SOVEREIGN WEALTH FUNDS AND THEIR IMPACT ON FINANCIAL STABILITY
Sovereign wealth Funds (SWFs) which manage the foreign assets of national states have recently emerged as a significant class of global investors. Indeed, such funds are already of a financially significant size, currently probably managing between USD 2 and 3 trillion. Sustained accumulation of foreign assets could transform several SWFs into important market players as their financial assets under management could soon exceed those of the largest private asset managers and pension funds.
The policy issues arising from the the emergence of SWFs as large global financial players range from concerns over a lack of transparency and a reversal in privatisation to risks to global financial stability. For example, SWFs could contribute to an unwinding of global imbalances through a diversification out of US dollar-denominated government bonds in which the bulk of traditional reserves is invested. Another concern relates to the question of whether such funds might distort asset prices through non-commercially motivated purchase or sale of securities.
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Over the long run , any impact of SWFs on global financial market structure and stability will depend critically on the motives underlying the investment decisions of such funds. While fully return and risk-motivated investments may affect financial stability rather positively due to the long-term investment horizon of such funds, non-commercial motives might have a negative impact on financial stability.
Sovereign wealth Funds ( SWFs) , broadly defined as public investment agencies which manage part of the ( foreign) assets of national states, have recently attracted considerable public attention. While such national investment vehicles have been operated by many countries for decades , SWFs have only recently become important players in global financial markets. In fact, the history of SWFs date back to at least 1953 when, according tpo Kuwait Investment Authority, the” Kuwait Investment Board was set up with the aim of investing surplus oil revenues to reduce the reliance of Kuwait on its finite oil resource” . The more recent rise of SWFs is mainly linked to the accumulation of sizeable foreign exchange reserves by emerging market economies as , over the past few years, an increasing number of such countries have created new SWFs to accumulate foreign assets and to improve the return on traditional foreign exchange reserves.
Although there exists no commonly accepted definitions of SWFs, three elements can be identified that are common to such funds: First, SWFs are state-owned. Second, SWFs have no or only very limited explicit liabilities and, third, SWFs are managed separately from official foreign exchange reserves. In addition , most SWFS share certain characteristics that originate in the specific nature of SWFs. For example, the lack of explicit liabilities ( or the stretched out maturity of liabilities) favours the4 pursuit of long-term investment strategies, as implemented by most SWFs. In this respect, sovereign wealth funds differ from sovereign pension funds that operate subject to explicit liabilities and a continuous stream of fixed payments , making sovereign wealth funds more similar to private mutual funds. Second the absence of explicit liabilities also has a bearing on the willingness to take risk, as standard portfolio theory predicts a higher share of fixed income securities for funds that are subject to recurring payments. Finally, most sovereign wealth funds appear to have substantial exposure to foreign investments or are even entirely invested in foreign assets.
The main group of countries that have established SWFs are resource-rich economies which currently benefit from high oil and commodity prices. In these countries, SWFs partly also serve the purpose of stabilising government and export revenues which would otherwise mirror the volatility of oil and commodity prices. Another purpose of such funds in resource - rich countries is the accumulation of savings for future generations as natural resources are non-renewable and are hence anticipated to be exhausted after such time. 
Prominent examples of such SWFs include Norway's Government Pension Fund , investment agencies set up by member countries of the Gulf Cooperation Council( GCC) , such as the Abu Dhabi Investment Authority ( ADIA) which manages the foreign assets of the Emirates (UAE) and the Russian oil stabilisation fund which has recently been partly transformed into a fund for future generations.
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A second group of countries, mostly notably in Asia, has established SWFs because reserves are being accumulated in excess of what may be needed for intervention or balance-of-payment purposes. The source of reserve accumulation for these countries is mostly not linked to primary commodities but rather related to the management of inflexible exchange rate regimes.
2: MARKET SIZE AND GROWTH TRENDS
As SWFs commonly do not disclose detailed information about their operations, individual figures and the total volume of assets managed by state-owned funds cannot be quantified with precision. Based on market estimates, assets under management by SWFs may currently amount to over USD 3.1 trillion. This is more than twice the size of the hedge fund industry's USD 1.4 trillion assets under management , but only a seventh of the global investment- fund industry ( USD 21 trillion assets under management) and less than 5 % of bank assets worldwide. In terms of size, therefore SWFs are a more significant industry than hedge funds, but - for the moment- are far smaller than most other type of institutional investors.
Their relative weight in global capital markets , however , may well change in the years to come given the growth dynamics behind state funds, especially in emerging economies, as the volume of funds disposable for SWF investments may increase substantially in future. This is, among other variables , reflected in the growth of official reserves, one of the major sources of SWF funding in many countries, and an even important indicator for the net capital flows into a country, even though the precise correlation between the two variables is not possible to specify owing the lack of data.
