is likely to be one of these consider-ations, especially given uncertainties about the “true” investment horizon. For example, the likelihood of a shortfall of real equity returns over bond returns is very much horizon-dependent—in many countries, the equity risk premium has been negative over 20- and even 50-year horizons (see, for example, Dimson, Marsh, and Staunton, 2004). Another important consideration is the SWF’s ability to tolerate large unrealized losses within the investment horizon, which could depend on institutional factors and the financial literacy of the owner and the public.
SWFs with small assets under management or funding inflows—relative to potential withdrawals—need to have a larger share of liquid assets to accommo-date liquidity needs.
The amount of unexploited resources may also help explain differences. For instance, countries with nearly depleted natural resources may be more concerned about conserving their financial resources, and their SWFs’ investment strategies may reflect this issue.
Other factors matter as well, including the maturity of the fund (i.e., how long it has been in operation) and its level of sophistication. Recently established SWFs—such as Australia’s Future Fund, Chile’s SWFs, and the China Investment Corporation—or those undergoing legal and institutional changes may not have been able to implement their SAAs fully. In such cases, the actual asset allocation and its changes may not be reflective of the targeted SAA.
As a consequence, even though SWFs may appear to be similar with regard to their type and funding, some notable patterns can be discerned between funds, and intrinsic SAAs may be quite different even among similar funds. At the same time, given the specific circumstances and investment objectives of individual SWFs, one may ask whether market developments should affect the basic under-lying SAA of these funds, and under what circumstances a fundamental realign-ment of their investment portfolios may, or may not, be warranted. These issues are explored in detail below.
UNRAVELING OF THE CRISIS
The global financial crisis affected SWFs worldwide. The sharp downturn in asset prices, particularly prices for equity and alternative investments, resulted in large
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Figure 11.1 Precrisis SWF Asset Allocation (Percentages)
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144 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
losses for many SWFs (Figure 11.2). In some cases, the losses reached 30 percent of the portfolio values for 2008, thereby impairing SWFs’ long-term returns as well.
These losses have sparked domestic debates on SWFs’ investment strategies. Some have been criticized for entering the equity market at the wrong time, some blamed for a lack of insight for investing in financial institutions at the early stage of the crisis and suffering heavy losses, and others reproached for investing abroad when their support for domestic markets was direly needed. These criticisms have put SWFs’ investment outlooks and strategies under increased scrutiny and their managers under pressure to avoid further losses.
Moreover, the crisis has led some SWFs to take prominent roles in their home countries. For instance, stabilization funds have been drawn upon to finance rising fiscal deficits, as per their mandate, and some of them have also supported stimulus packages to prop up economic activity. Rising sovereign or quasi- sovereign liabilities can be expected to weigh on demand for SWF resources for some time to come.
Some SWFs have also taken on new roles, beyond their original mandates. For example, several countries have used SWF resources to support domestic banks or corporations through the banking system. Some SWFs have provided liquidity to the banking system by depositing their assets in domestic banks, and others have helped with bank recapitalization. SWF assets have also been earmarked in some countries to support deposit insurance schemes and some SWFs have pur-chased domestic stocks to boost markets and investor confidence.
The heavy demands on SWF resources and the uncertainty in the economic environment have led many SWFs to take a more cautious approach toward investing. SWFs are wary about supporting further bailouts of distressed compa-nies, as a result of the heavy unrealized or realized losses some experienced after investing in financial institutions in developed countries (Financial Dynamics, 2009). Nonetheless, as financial market conditions started to improve in early 2009, some SWFs achieved record profits in 2009 (see Figure 11.3).
These developments are reflected in the dynamics of SWFs’ assets under man-agement during the crisis (Figure 11.4). The value of stabilization-fund assets
-40
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Chile-ESSF
Timor-Leste
Trinidad and Tobago
AzerbaijanCanada
United States
Singapore-TemasekNorway
Chile-PRF
Australia
New ZealandIreland
China
Korea, Rep. of
Sources: SWF Web sites; authors’ calculations.Note: Data in currency of reporting for January–December 2008, except Singapore-Temasek (annual returns April 2008–March 2009). ESSF = Economic and Social Stabilization Fund; PRF = Pension Reserve Fund.
Figure 11.2 SWF Returns (Percent), 2008
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Kunzel, Lu, Petrova, and Pihlman 145
Figure 11.3 SWF Returns (Percent), 2009
Note: The 2009 return of Singapore-Temasek is the annual return from April 2009 to March 2010.Sources: SWF Web sites; authors’ calculations.
0
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Chile-ESSF
Timor-Leste
Trinidad and Tobago
AzerbaijanCanada
United States
Singapore-Temasek
Norway
Chile-PRF
Australia
New ZealandIreland
China
Korea, Rep. of
Figure 11.4 SWF Assets Under Management, December 2007–December 2009
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Sources: SWF Web sites; authors’ calculations.Note: Norway classified as savings fund.
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Pension Reserve FundsAustraliaChile-PRFRussia-NWFNew ZealandIreland
Stabiliza�on and Savings Funds
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Russia-RF
Stabiliza�on Funds
Chile-ESSF
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146 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
remained on a steady growth path until the end of 2008, when it became evident that the implications of the crisis for domestic liquidity and fiscal conditions would be greater than originally anticipated. These funds declined by about 50 percent between the end of 2008 and the end of 2009, after withdrawals. Pension reserve funds and savings funds suffered equity valuation losses during the period September 2008 through March 2009, but have since recovered. Finally, SWFs with both stabilization and savings objectives—which are mostly invested in fixed-income assets—have weathered the crisis unscathed.
The implications of the crisis for asset allocations going forward will be fund-specific, and some of the driving factors are discussed below.
IMPLICATIONS OF THE CRISIS FOR STRATEGIC ASSET ALLOCATIONS
The crisis has affected SWFs’ asset allocations in different ways (see Figure 11.5). Several SWFs with stabilization objectives have reduced their shares of cash hold-ings either because of the use of cash resources (Chile–ESSF), or because of mov-ing to fixed income (Trinidad and Tobago). Alaska Permanent Fund and Ireland National Pension Reserve Fund have increased the share of their cash holdings. SWFs with previous investments in alternative assets have increased their invest-ments in alternative assets, presumably with a view to further diversifying their portfolios. The KIC has introduced alternative assets investments and increased its equity share. Notwithstanding the impact of the crisis, some SWFs have also continued with the implementation of previously approved SAAs—for example, Norway’s Government Pension Fund–Global has increased equity shares, and the Australian Future Fund has introduced fixed-income and increased equity and alternative assets investments in its portfolio. In the case of Norway’s SWF, the continuous implementation of the SAA helped it to benefit greatly from the rebound of risk assets since early 2009.
Geographic reallocation also seems to be occurring. Confidence in emerging markets’ recovery prospects has prompted some SWFs to tilt their investments toward these markets. For example, Singapore’s Temasek reportedly plans to focus on emerging markets in Asia, Brazil, and the Russian Federation and reduce emphasis on developed countries (from one-third to one-fifth of assets). Norway’s SWF has also increased its operations in Asia.
These shifts are fund-specific and reflect individual circumstances. In some cases, SWFs with longer-term mandates have encountered unexpected liquidity needs, thereby effectively shortening their investment horizons. In other cases, increased scrutiny and pressure to minimize future losses may have contributed to shifts to relatively more conservative investment positions, whereas some SWFs may have concluded that the market provided them with opportunities for upside value, even over the medium term.
Changes in their domestic economic and financial environments may have caused some SWFs to temporarily deviate from their original mandates. To address such concerns, some SWFs are thoroughly reviewing their investment strategies
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Figure 11.5 Postcrisis SWF Asset Allocation (Percentages)
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148 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
and risk-management frameworks. These reviews involve clarifying SWF objec-tives, potential liquidity needs, and related investment horizons and risks.
Some SWFs are reexamining the traditional asset class-based approach to SAA and have started to use, or are considering using, a risk factor-based approach. The Board of the Alaska Permanent Fund, for example, decided to choose an approach to asset allocation “that is a good fit for the goal of building an all-weather portfolio” and decided to group investments by their risk and return profiles, and by the market condition or liability that each group is intended to address (Alaska Permanent Fund Corporation, 2009).
Still, in many cases a profound change in an SWF’s SAA may not be justified. Instead, SWFs may need to improve their communication strategies and put more effort into educating stakeholders about their operations and risks. In the case of savings-type SWFs, this direction requires that owners and other stake-holders understand the likelihood of encountering short-term losses and have the ability to tolerate them. This may be easier to achieve in an environment of overall political and economic stability, with well-engrained frameworks for medium- and long-term planning, and good crisis-management planning and coordination.
POLICY CHALLENGES AHEAD
Sovereign Financing
More generally, the crisis demonstrates the importance of conducting regular macro-level risk assessments and weighing carefully the sovereign’s financing options, both in normal times and during financial stress.
First, having thorough reserve adequacy assessments, and stress testing foreign exchange liquidity needs, when setting SWF objectives can prevent having to realize losses in crisis situations. This is particularly relevant for countries estab-lishing SWFs with long investment horizons, because having to sell assets under stress could be extremely costly, especially when the assets have been allocated against specific liabilities.8
Second, automatically using SWF assets to cover liquidity needs may not be the best strategy; issuing debt may be a cheaper option. In some cases, an assessment can be made beforehand of whether borrowing is feasible and would be cost- effective in times of stress. Going a step further, if a country has excellent debt-management capacity, a commensurate credit rating, and deep and liquid local markets, establishing a large-scale stabilization fund may not be necessary in the first place. Still, for some countries, if the SWF can effec-tively sterilize large receipts that are cyclical, a stabilization fund may be a good macro management tool.
8For example, pension reserve SWFs that have been drawn down or reallocated to finance public interventions during the crisis may have to be recapitalized eventually, or the government may need to avail itself of other resources to meet the associated liabilities as they fall due. See IMF, 2009.
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By the same token, the government can lower the cost of macro stabilization by issuing more debt even without having a financing need when times are good and investor risk appetite is strong, to either finance an existing stabilization fund or establish a new one. When financing is needed during downturns, the govern-ment would not have to issue at high cost, but would draw down the stabilization fund. Such an approach can also have positive externalities, and if the SWF is properly set up, can help with developing local debt markets.
Regulatory Environment
International financial markets are likely to face increased regulation and demands for greater transparency and accountability, which may affect SWFs’ cross-border operations. Increased regulation, for example, in the financial sector may alter the relative attractiveness of some asset classes or industries in which SWFs invest. More directly, new transparency and disclosure requirements for financial institutions and investment vehicles or regulations could generate simi-lar demand for SWFs. At the same time, SWFs have actively participated in the discussion on the evolving global regulatory environment.9 Because the regula-tory environment could potentially affect their operations and the value of their investments, SWFs are eager to see well-targeted and good-quality financial regu-lation that is unlikely to inflict unintended consequences. SWFs also have shown considerable interest in promoting good corporate governance principles. Some SWFs have chosen to do this through active shareholder involvement, while some have chosen to take a less active approach to exercising their ownership rights and therefore are more reliant on recipient county governments promoting good corporate principles and monitoring their effective implementation.
CONCLUSION
The SAAs of SWFs reflect their inherent characteristics, notably including the type of SWF and its funding source. At the same time, differences among similar-type SWFs are evident, resulting from differences in views about the investment horizon and asset-class performance, the size of the SWF, the ability to tolerate losses, the amount of untapped funding sources, and the maturity and sophistica-tion of the SWF.
The crisis has affected SWFs’ SAAs in different ways, with some SWFs increas-ing liquidity and others opting for more conservative or less conservative portfo-lios depending on individual country circumstances. Still others have taken on new roles beyond their original mandates. The shift, however, may not be ideal or justified in all cases, and some SWFs are thoroughly reviewing their investment strategies and risk-management frameworks. SWFs may also need to enhance their communication strategies to ensure consistency of their SAAs with their fundamental investment objectives.
9See International Forum of Sovereign Wealth Funds, 2009, 2010.
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150 Investment Objectives of Sovereign Wealth Funds: A Shifting Paradigm
More generally, the crisis demonstrates the importance of macro-stability risk assessment and careful consideration of the financing options of the sovereign, both in normal times and during financial stress. Thorough reserve adequacy and liquidity assessments are needed, as are cost-risk assessments of funding sovereign asset and liability operations.
Looking ahead, the scope for SWFs’ stabilizing role in international capital markets will remain substantial. Despite their losses during the crisis and greater domestic focus, SWFs’ relative size and influence in the global market will remain large. Furthermore, SWFs’ longer-term investment strategies relative to most other investors will continue to play an important stabilizing role in the global economy.
Regulatory considerations also will become increasingly important to SWFs, as changes to the international regulatory environment are developed in response to the crisis. In this regard, active involvement by SWFs in the period ahead will be required.
REFERENCES
Alaska Permanent Fund Corporation, 2009, “Asset Allocation.” Available via the Internet: http://www.apfc.org/home/Content/investments/assetAllocation2009.cfm.
Bernstein, Peter L., 1996, “Are Stocks the Best Place to Be in the Long Run? A Contrary Opinion,” The Journal of Investing, Vol. 5, No. 4, pp. 9–12.
Bodie, Zvi, 1995, “On the Risks of Stocks in the Long Run,” Financial Analysts Journal, Vol. 51, No. 3, pp. 18–22.
Dimson, Elroy, Paul Marsh, and Mike Staunton, 2004, “Irrational Optimism,” Financial Analysts Journal, Vol. 60, No. 1, pp. 15–25.
Financial Dynamics, 2009, “Sovereign Wealth Fund Survey” (London and New York: Financial Dynamics).
Hammer, Cornelia, Peter Kunzel, and Iva Petrova, 2008, “Sovereign Wealth Funds: Current Institutional and Operational Practices,” IMF Working Paper WP/08/254 (Washington: International Monetary Fund).
International Monetary Fund, 2007, Global Financial Stability Report (Washington, October).———, 2008, “Sovereign Wealth Funds—A Work Program” (Washington).———, 2009, “Crisis-Related Measures in the Financial System and Sovereign Balance Sheet
Risks” (Washington).International Forum of Sovereign Wealth Funds, 2009, “Baku Statement.” Available via the
Internet: http://www.ifswf.org/pr/pr2.htm.———, 2010, “Sydney Statement.” Available via the Internet: http://www.ifswf.org/pr/pr4.htm.
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151
CHAPTER 12
Managing a Sovereign Wealth Fund: A View from Practitioners
DIDIER DARCET, MICHAEL DU JEU, AND THOMAS S. COLEMAN1
Sovereign wealth funds (SWFs) often have dual natures, serving both nonfinan-cial and financial objectives. On the one hand, they are created to achieve domes-tic and political aims, which can lead to strategic investments motivated by poli-tics or by social policy. On the other hand, they are purely financial investment vehicles, created to protect and expand the capital entrusted to them. Explicitly recognizing the dual nature of a wealth fund helps to clarify its objectives and governance. The ideal—and the view followed in this chapter—is to segregate the two functions: one arm pursuing the nonfinancial goals under political gover-nance, and a second arm with purely financial goals. Indeed, the nonfinancial goals will often be better served when the financial objectives are being met.
In this view, SWFs resemble endowment funds and can successfully learn from such funds’ investment models. Endowment funds’ investment practices have been studied and implemented by talented and successful investors for decades. Having a long-term horizon puts the investor in a unique and favorable position in the market. It drives the institution’s organization and governance, its invest-ments, and its perception of risk, and therefore its asset management practices.
SWFs, however, differ from endowment funds in two important respects. First, although SWFs’ asset growth comes from both investment returns and contributions of new assets (as for endowment funds), new contributions to SWFs are usually linked to taxation on exports, which often follows commodity prices. Second, because of their dual nature (nonfinancial as well as financial objectives), an SWF may be called on to transfer assets to its nonfinancial arm to support political objectives. These specific features (correlation with commodity prices and the possibility of liquidity calls) modify the composition of wealth funds’ utility functions and attention must be paid to mitigating these risks.
This chapter examines a conceptual framework for advising SWFs on portfolio allocation and construction, together with application of the framework in prac-tice.2 The first and second sections focus on the conceptual framework unique to SWFs: (1) their perceptions of asset risks and returns as long-term investors, and (2) the particular form of their utility function and how it incorporates both
1The authors wish to acknowledge stimulating discussions with Heiner P. T. Hartwich and to thank him for his contribution.2 Organizational issues are not discussed in this chapter because they are covered elsewhere in this volume.
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152 Managing a Sovereign Wealth Fund: A View from Practitioners
return expectations and cost of risks. The third section describes implementation of the conceptual framework.
RISK-RETURN PERCEPTION OF A LONG-TERM INVESTOR
Being a long-term investor means taking advantage of low redemption risk. Long-term investment does not imply focusing on return only and ignoring risk, because risk management has short- and long-term consequences for wealth cre-ation. Neither does long-term investment imply slavishly following long-term economic forecasts, which are themselves notoriously uncertain.
There are two ways to benefit from low redemption risk. The first is to increase the asset allocation toward illiquid assets and earn the resulting higher return (the illiquidity premium). The second is to invest in liquid assets but choose a long-term risk-return metric and an allocation that maximizes long-term wealth cre-ation with higher short-term volatility.
All SWFs exhibit redemption risks lower than the market average, but that redemption risk is not zero. Because of their dual mission to generate financial as well as social returns, their redemption risk is most probably higher than that of other long-term investors, such as endowment funds. SWFs will, therefore, ben-efit by maintaining liquidity and focusing on the second method of exploiting their favorable position in the market.
Long-Term Assets’ Returns
Gaining an understanding of long-term attributes requires that long periods of history be examined. Equities have historically returned more than other asset classes. In the United States since 1800, there has been no single 25-year period in which common stocks had a negative real return. For 85 percent of the periods, long-term government bonds would have returned less than common stocks (Siegel, 2007). For a shorter reference period—the last 80 years, say, to improve the macroeconomic homogeneity of the sample—the conclusion is the same (see Table 12.1). Over the long run, across many economic cycles, the market remu-nerates risk takers—investors who put more value at risk get higher returns.
Within the equity asset class, returns vary significantly, contrasting value ver-sus growth, or large capitalization (cap) versus small cap (Table 12.2).3
Equities have returned more on average than bonds and are expected to con-tinue to do so. The higher average return makes a substantial difference over time and should attract SWFs’ attention. Based on history, a fund invested in the Standard & Poor’s 500 index (S&P 500) would, after 20 years, be worth three times more than a fund invested in treasury bills, on average.
Private equities have recently been popular with endowment funds. Private equities can produce even higher returns than listed equities, but with a larger dispersion of returns and medium-term liquidity constraints. SWFs must analyze
3The S&P index is heavily weighted toward large cap growth stocks, so naturally the return on the S&P index is close to the return on the large cap growth index.
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the risk of redemption in recessions when nonfinancial objectives might take the lead. The probability is high that a product with a medium-term lock-up—for instance, more than seven years—will cross an economic downturn during its lifetime. The distribution of the length of economic cycles in the United States since 1900 exhibits a 4-year median duration and a 2.6-year standard deviation.
Long-Term versus Short-Term Risk-Return Trade-Offs
Although equities provide higher average returns than any other asset class over the long run, they also exhibit higher volatility and value-at-risk (VaR), which means they are riskier than other asset classes. Its long-term horizon, however, means an SWF will assess the trade-off between risk and return differently from a short-term investor. Therefore, the question is whether a long-term investor will suffer from higher risk when investing in assets with higher volatility and VaR.
Risk is a slippery concept, but as a working definition, risk is captured by the distribution of profits and losses (P&L), as shown in panel a of Figure 12.1. Generally speaking, a distribution that is less spread out will be less risky and, provided it has the same mean as a distribution that is more spread out, will be preferred by investors; panel b of Figure 12.1 shows a more risky versus less risky distribution. Other popular summary risk measures, in addition to volatility, are VaR, expected shortfall, and expected drawdown. None of these risk measures will change the conclusion that equities are riskier than bonds over the short run.
In the real world, assets are difficult to rank by riskiness. The real world is more like panel c of Figure 12.1, with lower volatility associated with lower mean return. In such a case there is no unique ranking of riskiness and investors’ risk preferences will matter.
TABLE 12.1
Real Returns Across U.S. Asset Classes, 1928–2008
Asset class Real returns1 Volatility2
U.S. treasury bills, 1-month 0.7 1.8U.S. government bonds, 10-year 2.1 5.9Corporate bonds, 10-year, Aaa 2.7 5.0Corporate bonds, 10-year, Baa 3.7 6.0Equities (S&P 500) 5.9 19.4
Sources: Global Financial Data (www.globalfinancialdata.com); U.S. Federal Reserve (www.federalreserve.gov/); Shiller (www.econ.yale.edu~shiller/).
1 Continuously compounded rates of real returns over the period, annualized, in percent.2 Annualized standard deviations of monthly returns.
TABLE 12.2
Real U.S. Equity Returns by Category, 1925–2008
Equity category Real equity returns1
Large-cap growth 5.5Small-cap growth 6.2Large-cap value 7.7Small-cap value 10.6
Source: Renaissance Investment Management. 1 Continuously compounded rates of real returns over the period, annualized, in percent.
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154 Managing a Sovereign Wealth Fund: A View from Practitioners
Most risk measures focus on short periods for which the mean return is not critical. Because many SWFs target long-term wealth creation, they have to look at risk in a different manner. Over the long term, the mean return becomes impor-tant and the relative ranking of assets’ riskiness can change, simply because the mean return grows relative to the volatility. Figure 12.2 shows diagrammatically what will happen for low-volatility bonds and high-volatility equities over a short
Prob
abili
ty
Returns
Probabilitydensity
Standard devia�onMean
Prob
abili
tyReturns
More risky
Mean
Less risky
Prob
abili
ty
ReturnsMean
Higher vola�lity,higher mean
a. P&L distribu�on forhypothe�cal por�olio
b. Two P&L distribu�onswith different risks
c. Two P&L distribu�onswith no unique risk ranking
Source: Authors’ compilation.Note: P&L = profit and loss.
Lowervola�lity,lower mean
Figure 12.1 Distribution of Returns
Long �me period: distribu�onsoverlap less, bonds may be morerisky
Time
Short �me period: distribu�onsoverlap almost completely, equi�esmore risky
Bond returndistribu�on
Bond returndistribu�on
Equity returndistribu�on
Probabilitydistribu�on
Probabilitydistribu�on
Equity returndistribu�on
Source: Authors’ compila�on.
Figure 12.2 Diagrammatic Representation of VaR for Higher-Volatility Equities Shifting Below VaR for Lower-Volatility Bonds
©International Monetary Fund. Not for Redistribution
Darcet, du Jeu, and Coleman 155
period and a long period. For the shorter period, the means are close enough that the distributions overlap substantially and an investor is more likely to suffer losses from equities. Equities will be risky relative to bonds.
For the longer period, however, the mean of the returns on equity shifts the distribution up enough that the distributions overlap less. Extreme losses are still more likely for stocks but so are large gains, while moderate losses are much more likely for bonds. The investor’s preferences for gains versus losses will determine the exact trade-off between stocks and bonds, but it should be clear that the trade-off differs when considering a long period versus a short period.
Figure 12.3 demonstrates the effect from a slightly different perspective. The figure shows the empirical frequency of losses worse than specific levels for the period 1907–2008. Panel a shows that the probability of large losses (more than 10, 20, or 30 percent) is higher for equities than for bonds for a one-year holding
a. One-year holding period
b. Seven-year holding period
Sources: Global Financial Data (www.globalfinancialdata.com); authors’ calculations.
0
5
10
15
20
25
30
35
40
>0 >10 >20 >30Real loss a�er holding period (percent)
Prob
abili
ty (p
erce
nt)
10Y US Tbond
S&P 500
0
5
10
15
20
25
30
35
40
>0 >10 >20 >30
Real loss a�er holding period (percent)
Prob
abili
ty (p
erce
nt)
S&P 500
10Y US Tbond
Figure 12.3 Empirical Distribution of Losses Based on Historical Returns, 1907–2008
©International Monetary Fund. Not for Redistribution
156 Managing a Sovereign Wealth Fund: A View from Practitioners
period. Panel b shows that for a seven-year holding period, the situation reverses, with the probability of large losses being lower for equities than for bonds. This is a result of the higher average return for equities offsetting the higher volatility for the longer period.
The end result is that a short-term investor will consider an investment in U.S. government bonds to be a safer strategy than an investment in equities, while a long-term investor could have the opposite view.
Single Asset Class Strategies Are Not Appropriate for SWFs
Equity Risk over the Economic Cycle
Although equities generally outperform bonds and ensure better capital protec-tion over the long term, exceptions occur (Bernstein, 1996). Returns will vary over time and can do so in a consistent manner over the economic cycle. Investors may experience significant shifts in the risk-return relationship if, for example, they invest at the early stage of a recession phase or the early stage of an expansion phase (Table 12.3). In an early expansion phase, the more capital an investor puts at risk, the higher the return that might be expected over time. If the investment is made in an early recession phase, the correlation between risk and return turns negative and the more capital an investor puts at risk, the higher the loss that might be suffered.
TABLE 12.3
U.S. Assets’ Returns in Early Recession and Expansion Phases, 1928–2008
Real return, early Real return, early
Asset class recession phase (%) expansion phase (%)
U.S. treasury bills, 1-month 2.7 –0.1U.S. government bonds, 10-year 2.2 –0.6Corporate bonds, 10-year, Aaa 1.1 3.9Corporate bonds, 10-year, Baa –2.0 6.4Equities (S&P 500) –22.9 11.0
Sources: U.S. Federal Reserve (www.federalreserve.gov/); Global Financial Data (www.globalfinancialdata.com).
Precise timing with respect to the economic cycle is not possible, but at any point an investor can know with some confidence which phase the economy is not in. When performing portfolio simulations and allocations, such phases can be excluded from the analysis and allocations chosen based on the reduced choice set.
The conclusion is that investing in equities only for the long run cannot protect an SWF from significant wealth destruction in the short run, particularly in reces-sion phases. A large loss, even if only temporary, may not be bearable by the SWF.
Long-Term Drawdown Risk for Single Asset Class Investment Strategies
Maximum drawdown is a summary risk measure particularly suited to SWFs’ long horizons. A drawdown is the peak-to-trough loss that an investor would suffer if the investor invests at a maximum of the market and sells at the minimum, before the
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Darcet, du Jeu, and Coleman 157
recovery. It captures the maximum loss that an investor could have experienced over the period. Over 80 years’ history for the United States, Table 12.4 shows that all asset classes have suffered extremely high drawdowns in real terms.
An investment in treasury bills, for instance, would have barely protected the capital over the whole period and would have incurred significant purchasing-power losses, almost 50 percent at a maximum. It took 45 years to recover the loss from the trough. The SWF investment model should search for alternatives that avoid large and prolonged purchasing-power losses. This chapter argues that this objective can be met by combining assets (multi-asset-class strategies) in such a way that the risk is reduced and the probability of large drawdowns is reduced, using either static allocation or dynamic allocation.
THE UTILITY FUNCTION OF SWFS
SWFs differ from other long-term investors for two important reasons—their dual nature (they serve both strategic and financial objectives) and, in most cases, their potential exposure to commodity price fluctuations. These specific features affect their financial objectives and constraints, and are most concisely incorporated by carefully defining the utility function. Precisely defining a fund’s utility function is an extremely valuable exercise because it helps decision makers set up structures, assign clear mandates, and establish benchmarking processes to measure performance.
Utility Function
Distinction Between Strategic Utility and Financial Utility
An SWF pursues financial objectives that may translate into strategic objectives, either planned and mandated, such as the funding of pension schemes, or on a one-time basis, such as during an economic downturn. Strategic objectives may include equity investment in strategic sectors (politically mandated investment in sectors considered important for political reasons, such as energy or high technology), but they may also include a wealth transfer to the government budget to support social policies.
Strategic objectives may be pursued at the expense of financial objectives. To avoid potential conflicts, SWFs can split their activities, teams, and legal bodies to separate strategic from financial objectives. This separation can be facilitated and highlighted by the exercise of defining the utility function. The conceptual
TABLE 12.4
Drawdowns by Asset Class, 1928–2008
Maximum
real Peak Trough End
Asset class drawdown (%) (month/year) (month/year) (month/year)
U.S. treasury bills, 1-month 49 05/33 11/51 04/97U.S. government bonds, 10-year 60 11/40 09/81 07/89Corporate bonds, 10-year, Aaa 51 11/40 09/81 02/86Corporate bonds, 10-year, Baa 37 09/77 09/81 09/84Equities (S&P 500) 79 08/29 06/32 02/45
Sources: Renaissance Investment Management; Global Financial Data (www.globalfinancialdata.com).
©International Monetary Fund. Not for Redistribution
158 Managing a Sovereign Wealth Fund: A View from Practitioners
distinction between the two sets of objectives in the utility function aids in trans-lating the distinction into practical structures and mandates.
One study (Bernstein, Lerner, and Schoar, 2009) examines the relationship between funds’ organizational structures and their private equity investments. The conclusion is that mixing strategic objectives with financial objectives leads to a higher likelihood of investing at home and to conflicts between financial targets and strategic objectives: “SWFs with external managers tend to invest in lower P/E industries, which see an increase in the P/E ratios in the year after the investment. By way of contrast, funds with politicians involved invest in higher P/E industries, which have a negative valuation change in the year after the investment” (Bernstein, Lerner, and Schoar, 2009, p. 28). The results of this study argue for a clear separa-tion of the strategic and the financial parts of the SWF’s utility function.
Figure 12.4 shows a pro forma utility function for an SWF, separating the utility into strategic and financial components. Figure 12.5 concentrates on the financial component.
SWF u�lity
Financial u�lity
Strategic u�lity
Domes�c lending power
Equity stake in strategic sectors
Purchasing power
Cost of risk
Source: Authors’ compila�on.
Figure 12.4 SWF Utility Function Components
Return
Infla�on
Average risk
Large risk
Dependency risk
Liquidity risk
+ expected return in a currencybasket over a �me horizon
- related infla�on
- func�on of vola�lity
- func�on of expected drawdown
- func�on of undesired correla�on
- func�on of liquidity
Financial u�lity
Cost of risk
Purchasing power
Source: Authors’ compila�on.
Figure 12.5 Financial Utility Function for an SWF
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Darcet, du Jeu, and Coleman 159
Mathematical Translation of the Financial Utility Function
The mathematical definition of a financial utility function requires a comprehen-sive understanding of both purchasing-power expectations and the cost of risk. The standard approach to portfolio optimization (mean-variance optimization) assumes utility depends on only the mean or expected return and the volatility of that return, as measured by its variance. This simple utility function is appropriate when either the distribution of returns is normal (in that case, the mean and vari-ance completely describe the distribution) or investors actually care only about expected return and volatility.
For SWFs, such a utility function is generally too simplistic. The wealth component of utility must specify a target for purchasing power in the denomi-nated currency. The cost or risk component of utility must be expanded; risk as a linear function of volatility may not be appropriate. First, risk measures such as VaR, expected shortfall, or drawdown risk may be included in addition to volatility. A normal distribution need not include VaR or expected shortfall because these measures will be simple functions (multiples) of volatility. In prac-tice, distributions of returns have fat tails and VaR or expected shortfall will help measure the loss the fund can suffer without being forced to modify its invest-ment philosophy. Second, liquidity measures may be included. These will depend on the amounts the fund could be requested to transfer to the strategic arm in the short term. Third, the unique funding position of SWFs—often from commodity revenues—means that correlations with particular asset classes may be specifically included.
The different components are blended into one utility function, written as
Utility = purchasing power – cost of risk.
This utility function can be used by portfolio managers to monitor asset allo-cation and risk parameters. The expected return function is based on assets’ yields and valuation models. The cost of risk function depends on the SWF’s risk metric and takes into account assets’ idiosyncratic risks, asset dependencies, and the SWF’s risk preferences.
Cost of Risk
Assets’ Idiosyncratic Risks
The P&L distribution of an asset incorporates all aspects of idiosyncratic risk, but it is generally convenient to concentrate on one or another risk measure that sum-marizes the variability of the distribution. Volatility (measured by standard devia-tion) is useful for its simplicity. In practice, there are additional risk measures that are as or more suitable:
• The tail of the P&L distribution, which is essentially a VaR measure but accounts for long periods and incorporates mean growth.
• Drawdown risk, which captures the possibility of serial correlation of losses leading to cumulated and prolonged diminution of wealth.
• Risk and return conditional on the economic and financial environment.
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160 Managing a Sovereign Wealth Fund: A View from Practitioners
The traditional VaR measures the lower tail of the distribution. It is a loss threshold, with a certain probability of losing more than that threshold amount at the end of a period. The period is usually short and the VaR is usually calcu-lated as a deviation from the mean or median. As argued above (see also Figure 12.2), the growth in the mean can be important for long-term investment and it is thus important to consider the distribution and the lower tail, including the mean growth.
Financial transactions exchange utilities between market participants, that is, expected trade-offs between return and risk as well as risk appetite. The inter-connection between market participants creates positive feedback mechanisms that can lead to self-fulfilling prophesies, particularly for the demand for cash or its counterpart, the so-called market risk appetite. Such feedback mecha-nisms can create extended periods of good or bad results and produce, for low returns, persistent underperformance. The drawdown risk measure is intended to capture persistency, that is, to be sensitive to persistence and serial correlation in losses.
Figure 12.6 shows drawdown and evidence of persistence in returns for the S&P index. The horizontal axis represents drawdown in year t + 1, that is, the maximum peak-to-valley percentage return during the year t + 1. The vertical axis represents the frequency (probability) of that drawdown. Each of the four lines represents a specified level of drawdown in year t (for example, draw-down worse than 10 percent or drawdown worse than 20 percent). From Figure 12.6, we can see that the curves for higher drawdowns in year t are above the curves for lower drawdowns. This represents persistence: the prob-ability of a severe drawdown in year t + 1 increases after a large drawdown in year t.
Sources: Shiller (www.econ.yale.edu~shiller/); authors’ calculations.Note: S&P 500 return data 1900–2009. Drawup means that the current price is the highest one for one year.
0
10
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30
40
50
60
70
80
5 10 15 20 25 30 35 40 45 50
Expected forward drawdown 1 year (percent)
Prob
abili
ty (p
erce
nt)
Drawup
Drawdown
Drawdown worse than 10%
Drawdown worse than 20%
Current drawdown from highest price in the past year
Figure 12.6 Drawdown Risk as a Function of Past Drawdown
©International Monetary Fund. Not for Redistribution
Darcet, du Jeu, and Coleman 161
Asset Dependencies
CORRELATION
Diversification is a well-known way to reduce risk and is the foundation of all modern portfolio theory. The risk of two assets held together will generally be lower than the sum of the risks of the assets held individually. Volatility is an example of a risk measure that exhibits this diversification effect. The linear cor-relation coefficient, which ranges between –1 and +1, is a measure of the degree of comovement between two assets: when the correlation is less than +1, the volatility of a portfolio will be less than the sum of the volatilities of the indi-vidual assets. This holds for most commonly used risk measures, including volatil-ity or standard deviation. However, it does not necessarily hold for VaR, unless losses are linear combinations of underlying elliptically distributed risk factors.
Table 12.5 shows the correlations between major asset classes for the United States.
Compared with volatility and risk of assets considered individually, however, asset dependencies or correlations are difficult to estimate. The number of cor-relations grows quadratically with the number of assets, so that the number of parameters quickly grows large relative to the number of observations. Furthermore, joint normality may not be a good description of return data and an appropriate description of dependence across assets may well require more than a single correlation per asset pair. This again increases the number of param-eters relative to observations and further aggravates the estimation problem. These problems are particularly acute for the tails of the distribution, exactly where dependencies are most critical.
There are two common approaches to handling correlation and asset depen-dence for the tail of the portfolio distribution:
• The bottom-up approach attempts to estimate the conditional dependence of assets in rare events only (but generally still relying on joint normality). Portfolio managers using such an approach might modify the correlation matrix to account for assets’ joint behavior in stressed periods. Such an approach is situation-dependent, given that local or conditional correlations can be very unstable.
TABLE 12.5
Return Correlation Matrix, Real U.S. Assets, 1945–2008
U.S. U.S. U.S. U.S.
treasury government Corporate Corporate
bills, bonds, bonds, bonds, Equities
Asset class 1-month 10-year 10-year, Aaa 10-year, Baa (S&P 500)
U.S. treasury bills, 1-month 1 U.S. government bonds, 10-year 0.35 1 Corporate bonds, 10-year, Aaa 0.43 0.85 1 Corporate bonds, 10-year, Baa 0.46 0.74 0.90 1 Equities (S&P 500) 0.19 0.21 0.25 0.27 1
Source: Renaissance Investment Management.
©International Monetary Fund. Not for Redistribution
162 Managing a Sovereign Wealth Fund: A View from Practitioners
• The top-down approach is based on the idea that fitting a single asset’s dis-tribution gives a high degree of statistical robustness. The return of the overall portfolio is calculated and the distribution fitted as a single synthetic asset. Elements of the conditional correlation between assets will be embed-ded in the distribution, together with the idiosyncratic behavior of each asset. The distribution fit could then be extrapolated to estimate in a more robust manner rare events that have never occurred.
One reason most statistical models failed to anticipate the proper level of risk during the global financial crisis of 2007–09 is because of the structural lack of statistical information on asset dependencies.
CONDITIONAL DEPENDENCE OF ASSETS
Risk is time dependent. Asset dependencies that might be unreliable in the short term can exhibit structures at longer terms. Figure 12.7 shows the correlation of various asset classes with inflation over increasingly longer periods. The figure illustrates that the strength of the correlation increases as the time scale increases. A long-term investor will consider asset dependencies over the long run and try to bypass the inherent instability of asset dependencies using other top-down risk indicators as well as by measuring conditional risks.
Risk is also dependent on economic growth. Risk and return vary across the business cycle and market phases, and analysts attempt to capture differences in risk and correlation structures conditional on specific market phases. Figure 12.8 shows the return/risk ratio, also called the information ratio, for U.S. equities and government bonds as a function of the economic phase. Over the long term, equities and bonds exhibit a low but positive correlation. However, information ratios are desynchronized, leading to increased diversification power of government
Sources: Shiller (www.econ.yale.edu~shiller/); Global Financial Data (www.globalfinancialdata.com);authors’ calculations.
-20
-10
0
10
20
30
40
50
60
70
80
1
month 3
months 1
year 2
years 5
years
Time
Corr
ela�
on w
ith
US
CPI (
perc
ent)
S&P 500
TBond US 10Y
Crude oil
Figure 12.7 Correlation of Asset Classes with Inflation, 1900–2009
©International Monetary Fund. Not for Redistribution
Darcet, du Jeu, and Coleman 163
bonds in early recession phases. This is why government bonds can be seen as a protection against financial accidents.
SWFS: INVESTMENT STRATEGY AND RISK MANAGEMENT IN PRACTICE
This section describes how this chapter’s authors, as wealth fund managers, have put the framework discussed above into practice, combining quantitative research and long-term asset management experience.
Static Allocation versus Dynamic Allocation
Static Allocation
Static allocation means an allocation of assets that is not based on the present eco-nomic environment. Developing a static allocation involves analyzing asset risk and dependencies over a long period (over many business cycles)—including times of high and low inflation, high and low equity risk premiums, and various economic growth situations—and calculating the optimal allocation on the long-term efficient frontier.
The standard portfolio allocation process of modern portfolio theory involves the efficient frontier, plotting returns as a function of volatility, and choosing the best possible asset allocation over a period. The process can be extended to incor-porate a measure of real drawdowns. We use genetic algorithm techniques that
Sources: Shiller (www.econ.yale.edu~shiller/); Global Financial Data (www.globalfinancialdata.com);authors’ calcula�ons.
2
1
0
-1
-2
US Tbond 10Y
Ann
ualiz
ed re
al re
turn
/ann
ualiz
ed v
ola�
lity
ra�o
S&P 500
Economic cycle
Earlyexpansion
Lateexpansion
Earlyrecession
Laterecession
Figure 12.8 Return-to-Risk Ratio Across the Economic Cycle, Equities (S&P 500) and Debt (U.S. Treasury Bond, 10-Year), Annualized Real Returns and Volatilities, 1900–2009
©International Monetary Fund. Not for Redistribution
164 Managing a Sovereign Wealth Fund: A View from Practitioners
create random populations of portfolios and mutate them to mimic a Darwinian selection process. The utility function, or “fitness,” of any portfolio includes the portfolio return together with a cost of risk, counted negatively, for instance, the maximum drawdown multiplied by a scaling parameter.
The algorithm randomly generates a large number of candidate solutions (portfolios). Each portfolio is defined by its genes, that is, its allocations to the underlying assets. The best candidates survive; the worst ones are eliminated and replaced by a new population of survivors or “children” (resulting from a recom-bination of “parents’ genes” and from random mutations of genes). The process is repeated many times to converge toward an optimal or near-optimal set of solutions.
Genetic algorithms are nothing but optimization tools but with two major qualities:
• The fitness function can include a variety of risk components, such as moments, drawdowns, correlation to various indices, and so forth. This flex-ibility is particularly important for monitoring complex utility functions, as described in the section above titled Mathematical Translation of the Financial Utility Function.
• Genetic algorithms can explore a vast universe of solutions relatively quickly.Static allocation is simple to implement and is a first step toward risk mitiga-
tion. The strategy does not, however, address the issue of model uncertainty and data (particularly correlation) instability. It can be quite rigid, particularly in times of crisis when asset correlations increase in tandem with market volatilities.
Among the most significant issues is that static allocation assumes that asset dependencies will be relatively stable, when in fact they can change for prolonged periods. Consider, as an example, the informal currency arrangements that have held during the decade since 2000: several countries have effectively fixed their currencies relative to the U.S. dollar (at undervalued levels according to many commentators) and funded the U.S. current account deficit. The behavior of all asset classes relative to the U.S. dollar has been distorted by this arrangement, altering dependencies relative to earlier periods. Another example is that in the decade to come, the increased risk of commodity shortages could alter the his-torical pattern of commodity dependencies versus traditional asset classes. For these and other reasons, dynamic allocation, considered next, is viewed as an essential alternative.
