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Sovereign Wealth Funds: Western Fears

Sovereign Wealth Funds: Western Fears

Sovereign wealth funds control assets of somewhere between $ 1.9 and $ 2.9 trillion. What are swfs, how are they governed and why are developed countries anxious about such funds being set up by developing countries? And should India consider setting up a swf with a part of its large foreign exchange reserves?

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Sovereign Wealth Funds: Western Fears

T T Ram Mohan

the problem arises when SWFs from the developing world move into the developed world.

What exactly are SWFs? What objectives govern the creation of SWFs? How large are they? How valid are concerns about SWFs? And is it time for India to float its SWF? In

Sovereign wealth funds control assets of somewhere between $ 1.9 and $ 2.9 trillion. What are SWFS, how are they governed and why are developed countries anxious about such funds being set up by developing countries? And should India consider setting up a SWF with a part of its large foreign exchange reserves?

T T Ram Mohan (ttr@iimahd.ernet.in) is at the Indian Institute of Management, Ahmedabad, India.

A
spectre haunts the western world today, the spectre of a revival of government ownership of commercial entities. That, we shall argue, is what the current hullabaloo about sovereign wealth funds (SWFs) boils down to.

Hedge funds made waves not long ago. Then, we had private equity. Now, SWFs are the talk of the town. But they are not, by any stretch of imagination, a recent financial innovation. They have been around for longer than people think. What is new is SWFs from the developing world flexing their muscles.

SWFs have shot into the limelight in the wake of the sub-prime crisis because of the recent high-profile investments made by some SWFs from the developing world. SWFs from China, the west Asia and Singapore have emerged as saviours of some of the best known names in the industrial and financial sectors. This has made many in the western world jittery – the mood is not very different from that in the 1980s when a Japanese invasion of corporate America seemed imminent. Among the beneficiaries of SWF investments in recent months are the leading private equity company – Blackstone; top investment banks – Merrill Lynch, Morgan Stanley and UBS; and the banking giant – Citigroup. Many in the western world may not care to admit it but they do regard the financial sector as “strategic”. That is part of the reason for jitters.

American concern about SWFs may seem a little odd because the US has its own high-profile SWF in the shape of Calpers, the California pension fund, with big investments worldwide. It may not be owned by the federal government; it is owned by one of the states in the US but that is a minor difference. Calpers’ investments abroad have been welcomed by host economies and American policymakers have no problems with these either. No, what follows, we address these questions.

Class of a Nation’s Foreign Assets

Although SWFs are a distinctive investment vehicle, it is useful to recognise that nations have long had foreign assets that they have managed. The dominant form of foreign assets held by a sovereign are foreign exchange reserves. These reserves are typically managed by a nation’s central bank. SWFs are merely another form in which forex reserves are managed. The differences between forex reserves and SWFs, as Y V Reddy (2007) points out, relate to the investment objectives and degree of disclosure and transparency.

Forex reserves are intended to make foreign exchange available for imports and for management of the exchange rate. This typically requires reserves to be invested in liquid, low-return foreign assets such as sovereign debt, deposits with the Bank for International Settlements and other central banks and commercial banks with high ratings. With SWFs, governments set higher return objectives and this opens up possibilities for investment in a range of riskier assets – corporate debt, equity, private equity, hedge funds, etc. Whereas the time horizon for investment of forex reserves is relatively short, it is much longer for SWFs.

Forex reserves are typically managed by the central bank. There are very clear laws and guidelines relating to the central bank’s management of forex reserves. There are also stringent norms for disclosure both within the country and to international agencies. SWFs may be managed directly by the central bank or separate corporate entity.

