Sovereign Wealth Funds (SWFs) – Meaning, Types, Benefits and Risks

Sovereign Wealth Funds (SWFs), investment vehicles of Governments are increasingly seen in action through acquisition of either natural resources like oil and gas fields or equity holdings in MNCs. While the reasons for establishing a SWF may vary from commercial to strategic ones, SWFs’ influence on the countries and corporate is substantial. Since they mostly stay invested for a long-term they do not pose threat of pulling out in the short term and creating huge volatility in the financial markets. Since their investment corpus run to billions, by staying invested for a long time, they have a stabilizing effect on the capital market even during crashes and short term fluctuations. However, regulations and guidelines of the SWF also needs to be put in place in order to avoid it from exercising any soft control or strategic moves that may affect the sovereignty of the country allowing investments.

Sovereign Wealth Funds (SWFs)

Sovereign Wealth Funds provide long-term funding to the countries where they are investing facilitating infrastructure development, capital mobilization and liquidity to the capital market. India has huge deficit in terms of financing for long-term projects, especially in infrastructure. While regulations have to be intact to avoid exploitation by foreign governments, letting SWFs in the country will create a huge advantage for the country’s myriad sectors.

Meaning and Purpose of Sovereign Wealth Funds (SWFs)

Sovereign wealth funds are investment funds managed by the state with an intention of earning revenues on its idle foreign resources. The investments are made in financial assets like stocks, bonds, gold and assets of the nature of resources like oil, mines or gas. These wealth funds can be funded by excess foreign reserves accumulated through trade, proceeds from privatization, fiscal surpluses in the economy or foreign currency operations. The reserves funding these SWFs do not include reserves that are to be employed in the normal conduct of monetary and balance of payment operations.

The purpose of establishing Sovereign Wealth Funds are as follows:

  1. Protecting and stabilizing the budget and economy from excess volatility in revenues/exports.
  2. Diversify from non-renewable commodity exports.
  3. Earn greater returns than on foreign exchange reserves.
  4. Assist monetary authorities dissipate unwanted liquidity.
  5. Increase savings for future generations.
  6. Fund social and economic development.
  7. Sustainable long term capital growth.
  8. Political strategy.

Types and Benefits of Sovereign Wealth Funds (SWFs)

Sovereign wealth funds can be either commodity based or non-commodity based.

  1. Commodity based SWFs generate their capital from revenues received from exports of those commodities. They also invest in acquiring new resources like oil wells, gas fields, mines in order to either achieve a strategic advantage or to boost up their wealth of resources.
  2. Non-commodity based SWFs have the fundamental purpose of increasing their returns and they invest in equities, bonds, infrastructure and other long-term projects. They also try to increase their holdings in multinational companies either through equity or through convertible debentures. They may also infuse their own management team in order to influence the company actions. SWFs that are pension-fund based which are seeking to increase their long-term assets are few examples.

The benefits arising out of sovereign wealth funds are multifold. They are as follows:

  1. Productive employment of resources (Savings Funds): The economies which have excess foreign reserves or fiscal stimulus do not earn any return from idle resources which can be put to use in order to earn returns on them. The returns earned can be utilized to stabilize the market in times of turbulence, downturn or recession.
  2. Resource acquisition: The fund invests in resources like oil and gas fields abroad in order to achieve energy security and meet its growing demands. CIC’s (China Investment corporation, the SWF of China) recent acquisition of gas fields and oil wells abroad is in this direction only.
  3. Market stabilizers (Stabilization Funds): SWF can act as market stabilizers in case of economic and financial downturns. It is mainly created in countries to insulate their economy from swings in commodity prices. They can mitigate market stress like they have done in Asian markets by financial backing of large banks thereby ensuring continuous bank-lending.
  4. Economic development (Development funds): Infrastructure is a huge priority in developing countries and requires lenders with long-term capital commitment. SWFs can fund the infrastructure operations of a country.
  5. Ensuring Social security (Contingent Pension Reserve Funds): The population of developed countries is ageing and the workforce is shrinking. Providing social security to the huge population will be a huge drain on the exchequer. Since the birth rate also has shrunk, taxing few to support many will neither be sustaining nor is socially acceptable to the masses. So it becomes imperative for these ageing countries to earn significant returns on its pension funds.

In the investing country, Sovereign Wealth Funds could lead to tax cuts, better public works, and stronger state-run businesses. It can also, as was previously said, provide a diversification in the investing country’s assets and a protection from the exchange rate volatility and from the downs of the market.

Sovereign Wealth Funds (SWFs) – Current Scenario

The power of Sovereign Wealth Funds was felt during the severe liquidity crunch experienced during the US sub-prime crisis of 2008. The SWFs were welcomed to pour capital into the liquidity-starved markets. The capital provided by Abu Dhabi Investment Authority (ADIA) from UAE into Citigroup is just one instance. Leading financial powerhouses of Wall Street like UBS, Merrill Lynch got similar funding from the SWFs of countries like Singapore, Saudi Arabia. The stabilizing effect of SWFs was realized and from then onwards many countries are trying to rope in SWFs to bring capital to aid long-term projects like infrastructure.

Though many SWFs were conservative in the choice of investments initially, they have moved to more risky assets with increase in risk-appetite and long investment horizons. Also with dollar depreciating, countries are scouting for alternative investment opportunities other than Treasury bills and bonds. SWFs are eyeing stocks, real estate and infrastructure, private equity and bonds. Temasek holdings for instance has holding in ICICI bank (India), Singapore Airlines (Singapore), Standard Chartered Bank (England).