Dynamic Allocation
Dynamic allocation among various asset classes is a way to both extract value from asset price behavior in various economic regimes and to control risk exposures. It is the most sophisticated and controlled process for monitoring drawdown risks. Dynamic allocation is based on the observation that there are long-term regularities in asset returns based on the phase of the economic cycle. Figure 12.9, for example, shows that commodity prices tend to follow the eco-nomic cycle; that is, prices accelerate with the expansion phase and decelerate
©International Monetary Fund. Not for Redistribution
Darcet, du Jeu, and Coleman 165
with the recession phase, while stock markets and bond markets tend to antici-pate the economic cycle.
Diversification and dynamic rebalancing provide a first layer of protection against risk, both readily identifiable day-to-day risk, and tail-end risks that are largely unknown and unpredictable.
Three Investment Principles
Principle I: Top-Down Macroeconomic Analysis
Top-down macroeconomic analysis acts as a filter to the investment universe. The objective is not to forecast the market but to try to avoid regional and global macro risks that can translate into sudden monetary outflows and the regional collapse of debt, equity, and currency markets. Regional imbalances can be gauged by measuring features such as external balances, debt levels and the cur-rency denomination of the debt liquidity profile, and currency regime (e.g., fixed versus floating). Investing in economies with sound macroeconomic fundamen-tals is a first layer of protection against the erratic behavior of so-called hot money.
The second objective of macro research is to estimate the current position of the economic cycle. Economies exhibit a succession of booms and busts. Asset returns are particularly sensitive to two factors: price levels and economic cycles. Figure 12.10 shows the dispersion of S&P equity returns in four different market phases as a function of price levels, measured as the P/E ratio at the entry into the market phase. The figure shows that equities provide higher returns when P/Es are low in any market phase. Figure 12.10 also shows that equity rebounds usually happen during the late recession phase, well in advance of the economy as a whole.
Sources: Shiller (www.econ.yale.edu~shiller/); Global Financial Data (www.globalfinancialdata.com);authors’ calculations.
-20
-15
-10
-5
0
5
10
15
20 Early expansion Late expansion Early recession Late recessionA
nnua
lized
ret
urn
(per
cent
)
Equi�es (S&P 500) U.S. government bonds, 10-year Crude oil
Figure 12.9 Returns to Asset Classes over the Economic Cycle, 1900–2009
©International Monetary Fund. Not for Redistribution
166 Managing a Sovereign Wealth Fund: A View from Practitioners
Measuring the precise position of the economic cycle can be a difficult and uncertain exercise. However, a few conclusions can be drawn with a high degree of confidence. At any moment, an investor knows which one of the four phases the economy is not in. For example, at the time of this writing in early 2009, the U.S. economy may be in early recession or late recession, but it most cer-tainly is not in a late expansion phase. When performing portfolio simulations, such historical phases can be excluded from the data set. The investor can also make reasonable assumptions about the relative likelihood of the remaining three phases. In the absence of satisfactory information, the investor can assign equal weight to the likelihood of each phase and stress test the portfolio in the three cases.
Principle II: Value Investing
Value investing across asset classes is a principle that improves the safety and mitigates the risk of a portfolio. Asset prices tend to oscillate around their fair values. A “cheap asset” has two advantages for a long-term investor: First, it offers higher yield, meaning the probability that it will deliver real value over time is high. Second, if the market moves adversely, a cheap asset is less likely than an expensive asset to be priced dramatically downward by the market, a situation that a long-term investor does not want to face.
The valuations of assets can be assessed with mathematical models. Although these models are imperfect, they are more robust for value investment than are market forecasts.
Figure 12.11 shows that investors usually overpay for the hope of growth. The earnings for equities classified as value investments turn out to be close to those predicted by analysts (actual is close to expected) and higher than in the prior
Sources: Shiller (www.econ.yale.edu~shiller/); authors’ calculations.
-60
-40
-20
0
20
40
60
80
100
0 5 10 15 20 25 30
PE at the beginning of the cycle phase
Ann
ualiz
ed r
etur
n (p
erce
nt)
Early recession Late recession Early expansion Late expansion
Figure 12.10 Returns to S&P 500 in Various Market Phases as a Function of P/E Ratio
©International Monetary Fund. Not for Redistribution
Darcet, du Jeu, and Coleman 167
period. In contrast, the earnings for equities classified as growth investments turn out to be lower than both predicted earnings and prior-period earnings. This shows that for growth companies analysts’ expectations for earnings seem to be based on priors, as if expectations were reverse engineered to match market price, and actual earnings disappoint relative to prior and expectations. For value com-panies the reverse is true, with the actual outcome close to expectations and higher than the prior.
Value concepts at the company level aggregate at the country or sector index levels and provide investment guidelines to enhance yield expectations across market phases.
For example, Table 12.6 shows the total return to the S&P 500 in different inflationary environments, and also for low versus high P/Es. Total returns are higher in low-inflation environments, but regardless of the circumstances, invest-ing in equities when P/Es are low provides higher returns than when P/Es are high. Dynamic reallocation across asset classes based on value concepts is a pro-cess used for extracting value.
TABLE 12.6
Total Returns to Equities, S&P 500, 1901–2009
High High Low Low
inflation1 inflation1 inflation2 inflation2
Indicator accelerating (%) decelerating (%) accelerating (%) decelerating (%)
Annualized return 0.6 9.4 8.0 17.9Annualized return when P/E ≤ 17 2.5 11.4 15.7 25.7Annualized return when P/E > 17 −5.5 −0.3 −2.6 6.7
Source: Shiller (www.econ.yale.edu~shiller/). Note: Accelerating means a year-over-year consumer price index (CPI) above its six-month average, decelerating means a
year-over-year CPI below its six-month average.1High inflation: U.S. year-over-year CPI > 3 percent.2Low inflation: U.S. year-over-year CPI ≤ 3 percent.
Source: SocGen Research (www.sgresearch.com).
0
2
4
6
8
10
12
14
16
18
htworGeulaV
Investment type con�nuum
Earn
ings
gro
wth
(per
cent
)
Expected return Prior period return Actual return
Figure 12.11 Annualized Earnings Growth in the United States, 1985–2007
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168 Managing a Sovereign Wealth Fund: A View from Practitioners
Although value investing focuses on yield, and therefore on expected returns, risk should not be ignored. Any market participant’s utility function combines expected return and risk. If asset prices tend to oscillate around their equilibrium value, so does the global appetite for risk, or its counterpart, the demand for cash.
The market’s risk appetite for a given asset or asset class can be measured in various ways, including by trend-following models using a medium-term time frame. The more favorable situation for a long-term investor occurs when risky assets are assigned a low price for embedded value while the market appetite for risk is growing. In 2009, analysts witnessed an example of this situation, in line with the historical behavior of equities and corporate bonds at the end of a reces-sion phase and the beginning of an expansion phase.
Inclusion of the risk component in the asset-valuation process can also protect the portfolio from secular shifts in assets’ offer and demand equilibrium, which cannot be predicted using historical data. This issue is especially relevant for com-modities, which do not bear interest and therefore cannot be easily integrated into a simple value-investing approach.
Principle III: Risk-Management Discipline
Risk-management discipline is an additional, critical layer of protection against tail-end risk. Asset managers make assumptions based on valuation methods and economic analysis, and those assumptions can turn out to be wrong. A crucial element of the investment process is to measure the consequences of being wrong and to ensure that such consequences would be bearable by the SWF owner.
Defining an SWF utility function is the process managers use to clarify the mandate entrusted to them. Risk-management discipline requires that the cost-of-risk function be monitored to ensure that the portfolio remains within its risk parameters.
Global Portfolio Construction
Process
Global portfolio construction starts with mapping the investment universe and filtering that universe using top-down macroeconomic considerations. This first step leads to investment restrictions and constraints (i.e., particular geographic regions or asset classes to include or exclude) that are used during the portfolio optimization process.
The second step involves assessing individual asset valuations. Considerations of risk and return presented in the previous sections are implemented at this stage. In general, an asset’s value in a portfolio results from the trade-off between expected return and risk, as well as its correlation with other assets. The valuation and filtering process at this stage selects suitable assets, so that each investment, taken individually, provides a favorable expected risk-return trade-off. Prefiltering to choose suitable assets reduces the universe of assets considered in the third stage by the optimization routine, and enhances the robustness of the optimization process, which otherwise can be overly sensitive to the assumptions made in the correlation structure.
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Darcet, du Jeu, and Coleman 169
The third stage involves the fund’s utility function, which is used to optimize allocations to various assets under several constraints, such as liquidity require-ments, macro restrictions on asset exposures, maximum tolerable volatility, or cost of transactions.
Back-Testing
Portfolio construction is a combination of science and art. The process requires the discretionary views of experienced managers in addition to computerized models to support the calculation process. It is not possible to look back in time and assume what discretionary decisions would have been made in the past. However, it is possible to build simplified models to simulate the actual process, and apply these models to past history. This exercise gives a reasonable semblance of the dynamics of the portfolio reallocation process and its potential strengths or weaknesses, at different time scales or under different economic regimes.
Such back-testing is essential, especially for measuring the potential conse-quences of being wrong. Managers and economists make mistakes all the time, and this is an intrinsic element of the investment process. The impact of making such mistakes can be examined by stress testing. For example, investing in equities in a late recession phase as opposed to in an early expansion phase has little con-sequence as measured by returns but significant costs in volatility. The control of the portfolio risk provided by a dynamic reallocation process offers some element of comfort with regard to economic uncertainties.
Managing Tail Event Risk
MEASURING TAIL-END RISKS
Financial returns are not normally distributed, as is well documented. Tails are fat relative to normal, in that rare events—large losses or gains—occur more fre-quently than for a normal distribution. Ignoring fat tails leads to substantial underestimation of the likelihood of large losses.
A couple of approaches can be used to remedy this problem. The first, extreme value theory, focuses specifically on the tail events. A functional form for the distribution of the tail events can then be used that is more appropriate than the normal distribution. (The distribution only applies to the upper or lower tail, not the complete distribution.) One distribution (which arises naturally as the limit-ing distribution for maxima or threshold exceedances) is the generalized Pareto distribution. Another functional form is the stretched exponential.4
A second, simple, and practical approach is to model the complete return distribution using a distribution with tails fatter than the tails of a normal distri-bution. This approach has the advantage of handling both day-to-day risk (vola-tility) and extreme risk within the same model. Two candidate distributions are Student’s t-distribution with a small number of degrees of freedom (three to six), and a discrete mixture of normals.
4For more information on extreme value theory and generalized Pareto distributions, see Chapter 7 of McNeil, Frey, and Embrechts, 2007; and Malevergne, Pisarenko, and Sornette, 2005, 2006.
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170 Managing a Sovereign Wealth Fund: A View from Practitioners
Regardless of the approach chosen, a long-term investor should use risk mod-els that can model the fat tails of return distributions. Risk mitigation, however, should not be sensitive to the exact measures of tails for two reasons: (1) tail events, by definition, are rare, and therefore can only be measured with a low confidence level; and (2) extreme events are usually triggered by a series of minor causes cascading throughout the system that are self-reinforcing and almost impossible to identify, even after the fact. Risk mitigation mainly comes from recognizing the reality of fat tails, and the dynamic of the investment process.
PRICE-TO-BOOK AS AN INDIRECT MEASURE OF SYSTEMIC RISK
The tangible value of a company is represented by its book value, that is, equity injec-tions and accumulated earnings (less dividends), which usually are invested in produc-tive capacity. The intangible value that results in the market price consists of two parts: (1) the ability of the organization and its employees to turn the productive capacity into an increasing flow of earnings, and (2) the favorable environmental factors that support the creation of wealth, that is, the systemic value of the economic system, which is redistributed to its members. The price given to the intangible value must turn into tangible earnings in the medium term or the price will eventually fall.
At the end of the 1990s, price-to-book in the United States jumped to 5, as it did in Japan in 1989 before Japan’s financial crash. A price-to-book of 5 means that market participants attribute 80 percent of the value of a company to its intangible assets, mostly to the systemic value of the integrated economic system and its ability to moderate macroeconomic fluctuations:
Price-to-book = 1 + (intangible value/tangible value).
When the market, which fears increased volatility or disappointing future flows of tangible earnings, starts to question systemic and intangible values, prices of all equities fall together and correlation across risky assets increases dramatically because those risky assets are all highly sensitive to the same factor.
Therefore, expensive equity markets, as measured by the price-to-book ratio, are not only likely to underperform in the long run but also to eventually suffer from systemic repricing.
MITIGATING TAIL-END RISKS
The investment process for SWFs laid out in the previous sections provides struc-tural protection against systemic risks for three reasons:
• The implementation of value-investing concepts is likely to drive the fund out of self-fulfilling asset bubbles ahead of a crash. Extreme events tend to happen when assets are very expensive and the appetite for risk turns nega-tive, two factors integral to the valuation method.
• The utility function guideline induces the fund to reduce its risky exposures when market volatilities and correlations increase significantly.
• Risk monitoring is driven by investment principles and not by economic forecasts.
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Darcet, du Jeu, and Coleman 171
CONCLUSION
SWFs are favorably positioned in the market. First, they are not in a competitive situation. Therefore, they can better resist the temptation to follow the consensus, particularly in times of asset bubbles, thus increasing their margin of safety. Second, as long-term investors, they can benefit from the scaling effect of risk-return relationships and get higher returns than a short-term investor would for a given level of risk. Fulfillment of this objective requires the assignment of clear mandates to the investment management team, supported by the definition of the fund’s utility function.
Creating a governance process that encourages long-term, independent invest-ing is an enormous challenge, especially for SWFs just starting up, when the temptation is to invest with a low-risk profile simply to meet short-term objec-tives of capital protection in nominal terms.
REFERENCES
Bernstein, Peter L., 1996, “Are Stocks the Best Place to be in the Long Run? A Contrary Opinion,” Journal of Investing, Vol. 5, No. 2, pp. 6–9.
Bernstein, Shai, Josh Lerner, and Antoinette Schoar, 2009, “The Investment Strategies of Sovereign Wealth Funds,” NBER Working Paper No. 14861 (Cambridge, Massachusetts: National Bureau of Economic Research).
McNeil, Alexander J., Rudiger Frey, and Paul Embrechts, 2005, Quantitative Risk Management: Concepts, Techniques, and Tools (Princeton, New Jersey: Princeton University Press).
Malevergne, Yannick, Vladilen Pisarenko, and Didier Sornette, 2005, “Empirical Distributions of Log-Returns: Between the Stretched Exponential and the Power Law?” Quantitative Finance, Vol. 5, No. 4, pp. 379–401.
———, 2006, “On the Power of Generalized Extreme Value (GEV) and Generalized Pareto Distribution (GPD) Estimators for Empirical Distributions of Log-Returns,” Applied Financial Economics, Vol. 16, No. 3, pp. 271–89.
Siegel, Jeremy, 2007, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long Term Investment Strategies (New York: McGraw-Hill; 4th ed.).
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173
CHAPTER 13
Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
TAO SUN AND HEIKO HESSE
Since the beginning of the global financial crisis in the summer of 2007, financial stability has been at the forefront of policy discussions. Sovereign wealth funds (SWFs) have become dominant players in global financial markets over the same period because they have injected significant capital into major financial institu-tions. In some countries, SWFs were instructed by their governments to invest in domestic financial institutions and the stock markets to support battered stock prices. Research on the financial-stability implications of these funds has been slowly emerging, hampered by lack of data on SWFs’ asset allocations.
Many arguments have been put forth about the potential positive and negative effects of SWFs on global financial markets. Some argue that SWFs can play a stabilizing role in global financial markets. First, many commentators point out that as long-term investors with no imminent call on their assets, and with mainly unleveraged positions, SWFs are able to sit out longer during market downturns or even go against market trends. In addition, SWFs in some countries, particu-larly in the Middle East, have recently supported domestic equity markets and financial institutions. Second, large SWFs may have an interest in pursuing port-folio reallocations gradually, to limit any adverse price effects of their transactions. Third, SWFs could, as long-term investors and by adding diversity to the global investor base, contribute to greater market efficiency and lower market volatility. Fourth, SWFs’ investments may enhance the depth and breadth of markets.
Although SWFs appear to have been a stabilizing force thus far, as a result of their size, there are circumstances in which they could cause volatility in markets. Having large and often unclear positions in financial markets, SWFs—like other large institutional investors—have the potential to cause market disturbances. For instance, actual or rumored transactions may affect relative valuations in particu-lar sectors and result in herd behavior, adding to volatility. Deeper markets, such as currency markets, can also be affected, at least temporarily, by rumors or announcements about changes in currency allocations by central banks or SWFs. To the extent that SWFs invest through hedge funds that rely on leverage or are subject to margin requirements, such investments may inadvertently magnify market changes. For markets to absorb flows from any major investor class with-out large price fluctuations, they need to be able to anticipate the broad allocation
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174 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
and risk-preference trends of such investor classes. Opacity about such trends can lead to inaccurate pricing and volatility. Both theoretical and empirical research are underway with regard to the financial-stability implications of SWFs.
Recent capital injections by SWFs have further intensified the debate about the impact of SWFs on financial stability. SWFs from East Asia and the Middle East were frequently in the news, as major mature-market financial institutions required additional capital. In total, SWFs have contributed more than US$50 billion of such capital since November 2007. The capital injections by SWFs have augmented the recipient financial institutions’ capital buffers and have been help-ful in reducing various firm-specific risk premiums, at least in the short term, because the injections curtailed the need to reduce bank assets to preserve capital. The announcements of capital injections from SWFs have assisted in stabilizing share prices and the elevated credit default swaps spreads, at least over the short run (IMF, 2008). In most cases, after the announcement of new SWF capital injections, the initial share price reaction was positive, with announcements of asset write-downs offset by concurrent capital injections from investor groups in which the SWFs had significant roles. Although other factors are not taken into account, this initial evidence supports the view that SWFs could have a volatility-reducing impact on markets.1
This chapter, using an event-study approach based on a hand-collected data-base, endeavors to deepen the analysis of SWFs’ impact on financial stability by differentiating between various scenarios comprising investments and divest-ments in advanced and emerging economies, financial and nonfinancial sectors, and SWFs with higher and lower levels of corporate governance. The overall find-ings suggest SWFs have no significant destabilizing effect on equity markets. This empirical study contributes to the emerging academic literature that seeks to analyze the behavior of SWFs in financial markets.
The chapter proceeds as follows: The first section briefly reviews the literature and some conceptual issues. The second section outlines the event-study approach and describes the data. The third section presents empirical results, and is fol-lowed by a concluding section.
LITERATURE REVIEW
SWFs are defined as special-purpose investment funds or arrangements owned by the government. They are often established out of balance of payments surpluses, official foreign currency operations, proceeds of privatizations, fiscal surpluses, or receipts from commodity exports. Their total size has been estimated at US$2
1With the continuing increase in banks’ losses and write-downs during the subprime crisis, the rescue of Bear Stearns, the collapse of Lehman Brothers, and U.S. government intervention into major financial institutions, the longer-term share price development of banks that obtained initial capital injections from various SWFs has been obviously negative. But the short-term reaction to SWFs’ financial support has been perceived as positive by the financial market in most cases.
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Sun and Hesse 175
trillion to US$4 trillion,2 but many of them have probably seen large unrealized losses from the crisis combined with a sharp reduction in oil prices. These unreal-ized losses have been higher for SWFs with higher shares of equities in their investment portfolios or large, illiquid positions in private-equity or hedge funds. Given that SWFs typically have fairly long investment horizons, they are likely to sit out these unrealized losses.
The lack of publicly available data on SWF asset allocations has led to a strand of IMF research on the theory side. Lam and Rossi (2010) develop a theoretical model that aims to examine the impact of SWFs on global financial stability during periods of stress. Their findings indicate that SWFs have a risk-sharing role in financial markets. As part of the IMF-coordinated process of the Santiago Principles, which provide generally accepted principles and practices for SWFs, Hammer, Kunzel, and Petrova (2008) examine the asset-allocation and risk-management frameworks of SWFs based on a detailed survey. The results show that SWFs have specific investment objectives in place, adopt asset approaches (mean-variance style) in determining their asset allocation strategies, use common risk measures (e.g., credit ratings, value-at-risk models, tracking errors, duration, and currency weights) for risk management, and have explicit limits in their investment classes and instruments.
Simulations of SWFs’ asset allocations have been undertaken by Kozack, Laxton, and Srinivasan (see Chapter 14 of this book). Specifically, they create two stylized diversified portfolios, one mimicking Norway’s SWF (the Government Pension Fund–Global) and the other representing some well-established SWFs. They then conduct a scenario analysis of the effect of diversification of sovereign assets. Although the calibrations are highly sensitive to the underlying model assumptions, the findings indicate that advanced economies will see lower capital inflows, while emerging-market countries will be the primary beneficiaries. The quantitative results of this work are consistent with the back-of-the-envelope calculations of Beck and Fidora (2008), which imply a net capital outflow from the United States and the euro area and net inflows to emerging-market coun-tries. In the same vein, Miles and Jen (2007) and Hoguet (2008) point out that there is scope for the global equity risk premium to fall and for real bond yields to rise if SWFs allocate their assets to equities. In addition, as SWFs increasingly diversify into global portfolios, their activities may place some pressure on the dollar (see Chapter 15 of this book).
Some empirical research using equity-market indicators and an event-study approach has examined the role of SWFs as major institutional investors. For instance, in an event study, Chhaochharia and Laeven (2008) find that the announcement effect of SWF investments is positive. They report that share prices of firms respond favorably when SWFs announce investments, partly because these investments often occur when firms are in financial distress, but the
2For instance, a report by International Financial Services, London (2010) revealed that SWFs’ total assets stood at US$3.8 trillion in 2009 and are likely to reach US$5.5 trillion by the end of 2012, a substantially lower estimate than had been made previously.
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176 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
long-run performance of equity investments by SWFs tends to be poor (see Fotak, Bortolotti, and Megginson, 2008, for similar results). Kotter and Lel (2008) show that the cumulative abnormal return of SWF investments has an announcement effect similar to that of investments by hedge funds and institu-tional investors such as the California Public Employees’ Retirement System on stock returns. In addition, investments by more transparent SWFs have a 3.5 percent larger cumulative abnormal return, suggesting that voluntary SWF dis-closure might serve as a signal device to investors. In addition, Kotter and Lel (2008) also obtain a significant negative, but small, announcement impact from SWFs’ divestitures. Beck and Fidora (2008) conducted a country case study of Norway’s SWF and asked whether its exclusion of companies that violate the ethical guidelines of the Ministry of Finance exerts price pressures on those com-panies. Their findings suggest no significant negative abnormal returns following the divestiture by the SWF of these companies.
To summarize, existing research on SWFs suggests that they can be a stabilizing force in global financial markets. Event studies do not find a destabilizing impact from SWF investments and divestments in equity markets, while simulations of SWF asset allocations imply only a gradual shift with modest economic effects. With SWFs improving their transparency and disclosure procedures over time, the avail-ability of historical data on SWF transactions would provide researchers with the necessary information to examine further their implications for financial stability.
DATA AND METHODOLOGY
The empirical research conducted for this chapter uses an event-study approach to assess whether stock markets react to SWFs’ announcements of investments in and divestments of firms. The objective is to investigate the information content of these announcements. Based on 166 publicly traceable, hand-collected events of investment and divestment (both announcement and action) by major SWFs during 1990 through 2009, this section evaluates the short-term financial impact of SWFs on selected public equity markets in which they invest and divest. The impact is further analyzed by different sectors (financial and nonfinancial), actions (buy and sell), mar-ket types (developed and emerging), and level of corporate governance of the SWF (higher and lower scores). The results are expected to suggest how stock markets react to capital investments and divestments by SWFs and present implications of SWFs’ actions for stability in global financial markets. The investigation of divestments is of particular interest because abnormally large stock price reactions (relative to the mar-ket) may be destabilizing to the degree that others mimic or act on SWFs’ divestment behavior. Such actions might be particularly troublesome if prices slip below other investors’ predefined target levels, thus prompting forced sales of their positions.
Data
Several SWFs that have bought or sold shares of firms in the advanced and emerg-ing stock markets are included in the study. Among them are the Abu Dhabi Investment Authority, the China Investment Corporation, the Government of
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Sun and Hesse 177
Singapore Investment Corporation (GIC), the Kuwait Investment Authority, the Korea Investment Corporation, the Libyan Investment Authority, Mubadala (in Abu Dhabi), the Qatar Investment Authority, and Temasek (in Singapore). Information on the events was gleaned from the SWFs’ Web sites and various financial news reports such as Factiva, a division of Dow Jones & Company. Target firm actual total returns (and price indices) and country stock market returns (and price indices) were obtained from the Datastream International database.3 This search resulted in a total of 166 investment and divestment events in 115 unique firms, with some firms receiving multiple SWF investments between 1990 and 2009.4 This information was then combined with firm-level and country-level data collected from Bloomberg, and SWF-specific data from various sources, including Truman (2008).5
Table 13.1 shows the number of SWF investments and divestments by coun-try of target firm. Table 13.2 displays the distribution of the sample by the iden-tity of the acquiring SWF, showing that Singapore’s two SWFs (GIC and Temasek) dominate the sample. Figure 13.1 shows the ratios of SWFs’ invest-ments (buy) and divestments (sell) to the full sample as well as similar ratios for the subsamples—financial and nonfinancial sectors, developed and emerging markets, and SWFs with high and low levels of corporate governance.
Methodology
If markets are rational, the effects of an event should be reflected immediately in stock returns and prices. Thus, a measure of an event’s impact can be constructed using stock prices and returns observed over a relatively short period. To bench-mark the returns of the stock relative to the event, the overall stock market returns, in percentage changes, for the country corresponding to the target firm are used.
Specifically, the following steps were taken to implement the event study: • Determination of the selection criteria for the inclusion of SWFs. SWFs were
chosen if data were available on their actions, and on stock prices and total returns. The sample contains several SWFs that have bought or sold stakes in financial firms and nonfinancial firms.
• Collection of a number of investment and divestment events and compilation of a list of firms and event dates by searching publicly available databases to find news announcements of SWFs’ actions.
• Identification of the event window for SWFs’ investments and divestments. Because the event date can be determined with precision, the short-term analysis employed a five-day (seven-day) event window, comprising two
3Datastream is the only data vendor that provides total return stock market indices for all the relevant countries, correcting index returns for dividend payments, stock splits, and other such changes.4Some events were discarded for invested companies that are not publicly listed, and therefore no data for stock price and total return were available.5The corporate governance score of each SWF is from the “total” score in Truman (2008). Those scores higher than 40 were designated “high” in this chapter’s econometric analysis, while those equal to or lower than 40 were designated “low.”
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178 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
TABLE 13.1
Country of Target Firms
Country Number of events
Australia 6Austria 1China 17Egypt 2France 8Germany 7Iceland 1India 13Indonesia 5Italy 6Japan 2Korea, Rep. of 3Malaysia 7Pakistan 4Philippines 1Portugal 2Singapore 22Spain 3Sweden 2Switzerland 2Taiwan Province of China 1Thailand 2United Kingdom 31United States 17Vietnam 1Total 166
Source: Authors ’ compilations.
TABLE 13.2
Events by Acquiring SWF
SWF Number of Events Country
Abu Dhabi Investment Authority 26 United Arab EmiratesChina Investment Corporation 11 ChinaGovernment of Singapore Investment Corporation 38 SingaporeKuwait Investment Authority 14 KuwaitKorea Investment Corporation 1 Korea, Rep. ofLibyan Investment Authority 2 LibyaMubadala 2 United Arab EmiratesQatar Investment Authority 23 QatarTemasek 49 SingaporeTotal 166
Source: Authors’ compilations.
(three) preevent days, the event day, and two (three) postevent days.6 Inclusion of the preevent days allowed rumors that preceded the formal announcement to enter the assessment. Postevent days were also included because prices in illiquid markets may take a couple of days to adjust to new information. To test for robustness, the event window was expanded to nine days: four preevent days, the event day, and four postevent days.
6Several event windows (specified in parentheses) were chosen to test robustness.
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Sun and Hesse 179
• Definition of the estimation period. Following Peterson’s framework (1989), the market model was estimated based on the 200 trading days ending 30 days before the announcement of each investment or divestment. Ending the sample before the event ensures that the “normal” behavior of returns is not contaminated by the event itself. To test for robustness, the estimation peri-ods were varied (separate estimations at 100 days and 300 days), and price indices were used instead of total returns to each firm and the economy.
• Estimation of a normal return during the event window in the absence of the event, using a one-factor ordinary least squares regression equation:7
Rit = αi + βiRmt + eit,
where Rit is the return of stock i in period t, Rmt is the overall stock market returns in period t, αi and βi are regression coefficients, and eit is an error term, i and t are individual stocks and time, respectively.
7Because the market model is most commonly used in research to generate expected returns and no better alternative has yet been found, despite the weak relationship between beta and actual returns (Armitage,1995), the market model was used in the analysis to predict “normal” return. To test for robustness, a three-factor model can also be employed.
Figure 13.1 Ratios of SWF Investments and Divestments
90
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Sources: SWF Web sites; Factiva; authors’ calculations.Note: The SWFs with high-level corporate governance refer to those whose total score is higher than 40; low level refers to atotal score equal to or lower than 40 (Truman, 2008).
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180 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
• Calculation of the abnormal return within the event window. Having calculated estimates of αi and βi with the data from the estimation period, abnormal returns (ARit) were calculated by differencing the actual and esti-mated returns,
ARit = Rit – Rit*
= Rit – (αi* + βi
*Rmt),
where Rit* is the estimated return.
The abnormal return observations for each day in the event window must be aggregated to draw overall inferences for the event of interest. The aggre-gation can be along two dimensions—through time and across securities—simultaneously.
The individual securities’ abnormal returns, in the 5-day case, can be aggregated for each event day, t = –2, –1, 0, +1, +2, during the event window. Given N events (a total of 166 in the entire sample), the sample aggregated average abnormal returns (AAR) for period t is
1 N
AARt = —– ∑ ARit. N i=1
• The aggregated average abnormal returns can then be aggregated over the event window to calculate the cumulative average abnormal return (CAAR).
2
CAAR = ∑ AARt. t=–2
• Testing whether the abnormal return is statistically different from zero. Because the number of observations in the event window (5 or 7 days) is limited, t-tests were used rather than the Z score, because Z scores usually require at least 50 observations to obtain statistically robust results.8
EMPIRICAL RESULTS
Table 13.3 presents the AAR and CAAR for the (–2, +2), and (–3, +3) windows. In general, the AAR is positively associated with SWFs’ buy actions and not significantly negatively associated with SWFs’ sell actions in the full sample. The results also suggest that the share-price responses to SWFs’ investments in devel-oped economies are statistically significant at the 5 percent confidence level, while
8 The t-test is of interest to examine whether there are differences of the abnormal returns over time and especially across types of markets. The event-study approach shows the explicit impact of SWF actions because the methodology is based on individual purchases and sales of publicly available equities.
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Sun and Hesse 181
TABLE 13.3
Stock Market Reactions to Announcements of SWF Investments and Divestments (Total Returns in Percent)
Event window t-statistic of AAR Mean of AAR t-statistic of CAAR CAAR
Panel A: Buy only, 134 events from 101 firms
(−2, +2) 4.31** 0.27 3.33** 0.77 (−3, +3) 3.75** 0.22 4.45*** 0.96
Panel B: Sell only, 32 events from 23 firms
(−2, +2) 0.00 0.00 − 0.31 − 0.07 (−3, +3) − 0.08 − 0.02 −1.21 − 0.19
Panel C: Buy and sell in developed economies only, 87 events from 55 firms
(−2, +2) 4.29** 0.21 4.95** 0.72 (−3, +3) 2.88** 0.18 6.17*** 0.94
Panel D: Buy and sell in emerging economies only, 79 events from 60 firms
(−2, +2) 1.20 0.17 1.67 0.34 (−3, +3) 0.98 0.11 1.14 0.20
Panel E: Buy in developed economies only, 72 events from 51 firms
(−2, +2) 5.47** 0.30 4.44** 0.91 (−3, +3) 3.13** 0.24 5.82*** 1.21
Panel F: Sell in developed economies only, 15 events from 9 firms
(−2, +2) − 0.49 − 0.19 −1.24 − 0.44 (−3, +3) − 0.56 − 0.16 −2.99** − 0.77
Panel G: Buy in emerging economies only, 62 events from 50 firms
(−2, +2) 2.07 0.24 2.31* 0.60 (−3, +3) 2.37* 0.20 2.94** 0.69
Panel H: Sell in emerging economies only, 17 events from 14 firms
(−2, +2) 0.44 0.16 0.99 0.23 (−3, +3) 0.37 0.09 1.62 0.29
Panel I: Buy in financial sector only, 41 events from 24 firms
(−2, +2) 2.72* 0.70 5.13** 2.53 (−3, +3) 3.09** 0.66 6.38*** 3.40
Panel J: Sell in financial sector only, 5 events from 3 firms
(−2, +2) — — — —(−3, +3) — — — —
Panel K: Buy in nonfinancial sector only, 93 events from 77 firms
(−2, +2) 0.31 0.04 −1.78 − 0.18 (−3, +3) − 0.15 − 0.01 − 4.06** − 0.35
Panel L: Sell in nonfinancial sector only, 27 events from 20 firms
(−2, +2) 0.00 0.00 − 0.31 − 0.07 (−3, +3) − 0.08 − 0.02 −1.21 − 0.19
Panel M: Buy by high-level governance SWF only, 76 events from 59 firms
(−2, +2) − 0.11 − 0.02 − 0.20 − 0.02 (−3, +3) 0.18 0.02 0.84 0.07
(continued)
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182 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
those in emerging economies are not. In addition, SWFs’ investments in the financial sector have a larger impact on share prices than do their investments in the nonfinancial sector. These differences in responses may be due to the relatively more liquid equity markets in developed economies and in the financial sector.
Different scenarios were tested using these events. Panel A of Table 13.3 reports the AAR and CAAR during the event windows of SWF investments for the entire sample of 134 investment observations during the period 1990 to 2009. The mean AAR is 0.27 percent and 0.22 percent for windows of (–2, +2), and (–3, +3), respectively, around the announcement date, and the CAAR is 0.77 percent and 0.96 percent, respectively. The sign-test statistics for the AAR are also highly significant for the two windows. Panel B reports the AAR and CAAR during the event windows of the announcements of SWF divestments for the entire sample of 32 observations during the period between 1990 and 2009. The mean AAR is 0 percent and –0.02 percent for the windows (–2, +2), and (–3, +3), respectively, and the CAAR is –0.07 percent and –0.19 percent, respectively. The sign-test statistics for the AAR and the CAAR are insignificant for the two windows.
Panel C reports the AAR and CAAR during the event windows of SWF investments and divestments for the developed-economy sample of 87 obser-vations during the period between 1990 and 2009. The mean AAR is 0.21 percent and 0.18 percent for the windows (–2, +2), and (–3, +3), respectively, and the CAAR is 0.72 percent and 0.94 percent, respectively. The sign-test statistics for the AAR and the CAAR are highly significant for the two win-dows. Panel D of Table 13.3 reports the AAR and CAAR during the event windows of SWF investments and divestments for the emerging-economy sample of 79 observations during the period between 1990 and 2009. The mean AAR is 0.17 percent and 0.11 percent for the windows (–2, +2), and (–3, +3), respectively, and the CAAR is 0.34 percent and 0.20 percent,
TABLE 13.3
Stock Market Reactions to Announcements of SWF Investments and Divestments (Total Returns in Percent) (cont.)
Event window t-statistic of AAR Mean of AAR t-statistic of CAAR CAAR
Panel N: Sell by high-level governance SWF only, 26 events from 19 firms
(−2, +2) 0.36 0.12 0.85 0.17 (−3, +3) 0.27 0.06 1.04 0.15
Panel O: Buy by low-level governance SWF only, 58 events from 45 firms
(−2, +2) 2.68* 0.68 3.03** 1.89 (−3, +3) 2.21* 0.50 4.05** 2.22
Panel P: Sell by low-level governance SWF only, 6 events from 4 firms
(−2, +2) −1.23 − 0.73 −1.96 −1.61 (−3, +3) −1.15 − 0.53 −3.67** −2.39
Source: Authors‘ estimates.Note: — in panel J means there were no qualified observations before or after the corresponding event dates.***significant at 1 percent level; **significant at 5 percent level; *significant at 10 percent level.
©International Monetary Fund. Not for Redistribution
Sun and Hesse 183
respectively. The sign-test statistics for the AAR and CAAR are insignificant for the two windows.
The impact is further analyzed on the investments and divestments in different market types (developed and emerging), different sectors (financial and nonfinancial), and level of corporate governance of the SWF (high and low). In general, according to the AAR, investments in developed economies (Panel E) and in the financial sector (Panel I) are statistically significant. In addition, the positive (negative) impact of the CAAR for the investments (divestments) by low-level governance SWFs are significantly larger than those by high-level governance SWFs. This could indicate that the improvement of corporate governance in SWFs would be helpful in reducing the impact on market volatility.9
The event window of (–4, +4) was used as a robustness check to test the impact of SWFs’ actions. In addition, the estimation periods were varied to 100 and 300 days. Finally, price indices for each firm and the economy were used instead of total returns. The results were robust to different event windows, dif-ferent estimation periods, and the use of price indices. (See Table 13.4 for the results using price indices.)
9 This result is in line with the positive market responses to the investments in the entire sample—SWFs with low-level corporate governance accounted for the majority of the sample of SWF investments.
TABLE 13.4
Stock Market Reactions to Announcements of SWF Investments and Divestments (Using Price Indices, Returns in Percent)
Event window t-statistic of AAR Mean of AAR t-statistic of CAAR CAAR
Panel A: Buy only, 134 events from 101 firms
(−2, +2) 4.09** 0.26 3.46** 0.75 (−3, +3) 3.84** 0.22 4.71*** 0.98
Panel B: Sell only, 32 events from 23 firms
(−2, +2) 0.24 0.07 1.32 0.26 (−3, +3) 0.16 0.03 1.67 0.24
Panel C: Buy and sell in developed economies only, 87 events from 55 firms
(−2, +2) 5.05** 0.25 5.45** 0.87 (−3, +3) 2.83** 0.20 6.37*** 1.10
Panel D: Buy and sell in emerging economies only, 79 events from 60 firms
(−2, +2) 0.98 0.14 1.58 0.28 (−3, +3) 0.94 0.10 1.33 0.20
Panel E: Buy in developed economies only, 72 events from 51 firms
(−2, +2) 5.5** 0.31 4.44** 0.95 (−3, +3) 3.22** 0.25 5.66*** 1.23
(continued)
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184 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
TABLE 13.4
Stock Market Reactions to Announcements of SWF Investments and Divestments (Using Price Indices, Returns in Percent) (cont.)
Event window t-statistic of AAR Mean of AAR t-statistic of CAAR CAAR
Panel F: Sell in developed economies only, 15 events from 9 firms
(−2, +2) − 0.12 − 0.04 1.02 0.28 (−3, +3) − 0.20 − 0.05 0.67 0.14
Panel G: Buy in emerging economies only, 62 events from 50 firms
(−2, +2) 1.94 0.21 2.37* 0.53 (−3, +3) 2.58** 0.19 3.41** 0.69
Panel H: Sell in emerging economies only, 17 events from 14 firms
(−2, +2) 0.47 0.17 1.05 0.24 (−3, +3) 0.40 0.10 1.80 0.32
Panel I: Buy in financial sector only, 41 events from 24 firms
(−2, +2) 2.46* 0.66 5.45** 2.45 (−3, +3) 2.91** 0.65 6.82*** 3.42
Panel J: Sell in financial sector only, 5 events from 3 firms
(−2, +2) — — — —(−3, +3) — — — —
Panel K: Buy in nonfinancial sector only, 93 events from 77 firms
(−2, +2) 0.35 0.04 −1.56 − 0.17 (−3, +3) − 0.10 − 0.01 −3.83** − 0.35
Panel L: Sell in nonfinancial sector only, 27 events from 20 firms
(−2, +2) 0.24 0.07 1.32 0.26 (−3, +3) 0.16 0.03 1.67 0.24
Panel M: Buy by high-level governance SWF only, 76 events from 59 firms
(−2, +2) − 0.22 − 0.04 − 0.50 − 0.07 (−3, +3) 0.11 0.02 0.68 0.06
Panel N: Sell by high-level governance SWF only, 26 events from 19 firms
(−2, +2) 0.38 0.12 0.92 0.18 (−3, +3) 0.27 0.06 0.91 0.14
Panel O: Buy by low-level governance SWF only, 58 events from 45 firms
(−2, +2) 2.72* 0.69 3.04** 1.91 (−3, +3) 2.26* 0.51 4.07** 2.26
Panel P: Sell by low-level governance SWF only, 6 events from 4 firms
(−2, +2) − 0.40 − 0.23 1.21 0.75 (−3, +3) − 0.32 − 0.13 1.64 0.88
Source: Authors‘ estimates.Note: — in panel J means there were no qualified observations before or after the corresponding event dates.***significant at 1 percent level; **significant at 5 percent level; *significant at 10 percent level.
©International Monetary Fund. Not for Redistribution
Sun and Hesse 185
CONCLUSION
This chapter uses an event-study approach to assess whether and how stock mar-kets react to SWFs’ announcements and actions of investments and divestments in firms. Based on 166 publicly traceable events collected on investments and divestments by major SWFs over the period 1990–2009, the analysis evaluated the short-term financial impact of SWFs on selected public equity markets in which they invested. The impact was further analyzed for different sectors (finan-cial and nonfinancial), actions (buy and sell), market types (developed and emerg-ing), and level of corporate governance of the SWF (high and low). Overall, this event study did not find any significant destabilizing effect of SWFs on equity markets, which is consistent with the emerging academic literature that uses the event-study methodology.
