Sovereign wealth funds

Many capital-exporting developing countries look for systematic ways of raising returns on their international currency reserves on a long-term basis by creating sovereign wealth funds (SWFs), which are designated pools of assets owned and managed by governments and predominantly deployed worldwide to attain higher returns.

Countries usually have their international reserves managed by their central banks and held in liquid assets in reserve currencies. Since the primary functions of international reserves are to finance payment imbalances and limit exchange rate volatility, the reserves must have a high degree of liquidity. Since assets typically have lower rates of return the more liquid they are, however, it can make sense for governments to invest in longer term, less liquid assets such as bonds and equities. Similarly there may be gains from diversification by investing in a broader range of countries than only thosewithmajor reserve currencies.

Perhaps the clearest rationale for the establishment of an SWF is to accumulate reserves in countries that are major exporters of nonrenewable resources such as oil and gas. Concern for future generationsdictates that all current revenues fromthe sale of such commodities not be spent on current consumption. Nor, typically, could all of the remainder be spent productively on domestic investment. Usually a substantial proportion of these revenues accrue to governments from tax receipts or direct ownership. Thus governments accumulate reserves.

Oil-producing countries make up more than half of all SWF funds (i.e., commodity-based funds) in terms of assets under management. Kuwait’s International Authority, funded by oil, was established in 1953 and is the oldestSWF. Another prime example is Norway’s Global Pension Fund, funded by a portion of North Sea oil and gas. The United Arab Emirates’ Abu Dhabi Investment Authority Fund, which was established in 1976, is the world’s largest SWF currently, with U.S. $625 billion under management. Other oil exporters,Oman andBrunei, also created investment agencies to recycle their reserve holdings in the 1970s and 1980s, and Russia followed suit more recently, creating a Stabilization Fund in 2003 (Lyons 2007).

Among the better-known non-commodity-based SWFs in Asia are Singapore’s Government Investment Corporation (GIC) and Temasek Holdings. Since some of the funding sources for the agencies also include pension contributions from Singapore residents, however, these entities are strictly speaking a combination of SWFs and sovereign provident funds. GIC, established in 1981, has around U.S. $215 billion under management and tends predominantly to make financial and real estate investments. Temasek, established in 1974, has around U.S. $100 billion under management and is a more active investor in international companies regionally and globally.

Although SWFs have been around since the 1950s, they have only recently attractedmuch public attention. SWFs have taken on increased prominence with their phenomenal growth in recent times (both in numbers as well as funds under management), especially with the creation of the China Investment Corporation (CIC) in 2007. The CIC, which is said to be modeled on Singapore’s GIC in both concept and design, began operations when the Chinese government transferred U.S. $200 billion of itsU.S. $1.3 trillion in reserves to the agency,making it the world’s fifth largest SWF. The new fund’s first major investment was a $3 billion investment in the U.S.-based Blackstone private equity group. SWFs took center stage at the October 2007 World Bank and the InternationalMonetary Fund (IMF) annual meetings, and theG7 industrial countries have begun to pay greater attention to these entities.

Since many of the SWFs practice considerable secrecy, the total value of their assets is not known, but estimates put the figure at between $2 and $3 trillion, substantially larger than the global aggregate of all hedge funds. Estimates also project a rapid rate of growth, with figures of $10 trillion and more expected to be reached by early in the 2010s.

Another rationale for SWFs is to minimize the destabilizing effects of fluctuations in exports due to periods of more and less rapid growth in the world economy. Medium-term fluctuations are common for a wide range of agricultural as well as both renewable and nonrenewable raw materials, so economists have long recommended that governments should accumulate international reserves in good times and draw themdown in bad. This has proven difficult to do inmany developing countries because of political pressures to spend all increases in reserves. These tendencies can be partially countered through the establishment of SWFs. An example is Chile’s Economic and Social Fund, established in 2006.