The investment avenues range depending on the purpose of establishing the SWF in the first place. Countries like Norway and Singapore look for long term investment opportunities and so invest in high-maturity infrastructure bonds and stocks undertaking credit and liquidity risk whereas countries which are export dependent will have to hedge themselves against price risks and recession and they will take corresponding positions in commodities. Stabilization funds will invest in short and medium term treasury bonds so that the liquidity is provided at the right time by selling the liquid securities. Thus the SWFs have to choose the appropriate asset allocation and investment strategy.

The major junk of the investment made before the US sub-prime crisis was in financial services and real estate by all the SWFs. This turned out to be loss-generating for the SWFs and they are looking to diverse their holdings by investing over different asset classes and across countries. The investment of SWFs into the stock market will work good for the world markets as it brings lot of liquidity into the market. Estimates have been made that around $400 billion dollars will flow into the markets every year and this is expected to rise the risk-free rate by 30-40 basis points.

However not all countries are equally enthusiastic about the roles of SWFs as there is a fear of losing control to the foreign entities. While some countries like UK are playing down the threat of SWFs, few countries like US and Germany have raised objection to the lack of transparency in the operations of SWFs. The recent agitation in US regarding the acquisition of 6 American ports by Dubai Port World shows the lack of trust in SWFs. A uniform standard set by international bodies like IMF making it compulsory for SWFs to publish annual reports and disclosures will go a long way in building trust in SWFs and thus encourage cross-country movement of capital.

However the returns generated by the equity markets of the developed world is only around 10-15% while that given by emerging countries is around 25-30% in the same period. This attracts more and more SWFs into the emerging market. Also SWFs who stayed invested in US market during the sub-prime crisis lost due to aggressive holdings like junk bonds and poor risk management of the market. SWFs worldwide lost $57 billion in listed forms. India and China which quickly rebound from the economic crises and has robust risk control measures have caught the attention of the SWFs.

Risks of Sovereign Wealth Funds (SWFs)

Sovereign Wealth Funds were considered the saviors providing liquidity through direct and indirect investment in financial services industry at a time when sub-prime crisis crippled the availability of a steady source of financing to the corporate. SWFs were openly welcomed to invest in the respective countries, however not without any reservation. There was a compelling decision to be made between access to huge liquidity and national security. Though no such action like forcing their influence on the host country or holding-company was exercised either through management control or voting rights, as perceived by proponents of national security, there is a compelling need to have a set governing principles and standards in order to benefit the SWF as well as the recipient country. SWFs invested $24.8 billion dollars in just the first two months of 2008, bringing the total investment in the US financial industry to $60.7 billion since 2007. Since SWFs bring with them such huge liquidity it is difficult to close the gates to them.

However, there is a growing fear in US for SWFs, especially that of China. SWFs characterized as power brokers are feared to function with purposes other than merely commercial ones though no such action has been witnesses in the past. The risk related to the homecoming of SWFs can be classified into three risks, namely;

  • Risk of Financial Contagion
  • Exercise of soft political power
  • National security considerations

While the purpose of Sovereign Wealth Funds can be purely commercial, there is a strong need for transparency and accountability among the SWFs.

Risk of Financial Contagion: The credibility of a SWF can be judged by its investment strategies. Any shorting strategies in commodities or stocks can be destabilizing to the market and can turn away new entrants to the market. There is also a danger of sudden capital flows which would further destabilize the market. For the same reason, Western countries, home to major chunk of SWF investment, demand a set of guidelines and principles to regulate the SWFs as it is not in the purview of host countries to govern them.

The SWFs claim that their assets are managed professionally with the help of management control of leading companies like Merrill Lynch thus insulating the fund from political or strategic influences.

The Exercise of Soft Power: For the larger established funds there is no evidence that investment strategies differ in substance from those of traditional pension funds. Indeed it is arguable that any short-term attempt to destabilize the market would be exceptionally counter-productive to longer-term interests precisely because the initial exit could easily be traced. The boom in commodity prices in particular compounds the perception that investment strategies could be used to advance the potential exercise of political soft power. Corporate takeovers and the acquisition of strategic stakes (particularly if accompanied by board rights) give state actors potential access to proprietary intellectual capital. Without appropriate and enforceable checks and balances, misuse of this information could be disseminated to a wider range of national champions. A related risk is that the investment could influence strategic imperatives (for example by skewing lending priorities towards projects favored by donor countries) thus undermining the efficacy of specific corporate governance controls.

The more aggressive investment strategies developed by China and Russia, in particular, but also from authoritarian governments in the Gulf, have exacerbated these concerns. While there is no evidence that any SWFs have ever been used to further political ambitions, ascertaining the motives of secretive or authoritarian governments is a notoriously imprecise exercise.

The Protection of the National Interest: Many countries impose restrictions on foreign direct investment in parts of the critical infrastructure because of strategic and cultural factors. These can include restrictions in dual-use technologies or protection of core communication portals, such as media markets, from undue foreign influence. The restrictions can be complete, partial, or entail a review process that, in turn, may or may not privilege investment (dependent on the salience of wider security concerns). The problem centers on a lack of agreement on what “critical” means and the parameters that governments can use to define “national security” interests. The inevitable consequence is a lack of transparency in investment review process. This lack of transparency makes the entire process susceptible to political and economic populism.

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