However, any assessment of the longer-term impact and the potentially sta-bilizing role of SWFs as major institutional investors will require a broader set of data and a more rigorous empirical assessment. In addition, the long-run impact of SWFs’ investments could be influenced by macroeconomic and financial conditions. SWFs’ recent investments in some U.S. and European financial institutions could not buffer those institutions from further large losses. Therefore, it will be hard to draw conclusions for overall global and regional financial stability, or stability in markets other than equity markets, from these event studies. Other methods to examine the empirical impact of SWFs would require more detailed knowledge of SWFs’ investments and their timing and amount—data that is presently not available. Hypothetical market responses to SWFs’ investments require a thorough understanding of the way in which asset allocations are constructed and the size, depth, and breadth of the corresponding markets.
REFERENCES
Armitage, Seth, 1995, “Event Study Methods and Evidence on Their Performance,” Journal of Economic Surveys, Vol. 9, No. 1, pp. 25–52.
Beck, Roland, and Michael Fidora, 2008, “The Impact of Sovereign Wealth Funds on Global Financial Markets,” ECB Occasional Paper 91 (Frankfurt: European Central Bank).
Chhaochharia, Vidhi, and Luc Laeven, 2008, “Sovereign Wealth Funds: Their Investment Strategies and Performance,” CEPR Discussion Paper No. 6959 (London: Center for Economic Policy Research).
Fotak, Veljko, Bernardo Bortolotti, and William Megginson, 2008, “The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies” (unpublished; Norman, Oklahoma: University of Oklahoma).
Hammer, Cornelia, Peter Kunzel, and Iva Petrova, 2008, “Sovereign Wealth Funds: Current Institutional and Operational Practices,” IMF Working Paper WP/08/254 (Washington: International Monetary Fund).
Hoguet, George R., 2008, “The Potential Impact of Sovereign Wealth Funds on Global Asset Prices,” Vision, Vol. 3, No. 2, pp. 23–30.
International Financial Services, London, 2010, “Sovereign Wealth Funds 2010.” IFSL Research. Available via the Internet: http://www.ifsl.org.uk/output/ReportItem.aspx?NewsID=20.
©International Monetary Fund. Not for Redistribution
186 Sovereign Wealth Funds and Financial Stability: An Event-Study Analysis
International Monetary Fund, 2008, “Box 1.2. Do Sovereign Wealth Funds Have a Volatility-Absorbing Market Impact?” in Global Financial Stability Report (Washington, April).
Kotter, Jason, and Ugur Lel, 2008, “Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the Price of Keeping Secrets,” International Finance Discussion Papers No. 940 (Washington: Board of Governors of the Federal Reserve System).
Kozack, Julie, Doug Laxton, and Krishna Srinivasan, 2010, “The Macroeconomic Impact of Sovereign Wealth Funds,” Chapter 14 in this volume.
Lam, Raphael W., and Marco Rossi, 2010, “Sovereign Wealth Funds—Investment Strategies and Financial Stress,” Journal of Derivatives and Hedge Funds, Vol. 15, pp. 304–22.
Miles, David, and Stephen Jen, 2007, “Sovereign Wealth Funds and Bond and Equity Prices,” Morgan Stanley Research, June 1.
Peterson, Pamela Drake, 1989, "Event Studies: A Review of Issues and Methodology," Quarterly Journal of Business and Economics, Vol. 28 (Summer), pp. 36–66.
Truman, Edwin M., 2008, “A Blueprint for Sovereign Wealth Fund Best Practices,” Peterson Institute Policy Brief Number PB08-3 (Washington: Peterson Institute).
©International Monetary Fund. Not for Redistribution
187
CHAPTER 14
The Macroeconomic Impact of Sovereign Wealth Funds
JULIE KOZACK, DOUG LAXTON, AND KRISHNA SRINIVASAN1
Sovereign wealth funds (SWFs) have come to play an increasingly large role in the global financial landscape. Their rise reflects, in part, the buildup of global cur-rent account imbalances in the run-up to the 2007–09 global financial crisis. In particular, large current account surpluses in several Asian and oil-exporting countries—reflecting their savings-investment imbalances and the sharp increase in oil prices between 2000 and mid-2008—translated into a rapid accumulation of foreign reserves by central banks (Figure 14.1). Coinciding with this accumula-tion of reserves was a reduction in these countries’ public debt, making them significant net creditors to the rest of the world. The combination of higher levels of international reserves and lower public debt, and often lower external debt as well, led to substantial improvements in the standard reserves adequacy measures for several of these countries.
1The authors are grateful to Chanpheng Dara, Ashwin Goyal, and Susana Mursula for excellent research assistance. The authors are also grateful for comments and suggestions from participants at the Conference on Sovereign Wealth Funds in an Evolving Global Financial System, hosted by the Centre for Applied Macroeconomic Analysis and the Lowy Institute for International Policy, Sydney, September 2008, as well as for useful discussions with Simon Johnson, Udaibir S. Das, Adnan Mazarei, Alison Stuart, and David Hofman.
0
1,000
2,000
3,000
4,000
5,000
6,000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
U.S
. dol
lars
(bill
ion)
Source: IMF, 2009.
Figure 14.1 Emerging-Economy Reserves
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188 The Macroeconomic Impact of Sovereign Wealth Funds
Reserves accumulation reached a point that led many countries to believe they had sufficient cushions against financial or economic shocks. Notwithstanding enormous development needs, limited absorptive capacity meant that quickly spending much of the oil or export windfall was neither appropriate nor feasible. Moreover, policymakers in these countries were increasingly of the view that an important way to transfer wealth across generations would be to turn “resources in the ground” into financial assets. As a result, many countries sought to enhance the return on these large pools of funds. Instead of continuing to invest conser-vatively through sustained reserves accumulation with resources largely held in government securities, assets were transferred to SWFs with broader investment mandates, resulting in the sharp increase since 2000 in the number of SWFs and in the assets under their management (Figure 14.2).
Like most other financial institutions, SWFs were affected adversely by the global financial crisis. Before the crisis, given their size and projected growth, SWFs were seen to be well placed to play a more prominent role in global finance. In the context of low interest rates, market participants were of the view that SWFs were poised to move up the risk frontier in their quest for yield, including the increase of their exposure to emerging economies. The crisis, however, is believed to have had a sobering influence on SWFs’ investment behavior and focus; many SWF portfolios suffered large losses, and with home economies fac-ing recession, their focus turned, at least temporarily, to domestic matters. Nonetheless, SWF assets are still sizable. Their estimated assets under manage-ment ranged from US$1.8 trillion to US$2.4 trillion at end-2008—down from a range of US$2 trillion to US$3 trillion at end-2007.2
2 For the purposes of this chapter, SWFs include the 23 IMF member countries with SWFs that constituted the International Working Group of Sovereign Wealth Funds (IWG); the three countries
Source: Market reports.Note: Assets under management are the assets currently managed by the SWFsestablished in each time period.
0
5
10
15
20
25
30
1970–79 1980–89 1990–99 since 20001960–691950–590
200
400
600
800
1,000
1,200
1,400
Ass
ets
unde
r m
anag
emen
t (U
S$ b
illio
n)
Num
ber
of S
WFs
est
ablis
hed
Number of SWFs(le� scale)
Current assets under management(right scale)
Figure 14.2 SWF Formation
©International Monetary Fund. Not for Redistribution
Kozack, Laxton, and Srinivasan 189
This chapter discusses the growing role of SWFs and their potential effects on global financial markets. Thus far, SWFs have not been a destabilizing force in the global financial system. To the contrary, they made significant investments in global financial institutions in the early stages of the crisis, although these actions were overtaken by events as the crisis intensified in late 2008. Nonetheless, even benign shifts in the risk appetites and investment behaviors of SWFs, including changes in the currency composition of their assets, could have an impact on global capital flows and asset prices. This chapter analyzes the possible impact of shifts in SWF portfolios or strategic asset allocations on global capital flows and asset prices. Using illustrative scenario analysis and model-based simulations, the investigation gauges the effect of relatively modest shifts in SWF behavior on capital flows, major currencies, and global interest rates, as well as on key macro-economic variables such as consumption and investment.
The first section of this chapter presents estimates of the potential growth of SWF assets. The second section discusses the impact of the global financial crisis on SWF assets and investment behavior. The third section explores the implica-tions of the growing presence of SWFs for global capital flows and asset prices, and is followed by a concluding section.
CURRENT AND FUTURE SIZE OF SWFS
Although SWFs have been around for decades, few attempts have been made, until recently, to estimate the size of their assets under management. This chapter estimates these assets using data provided by SWFs through their regular report-ing and, where such data are not available, approximations by market participants. Taken together, these various sources suggest that SWF assets under management currently total US$1.8 trillion to US$2.4 trillion (Table 14.1). Assets under man-agement are highly concentrated among the five largest SWFs, which account for about two-thirds of estimated total assets. Looking across regions, nearly 40 per-cent of SWFs are located in the Middle East and North Africa, with another 25 percent in non-Japan Asia and about 20 percent in industrial economies. The remaining 15 percent are concentrated in the Commonwealth of Independent States (CIS), with a small share in Latin America (Figure 14.3). Commodity exporters account for roughly three-fourths of estimated assets under manage-ment (Figure 14.4).
SWFs have the potential to grow rapidly over the next decade, although the crisis has clearly affected key revenue sources through reduced capital inflows and lower commodity prices. Based on projections of the size of external surpluses in SWF
that were permanent observers to the IWG; plus Brunei Darussalam, Kazakhstan, Malaysia, and Oman. IWG member countries were Australia, Azerbaijan, Bahrain, Botswana, Canada, Chile, China, Equatorial Guinea, the Islamic Republic of Iran, Ireland, the Republic of Korea, Kuwait, Libya, Mexico, New Zealand, Norway, Qatar, the Russian Federation, Singapore, Timor-Leste, Trinidad and Tobago, the United Arab Emirates, and the United States. Permanent observers of the IWG were Oman, Saudi Arabia, Vietnam, the Organisation for Economic Co-operation and Development, and the World Bank.
©International Monetary Fund. Not for Redistribution
190 The Macroeconomic Impact of Sovereign Wealth Funds
TABLE 14.1
Estimated SWF Assets Under Management, End-20081
Country Name of fund
Date
established
Assets (range)
Lower Upper
(US$ billions)
Oil and gas exporting countries
UAE (Abu Dhabi) Abu Dhabi Investment Authority 1976 250 627Norway Government Pension Fund–Global2 1990 330 330Kuwait Kuwait Investment Authority 1953 228 228Russian Federation Reserve Fund3 2008 137 137Russian Federation National Wealth Fund3 2008 88 88Qatar Qatar Investment Authority 2005 60 70Libya Libyan Investment Authority 2006 65 65United States Alaska Permanent Reserve Fund 1976 30 30Brunei Darussalam Brunei Investment Authority 1983 30 35Kazakhstan National Fund 2000 27 27Canada Alberta Heritage Savings Trust Fund 1976 12 12Oman State General Reserve Fund 1980 8 8Bahrain Reserve Fund for Strategic Projects 2006 1 1Mexico Oil Income Stabilization 2000 6 6Azerbaijan State Oil Fund 1999 11 11Timor-Leste Petroleum Fund 2005 4 4Trinidad and Tobago Heritage and Stabilization Fund 2007 3 3
Other commodity exporters
Chile Economic and Social Stabilization Fund 2006 2 20Chile Pension Reserve Fund 2006 3 3Botswana Pula Fund 1993 7 7
Asian manufacturing exporters
Singapore Government Investment Corporation 1981 70 300Singapore Temasek 1974 84 84China China Investment Corporation 2007 190 190Korea, Rep. of Korea Investment Corporation 2005 25 25Malaysia Khazanah Nasional BHD 1993 16 16
Pension reserve funds
Australia Future Fund 2006 42 42Ireland National Pensions Reserve Fund 2001 23 23New Zealand Superannuation Fund 2001 7 7
Total 1,800 2,400
Sources: Annual or quarterly reports of SWFs; SWF Web sites; analyst reports; media reports.1Does not include reserve assets. Does not include estimates for the Islamic Republic of Iran or Equatorial Guinea.2Formerly know as the Petroleum Fund. 3The Reserve Fund and National Wealth Fund were funded initially with transfers from the Stabilization Fund of the Russian
Federation, after which the Stabilization Fund ceased to exist.
©International Monetary Fund. Not for Redistribution
Kozack, Laxton, and Srinivasan 191
countries—along with assumptions about annual returns and the share of the external
surplus allocated to the SWF (rather than continued reserves accumulation)—a range
of estimates for the future size of SWFs is calculated (Figure 14.5).3
• Based on these calculations, SWFs could grow to between US$4 trillion and
US$6 trillion by 2014. This is about a third lower than previous estimates,
given revised projections of the size of external surpluses in these countries.4
3The range is based on projections of foreign currency inflows over 2009–14, calculated as the sum of each
country’s current account balance and net private capital flows less reserve accumulation, drawn from the
IMF’s April 2009 World Economic Outlook. It is assumed that all new flows into SWFs are invested abroad,
earning the London Interbank Offered Rate (LIBOR) rate of interest (lower bound of range) or LIBOR +
200 basis points (upper bound of range). For countries with relatively new SWFs (i.e., those established
after 2003), new flows are calculated as the sum of the current account balance and net private capital flows.
From the sample, these countries include Bahrain, Chile, China, the Republic of Korea, Libya, Qatar, the
Russian Federation, Timor-Leste, and Trinidad and Tobago. For these countries, it is assumed that 50–100
percent of new resources flow to their SWFs, with the 50 percent assumption forming the lower bound of
the range estimates and the 100 percent assumption forming the upper bound. For China, prospective
foreign exchange inflows are assumed to be equal to the sum of the current account balance and net private
capital flows less half of the current projected reserve accumulation.4See IMF (2008b), which projected that SWF assets under management could reach US$6 trillion to
US$10 trillion by 2013.
Source: Authors’ calculations.
75%Commodity
25%Noncommodity
Figure 14.4 SWFs by Type (Percent Share of Assets under Management)
25% Emerging Asia
2% La�n America
38% Middle East and North Africa
CIS 13%
22%Industrialeconomics
Source: Authors’ calculations.
Figure 14.3 SWFs by Region (Percent Share)
©International Monetary Fund. Not for Redistribution
192 The Macroeconomic Impact of Sovereign Wealth Funds
• Funds of commodity exporters could grow by 75 percent, to reach US$2.75
trillion to US$3 trillion, while other funds could increase by between four and
five times to US$1.5 trillion to US$3 trillion, led by China and Singapore.
• Geographically, SWFs located in East Asia—led by China—could grow
tremendously, although the ultimate outcome depends on the share of for-
eign currency inflows allocated to SWFs instead of reserves. In the Middle
East and industrial economies, SWFs are projected to grow to nearly twice
their current size, while those in the CIS and Latin America would remain
roughly flat over time because the sharp deterioration in current account
balances would reduce amounts available to SWFs.
HOW HAVE SWFS COPED WITH THE 200709 GLOBAL FINANCIAL CRISIS?Against the backdrop of ample global liquidity and low interest rates in the run-up
to the financial crisis, SWFs had moved up the risk spectrum in search of yield. This
increased appetite for risk was increasingly reflected in a rebalancing of their portfo-
lios by geography, asset class, and leverage. Geographically, SWFs gradually had
begun to shift assets away from investments in industrial economies and toward
those in emerging economies. With respect to asset class, SWFs increased their expo-
sure to equities and alternative investments, including real estate and private equity,
and, in some instances, used leverage (either directly or indirectly) to amplify returns.
The limited data available on SWF investments provide evidence of these
shifts. For instance, Temasek’s investments in industrial economies had declined,
albeit modestly, from nearly 85 percent of total assets under management in 2006
to less than 80 percent in 2008, matched by greater exposure to emerging econo-
mies, notably in South Asia. Similarly, Norway’s Government Pension Fund–
Global decided in 2007 to increase investments in equities, while reducing
Figure 14.5 SWF Projections by Region, 2014
0
500
1,000
1,500
2,000
2,500
3,000
3,500
U.S
. dol
lars
(bill
ion)
Source: Authors’ calculations.Note: The black bars in panel b illustrate the upper and lower bounds of the projected range.
a. Percent share b. Assets under management
28%
Non-JapanAsia
MiddleEastandNorthAfrica
Industrialeconomies
La�nAmerica
CIS
20%Industrialeconomics
Middle Eastand North Africa
CIS 6% 1% La�n America
45%Non-JapanAsia
©International Monetary Fund. Not for Redistribution
Kozack, Laxton, and Srinivasan 193
exposure to fixed-income assets. As a result, investments in equities increased from 40 percent in 2007 to 52 percent in the first quarter of 2009, matched by offsetting changes in exposure to fixed-income assets.
The investment behavior of SWFs in the context of the crisis can be viewed as reflecting a combination of opportunism and sensitivity to international and domes-tic political economy considerations. In the initial phase of the crisis, extending from the summer of 2007 through the spring of 2008, SWFs played an important role in efforts aimed at alleviating financial market strains. Their actions included capital injections into major industrial-economy financial institutions—these investments were large, privately negotiated rather than executed in public markets, and often in the form of bonds that were to be converted to equity stakes in the future. In mak-ing these investments, SWFs were attracted by below-average valuations of equities in crisis-hit financial markets that provided them with a window of opportunity to increase their exposure to the global financial sector. At the same time, however, one could speculate that—against the background of simmering discontent with the growing role of SWFs—these investments may have also been motivated by political economy considerations, given that they were seen as having a stabilizing influence on industrial-country financial markets. Regardless of the reason, SWFs invested about US$80 billion in U.S. and Western European banks over this period; invest-ments in the financial sector of the industrial economies accounted for about 50 percent of SWFs’ total investments in 2008 (IMF, 2008a).
As the crisis deepened during the first half of 2008, SWFs were soon subject to large losses on those investments in major financial institutions. At the same time, prospects in emerging economies appeared more promising, with some observers arguing that these economies may have decoupled from the industrial economies. In light of the differentiation in economic prospects, investments by SWFs from the spring of 2008 through the intensification of the crisis in the fall were, in large part, targeted at emerging economies. In particular, while invest-ment in Organisation for Economic Co-operation and Development (OECD) countries declined sharply, from an estimated US$37 billion in the first quarter of 2008 to about US$17 billion in the next two quarters combined, investment in emerging economies increased by about US$23 billion, and accounted for more than 50 percent of the U.S.-dollar value of transactions over this period (Monitor Group, 2008). Moreover, there was also greater differentiation in SWF investments within the group of emerging economies, possibly reflecting their differing growth prospects. In particular, emerging economies in the Asia Pacific, Middle East, and North Africa regions accounted for 65 percent of the publicly reported transactions undertaken by SWFs in the third quarter of 2008, repre-senting nearly 50 percent of the U.S.-dollar value of those transactions.
The dramatic intensification of the crisis after the collapse of Lehman Brothers in September 2008, and the abrupt slowing of economic activity in emerging economies, led to yet another shift in the focus of SWF investments. From large investments in major financial institutions in industrial economies in the early phases of the crisis to a greater focus on emerging economies, the fallout of the Lehman collapse on global trade and commodity prices led SWFs to focus greater
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194 The Macroeconomic Impact of Sovereign Wealth Funds
attention on their home economies. In particular, many SWFs made large invest-ments in their domestic financial sectors as they came under strain. For instance, the Qatar Investment Authority purchased 5 percent stakes in the Commercial Bank of Qatar, Al Ahli Bank, and Qatar International Islamic Bank as part of efforts to strengthen the banking system in the wake of the global financial crisis. Similar investments in their domestic financial sectors were also made by other SWFs, including the Kuwait Investment Authority, the China Investment Corporation, and the Abu Dhabi Investment Authority. Moreover, SWFs in countries hit hard by the crisis—such as Kazakhstan and the Russian Federation—are facing significant drawdowns as their “rainy day” resources are being used to finance fiscal stimulus.
With clear signs in late 2009 that the global economy is now emerging from the most severe recession since the Great Depression, and with financial condi-tions gradually improving, SWFs appear to have regained their appetite for expo-sure to the industrial economies.
Although the growth rebound is most widespread in emerging Asia, there are also indications that activity is starting to turn around in the United States and Western Europe. Although total SWF investments in the first quarter of 2009 were at their lowest point since 2005, the share of investment in OECD countries appears to have rebounded during that quarter (to about 65 percent) from its precipitous decline the previous year. More specifically, investments in these countries amounted to 94 percent of total SWF investments in the first quarter of 2008—largely reflecting investments in major industrial-economy financial institutions—before plummeting to 27 percent of total SWF investments by the fourth quarter of 2008 (Table 14.2).
IMPLICATIONS FOR GLOBAL CAPITAL FLOWS AND ASSET PRICES
Against this background, a critical issue concerns the impact of SWF investment decisions on the pattern of global capital flows and asset prices. SWFs typically have medium- to long-term investment horizons, suggesting that they are less likely to make abrupt portfolio shifts that could affect market stability. Indeed, as noted above, SWFs were a source of initial capital injections into systemically important financial institutions, suggesting that they can play a stabilizing role in global financial markets. Nonetheless, even a gradual shift toward greater portfo-lio diversification of reserve assets by sovereigns, including through SWFs, could
TABLE 14.2
Gross Value of SWF Transactions (US$ billion) 2008
Indicator 2007 2008 Q1 Q2 Q3 Q4 2009:Q1
Total 101.7 127.7 67.8 9.5 15.3 35.1 6.8OECD 60.0 86.8 63.7 4.9 8.7 9.5 4.4Emerging economies 41.7 40.9 4.1 4.6 6.6 25.6 2.4
Source: Monitor Group.
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Kozack, Laxton, and Srinivasan 195
have implications for the flow of funds between countries and for the absolute and relative prices of assets.
From a global macroeconomic perspective, three factors point to the possibil-ity of a more subdued outlook for net capital flows to the United States in the coming years as investors seek to diversify their portfolios.
• A shift in risk appetite for U.S. assets. The global financial crisis has been associ-ated with a safe-haven dynamic, which has dramatically increased demand for U.S.-dollar assets, particularly government securities. As this dynamic fades, investors may view U.S. assets as riskier—particularly given the sharp losses on credit and equity instruments since the crisis erupted. Investors may also come to view government debt as increasingly risky, given the very large issu-ance already in the pipeline to finance the fiscal expansion and the longer-term fiscal pressures associated with entitlements. Both of these factors could lead to an increase in the country risk premium on U.S. assets.
• Lower world demand for U.S. assets. Independent of risk-return consider-ations for global portfolios, global demand for U.S. assets could contract sharply if national savings in U.S. creditor countries, such as China, fall as a result of global rebalancing triggered by an increase in private-sector demand. This could reduce capital inflows into the United States.
• Global diversification of foreign exchange reserves. Global demand for U.S. dollars relative to other currencies, which had already begun to ease in recent years, may decline further over the long term, as investors seek to diversify the currency exposure of their portfolios. This could put downward pressure on the U.S. dollar.
Taken together, these shifts in investor sentiment and behavior could have an impact on the U.S. dollar and U.S. interest rates, as well as on capital inflows to other countries, particularly emerging economies.
• Effect on the U.S. dollar. A shift into riskier assets by SWFs could lead to less demand for U.S.-dollar assets. At the same time, however, it could simply lead to a shift in the composition of dollar assets—away from U.S. government securities and into equities or alternatives, with minimal effect on the dollar.
• Effect on U.S. interest rates. A shift from a conservative line of investing to one of greater risk-taking could lead to an increase in U.S. interest rates, as demand for U.S. government securities declines.
• Effect on emerging economies. The rising presence of SWFs in global capital markets could be favorable to emerging-economy and high-yield corporate assets. As SWFs look to diversify their holdings and seek higher returns, capi-tal could flow into riskier asset classes, including those of emerging economies.
Stylized Portfolio Analysis
This section estimates the potential impact of a diversification of sovereign reserves through SWFs on global capital flows using scenario analysis. In the
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196 The Macroeconomic Impact of Sovereign Wealth Funds
scenario, SWFs diversify their assets across two spectra: asset class and geography. First, SWFs could diversify away from low-risk, low-return assets, such as govern-ment securities, into equities and other higher-risk instruments, such as private equity and real estate. Second, SWFs could also focus more on emerging econo-mies, with attendant implications for capital flows to industrial economies, par-ticularly the United States. This geographic shift may be increasingly likely if the significant deterioration in the fiscal positions of many industrial economies gives rise to longer-term sustainability concerns, thereby shifting perceptions of risk-return trade-offs.
Any such estimation exercise is challenging because of the lack of reliable information for several large SWFs, especially information about their asset allo-cations. To examine the possible implications of the growing presence of SWFs, illustrative scenarios of asset allocations were constructed for countries that are in the process of shifting away from holding reserves to holding more diversified assets through SWFs.
• Two stylized, diversified portfolios—one replicating Norway’s Government Pension Fund–Global and the second representing a more diversified SWF—were calibrated and compared with a stylized portfolio of foreign exchange reserve assets (Figure 14.6), with a view to assessing likely changes in the pattern of global capital flows and the impact on asset prices.5
• To complement this scenario analysis, the exercise also estimates the impact of a modest shift away from U.S.-dollar assets in the current stock of reserves for the 10 largest emerging-economy reserves holders. Such a shift is within the realm of possibility, especially given recent statements by officials from some emerging economies raising concerns about the dollar’s future as a reserve currency (Financial Times, 2009). The analysis assumes that coun-tries that have either recently established SWFs or announced their inten-tion to establish one will channel a portion of their prospective foreign exchange inflows to their respective SWFs. Countries that have established SWFs over the past half decade or so include Bahrain, Chile, China, the Republic of Korea, Libya, Qatar, the Russian Federation, Timor-Leste, and Trinidad and Tobago.
• The prospective foreign exchange flows are calculated as the sum of each country’s current account balance and net private capital flows, based on World Economic Outlook projections for 2009–14 (IMF, 2009).6 The analy-sis provides for a lower bound, which assumes that countries that have
5 The stylized portfolio of a diversified SWF is based on market reports concerning asset allocation and currency composition. The Norway-like portfolio is based on publicly available data from Norges Bank Investment Management (which manages the Government Pension Fund–Global) as of end-December 2008. The reserves portfolio is based on the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) database, which records end-of-period quarterly data. Aggregate COFER data are used to derive a stylized reserves portfolio, assuming that assets are allocated exclu-sively to government bonds according to the COFER currency composition.6 For China, prospective foreign exchange inflows are assumed to be equal to the sum of the current account balance and net private capital flows less half of the current projected reserve accumulation.
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Kozack, Laxton, and Srinivasan 197
recently established SWFs will transfer 50 percent of newly available foreign
currency inflows to their SWFs, and an upper bound, which assumes that
in addition, countries that are contemplating setting up SWFs transfer 100
percent of newly available foreign currency inflows to their SWFs. The
upper bound also assumes that 15 percent of the stock of the existing
reserves of the top 10 emerging-market reserves holders is shifted from
reserves to SWF holdings over the period 2009–14. All new flows into
SWFs are assumed to be invested abroad.
As in many illustrative exercises, the results are highly sensitive to the underly-
ing assumptions. For instance, by focusing largely on new sovereign investments,
the exercise provides only a partial picture of the possible magnitude of the
impact on capital flows and asset prices arising from the diversification strategy.
Moreover, other sovereigns (and not just the top 10 emerging-market reserves
holders, as assumed in the exercise) may choose to diversify their existing reserve
assets. Nevertheless, this limited exercise provides a sense of the direction and
magnitude of the possible impact on markets.
The analysis suggests that the pattern of global capital flows could change
significantly, with the United States facing lower capital inflows and emerging
b. Norway-like stylized por�olio
32%
36%
12%
7%
13%
a. Foreign exchange reserve assets
60%
31%
5% 2% 2%
U.S. dollarEuroPound sterlingYenOther, including emerging economies
c. Diversified SWF por�olio
38%
14%14%
10%
24%
Source: Authors’ calculations, based on COFER data.
Figure 14.6 Currency Composition of Stylized Portfolios
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198 The Macroeconomic Impact of Sovereign Wealth Funds
economies attracting substantially larger inflows (Figure 14.7). Relative to reserve assets, which are predominantly dollar-denominated and generally held in the form of U.S. treasury or agency securities, the stylized SWF portfolios are more diversified across both asset classes and currency exposures. This suggests lower inflows into government bond markets, with attendant implications for interest rates. The shift away from reserve assets could have the most significant effect on markets in the United States, if countries diversify away from U.S.-dollar holdings.
Estimates in this analysis show that inflows into the United States could decline by 0.5–0.75 percent of U.S. GDP per year on average, depending on the number of countries in the sample and the assumption made about the currency composition of reserves for the 10 largest emerging-economy reserves holders. The results also hinge on the asset allocation strategy used to model investments by the prospective SWFs. Portfolios more weighted to emerging economies—such as the stylized diversified portfolio—would result in lower flows into both U.S.-dollar and euro assets, while flows to emerging economies would tend to increase substantially. However, the adverse effect on demand for euro assets fades as large emerging-economy reserves holders shift out of U.S.-dollar assets and into euros and other currencies. By contrast, a portfolio similar to Norway’s SWF, which is heavily weighted to investments in Europe, would suggest a somewhat lower investment in U.S.-dollar assets even before the reserves shift is taken into account and a less sizable, but still positive, inflow to emerging markets.
Model Simulations
To quantify the implications of potential changes in the pattern of capital flows on interest rates and exchange rates, simulations were undertaken using an annual version of the Global Integrated Monetary Fiscal Model (GIMF).7 The
7 GIMF is a multicountry, dynamic stochastic general equilibrium model designed for studying mac-roeconomic policy issues that emphasize stock-flow consistency. The model is based on an overlapping generation setup, which produces a well-defined steady state in which countries can be either net creditors or debtors, depending on their savings behavior (Kumhof and Laxton, 2007). The simula-tions are based on an extended version of the GIMF model that includes separate models for the United States, the euro area, Japan, emerging Asia, and “remaining countries.” For the code used to produce these simulations, see www.douglaslaxton.org.
-150-125-100-75-50-25
0255075
100125150
2009 2010 2011 2012 2013 2014 2009 2010 2011 2012 2013 2014
U.S. dollar
a. Norway-like por�olio
Source: Authors’ calculations.
b. Diversified SWF por�olio
EuroPound sterlingYenOther, including emerging economies
U.S
. dol
lars
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ion)
-150-125-100-75-50-25
0255075
100125150
U.S. dollarEuroPound sterlingYenOther, including emerging economies
U.S
. dol
lars
(bill
ion)
Figure 14.7 Change in Pattern of Capital Flows, by Currency
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Kozack, Laxton, and Srinivasan 199
change in the pattern of capital flows is modeled as a shock to portfolio prefer-ences, as investors shift out of U.S. assets in favor of more diversified portfolios. Within the mechanics of GIMF, the shock is modeled as an increase in the country risk premium on U.S. assets (reflecting lower demand for U.S. assets). Figure 14.8 presents three variants based on different magnitudes of the shock—low, moderate, and high. The low case assumes a 50-basis-point permanent increase in the U.S. country risk premium and is associated with the lower bound of the change in the pattern of capital flows. The high case assumes a shock that is 150 basis points, representing a more extreme shift in portfolio preferences than those presented in the previous section. The text below focuses on the moderate variant, which assumes a 100-basis-point shock and is associ-ated with the upper bound of the change in the pattern of capital flows com-puted in the previous section.
The model results point to significant, but manageable, effects on exchange rates, current account balances, and trade balances in three economic regions—the United States, the euro area, and emerging Asia (Figure 14.8 ).8 All results are shown as deviations from a baseline.
• The increase in the U.S. country risk premium would induce a temporary depreciation of the U.S. dollar in real effective terms and an improvement in the current account balance. The U.S. dollar would immediately depreci-ate by about 7 percent in real effective terms. This would induce an improvement in the current account balance in the United States of about 0.5 percentage points of GDP in the first year (panel a of Figure 14.8). Intuitively, in the short run, the U.S. real effective exchange rate must depreciate to generate an improvement in the trade balance consistent with savings behavior and capital flows. Over time, the depreciation in the real effective exchange rate would result in a further improvement in the current account balance, which would eventually stabilize at a value that is 0.75 percent higher than in the baseline (panel a of Figure 14.8). However, this longer-term improvement in the U.S. current account would result in a significant improvement in the net foreign asset position, reducing U.S. interest obligations to the rest of the world. To equilibrate this process, the real exchange rate must therefore appreciate in the long run (relative to the baseline) to generate a decline in the trade balance (panels c and f of Figure 14.8). Essentially, the composition of the current account changes over time—the initial improvement would arise from an improvement in the trade balance, while the long-run improvement would arise from lower interest payments as the stock of net foreign assets increases (or becomes less negative).
• The shock to the U.S. country risk premium would induce a temporary real effective appreciation of the euro and emerging Asian currencies (panel c of Figure 14.8). The euro would appreciate in real effective terms, initially by
8 The results focus on emerging Asia rather than emerging economies as a group because of the model’s structure, which does not (at this time) contain a separate block for emerging economies as a group or by regions outside of Asia.
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0
The
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RunYears1 2 3 4 5 6 7 8 9 10 Long
RunYears1 2 3 4 5 6 7 8 9 10 Long
RunYears1 2 3 4 5 6 7 8 9 10 Long
Figure 14.8 Model Simulations, Deviations from Baseline (continued)
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K
ozack, Laxto
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1
United States
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RunYears1 2 3 4 5 6 7 8 9 10 Long
Figure 14.8 (cont.) (continued)
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2
The
Macro
eco
no
mic Im
pact o
f Sove
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e. Investment
f. Trade balance
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RunYears1 2 3 4 5 6 7 8 9 10 LongRunYears
1 2 3 4 5 6 7 8 9 10 Long
RunYears1 2 3 4 5 6 7 8 9 10 Long
Figure 14.8 (cont.)
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Kozack, Laxton, and Srinivasan 203
about 3 percent and by smaller amounts over time. In emerging Asia, the dynamics are more rapid, given the region’s openness to trade. Currencies initially appreciate by 0.5 percent in real effective terms, but relatively quickly begin to depreciate. In the long run, current account balances dete-riorate by less in the euro area and in emerging Asia—by about 0.5 and 0.25 percent, respectively, than in the United States. As in the United States, the composition of the current account balance would change over time, reflect-ing the impact of the real exchange rate path on the trade balance and the associated change in the net foreign asset position. Thus, over time, the exchange rate must depreciate in real effective terms to induce an improve-ment in the trade balance to offset the decline in interest earnings on net foreign assets. In these simulations, the real exchange rate has to adjust by more in the euro area than in emerging Asia because the latter (as a region) is more open.
According to the model results, real interest rate differentials between the euro area and emerging Asia versus the United States would fall (panel b of Figure 14.8). When real effective exchange rates stabilize at their long-run values, a per-manent increase in the country risk premium of 100 basis points would also be reflected in a 100-basis-point decline in real interest rate differentials between the rest of the world (in this case, the euro area and emerging Asia) and the United States. However, over the transition path, during which the real exchange rate is still adjusting to generate a path for the trade balance that is consistent with port-folio preferences, real interest rate differentials in the rest of the world (relative to the United States) would decline by less than 100 basis points.9 Higher interest rates in the United States and lower interest rates in the rest of the world would shift production to the rest of the world. As a result, investment would decline in the United States and rise in the euro area and emerging Asia (panel e). This would lead to lower levels of permanent income and consumption in the United States, and higher levels elsewhere (panel d).
While these simulations provide important analytical support to the qualita-tive assessment made earlier in the chapter, it is important to note that they deliberately abstract from a number of real-world issues. First, they assume that nominal exchange rates are flexible and adjust instantaneously to be consistent with risk-adjusted asset returns and fundamentals. Second, the model assumes that there is only one type of bond traded internationally and that it is denomi-nated in U.S. dollars. Third, valuation effects that would be associated with a sudden decline in the value of the U.S. dollar are not taken into account. Including valuation effects in the analysis would require extending the model to include different types of asset classes. For example, modeling emerging Asia as a net-creditor country would tend to weaken its consumption responses because a
9 The model has an overlapping generation structure, which allows it to have a well-defined steady state in which countries or economic regions can be either net creditors or debtors. This feature is critical because it is possible to consider permanent shocks to study the transition from one steady state to another.
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204 The Macroeconomic Impact of Sovereign Wealth Funds
depreciation in the U.S. dollar would result in a negative valuation effect on emerging Asia’s stock of financial assets denominated in U.S. dollars.
CONCLUSION
Although the global financial crisis has generally taken SWFs out of the headlines, they are still key players in global finance. Given their size and scope, their actions plausibly would have implications for global capital flows and asset prices. Even a gradual shift toward greater portfolio diversification of foreign assets by sover-eigns, including through SWFs, could have implications for the flow of funds between countries and the absolute and relative prices of assets.
Using illustrative scenario analysis combined with model-based simulations, this chapter attempts to further the understanding of the implications of portfo-lio-allocation decisions of SWFs on global capital flows and asset prices. The analysis suggests that the pattern of global capital flows could change significantly if countries shift away from U.S.-dollar assets, including through more diversified SWF portfolios. In the scenario analysis, industrial economies would face lower capital inflows and emerging economies would attract substantially larger inflows. The results of the model-based simulations show that such a change in the pattern of global capital flows would lead to higher U.S. interest rates (lower interest rates elsewhere) and a depreciation of the U.S. dollar (an appreciation of other curren-cies). These findings are consistent with the economic intuition prevailing before the crisis and may yet come to pass as the global economy gradually recovers and risk appetite returns.
REFERENCES
Financial Times, 2009, “China Urges Switch from Dollar as Reserve Currency,” March 24.International Monetary Fund, 2008a, “Box 1.2. Do Sovereign Wealth Funds Have a Volatility-
Absorbing Market Impact?” in Global Financial Stability Report (Washington, April).———, 2008b, “Sovereign Wealth Funds—a Work Agenda” (Washington).———, 2009, World Economic Outlook (Washington, April).Kumhof, Michael, and Douglas Laxton, 2007, “A Party without a Hangover? On the Effects of
U.S. Fiscal Deficits,” IMF Working Paper 07/202 (Washington: International Monetary Fund). Monitor Group, 2008, Sovereign Wealth Fund Investment Behavior: Analysis of SWF Transactions
During Q2 2008 (Cambridge, Massachusetts: Monitor Group).
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CHAPTER 15
A Market View of the Impact of Sovereign Wealth Funds on Global Financial Markets
JENS NYSTEDT
After having been the center of attention through most of 2007 and the first half of 2008, sovereign wealth funds (SWFs) returned to relative obscurity once the commodity price bubble burst in mid-2008. While many SWFs appreciate being out of the spotlight, they remain relevant and important actors.1 Their impor-tance expanded even though their overall assets under management (AUM) may have shrunk. Any work on SWFs starts by carefully defining them. For example, in their release of the Santiago Principles (voluntary “generally accepted principles and practices that properly reflect SWFs investment practices and objectives”) SWFs defined themselves as
…special purpose investment funds or arrangements, owned by the general government. Created by the general government for macroeconomic purposes, SWFs hold, manage, or administer assets to achieve financial objectives, and employ a set of investment strategies which include investing in foreign finan-cial assets. The SWFs are commonly established out of balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports. (IWG, 2008a, p. 3)
Following this definition, central bank official reserves and public pension funds are not SWFs. From the market perspective, the exact definition is much less important than who controls these actors and their motives. Given their growing role and their participation in both local and international markets, SWFs are closely watched, but generally seen as another type of state-controlled actor investing for not-only-financial gain with a longer than usual investment horizon. A distinction is made in the market between SWFs and central bank reserve managers because SWFs are frequently viewed, especially in noncom-modity countries, as attempting to diversify away from the U.S. dollar and U.S.
1For example, private equity and hedge fund assets under management (AUM) have shrunk more drastically than those of SWFs, adjusting for double counting. Moreover, going forward, liquidity and financing conditions are unlikely to return to precrisis levels, meaning that, on a levered basis, the role of hedge funds in global financial markets has diminished more than the decline in AUM would suggest.
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206 A Market View of the Impact of Sovereign Wealth Funds on Global Financial Markets
fixed-income assets.2 By going down the credit spectrum and widening their investment choices to include less liquid assets, SWFs should generally outper-form their reserve manager cousins, but so far not enough data are available to indicate whether this has been the case.
Lack of data and transparency severely affect any analysis of the impact of SWFs on global capital markets. Data on several SWFs’ high-profile public equity transactions are available, but much less is known outside of large equity transac-tions. Hence, any conclusions about the possible impact of SWF decisions on equity, fixed-income, and foreign exchange (FX) markets are more tentative and are more driven by these funds’ likely asset allocation choices as they mature. Analysis is also limited to largely anecdotal evidence, press reports, and the SWFs’ own efforts to increase transparency into their holdings. As a result, the market implications of SWF investments highlighted in this chapter represent a market view rather than the market view.
This chapter is organized in six sections. The first section discusses whether the size (relative and absolute) of SWFs should be an independent source of worry for authorities and market participants. Next, the chapter looks at the academic lit-erature on the effect of SWFs’ public equity investments on markets and notes that very little information is available regarding SWFs nonequity investments. The third section discusses where SWFs invest geographically and observes that SWFs invest most heavily in their own countries, followed by investments in Organisation for Economic Co-operation and Development (OECD) countries. Investments in non-home emerging markets by emerging-market SWFs are still miniscule. In the subsequent section the macro and market implications of a shift away from official reserves to SWFs are discussed. The discussion maintains that were the shift into SWFs to accelerate, emerging markets and Japan could be the big winners. The fifth section describes how market participants tend to react to the news of new SWF investments in new companies, sectors, or assets. The penultimate section discusses from a market participant’s point of view the impact on asset prices of SWFs’ different degrees of transparency. The chapter finishes with conclusions.
ABSOLUTE AND RELATIVE SIZE OF SWFS IN CONTEXT
Relatively speaking, the current AUM among SWFs are not particularly large or concentrated. Most estimates of the current size of SWFs put them at US$2 trillion
2 In practice, the distinction is more difficult to make. Reserve managers have been known to also invest in equities, private equity funds, and so on. In general, however, to the extent that a country wants its foreign assets to be counted as official reserves, it is limited in how much non-fixed income exposure can be taken (excluding FX deposits and money market fund investments). Another tough distinction is the SWF-like role sometimes played by internationally active state-owned enterprises (SOEs) buying up strategic assets, presumably for political reasons. Such SOE-driven transactions have become much more frequent in the wake of the commodity price bubble and frequently target emerging markets.