However, Reddy (2007) makes the point that as long as the assets of SWFs are available to the monetary authority, they qualify as “international reserves”. Whether they meet the technical

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definition of reserves or not, the assets of funds have identified pension and/or
SWFs would become available to the mon contingent-type liabilities in the govern
etary authority if required. ment’s balance sheet.
Whichever way one looks at it, SWFs are The allocation of assets to an SWF will
an integral part of the foreign assets of the depend upon its policy objective. A stabili
public sector. These assets may be either sation fund, for instance, would want to
low-risk, low-return investments (when invest in assets that are negatively corre
they are forex reserves) or they may be of lated with a country’s major exports
the higher-risk, higher return investments (for example, oil). These funds would be
(when they are SWFs). Forex reserves are conservative in their asset allocation
typically concentrated in a limited number policies, using relatively shorter-term
of assets and currencies (the dollar, mainly). horizons and investing in low risk-return
What SWFs help achieve is diversification instruments, given that their objective is
across a range of assets and currencies. primarily to insulate an economy from
terms of trade shocks.
Taxonomy of SWFs A pension fund would have to match its
The International Monetary Fund’s (IMF) asset allocations to meet the maturity
Global Financial Stability Report, 2007 pro profile of its liabilities. It would have a
vides a detailed taxonomy of SWFs, based on: longer time horizon for its investments. So
(i) sources of SWFs; and (ii) policy objectives. also a savings fund.
Funds that do not have identified liabili-
Sources of SWFs: SWFs typically owe ties can focus more on maximising returns
their funds to balance of payments subject to an acceptable level of risk. How
surpluses or the byproduct of fiscal budget ever, as the IMF points out, for some funds
surpluses, reflected in large export reve there could be implicit liabilities in the
nues and spending restraint. But there shape of sterilisation instruments that are
could be other sources such as public used to mop up excess liability.
savings generated domestically, such as Can SWFs be used for domestic invest
privatisation receipts. ment? The question is relevant to India
given the move to create a special purpose
Policy Objectives: We reproduce ver vehicle that would use about $ 5 billion of
batim the IMF’s list of SWFs based on policy forex reserves to invest in domestic infra
objectives: structure. First, when an SWF invests
Stabilisation funds are set up by coun domestically, the authorities would be revers
tries rich in natural resources to insulate ing the process that led to the reserve
the budget and economy from volatile accumulation in the first place. This has obvi
commodity prices (usually oil). The funds ous macroeconomic implications, notably
build up assets during the years of ample for the management of exchange rates.
fiscal revenues to prepare for leaner years. Second, if the SWF has been carved out
Savings funds are intended to share of forex reserves, it would be a part of the
wealth across generations. For countries central bank’s balance sheet. If the gov
rich in natural resources, savings funds ernment draws upon this SWF to invest in
transfer non-renewable assets into a domestic infrastructure, it constitutes a
diversified portfolio of international finan form of government borrowing. It would
cial assets to provide for future genera be an off-balance sheet liability of the gov
tions, or other long-term objectives. ernment and would qualify for inclusion
Reserve investment corporations are in overall public debt.
funds established as a separate entity For a government that is constrained by
either to reduce the negative cost-of-carry legislation on fiscal deficit limits, creating
of holding reserves or to pursue invest and using such an SWF has its attractions
ment policies with higher returns. Often, – it enables the government to get around
the assets in such arrangements are still the limits on government spending. But
counted as reserves. we should recognise it as such and not be
Development funds allocate resources for deluded into thinking that incremental
funding priority socio-economic projects, spending on infrastructure has taken
such as infrastructure. Pension reserve place without any additional government
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borrowing. Precisely because the use of an SWF for domestic investment raises issues of fiscal transparency, such investment is not considered desirable.

Size of SWFs

As mentioned earlier, SWFs have been around for a while. Hildebrand (2007) points out that France set up an SWF way back in 1816. The Kuwait Investment Authority was set up in 1953. SWFs have acquired prominence of late because many SWFs of a large size have sprung up. Oil prices have soared since 2000. Global imbalances have widened with the US current account deficit rising to 7 per cent of GDP in 2007. This has left many countries with a large accumulation of foreign exchange reserves.

The IMF estimates SWF assets to be anywhere between $ 1.9 and $ 2.9 trillion. This compares with international reserves of $ 5.6 trillion. Assets under SWF are a small fraction of assets under management of mature market institutional investors ($ 53 trillion). If we were to compare this with leading categories of funds, SWFs are smaller than mutual funds ($ 19.3 trillion) and global pension funds ($ 21.6 trillion) and slightly bigger than hedge funds ($ 1-1.5 trillion).