A third rationale for the creation of SWFs is to eliminate a continual surplus.When continuing disequilibrium in a country’s balance of payments has led it to accumulate far more international reserves than it needs based on traditional criteria, and the country expects to continue to accumulate reserves (or at least, not have huge reductions), then it makes no sense to hold all of its reserves in low-yield liquid assets.The country could put its excess reserves into a new facility to earn higher returns, but if reserves are clearly excessive then it would most likely take actions to eliminate its continual balance of payments surplus. Only if the rate of return on domestic investment was quite low would it make sense for the government to continue to accumulate international financial assets, even if these were invested in less liquid, higher return securities. In a market-oriented economy without capital controls, private investment would tend to flow fromlower- to higher-yield areas. Thus, if domestic investments were indeed lower yield, capital would flow out and eliminate the balance of payments surplus.

A prime example of such clearly excessive reserve accumulation is China since around 2000. China does have extensive capital controls that block this equilibrating flowof capital.The primary reason that the Chinese government has not taken sufficient adjustment actions to slowor reverseChina’s balance of payments surplus and accompanying reserves accumulation is that in the short run the needed adjustments would hurt some sectors of the economy, and the government is greatly concerned about the short-run political and social instability that such disruptions might generate. Thus, although adjustment is in China’s longer-run economic interest, in the government’s calculation, this is outweighed by the likely short-run political costs. Numerous policy announcements have made clear that the government would be happier if the surplus were reduced, but its limited actions reveal the high priority given to avoiding short-run adjustment costs.

The limited adjustments taken by the Chinese government have also contributed to global economic imbalances and the risk they pose to global financial stability. Of course, China alone is not responsible for such global imbalances. From a global perspective, however, the creation of the SWF reduces the national economic cost of these continual reserve accumulations and hence reduces somewhat the pressures on China to do its part toward the needed mutual adjustments.

The greatest concerns about SWFs focus on a different type of issue, however: the fear of foreign government influence over the operation of key segments of domestic economies. As long as SWFs limit themselves to passive portfolio investments they do not pose major problems on this score. The problems come when they make direct investments of substantial stakes in sensitive industries. Such fears have been highlighted by the recent efforts of government- controlled enterprises in China and Dubai to purchase a U.S. oil company and port operator, respectively. Although in neither of these caseswas an SWF involved (the bidders were state-owned companies), they have led to considerable speculation about what could occur. Concerns have also been raised that the large amounts ofmoney controlled by some SWFs could generate disruptions in financial markets. These concerns and questions have been fuelled further by the purchase of fairly large stakes in major U.S. financial institutions by various SWFs. Although creating such disruptions would seldom, if ever, be in the interest of SWFs, this may not be sufficient to calmall fears.The likely greater danger is that this range of fear would stimulate protectionist backlashes that could hurt both the SWFs and potential investment recipient countries.

Certainly, some SWFs follow policies that are unlikely to generate conflicts. Norway, for example, provides considerable transparency and spreads its investments over awide range of equities, taking only small stakes in any one. Many funds are currently quite opaque, however. Such considerations suggest that the development of an international code of conduct forSWFs could be in themutual interests of both capital-exporting and capital-importing countries. The possibility of developing such codes has become amajor topic of attention inmany countries and international forums such as theG7and the IMF (for instance, see Truman 2007).

See also capital controls; capital flows to developing countries; exchange rate volatility; fear of floating; foreign exchange intervention; global imbalances; hedge funds; InternationalMonetary Fund (IMF); international reserves; reserve currency

FURTHER READING

• Lyons, Gerard. 2007. ‘‘State Capitalism: The Rise of Sov ereign Wealth Funds.’’ Standard Chartered Bank (October 15). United Kingdom. Offers a detailed analysis of SWFs worldwide.

• Truman, Edwin, M. 2007. ‘‘Sovereign Wealth Funds: The Need for Greater Transparency and Accountability.’’ Policy Brief No. PB07 6 (August). Washington, DC: Peterson Institute. Offers an overview ofSWFs, focusing on their lack of transparency, and presents a framework to help evaluate the extent of transparency and ac countability of the SWFs.

THOMAS D. WILLETT AND RAMKISHEN S. RAJAN