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Nystedt 207
to US$3 trillion at the end of 2008.3 At the peak of media and political interest in SWFs in 2007, their total AUM was expected to grow to US$12 trillion by 2015 (Jen and Andreopoulos, 2007). To put this number in perspective, the IMF estimates the market capitalization at the end of 2007 of global stock and fixed-income markets at US$135 trillion. Hence, it is hard to argue that SWFs’ total size is currently too big for the market. For example, the OECD estimates that at the end of 2008, U.S. insurance companies and pension funds managed about US$14 trillion and U.S. mutual funds about US$10 trillion. This is, of course, the common argument for why the current size of SWFs is not a particu-larly significant concern. However, just as interesting could be their flow, that is, during periods of high commodity prices SWFs may be a much larger part of the new investable flows into various asset classes. This idea is returned to later in the chapter.
Even as individual asset managers, the size of SWFs is not particularly unusual. The Abu Dhabi Investment Authority (ADIA) is often named as the largest SWF, and is alleged to manage assets of about US$875 billion (Bortolotti and others, 2008),4 but this is still far smaller than some of the largest private asset managers, such as State Street Global (US$1.2 trillion), Barclays Global (US$1.1 trillion), and BlackRock (US$1.1 trillion).5 The next largest SWFs are generally believed to be the foreign holdings of the Saudi Arabian Monetary Authority (SAMA; US$433 billion), China’s State Administration of Foreign Exchange Investment Company (SAFE; US$312 billion), and Norway’s Government Pension Fund–Global (US$300 billion). Relative to managers of emerging-market official reserves, with a total size of US$4.1 trillion, SWFs are a growing share of the total, but still will not outgrow total official reserves for years (partly because SWFs’ assets are directly funded out of reserves in several countries).
SWFs are roughly comparable in size to other types of asset managers, but appear to trade much more like typical real-money managers than like hedge funds. Comparing SWFs’ AUM with the AUM of other investment managers should ideally acknowledge a degree of double counting because SWFs are known to have invested in both hedge funds and private equity funds. Hedge Fund Research (2009) estimates that the AUM for hedge funds declined from a peak of nearly US$2 trillion in mid-2008 to a low of US$1.3 trillion in 2009:Q1 and US$1.4 trillion in 2009:Q2. Private equity funds were estimated
3 Estimates clearly vary across the literature. Bortolotti and others (2008) estimate total size (using a broad definition of SWFs) at about US$3.3 trillion, of which oil and gas-related SWFs accounted for roughly US$2.5 trillion. Kern (2009) put AUM at about US$3 trillion. Setser and Ziemba (2009b) estimated the foreign assets of major SWFs at US$1.5 trillion. Part of the differences is definitional; others relate to the lack of transparency of the largest funds. Finally, 2008 and the beginning of 2009 were difficult times, such that AUM shrank for several SWFs, accounting for another portion of the difference in estimates.4 There is a discussion of ADIA’s ultimate size, with some commentators putting it closer to US$340 billion at the end of 2008 (Setser and Ziemba, 2009b).5 Pensions and Investments Largest Money Managers survey, May 2009 (http://www.pionline.com/section/MoneyManagerDirectoryArchive). Presumably these large asset managers have SWFs among their clients, so there may be some double counting in the comparison of AUM.
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to be managing about US$900 billion at the end of 2008 (Roxburgh and others, 2009). Although broadly comparable in size, hedge funds span the spectrum of investment strategies and frequently employ leverage. Private equity funds also employ leverage, but to a lesser extent than hedge funds. Although average leverage ratios are hard to estimate for the hedge fund industry, an end-2009 reasonable average would be one to two times after the 2007–09 global financial crisis versus perhaps three to four before the crisis. Hence, the importance of hedge funds in global financial markets has shrunk dramatically during and since the crisis, even though hedge fund industry AUM started to recover in the second quarter of 2009 as a result of better performance. SWFs, however, are not frequent users of leverage, and have not been broadly affected by the credit crunch because of the stability of their funding. Hence, on the private equity side, SWFs outpaced private equity funds as measured by the number and size of deals in 2008 (Ernst & Young, 2009). An IWG (2008a) survey suggests that only 23 percent of SWFs are absolute-return focused and that the vast majority (about 80 percent) do not employ leverage. The few that do, according to the IWG survey, mostly use leverage for hedging purposes, or invest in leveraged funds (so leverage is indirect), or both.
Another case made for the importance of SWFs has been their projected rapid growth, that is, they may not be significant enough today to have a major influence, but could soon be large enough to play a much greater role in the price formation of financial assets. The global financial crisis of 2007–09, as well as the popping of the oil bubble in 2008, hit many SWFs hard and their investment strategies were either redirected toward domestic development and macro support or, because their liquid assets formed part of official reserves, they were tapped for FX stabilization purposes. Suffice it to say that commodity exporters’ ability to allocate a significant share of their ample current account surpluses to SWFs when commodity prices were high shrank rapidly as oil col-lapsed from US$147 per barrel to US$35 per barrel. In fact, Setser and Ziemba (2009a) calculate that for the oil-exporting-country SWFs to see renewed inflows, oil prices would have to average above US$50 per barrel. At an oil price of US$75 per barrel, Gulf Cooperation Council SWFs would add about US$175 billion per year to their official reserves and wealth funds—a far smaller sum than the US$300 billion in annualized inflows these entities reportedly enjoyed during the first nine months of 2008. Hence, estimates about the future growth rates for SWFs are largely driven by current account surplus assumptions for commodity exporters and the extent to which countries want to reallocate from official reserves to SWFs. Given the generally poor investment performance of SWFs in 2008–09 and the fact that the global financial crisis has led to an upward revision in the desirable level of official reserves for many countries, the growth rate for SWFs going forward will prob-ably slow compared with 2007 and 2008.
Analysts’ estimates for SWF AUM growth are being scaled back. At the height of market focus on SWFs in May 2007, Jen and Andreopoulos (2007) estimated
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that SWFs’ AUM would grow to US$12 trillion by 2015. They scaled back their estimate in November 2008 to US$10 trillion (Jen and Andreopoulos, 2008). More recently, Kern (2009) estimated in July 2009 that the AUM of SWFs would reach US$7 trillion in 2019 and about US$5 trillion by 2015. Kern’s more sober-ing forecast assumed a higher starting point of US$3.5 trillion at the end of 2008, but presumably marked-to-market losses reduced his starting point to about US$3 trillion by mid-2009.
Fears about the overall absolute size of SWFs almost certainly reflect political rather than market concerns. Given the arguments presented above, any concerns about the absolute size of SWFs have to be based on an argument that they are not being run on a financial basis and perhaps would seek to take controlling stakes in firms strategically important to their host countries. In fact, many large SWFs take stakes of more than 5 percent on very few occasions (unless this is their specific remit), especially in foreign markets, to reduce any political back-lash. However, individual SWFs are large enough that were they to concentrate their holdings in less liquid markets, monitoring them to avoid any sudden dis-ruption if the SWF decides to divest would be warranted, just as it would be for any other large institutional investor.
HOW DO SWFS’ PUBLICLY ANNOUNCED EQUITY INVESTMENTS AFFECT MARKETS?
Extensive finance literature examines the ways in which a large new investor can affect asset prices in a given stock, currency, or fixed-income instrument. The driving factors behind how large an impact a particular investment or transaction has on a target’s asset price depend on (1) the size of the investment relative to the market capitalization or liquidity of the asset, (2) whether the investor acquires a controlling stake, (3) whether the investor has nonpublic information, (4) whether the transaction takes place on or off an exchange, (5) whether the trans-action is publicly announced, (6) the investor’s holding horizon, and (7) the investment decision’s implications for future investments by the same or similar entities. Most of these factors are equally relevant for SWFs. For state-controlled entities such as SWFs, however, another important factor can be added—is the transaction taking place for purely financial reasons or are noneconomic factors, such as resource diversification or technology transfers, also playing a role? In general, this issue is crucial to the way in which the media and politicians see SWF investments in their economies, but from a market perspective, the underly-ing rationale for an SWF transaction only matters if it indicates whether addi-tional similar transactions are likely or if one SWF’s action signals probable next steps for other SWFs.
An academic literature regarding the impact of SWFs on global financial markets is emerging, but so far focuses only on the effect on equity prices. A useful literature review is provided by Miracky and Bortolotti (2009); their general conclusion seems to be that the target company’s stock price reacts favorably to an SWF investment, especially if the SWF is transparent in its investments. The literature suggests that the
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size of the stake bought by the SWF does not matter and that the investment signal is even more important if the target asset’s share price has underperformed. It can be argued that this result picks up the significant investments by SWFs in the financial sector during 2007–08 and to a more limited extent in 2009. Reasonably, the studies suggest, follow-up SWF investments in a particular company have much less impact on equity prices. Divestment decisions by SWFs, which represent a more limited sample, seem to have a negative effect on the divested company’s share price. Miracky and Bortolotti’s literature review does not clearly indicate whether SWFs have a dif-ferent impact on a target’s share price than do the investment decisions of other large fund managers, that is, whether there is something special about investments made by a government-controlled entity, or whether the effect depends more on how financially focused or transparent the type of investor is. There does, however, seem to be an indirect link suggesting that the more transparent an SWF, the bigger the positive impact, presumably akin to the impact of a large private institutional fund manager (see Kotter and Lel, 2008). Most likely the positive effect on a firm’s share price following the announcement of an investment reflects the increased demand for the asset rather than a belief that an SWF investment would result in assistance in managing the firm. However, SWFs are generally seen as stable, long-term inves-tors, which should be reflected in the target’s share price similarly to what would typically be seen following the investment decision by a large pension fund. So far, this chapter’s author is not aware of any comprehensive research that has examined the impact of SWF investment announcements on macro indicators such as FX or government bond prices, although a number of recent studies—Beck and Fidora (2008); Kozack, Laxton, and Srinivasan (Chapter 14 of this book)—have started to explore this important field.
WHERE DO SWFS INVEST?
Although the current aggregate size of SWFs is not of any special concern, their market impact is affected by where they invest and the liquidity of that market. Thus, their relative size compared with the overall size of the market matters more than the overall size of their AUM. Buying US$10 billion of U.S. treasur-ies has a very different impact from buying US$10 billion of local emerging-market bonds. From a macro market perspective, SWF investments could have far bigger impacts in nontraditional asset classes, such as emerging markets, commodities, real estate, and private equity. In general, the IWG (2008a) study makes clear that most SWFs follow a typical asset allocation framework with a fairly high tolerance for nontraditional investment classes, such as private equity (about 35 percent of SWFs indicated such assets are eligible), real estate (35 percent indicated assets are eligible), and commodities (25 percent indi-cated assets are eligible).
Less information is available about geographic diversification, other than SWFs’ public equity investments, but the information to be had suggests signifi-cant scope for more international investments by SWFs in equities. In general, the traditional optimal portfolio allocation yielded by an intertemporal capital asset
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pricing model (ICAPM) dictates holding portfolio shares equivalent to the market capitalization shares of individual countries. So far, as a result of home bias, actual institutional investor holdings typically fall far short of the international exposure suggested by ICAPM. With a handful of exceptions, the SWFs’ asset allocations are not known for their nonequity holdings, but those nonequity holdings are likely to be much more diversified than their equity holdings. For instance, fixed-income investments seem to be routinely diversified across countries in the devel-oped markets (see, for example, the diversification strategy of Norway’s Government Pension Fund–Global). Investments in emerging-market fixed-income assets seem to be occurring more gradually, but the process is gaining momentum given the perceived opportunities and diversification benefits.
Despite the well-publicized investments by SWFs in “G3” (the United States, the euro area, and to a lesser extent Japan) financial institutions, the majority of investments occurred locally to support domestic economies. During 2006–08, about two-thirds of all large equity investments by SWFs occurred in emerging markets, most of those in the SWFs’ own countries (see Figure 15.1). Clearly, these transactions preceded the 2007–09 global financial crisis and thus suggest that the perception that SWFs predominantly invest abroad is not borne out by the data so far. Miracky and Bortolotti’s (2009) data for publicly disclosed equity investments in 2008 show that about 96 percent of SWF’s emerging-market equity investments were in their own countries, which leaves only US$1 billion invested in non-home emerging markets. This probably reflects both the per-ceived lower risk-adjusted return in non-home emerging markets and that given their own substantial investments in their own countries, their overall emerging-market exposure is still significant. One could also argue that the host country skepticism for large SWF investments also reduces the chance for this channel of
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Source: Miracky and Bortolotti, 2009.Note: Captures publicly disclosed investments by SWFs.
Figure 15.1 Emerging-Market SWFs Tend to Invest Locally
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portfolio diversification. This probably means that the main channel for foreign investments is through foreign exchange and fixed-income exposures in the G10.
In general, the vast differences in international exposure between various SWFs is also explained by their reasons for being established. Some are much more explicit in their goals of investing substantial shares of their assets at home, while others are explicitly funded in foreign exchange and hence almost by defini-tion fully invested in non-home country assets.
As many of the recently launched SWFs mature and establish firm investment processes and guidelines, it would make sense for the share of emerging-market investments in SWFs’ portfolios to increase. For example, the China Investment Corporation (CIC) disclosed in its first annual report that “because it was build-ing its organization, infrastructure and capabilities, CIC had set relatively modest goals for deploying its capital in 2008. As the year unfolded, CIC made the deci-sion to reduce the pace of its investing even further” (CIC, 2009, p. 33). In fact, by the end of 2008, 87 percent of CIC’s assets were still in cash and 9 percent were in fixed-income securities, with only 3 percent in equities. Overall, CIC’s investment guidelines suggest that “slightly over 50 percent” of its non-Central Huijin6 assets would be invested abroad and that its “investments are not limited to any sector, geography or asset class” (CIC, 2009, p. 28). Over time, SWFs would be expected to invest more widely internationally than a typical home-bias-driven investment manager given SWFs’ longer investment horizon, foreign cur-rency funding, and appetite for higher risk-adjusted returns.7
MARKET AND MACRO IMPLICATIONS OF THE SHIFT TOWARD SWFS FROM OFFICIAL RESERVES
The rationale for shifting a share of a country’s conservatively run official reserves to an SWF must be to boost risk-adjusted returns and increase diversification. Therefore, there is potential scope for broader market implications for the major exchange rates and government bond yields that go beyond day-to-day announce-ment effects of any particular investment. The IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) database indicates that, on average, central banks of emerging and developing countries held about 58 percent of their official reserves in U.S. dollars and 31 percent in euros by end-2009.8 As discussed by Beck and Fidora (2008), global market capitalization weights for the dollar and euro, if a more traditional ICAPM-type portfolio management model is pursued, suggest a significantly smaller allocation to dollar- and euro- denominated assets and a much larger allocation to the assets of emerging markets and Japan. As newly launched SWFs gain confidence and experience, it is likely that there will
6 Central Huijin is a CIC subsidiary managing the sovereign’s investment in the local financial sector.7 As previously noted, the traditional optimal portfolio allocation from an ICAPM-type model would be to hold portfolio shares equivalent to the market cap shares of individual countries. 8 These are the percentages for those central banks that disclose their reserves compositions. The actual percentage of US$ shares may be higher if China’s reserves composition were known.
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be a gradual, but sustained, shift away from investing new inflows into dollar and euro financial markets and toward a focus on assets denominated in other curren-cies. Using market-cap weights, Beck and Fidora (2008) suggest three interesting implications of a shift from central bank reserves to SWFs:
• Inflows into global equity markets could be substantial given that official reserves are basically all invested in fixed income. Setser and Ziemba’s (2009a) research suggests that well-established SWFs—those of commod-ity-producing countries—are already large holders of equities. However, those SWFs funded through official reserves seem to be far behind “opti-mal” portfolio allocations of equity. The degree of progress on this front for some of the newer SWFs seems also to have been limited; for example, CIC’s 87 percent cash holdings are probably parked in liquid short-end securities, and the most liquid markets are denominated in U.S. dollars.
• Given that the United States has the world’s largest equity market, the implicit portfolio shift away from dollar to nondollar and non-euro currencies will be somewhat mitigated. Nevertheless, the U.S. market cap share of global finan-cial markets (equity plus debt according to IMF, 2009) was roughly 35 per-cent at the end of 2009 compared with a share of U.S. dollars in reserves of 58 percent. For the euro area, the market cap share was 23 percent, compared with a share in reserves of 31 percent. This suggests an overweight of U.S. dollar and euro holdings in reserves. The big gainers of a shift toward the market capitalization would be emerging markets with a current global mar-ket cap of 20 percent and Japan of 9.5 percent. However, as the experience with the gradual diversification strategy already under way in many central banks has shown, SWFs are unlikely to engage in any market-destabilizing moves, and any investment strategies and portfolio reallocations will most likely be gradual and sustained, but quicker than for official reserves.9
• Considering the assets currently managed by newer SWFs (as of the end of 2008, covering those SWFs set up in 2006 or later according to the Sovereign Wealth Fund Institute, 2009) of US$530 billion and assuming that they are still in the process of investing those assets, the maximum inflows from these sources to emerging markets and Japan could be US$105 billion and US$51 billion, respec-tively, with the biggest loser being the U.S. dollar. Because SWFs are likely to invest much more in equities than are central banks, they are also likely to diver-sify away from the U.S. dollar more than central banks, and much more quickly.10
9 This holds true during normal times. The recent crisis has made this assumption more tenuous. There have been a few recent examples of more abrupt changes in US$ assets, for example, U.S. agen-cies or FX deposits. Large shifts are possible, but these shifts have been in the minority and not clearly destabilizing given the liquidity in these markets.10 If we assume no equity investments of central banks’ official reserves, then the 58 percent share held in U.S. dollars should drop to 37.8 percent if an ICAPM-level result is sought. In reality, it would be hard to believe that as long as the U.S. dollar remains the dominant reserve currency, official reserves holdings in U.S. dollars would drop below 50 percent. Emerging markets remain the main benefi-ciary of any shift of assets to SWFs from central bank reserves because emerging markets’ share of global equity markets is much higher than their share of global debt markets.
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While the creation of new SWFs should boost inflows to emerging markets and Japan, the portfolio composition of well-established SWFs suggests that SWFs may go beyond the ICAPM-type result and invest more heavily in risky assets. Setser and Ziemba (2009a) estimate the portfolio composition of the large Gulf Cooperation Council-based SWFs and show that their risk appetites increased from the end of 2004 to mid-2008 with, on average, 50 percent of their international purchases in the form of equities and 50 percent in fixed income. Overall, Setser and Ziemba (2009a) estimate that equity holdings average about 50–60 percent with a fairly substantial 20–25 percent in alternatives (such as private equity, real estate, commodities, or hedge funds; see Figure 15.2). This suggests that the risk appetite of SWFs could be higher than indicated by a traditional model given that the share of global equity markets to total financial markets was roughly 45 percent at the end of 2007. Nevertheless, these large equity allocations may have been the high point and the les-sons to be drawn by commodity-exporter SWFs are to be more conservative. SAMA, the Saudi Arabian Monetary Agency, seems to have fared the best during the recent crisis and it is also the most conservatively managed SWF in the region. In fact, Setser and Ziemba (2009a) point out that an important lesson from the crisis for commodity-exporter SWFs is to reduce their holdings of risky assets that are highly correlated to the global growth cycle (such as equities or emerging markets) because SWFs’ capital inflows are directly linked to global growth as well. The Norwegian Government Pension Fund–Global still strives for a high 60 percent strategic alloca-tion to equities and 40 percent to fixed income. As a result of weak equity perfor-mance (the fund lost about 23 percent in 2008), the actual composition was 52 percent and 48 percent at the end of 2009:Q1. More recent data suggest very strong performance during 2009:Q2, given that the fund went overweight relative to its strategic benchmark. Its allocation to emerging markets still seems too low, but this may change (see Price, 2009). The fund requested during 2008 that its benchmark be
Figure 15.2 Value of SWFs’ Investments by Target Sector
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altered to include more emerging-market equities and private equity (however, in mid-2009 they decided to wait to invest in emerging-market and high-yield bonds).
As the analysis above suggests, the impact of SWFs on emerging financial markets and Japan is only set to grow. Even one of the most professionally man-aged and transparent funds—Norway’s Government Pension Fund–Global—still does not actively invest directly in high-yield and emerging-market bonds. Presumably that also excludes local-currency emerging-market investments. Thus, given the size of SWFs and their ongoing strategic reallocation of assets to new classes, regions, and currencies, it will be important for macro players to fol-low them because their actions can drive the short-term performance of currency and rates. It remains to be seen whether the asset flows are large enough to affect the major currencies, but it would be reasonable to assume that a steady and fairly long-term portfolio investment inflow into emerging markets will have an impact on valuations given the less liquid nature of these asset markets (see Figure 15.3).
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Figure 15.3 Large Potential for Emerging-Market Central Bank Reserves Diversification
HOW DO MARKET PARTICIPANTS REACT TO SWF INVESTMENTS?
Investments by SWFs are widely followed by the market because of the size of the potential flows and the funds’ long investment horizons. The lack of transparency of many SWFs probably causes more market speculation about alleged invest-ments than is warranted. In an environment in which other important market participants, such as hedge funds, have been in retreat, the relative role of SWFs has increased. The impact of SWFs’ investments on equity markets, when they invest directly in their own names, has been evaluated in a handful of academic studies. The clearest recent example of a direct, broadly based market impact was
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the episode of large and sustained investments by several of the largest SWFs into the U.S. and U.K. financial sectors. Although studies focused on the individual stock impacts of the investment announcements, the capital injections from the SWFs had implications for the entire financial sector and for broader market indices—much-needed capital injections were coming from a source that would have been largely unexpected before the recent global financial crisis. However, these sectoral macro implications have not been widely studied. Having incurred major marked-to-market losses on their investments in western banks, and having confirmed that SWFs have a tendency to herd behavior, many SWFs must be in the process of reviewing their investment guidelines and slowing their diversifica-tion processes.
The dearth of studies about SWF investments’ impacts on FX and nonequity asset classes leaves researchers largely with anecdotal evidence and press reports. As mentioned, suggestions that a new asset class has been added to the list of eligible classes for a particular SWF can be very important. As shown in the IWG report (2008a) almost all SWFs make use of external managers, which means SWFs can invest indirectly and anonymously. However, the announce-ment of the selection of an external manager can lead to a repricing of assets in the asset class in which a particular asset manager specializes under the assump-tion that more SWFs could follow or that the announcement reflects an initial investment that could later be augmented. One example of this type of market impact was CIC’s announcement that it was planning to launch a US$4 billion private equity fund together with JC Flowers in 2008 (Chen, 2008). This announcement led to renewed optimism that additional funds would be made available to the private equity world, which was starting to feel the squeeze of the upcoming credit crunch. On March 3, 2009, various news agencies reported that China was again considering investment opportunities in the natural resources sector and a senior official for CIC was quoted in the reports (Heng, 2009). Oil prices jumped 9 percent the following day, while the S&P 500 (as a benchmark) rallied 2.4 percent on the day with the EUR/US$ largely unchanged. Of course, market sensitivity to SWF investment announcements is not limited to CIC. The Norwegian Government Pension Fund–Global was reported to be considering external managers to increase its exposure to Brazilian companies through allocations of US$250 million (see Price, 2009). The news stories were immediately circulated among market participants and helped support the Brazilian real during a day when nervousness remained high because of weak U.S. equity market performance.
Moreover, as mentioned briefly earlier, the market perceives that there are lead-ers and followers among the SWFs. Among the leaders are the more transparent and well-established funds. The Norwegian Government Pension Fund–Global has a wide following because it makes public its strategic investment strategy as well as most of its holdings. For the less transparent funds, the market is left to follow any large public announcements. A new initiative of, for example, invest-ing in banks in emerging markets would rapidly be interpreted by market participants as setting the stage for a wave of new investments into
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the emerging-market financial sector (as was in fact the case). Regardless of whether it was correct, this perception was strengthened by the activities of SWFs in the context of investing in western banks in 2008. An example is the Industrial and Commercial Bank of China’s (ICBC’s) 2007 US$5.5 billion investment in South Africa’s Standard Bank; not only did the South African rand rally 1.7 percent on the day, but market speculation about other emerging-market banks that could be attractive destinations for SWF investment began immedi-ately. This occurred even though ICBC, while state controlled, is not an SWF (although it is 35 percent owned by a subsidiary of CIC [CIC, 2009]).
MARKET IMPACT AND TRANSPARENCY
Public investment decisions by SWFs do not only have a market impact, but a political impact as well. Although much of the political concern about SWF investments died down after SWFs came to the rescue of many western banks, the market impact of SWF investments and the focus the market places on them has, as argued above, only grown. In addition, some of the concerns about political transparency, and those related to the belief that SWFs’ investment decisions should be guided by purely financial considerations, have been some-what mitigated by the publication of the voluntary Santiago Principles. In prac-tice, signatories to the principles are already applying them, as evidenced by the release of CIC’s first annual report.11 Moreover, trigger rules, such as the rule requiring any owner with a stake greater than 2 percent to disclose that interest, work as well for SWFs as for any other institutional investors. Whether SWFs should face special disclosure requirements is, again, more political, but from a market point of view those rules that typically exist in developed equity markets serve well. Being too restrictive would actually increase the incentive for SWFs to invest through external managers, and without explicit “look through” provi-sions, it would be very difficult for the host country to know the identity of the end investor.
Nevertheless, beyond political considerations, transparency for SWFs, as for any other large investor, is a dual-edged sword. Given the increased market focus on SWFs and the market reaction to publicly announced investments (including the backlash if a publicly acquired stake has to be sold), SWFs have to strike a careful balance between being transparent and revealing too much. However, little evidence so far indicates that the transparency level of the Norwegian Government Pension Fund–Global (managed by Norges Bank Investment Management) has affected its investment performance. As described by Beck and Fidora (2008), the Norwegian Government Pension Fund–Global discloses after
11 The Santiago Principles were developed by the International Working Group of Sovereign Wealth Funds. Among the generally accepted principles and practices, SWFs ensure that they will “invest on the basis of economic and financial risk and return-related considerations” (unless otherwise dis-closed), take into account the stability of the global financial system, and step up their public disclo-sures (see IWG, 2008b; and Chapter 5 of this book).
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the fact that it has divested a stock and no significant negative price impact fol-lows such an announcement. Conversely, the disclosure that the Norwegian Government Pension Fund–Global has purchased a particular stock has a positive impact; in many cases, however, this positive impact is to the SWF’s advantage and hence does not raise any real transparency concerns and should be easier to disclose. However, disclosing only the purchases and not the sales might subject an SWF to criticism by the broader market.
Disclosure of the identity of external managers provides some information about investment strategy. As a result of increased political sensitivity to direct investment, as well as its market impact, the use of external managers is popular. Norges Bank International Management publishes a list of its external managers, as did CIC in its latest annual report. The use of an external manager significantly changes the influence of an SWF in any given market. It is very difficult for the market to discern whether the external manager is investing on its own account, executing on behalf of an SWF, or simply managing a fund in which the SWF together with other investors has invested. While the use of external managers is traditionally more related to helping the SWF invest in areas in which it may not have sufficient expertise, or to creating an external benchmark to compare itself against, the implications for diminished market impact (and diminished political impact as well) must be a benefit. Of course, because many real-money managers have to disclose their holdings, SWF investments through real-money managers are disclosed—but without identifying the end investor. To the extent that SWFs invest in hedge funds, the transparency of their investments is even further reduced. However, using well-established asset managers as intermediaries should help assuage concerns that SWFs are investing with mixed financial and political motives. As the experience with the Norwegian Government Pension Fund–Global has shown, a mix of external managers and direct investment would be a natural outcome, and the composition will be dictated by the SWF’s in-house expertise and willingness to invest in more exotic asset classes with which it might have less experience.
CONCLUSION
SWFs faced intense public scrutiny in 2007 and 2008 as they emerged on the global scene as new and important market participants. Some of the political concerns about the entrance of state-controlled market participants have been allayed by the 2007–09 global financial crisis and by steps the SWFs have taken to gradually increase their transparency. From a financial-market perspective, the rise of SWFs raises far fewer concerns while presenting new profit-making oppor-tunities for many investment banks and external managers vying for SWF busi-ness, which may affect this sanguine view. Unfortunately, despite recent improve-ments, the lack of data and transparency severely affects any analysis of the impact of SWFs on global capital markets. Data are available on several large SWF equity transactions, but much less is known outside of equities. Hence, any conclusions about the possible impact of SWF decisions on fixed-income and FX markets are
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tentative and are more driven by speculation about their probable asset allocation choices as they mature. Ironically, as noted by some observers, the shifting of assets away from central bank reserves (the currency composition of which is reported by COFER) to SWFs may reduce the level of transparency in the system of emerging-market FX assets.
Concerns about the absolute size of an SWF more likely reflect political rather than market issues. From a market perspective, the size of individual funds or the SWF industry as a whole are not particularly unusual and do not cause any real distress. A market concern could arise, however, with any sectoral, geographic, or asset concentration by SWFs. This is not an idle worry. SWFs tend to cluster in similar sectors during similar periods, as revealed by the wave of investments in the U.S., euro area, and Japanese banking sectors during the recent crisis, which bought time for the banking sectors to restructure, but these capital injections ultimately proved to be insufficient. An interesting element of these investments was that they were fully transparent—the investing SWF was known as were most of the terms—which was probably a function of the regulated nature of the bank-ing system, including the requirement for banks to disclose material information to their shareholders. However, were SWFs to invest to a significant extent in emerging markets, as an optimal portfolio allocation approach would suggest, the overall size of these funds and the new flows they could generate would then raise both market and macro issues. Would their entry dislocate asset prices and cur-rencies? Would the market know when they exited? Would these sustained inflows allow the recipient country to run a different, more accommodative pol-icy mix? These concerns, however, are generally no different from market con-cerns about any other large, nontransparent, institutional investor.
SWFs raise few specific concerns for market participants, and greater disclosure can do much to mitigate concerns. As a precedent, the U.S. mutual fund industry, through its representative organization the Investment Company Institute, pro-vides useful data and general portfolio allocations and inflows for the industry as a whole.12 From a market perspective, such information is useful in monitoring broader industry trends and watching for any overconcentration. In fact, the development of an international working group of SWFs seems to be a first step toward greater transparency and disclosure, which will promote better under-standing of the role SWFs play in the market. Supervisors and host-country gov-ernments also have an interest in gathering more information to ensure that investments are financially motivated and adhere to the standards of the host country. Based on the increased pressure for extended supervision and regulation of previously unsupervised pools of capital following the crisis, it would be hard to argue that SWFs should be exempt from host-country supervision. In fact, con-centrated SWF investments could raise systemic risks and need to be supervised.
12 See www.ici.org, which provides this mission statement: “Encouraging adherence to high ethical standards by all industry participants; advancing the interests of funds, their shareholders, directors, and investment advisers; and promoting public understanding of mutual funds and other investment companies.”
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220 A Market View of the Impact of Sovereign Wealth Funds on Global Financial Markets
As newly established SWFs build track records, the market will become accus-tomed to the funds’ growing role, and whether portfolio concentration in one sector actually triggers any broader-based problems will be determined. Much of the market’s current perception of SWFs is still based on anecdotes and informa-tion from market intermediaries rather than on hard facts. To reduce the risk of political backlash against SWF investments in target countries, SWFs themselves would be well served to increase their transparency even further. Transparency need not be public, but could instead be directed toward the regulators and super-visors in the target country.
The true market implications of the rise of SWFs are likely to arise from long-term trends rather than any individual transaction. The growth in SWFs will mean greater headwinds for the U.S. dollar and the euro, and could benefit emerging markets and the yen. These results stem from the ongoing diversifica-tion of official reserves away from the U.S. dollar, and the fact that SWFs provide an attractive vehicle for emerging-market governments to speed up this diversifi-cation process.
The global financial crisis has slowed the growth of SWFs, but as the crisis dissipates, commodity prices recover, and the need for home-country investment support financed by the SWFs declines, the funds’ AUM should return to a growth path. This growth path will be driven by both macro and political factors, such as the choice of FX regime and whether sustainable current account sur-pluses can be run over the medium term. It is conceivable that the AUM of SWFs will triple by 2020; therefore, it is crucial to address residual political and market concerns now, before SWFs play an even bigger role.
SWFs will confront the market with challenges similar to those in previ-ous episodes of the emergence of new classes of institutional investors. The rise of mutual funds, hedge funds, and private equity funds all presented the market with new issues, but in general, all these entrants have increased liquidity and stimulated deeper and broader markets globally. SWFs managed on the basis of financial rather than political principles fit that mold. Although it is reasonable to expect some accidents along the way, nothing particular about SWFs leads to doubts that the end result will be similar to that of other emerging institutional investors. However, there may be macro implications rather than market implications, as global imbalances fuel a faster growth of SWFs. SWFs have existed since the 1950s, so their institu-tional set-up is not new—the assets they manage and are likely to manage lead to the questions. Although the market implications of SWF investments highlighted in this chapter represent a market view rather than the market view, it appears the concerns raised by SWF investments are much more political than market driven.
REFERENCES
Beck, R., and M. Fidora, 2008, “The Impact of Sovereign Wealth Funds on Global Financial Markets,” ECB Occasional Paper 91 (Frankfurt: European Central Bank).
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Bortolotti, Bernardo, Veljko Fotak, William L. Megginson, and William Miracky, 2008, Sovereign Wealth Fund Investment Patterns and Performance (Unpublished; Norman, OK: University of Oklahoma).
Chen, G., 2008, “China’s CIC to Launch $4 Billion Fund with JC Flowers,” Reuters, April 3.CIC (China Investment Corporation), 2009, “Annual Report 2008.” Available via the Internet:
http://www.china-inv.cn/cicen/include/resources/CIC_2008_annualreport_en.pdf.Ernst & Young, 2009, “2009 US Private Equity Watch: An Industry in Flux,” Ernst & Young.
Available via the Internet: http://www.ey.com/Publication/vwLUAssets/US_private_equity_watch_an_industry_in_flux_Ernst_and_Youngs_2009_state_of_the_industry_report/$FILE/2009_US_private_equity_watch_an_industry_in_flux.pdf.
Hedge Fund Research, 2009, “HFR Global Hedge Fund Industry Report: Second Quarter 2009.” Available via the Internet: http://www.hedgefundresearch.com/.
Heng, X., 2009, “China Wealth Fund CIC Sees Investment Chances in Energy, Commodities-Official,” Reuters, March 3.
International Monetary Fund, 2009, Global Financial Stability Report (Washington, April).IWG (International Working Group of Sovereign Wealth Funds), 2008a, “Current Institutional
and Operational Practices” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/swfsurvey.pdf.
———, 2008b, “IWG of Sovereign Wealth Funds Presents the ‘Santiago Principles’ to the International Monetary and Financial Committee,” Press Release No. 08/06, October 11 (Washington).
———, 2008c, Sovereign Wealth Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
Jen, S., and S. Andreopoulos, 2007, “How Big Could SWFs Be by 2015?” Morgan Stanley Research, May 3.
———, 2008, “SWFs’ Growth Tempered: US$10 Trillion by 2015,” Morgan Stanley Research, November 6.
Kern, S., 2009, “Sovereign Wealth Funds – State Investments During the Financial Crisis,” Deutsche Bank Research. Available via the Internet: http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000244283.pdf.
Kotter, J., and U. Lel, 2008, “Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the Price of Keeping Secrets,” International Finance Discussion Papers No. 940 (Washington: Board of Governors of the Federal Reserve System).
Miracky, W., and B. Bortolotti, ed., 2009, “Weathering the Storm: Sovereign Wealth Funds in the Global Economic Crisis of 2008” (Monitor Group and Fondazione Eni Enrico Mattei).
Miracky, W., and others, 2009, “Sovereign Wealth Fund Investment Behavior,” (Monitor Group and Fondazione Eni Enrico Mattei).
Norges Bank Investment Management, 2009, “Government Pension Fund–Global Annual Report 2008.” Available via the Internet: http://www.norges-bank.no/upload/73979/nbim_annualreport08_rev.pdf.
Price, L., 2009, “Norway Sovereign Fund May Boost Stakes in Brazil, Valor Says,” Bloomberg News, August 12.
Roxburgh, C., and others, 2009, “The New Power Brokers: How Oil, Asia, Hedge Funds, and Private Equity are Faring in the Financial Crisis,” McKinsey Global Institute. Available via the Internet: http://www.mckinsey.com/mgi/publications/the_new_power_brokers_financial_crisis/.
Setser, B., and R. Ziemba, 2009a, “GCC Sovereign Funds: Reversal of Fortune,” Working paper (New York: Council on Foreign Relations).
———, 2009b, How Much Do the Major Sovereign Wealth Funds Manage? (New York: Roubini Global Economics). Available via the Internet: http://blogs.cfr.org/setser/2009/08/02/how-much-do-sovereign-wealth-funds-manage/.
Sovereign Wealth Fund Institute, 2009, “Sovereign Wealth Fund Rankings.” Available via the Internet: http://www.swfinstitute.org/funds.php.
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SECTION IV
Postcrisis Outlook
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CHAPTER 16
Sovereign Wealth Funds in the New Normal
MOHAMED A. EL-ERIAN
The worldwide economy that emerges from the 2007–09 global financial crisis will differ in a number of important ways from what had prevailed in previous years. At a minimum, watchers and participants should anticipate lower steady-state growth in industrial countries, greater financial regulation, lower credit intermediation, simplified capital structures, continued migration of growth and wealth dynamics to systemically important emerging economies, higher protectionist pressures, and an even blurrier line between economic rationality and political exigencies.
This “new normal” will not materialize overnight. It will evolve over several years. The journey will be far from linear and will involve various head fakes, detours, and related market overshoots. Indeed, the global system has entered a more uncertain, more volatile, riskier phase that combines cyclical shocks with secular realignments. To navigate this bumpy journey successfully to a new nor-mal, virtually every dimension—economic, financial, and sociopolitical—in the global system will be required to demonstrate a high degree of adaptability and agility (Sull, 2009b).
Among retail and institutional investors, sovereign wealth funds (SWFs) as a group enter this historic phase with the best set of initial conditions—at least on paper. They are well capitalized; their fiduciary responsibilities direct them to take a long-term view; and their standing in the marketplace is enhanced at a time when the private sector is in a general deleveraging mode and worries about the financing of ballooning public sector balance sheets are growing.
This powerful trio of conditions places SWFs apart when it comes to the strength of their self-insurance and their ability to be appropriately countercycli-cal and responsively secular. Yet they too face important challenges in this journey to a new normal.
Governance structures will be tested as SWFs seek to strike the right intergen-erational equity and efficiency balances in a more fluid environment, and as a wider range of national claims compete with the institutions’ fiduciary responsi-bilities. For some SWFs, the appropriate investment positioning will require a degree of adaptability and agility that is a multiple of what has been pursued in the past—be it in adjusting asset allocation and risk management, or selecting the right investment vehicles. And communication needs will become even more important if SWFs are to maintain sufficient domestic and international buy-in.
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The purpose of this chapter is to shed light on the opportunities and risks that SWFs face in the aftermath of the recent global financial crisis. Following the first section’s quick review of the immediate impact of the global financial crisis on SWFs, the second section outlines the potential components of the new normal that are directly relevant to SWFs. The third section illustrates some of the operational implications for SWFs. The chapter’s concluding remarks appear in the last section.
SWFS AND THE GLOBAL FINANCIAL CRISIS
For the purpose of the current discussion (and abstracting from differences within the set of SWFs), three factors are important to the characterization of SWFs as a group in the run-up to the most acute phase of the global financial crisis, and the global economic and sociopolitical dislocations that followed (and that continue to materialize). These factors defined where the group stood on the eve of the major disruptions occasioned by the global financial crisis in general and, in particular, by the sudden stop experienced by the global economy in the last three-and-a-half months of 2008.1
First, and consistent with their long-term orientation, SWFs were gradually getting bolder in underwriting significantly greater liquidity and equity risk fac-tors to allow them to deliver higher returns over time.2 Specifically, SWFs were opting for bigger allocations to public equities (relative to fixed income), to less liquid and levered investment vehicles (such as private equity and hedge funds), and to direct corporate holdings at the bottom of the capital structure (which, consistent with the insights of the behavioral finance literature, involved a focus on sectors that were historically most familiar to them, led by financials).
Second, SWFs showed growing awareness of some industrial countries’ sensi-tivities to foreign ownership and especially, when these countries bothered to make the distinction (which was not very often), control of domestic assets. Accordingly, they were more willing to participate in multilateral deliberations on a suitable code of conduct. Most notably, a leading group of SWFs agreed on a set of voluntary principles (the Santiago Principles) emphasizing “transparent and sound governance structures,” appropriate “regulatory and disclosure require-ments,” and SWF investing on “the basis of economic and financial risk and return-related considerations” (IMF, 2008).
Third, SWFs operated in highly supportive domestic environments fueled by booming economic growth, continued large accumulation of international reserves, and ready availability of credit. As a result, they were major recipients of cash inflows, but were subject to little pressure to deploy their assets internally or
1Specifically, following the manner in which Lehman Brothers failed on September 15, 2008—an event that disrupted the global payments and settlements system, resulting in cascading market fail-ures, acute pricing anomalies, and a series of emergency (and experimental) policy responses.2 For a contextual discussion, see Summers, 2007.
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even regionally. SWFs’ major operational stress involved finding ways to step up the pace of investment, but they worried less about potential cash flow issues.
Each of these factors was deemed consistent with delivering higher risk-adjusted returns over time. Most importantly, they reflected the majority percep-tion at that time of a favorable (and durable) set of cyclical and secular conditions. Indeed, the predominant world view—in both the private and public sectors—romanced a “great moderation” in the economic and policy realms. Goldilocks (as in “neither too hot, nor too cold”) became the one-word bumper sticker for this period.