The IMF projects an increase in sovereign (mostly emerging market) funds at the rate of $ 800-900 billion every year. SWF assets are projected to touch $ 10-$ 12 trillion by 2012. It is possible that reserve accumulation may not increase in a linear manner and that the rate of accumulation may slow down. At the same time, however, we must factor in the possibility that as economies’ reserves grow in absolute terms, a greater proportion of reserves may be earmarked for SWFs in the past.

Most SWFs have been set up in (west and east) Asia, the biggest gainers from oil prices and current account surpluses. These two regions account for 77 per cent of the assets of the largest SWFs. The largest SWF is said to be housed in Abu Dhabi. The table (p 10) lists the leading SWFs.

Concerns about SWFs

Some high-profile investments made by SWFs have raised concerns in the developed world. It is not as if some of these investments are not welcome today – the infusion

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of capital into western banks and investment banks is seen as timely, given the troubled conditions of the financial markets. But many worry about the implications of the growing clout of SWFs from the developing world. The worry is on three counts

– financial, political and ideological.

Table: Major Sovereign Wealth Funds

opposing SWFs on grounds of posing a threat to financial stability.

The political concern is that SWFs will be used by foreign governments to advance strategic objectives. One scare scenario, for instance, is that a foreign government may acquire a controlling interest in an

American manufac-

Country Fund Name Assets turing company, then
United Arab Emirates Abu Dhabi Investment Authority $ 250 billion to $ 875 billion use its control to
Norway Saudi Arabia (ADIA)/Abu Dhabi Investment Council (ADIC) Government Pension Fund - Global No designated name $ 308 billion (as of March 31, 2007) $ 250+ billion simply dismantle the facilities in the US and relocate these to
Kuwait Kuwait Investment Authority (KIA), $ 160 billion to $ 250 billion the foreign country
General Reserve Fund (GRF) and or elsewhere. Thus,
Future Generations Fund (FGF) financial control will
Singapore China Government Investment Corporation (GIC); Temasek Holdings State Foreign Exchange Investment $ 100+ billion $ 100+ billion be used to weaken American manufac-
Corporation $ 200 billion turing capability.
Russia Oil Stabilisation Fund $ 127 billion (as of August 1, 2007) Scary as this

Source: IMF (2007).

The financial concerns are plain enough and can be addressed without too much difficulty. Many SWFs lack transparency in their operations. Neither their investment objectives nor their size nor their asset allocations are known. This raises supervisory and other concerns for economies in which SWFs have made investments. SWFs, it is contended, could pose a threat to financial stability. For instance, what if an SWF with a significant exposure to a given market were to abruptly make changes in asset allocations – say, it made large sales? This is a fair concern but also one that is readily addressed by subjecting SWF to reasonable levels of transparency.

The IMF and the Organisation for Economic Cooperation and Development (OECD) are said to be working on disclosure norms for SWFs. The US has already reached an agreement with Abu Dhabi and Singapore on principles for investment by SWFs. As reported in the Financial Times the agreement stated SWF investments “should be based solely on commercial grounds, rather than to advance directly or indirectly the geopolitical goals of the controlling government”. It emphasised the need “for strong governance structures” and internal controls for the funds as well as respect for host country regulatory disclosure rules. This almost covers the entire gamut of issues relating to transparency. As long as SWFs commit to these, there should be little room for

sounds, it is not a very plausible scenario. If relocation of facilities away from the US does not make economic sense, then the foreign SWF stands to lose significantly on its investment. Such losses, if multiplied in other investments could hurt the foreign government seriously. It would certainly undermine one of the objectives of SWFs, which is to increase returns on overseas assets.

Assuming, however, that foreign governments might entertain such nefarious objectives, the code of conduct mentioned above does address the underlying concern. It states clearly that SWFs must be guided by commercial objectives. Where an SWF is seen to depart from such objectives, the host government will obviously retain its right to respond as required.

If we accept that SWFs seek to maximise value, then their investments in overseas assets, in fact, give them a significant stake in other economies. It is more plausible to think of SWFs as giving nations a stake in each others’ prosperity. When a Chinese SWF invests in an American bank or investment bank in today’s financial markets, it helps stabilise the US financial market and contributes to American prosperity. When the American market recovers, the Chinese SWF will be a big gainer.

