Effective management of the rising forex reserves is important for a number of reasons. The massive inflows puts an upward pressure on the local currency with respect to the dollar, thereby leading to its appreciation. This in turn affects export competitiveness, and necessitates Central Bank intervention to purchase the dollars, thereby offloading the local currency into the market. This sets up inflationary pressures, and the Central Banks are often forced to sterilize the local currency outflows by issuing Government Bonds, for which it has to incur the interest cost.
The two major concerns for Central Banks in managing their foreign exchange surpluses are liquidity and safety. Faced with not very distant memories of bitter experiences from speculative runs on their currencies, Asian Central banks in particular, have been directing their massive surpluses to US T Bonds. These T Bonds, despite their low yields, offered safety and liquidity in abundant measure. But now, with a weakening dollar and surging reserves, the attractions of T Bonds have started waning. These countries have started looking at more remunerative investment options and more professional management of the reserves. Sovereign Wealth Funds (SWFs) have consequently emerged, attracting strong opinions from many quarters.
The whole SWF story has gained importance especially because of the looming Chinese presence. The Chinese forex surplus has grown 45.1% in the first nine months of 2007 to $1.43 trillion. Its trade surplus was $177.5 bn for 2006, and is expected to be well over $225 bn for 2007, thereby further swelling the forex reserves. At the start of the year, China held $350 bn worth of low-yielding US T Bonds, and $230 bn bonds in US Government backed agencies like the Freddie Mac and Fannie Mae. In June 2007, the global financial markets got a wake up call as the Chinese announced the purchase of a $ 3 bn (non-voting), 10% stake in one of the largest Private Equity firms, Blackstone Group. With its reserves far in excess of the required amount for hedging foreign exchange risks, the Chinese Government set up a new fund, China Investment Corporation (CIC) with a corpus of $200 bn to get higher yields on its surplus.
The story of wealth funds starts with the little known, Petroleum Fund of Norway, worth over $200 bn today. Daniel Gross traces the evolution of this and other similar wealth funds in his article, Avoiding the Oil Curse. The Singapore Government's investment arm, Temasek Holdings, manages assets worth over $300 bn, and is one of the best known examples of SWFs. Since then, the value of such funds have grown manifold, forcing many countries to explore options of making more efficient use of these assets. UBS’s sale of a 9 per cent stake to the Government of Singapore Investment Corporation, and Citigroup’s sale of 4.9 per cent to the Abu Dhabi Investment Authority, are only the most recent examples of the SWF story.
Lawrence Summers explores the recent developments in the emergence of such Funds in Funds that shake capitalist logic. Morgan Stanley has estimated the present value of SWFs to be over $2.5 trillion, and growing at more than $500 bn a year. Prof Summers expresses his view that SWFs would be motivated by concerns other than maximizin risk-adjusted returns, and in the process introduce other variables into the global financial markets. In particular, Prof Summers indirectly hints at the possibility of SWFs becoming instruments of foreign policy and a powerful lever to buy influence.
The influence of SWFs have to be seen in its true perspective. Yes, SWFs are $2.5 trillion today and set to touch $12 trillion by 2015. But this is a miniscule share at 1.3%, compared to the massive, $170 trillion global financial markets today. But the reality of SWFs and the potential challenges posed by them remains and cannot be wished away. The interlocking and interdependent nature of the global financial markets would mean that no country can manage its SWF as an independent arm of its foreign policy, without incurring costs which are most likely to be prohibitively high and hence unaffordable. Such national interest risks can be mitigated by appropriately hedging the investment conditions. In any case such concerns have been part of the financial markets since its origins, especially over monopoly and anti-trust restrictions.
Many of the risks associated with SWFs are also shared with many regular funds. There have been many instances of investments by financial institutions with immediate and even primary concerns which are other than commercial. That strategic considerations are not the exclusive concern of the nations, have been well documented in the actions of the major multi-national companies of the world. These risks are mitigated to a large extent by sectoral restrictions and investment limits. Many countries, including the US continue to place limits on foreign investment in certain strategically important sectors like telecoms, media etc. It is therefore natural that SWFs will be restricted from investments in sectors of national interest like defence.
Martin Wolf, writing in the FT, The brave new world of state capitalism, argues for favoring,
"... the emergence of these funds as part of the integration of countries that accept a bigger role of the state in markets than western countries do today. So be it. It is better for such countries to prosper inside the market system than glower outside it. It is absurd to take a country’s exports of oil and refuse to allow it to buy assets, in return."
James Surowiecki, in a recent New Yorker column, Sovereign Wealth World, argues that Governments already own sizeable shares in strategic sectors. He writes,
"In fact, for all the anxiety about government-run funds corrupting the purity of the free market, the truth is that the global economy is already pretty impure. In the U.S., after all, public pension funds account for forty per cent of all institutional investment. In Europe, even now, governments own sizable stakes in a number of major corporations, while in many of the most successful Asian economies government and industry have historically worked hand in hand. Almost eighty per cent of the oil in the world is pumped by state-owned firms, and, even as China’s economy continues to explode, a large percentage remains state-owned. The rise of sovereign funds will create plenty of strange situations, like having a foreign government own your local supermarket—the Qatar Investment Authority recently considered buying the British grocer Sainsbury’s. But it’s not as radical a shift from the current state of things as one might think. Every time you buy gas at a Citgo gas station, after all, you’re doing business with the Venezuelan government, which owns the chain."
There are a few proposals to restrain the power of these funds. One proposal is to limit sovereign wealth fund acquisitions to non-voting shares, in order to avoid political interference in business decisions or strategies. Another possible restriction would put a cap – say 15-20 % - on their share in any company. There are also calls for more transparency - annual or more frequent sovereign wealth fund reports on portfolio composition and investment strategies. But such restrictions are less likely to succeed in the long run.
Ultimately the most definitive hedge against the risks posed by the non-commercial objectives of SWFs is to integrate them ever further into the global financial markets. Interestingly, the ever growing Chinese investments could be the best example of such risk mitigation through deeper integration. As the saying goes, the most effective way of reining in your enemy is to embrace him!
Where does this put India? We have forex reserves of $243 bn and growing. All of its invested in low yielding bonds, and not exposed to the equity markets. Apart from equity and related investments, there are other way of effectively utilizing this surplus. Despite a two year long debate for setting up an Special Investment Vehicle to manage atleast a portion of these reserves, so as to use them to fund infrastructure projects, nothing concrete has come through. It makes great economic sense to utilize this SIV to fund the import of capital equipment and foreign technology, and various consultancy and other services.
Update 1
Andrew Leonard has the latest scorecard on the SWF story
Citigroup: $7.5 billion from Abu Dhabi Investment Authority and $6.88 billion from Government Investment Corp. of Singapore.
Morgan Stanley: $5 billion from China Investment Corp.
Merrill-Lynch: $5 Billion from Singapore's Temasek Holdings, $6.5 from Kuwait Investment Authority, $2 billion from Korean Investment Corporation
Bear Stearns: $1 billion from China Investment Corp.
UBS: $10 billion from the Government Investment Corp. of Singapore.
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