Like virtually every sector of the financial and policy complex, the group of SWFs as a whole was caught off guard by the disruption in global payments and settlements occasioned by the manner in which Lehman Brothers failed. Virtually overnight, and as a cascading number of markets seized up, investors around the world experienced a dramatic repricing in all risk factors—particularly liquidity.
With the global financial services sector at the center of the storm, SWFs’ direct holdings in financial companies came under intense pressure. Meanwhile, rather than remaining on the receiving end of large new inflows, some SWFs found themselves under pressure to support other national (and, in some cases, regional) entities that were facing sudden and acute cash needs.
As a result, the six-month period that ended in March 2009 constituted a dramatic regime change for SWFs (similar to the experience felt by many others): investment returns turned dramatically negative; cash, collateral, and counter-party management became more of an issue; some isolated liquidity pressures emerged; and forward-looking decisions were postponed pending greater clarity on the global financial system.
More generally, the sudden stop experienced by the global economy served to pause the longer-term evolutionary process in the asset-liability management (ALM) of emerging economies—a process that had seen a number of systemi-cally important countries and regions evolve from delayed recognition of their improving circumstances through to liability retirement and more sophisticated asset management (detailed in El-Erian, 2007). Pending clarity on the changes to the global economy, several countries felt it best to wait and see before embarking on the subsequent stages of their own evolution.
SWFs also experienced a significant shift in how they were being perceived in many industrial countries. Most notably, countries that had warned against SWFs taking direct stakes in their domestic companies were now actively seeking SWF funding as a means of countering the highly disruptive impact of the deleveraging by these countries’ private sectors. The tables had turned, with SWFs now being urged to help recapitalize struggling companies, either through new cash injec-tions or by accepting an exchange of existing claims for other instruments lower down in the companies’ capital structures.
This striking change was captured well in an April 2009 editorial in the Financial Times entitled “From Vultures to White Knights.” The editorial observed, “A year ago, sovereign wealth funds were portrayed in the U.S., Europe and Japan as vultures bent on gaining political influence through their invest-
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ments. These days, in a welcoming change of attitude, governments and compa-nies cannot throw their doors wide enough” (Financial Times, 2009).
AFTERMATH OF THE FINANCIAL CRISIS: A NEW NORMAL
Thanks to a massive injection of public sector capital and liquidity, undertaken in a dramatic “whatever it takes” crisis-management mode, the global financial system began normalizing in 2009. Key financial markets—particularly in the short-term complex—are operating smoothly again; companies are able again to access new funds via bond issuance; and trust has been restored to a range of counterparty relationships that underpin the orderly functioning of the global payments and settlements system.
The core of the global financial system has overcome the massive cardiac arrest experienced after September 15, 2008. That is the good news, and it has come as a result of bold and imaginative policy responses. Yet, the policy reactions were not sufficiently effective to fully offset the damage to other parts of the global economy. In addition, such policy responses inevitably entailed risks and unin-tended consequences that, in themselves, are subsequently becoming important drivers of markets and economies.
The best analytical framework to put all this in perspective may be one that characterizes the recent disruptions not as a crisis within the global system but, rather, as a crisis of the global system. After all, the epicenter was in the most economically important country in the world (the United States, which is also the provider of important global public goods) and, by massively disrupting the financial sector, it ruptured long-standing operational links among sectors nation-ally, as well as across borders.
Faced with a crisis of the system, internal circuit breakers lacked potency. Rather than getting stopped in its tracks, the crisis spread from one balance sheet to another (starting with U.S. housing and proceeding to banks, nonbank financial institutions, the consumer, and ultimately, the rest of the world). As the crisis intensified, authorities around the world had no choice but to step in with their own balance sheets, and do so in a massive and historically unprece-dented fashion.
The failure of circuit breakers is not even the biggest concern. Policy respons-es to a crisis of the system had to be undertaken in the context of limited informa-tion and broken transmission mechanisms; they required the deployment of new tools that had not been properly tested; and they risked collateral damage that is hard to see beforehand and counter appropriately.
Thus, the global financial crisis has now given way to serial economic, insti-tutional, and political dislocations. As an example, the bulk of 2010 will witness the delayed reactions of nonbank actors. In the process, the secular landscape will be further redefined, resulting in a new normal (El-Erian, 2009). Indeed, as Reinhart and Rogoff (2009) observe in their book on the history of crises, this “is a transformative moment in global economic history whose
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ultimate resolution will likely reshape politics and economics for at least a generation” (p. 208).
Although it is too early to predict every component of the new normal, certain elements are already clear at this early stage, and they mainly affect industrial countries (the United States and the United Kingdom, in particular).
The list of consequential changes for the next three to five years includes• a dramatic shift from unfettered market activities to greater government
involvement;• a notable, regulatory-led derisking of the financial sector;• a massive jump in public indebtedness, in absolute terms and as a percent-
age of GDP, with related concerns about sovereign risk;• a significant increase in unemployment, followed by a slower reversion to
what will be a higher natural rate; and• a reduction in the trend rate of economic growth.The nature of the new normal’s inflation dynamics is more difficult to specify.
On the one hand, the enormous size of the output gap during the journey will serve to dilute inflationary pressures. On the other hand, the journey will almost certainly involve a large degree of destruction of productive capacity, including in areas that are unlikely to recover for quite a while, if ever. This includes activities that relied on a seemingly endless ability to borrow cheaply.
Ultimately tilting this balance toward a world of higher and less stable infla-tion is the call on the U.S.-specific component. The new normal is likely to involve an important gradual shift in the analytical characterization of the United States—away from an economy that operates essentially as large and closed and toward one that is more open and more heavily affected by developments in the rest of the world. This shift comes as part and parcel of the process of a slow and gradual erosion in the valuation of the public goods provided by the United States, as well as the country’s reliance on foreign capital associated with its rap-idly increasing public sector borrowing requirement and debt levels.3
Clearly, these national changes will have important international implica-tions. Yet the global consequences go well beyond this. After all, the global financial crisis has undermined the credibility of the Anglo-Saxon model, which hitherto acted as an important global convergence magnet. Moreover, the United States is no longer in a position to press other countries to deregulate, liberalize, and globalize.
Simply put, a dominant financial services sector—as measured by contribu-tions to economic activity, employment, and profitability—is no longer deemed to legitimately constitute the highest level in economic maturation. Given the absence of an alternative convergence magnet, the risk of global economic frag-mentation in the new normal is not immaterial. Protectionist threats will prevail, as will a slow process of partial erosion in two important public goods: the role of
3 The United States also starts from a position where the average maturity of its outstanding debt has fallen to a more vulnerable level—a level not seen since the early 1980s.
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the U.S. dollar as the global reserve currency, and the attractiveness of the U.S. financial system as the totally dominant destination for intermediation out-sourced by other countries.
Together, these factors constitute an important change in the operational landscape for investors, including SWFs. They call for a retooling of investment strategies and risk management, as well as business and other operational strategies. They involve adaptations in human resources, technological systems, and processes. And they require a higher degree of communication with eco-nomic and political stakeholders, as well as with national and international counterparties.
IMPLICATIONS FOR SWFS
SWFs have an important advantage in managing the road to the new normal: Their capital characteristics and the long-term nature of their objective function are key enablers when it comes to the potential to capture first-mover advantages. Indeed, the question should not be whether this pool of patient capital is able to pursue a first-mover strategy—it is. The question is whether it is willing to do so. The process will test the responsiveness of SWFs’ governance structures, the robustness of their investment processes, and the effectiveness of their internal and external communication activities.
Governance
Governance structures will be called on to respond to the combination of cyclical and secular changes, appropriately shifting the emphasis over time from defense to offense. At the most fundamental level, this response will require that the institutions obtain overall guidance from their governing bodies—directly, and by those bodies’ shielding SWFs from distractions—that enables the SWFs to (1) adopt forward-looking secular asset allocations that are (2) anchored by solid cash, liquidity, counterparty, and collateral management; and (3) supplemented by appropriate exposure to cyclical dislocations. Implementation will (4) require using investment-savvy vehicles that (5) reside in robust institutional platforms. All this must be (6) accompanied by holistic risk-management frameworks that (7) supplement conventional asset class diversification with targeted and cost-effective tail risk management.
Having set the overall principles to guide a favorable outcome on these seven points, the governing bodies of SWFs will need to rely on management and staff for effective execution. The governing bodies must also play a more important role in protecting SWFs from pressures to become subservient in funding non-commercial activities—domestically, regionally, and internationally.4
Given the fluidity of the global system, governing bodies will also need to provide more frequent assessment and verification with an open mind toward
4 Such funding is best undertaken in the context of explicit budgetary appropriation.
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midcourse correction as needed. Policy portfolios will inevitably be subject to greater variability over time, and traditional backward-looking indices for specific asset classes will have to become more forward-looking.
Investment Processes
Adaptability and agility in investment management cannot be created overnight. They require that significant and sustained efforts be devoted to processes and structures that are able to dynamically develop responsive frameworks and, as a result, ensure that investment decisions are made in the context of a relatively high degree of conviction and foundation. Several SWFs are well advanced in internalizing such processes and structures. Their effectiveness will be tested in how well they enable the institutions to navigate the journey and to position for the new normal.
Superior navigation of the journey requires, first, a strong defense in the form of prudent cash, liquidity, and counterparty and collateral management. Once this is achieved, investors can pursue with more confidence opportunities that mesh well with SWFs’ greater ability to underwrite liquidity risk factors. These involve situations where (1) valuations are already disrupted; (2) price apprecia-tion is consistent with the realities of the new normal; and (3) there are identifi-able short-term catalysts that allow for the price appreciation to occur, closing the valuation gap between technicals and fundamentals.
As Sull (2009a) points out, institutions that seize such opportunities do so because of their ability to collect and process “rush data,” as well as to “use simple rules for a complex world.” Critically, “rather than match market complexity with complicated strategy,” these institutions are able to “apply a small number of heuristics to critical processes.”
Positioning for the new normal also requires adaptability and agility. Once again, SWFs dominate most other investors when it comes to enabling structural attributes. For example, lacking the home bias trap of many other investors,5 several SWFs are already well advanced in formulating and implementing for-ward-looking asset allocations.
Three elements will stand out for those SWFs that end up securing a remu-nerative first-mover advantage in positioning for the new normal:
First, these SWFs will have relatively larger, and carefully differentiated, expo-sures to equity and credit risk factors in those parts of the world that are likely to account for an even higher percentage of growth in the global economy. They will also be able to invest in activities that complete markets, be they in the rapidly developing segments of the mortgage complex in Brazil or the still-lagging com-ponents of the corporate bond arena in east Asia.
Second, these SWFs will be among the first to protect against the potential medium-term resurgence of higher and less stable inflation. Such protection will involve a range of asset classes, starting with appropriately priced inflation linkers
5 For a related discussion, see French and Poterba, 1991.
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(such as Treasury Inflation-Protected Securities in the United States) to utility-oriented infrastructure investments and commodity baskets.
Third, these SWFs will actively clip their tails through the use of more focused risk-management techniques. Such tail hedging must treat the task as equivalent to managing a distinct asset class using an active, responsive, and cost-effective approach. The critical inputs will come from scenarios that take their cues from the underlying risk factor exposures (rather than conventional asset classes) and the appropriate mix of self- and external insurance.6
Communication
SWFs operate in a complex sociopolitical context, at home and abroad. They must, therefore, achieve a sufficient degree of trust from the political masters and from society at large. Indeed, this is an inherent part of successfully meeting the implicit contract that comes with setting up an investment management opera-tion in the public sector.
Communication is increasingly recognized as crucial to ensuring the appropri-ate amount of buy-in—in both the good times and the bad times. The global financial crisis has highlighted the importance of establishing a proper context for politicians and others to evaluate what is taking place in the portfolios of SWFs.
Appropriate communication is also key to minimizing the risk of improper capture of SWFs by narrow interests. Yet, with the exception of some SWFs (most notably Norway’s Government Pension Fund–Global), implementation of ade-quate communication is still evolving. The key lies in aiming for greater clarity in disseminating timely information on SWFs’ objective setting, on their overall strategy, and on medium-term evaluation metrics.
The operational effectiveness of some SWFs is challenged by domestic and external confusion about their objectives. This lack of clarity renders these funds’ decisions more vulnerable to misunderstandings, to a misspecification of underly-ing motives, and accordingly, to disruptive interference.
The situation becomes even more troublesome when paired with limited transparency into how SWFs pursue their objectives. Individual actions can be easily misinterpreted if viewed in isolation rather than as part of a series of mutu-ally consistent steps. This is particularly the case for individual investment deci-sions that often are viewed as unique events as opposed to integral to an overall portfolio strategy that involves the effectiveness over time of many potential return engines.
Finally, these risks can be easily compounded by a lack of subsequent evalua-tion mechanisms. The bumpy journey to the new normal calls for even greater dissemination of results. Critically, and consistent with the mandate of SWFs, reported results should be placed in a medium-term context. Evaluations should involve both the absolute numbers, and those numbers in relation to internal and peer-group benchmarks.
6 For additional information on this topic, see Bhansali, 2008.
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CONCLUSION
In the aftermath of the 2007–09 global financial crisis, the world is in the midst of both major cyclical dislocations and large secular realignments. The bumpy road to the new normal is a consequential phenomenon that requires retooling by virtually every segment of the global economy.
Although SWFs were not able to sidestep the global financial crisis, they are well placed as a group to navigate the journey and position for the destination. Indeed, the patient characteristics of their large capital pools result in the best set of enabling conditions among virtually all investors.
Exploiting these enabling conditions is far from ensured or automatic. Success requires continuous improvement in the institutional responsiveness of SWFs, which, as argued in this chapter, brings to the fore issues of governance, invest-ment processes, and communication.
Such improvements are not easy to deliver. They may take some SWFs out of their operational comfort zones, and they involve risks. Yet, given the scale of ongoing and prospective changes in the global economy, the alternative of main-taining a business-as-usual approach could involve even greater risks.
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Principles,” IMF Survey online, October 15. Available via the Internet: http://www.imf.org/external/pubs/ft/survey/so/2008/NEW101508B.htm.
Reinhart, Carmen M., and Kenneth S. Rogoff, 2009, This Time is Different: Eight Centuries of Financial Folly (Princeton, New Jersey: Princeton University Press).
Sull, Donald, 2009a, “Survival in an Age of Turbulence,” Financial Times, April 16. ———, 2009b, The Upside of Turbulence (New York: Harper Collins).Summers, Lawrence H., 2007, “Opportunities in an Era of Large and Growing Official
Wealth,” in Sovereign Wealth Management, ed. by Jennifer Johnson-Calari and Malan Rietveld (London: Central Banking Publications).
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CHAPTER 17
The Future of Sovereign Wealth Funds
EDWIN M. TRUMAN
Sovereign wealth funds (SWFs) largely disappeared from the radar screen in 2009, but the issues they raised in home and host countries over the previous two years remain unresolved. Those economic, political, and philosophical issues were somewhat mitigated by developments over the course of 2007–08, but are likely to reemerge as the global economic and financial crisis recedes. The question is whether the international financial system is equipped to restrain the forces of overreaction. This chapter argues that the system is now better equipped, but striking the right balance will continue to be difficult for the SWFs and their home and host countries.
THE PAST: PROLOGUE TO THE FUTURE
From early 2007 until about the middle of 2008, SWFs commanded increasing attention and concern in the host countries in which they invested. The issues are now familiar. Many of the government owners of these funds are countries with limited stakes or experience in participating in the global economic and financial system as it has developed since the end of World War II. Some are philosophi-cally hostile to that system. Moreover, because the SWF owners are governments, they are by definition motivated, influenced, or constrained by political consid-erations; those considerations have the potential to be inconsistent with the out-look and orientation of the host countries to those SWFs’ investments. At the same time, politicians, pundits, and the general public in host countries tend to ignore the implications for the home countries of SWF investments—the poten-tial adverse effects of misallocated investments on the home country’s economic, financial, and political stability, and the resulting feedback effects on host coun-tries and the global economic and financial system.
For a brief period at the end of 2007 and in the first quarter of 2008, some observers regarded SWFs as the saviors or white knights of the major western private financial institutions. The economic reasoning underlying this view was always questionable. There were winners as well as losers—SWFs invested in Citigroup by disinvesting, or not investing, in General Motors. Moreover, few foresaw the backlash that was to come in the home countries when these
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investments soured. That experience will likely color darkly many dimensions of the investment strategies of at least some SWFs in the future.
From a U.S. perspective as of mid-2009, not only have issues involving SWFs dropped from sight, but there is considerably more understanding of these funds. SWFs have been substantially demystified. Those who are inclined to approach issues of international finance and international relations with an open mind have educated themselves and are somewhat reassured. (This judgment is based largely on personal observations, including my own Congressional testi-mony in November 2007, May 2008, and September 2008.) Senators and Representatives were progressively better informed, expressed less anxiety, and asked more sophisticated questions. Staff members both guided and reflected their members’ attitudes.1
One factor contributing to lowering the heat under the SWF kettle was the process that led to the development by the International Working Group (IWG) on SWFs of generally accepted principles and practices (GAPP) for sovereign wealth funds, known as the Santiago Principles (IWG, 2008). These principles, not entirely by accident, bear some resemblance to the elements in this chapter’s author’s “Blueprint for SWF Best Practices” (Truman, 2008a). The Santiago Principles are an impressive example of international cooperation in a complex and challenging policy area with multiple cross-cutting considerations. They are a good start at establishing a basis for greater accountability of SWFs to their home countries’ citizens, to citizens and governments of host countries, and to financial markets.
On April 6, 2009, via the Kuwait Declaration (IWG, 2009a), the IWG announced the formation of the International Forum of Sovereign Wealth Funds. This voluntary organization will accept other eligible members that endorse the Santiago Principles. The forum will exchange ideas and views among SWFs, share views on the application of the Santiago Principles, and encourage cooperation with host countries. An analysis of the Santiago Principles based on the “Blueprint for SWF Best Practices” reveals that the GAPP scores 74 out of 100 (Truman, 2008b). However, based on the intersection of the GAPP with the blueprint, the SWFs of participants in the IWG complied with only about 60 percent of the Santiago Principles on average as of early 2008. It follows that enhanced applica-tion of the GAPP will be an important test for the forum and its members.
Those host countries that are members of the Organisation for Economic Co-operation and Development (OECD) undertook an examination of whether SWF investments in OECD member countries should be subjected to a special regime. The OECD members concluded in the negative; existing OECD invest-ment principles, codes, and declarations were judged to be sufficient to provide
1Those who are inclined to express exasperation about the chaotic U.S. political process might be reassured by this experience. None of the hearings (there were more than 10 hearings devoted to SWFs in various committees and subcommittees of the two houses of Congress) was directly connected with pending legislation. The staffs of the members and the committees used the hearings to educate the members and, in the process, lowered the heat about and increased the understanding of issues sur-rounding SWFs.
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an appropriate framework for reviewing this type of foreign investment, in some cases in connection with approval and in other cases, at least formally as in the United States, nonrejection of such investment. However, the OECD countries did not strengthen the openness of their investment regimes. As part of its broader program reviewing investment regimes, a set of guidelines for recipient country investment policies relating to national security was issued (OECD, 2009), but those guidelines apply to all types of investments, not only to govern-ment-controlled investments. The guidelines were also essentially an elaboration and codification of the OECD-recommended regime; they were not part of an effort to encourage OECD members as a group to be more receptive to foreign investment by government or nongovernment investors.2
On the basis of the available public record, it can be concluded that no effort to strengthen the collective openness of national investment regimes to SWFs was considered as part of this process. Thus, for example, (1) OECD commitments with respect to the treatment of foreign investment, including by SWFs, apply only to members, and are only extended to nonmembers on a best-efforts basis; (2) individual OECD countries have invoked multiple exceptions to the princi-ples and guidelines even as they apply to OECD members; and (3) the national security exemption is broadly defined, unchallengeable, and cases are not review-able outside the country in question.3 The Investment Committee of the OECD has agreed to an invigorated peer review process, but that is normally not likely to include participation by nonmembers. The OECD Investment Committee has reached out to nonmember countries, including those with SWFs, but with mixed success as of the writing of this chapter.
In the United States, in the wake of the controversy over the proposed Dubai Ports World investment in the management of six U.S. ports in February 2006, the Congress passed the 2007 Foreign Investment and National Security Act (FINSA), which revised the framework and procedures of the Committee on Foreign Investment in the United States (CFIUS), which was initially established by law in 1988.4 FINSA was enacted before the full force of concern about SWFs had surfaced. The result was a tightening of U.S. procedures, but again without special application to SWFs, although the procedures applicable to investments by governments have been strengthened and the national security standard rubric has been stretched by the implicit inclusion of critical infrastructure and the requirement that the CFIUS report to Congress on investments that may involve critical technologies. One source of confusion about the U.S. foreign investment regime is that the power of the CFIUS to recommend to the president that an investment be prevented is limited to those investments that would result in a controlling interest. Similarly, agreements to ameliorate the potential adverse
2 The adoption of these guidelines in October 2008 was initially at the level of officials of the OECD Investment Committee, but on May 25, 2009, they were endorsed by OECD ambassadors as an OECD Recommendation, which raises the guidelines’ political and policy profile.3The guidelines do recommend a transparent national review process.4 The CFIUS was set up by Executive Order in 1975 to monitor foreign investment in the United States, but it did not have the power to disapprove such investments.
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effects on national security in connection with nondisapprovals are limited to controlling investments. However, for noncontrolling investments, other types of reporting and disclosure requirements are required in the United States, for example, by the Securities and Exchange Commission, on a national treatment basis in which there is no discrimination between the rules and regulations applied to domestic and foreign investors. In 2007–08, suggestions that the FINSA legislation be reopened in light of perceived threats from SWFs did not generate much traction, as noted above.
Nevertheless, this generally positive situation in the United States for SWFs should be qualified in two respects. First, some in the United States would like to subject each dollar of foreign government-related investment in the United States—direct investment of any size and purchases of stocks, bonds, and U.S. treasury securities—on a case-by-case basis to a range of tests, including the current state of U.S. relations with the country making the investment and whether the country offers reciprocal treatment.5 Such a regime would be tech-nically impossible to implement without dramatic changes in today’s globalized financial system.
Second, the reality is that the CFIUS process has been tightened in the United States. The number of cases submitted to the committee for what, in effect, is prior approval has ballooned, not since September 11, 2001, but since the Dubai Ports World episode in 2006. The CFIUS process has become not a disapproval process with respect to governmental investments but a de facto approval process, creating a qualified safe harbor for those state investors. At a minimum, the transactions costs of investing in the United States have been raised, in particular for government investors, and some are unwilling to pay those financial and political costs.
In December 2008, the U.S. Treasury released the 2008 report on CFIUS transactions covering the period 2005 through 2007. A classified version was provided to Congress in mid-November 2008. The release appears to have been a nonevent, with limited press coverage. The report documents the doubling of notices to the CFIUS between 2005 and 2007, from 64 to 138. It does not, of course, report how many investments were discouraged by the CFIUS process because of the added costs of those investments in time (which can be as long as 75 days) and financial resources (legal fees and other expenses). About 10 percent of the 313 CFIUS notices during the three-year period were from countries with SWFs or equivalent investment vehicles of significant size. The same was true for 2007 alone. It is reasonable to expect that U.S. authorities will continue to be vigorous in following the requirements of the FINSA legislation and the treasury regulations implementing that legislation.
More broadly, the economic and financial environment for SWFs has changed since mid-2008. First, SWFs, along with essentially all other global investors, have suffered financial losses although a larger proportion of SWF
5 See the testimony of Gal Luft and the exchanges on pages 64–65 in Committee on Foreign Relations of the U.S. House of Representatives, 2008.
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losses have not been realized. Kern (2009) estimated that the imputed losses on equity investments by SWFs may have been 45 percent between the end of 2007 and early 2009, most of which were not realized. Second, those losses, even on paper, have been subjected to greater scrutiny at home than would have been the case several years ago because SWFs in general are more exposed on home radar screens as well as internationally. Third, the flow of new resources into most SWFs slowed substantially after the first half of 2008. Kern’s estimate is that the assets under management of SWFs had declined 17 percent as of mid-2009 compared with the end of 2007 (Kern, 2009). His estimate reflects inflows, outflows, and the SWFs’ realized and unrealized capital gains and losses. Fourth, many funds turned either by initial institutional design or sub-sequent ad hoc policy decision from investing abroad to investing at home. For example, stabilization SWFs have used their resources as intended to offset reduced inflows of foreign exchange, and other types of SWFs have acted delib-erately to support domestic financial institutions or other forms of domestic investment. All four factors have lowered the profile of SWFs and added an ele-ment of realism to their operations as viewed from at home or abroad. In the context of the global economic and financial crisis as of the middle of 2009, SWFs do not bulk as large global economic and financial power brokers or as potential real or imagined threats.
THE FUTURE
The global economic and financial crisis that started in 2007 will come to an end. Whether the not-so-old pattern of SWFs investing increasingly vast sums abroad will reemerge is more difficult to forecast, but SWFs will recover and many will resume or accelerate their foreign investment activities.
One issue is the extent of the damage suffered by the international financial system in the meantime. Many specters haunt the international environment as of the middle of 2009: the worst global economic contraction since the Great Depression, the collapse of many financial institutions around the world, and a potential reversal of the process of real and financial globalization that started at the end of World War II. This last specter—an outbreak of financial protection-ism—is most troubling and relevant with respect to SWFs.
Protectionism in all forms lies just below the surface in all countries. A survey released on February 9, 2009, found that two-thirds of respondents said that it is a good idea to require the U.S. stimulus funds to be spent on U.S. goods to keep jobs in the United States and only a quarter of respondents said it is a bad idea because it risks trade retaliation (Pew, 2009). The questions might have been phrased dif-ferently and, as a result, have elicited a narrower margin between the two responses, but the interesting point is that no significant difference emerged between the views expressed by self-described Republicans, Democrats, and Independents. If these reported views are examined alongside those in a poll a year earlier (Public Strategies, 2008) that found that only 6 percent of 1,000 U.S. respondents had seen or heard anything recently about SWFs, but that 49 percent thought that
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investments in the United States by foreign governments have a negative effect on the U.S. economy and 55 percent thought that they have a negative effect on U.S. national security, one can appreciate that financial protectionism is just below the surface in the United States. The United States is not unique. Many actions by governments in the crisis served to fan these flames, for example, unilateral actions to raise deposit insurance limits, guarantees of the senior debt of banks but primar-ily domestically chartered banks, closure of financial institutions while ignoring the concerns of their foreign creditors, and criticisms of foreign banks for pulling back on lending to domestic borrowers.
Moreover, the low market values of many financial and industrial enterprises will at some point make them attractive to foreign buyers, including SWFs.6 Economic nationalists viscerally oppose selling off national champions, particu-larly at bargain-basement prices. Thus, the actual or potential establishment by France and Japan of funds, which some advocates in those countries describe as sovereign wealth funds, to invest in key domestic firms can be viewed as attempts to support domestic firms as well as to reduce the risk that these firms will fall into the wrong—that is, foreign—hands. Similar motivations can be found in all countries.
As a result, the degree of openness to SWF investments, which was never 100 percent, may shrink substantially in the years ahead. It is no accident that the IWG meeting in Kuwait City on April 6, 2009, welcomed the April Group of Twenty Communiqué and its pledge to do whatever is necessary to promote global trade and investment and to reject protectionism (IWG, 2009b).
Beyond the issue of financial protectionism, the global economic and finan-cial crisis that began in 2007 has transformed the role of the state in all economies and the way in which many think about the government’s proper role. At this point, these dramatic events’ longer-term influence on the actual and perceived roles of governments in the future is subject to speculation. It is reasonable to suppose that more people are more comfortable with a larger role for their governments in their economies than several years ago and that those attitudes will translate into acceptance or encouragement of an increased role for governments in economies. Some might argue that as a consequence greater acceptance of the role of governments generally should reduce conflicts over state-sponsored foreign investments via SWFs. A less sanguine prospect is that the increased role of governments in all economic and financial systems will fan the flames of national competition and of efforts by governments to save and to create jobs at home in an environment of less-than-robust eco-nomic growth.
With respect to SWFs in particular, the current trend of countries to redirect a larger proportion of SWF investment inward—although understandable and in many cases appropriate in the current environment, especially for SWFs with
6 However, only a small proportion of all SWFs make controlling investments (probably less than a quarter) and a small percentage of total SWF assets (probably less than 10 percent) take the form of such investments. These facts are often ignored in public debates about SWFs.
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stabilization objectives—could lead to problems going forward. First, the SWFs may squander their financial resources in low-return domestic investments. Second, the potential for corruption associated with the large amounts involved is amplified by increased spending on domestic investments, through which deals that pass funds into personal accounts are easier to arrange. Third, once SWFs get into a pattern of investing in the domestic operations of financial and nonfinan-cial firms, it will be natural for them to invest more heavily than at present in the foreign operations of those firms, which raises many sensitive issues in the coun-tries in which they invest, including with respect to fair international competi-tion, again raising the issue of the role of the state in the global economy. The issue of state capitalism and its effects on the global competitive playing field received fresh attention in mid-2009 when the Financial Times on July 21 reported that China’s Premier Wen Jiabao endorsed a strategy of using China’s foreign exchange reserves to support the foreign expansion of Chinese industries (Anderlini, 2009).
Returning to the issue of accountability of SWFs, it is important that they raise their scores on the scoreboard in the blueprint, or more specifically, on the GAPP version of my SWF scoreboard in the Santiago Principles. Doing so is essential if the progress that has been made in demystifying the funds is to con-tinue. Conversely, the definition of SWFs is loose, and many countries have mechanisms to deploy their investments internationally other than entities that fall within the IWG’s definition of an SWF. For example, the Saudi Arabian Monetary Agency reported that as of May 2009 the government of Saudi Arabia was managing US$412 billion in international investments other than their for-eign exchange reserves, but not in the framework of an SWF as defined by the IWG.7 Saudi Arabia participated in the IWG as an observer, but unless it estab-lishes an SWF, it does not have even an implicit obligation to follow the GAPP in managing its foreign investments.8 Excluded from the IWG definition of SWFs are foreign currency reserve assets (although some reserve assets are part of or are managed by SWFs), operations of state-owned enterprises, government-employee pension funds, and assets managed for the benefit of individuals.9
Thus arises the potential for regulatory arbitrage. If countries perceive that the global standards applied to SWFs are inconvenient or too tough, they will make their foreign investments through other vehicles such as investment subaccounts of their international reserves or through state-owned financial institutions.
7 See also Chapter 5 of this volume.8 In March 2009, the press reported that Saudi Arabia had established the Hassana Investment Company owned by the General Organization for Social Insurance in Saudi Arabia (Karam, 2009). However, this appears to be a pension SWF that would not be included within the IWG definition of an SWF, which includes pension reserve funds without explicit pension liabilities but excludes government-employee pension funds in which the assets are managed for the benefit of individuals.9 Some public pension reserve funds are included in the definition of SWFs because they are not directly tied to pension programs. Truman (2008a) scores both nonpension and some pension SWFs because both types of governmental investment vehicles raise similar policy issues in home and host countries.
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As often is the case in the twenty-first century, China is likely to be a particular focus of attention because it is large and increasingly influential in international finance. Its China Investment Corporation (CIC) is an SWF, but its assets under management were only US$200 billion as of the end of 2008, and almost half of its investments were domestic. Much more important are China’s foreign exchange reserves, which as of mid-2009 were 10 times the total size of the CIC. China’s State Administration of Foreign Exchange (SAFE), which is under the People’s Bank of China, is more opaque in its operations than most other emerging-market countries’ foreign exchange managers, which in turn are more opaque than many SWFs, and the SAFE is known to make many SWF-type investments. Perhaps more critical are China’s government enterprises and its government-owned banks. The CIC is the majority owner of most of China’s government-owned banks and is considered a bank holding company under U.S. banking law. When the global economic and financial crisis ends, the world’s economic and financial systems will not revert to the precrisis written and unwritten rules and conventions of interna-tional finance and the precrisis roles of governments. The views attributed to China’s Premier Wen Jiabao, noted above, illustrate the changing landscape. China will greatly influence the way in which the environment changes, including for SWFs. In this context, it is also noteworthy that Jin Liqun, Chairman of the Board of Supervisors of the CIC, has been chosen as one of two vice chairs of the International Forum of SWFs.
CONCLUSION
Substantial strides have been made since late 2007 in making the world safer for sovereign wealth funds.
For the future, SWFs need to build on that progress by embracing the Santiago Principles, participating in the International Forum, and individually increasing their transparency. At the same time, countries receiving SWF invest-ments need to resist financial protectionism and look for ways to codify and strengthen that resistance. This is not to say that doors have to be wide open. SWF investments raise real economic, political, and philosophical problems. Participants in the global system should continue to seek a balanced approach to those issues through the maximum possible application of principles of national treatment, accountability, and transparency. In the future, these issues will become larger, not smaller, and the challenge will not be just for the SWFs but for all forms of cross-border investments by governments.
REFERENCES
Anderlini, Jamil, 2009, “China to Deploy Foreign Reserves,” Financial Times, July 21.Committee on Foreign Relations of the U.S. House of Representatives, 2009, The Rise of
Sovereign Wealth Funds: Impacts on U.S. Foreign Policy and Economic Interests, May 21 (Washington: U.S. Government Printing Office).
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IWG (International Working Group of Sovereign Wealth Funds), 2008, Sovereign Wealth Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
———, 2009a, “Kuwait Declaration.” Available via the Internet: http://www.iwg-swf.org/mis/kuwaitdec.htm.
———, 2009b, “Working Group Announces Creation of International Forum of Sovereign Wealth Funds.” Press Release 09/01. Available via the Internet: http://www.iwg-swf.org/pr/swfpr0901.htm.
Karam, Souhail, 2009, “Saudi Government Approves Investment Firm for Pension Fund,” Reuters, March 23.
Kern, Steffen, 2009, “Sovereign Wealth Funds—State Investment during the Financial Crisis” (Frankfurt: Deutsche Bank Research).
OECD (Organisation for Economic Co-operation and Development), 2009, Guidelines for Recipient Country Investment Policies Relating to National Security (Paris).
Pew (Pew Research Center for the People & the Press), 2009, Support for Stimulus Plan Slips, But Obama Rides High, April 9. Available via the Internet: http://people-press.org/report/490/obama-stimulus.
Public Strategies, Inc., 2008, U.S. National Omnibus Survey Conducted on February 12–13. Available via the Internet: www.pstrategies.com.
Truman, Edwin M., 2008a, “A Blueprint for SWF Best Practices.” Peterson Institute for International Economics Policy Brief PB 08-3 (Washington: Peterson Institute for International Economics).
———, 2008b, Making the World Safe for Sovereign Wealth Funds. Peterson Institute for International Economics Real Time Economic Issues Watch (October 16). Available via the Internet: http://www.petersoninstitute.org/realtime/?p=105.
U.S. Department of the Treasury, 2008, “Committee on Foreign Investment in the United States, Annual Report to Congress, Public Version (December)” (Washington). Available via the Internet: http://www.ustreas.gov/offices/international-affairs/cfius/docs/CFIUS-Annual-Rpt-2008.pdf.
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CHAPTER 18
Long-Term Implications of the Global Financial Crisis for Sovereign Wealth Funds
ANDREW ROZANOV
This crisis will leave an indelible mark on the psyche of every sovereign fund investor.– Senior reserve management official at a major Asian monetary authority,
Institutional Investor Sovereign Funds Roundtable, Singapore (2008)1
The global financial crisis that began in 2007 shook the foundations of modern financial markets and tested some core assumptions on which our understanding of those markets is based. Sovereign wealth funds (SWFs) were caught in the middle of these turbulent developments: the dramatic drop in commodity prices, the collapse of world trade, and the reversal of foreign capital flows undermined the funding sources of many SWFs around the world, just as their portfolios were being decimated by sharp declines across various asset classes. And this happened just when many SWFs found themselves being directed by their sponsoring gov-ernments to help support domestic spending and investment and to help stabilize domestic banks and financial markets.
This situation had a direct impact on the day-to-day operations and immedi-ate future plans of many SWFs. The first response was to refocus on liquidity: many institutions that were moving into riskier asset classes in search of higher yields and diversification benefits put those plans on hold and started building up large liquidity buffers. This knee-jerk derisking of investment programs led to an increased appetite for traditional reserve assets, such as the U.S. dollar and U.S. government paper.
Second, the pressing need to provide emergency support to domestic econo-mies and institutions led to an increased focus—and in some cases an entirely new focus—on domestic markets. Some countries, such as Norway and Chile, responded by drawing on their sovereign wealth, either directly or indirectly, to support budget spending, while leaving intact the core principle of keeping all of
1 The roundtable was held under the Chatham House Rule, which states: “When a meeting, or part thereof, is held under the Chatham House Rule, participants are free to use the information received, but neither the identity nor the affiliation of the speaker(s), nor that of any other participant, may be revealed.”
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their SWF investments offshore.2 But other nations with SWFs went further. Countries as diverse as France, Ireland, Kazakhstan, the Republic of Korea, Kuwait, Qatar, the Russian Federation, and the United Arab Emirates found themselves having to become much more creative, flexible, and pragmatic in their deployment of sovereign wealth in domestic markets.3
Policy measures drawing on sovereign wealth to deal with the crisis are logical and understandable. However, they point to a bigger set of issues that SWFs and their sponsoring governments need to consider in the longer term, once the crisis subsides. For example, many emerging-market economies may want to revisit their criteria for determining reserve adequacy—monetary authorities in some countries may have underestimated the amount of U.S. dollar liquidity they actually need in times of distress, especially in the context of once-in-a-lifetime global financial crises. No hard and fast, universally applicable rule aids in the calculation of sufficient levels of reserves. It appears to be more art than science, and adequate levels will be different for each country.4 However, one fact is certain: countries hit hard by the crisis will most likely err on the side of cau-tion and set aside more, rather than less, reserves for prudential policy purposes going forward.
Related to the issue of how much protective liquidity to maintain in a sover-eign portfolio is the issue of the best way to structure and manage the remaining part of the portfolio. The painful, dramatic increases in correlations across all risk asset classes in the global financial crisis will most likely prompt some SWFs to revisit the validity of key tenets of modern portfolio theory. In principle, many of these funds represent patient capital with high risk tolerance and very long investment horizons. As such, they should be ideally positioned to invest large proportions of their wealth in broadly diversified portfolios of higher-risk and lower-liquidity assets. In this context, an occasional spike in short-term volatility and correlations is part of the price to pay for higher expected long-term returns.
However, the crisis has put to the test a number of other important aspects of sovereign wealth management. Some SWFs discovered that the range of contingent liabilities leading to potential calls on their capital turned out to be much broader than originally anticipated, while others learned that the political establishment, the media, and the general public in their home countries have
2 Norway dramatically increased the spending of oil revenues to deal with the financial crisis, reducing inflows into the SWF and thus slowing its asset growth considerably: measured by the change in the structural, non-oil deficit, the fiscal stimulus in 2009 can be estimated at 3 percent of trend GDP (for more information on Norway’s fiscal situation and how it relates to the sovereign fund, see Norway, Royal Ministry of Finance, 2010). Chile tapped one of its SWFs directly, spending close to US$4 billion, or 2.8 percent of GDP, from the Economic and Social Stabilization Fund by way of fiscal stimulus in 2009. According to the author’s sources at the Ministry of Finance, subsequent withdraw-als brought the total expenditure from the fund to US$9.3 billion. 3See the annex to this chapter for specific examples of policy actions in these and other countries dur-ing the crisis.4 For comprehensive reviews and discussion of reserve adequacy, see Wijnholds and Kapteyn, 2001; Edison, 2003; Aizenman and Lee, 2005; and European Central Bank, 2006.
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much lower tolerance for short-term volatility and unrealized investment losses than modern portfolio theory would prescribe. Part of the solution would be to ramp up public relations and education campaigns. But the bigger and much more difficult task will be to go back to the drawing board and undertake a comprehensive review of the sovereign’s broadly defined assets and liabilities and determine what they mean for the optimal structure and management of the SWF.
Another long-term consideration coming out of the current crisis is the role of the state in the domestic economy. A government acting as a portfolio investor and a minority shareholder in a foreign company, which is located and regulated outside its jurisdiction and control, is quite a different matter from an owner government that also happens to be the rule-setter and regulator.5 While the crisis certainly favors a pragmatic approach over ideological dogma, it is nonetheless important not to lose sight of the difficult lessons—which many societies learned the hard way—about corruption, waste, and inefficiency that often result from government interference.
The issue, however, is more nuanced than simply whether a government should be an active market participant and an actor in its own domestic economy. Rather, one should consider how to structure a government’s par-ticipation to mitigate the concomitant risks, while allowing the investee company to succeed in a free and fairly regulated market economy. In delib-erating this question, it may be useful to draw on the practices of different sovereign funds around the world that are currently outside the narrowly defined scope of SWFs, but that have the unique experience of investing in and running domestic business operations across a variety of sectors and industries—funds such as Mubadala Development Company of Abu Dhabi, Khazanah Nasional Berhad of Malaysia, State Capital Investment Corporation of Vietnam, or Samruk-Kazyna National Wealth Fund of Kazakhstan, to name just a few.6
The rest of this chapter discusses in more detail the two long-term implications highlighted above: the importance of analyzing and managing SWFs in the context of broader national assets and liabilities, and the need to recognize and mitigate the risks that come with an increased role for the state in the domestic economy.
5 While this includes cases where home governments act through SWFs and other sovereign funds, potential problems are arguably much broader in scope, given that they may arise from direct govern-ment ownership and participation in the domestic economy through partially or fully state-owned enterprises, development banks, and other non-SWF vehicles.6 Of this type of fund, only Singapore’s Temasek has been classified as an SWF within the meaning of the Santiago Principles and included in the International Working Group of Sovereign Wealth Funds. It is not clear why other similar funds are excluded from this forum—most notably, Mubadala Development Company of Abu Dhabi, which appears to satisfy all of the definitional criteria of an SWF as set out in the Santiago Principles. Other such funds appear to be excluded solely on the grounds that they invest only in domestic assets, but Temasek was originally established and continued to operate for a long time as a sovereign fund investing exclusively in domestic assets.