There are, of course, certain areas where SWF investment can legitimately give rise to security concerns. When China National Offshore Oil Corporation sought to buy Unocal, a Californian oil company in June 2005, there was an uproar in the US. So also when DP World, the Dubai port operator, attempted to take over Peninsular and Oriental’s business in the US. Oil and ports are regarded as “strategic” sectors with security implications. Fair enough but these concerns are best addressed by having a limited negative list for SWF investment or indeed for foreign direct investment (FDI) in general.

Similarly, if SWF ownership of banks is an issue, then SWF investment can be subjected to a ceiling on ownership that applies to FDI. In other words, we do not need a special dispensation for SWFs in order to address strategic or other concerns; it is easier to apply to SWFs the same restrictions that apply to foreign ownership in general. Once this is accepted, the political opposition to SWFs can be overcome.

There remain concerns of an ideological variety. Given that the financial and political concerns can be addressed without great difficulty, it is the ideological concern that is at the root of much of the hostility towards SWFs. It is worth addressing this concern at some length.

Many dislike the very fact that SWFs are government-owned. When SWFs acquire a stake in private companies, this is seen as government ownership coming in through the back door and it does not help that many of the SWFs come from countries such as China or Abu Dhabi where government ownership in the domestic economy is pervasive. Since government ownership is thought to be inconsistent with the pursuit of efficiency, it is feared that many of the developing countries with large government ownership will export their inefficiency to the west.

Jeffrey Garten (2008), professor of finance at Yale School of Management, makes no secret as to why SWFs pose a big headache:

While prudent regulation in selected areas can be justified, the new zeitgeist is likely to produce too much government intervention, too fast. We can expect less productivity, less innovation and less growth, since governments have many goals that the private sector does not. These include employment generation, income redistribution and the aggrandisement of political power…

In the late 18th century, capitalism was replacing feudalism. In the 20th century, freer markets won the day. Now the world is

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flirting with another big transformation in the philosophy and rules of global commerce. Unlike the changes of the past, this new trajectory does not represent progress.

This is not by any means an isolated point of view. Hildebrand (2007) echoes the same sentiments:

…since the early 1980s, we have witnessed broad-based and sustained political momentum to deregulate and liberalise economic structures, enhance the role of market forces and attempt to reduce the role of governments in the global economy. Looking back, Ronald Reagan’s confrontation with the air traffic controllers union in 1981 marks the beginning of this process…

…the secular trend to strengthen the role of free markets and competition as the overarching organising principles of the global economy has contributed significantly to the long period of prosperity that the world economy has enjoyed. In this context, SWFs represent a potential threat. Sizeable statesponsored foreign investments in mature economies can be perceived to be a threat to free market forces.

As we saw earlier, legitimate financial and political concerns about SWFs can be addressed through appropriate rules and laws. Once that is done, opposition to SWFs ought to die down. The danger of a protectionist backlash brought on by SWF investments should recede. It is unlikely that it will. The ideological opposition to SWFs will remain and it may well masquerade as one of the two other concerns.

What do we make of the ideological opposition to SWFs? One can discern two strands of thought here. One, a revival of state ownership is inherently bad – as a doctrine it is to be detested – and must be discouraged. Two, state ownership is likely to malign consequences for economies everywhere. Therefore, it must be opposed.

There is little one can do about the first objection. As for the consequences of state ownership, if SWFs mess up the firms in which they invest, then foreign governments and their taxpayers are likely to suffer as much as other shareholders. One would suppose, therefore, self-interest would require SWFs not to mess up the companies they invest in.

In any case, for such an outcome to come about, SWFs would need to acquire a controlling stake in companies, if not a majority stake. We are still far from such a denouement, so fear of SWF investment

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sapping innovation or efficiency is premature to say the least. It is also reasonable to expect that knowing the distrust and fears they arouse, SWFs will play it safe for a while and will be content to be both minority investors and passive investors. One is not sure whether the latter is such a good thing – there are people who would argue that SWFs ought to be asking tough questions today of the likes of Citigroup and Morgan Stanley. Be that as it may, SWFs are likely to play it safe and keep a low profile in the near future.