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SOVEREIGN ASSETS AND LIABILITIES: A BROADER PERSPECTIVE
The best way to minimize risk is to scale down the size of foreign currency reserves.–Wu Xiaoling, Vice President of National People’s Congress Financial and Economic Affairs Committee, ex-Deputy Governor of the People’s Bank of
China and former chief of SAFE, China (Wang, 2009)
Just like other large institutional investors, long-established SWFs with meaning-ful exposure to risk assets suffered steep, double-digit percentage-point drops in portfolio wealth.7 But what makes this crisis even more challenging for many of them is the simultaneous impact on the liability side of their balance sheets—a sudden drop in funding combined with increased calls on diminishing capital. The crisis stressed not only asset portfolios of SWFs, but also their liabilities, and it did so along both dimensions—sources and uses of funds.
With regard to sources of funds, approximately two-thirds of total SWF assets are derived from hydrocarbon and other commodity-export revenues and consti-tute genuine public sector savings. Therefore, as per-barrel oil prices crashed from a peak of US$147 in July 2008 to about US$35 by the end of December 2008, most oil-rich SWF nations saw a marked decrease in their funding flows. Another important group of SWFs, located in Asia and funded from excess foreign exchange reserves, faced a similar shift in their funding environment, as the col-lapse in international trade led to shrinking current account surpluses and as capital flight from emerging markets reversed previous capital account surpluses.8 These SWFs faced an additional complication: their assets are supported by local currency-denominated, interest-bearing liabilities that have been placed with domestic commercial banks and other domestic institutions. Some analysts argue, therefore, that heavy investment losses may potentially have negative implications broader in scope and more systemic in nature than originally envisaged.9
To what extent are these broader liability considerations taken into account when SWFs determine their asset allocation and investment strategies? This dis-cussion first considers the case of a commodity-based fund and then turns its attention to an SWF funded with foreign reserves.
7 In 2008, Norway’s SWF suffered the worst performance in its 12-year investment history, losing 23.3 percent or US$96.3 billion, thus wiping out most of its cumulative investment gains since inception. Singapore’s Temasek reportedly lost 31 percent in the eight months ending November 30, 2008, with the Government of Singapore Investment Company estimated by the Wall Street Journal to have suf-fered a similar drop in 2008, probably about US$33 billion (Paris, 2009). Some analysts following SWFs in the Gulf Cooperation Council put losses at the largest funds in the range of 18–40 percent (see Setser and Ziemba, 2009, and Reed, 2008).8 In 2008, China’s current account surplus declined 27 percent year-on-year, slowing the growth of foreign reserves. The Institute of International Finance forecasted a drop of 33 percent in 2009 in net financial flows to emerging Asia from its peak in 2007 (Institute of International Finance, 2009). The challenges and implications of this are discussed in the interview with Wu Xiaoling (Wang, 2009).9 For more on this point, see Park, 2008.
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On the one hand, the logic of oil-to-equity transformation was well estab-lished long before the current crisis: a nonrenewable resource with mediocre long-term returns and very high volatility is gradually transformed into a broadly diversified financial portfolio with higher expected returns, lower volatility, and the potential to benefit multiple generations. (See Kjær, 2006, for a detailed account.) Within this framework, some oil-based funds carefully designed their asset allocations to avoid exposure overlaps with oil in the ground; for example, Norway reportedly looked into a commodity allocation for its SWF, but rejected it precisely for this reason, while Kazakhstan’s National Wealth Fund went even further and customized its developed-market equity investments by excluding any exposure to the energy industry.10 Anecdotal evidence also suggests that some of the larger and more established Middle Eastern SWFs have carefully structured their commodity exposures, taking into account oil in the ground.11
On the other hand, little evidence to date, at least in the public domain, indi-cates that any SWF is incorporating its physical commodity endowment into the formal asset allocation and portfolio construction process. But the crisis is refo-cusing people’s minds on the interplay between commodity prices and sovereign portfolio returns. Recently there have been a number of attempts to address this question: how does one account for oil in the ground when determining the optimal asset allocation for an oil-based SWF? And how does this optimal port-folio change over time as oil is extracted, exported, and converted into financial wealth? And what is the expected pace of this oil-to-equity transformation? Intuitively, one would want to extract and sell more oil when its real price is high and when equity is relatively cheap, and vice versa.
Academics and practitioners are just beginning to explore these issues by applying quantitative rigor and analytical models, but the first results are promis-ing. Although the exact methodology and specific data used in these analyses may differ, they tend to point toward the same broad conclusion: a relatively new SWF representing only a small fraction of a nation’s total wealth, which includes oil in the ground, should invest fairly aggressively in growth assets such as public equi-ties, but as the financial portfolio increases in size it should gradually be moved toward a more balanced combination of risk assets and safe bonds.12
Broadening the optimization procedure to explicitly include oil in the ground will not necessarily protect against periods like 2008, when risk assets and com-modity prices dropped in unison—oil is not perfectly negatively correlated to equity and other risk assets, but rather is uncorrelated over the long term, which
10 See NBIM, 2002; for Kazakhstan, the information can be found on the central bank’s Web site: www.nationalbank.kz/index.cfm/.11 At an international sovereign funds conference in May 2007, a senior representative from a large Gulf Cooperation Council SWF explained that although they were mindful of preexisting commod-ity exposure via oil in the ground, they took a more granular approach: while avoiding assets in the upstream sector, they had the ability to invest in the downstream sector. Also, nonhydrocarbon com-modities—such as metals or agriculture—were viewed as potentially legitimate investments.12 For a practitioner’s perspective, see Scherer, 2009; and State Street, 2009. For an academic perspec-tive, see Martellini, 2008.
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will mask the occasional subperiod of comovement in prices. However, rigorous optimizations based on hard numbers and scientifically defensible analyses will provide the necessary basis for communication and educational efforts to per-suade politicians and the broader public of the need to take the long-term view and to be more tolerant of short-term risks and unrealized losses.13
However, the approach described above helps address only one part of the liability equation—source of funds. An equally important consideration is expected uses of funds, and to the extent these are contingent and difficult to quantify, statistical modeling may have its limitations. Still, an internally consis-tent and logical approach to liability profiling should be possible. For example, as it considers its approaches to sovereign wealth management, an oil-rich country with a relatively large, young, and growing population (e.g., Saudi Arabia) will probably focus more on the need to create plentiful employment opportunities, while a hydrocarbon-rich nation with a shrinking and aging population (e.g., the Russian Federation) will likely have a stronger focus on supporting and augment-ing its pension system. And both countries will be considerably more constrained, at least in theory, than their peers with much smaller populations and only mar-ginally smaller hydrocarbon endowments (e.g., Abu Dhabi and Qatar). Sovereign funds in the latter two economies have unique asset and liability profiles, giving them the maximum possible investment freedom:
• among the world’s highest per capita hydrocarbon endowments,• among the world’s largest per capita financial and real asset portfolios,• lack of explicit liabilities attached to the assets of the funds,• comfortable financial cushion to cover implicit liabilities, and• culture of risk-taking and increased focus on real assets.This combination of factors makes SWFs in relatively small but hydrocarbon-
rich Gulf economies the ultimate pools of long-term and patient risk capital available anywhere in the world; they have the ability to deploy funds in search of both attractive financial returns and important nonfinancial benefits accruing to their economies, almost entirely unconstrained on the liability side of their balance sheets. In this light, it would be natural to expect them to continue investing not only in publicly listed securities, but also in private equity, real estate, infrastructure, venture capital, and other alternative assets, and to focus increasingly on transformational strategic investments.14
13A commodity endowment may be the single most important national asset, but it is not the only one. Authorities may want to keep in mind the state’s other national assets when determining the optimal asset allocation and investment strategy for their SWF. For example, Abu Dhabi Investment Authority may want to be aware of investments made through other sovereign vehicles, such as Mubadala Development Company, the Abu Dhabi Investment Council, and the International Petroleum Investment Company. Similarly, Singapore’s government may want to jointly optimize and control risk exposures taken through the Government of Singapore Investment Corporation, Temasek, and the Monetary Authority of Singapore.14One possible consequence of the current crisis could be a stronger emphasis by SWFs and their sponsoring governments on strategic or “extra-financial” policy objectives. For more on this point, see State Street, 2009.
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On the other end of the liability spectrum are large sovereign wealth owners in foreign exchange reserve-rich Asian nations. Historically, most of them—with the possible exceptions of Singapore and Brunei—have been somewhat reluctant accumulators of sovereign wealth. That accumulation was just a by-product of their exchange rate policies, and as such, it initially built up in the form of massive foreign exchange reserves at their central banks. As a result, these reserves did not constitute genuine public sector savings, but rather foreign assets funded in local currency debt markets, thus leading to a liability profile completely different from the typical commodity-based SWF.
Some countries then decided to follow the Singaporean model by carving out a portion of these reserves to form separate and independent SWFs (e.g., the Republic of Korea established the Korea Investment Corporation in 2005 and China created the China Investment Corporation in 2007). Other nations in the region (e.g., India, Japan, and Thailand) debated the relative merits of this approach, but as of the time of this writing in mid-2009, for various reasons decided against it.15 However, the public debate in some of these countries con-tinues and will probably not subside as long as sizable domestic savings are effec-tively tied up in the form of local debt-funded, de facto sovereign wealth.
Some of these countries could consider alternatives to both endless reserve accumulation and establishment of separate SWFs. Open-minded and creative thinking about excess reserves in the context of broader national assets and liabil-ities could yield a number of ways to optimize the broader national balance sheet while at the same time shrinking the overall size of foreign reserves. For example, it may be constructive to explore whether some foreign assets currently residing in a domestic debt-funded foreign reserve portfolio might be more optimally swapped against such debt with the national pension fund. This would help domestic monetary authorities, who are reluctant holders of reserves in the first place, to shrink their balance sheet, while helping the national pension fund expand its allocation to foreign assets in one fell swoop without the associated market impact.
Other creative asset-liability management ideas may include the innovative use of exchange-traded funds or exchangeable bonds to dispose of a portion of excess reserves in an orderly and market-friendly way. Such actions by the official sector would not be entirely unprecedented: the Hong Kong Monetary Authority par-tially disposed of its domestic share portfolio, which it had accumulated during the defense of Hong Kong SAR markets against the so-called double play specula-tors in 1998, using a creative solution based on exchange-traded funds, while some European states in the past issued exchangeable bonds to reduce their stakes and lower their debt burdens. In 2009, UK Financial Investments (UKFI), the entity created to hold and manage the shares acquired by the British government in bailed-out domestic banks, is reportedly considering issuing an exchangeable bond (see Aldrick, 2009).
15For more information on India, see Choudhury, 2008; on Japan, see Rowley, 2008; on Thailand, see Srisukkasem, 2008; and Phuvanatnaranubala, 2008.
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While most discussions to date surrounding SWFs have focused primarily on asset acquisition and asset management, the crisis has brought forward the impor-tance of understanding and managing sovereign liabilities. Therefore, it would not be unreasonable to expect the SWF policy debate to become considerably broader in scope, encompassing both the asset and the liability sides of the national balance sheet.
DOMESTIC SOVEREIGN INVESTMENTS: TOWARD A NEW WASHINGTON CONSENSUS
The question … is not whether our government is too big or too small, but whether it works.
–Barack Obama, President of the United States (2009)
In the global financial crisis many nations with SWFs were forced to deploy some of their accumulated sovereign wealth domestically to support domestic econo-mies and institutions. Although some of these measures took the form of straightforward stimulus packages and one-time increases in budget spending, many SWFs were also instructed by their governments to invest directly in domestic markets and institutions, often requiring changes in the SWFs’ invest-ment guidelines and lists of eligible assets, and sometimes—as was the case in Ireland—even changes in the legislation governing the SWF. The appendix at the end of this chapter contains some specific examples of SWF-sponsoring govern-ments taking bold and innovative action with regard to domestic investments by their sovereign funds.
The reserve-rich governments in emerging markets and in small developed countries were not alone in being forced by the crisis into massive domestic interventions. Authorities in some of the largest and most developed free-mar-ket economies, with sizable budget and current account deficits—countries like the United States and the United Kingdom—were also forced to intervene heavily and to take on, albeit very reluctantly, ownership of important chunks of their domestic economies. This happened on the back of massive bailouts of commercial and investment banks, insurance companies, and automobile manufacturers.16
To be sure, such reluctant accumulation of assets by governments in developed countries does not automatically make them owners of SWFs, certainly not as defined within the context of the Santiago Principles (IWG, 2008). However, even in a broader sense, the two phenomena differ in too many fundamental ways to allow them to be equated: differences of objective (temporary rescue versus long-term wealth management), control (ownership of last resort versus a minor-ity stake on par with other shareholders), and management style (accelerating
16The massive expansion of the role of government in the United States and other developed econo-mies resulting from the crisis goes well beyond bailouts or reluctant share ownership. For a broad overview of the issues and challenges, see McKinsey & Company, 2009.
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economic recovery with eventual reprivatization versus maximizing shareholder value in perpetuity).17
Despite these differences, even in the most optimistic scenario governments in the west will probably need to hold their newly acquired assets for a considerable time before they can safely and profitably return them to private ownership. In this context, one of the key questions is how a government with no asset-management experience, no proper institutional arrangements, and no specialist staff can assure the taxpayer that the acquired stakes will be managed in the most efficient and professional manner, in single-minded pursuit of a fiscally optimal exit. Put differ-ently, how do we know that the authorities, in their capacity as temporary bank owners, will prioritize long-term profit maximization and sound risk management over short-term political dividends that may come from forcing banks to maintain lending to corporations and households regardless of risks and profitability? Or how do we know, for example, that the government will not be tempted to use its pow-erful new position in the automobile industry to force upon car companies a “green” agenda that does not necessarily make business and financial sense?
Typically, monetary authorities and regulators command a powerful presence in their respective financial markets in the best of times. When the government becomes the only source of support and liquidity among the carnage of a financial crisis and economic downturn, its relative strength and influence vis-à-vis the private sector increases dramatically. If the authorities then take on the role of a principal player in the domestic financial market, the power they project—and correspondingly, the damage they can do—can become overwhelming. Glen Moreno, who at one point worked as chief executive of Fidelity International and at the time of this writing is acting chairman of UKFI, put it colorfully and suc-cinctly when he referred to his new employer as “Fidelity with nuclear weapons” (Wilson, 2009).
Arguably, the risks of mistakes and abuses are highest in countries with no his-tory of the government running financial portfolios or operating complex busi-nesses. These governments have no institutions, no infrastructure, no skilled public servants versed in complex technical matters critical for success. And typically, no safeguards or mechanisms shield those responsible for managing the assets from intense political pressures. The unique experiences of a number of sovereign funds in emerging-market economies can be helpful and informative in these situations. This is not to say that they have all the answers or that all of their experiences have been positive. The important point is that all of them—albeit to varying degrees—have strived to set up professional fund-management operations at arm’s length from the government, based on commercial principles, and staffed with experienced market practitioners whose compensation is benchmarked to the private sector.
The most experienced and longest standing among these entities is Temasek Holdings of Singapore. Established in 1974, it spent its first 25 years focusing primarily on managing domestic assets and nurturing portfolio companies in the city-state. Only since the turn of the century has it focused increasingly on Asia
17I am grateful to John Nugee of State Street for this insight.
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and the broader world, to a point where only one-third of its investments are now in the domestic economy. During the 35 years of its existence, Temasek has achieved solid investment returns, often on par with or better than most of the private-sector peers against which it gauges its performance. But the significance of the Temasek model goes beyond just attractive returns: by interposing an investment holding company, operating on purely commercial principles, between the state and its investee companies, the government managed to sepa-rate its roles as owner and shareholder from those of policymaker and market regulator. This also freed government-owned companies to operate purely as commercial enterprises and focused Temasek’s efforts on the bottom line.18
Over the years, many other sovereign funds have been established in other parts of the developing world along broadly similar lines, striving to achieve broadly similar objectives, thus providing a unique set of experiences and a rich collection of case studies for policymakers in developed countries. In fact, some western countries have already set up entities that could serve as the basis for similar types of sovereign funds (e.g., the Shareholder Executive and the UKFI in the United Kingdom). Even if the eventual objective of these organizations is complete and unambiguous disposal of the acquired shares back into the private sector, in the interim they could do much worse than turn to the likes of Temasek for lessons on organizational structure, governance, asset management, and active ownership.
Will the authorities in developed countries rise to this challenge? Or will the dogma of free-market ideology, which tends to dismiss any form of government participation in the economy, preclude a calm and pragmatic discussion? Perhaps what the world needs is a new version of the Washington Consensus, which would embrace government participation in free markets, but would do so on the basis of a strict set of terms and conditions. While reiterating the key principles of the original Washington Consensus and reconfirming the supremacy of mar-kets, it would at the same time take a much more nuanced and sophisticated view of a government’s participation in the economy.19 Specifically, it would acknowl-edge that differences in history, social and political traditions, and levels of eco-nomic development may legitimately lead to materially different levels and forms of government participation in domestic economies. It would also acknowledge that, in light of the global financial crisis, even in the most laissez-faire of econo-mies, governments from time to time may need to get involved in the domestic economy and financial markets as a principal.
18For more information on Temasek Holdings, see Ho, 2004; and Lim and Tsai, 2009; also, see Temasek’s Web site at www.temasekholdings.com.sg.19The term Washington Consensus was originally coined in 1989 by John Williamson (with the Peterson Institute at the time of writing of this chapter) in the narrow context of specific policy advice to Latin American countries in the late 1980s. Over time it has acquired a much broader meaning, often with a negative connotation, to refer to neoliberal policies and “market fundamentalist” views. For more information on the history of the term, see “Washington Consensus” at http://www.cid.harvard.edu/cidtrade/issues/washington.html.
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At the same time, the new Washington Consensus20 would lay out a clearly formulated set of standards and practices, not unlike the Santiago Principles, that governments would need to follow to be seen as compliant and up to the standard in their approaches to domestic investments and businesses. These would explic-itly include best practices in organizational setup, governance, investment policy, operations, and risk management, among other issues. This approach could assist significantly in reconciling the increased activity of sovereign investors in domes-tic economies with free-market principles.
REFERENCES
Aizenman, J., and J. Lee, 2005, “International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence.” IMF Working Paper 05/198 (Washington: International Monetary Fund).
Aldrick, P., 2009, “UKFI Mulls Bond Plan for Bank Sales,” Telegraph, June 10.Capellan, J., 2009, “ADIA May Invest in UAE Bonds, Says Saudi Bank,” Emirates Business 24/7,
July 19.Choudhury, G., 2008, “RBI Not Keen on Managing Sovereign Wealth Fund,” Hindustan Times,
August 18.Edison, H., 2003, “Are Foreign Reserves Too High?” Staff studies for the World Economic
Outlook 2003 Update (Washington: International Monetary Fund). European Central Bank, 2006, “The Accumulation of Foreign Reserves,” ECB Occasional
Paper 43 (Frankfurt).Hall, C., 2009, “U.A.E. Plans to Back Bond Sales, Al-Suwaidi Says,” Bloomberg News, June 28.Ho, C., 2004, “Temasek Holdings: Building Sustainable Value,” speech at Institute of Policy
Studies Corporate Associates Lunch, Singapore, February 12.International Monetary Fund, 2009, Regional Economic Outlook: Middle East and Central Asia
(Washington).Institute of International Finance, 2009, Capital Flows to Emerging Market Economies
(Washington). Available via the Internet: http://www.iif.com.Institutional Investor Sovereign Funds Roundtable, 2008, Singapore.IWG (International Working Group of Sovereign Wealth Funds), 2008, Sovereign Wealth
Funds: Generally Accepted Principles and Practices—“Santiago Principles” (Washington). Available via the Internet: http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf. (Reprinted as Appendix 1 to this volume.)
Kjær, K., 2006, “From Oil to Equities,” address at the Norwegian Polytechnic Society, November 2. Available via the Internet: http://www.nbim.no/templates/article____51952.aspx.
Lee, H., 2009, “KIC to Invest in Domestic Assets,” Korea Times, January 15.Lim, J.S., and Y.Y. Tsai, 2009, “Temasek’s New Direction,” Nomura Research Report
(Singapore: Nomura Singapore Limited). Available via the Internet: http://www.scribd.com/doc/16241839/SingStrategy0206SGSA.
Martellini, L., 2008, “Edhec Points the Way for SWFs,” Financial Times, December 14.McKinsey & Company, 2009, “Government and Business: New Rules for a New Era,”
McKinsey Quarterly, No. 3.
20The idea of a new Washington Consensus has been explored before: for example, some commenta-tors have suggested that the policy recommendations contained in the final report of the Commission on Growth and Development, chaired by Nobel Laureate Michael Spence, effectively amount to such a phenomenon. For more details, see Rodrik, 2008.
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NBIM (Norges Bank Investment Management), 2002, “Expanding the Petroleum Fund’s Investment Universe,” letter submitted to the Ministry of Finance, March 21, Oslo. Available via the Internet: http://www.norges-bank.no/upload/import/english/publications/submissions/submission-2002-03-21.pdf.
NPRF (National Pensions Reserve Fund Commission of Ireland), 2009, “Quarterly Performance and Portfolio Update at 31 March 2009.” Available via the Internet: http://www.nprf.ie/Publications/2009/FirstQuarter09PerformancePortfolioUpdate.pdf.
Norway, Royal Ministry of Finance, 2010, “The National Budget, A Summary.” Available via the Internet: http://www.statsbudsjettet.dep.no/upload/Statsbudsjett_2010/dokumenter/pdf/summary_national%20_budget_2010.pdf.
Obama, Barack, 2009, “President Barack Obama’s Inaugural Address,” January 21. Available via the Internet: http://www.whitehouse.gov/blog/inaugural-address/.
Paris, C., 2009, “Singapore Government Fund’s Loss Pegged at $33 Billion,” The Wall Street Journal, February 18.
Park, D., 2008, “Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia,” ADB Economic Working Paper Series No. 129 (Manila: Asian Development Bank).
Pensions & Investments, 2009, “Fund Profile: New Zealand. Government Putting Squeeze on Officials for Domestic Investment,” July 13.
Phuvanatnaranubala, T., 2008, “Sovereign Wealth Fund for Thailand?” speech at the Ministry of Finance Conference, Bangkok, May 15.
Prime-Tass, 2008, “Putin Signs Ruling to Invest National Wealth Fund on Russian Market,” October 21.
Reed, S., 2008, “Sovereign Wealth Funds Take a Big Hit,” Business Week, December 31.Rehse, D., 2009, “Sovereign Wealth Funds Try to Draw the Fires in Their Home Economies,”
Edhec-Risk Institute, June 10.Rodrik, D., 2008, “Is There a New Washington Consensus?” Project Syndicate. Available via
the Internet: http://www.project-syndicate.org/commentary/rodrik20/English.Rowley, A., 2008, “Can Japan Put Its Wealth to Work?” Institutional Investor, Vol. 33, No. 10,
pp. 62–65.Sarkozy, N., 2008, “Strategic Investment Fund,” speech in Montrichard, November 20.
Available via the Internet: https://pastel.diplomatie.gouv.fr/editorial/actual/ael2/bulletin.gb.asp?liste=20081127.gb.html#Chapitre3.
Scherer, B., 2009, “Portfolio Choices for Oil Based Sovereign Wealth Funds,” Morgan Stanley Investment Management White Paper, January.
Setser, B., and R. Ziemba, 2009, GCC Sovereign Funds: Reversal of Fortune (New York: Council on Foreign Relations, Center for Geoeconomic Studies).
Srisukkasem, A., 2008, “Wealth Fund Under Review,” The Nation, May 12.State Street, 2009, “Sovereign Wealth Funds: Emerging from the Financial Crisis,” Vision Paper,
Volume IV, Issue 1. Available via the Internet: http://www.statestreet.com/vision/downloads/Vision_SovereignWealth_2009_IV-1.pdf.
Wang Biqiang, 2009, “China’s Foreign Reserves: Which Button to Press?” The Economic Observer Online, March 13. Available via the Internet: http://www.eeo.com.cn/ens/.
Wigglesworth, R., 2009, “Qatari Bail-Outs Boost Local Bourse,” Financial Times, June 11.Wijnholds, J.O. de B., and A. Kapteyn, 2001, “Reserve Adequacy in Emerging Market
Economies,” IMF Working Paper 01/143 (Washington: International Monetary Fund).Wilson, H., 2009, “UKFI Gets Off to a Shaky Start—Key People,” Financial News, March 9.
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ANNEX
Country Policy Actions
France In November 2008, French President Sarkozy announced the establishment of the Strategic Investment Fund as an “anti-crisis weapon.” Capitalized at €20 bil-lion (about US$26 billion), the fund is designed to support domestic small and medium enterprises and strategically important companies during crises, with a view to eventual exit via share disposals during normal times.
Ireland Legislation was passed in March 2009 to enable use of about €7 billion (about US$9.1 billion) from the National Pension Reserve Fund to recapitalize failing domestic banks, under Ministerial direction and outside the fund’s statutory investment policy. On March 31, the fund’s government bond investments were liquidated and accumulated cash balances tapped to finance the €3.5 billion (about US$4.6 billion) purchase of Bank of Ireland preference shares.
Kazakhstan About US$10 billion was allocated from the National Fund of Kazakhstan to Samruk-Kazyna National Wealth Fund to implement a series of stabilization mea-sures, including purchases of ordinary and preferred shares of domestic banks, acquisition of distressed real assets, and provision of subordinated loans to struggling domestic borrowers. The objective is to substitute market-based external borrowing with longer-term, sovereign-based internal (National Fund and Samruk-Kazyna) and external (China, Russian Federation, United Arab Emirates) sources.
Republic of Korea Legislation was introduced to allow the Korea Investment Corporation to invest in domestic shares, real estate, and other domestic assets, ostensibly to have it act as a co-investor to “crowd in” and facilitate foreign investment into Korea.
Kuwait The Kuwait Investment Authority instituted several measures: (1) repatriated part of its foreign assets and deposited them in domestic banks to provide liquidity; (2) set up a dedicated fund investing in the domestic stock market; and (3) bought domestic bank shares to help boost bank capitalization and confidence. An estimated US$4 billion to US$5 billion has been withdrawn by the Kuwait Investment Authority from international capital markets for domestic deploy-ment.
New Zealand Government leaned on the New Zealand Superannuation Fund (NZSF) to increase domestic investments, thereby aiding the domestic economy, infra-structure, and capital markets. NZSF is required by law to consider the govern-ment’s advice, but must weigh it against the statutory obligation for prudent commercial investment.
Qatar Qatar’s government has intervened three times since late 2008: (1) asked Qatar Investment Authority to spend US$5.3 billion to acquire 20 percent stakes in each bank listed on the Doha stock exchange; (2) bought nearly the entire domestic equity portfolio of the banking sector; (3) spent up to US$4.1 billion to buy up commercial banks’ property investments.
Russian Federation Prime Minister Putin signed an official ruling to allow the government to invest part of the National Wealth Fund in Russian stocks, bonds, and unit investment funds. Approximately US$6 billion allocated from the fund to Vneshekonombank, a state-owned development bank, for domestic stock and corporate bond investments, with a further approximately US$16 billion earmarked for subordi-nated loans to domestic banks.
Saudi Arabia The Saudi Arabian Monetary Agency is the Saudi central bank and technically not an SWF, but it does manage nonreserve assets and invests in international equity markets. During the crisis, SAMA made US$3 billion deposits in struggling domestic banks. Also, the Public Investment Fund, which operates under the aus-pices of the Saudi Ministry of Finance and is entirely focused on domestic institu-tions and markets, is playing an important role in supporting the Saudi economy.
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Country Policy Actions
United Arab Emirates
The United Arab Emirates (UAE) undertook several measures: (1) A.A. al-Ghurair, speaker of the Federal National Council, which advises the rulers, called for spending part of UAE SWF assets to revive the economy; (2) Mubadala is report-ed to have shifted assets from international to domestic markets, with its domes-tic portfolio increasing by a factor of more than five from 2007 to 2008; (3) in February 2009, the government of Dubai raised US$20 billion in debt, half of it underwritten by the UAE central bank. The UAE federal government is reportedly planning to issue federal bonds, and market sources suggest Abu Dhabi Investment Authority may be a potential investor.
Sources: Capellan, 2009; Hall, 2009; IMF, 2009; Lee, 2009; NPRF, 2009; Pensions & Investments, 2009; Prime-Tass, 2008; Rehse, 2009; Samruk-Kazyna Web site http://www.samruk-kazyna.kz/page.php?lang=3; Sarkozy, 2008; and Wigglesworth, 2009.
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CHAPTER 19
A Final Word: Views of the Sovereigns
A. Alberta Heritage Savings Trust Fund: Looking Forward
AARON BROWN AND ROD MATHESON
Under the constitution in Canada, all natural resources belong to and are man-aged by the provinces. The province of Alberta is in the fortunate situation of being endowed with vast reserves of crude oil, natural gas, and heavy oil. As owner of those resources, Alberta collects economic rent in the form of a royalty when the resources are extracted and sold. In addition, Alberta collects corporate income taxes based on the net income earned by oil and gas companies operating in Alberta.
The Alberta Heritage Fund was established in 1976 with the purpose of set-ting aside a portion of the revenues the province was receiving from nonrenew-able resources. The Alberta Heritage Savings Trust Fund Act establishes the fund’s mission as providing prudent stewardship of the savings from Alberta’s nonrenew-able resources by providing the greatest financial returns on those savings for current and future generations of Albertans. Income from the fund forms part of the annual budgetary revenue used to support government spending.
From 1987 to 1994, when the province was running fiscal deficits, saving in the Alberta Heritage Fund was suspended. In 1995, Albertans were surveyed on whether the fund should continue and, if yes, how it should be managed. From that survey, the fund’s mandate was changed to be structured and managed like a traditional endowment fund with a long-term focus and an investment process independent of the government’s policy priorities. This structure remains in place today.
In 2005, when Alberta retired the debt accumulated during the 1980s and early 1990s, the government again began saving in the Alberta Heritage Fund. Savings took the form of new capital contributions from budgetary surpluses—the first since 1987—and a legislated inflation-proofing program to preserve the real value of the fund.
The government of Alberta, through the Minister of Finance and Enterprise, establishes the investment policies for the Alberta Heritage Fund but the execu-tion of investments in accordance with those policies is accomplished through a
©International Monetary Fund. Not for Redistribution
260 A Final Word: Views of the Sovereigns
crown corporation to ensure investments are made on an arms-length basis, inde-pendent of any interference by the government.
Sovereign wealth funds (SWFs) take on many different legal forms and struc-tures. The Alberta Heritage Fund’s monies are fully consolidated on the province’s balance sheet and the investment income earned on the fund is included in the province’s annual income statement as revenue. Because of this, it is important to consider how the fund interacts within the broader fiscal framework and policies of the province.
An example of the need to consider the Alberta Heritage Fund in the context of the broad fiscal framework is the revenue volatility faced by the government of Alberta. The province’s revenue is significantly resource driven and, as such, is subject to large swings caused by changes in the market prices of oil and natural gas. Since 2000, natural resource revenues have accounted for, on average, about 30 percent of total annual revenues. The fund can be used as a tool in fiscal man-agement by creating a countercyclical investment income stream.
A key component of the province’s revenue volatility is currency exposure. In 2008, a new asset allocation for the Alberta Heritage Fund with more non- Canadian assets was established. At the same time, the government’s investment manager began building capacity to increase direct investments in global infrastructure and real estate. As of the end of fiscal 2010 (March 31, 2010), the Alberta Heritage Fund’s total non-Canadian exposure was 36 percent. Although the exposure is to a broad range of foreign currencies, the predominant currency is the U.S. dollar, at about 20 percent. The foreign currency exposure is expected to rise over the next four years as the new asset mix is implemented.
Currency fluctuations are an issue for any fund that invests outside its home country and reports its results in the home currency. In the context of the Canadian institutional investor, the currency question may be fairly straightfor-ward. For example, a Canadian pension plan can consider hedge ratios on the underlying foreign-currency-denominated assets and determine whether the short-term risks from volatility outweigh any potential long-term benefit from diversification. Canadian hedges against major world currencies are also fairly easy and inexpensive to implement.
For the Alberta Heritage Fund, and potentially any resource-driven SWF, the currency question is more complex. Alberta’s revenues are highly susceptible to fluctuations in the value of the Canadian dollar relative to the U.S. dollar. A Department of Finance and Enterprise analysis published in the 2010 budget shows that Alberta’s revenues are more sensitive to currency fluctuations than to any other single factor. Every one cent change in the US$/Can$ exchange rate results in a revenue change of Can$215 million. This can have a major impact on the budget, of Can$38 billion.
When viewing the Alberta Heritage Fund in the broader provincial landscape, in the first instance, the U.S. dollar-denominated investments amplify the risks of the natural resource assets, also typically denominated in U.S. dollars, which may be an argument for more extensive hedging. However, a second factor that must be considered is the correlation between the price of the resource commodities and
©International Monetary Fund. Not for Redistribution
Brown and Matheson 261
the exchange rate. The Canadian dollar has significant positive correlation with the prices of oil and gas. Thus, a drop in the price of oil leads to a decline in the value of the Canadian dollar, which in turn increases the value of the U.S. dollar finan-cial investments in the fund. Therefore, owning financial assets denominated in U.S. dollars may provide a natural hedge against declining commodity prices.
A thorough review of and decision on the currency risks facing both the Alberta Heritage Fund and the broader provincial revenue base is essential. The foreign currency exposure derived from a well-diversified global investment port-folio can be used as a tool in limiting revenue volatility.
Going forward, the Minister of Finance and Enterprise has made it a top pri-ority to evaluate how the province saves and what role long-term savings instru-ments like the Alberta Heritage Fund play within a comprehensive fiscal and savings strategy. The minister and colleagues in the legislature will review when and how to add new money to the fund to benefit future generations while pro-tecting the essential services that the fund’s income currently supports.
Since the inception of the Alberta Heritage Fund in 1976, Alberta has had a strong tradition of saving, both in the fund and in other savings vehicles. At the moment, aside from annual inflation proofing, new funds for the Alberta Heritage Fund are contributed on an ad hoc basis, and income from the fund is used to maintain a low-tax environment and provide essential services. There is wide consensus among Albertans that the government should save for our future. How that is accomplished is the question.
The first challenge for Alberta is to create a savings policy that is in the best interests of Albertans and flexible enough to be relevant in a variety of economic situations. The province will look at a variety of savings recommendations from private industry, public think tanks, and stakeholder groups, as well as a report from a Financial Investment and Planning Advisory Commission, established by the government in 2008. Among other things, the commission encouraged the government to grow the size of the fund so that significant investment income would be generated and available to replace the reduced revenues derived from diminished (or obsolete) natural resources in the future. A range of options for a savings policy will be considered. Important considerations include the trade-off between the discipline provided by an “off the top” revenue capture strategy and the flexibility provided with an “off the bottom” budget surplus allocation plan.
A second challenge will be finding the right balance between the need for short-term savings to manage fiscal imbalances—which may occur for relatively short periods (say three to five years), caused by declines in the market price of the commodity—and long-term savings to achieve the objective of providing significant investment income to replace the income when the commodity has been depleted or is worth much less.
Regardless of what decisions are eventually made on these issues, the Alberta Heritage Savings Trust Fund is and will continue to be an outstanding legacy for Albertans. The government will do its utmost to maintain the fund’s mandate of providing prudent stewardship of Alberta’s savings and providing the greatest benefit to both current and future generations of Albertans.
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262 A Final Word: Views of the Sovereigns
B. Managing Chile’s SWFS Beyond the Global Financial Crisis
ERIC PARRADO
CHILEAN FISCAL POLICY AND SWFS
During the last decade, Chilean governments have followed a countercyclical fis-cal policy that seeks to decouple government spending from the effects of eco-nomic and commodity-price cycles, and to ease business cycle fluctuations. In 2001, a structural surplus rule was introduced for the central government budget. Under the rule, annual fiscal expenditure is calculated in accordance with the central government’s structural income, independently of fluctuations in revenues caused by cyclical swings in economic activity, the price of copper, and other variables that determine effective fiscal income. This implies that the government saves during upswings, when it receives significant transitory revenues, and can avoid the need for a drastic tightening of fiscal spending during downturns, thereby stabilizing the growth of public expenditure over time.
The fiscal rule was complemented by the introduction of a Fiscal Responsibility Law in 2006 that created two sovereign wealth funds (SWFs) as vehicles for man-aging the surpluses resulting from the application of the structural policy rule. The Pension Reserve Fund (PRF) was designed to help fulfill fiscal obligations in the areas of pensions and social security. Specifically, the fund is earmarked as backing for the government’s guarantee to basic old-age and disability solidarity pensions and solidarity pension contributions for low-income pensioners. The Economic and Social Stabilization Fund (ESSF) was created to finance fiscal deficits that may occur during periods of weak growth or low copper prices; it can also be used to pay down public debt and finance the PRF. In this way, it helps to reduce cyclical variations in fiscal spending, ensuring long-term financing for social programs.
Capital Contributions
The minimum annual amount paid into the PRF is equivalent to 0.2 percent of the previous year’s GDP, although if the effective fiscal surplus exceeds this amount, the contribution can rise to a maximum of 0.5 percent of the previ-ous year’s GDP. The transfer of resources must be made during the first half of the year.
Under the Fiscal Responsibility Law, the government was authorized to recapitalize the Central Bank of Chile (CBC) during five years beginning in 2006 by an annual amount of up to the difference between the government’s contributions to the PRF and the effective fiscal surplus, with an upper limit of
©International Monetary Fund. Not for Redistribution
Parrado 263
0.5 percent of GDP. In 2006, 2007, and 2008, this recapitalization was equiva-lent to 0.5 percent of GDP.
The remainder of the effective surplus, after payment into the PRF and recapitalization of the CBC, must be paid into the ESSF. Repayments of public debt and advanced payments into the ESSF during the previous year can, how-ever, be subtracted from this contribution (see Figure 19B.1).
Institutional Framework
Investment of the assets of the PRF and the ESSF calls for a clear and transparent institutional framework that provides the necessary structure for making and implementing decisions, monitoring risk, and controlling investment policy. The basis for this framework was established in the Fiscal Responsibility Law. In addi-tion, in 2006 the Finance Ministry appointed the CBC—subject to the approval of its governing board—as the fiscal agent for the management of both funds and established the general framework for their administration. The Finance Ministry also created the Financial Committee in 2007 to advise the Finance Minister on the investment of the assets of the ESSF and the PRF (see Figure 19B.2).
Investment Policy
The investment policy, defined when the PRF and the ESSF were created, involved asset classes similar to those used by the CBC for international reserves. This choice was based mainly on the CBC’s vast experience managing these asset classes. In the first quarter of 2008, a new investment policy more closely aligned with the funds’ characteristics was drawn up, but its implementation was
Source: Ministry of Finance.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
-0.5 -0.2 0.1 0.4 0.7 1.0 1.3 1.6 1.9 2.2 2.5 2.8
Effec�ve fiscal balance(In percent of GDP)
ESSF CBC's recapitaliza�on PRF
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Figure 19B.1 Fiscal Savings Rule
©International Monetary Fund. Not for Redistribution
264 A Final Word: Views of the Sovereigns
postponed as a result of the global financial crisis, and the original investment policy remained in force throughout 2008.
Under the original policy, 66.5 percent of the funds’ assets are held as nominal sovereign bonds, 30 percent as money market instruments—such as short-term highly rated bank deposits and treasury bills—and 3.5 percent as inflation-indexed sovereign bonds (see Figure 19B.3). This is a conservative policy given that it does not include asset classes with higher levels of risk such as equities, corporate bonds, and alternative investments.
In addition, a reference allocation by currency has been established, specifying 50 percent in U.S. dollars, 40 percent in euros, and 10 percent in yen, with a restriction of up to a 5 percentage point variation on these values. These guidelines
Source: Ministry of Finance.
Ministry of Finance
Financial Commi�ee
Central Bank
Investment guidelines
Investment policy defini�on
Execu�on
Figure 19B.2 Governance Structure
29.7%
3.6%
66.5%
29.9%
3.6%
66.7%
Sovereign bonds
Money market
Sovereign infla�on-indexed bonds
PRFPRFESSFESSF
Source: Ministry of Finance.
Figure 19B.3 Asset Allocation
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Parrado 265
also allow investments in instruments in other currencies but require exchange-rate coverage tied to one of the three other currencies.
Transparency
The Chilean government’s commitment to developing and improving all aspects of the funds’ management includes the transparency of their decisions and access to relevant information. To this end, it systematically prepares and publishes reports about the SWFs’ situations, provides information about the main issues discussed in each meeting of the Financial Committee and about its recommen-dations, and discloses all significant decisions about the SWFs’ management adopted by the Finance Ministry.
To guarantee public access to all relevant information about the ESSF and the PRF, the Finance Ministry has created special Web sites in Spanish and English containing all monthly, quarterly, and annual reports about the funds; the recom-mendations of the Financial Committee and its annual report; the legal and institutional framework for the funds; and press releases and other information. This commitment to effective and opportune access to information was particu-larly important in 2008 when the global financial crisis and the liquidity prob-lems experienced by different financial institutions around the world meant increased demand for information about the position of the institutions in which the funds’ assets were deposited as well as about the intermediaries and custody services used. This led to a decision to publish quarterly reports about these insti-tutions, rather than the annual report issued through September 2008.
As part of Chile’s commitment to best SWF practices, the government decided to participate actively in initiatives launched by several international organizations in a bid to establish an operating framework for SWFs and pro-mote their transparency. Both the Finance Ministry and the CBC have taken an active role in the International Working Group of Sovereign Wealth Funds (IWG). The IWG concluded its discussions with a broad agreement on best principles and practices of SWFs. This agreement is known internationally as the “Santiago Principles.” Chile’s active role in this meeting reflects its government’s commitment to promoting transparency in the management of resources that belong to all Chileans and to the creation of a permanent forum for the exchange of views and information among different SWFs and the countries in which they invest.
Chile’s efforts to improve transparency have been internationally recognized. In a ranking published by the Peterson Institute for International Economics in April 2008 the ESSF was awarded 82 points out of 100 for transparency and accountability, taking sixth place out of 34 SWFs. In the overall ranking, which also included other aspects, such as fund structure, objectives, fiscal treatment, organization, corporate governance, and use of derivatives, the ESSF ranked eighth. Similarly, in 2009, Chile obtained a perfect score in the Sovereign Wealth Fund Institute’s global ranking of transparency and good administration of the world’s 45 major sovereign funds.
©International Monetary Fund. Not for Redistribution
266 A Final Word: Views of the Sovereigns
IMPACT OF THE GLOBAL FINANCIAL CRISIS
When the global financial crisis hit, Chile’s economy was in an excellent position to mitigate its effects. The country’s preparedness was, to a great extent, the result of lessons learned from previous crises. After a 1982 banking crisis, Chile began to implement prudent and modern financial regulations with high standards of supervision. This allowed Chile to face the recent global credit crunch with a solid and well-capitalized financial system. Likewise, after the Asian crisis in the late 1990s, Chile implemented macroeconomic policies that included accumulating financial capital in boom periods to be used during periods of greater difficulty. This improved Chile’s credibility.
The 2007–09 global financial crisis was the first crisis Chile had confronted with a flexible exchange rate. That policy helped it avoid building up currency exchange imbalances and facilitated the application of countercyclical policies.
Chile’s public sector has been known for saving its surpluses. For the first time in its modern history, the Chilean Treasury is a net creditor. This was possible thanks to a framework of rules stipulating that public expenditure levels in each period must be in line with the treasury’s structural or permanent income. These policies isolate public expenditure decisions, particularly those related to social spending and investment, from the economic cycle and from fluctuations in the prices of copper and molybdenum.
Aside from the favorable fiscal situation, the inflation-targeting framework implemented by the CBC led naturally to an easing of monetary policy in the context of plummeting inflationary expectations resulting from the softening of the business cycle and the collapse of oil prices. The flexible exchange rate pro-vided a natural cushion to accommodate fluctuations in external conditions. The CBC also accumulated a prudent quantity of international reserves that, together with treasury assets, helped Chile face the liquidity restrictions that began to arise in the latter months of 2008.
The first policy reaction was oriented toward moderating the concern associ-ated with the initial shock and any possible impact on the local financial system. Following this rationale, in October 2008, the Finance Ministry and the CBC implemented a number of measures to ensure the economy’s liquidity in both national and foreign currencies. The CBC put an end to a program of buying U.S. dollars that it had begun in April to accumulate reserves; opened a window for US$500 million auctions of 28-day currency swaps, which it later expanded to 180 days; eased collateral requirements for repo operations; and temporarily loosened bank reserve rules. For its part, the government auctioned off US$1.05 billion of treasury assets in U.S. dollars for deposits in the local banking system.
Chile’s government put in place opportune, substantial, and temporary fiscal measures. In January 2009, Chile became one of the first countries to react to the global crisis by announcing an extraordinary fiscal stimulus plan. Close to US$4 billion, equivalent to 2.8 percent of GDP, was assigned to this package from the ESSF. At the time it was announced, this 2009 fiscal reactivation plan was the world’s second largest as measured by resources committed relative to the economy’s size.
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Parrado 267
These measures were proportional to the shock the country was facing. The 2009 fiscal impulse (drop in tax collection plus increased spending) was similar in magnitude to the estimated decline in nonmining exports, which would help stabilize available private income.
The fiscal plan was enhanced in March 2009 with 20 additional measures to stimulate the credit market—known as the Pro-Credit Initiative—and one month later with an unprecedented pro-employment agreement among the gov-ernment, workers, and businesses. To implement this expansive fiscal policy, Chile opted for a diversified strategy, complementing increases in public invest-ment with transfers, employment subsidies, credit subsidies and stimuli, capital-ization of state enterprises, and tax discounts. Special emphasis was placed on transitory measures, giving economic agents greater incentives to increase their short-term demand to take advantage of these stimuli.
The implementation of the stimulus plans and the drop in tax collection led the government to use the ESSF again in June 2009, drawing down US$4 billion on top of what had already been withdrawn in the first half of the year. Given the objectives of the funds, countercyclical fiscal policy triggered disbursements from the ESSF and not from the PRF (see Figures 19B.4 and 19B.5).
Despite the financial turbulence, the Chilean SWFs had among the highest returns of all the world’s SWFs with data available in 2008. In 2009, interna-tional markets displayed a boom in riskier asset prices, so many SWFs enjoyed strong recoveries in their market values; meanwhile, Chile stayed with the same prudent portfolio with consequent lower returns in the year. On average, the rates of return of the Chilean funds in the 2007–09 period were still higher than those of their peers.
Expansive countercyclical policies were aided by an aggressive reduction in the CBC’s monetary policy rate, taking advantage of lower inflationary perspectives and a widening output gap. The 775 basis point rate decrease over the course of 2009 brought the CBC’s interest rate to a historic low of 0.5 percent.
Source: Ministry of Finance.
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Fund balance Cumula�ve withdrawals
Figure 19B.4 ESSF Market Value
©International Monetary Fund. Not for Redistribution
268 A Final Word: Views of the Sovereigns
To enhance the monetary policy stimulus, in mid-2009 the CBC adopted unconventional monetary policy measures, mostly by establishing a term lending facility for the banking system at the current monetary policy rate. The CBC stated that monetary policy would remain at that level until at least the second quarter of 2010.
One of the more notable ways in which Chile confronted the crisis was by coordinating its fiscal and monetary policies. Coordination between the Finance Ministry and the CBC meant more efficient decision making. Chile stood out as the country with the most aggressive countercyclical policies, which substantially eased credit conditions (see Figure 19B.6).
Source: Ministry of Finance.
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l-09
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US$
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ion
Figure 19B.5 PRF Market Value
Source: Bloomberg; author’s calculations.Note: MPR = Monetary Policy Rate.
India
Indonesia
Rep. of Korea
Germany
France
Saudi Arabia
Mexico
Russian Fed.
CanadaAustralia
South AfricaUnited States
Brazil
United Kingdom
Peru
Chile
Turkey
Japan
Italy
0.5
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-1,000-900-800-700-600-500-400-300-200-1000
Actual MPR vs. maximum MPR for the period 2007–09 (basis points)
Fisc
al s
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us p
acka
ges
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(% G
DP)
Figure 19B.6 Fiscal and Monetary Stimulus
©International Monetary Fund. Not for Redistribution
Parrado 269
BancoEstado—Chile’s state-owned bank—played an important role in pro-viding credit during the crisis. While the financial system’s total loans outstanding declined in key areas, credit provided by the state-owned lender grew signifi-cantly, especially in the commercial and consumer segments, allowing BancoEstado to increase its market share. The most recent data reveals changes in patterns of consumer lending, as other banks have begun to adjust to BancoEstado’s relative aggressiveness.
FINAL REMARKS
When the global financial crisis hit, Chile’s Finance Ministry had done its home-work, especially regarding fiscal policy. The government coped with the crisis with resources saved during the good years. All fiscal surpluses reached US$42 billion during the 2004–08 period. These surpluses helped to diminish gross public debt from almost 45 percent of GDP in 1990 to 5.2 percent on average in 2006–09 and accumulate resources in the Chilean SWFs of more than US$20 billion when the global financial crisis started. Moreover, these funds were prudently invested, so did not have losses during the crisis as compared with most SWFs of the world.
Economic measures implemented by Chile were timely and substantial. It was one of the first countries to react to the crisis in January 2009 with a fiscal stimu-lus plan of close to US$4 billion (2.8 percent of GDP). The country opted for a diversified strategy: public investments, transfers, job subsidies, subsidies and stimulus to credit, capitalization of state-owned companies, and tax benefits. Temporary measures received special emphasis. The measures above were comple-mented by the CBC’s significant decrease in interest rates.
The appetite for risk changed dramatically. Severe losses experienced by other SWFs provided considerable insight into actual risk tolerance within their home countries. In 2007, the Chilean Financial Committee recommended a gradual modification of the funds’ investment policies on the grounds that they have longer investment horizons than international reserves and should, therefore, be permitted a higher level of risk in a bid to achieve higher returns. The Financial Committee’s recommendation envisaged a reduction in the proportion of nomi-nal sovereign bonds and money market instruments in favor of an increase in inflation-indexed sovereign bonds and the inclusion of equities and corporate bonds. As a result, it was hoped that the funds would be able to achieve higher long-term returns (see Figure 19B.7).
The Finance Minister accepted this recommendation and the new policy was scheduled to come into force at the end of 2008. However, its implementation was postponed in view of the exceptional level of uncertainty seen in international markets in the last quarter of the year. The new assessment provided a better under-standing of investment parameters: a shorter investment horizon for the stabiliza-tion fund and lower risk tolerance in each fund (high reputational risk).
Prudence, transparency, and good results improve credibility. The full cycle of the savings and expenditure process legitimized the implementation of the Chilean
©International Monetary Fund. Not for Redistribution
270 A Final Word: Views of the Sovereigns
SWFs. The government’s credibility and approval rate improved, especially with regard to its fiscal policy. The ESSF has been fundamental in mitigating the impact of the global financial crisis. Finally, it was learned that transparency is crucial to educating the public, especially about more aggressive asset classes, but considerable effort is necessary to explain short-term volatility.
Chile has followed a long path in a few years to construct a strong institutional arrangement for its funds. The task now is to consolidate its institutions and avoid any complacency arising from its strong results in recent years. This is an everyday task. The benefits of these efforts are reflected in the positive valuation of Chile’s citizens, the owners of the resources of the funds. This is the real sovereign success.
C. SWFS and Recipient Countries: Toward a Win-Win Situation
JIN LIQUN
The China Investment Corporation (CIC) was established in September 2007 as a wholly state-owned company with the objectives of diversifying and obtaining
Source: Ministry of Finance.
66.5
45
30.0
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3.5
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20
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0
10
20
30
40
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60
70
80
90
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Current policy Financial Commi�eerecommenda�on
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Externalmanagers
Figure 19B.7 Current Investment Policy vs. Financial Committee Recommendation
©International Monetary Fund. Not for Redistribution
Liqun 271
higher long-term risk-adjusted returns on China’s foreign exchange holdings. As a sovereign wealth fund (SWF), CIC was born concurrently with the arrival of the daunting challenges that accompanied the 2007–09 global financial crisis. Its managers have tried their best, however, to navigate the rough-and-tumble waters of global finance and to draw important lessons and inspiration for the future. It is these lessons that are most important for long-term investors like SWFs. Since its launch, CIC has steadily built up its institutional capacity to strengthen its governance and risk-management framework, improve its strategic asset alloca-tion, and optimize its operating mechanism.
Many challenges, however, remain, as economies recover and risk appetite returns. During the 2007–09 global financial crisis, capital flows from SWFs were a welcome source of funding for the financial sector and other industries in many western countries, which lifted, at least temporarily, some of the barriers to foreign direct investment. SWFs were increasingly recognized as mature and credible insti-tutional investors, playing an important role in the international monetary and financial system. Paradoxically, as their relevance to international financial and economic stability increased, their existence became a cause for concern rather than a source of comfort to some recipient countries. Keeping economies open is a chal-lenge. Short-termism tends to prevail in difficult times, when protectionism may be perceived as a convenient policy instrument. As an example, during the crisis, many countries that previously had relaxed SWF inflows introduced support measures that favored domestic industries and domestic jobs over foreign competitors. The risk of financial protectionism is one of the key challenges that has to be addressed through concerted efforts by SWFs and recipient countries alike.
THE SANTIAGO PRINCIPLES AND OECD GUIDANCE ON RECIPIENT COUNTRY POLICIES TOWARD SWFS
It is encouraging that both SWFs and recipient countries—at least as a group—are aware of the potential implications of protectionism for both sides and have dem-onstrated a willingness to address the issues. Two milestones, discussed in detail in earlier chapters of this book, were the publication of the “Generally Accepted Principles and Practices, ‘Santiago Principles’” by the International Working Group (IWG) of SWFs, and the Organisation for Economic Co-operation and Development’s “OECD Guidance on Recipient Country Policies towards SWFs,” which were completed nearly simultaneously. Each addresses the threat of protec-tionism, as well as many other topics, from a different angle. Protectionism is mentioned explicitly in the OECD guidance as an issue to be tackled in line with the OECD’s general investment policy principles and its broader Freedom of Investment process. The guidance calls on recipient countries to refrain from erect-ing protectionist barriers to foreign investment, including investments from SWFs, while acknowledging legitimate needs to protect national security interests.
It is gratifying to note that the OECD is committed to remaining a strong advocate of the free movement of capital and its long-term benefits. This policy
©International Monetary Fund. Not for Redistribution
272 A Final Word: Views of the Sovereigns
stance is important for the smooth operations of SWFs, particularly at a time when protectionism is poised to disrupt global economic stability. Protectionist barriers set up to block the free movement of capital pose the risk of setting the economic recovery in reverse at a critical time. The OECD recognizes the key role that SWFs have been playing in the globalized economy and the immense bene-fits they have brought to home and host countries.
The Santiago Principles were a landmark achievement in the efforts toward best practice by SWFs, especially given that this voluntary code was endorsed by all 26 IWG member and observer countries. The principles reflect appropriate governance and accountability arrangements, as well as the conduct of investment practices by SWFs on a prudent and sound basis. They set the standards for SWFs’ operations. SWFs should help maintain a stable global financial system and the free flow of capital; comply with all applicable regulatory and disclosure requirements in the countries in which they invest; invest on the basis of eco-nomic and financial risk-and-return-related considerations; and have in place transparent and sound governance structures that provide for adequate opera-tional controls, risk management, and accountability. Although the Santiago Principles do not deal with protectionism specifically, compliance with the prin-ciples should reassure recipient countries that SWFs’ investment decisions are not driven by political motives and, hence, should reduce the perceived risks that recipient countries may tend to try to abate through resort to protectionism.
The publication of the Santiago Principles and the OECD guidance are important first steps, but it is crucial that they are implemented and adhered to by all SWFs and recipient countries. Shortly after the publication of the Santiago Principles, SWFs established the International Forum of Sovereign Wealth Funds (IFSWF), which acts as a platform for sharing views on the application of the Santiago Principles. Progress toward implementation of the Santiago Principles is being made by members of the IFSWF, which is an encouraging, albeit slow, process.
Adherence to the OECD guidance is monitored through a peer review process. It is helpful that nonmembers participate in this peer review, and it is hoped that the majority of countries subscribe without further delay to the OECD’s 1976 Declaration on International Investment and Multinational Enterprises. At present, only 30 members and 12 nonmember countries have endorsed the declaration. Moreover, invoking the national security clause appears to be tempting for some recipient countries, even if their arguments are stretched. This author has, for instance, difficulty understanding why taking an equity share of more than 10 percent in a financial institution could be a problem for national security in the recipient country. Therefore, future work by the OECD on the Freedom of Investment pro-cess, including the surveillance of national policy developments, will be welcome.
THE CASE OF CHINA
China is the world’s largest holder of foreign exchange reserve assets. Size seems to matter, at least from the perception of the recipient country. In the aggregate, size is an important factor for central banks and SWFs, because in the last five
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years the total amount of official reserves has exceeded the supply of short-term government debt in the major reserve currencies.1 Hence, official institutions need investment opportunities beyond those offered by traditional asset classes.
It must be stressed, though, that like any other SWF or financial institution, CIC is defined by its behavior, which is determined by its governance and man-date, not by its size. Any individual SWF’s behavior is far more relevant than its size, so far as recipient countries are concerned. There should not be any cause for concern when an SWF is committed to making long-term investments in a recipient country to achieve a win-win situation for both sides. CIC aims to maximize the return on investment for its shareholders, under a risk-management framework consistent with its investment strategy and portfolio requirements. As a long-term investor, CIC is committed to contributing to the financial stability of the host countries, which is also in its own interest.
CIC participated in the full-scale deliberations in the process of drafting the Santiago Principles, and did a great amount of work toward the establishment of the IFSWF. Implementation of the principles is in full swing in CIC, although it is just two years into operation. Transparency is important and CIC believes in transparency. As an illustration, in 2009, CIC published its Annual Report 2008, upon completion of its first accounting year since inception. CIC has also set up an international advisory council in an effort to seek guidance on the conduct of its global investment activities, which enables CIC to assimilate the experience of well-established SWFs and other institutional investors.
CIC’s managers believe that mutual trust between SWFs and the recipient countries is the key to promoting prosperity and financial stability through cross-border capital flows, particularly long-term investments. For a variety of reasons, a high level of mutual trust and cooperation remains an aspiration rather than a reality. It will take time to attain this goal and the journey may not be smooth. However, it can be achieved. CIC is a young institution, and is working hard toward that objective, and it is gratifying to see that CIC is not alone.
D. The New Zealand Superannuation Fund: Surviving Through and Seeing Beyond the Global Financial Crisis
ADRIAN ORR
The New Zealand Superannuation Fund is a pool of assets purposed with reduc-ing the taxation burden on future taxpayers of the cost of retirement benefits paid
1See the IMF’s International Financial Statistics for reserves, and BIS’ Securities Statistics for short-term debt. Included in the calculation of short-term government debt are the major and most liquid issuers in currencies of the Special Drawing Rights basket, that is, the United States, Japan, and the United Kingdom, and for the euro area, Germany and France. Short-term is defined as securities with a remaining maturity of less than one year.
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by the government of New Zealand to all eligible New Zealanders when they reach age 65. The Guardians of New Zealand Superannuation is the organization set up to manage the fund.
The cost of retirement benefits is expected to double over time as New Zealand’s population ages. The fund smoothes the associated tax burden by investing government contributions—and the returns on those investments—now, to be withdrawn later (foreseen to begin in 2031) as the tax burden rises. The fund is therefore characterized as a sovereign wealth fund (SWF) because the Guardians as its manager are a wholly government-owned asset manager without explicit liabilities.
The job of the Guardians is to invest so as to maximize returns without undue risk, according to best practice and without prejudice to New Zealand’s reputa-tion globally. The long horizon for the investment of the fund means the portfo-lio is significantly biased toward growth (the ratio of growth to income assets is roughly 80:20) and seeks returns from illiquid investments. The Guardians also actively invest.
Such a long horizon and tolerance for illiquidity bring their own challenges, especially when it comes to weathering and profiting from volatile market condi-tions. The significant challenge is to maintain the focus on the long-term goal, and avoid being “stopped out” of investments because of concerns about marked-to-market losses in down times.
The legislative framework for the fund facilitates a long-term investment per-spective. Board members are selected for their investment expertise, arms-length from political influence. And both the legislation and funding arrangements make the fund’s purpose and operational independence clear.
The Guardians also operate the fund in arguably the most transparent manner of all SWFs. Returns are reported monthly, as are much of the underlying invest-ment rationale and asset holdings. This transparency brings significant strength because it is easy for the public to discover, understand, and have confidence in the Guardians’ investment activity.
A crucial element of this public insight is that the Guardians manage the fund relative to a notional passive alternative fund, the structure and performance of which is published. Thus, stakeholders can see both the fund’s absolute perfor-mance, as well as the value added from actively investing. Both measures of per-formance are important to maintaining stakeholder confidence over relevant medium-term periods.
The fund is young, with investment having commenced in late 2003. In the first four years of its existence, given its heavy growth-biased portfolio and the booming financial markets of the era, the fund earned almost twice the risk-free rate of return and experienced significant gains. It was then hit by the collapse in asset prices in late 2008 and 2009 in addition to significant corre-lated behavior across all asset types. Since mid-2009, fund performance has recovered strongly.
Naturally, the significant swings in investment performance during the global financial crisis resulted in a careful examination of every aspect of the
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Guardians’ investment practices and how they might be improved. Most important, the examination caused investment beliefs to be revisited to ensure they were well-founded and supported by the investment team and the board.
Every investment activity undertaken by the Guardians is supported by a clearly articulated investment belief, a clear strategy to exploit that belief, and a clear assessment that the fund’s resource capacity can exercise the investment strategy successfully on an ongoing basis. If these three components do not exist, the investment is not made.
During and after the global financial crisis, the following were confirmed:
• Diversification is absolutely necessary to mitigate risk. • Capacity in both skills and experience to take advantage of opportunities is
highly complementary to diversification. • Be wary of investing where the crowd does. Even good ideas can turn out to
be not so good if everyone piles in at the same time. • It is important to ensure sufficient liquidity to remain focused on the long
term and not be put in “fire sale” situations. • When choosing an investment manager, ensuring that the market in which
it operates is conducive to excess return is as important as the manager’s ability.
• Operational due diligence on managers is crucial, and standards need to be applied consistently to external managers.
• Having some spare capacity in access to external managers and counterpar-ties is critical because identifying new relationships during down times is very difficult.
• Finally, communicating clearly and often with stakeholders—in particular, the board and the government—is conducive to a strong relationship and sound investment.
In the past six years, the Guardians have grown their capabilities, both through attracting and developing passionate and talented people, and through building and sharing knowledge through frequent engagement with peer organizations globally. Consistent with these stronger capabilities, the Guardians have widened their investment strategies.
In building and maintaining its international reputation, the Guardians par-ticipated in the International Working Group of Sovereign Wealth Funds, are represented on the International Forum of Sovereign Wealth Funds, and are a founding signatory to the United Nations Principles of Responsible Investment. The Guardians’ team is regularly invited to address experienced international audiences on every aspect of fund management.
The Guardians’ clearly articulated vision, value set, culture, investment beliefs, and investment strategies have proved necessary and invaluable to remaining a long-term and successful investor.
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E. Norway: Dealing with Risk in an Uncertain World
THOMAS EKELI AND MARTIN SKANCKE
Much has been written about the value of good governance of sovereign wealth funds (SWFs). Good governance is the foundation of the Santiago Principles, which have received broad support from international observers and have proved useful to many SWFs in improving their governance systems.
A crucial aspect of a sound governance system is the way in which the SWF deals with risk. The first topic that normally springs to mind is management of the SWF’s financial and operational risks. Recent history has shown shortcomings in the construction and use of quantitative risk models, as well as in the qualita-tive understanding of risk at a more senior level in many organizations.
There are areas that SWFs and other institutional investors now have on their radar screens. For SWFs there is also the need to focus on risk management at the national level, in addition to risk management within the SWF’s investment operations. Many SWFs were set up specifically to mitigate risk associated with income from natural resources. These funds are the cornerstones of macroeconomic policies in their respec-tive countries. By transforming natural resources into diversified portfolios of financial assets, the funds contribute directly to spreading risk. But the SWFs also support policies designed to diversify the economic structures of their home countries, for example, by avoiding crowding out production of tradable goods and services (Dutch disease). Thus, SWFs are risk-management tools in themselves.
Management of sovereign wealth spans financial, macroeconomic, and politi-cal issues. Risk management for an SWF thus needs to take all these issues into account to improve the chances of a good outcome for the country, both in the present and in the future. Only by securing support from the owners can sover-eign wealth management be sufficiently robust to withstand the tests of time.
This book’s examination of the developments of recent years has highlighted the importance of dealing with uncertainty and risk. Financial market optimism and faith in elaborate risk-management systems evaporated as evidence surfaced of the inherent instability of the global financial system and the inadequacy of many risk models. As commodity and energy prices swiftly retraced their previous climbs, and economic activity shifted from stable growth to sharp contraction, it also became clear that the concept of risk management needs to stretch beyond the financial and operational risks associated with the investment activities of an SWF.
Many SWFs saw sharp drops in net inflows as export revenues shrank and domestic outlays rose. Those events, coupled with abysmal market returns on risky assets in the midst of the global financial crisis and the operational challenges arising from a financial system in distress, made it clear that the robustness of many SWFs’ governance arrangements would be seriously tested. Although attention before the crisis may have been focused on the management of financial and operational risks,
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recent events provided a backdrop that could threaten stakeholders’ confidence in the SWF arrangement itself. The implicit contract entrusting the state with the task of managing sovereign wealth on behalf of its citizens could be in danger if stake-holders no longer have sufficient trust in the sovereign and its ability to deliver public services and prudent asset management. Addressing such concerns has become an important task for many SWFs, since recent experience has highlighted the importance of strong support from stakeholders in times of crises.
SWFs are a heterogeneous group with different organizational structures, gov-ernance models, and transparency arrangements. Nonetheless, to secure long-term management of sovereign assets and to develop robust investment strategies, they share the need for strong support from their owners. Insufficient trust and confidence in the SWF arrangement by the owner can, in a period of turmoil, result in major changes that may not be conducive to the long-term interests of the sovereign or its stakeholders. For an SWF to fulfill its objective and deliver sound financial risk-adjusted returns over time, it must have in place both a robust investment risk-management framework and strong support from its own-ers to allow it to stick to the right strategy through changing circumstances.
Building support and trust of owners and stakeholders is a continuous process, the results of which often lag far behind the inputs to the process. Despite the many similarities between managing public money and managing private money, such as the need to enlist owners’ support for the chosen investment management strategy to ensure the necessary robustness through a business cycle, sovereign funds often bear a higher degree of public scrutiny and therefore need to partici-pate more actively in the public deliberations.
Enabling political representatives to debate and decide key strategic issues about the management of sovereign wealth can be a demanding process, but is in many instances a precondition to achieving a good, sustainable outcome. Despite the temptation to confine the risk-management discussions to a professional group concentrating on the SWF’s investment and operational risks, ultimate goals will be best served by a broadening of the assessment to include those eco-nomic and political aspects of risk relevant to the SWF. Transparency will, in most cases, be an important part of a risk-management strategy at the national level.
The Santiago Principles offer a good starting point for work on these issues in individual countries, with the focus embodied in the principles of coordination with macroeconomic policies, governance systems, reporting, and risk management.
F. The Russian Federation: Challenges for a Rainy Day
PETER KAZAKEVITCH AND ALEXANDRA TRISHKINA
Since 2000, the Russian Federation has experienced booming oil prices. The country took advantage of the situation and accumulated substantial resources
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in its sovereign wealth fund (SWF), known as the Stabilization Fund (SF). Establishment of the SF in 2004 reflected the government’s will to shield itself from external forces that could not be handled in alternative ways, to accumulate reserves to pay off foreign debt, and to curb inflation. Eventually, the SF turned out to be a significant tool among the government’s economic policy measures. In the period 2005–07, the SF and other budget sources were deployed for early government debt repayment of US$47 billion in total, saving at least US$13 bil-lion in interest payments and smoothing budget expenses.
In 2008, the SF was split into the Reserve Fund (RF) and the National Wealth Fund (NWF). As of March 1, 2009, the RF and the NWF had reached US$136 billion and US$84 billion, respectively, in assets under management. The objec-tive of the RF is to finance federal budget expenses in periods of fiscal deficit, and the NWF’s mission is to cofinance the voluntary pension savings of Russians and to maintain a balanced budget for the Pension Fund of Russia.
In 2009–10, the Russian government used, for the first time, a sizable part of the assets of its SWFs to overcome the effects of the global financial crisis. Some US$117 billion was withdrawn from the RF to cover budget deficits.2 In addi-tion, the government placed US$22 billion of NWF assets in long-term ruble deposits with Vnesheconombank to implement a number of unprecedented crisis measures, supporting the banking system and financial markets as well as several other sectors.
According to the federal budget law, the RF could be exhausted in 2010. Moreover, in 2010–12, the government may spend US$56 billion from the NWF to cover a deficit in the Pension Fund of Russia. Meanwhile, the government is exploring alternative means to cover a budget deficit, including internal and external borrowing and privatization, in addition to oil and gas revenues. Careful use of SWF assets permits state borrowing at more favorable terms than without these reserves.
“The crisis is unprecedented, the kind the world never faced before. In such conditions, the Reserve Fund will save Russia and protect us from the most severe and dramatic outcomes,” underscored Minister of Finance Kudrin.3 The SWFs provide the Russian Federation with a competitive advantage, adding stability to the economy. The RF and the NWF have allowed the government to continue to fulfill social commitments and to implement anticrisis measures. At the same time, however, expenditures from the funds should be monitored to ensure they are justified and effective.
In his budget speech to the Parliament on May 25, 2009, President Medvedev pointed out that the crisis demonstrated the importance of avoiding or minimiz-ing future shocks to the Russian economy. Unfortunately, not only commodity budget revenues but other budget inflows are still highly dependent on com-modities. Therefore, budget planning should be based on conservative forecasts for the prices of oil and other commodities. Windfall revenues must still be
2As of May 1, 2010.3RIA Vesti, April 22, 2009.
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accumulated in sunny days. The president also stressed the need for rational con-tainment of increases in budget spending.
Since their inception, Russian SWFs have mainly invested in low-risk and thus low-yield foreign fixed income instruments. Assets with higher risk, such as equi-ties or corporate bonds, were never used. This approach resulted from the high liquidity requirements imposed on the funds. In 2009, the Ministry of Finance (MOF) excluded bonds issued by foreign state agencies, central banks, and supra-nationals from the funds’ investment universe, leaving only foreign government bonds. That made the Russian government, as owner of the RF, an extremely conservative investor. In 2008–09, this strategy ensured substantial investment income for the SWFs.
At the same time, the MOF realized that a diversified investment portfolio would give it more opportunities to manage risks carefully, even on the relatively short-term horizon. Therefore, the MOF is looking ahead and setting the groundwork for diversification of the SWFs’ investment strategies toward assets more profitable than foreign sovereign bonds and deposits placed with Vnesheconombank. The MOF is currently limited in implementing the funds’ investment strategies by regulation of the central bank, because the Bank of Russia is the only agent allowed to work with the MOF with regard to SWF management. The Bank of Russia is not allowed to invest in either corporate securities or alternative assets. It also cannot hire external managers. The feasibil-ity of creating a vehicle for such investments directly at the MOF is limited for business and legal reasons.
This situation requires that a specialized financial institution with adequate capacity and expertise be set up under state control. President Medvedev con-firmed this requirement in the above-mentioned speech to the Parliament. In April 2010, the MOF introduced a draft law on the Russian Financial Agency (RFA) to the government. The agency’s primary function would be management of the NWF and public debt. Further responsibilities may be added, including RF and Pension Fund of Russia money management, and Federal Treasury cash management. This leads to the concept of asset-liability management with the intent of managing risks that arise from mismatches between assets and liabilities of the state. It is expected that the RFA will be an efficient tool for public asset and debt management and at the same time a responsible advisor to the govern-ment in relevant fields.
After the breakup of the Soviet Union, the Russian Federation went through two periods: a period of rapid increases in debt followed by a period of substantial asset accumulation. Both conveyed significant lessons and now the country is at the beginning of a third period—a period of prudent asset-liability management with a Russian financial agency as the main implementing tool.
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Appendix 1. The Santiago Principles
• Principle 1.The legal framework for the SWF should be sound and support its effective operation and the achievement of its stated objective(s). o Subprinciple 1.1. The legal framework for the SWF should ensure the
legal soundness of the SWF and its transactions. o Subprinciple 1.2. The key features of the SWF’s legal basis and structure,
as well as the legal relationship between the SWF and the other state bod-ies, should be publicly disclosed.
• Principle 2.The policy purpose of the SWF should be clearly defined and publicly disclosed.
• Principle 3.Where the SWF’s activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domes-tic fiscal and monetary authorities, so as to ensure consistency with the overall macroeconomic policies.
• Principle 4.There should be clear and publicly disclosed policies, rules, procedures, or arrangements in relation to the SWF’s general approach to funding, with-drawal, and spending operations. o Subprinciple 4.1. The source of SWF funding should be publicly disclosed. o Subprinciple 4.2. The general approach to withdrawals from the SWF and
spending on behalf of the government should be publicly disclosed.• Principle 5.
The relevant statistical data pertaining to the SWF should be reported on a timely basis to the owner, or as otherwise required, for inclusion where appropriate in macroeconomic data sets.
• Principle 6.The governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives.
• Principle 7.The owner should set the objectives of the SWF, appoint the members of its governing body(ies) in accordance with clearly defined procedures, and exercise oversight over the SWF’s operations.
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• Principle 8.The governing body(ies) should act in the best interests of the SWF, and have a clear mandate and adequate authority and competency to carry out its functions.
• Principle 9.The operational management of the SWF should implement the SWF’s strategies in an independent manner and in accordance with clearly defined responsibilities.
• Principle 10.The accountability framework for the SWF’s operations should be clearly defined in the relevant legislation, charter, other constitutive documents, or management agreement.
• Principle 11.An annual report and accompanying financial statements on the SWF’s operations and performance should be prepared in a timely fashion and in accordance with recognized international or national accounting standards in a consistent manner.
• Principle 12.The SWF’s operations and financial statements should be audited annually in accordance with recognized international or national auditing standards in a consistent manner.
• Principle 13.Professional and ethical standards should be clearly defined and made known to the members of the SWF’s governing body(ies), management, and staff.
• Principle 14.Dealing with third parties for the purpose of the SWF’s operational manage-ment should be based on economic and financial grounds, and follow clear rules and procedures.
• Principle 15.SWF operations and activities in host countries should be conducted in compliance with all applicable regulatory and disclosure requirements of the countries in which they operate.
• Principle 16.The governance framework and objectives, as well as the manner in which the SWF’s management is operationally independent from the owner, should be publicly disclosed.
• Principle 17.Relevant financial information regarding the SWF should be publicly dis-closed to demonstrate its economic and financial orientation, so as to con-tribute to stability in international financial markets and enhance trust in recipient countries.
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• Principle 18.The SWF’s investment policy should be clear and consistent with its defined objectives, risk tolerance, and investment strategy, as set by the owner or the governing body(ies), and be based on sound portfolio management principles. o Subprinciple 18.1. The investment policy should guide the SWF’s finan-
cial risk exposures and the possible use of leverage. o Subprinciple 18.2. The investment policy should address the extent to
which internal and/or external investment managers are used, the range of their activities and authority, and the process by which they are select-ed and their performance monitored.
o Subprinciple 18.3. A description of the investment policy of the SWF should be publicly disclosed.
• Principle 19.The SWF’s investment decisions should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds. o Subprinciple 19.1. If investment decisions are subject to other than eco-
nomic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed.
o Subprinciple 19.2. The management of an SWF’s assets should be consistent with what is generally accepted as sound asset management principles.
• Principle 20.The SWF should not seek or take advantage of privileged information or inappropriate influence by the broader government in competing with pri-vate entities.
• Principle 21.SWFs view shareholder ownership rights as a fundamental element of their equity investments’ value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.
• Principle 22.The SWF should have a framework that identifies, assesses, and manages the risks of its operations. o Subprinciple 22.1. The risk management framework should include reli-
able information and timely reporting systems, which should enable the adequate monitoring and management of relevant risks within acceptable parameters and levels, control and incentive mechanisms, codes of con-duct, business continuity planning, and an independent audit function.
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o Subprinciple 22.2. The general approach to the SWF’s risk management framework should be publicly disclosed.
• Principle 23.The assets and investment performance (absolute and relative to bench-marks, if any) of the SWF should be measured and reported to the owner according to clearly defined principles or standards.
• Principle 24.A process of regular review of the implementation of the Principles should be engaged in by or on behalf of the SWF.
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Appendix 2. The International Forum of Sovereign Wealth Funds
On April 6, 2009, the International Working Group of Sovereign Wealth Funds (IWG), upon completion of its work culminating in publication of the Santiago Principles, established the International Forum of Sovereign Wealth Funds (IFSWF).
The following are the purpose, mandate, and membership structure of the IFSWF.
A. PURPOSE OF THE IFSWF
The IFSWF is a voluntary group of sovereign wealth funds (SWFs). The purpose is to meet, exchange views on issues of common interest, and facilitate an under-standing of the Santiago Principles and SWF activities. The IFSWF is not a for-mal supranational authority and its work does not carry any legal force.
The IFSWF acts as a platform for:1 exchanging ideas and views among SWFs and with other relevant parties.
These will cover, inter alia, issues such as trends and developments pertain-ing to SWF activities, risk management, investment regimes, market and institutional conditions affecting investment operations, and interactions with the economic and financial stability framework;
2 sharing views on the application of the Santiago Principles including operational and technical matters; and
3 encouraging cooperation with investment-recipient countries, relevant international organizations, and capital market functionaries to identify potential risks that may affect cross-border investments, and to foster a nondiscriminatory, constructive, and mutually beneficial investment environment.
B. MANDATE OF THE IFSWF
The IFSWF operates in an inclusive manner and facilitates communication among SWFs, as well as with recipient country officials, and representatives of multilateral organizations and the private sector. Through its work, the IFSWF contributes to the development and maintenance of an open and stable invest-ment environment, thereby supporting the four guiding objectives underlying the Santiago Principles:
1 to help maintain a stable global financial system and free flow of capital and investment;
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2 to comply with all applicable regulatory and disclosure requirements in the countries in which they invest;
3 to invest on the basis of economic and financial risk and return-related considerations; and
4 to have in place a transparent and sound governance structure that provides for adequate operational controls, risk management, and accountability.
C. MEMBERSHIP OF THE IFSWF
The IFSWF members are the SWFs who participated in the IWG and endorsed the Santiago Principles. Membership is open to other funds that meet the Santiago Principles’ definition of an SWF and endorse the Santiago Principles.
D. MEETINGS
The IFSWF meets at least once a year. Meetings for special purposes can be held as required.
The IFSWF can invite relevant recipient countries, and any other person, entity, or organization, private or public, with an interest in the business of SWFs, as observers.
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Wouter Bossu is senior counsel in the International Monetary Fund’s Legal Department, where he works primarily on the legal underpinnings of financial stability. Before joining the IMF, he worked in the legal departments of the National Bank of Belgium and the European Central Bank. He holds degrees in law (Leuven) and business economics (Louvain-la-Neuve).
Aaron Brown is director of portfolio management at the Alberta Finance and Enterprise Department. The portfolio management team is responsible for devel-oping investment policies for over Can$40 billion in funds, including the Alberta Heritage Savings Trust Fund, several research and scholarship endowment funds, and the province’s Sustainability Fund. He is also chair of the investment com-mittees for two Alberta public sector pension plans. He has a Bachelor of Commerce degree from the University of Alberta and is a Chartered Financial Analyst.
Thomas S. Coleman has worked in the finance industry for more than 20 years and has developed considerable experience in quantitative modeling, trading, and risk management. Before entering the financial industry, he taught graduate and undergraduate economics and finance at the State University of New York at Stony Brook. He earned a Ph.D. in economics from the University of Chicago, and a B.A. in physics from Harvard University. He is the author, together with Roger Ibbotson and Larry Fisher, of Historical U.S. Treasury Yield Curves, and continues to publish in various journals.
Didier Darcet has been an investment professional since 1989, managing bank capital, hedge funds, and wealth funds. In the 1990s, he was head of the arbitrage and proprietary investment desks at Bank of America in Paris and London. In 1999, he cofounded Insight Finance S.A., a hedge fund asset management com-pany and Insight Research & Trading L.L.C., a U.S. research and development company providing research and models to the asset management industry. Since 2006, he has been cohead of Dedicated Capital Management at Renaissance Investment Management. He is dual qualified as an engineer (Supélec) and an economist (Sciences Po).
Udaibir S. Das is an assistant director in the Monetary and Capital Markets Department of the International Monetary Fund where he heads the Sovereign Asset and Liability Management Division. He leads a team that covers policy and operational issues relating to sovereign balance sheet risk management, debt, reserves and sovereign asset management, and local and regional sovereign bond markets. He is also associated with country-specific vulnerability assessments and
Contributors
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288 Contributors
financial stability surveillance. He joined the IMF in 1996. Before joining the IMF, he was with the Reserve Bank of India for 18 years. He has participated in various financial sector assessment programs and technical assistance missions, and has been closely associated with several international and regional initiatives in financial sector and capital market areas. He was the resident advisor in Guyana during 1996–98. In his career with the IMF, he has represented staff on various Organisation for Economic Co-operation and Development working par-ties, the Basel-based Joint Forum, the International Association of Insurance Supervisors, and the International Working Group of Sovereign Wealth Funds. He is a Fulbright-Humphrey scholar with graduate degrees in economics and management. He was a lecturer in economics and finance at Boston University during 1989–91. He has published in several international and professional jour-nals and holds a research interest in central banking, sovereign asset-liability management, nonbank financial institutions, and different aspects of debt and fixed-income markets.
André de Palma is a full professor at Ecole Normale Supérieure de Cachan and at Ecole Polytechnique, Paris. He is a senior member of Institut Universitaire de France and a member of the Centre for Economic Policy Research. He has Ph.D. degrees in physics and economics. He has held faculty positions at Queen’s University, Northwestern University, and University of Geneva. He is a specialist in industrial organization, transportation economics, and decision making under risk and uncertainty. He has published five books and more than 200 articles in international journals. He has also consulted for major financial organizations in Belgium, France, Spain, Switzerland, and the United States.
Michael du Jeu has worked in the finance industry for more than 20 years. He has spent his career managing capital in various forms, heading market-making operations and proprietary investment desks at S.G. Warburg and Lehman Brothers in London in the 1990s; cofounding and comanaging a global macro hedge fund in London between 1998 and 2005; and since 2006, coheading the Dedicated Capital Management unit at Renaissance Investment Management, a specific investment process for long-term wealth creation based on macro analysis and computerized technology. He studied law (Assas Université, Paris).
Thomas Ekeli is counsellor for economic and financial affairs with the Norwegian delegation to the Organisation for Economic Co-operation and Development in Paris, following several years as investment director in the Asset Management Department of the Norwegian Ministry of Finance. He previously worked on mon-etary policy and financial market issues in the ministry and served as deputy direc-tor general of the Economic Policy Department. He was also an international economist with Lehman Brothers in London (1997–2000), chief economist with Pareto Securities in Oslo (2001–04), IMF Petroleum Fund Advisor in Timor-Leste (2004–05), and portfolio manager with Norges Bank Investment Management in London (2005–06). He has an economics degree from the University of Oslo.