There is also the possibility that SWFs will do well with their investments. Many have argued that SWFs are incapable of doing so because government-owned entities cannot attract the best fund managers. Of late, however, many SWFs in the developing world have developed incentive systems designed to attract the best fund managers. If they also put in place appropriate governance structures, they may indeed do well. The case of Unit Trust of India (UTI) comes to mind. When UTI ran into problems a few years ago, many were quick to argue that government ownership was not consistent with performance in mutual funds. But UTI has successfully reinvented itself and remained a formidable player in the mutual fund business.

If SWFs end up delivering a good performance, we should expect the ideological opposition to get even louder. A non-performing SWF is bad; a performing SWF is worse because it is likely to send the wrong signals all round. If government ownership through SWFs can deliver, why not direct government ownership in companies?

In many parts of the world, notably India and China, many governmentowned companies have shown that they can stand up to competition, domestic and foreign. One can well understand why the prospect of successful SWFs upsets free market ideologues. This is a debate, one suspects, that will not go away easily, certainly not just with better transparency and norms for SWF investment.

Should India Have Its Own SWF?

We turn to the last of the questions we posed in the introduction: Is the time ripe for an Indian SWF?

As Reddy (2007) has argued, the rationale for an SWF does not exist in India as yet. We do not have volatile commodity exports that need to be smoothed out through a stabilisation fund. We have not had consistent current account surpluses

– for the most part, the current account has been in deficit.

One might add that we do not have a fiscal surplus either, which would warrant excessive savings being parked abroad. Given the shortages in infrastructure for meeting which we need foreign inflows, the argument would be to the contrary. Instead of building up forex reserves out of which we carve out SWFs, we must create conditions for absorption of inflows into infrastructure so that forex reserves decline.

Another argument made for an Indian SWF is that India clearly has “excess” forex reserves, meaning reserves in excess of what would be required for the purposes of imports and meeting contingencies. Hildebrand (2007) estimates that India has excess reserves of $ 80 billion, meaning this is the amount of reserves that is earning a low rate of return and could be put to better use through the creation of an SWF.

The difficulty is with the computation of “excess” reserves. It cannot be presumed that all inflows on the capital account are stable and irreversible. Elements of capital inflows that have contributed to the swelling of forex reserves in India in recent years are indeed of the volatile variety. Reddy (2007) makes the point with characteristic verve:

It is sometimes argued that in the context of significant growth in foreign exchange reserves in recent years, the portion of the reserves that is in excess of a certain recommended level may be carved out and invested separately for maximising returns. In this regard, it is necessary to view the concept of “excess reserves” from several angles, including from the perspective of possible real sector shocks to the current account and the nature of capital flows. India is vulnerable to shocks on account of oil price and fluctuations in foodgrain production, which is still largely dependent on monsoon conditions.

Additionally, a large part of the capital flows are portfolio flows and a significant component of foreign direct investment is in the nature of private equity or for acquisition of existing firms and not in greenfield projects. In a sense, therefore, capital account shocks, which would be independent of the

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economic fundamentals of the country or domestic macroeconomic environment cannot be fully ruled out.

We must also take into account the possibility of short-term losses in SWF investments in markets in conditions such as the present one. Suppose we accept that we have “excess” reserves of $ 80 billion and decide to park these in higher return opportunities. If the market were to drop by 50 per cent, we would suffer a loss of $ 40 billion – half the “excess” would be wiped out and we would be left with an “excess” of only $ 40 billion.

This could prove politically difficult to handle, of course, but the economic implications are also significant. It follows that the level of reserves must be such that even if, say, we take into account a 50 per cent drop in the value of SWF investments, we have enough reserves available for contingencies. It is fair to suggest that we are still some distance from such a happy situation.

References

Hildebrand, Philippe (2007): ‘The Challenge of Sovereign Wealth Funds’, speech at the International Centre for Monetary and Banking Studies, Geneva, December.

Garten, Jeffrey (2008): ‘The Unsettling Zeitgeist of State Capitalism’, Financial Times, January 14. IMF (2007): Global Financial Stability Report, October.

Reddy, Y V (2007): ‘Forex Reserves, Stabilisation Funds and Sovereign Wealth Funds – Indian Perspective’, address at the Foreign Exchange Dealers’ Association of India, Mumbai, October.

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