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Mohamed A. El-Erian is chief executive officer and co-chief information officer of PIMCO. Before rejoining PIMCO in December 2007, he was president and chief executive officer of Harvard Management Company and a member of the Harvard Business School faculty. He earned a B.A. in economics from Cambridge University and doctorate and master’s degrees in economics from Oxford. He spent 15 years at the International Monetary Fund before moving to the private sector in 1998. He serves on the boards of Cambridge in America, the National Bureau of Economic Research, and the Peterson Institute for International Economics. He is a frequent contributor to the Financial Times. His 2008 book, When Markets Collide, was a New York Times and Wall Street Journal bestseller, a 2008 The Economist : Best Book, and winner of the Financial Times and Goldman Sachs 2008 Business Book of the Year.
Obianuju Ezejiofor is a consultant with the Conflict Resolution System at the World Bank. She was a legal research officer at the International Monetary Fund when working on her contribution to this book. She received her legal training in Nigeria and England. She is a Ph.D. candidate at Queen Mary and Westfield College, University of London. Before joining the IMF, she was a legal intern at the United Nations in New York. She also has work experience in the legal sector in both Nigeria and England, and in the Nigerian banking sector.
Antonio Galicia-Escotto is senior economist in the International Monetary Fund’s Statistics Department. He has been a staff member at Banco de Mexico and assistant to the Executive Director at the IMF. He holds a B.A. in economics from the Instituto Tecnologico Autonomo de Mexico and an M.A. in applied economics from American University, Washington. He published several articles on international economics during his tenure at Banco de Mexico and taught at Universidad Iberoamericana in Mexico City.
Kathryn Gordon is senior economist in the Investment Division of the Organisation for Economic Co-operation and Development (OECD). She is currently working on international investment law and investment policy moni-toring. She was one of the main secretariat participants in the negotiations that led to the successful review of the OECD Guidelines for Multinational Enterprises and was responsible for OECD research on corporate responsibility. In earlier positions at the OECD, she dealt with fiscal, tax, and regulatory issues. Before taking her position at the OECD, she was a professor at École Supérieure des Sciences Économiques et Commerciales. She obtained a Ph.D. and an M.B.A in finance from the University of California, Berkeley.
Robert Heath is an assistant director in the International Monetary Fund’s Statistics Department. Before joining the IMF, he worked at the Bank of England and HM Treasury in the UK. At the IMF, he has taken a leading role in develop-ing statistical reporting and conceptual standards, being the lead editor and drafter for the Coordinated Portfolio Investment Survey Guide, first edition (1996);
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290 Contributors
“The Statistical Measurement of Financial Derivatives” (1998); External Debt Statistics: Guide for Compilers and Users (2003); and Financial Soundness Indicators: Compilation Guide (2006). He supervised the production of the Balance of Payments and International Investment Position Manual, 6th edition, during 2003–08 and was a member of the Advisory Expert Group on National Accounts for the 2008 System of National Accounts.
Heiko Hesse is an economist in the Middle East and Central Asia Department at the International Monetary Fund, after having worked two years on the IMF’s Global Financial Stability Report. He was an economist at the World Bank (2006–07), working on the Commission on Growth and Development, which brings together 21 leading practitioners from government, business, and the policy-making arenas. In 2005–06, he was a Visiting Scholar at Yale University and a consultant at the World Bank. He also worked at McKinsey & Co., NERA Economic Consulting, and PricewaterhouseCoopers. He regularly contributes to the economics blogs VOX and RGE Monitor, has published in refereed aca-demic journals, and often speaks at conferences and central banks. His recent research has focused on systemic risks, spillovers to emerging-market countries, sovereign wealth funds, local bond markets, banking issues, and Middle East and Islamic finance. He obtained his Ph.D. in economics from Nuffield College, University of Oxford, and his B.Sc. in financial economics from the University of Essex.
Stephen L. Jen is managing director of macroeconomics and currencies at BlueGold Capital, in charge of managing BlueGold Capital’s currency exposures and macro strategies. Before joining BlueGold Capital in May 2009, he was a managing director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including global head of currency research and chief global foreign exchange and emerging markets strategist. Before Morgan Stanley, he spent four years as an economist with the International Monetary Fund, covering economies in Eastern Europe and Asia. In addition, he was actively involved in the design of the IMF’s framework to provide debt relief to highly indebted coun-tries. He also worked for the Board of Governors of the Federal Reserve and the World Bank, and was a lecturer at Massachusetts Institute of Technology and Georgetown University School of Business. He holds a Ph.D. in economics from the Massachusetts Institute of Technology, with concentrations in international economics and monetary economics. He also earned a B.Sc. in electrical engi-neering (summa cum laude) from the University of California, Irvine.
Peter Kazakevitch supervises the Sovereign Funds Management division at the Ministry of Finance of the Russian Federation as a deputy director of the Department of State Debt and State Financial Assets. He has headed this division (formerly Stabilization Fund Management) since its inception in April 2005. He is responsible for establishing and implementing the Reserve Fund and National Wealth Fund management policy and Federal Treasury cash management. Before
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joining the Ministry of Finance, he worked at the Bank for Foreign Economic Affairs (Vnesheconombank) for 14 years. He holds a Ph.D. in finance from the Finance Academy of the Russian Federation in Moscow.
Steffen Kern is director for international financial market policy at Deutsche Bank, focusing on international financial market integration and cross-border regulatory convergence between the European Union, the United States, and with countries in Asia and Latin America. Before his current position he served as executive assistant to the chief executive officer of Deutsche Bank Group, follow-ing eight years as senior economist for European financial market policy and integration. He holds degrees in economics, politics, and philosophy from the universities of Oxford and Leuven and a Ph.D. from Erasmus University Rotterdam, and is a lecturer in international finance at the University of Mainz.
Espen Klitzing is a principal based in McKinsey & Company’s Oslo office. His main client service focus is on institutional asset management, and he serves insurers, pension funds, and sovereign wealth funds. Before rejoining McKinsey, he held various management and board positions within the Scandinavian insur-ance and asset management industries. He was the chief financial officer and deputy chief executive officer of Norway’s Government Pension Fund–Global in 2007. He holds a master’s degree from the Norwegian School of Economics and Business Administration.
Julie Kozack is a deputy division chief in the European Department of the International Monetary Fund, where she covers the Russian Federation. She has been with the IMF since 1999 and has worked on a wide range of policy and country issues, including developments in global economics and the role of sov-ereign wealth funds. She received a Ph.D. in economics from Columbia University. She has also worked as a consultant to the World Bank and as a teach-ing assistant and research assistant at Columbia University.
Peter Kunzel is senior economist in the European Department of the International Monetary Fund. Over the past 10 years he has worked at the IMF, the Institute of International Finance, and the European Investment Bank on macroeconomic and financial sector issues, capital markets, sovereign asset and liability manage-ment, risk analysis, and pricing. He holds a Ph.D. in economics from the George Washington University.
Thomas Laryea is a former assistant general counsel at the International Monetary Fund. He received his legal education in England and the United States. His doctoral thesis was in international civil procedure. Before joining the IMF’s Legal Department in 2000, he was in private practice with Sullivan & Cromwell in New York and London, focusing on international litigation and antitrust. He has also taught European Union Law at the University of London, School of Oriental and African Studies. His work at the IMF has included advice
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292 Contributors
on the IMF’s legal relations with member countries, capital market legal reform, and debt restructuring at the policy and individual country levels.
Doug Laxton is an advisor in the Research Department of the International Monetary Fund. He is currently head of the Economic Modeling Unit and man-ages a team of economists building macroeconomic models to support monetary and fiscal policy analysis. His team’s modeling work features in the IMF’s World Economic Outlook as well as in the IMF’s numerous reports to the Group of Twenty. He has worked with officials in many countries to help develop macro-economic models to support a transition to full-fledged inflation targeting. He has a prolific publication record on a wide range of issues.
Luc Leruth has an M.Sc. in mathematics as well as a Ph.D. in economics. He has held a number of academic positions and, before joining the International Monetary Fund in 1993, worked at the Asian Development Bank as a country officer for Pakistan. Before moving to the Paris IMF Offices in Europe in 2005, he was the project coordinator of the Pacific Financial Technical Assistance Center in Suva, Fiji, between 2002 and 2004, then head of the Fiscal Transparency Unit of the Fiscal Affairs Department. He was recently appointed project coordinator of the Central Africa Regional Technical Assistance Center, located in Libreville, Gabon. He has published numerous papers in international journals specializing in economics and other fields.
Diaan-Yi Lin is partner with the Corporate Finance and Principal Investors Practice in the Singapore office of McKinsey & Company and leads its sovereign wealth fund service line in Asia. She has worked extensively with government entities, sovereign wealth funds, and government-linked companies across Asia on topics ranging from defining the role and mandate of government-linked entities, to the importance of corporate governance, to driving performance transforma-tion, and regional development. Before joining McKinsey, she was an investment banker at Credit Suisse First Boston in New York and London, where she was a core member of equity private placements. She received her M.A. (Hons) in law from Trinity Hall, Cambridge University, where she was a Cambridge Commonwealth Trust Scholar and received the Dr. Cooper’s Law Studentship for academic excellence. As a Fulbright Scholar, she obtained an M.B.A., with dis-tinction, from the Harvard Business School.
Jin Liqun is chairman of the Board of Supervisors of China Investment Corporation (CIC). Before joining CIC, he served as ranking vice president, Asian Development Bank (ADB), responsible for operations in the South Asia, the Central and West Asia, and the Private Sector Operations departments. Before joining the ADB, he was Vice Minister, the Ministry of Finance, the People’s Republic of China (PRC). In that capacity, he served as Alternate Governor for the PRC at ADB, the World Bank Group, and the Global Environment Facility. After serving as Alternate Executive Director at the World
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Bank Group for four years, he was appointed Director General of the World Bank Department of the Ministry of Finance in 1995. The same year, he was promoted to be Assistant Minister of Finance and in 1998 was appointed Vice Minister of Finance. He writes extensively on economics and finance, and has published a number of books in these areas. He holds a master’s in English literature from Beijing Foreign Studies University. He was also a Hubert Humphrey Fellow at the graduate program in economics at Boston University from 1987 to 1988.
Yan Liu is senior counsel in the Legal Department of the International Monetary Fund. Her work at the IMF has focused on operational and policy matters includ-ing IMF lending, debt restructuring, and insolvency law reform. Before joining the IMF in 1999, she was a corporate and securities lawyer at Fried Frank Harris Shriver & Jacobson and Milbank Tweed Hadley & McCloy in New York and Washington. She received her legal education in China and the United States and also holds an M.A. in history.
Yinqiu Lu is an economist in the Monetary and Capital Markets Department of the International Monetary Fund. Her work focuses on sovereign asset and reserve management, sovereign debt management, sovereign risk management, capital market development, and financial stability. She has advised country authorities on these issues in many IMF missions and outreach activities. She has published work on sovereign asset management, commodity price hedging, and credit derivatives. She holds a Ph.D. in economics from the City University of New York, an M.A. in economics from Fudan University, and a B.A. from Nanjing University. She is a Chartered Financial Analyst.
Susan Lund is director of research at the McKinsey Global Institute, McKinsey & Company’s economics research arm, in Washington, DC. Her research focuses on global capital markets, with recent efforts assessing the economic consequenc-es of debt and deleveraging and implications of new participants in financial markets. She has authored numerous articles in leading business and academic publications and is a frequent speaker at conferences on economics and financial markets. She holds a Ph.D. in applied economics from Stanford University and a B.A. with highest distinction in economics from Northwestern University.
Rod Matheson is Assistant Deputy Minister of the Alberta Finance and Enterprise Department, where he has responsibility for both the Treasury Management and Risk Management and Insurance Divisions. Treasury Management is responsible for all banking and cash management for the prov-ince, and debt origination and financial risk management for the province and various Crown agencies. The division also has responsibility for establishing investment policies for the province’s operating and endowment funds, includ-ing the Alberta Heritage Savings Trust Fund, and oversight of the execution of the investment policies and performance of the investment manager. He has a Bachelor of Commerce degree and an M.B.A. from the University of
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Alberta; he is also a Certified Management Accountant and a Chartered Financial Analyst.
Adnan Mazarei is assistant director of the Middle East and Central Asia Department at the International Monetary Fund. He has made important contri-butions to the IMF’s policy work, including debt sustainability work for low-income countries, as well as recent work on sovereign wealth funds and the for-mulation of the Santiago Principles. Additionally, he served for four years as an advisor to IMF management. He has published work on economic issues in the Middle East, and received a Ph.D. in economics from the University of California, Los Angeles.
Christian Mulder is deputy division chief in the Sovereign Asset and Liability Management Division, Monetary and Capital Markets Department of the International Monetary Fund. He has prepared policy papers at the IMF on the methodology for holding official international reserves, and on analyzing and reporting reserves data. He has recently been involved in developing the IMF –World Bank program to advise countries on medium-term debt strategies, sup-ported the efforts to prepare the Santiago Principles for sovereign wealth funds, and helped to develop policies to advise countries on moving from fixed to flexible exchange regimes. He holds a Ph.D. from the London School of Economics and previously worked at the Dutch treasury and lectured at Tilburg University.
Laurent Nordin is a director in McKinsey & Company’s Dubai office. He leads the sovereign wealth funds practice for Europe, Middle-East and Africa and has been serving three leading sovereign wealth funds in the Gulf. His main interests are corporate transformations and governance, both critical areas for sovereign wealth funds. He also leads McKinsey’s involvement in the Gulf Cooperation Council’s Board Directors’ Institute, a not-for-profit organization that he started. He holds a master’s of science in electrical engineering from Supélec and an M.B.A. from INSEAD. Before joining McKinsey, he was a turnkey project man-ager at Alcatel-Alsthom for four years.
Jens Nystedt is a strategist at Moore Capital with a role in asset management and global macro analysis. He holds an M.Sc. in international finance and a Ph.D. in international economics and finance from the Stockholm School of Economics, Sweden. He worked for almost six years as an economist at the International Monetary Fund, in the Research, Policy Development, Special Operations, and International Capital Markets departments. He also participated in the IMF’s efforts to resolve several sovereign debt restructurings and currency crises across emerging markets. After leaving the IMF, he joined Deutsche Bank with senior research positions in both emerging market and global FX research. He initially joined in 2004 as chief economist for the Emerging Europe, Middle East, and Africa region and head of Local Markets Strategy. He worked at GLG Partners as the chief economist and strategist in 2007–08.
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Adrian Orr joined the New Zealand Superannuation Fund in February 2007 from the Reserve Bank of New Zealand, where he was deputy governor and head of financial stability. Before joining the Guardians, he held the positions of chief economist at Westpac Banking Corporation, chief manager of the Economics Department of the Reserve Bank of New Zealand, and chief economist at the National Bank of New Zealand. He also worked at the New Zealand Treasury and the Organisation for Economic Co-operation and Development. He has a master’s in development economics from Leicester University and a Bachelor of Social Sciences from Waikato University.
Michael Papaioannou is deputy division chief of the Sovereign Asset and Liability Management Division, Monetary and Capital Markets Department of the International Monetary Fund. While at the IMF, he has served as a special advisor to the Governing Board of the Bank of Greece. Before joining the IMF, he was a senior vice president for international financial services and director of the foreign exchange service at the WEFA Group (Wharton Econometrics Forecasting Associates) and served as chief economist of the Council of Economic Advisors of Greece. He has also taught at Temple University as an adjunct associ-ate professor of finance and was a Principal Research Fellow at the University of Pennsylvania, Department of Economics. He holds a Ph.D. in economics from the University of Pennsylvania and an M.A. in economics from Georgetown University.
Eric Parrado was the international finance coordinator for Chile’s Ministry of Finance between September 2007 and March 2010. He oversaw the resources of the Economic and Social Stabilization Fund and the Pension Reserve Fund. From 2005 to 2007, he was a senior economist in the Financial Stability Division of the Central Bank of Chile, and from 2000 to 2004, he was an economist for the International Monetary Fund in Washington. He is a consultant for the IMF and the World Bank. As a consultant, he has provided advisory services to the central banks of Bolivia, China, El Salvador, Guatemala, Kenya, and to the government of Mongolia. He holds a Ph.D. and an M.A. in economics from New York University, and a B.A. in economics from the University of Chile.
Iva Petrova was a member of the secretariat of the International Forum of Sovereign Wealth Funds until December 2009. She participated in the drafting of the Santiago Principles as a member of the secretariat of the International Working Group of Sovereign Wealth Funds and coauthored papers on sovereign wealth funds’ institutional and operational practices and on macrofinancial link-ages of sovereign wealth funds’ strategic asset allocations. She has worked at the International Monetary Fund since 2004, in the European Department, the Monetary and Capital Markets Department, and currently in the Fiscal Affairs Department. She completed her Ph.D. studies at Michigan State University in 2004. She worked in the Balance of Payments Division and the Research Department of the Bulgarian National Bank in 1997–98.
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Jukka Pihlman is an asset management advisor in the Sovereign Asset and Liability Management Division of the International Monetary Fund. He has participated in and reviewed the work of several IMF technical assistance missions on sovereign ALM and reserves management. He was also heavily involved with the International Working Group of Sovereign Wealth Funds in drafting the Santiago Principles, and is currently part of the secretariat team for the International Forum of Sovereign Wealth Funds. Before joining the IMF he was manager of the Risk Unit at the Reserve Bank of New Zealand, which was respon-sible for the risk-management framework for foreign reserves and domestic mar-ket operations. In his earlier career he worked as financial economist in the Market Operations Department of the Bank of Finland and as instructor at the University of Tampere, Finland, from which he holds M.Sc. (economics and finance; statistics and mathematics) degrees.
Andrew Rozanov is a managing director and head of sovereign advisory at Permal Group, where he is responsible for developing relationships with sovereign wealth funds and other official institutions, with a particular focus on providing special-ist advice on asset allocation, portfolio construction, risk management, and alter-native investments. Previously, he held a similar position at State Street Corporation, where he had focused exclusively on the sovereign sector for almost seven years. Prior to that, he held various positions at State Street Global Advisors and UBS Investment Bank in Tokyo. He holds a master’s degree in Asian studies, with a concentration in Japan, from Moscow State University. He is a Chartered Financial Analyst and holds designations of Financial Risk Manager from the Global Association of Risk Professionals and Chartered Alternative Investment Analyst from the CAIA Association. His work has been published in The Wall Street Journal, Central Banking Journal, The World Today, Professional Investor, and other media. He has also contributed chapters on various aspects of sovereign wealth management to books published by the Asian Development Bank, Gulf Research Center, Chatham House, and Revue d’Economie Financiere.
John Shields is a senior economist in the IMF’s African Department. From 2006 to 2008, as head of the Fiscal Transparency Unit in the Fiscal Affairs Department, he was responsible for the updates of the IMF’s Code of Good Practices on Fiscal Transparency and the Guide on Resource Revenue Transparency. Previously, he led IMF missions to Angola, The Gambia, Liberia, and Malawi. From 1994–98, he served as IMF Alternate Executive Director for the United Kingdom. In the United Kingdom, he worked in both the private and public sectors, including as a senior economic advisor at HM Treasury and the Bank of England. He has published and lectured on macroeconomic policy and labor market issues. He holds a mathematics degree from the University of London, Imperial College, and an economics degree from the University of Cambridge.
Martin Skancke is director general of the Norwegian Ministry of Finance and head of the Asset Management Department. He has previously worked on monetary
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policy and public finance issues in the ministry, and served as deputy director gen-eral of the Economic Policy Department from 1994 to 2001. From 2002 to 2006 he was director general and head of the Domestic Policy Department of the Office of the Prime Minister. He has also worked as a management consultant for McKinsey & Co. He has a business degree from the Norwegian School of Economics and Business Administration and an M.Sc. (economics) from the London School of Economics, in addition to a Russian language degree from the University of Oslo. He is a certified financial analyst.
Krishna Srinivasan is chief of the Multilateral Surveillance Division in the Research Department of the International Monetary Fund. He has been with the IMF since 1994 and has served in various capacities across many departments. He secured his Ph.D. in international finance in 1993 from Indiana University, Bloomington. He has also been a consultant to the World Bank and the Planning Commission in India. He has published several papers at the IMF and in academic journals.
Alison Stuart is a senior economist in the Emerging Markets Division of the Strategy, Policy, and Review Department of the International Monetary Fund. Before joining the IMF, she worked in the UK Executive Director’s office of the IMF and World Bank. She has many years’ experience as a macroeconomist at the Bank of England and HM Treasury.
Tao Sun received his Ph.D. in economics from the Chinese Academy of Social Sciences in 1998 and began working first in the International Department and then the Financial Stability Bureau of the People’s Bank of China, focusing on the annual China Financial Stability Report. Since 2007, he has been an economist in the Monetary and Capital Market Department at the International Monetary Fund. He is now part of the team that produces the semi-annual Global Financial Stability Report and a member of the China Financial Stability Assessment Program. His recent research has focused on systemic risks and prudential regula-tion frameworks, global liquidity and capital flows, spillovers to emerging-market countries, asset prices, and sovereign wealth funds.
Alexandra Trishkina is a deputy head of the Capital Markets Funding Division in the Department of State Debt and State Financial Assets at the Ministry of Finance of the Russian Federation. She assumed that position in March 2010 and is responsible for issuing external government debt. She worked in the ministry’s division that was responsible for management of the Reserve Fund and the National Wealth Fund since the division was established in 2005, developing and implementing fund management policy. She was engaged in management of the Stabilization Fund’s assets before it was transformed into the two new funds in 2008. Before joining the Ministry of Finance, she worked at the Federal Treasury for three years, where she dealt with Russian government bonds. She graduated from the Russian Academy for Foreign Trade under the Ministry of Economic Development and Foreign Trade in Moscow.
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Edwin M. Truman, senior fellow at the Peterson Institute for International Economics since 2001, served as assistant secretary for international affairs at the U.S. Treasury from December 1998 to January 2001 and as counselor to the secretary from March to May 2009. He directed the Division of International Finance of the Board of Governors of the Federal Reserve System from 1977 to 1998. He has been a member of several international working groups and has taught at Yale, Amherst, and Williams. He is the author, coauthor, or editor of Reforming the IMF for the 21st Century (2006), A Strategy for IMF Reform (2006), Chasing Dirty Money: The Fight Against Money Laundering (2004), Inflation Targeting in the World Economy (2003), and Sovereign Wealth Funds: Threat or Salvation? (2010). He has a B.A. from Amherst College and a Ph.D. from Yale University, both in economics.
Han van der Hoorn is an asset management advisor in the Sovereign Asset and Liability Management Division of the International Monetary Fund. In that posi-tion, he works with and advises central banks and sovereign wealth funds on strategic asset allocation and risk management. Before joining the IMF, he was a senior economist in the Risk Management Division of the European Central Bank, and held various positions in supervision, asset management, and risk management at the Dutch central bank. He started his career at Coopers & Lybrand. He holds master’s degrees in econometrics from Erasmus University and economics from the University of Amsterdam.
Mauricio Villafuerte is deputy division chief in the Fiscal Affairs Department at the International Monetary Fund. He is a Ph.D. candidate in economics at the University of California, Los Angeles. Before joining the IMF in 1997, he worked at the Ministry of Finance and the Central Bank of Ecuador. He specializes in fiscal and monetary policy issues in natural resource–dependent countries, having worked extensively on oil-producing countries (e.g., Nigeria, Norway, República Bolivariana de Venezuela), and has produced several publications on fiscal policy management and fiscal institutions (specifically fiscal rules and oil funds) in those countries. More recently, he has been involved in the design of strategies for fiscal consolidation and the management of sovereign balance sheet risks in the postcri-sis world.
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Abu Dhabi Investment Authority (ADIA), 8, 10–11, 207
Aging populations, 16 Alberta Heritage Fund, 259–261 Alberta Heritage Savings Trust Fund
Act , 259 Assets, 26–28, 126, 127 f
classes by volume, 27 f conditional dependence, 162–163 dependencies, 161–163 idiosyncratic risks, 159–160 projected 2013, 12 f projected growth through 2020, 30 f regional distribution, 26 f
Assets Supervision and Administration Commission, 5
Australia, national policy responses, protectionism, 33–34
Azerbaijan, 47
Back-testing, 169 Balance of Payments and International
Investment Position Manual (BPM6) , 87 t , 90–91
Bank share prices, 31, 32 f Bilateral investment treaties (BITs), 77 BPM6. See Balance of Payments and
International Investment Position Manual
Brazil, 76
Capital account liberalization BITs and, 77 COMESA and, 78 domestic law, 76 EU and, 78 GCC and, 78 IMF Articles of Agreement, 78–79
IMF financing, 80 IMF jurisdiction, 79–81 IMF surveillance, 79–80 IMF technical assistance, 80 international law, 76 methods, 75 NAFTA and, 77–78 regional trade, investment treaties,
77–78 soft law, Santiago Principles,
81–83 Capital sources, risk tolerance,
129–131 CDIS. See Coordinated Direct
Investment Survey Central bank investment strategies
equities, corporate bonds, 133 f foreign reserves, 6 f , 125 SWFs vs., 132–134, 205–206
Central Bank of Chile (CBC), 262–263, 265–269
CFIUS. See Committee on Foreign Investment in the United States
Chilean fiscal policy, SWFs, 47 asset allocation, 264 f capital contributions, 262–263 current investment policy, 270 f ESSF, 260, 262–263, 267, 267 f fiscal, monetary stimulus, 268 f fiscal savings rate, 263 f global financial crisis, 266–269 governance structure, 264 f institutional framework, 263 transparency, 265
China Investment Corporation (CIC), 212, 242, 271–273
China State Administration of Foreign Exchange (SAFE), 6, 207
Index
Note : Figures, boxes, and tables are indicated by f , b , and t , respectively.
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Classification implications, 137, 138–139 t , 140
Code of Good Practices on Fiscal Responsibility , 54
COFER. See Currency Composition of Foreign Exchange Reserves
COMESA. See Common Market for Eastern and Southern Africa
Commercial vs. political objectives, 62 Committee on Foreign Investment in
the United States (CFIUS), 35, 237–238
Common Market for Eastern and Southern Africa (COMESA), 78
Communication, 232 Conservative, passive investors, 7 Contingent pension reserve funds, 60 Coordinated Direct Investment
Survey (CDIS), 88–89, 88 t Coordinated Portfolio Investment
Survey (CPIS), 86, 88–89, 88 t Corporate governance, 33 Corporate ownership, global, 26–30 Cost of risk, 159–160 CPIS. See Coordinated Portfolio
Investment Survey Cross-border investments, 26–30, 86,
87 – 88 t , 88–89 Currency Composition of Foreign
Exchange Reserves (COFER), 88 t
Data Quality Assessment Framework (DQAF), 87 t
Declaration on Sovereign Wealth Funds and Recipient Country Policies (OECD), 37–38, 81
Development funds, 46, 49, 60, 96 Domestic financial crises, 19–20 Domestic policy goals, 15–16, 61 Domestic sovereign investments,
252–255 Domestic stakeholders, 62 Domestic statistics, 89–90 DQAF. See Data Quality Assessment
Framework
Drawdown risk, 160 f Dubai Ports World, 237 Dutch disease, 6, 15, 19, 60, 276
Economic and Social Stabilization Fund (ESSF), Chile, 260, 262–263, 267, 267 f
Emerging-economy reserves, 187 f Emerging markets, 10–11, 211–212,
211 f , 215 f Endowment funds, 6, 151 ESSF. See Economic and Social
Stabilization Fund European Free Trade Association, 34 European Union (EU), 35–36 Event-study analysis
country of target firms, 178 f data, 176–177 empirical results, 180, 182–183 events by acquiring SWF, 178 f literature review, 174–176 methodology, 177–180 SWF investments/divestments,
ratios, 179 f SWF investments/divestments,
stock market reactions, 181–182 t , 183–184 t
Exchange rate issues, 22 External fund managers, 97–99 External sector statistics, 90–91
Financial market stability, 31 Financial risk-return balance, 130 f Financial utility function, mathematical
translation, 159 FINSA. See Foreign Investment and
National Security Act FIRB. See Foreign Investment Review
Board Fiscal policy, 20–21 Fiscal stabilization, 44 FOI. See Freedom of Investment
Roundtables Foreign Acquisitions and Takeovers
Act, 33
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Foreign Investment and National Security Act (FINSA), 35, 237
Foreign Investment Review Board (FIRB), 33
Foreign investors in U.S. and EU bank share price effects, 31, 32 f corporate governance, 33 financial market stability, 31 state funding, 31–32 strategic assets sale, know-how,
32–33 Foreign reserves
adequate levels, 16–17 ample reserves options, 18–19 in central banks, 6 f
Freedom of Investment (FOI) Roundtables, 113, 117, 120
Fund for Economic and Social Stabilization, Chile, 47
GCC. See Gulf Cooperation Council General Data Dissemination System
(GDDS), 87 t Generally Accepted Principles and
Practices (GAAP), 38, 281–284 oversights, implementation, 38 stakeholders, 38 support, adherence, 38
Germany national policy responses, protectionism, 34–35
Global financial crisis, 8–9, 9 f , 144–148, 192–194, 225–233, 245–248
communication, post crisis, 232–233 governance, post crisis, 230–231 investment processes, post crisis,
231–232 macroeconomic policy framework,
SWF role, 49, 49 b postcrisis SAA, 143 f , 147 f
Global Integrated Monetary Fiscal Model (GIMF), 198–199
Global markets, 61–62 SWF absolute, relative size in
context, 206–209
SWF investments, 210–212, 211 f SWF investments, market
participants reaction, 215–217 SWF market impact, transparency,
217–218 SWF publicly announced equity
investments impact, 209–210 SWF shift from official reserves,
market and macro implications, 212–215, 215 f
SWF value, by target sector, 214 f Global portfolio construction,
168–170 Good conduct rule, 37–38 Governance, post global financial
crisis, 230–231 Government holding companies, 7 Governments role, 96 Greenspan-Guidotti rule, 17 Gross value of transactions, 194 t Growth
by 2015, 126 after 2002, 4 profile, returns vs. risk, 127–129,
128 f projected through 2020, 30 f prospects, post 2008, 11
Gulf Cooperation Council (GCC), 78
Hedge Fund Research, 207
ICAPM. See Intertemporal capital asset pricing model
IFSWF. See International Forum of Sovereign Wealth Funds
IIAs. See international investment agreements
IIP. See International Investment Position Statistics
IMF. See International Monetary Fund Industrial and Commercial Bank
of China, 11 International Forum of Sovereign
Wealth Funds (IFSWF), 39, 72, 236, 285–286
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302 Index
International investment agreements (IIAs), 36
International Investment Position (IIP) Statistics, 87 t
International Monetary Fund (IMF) Articles of Agreement, 78–79 capital account liberalization
and, 78–81 financing, 80 jurisdiction, current payments
restriction, 79–81 surveillance, 79–80 SWFs and, 59–60, 71 technical assistance, 80
International open markets, regulatory environments, 35–37
International Organization of Securities Commissions, 63
International Working Group of Sovereign Wealth Funds (IWG), 38–39, 59, 285
Intertemporal capital asset pricing model (ICAPM), 210–214
Investment barriers, 35–37 Investment Company Institute, 219 Investment flows, transparency
cross-border data, 86, 87–88 t , 88–89
domestic statistics, 89–90 external sector statistics, 90–91 SWFs statistic data reporting
practices, 91–92, 91 f , 92 f Investment strategy, 163–170, 231–232
annualized earnings growth in U.S. 1985–2008, 167 f
back-testing, 169 global portfolio construction,
168–170 investment places, types, 210–212 price-to-book measurement, 170 returns to S&P 500 as function of
P/E, 166 f risk-management discipline, 168 static vs. dynamic allocation,
163–165
tail event risk management, 169–170 top-down macroeconomic analysis,
165–166 total percentage returns to equities,
S&P 500, 1901–2009, 167 t value investing, 166–168
Investments, asset sales, 28 f Investments value, by target sector,
214 f Istithmar World, 8 IWG. See International Working
Group of Sovereign Wealth Funds
Khazanah Nasional Berhad, 5 Kiribati’s Revenue Equalisation
Reserve Fund, 4 Korea Investment Corporation, 47 Kuwait Declaration, 236 Kuwait Investment Authority, 4, 7, 10
Lisbon Treaty, 35 Long-term investors, risk-return
perception drawdowns by asset class, 157 t equity risk over economic cycle, 156 long-term assets’ return, 152–153 long-term drawdown risk, single
asset class investment strategies, 156–157
long-term vs. short-term risk-return trade-offs, 153 – 156
losses, historical returns, 1907–2008, 155 f
real returns across U.S. asset classes, 1928–2008, 153 t
real U.S. equity returns by category, 1925–2008, 153 t
single asset class strategies, 156–157 VaR for higher-volatility
equities, 154
Macroeconomic impacts estimated assets under management,
end-2008, 190 t macroeconomic stabilization, 44
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Index 303
projections by region, 192 f SWFs by type, percent share assets
under management, 191 f SWFs, current/future size, 189,
191–192 Macroeconomic policy framework,
SWF role, 20–22 accountability, 53–55 aggregate demand, economic
activity, 45 asset-liability management, 52–53,
56 direct resource spending, 55 domestic economy impact,
44–46, 61 domestic market investing, 55 economic policy coordination, 56 fiscal risks, public sector’s balance
sheet, 51–52 global financial crisis and, 49, 49 b investment barriers, risk tolerance, 53 monetary, exchange rate policies,
45, 50–51 national budget relationship, 50 objectives, 44, 47 b operational framework, 46–50, 55 private sector behavior, 45–46 public spending path, 45 returns from public resources, 46 SAA, 52–53 SWF accounting, 53–54 SWF types, overall policy
objectives, 46 transparency, 54–56, 61 vulnerable economy, 46
Market impact, transparency, 217–218 Models
basic assumptions, 100–103 dynamic model, learning by
investing, 111–112 GIMF, 198–199 ICAPM, 210–214 imperfect information, 104–106 model simulations, 198–199,
200–202 f , 203–204
P-A model, 99–103, 101 f , 106–110
perfect information, 103–104 results, interpretations, policy
implications, 103–106 theoretical considerations,
99–103, 100 f 25:45:30 long-term model portfolio,
131–132 Monetary policy, 21–22, 45, 50,
266–268 Mubadala Development Company, 7
NAFTA. See North American Free Trade Agreement
National policy responses, protectionism Australia, 33–34 EU, 35–36 Germany, 33–34 Russian Federation, 34–35 United States, 35
National Wealth Fund, Russian Federation, 7
New funds, targeted goals, 11 New Zealand Superannuatation
Fund, 273–276 Nontraditional asset class
diversification, 10 North American Free Trade
Agreement (NAFTA), 77–78 Norway Government Pension Fund-
Global, 8, 28, 47, 131, 207, 215
OECD Guidelines on Corporate Governance of State-Owned Enterprises , 68
Organisation for Economic Co-operation and Development (OECD), 60, 63–64, 236–237
advocacy, guidance, 113–114 background documents, 120–121 FOI Roundtables, 113, 117, 120 national security vs. protectionism,
115–117, 118–119 b OECD investment instruments, 121
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304 Index
P-A model, 99–103, 101 f , 106–110 Passive investors, 7 Pension Reserve Fund (PRF), Chile
asset allocation, 264 f capital contributions, 262–263 fiscal savings rate, 263 f governance structure, 264 f institutional framework, 263 investment policy, 263–265 market value, 268 f transparency, 265
Pension reserve funds, 46, 138–139t Postcrisis SAA, 143 f , 147 f Price-to-book measurement, 170 Primary sources of funds, 92 f Projections by region, 192 f Protectionism, 33–35 Publicly announced equity
investments, market impact, 209–210
Pula Fund, 4
Qatar Investment Authority, 10–11
Real returns across U.S. asset classes, 1928–2008, 153 t
Real U.S. equity returns by category, 1925–2008, 153 t
Recipient-country investment policies, OECD perspectives
advocacy, guidance, 113–114 background documents by, 120–121 FOI Roundtables, 113, 117, 120 national security vs. protectionism,
115–117, 118–119 b OECD investment instruments, 121
Regulation, 95–96, 149 Relative buy/hold returns, asset
classes, 128 f Republic of Korea, 47 Reserve Assets and the Data Template
on International Reserves and Foreign Currency Liquidity (Data Template), 87 t
Reserve investment corporations, 46, 60
Return correlation matrix, real U.S. assets 1945–2008, 161 t
Return-to-risk ratio across economic cycle, 1900–2009, 163 f
Return-to-risk ratio across economic cycle, equities and debt, 163 f
Risk-management discipline, 168 Russian Federation, 5, 34–35, 277–279
SAA. See strategic asset allocation SAFE. See China State Administration
of Foreign Exchange SAMA. See Saudi Arabian Monetary
Agency Santiago Principles, 37, 236, 271–272,
281–284 accountability, 82 commercial behavior, 67 b fair competition in markets, 67 b financial market stability, 67 b governance, accountability, 66 b ,
82, 276–277 institutional framework, governance
structure, 68–69 investment, risk management
framework, 69–70 IWG and, 59, 63–64, 81 key features, 65–70, 66–67 b legal framework, 65, 67–68, 82–83 macroeconomic policies
coordination, 65, 67–68 macroeconomic policy
challenges, 66 b management of nation’s
wealth, 66 b objectives, 65, 67–68 public policy concerns, 59 risk management, 82 voting rights, 83
Saudi Arabian Monetary Agency (SAMA), 7, 207
Savings funds, 46, 52, 60, 96, 137–142, 146
SDDS. See Special Data Dissemination Standard
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Index 305
Securities and Exchange Commission (SEC), 63
Shift from official reserves impact, 212–215
Sovereign assets and liabilities, 248–252 Sovereign financing, 148–149 Sovereign pension funds (SPFs),
134, 135 t Sovereign wealth funds (SWFs)
absolute, relative size in context, 206–209
aims, strategies, 6–8, 8 f asset dependencies, 161–163 assets, 26–28, 126, 127 f assets, classes by volume, 27 f assets, conditional dependence,
162–163 assets, Dec ’07–Dec ’09, 145 f assets’ idiosyncratic risks, 159–160 assets, projected growth through
2020, 30 f assets, regional distribution, 26 f biggest, 4–5 capital sources, risk tolerance,
129–131 categories, 7–8 classification implications, 137,
138–139 t , 140 communication, post global
financial crisis, 232–233 contingent pension reserve funds, 60 cost of risk, 159–160 cross-border flows, 86, 87 – 88 t ,
88–89 defined, 4–5 development funds, 46, 49, 60, 96 domestic financial crises and, 19–20 domestic statistics, 89–90 drawdown risk as function of past
drawdown, 160 f emerging markets, 10–11, 215 f endowment funds vs., 151 estimated assets, 5 f estimated assets under
management, end-2008, 190 t
exchange rate issues, 22 external sector statistics and, 90–91 financial risk-return balance, 130 f financial utility function,
mathematical translation, 159 fiscal policy, 20–21 future, 235–242 global market impact, 61–62 governance, post global financial
crisis, 230–231 governments role, 96 gross value of transactions, 194 t growth after 2002, 4 growth by 2015, 126 growth profile, returns vs. risk,
127–129, 128 f growth prospects, post 2008, 11 investment places, types, 210–212 investment processes, post global
financial crisis, 231–232 investments, asset sales, 28 f investments value, by target
sector, 214 f issues surrounding, 61–63 market impact, transparency,
217–218 market participants’ reaction,
215–217 monetary policy, 21–22 new funds, targeted goals, 11 nontraditional asset class
diversification, 10 objectives, taxonomy, 60–61 observed asset allocations,
comparison, 141–142, 143 f , 144 policy changes ahead, 148–149 postcrisis SAA, 143 f , 147 f primary sources of funds, 92 f projected 2013 assets, 12 f projections by region, 192 f proliferation, 3 publicly announced equity
investments, market impact, 209–210
regulation, 95–96, 149
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306 Index
relative buy/hold returns, asset classes, 128 f
reserve investment corporations, 60, 139t
return correlation matrix, real U.S. assets 1945–2008, 161 t
returns, 2008, 144 f returns, 2009, 145 f return-to-risk ratio across
economic cycle, 1900–2009, 163 f return-to-risk ratio across economic
cycle, equities and debt, 163 f SAAs, funding source, 141 SAAs, investment horizon,
140–141 SAAs, theoretical considerations,
140–141 savings funds, 46, 52, 60, 96, 137,
138–139t, 140 shift from official reserves impact,
212–215 sources of funds, 4 sovereign financing, 148–149 stabilization funds, 6–7, 20–22, 52,
60, 96, 137, 138–139t, 140, 144 stakes in individual companies,
28, 29 f state-owned, 5 statistical reporting practices, 91–92 strategic shifts, post 2008, 9–11 strategic vs. financial utility,
157–158, 158 f talent hiring, 11 25:45:30 long-term model
portfolio, 131–132 by type, percent share assets under
management, 191 f utility function, 157–163
Special Data Dissemination Standard (SDDS), 87 t
Stabilization funds, 6–7, 20–22, 52, 60, 96, 137, 138–139t, 140, 144
State Administration of Foreign Exchange, China, 6
State funding, 31–32 State Oil Fund, Azerbaijan, 47 Static vs. dynamic allocation,
163–165 Statistical reporting practices, 91–92 Strategic active investors, 8 Strategic asset allocation (SAA), 20,
52–53 funding source, 141 investment horizon, 140–141 theoretical considerations,
140–141 Strategic assets sale, know-how,
32–33 Strategic vs. financial utility,
157–158, 158 f Stylized portfolio analysis,
195–198, 197 f
Tail event risk management, 169–170 Temasek Holdings, 5, 7 The Carlyle Group, 7 Transparency, 54–56, 61. See also
investment flows, transparency 25:45:30 long-term model portfolio,
131–132
United States (U.S.) CFIUS, 35 Foreign Investment and National
Security Act, 33 national policy responses,
protectionism, 35
Value investing, 166–168
Yield-seeking, passive investors, 7–8
Sovereign wealth funds (SWFs) (continued)
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