International reserves have been growing steadily over the past years. This has particularly been the case in many emerging economies which benefited from oil revenues, such as oil-exporting countries in the Middle East or Latin America, or rising competitiveness and improving balances of payments vis-a- vis established industrialised economies, especially China, south Korea or Taiwan. The substantial absorption of commodities and goods and services by industrialised economies from these regions is at the centre of this success , causing large current account surpluses there as well as the frequently criticised deficit in the US. The distribution of SWFs in regional terms reflects this development and stands in close relationship with that of official reserves.
In quantitative terms , the growth of official reserves worldwide has been strong, with a compound annual rate of growth of 13 % over the past decade and even 20% in the past five years. The accumulation of revenues and reserves in the relevant countries is set to continue as long as consumption and production patterns in industrialised and emerging economies and the resulting current account surpluses prevail and major adjustments in exchange rates and exchange-rate policies are excluded. Likely increase in savings ratio , especially in the US, as well as strengthening domestic demand in Asian economies and further revenue diversification in the Middle East may, however, mitigate the global current account imbalances in the years to come. Thus , if official reserves were to grow at the ten-year average pace going forward, and assuming SWF funds were to increase in line , total SWF assets under management may ceteris paribus increase to more than USD 5 trillion by 2012 and in excess of USD 10 trillion by 2020.
3: MAJOR STATE INVESTMENT PROJECTS BY SWFS AND OTHER STATE ENTITIES
¨ USD 1.75 billion takeover of IBM's personal computer business by China's Lenovo
¨ USD 1.85 billion bid by China National Offshore Oil Corporation ( CNDOC)- 70 % owned by the Chinese government- to buy US oil major Unocal Oil Company in July 2005, eventually withdrawn.
¨ So called Dubai Ports deal- the attempt on the part of DP World, a company owned by the government of Dubai, to acquire the Peninsular and Oriental Steam Navigation Company ( P & O), domiciled in London, which was then the fourth largest ports operator in the world, running major US port facilities in New York, New Jersey, Philadelphia, Baltimore, New Orleans and Miami. The eventually failed transaction was a catalyst for the debate on a reform of the existing CFIUS legislation in the US
¨ Acquisition of a 9.9% stake in The Blackstone Group L.P. by the yet to be established state foreign exchange investment company in China in May 2007. The USD 3 billion investment was made in the form of non-voting common units.
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¨ Increase in the existing 7.6 % stake of Delta Two- an investment vehicle owned by the Royal Family of the Kingdom of Qatar- in J. Sainsbury plc to a total of 25% in June 2007 by acquiring an additional USD 1.45 billion stake , making Delta Two the largest single shareholder.
¨ USD 3 billion and USD 2 billion July 2007 investment in Barclays PLC by china Development Bank and Temasek Holdings Ltd. For a 3.1% and 2.1% stake, respectively , with a conditional offer to increase their investment to a combined total of USD 19 billion in case the planned merger with ABN Amro succeeds.
¨ Rising engagement of China in Africa and Latin America. More than 650 Chinese state companies are invested in Africa , especially in sectors such as oil, other commodities and telecommunications. At USD 1.6 billion at end-05 , China is increasingly securing strategic assets in the region, an approach recently underscored by a USD 2.3 billion investment by China National Offshore Oil Corporation (CNOOC) in Nigerian oil and gas exploration .
4: STABILIZING EFFECTS OF SWF
SWFs have proven to be a stabilizing force on global financial stability in a number of ways. At the country level, they have allowed states to manage capital inflows, while addressing long-run structural issues , thus providing a basis for sustained economic growth in EMEs. At the same time, by virtue of their size and investment strategies , SWFs are liquidity providers and contrarian investors that support global market in times of stress while facilitating the gradual unwinding of global imbalances. These functions are examined below.
Managing capital inflows
SWFs can aid in the macroeconomic management of large current account surpluses. By transferring excess revenues into investment funds , states can alleviate inflationary pressure arising from capital inflows. Many of these states are already growing at a rapid rate, putting upward pressure on asset prices. Capital inflows also place upward pressure on nominal exchange rates, reducing demand for exports and slowing growth. For countries with a pegged exchange rate regime or managed float , maintaining competitive exchange rates increases the attractiveness of their exports, the very sources of growth for many of those countries that have depended on export-led growth. Offshoring capital inflows allows SWF states to achieve these objectives.
Portfolio diversification and a higher risk appetite
Traditional reserve assets are safe, liquid investments offering low returns. By diversifying their investment portfolio , SWFs hope to earn higher returns on their holdings. Table 1 provides an example of this portfolio diversification based on the estimated investment portfolio of the Abu Dhabi Investment agency ( ADIA). The ADIA allocates approximately 60 percent of their portfolios to listed equities , 20 percent to fixed income, and the remainder to other assets such as private equity, real estate and alternative investments.
Table 1: Asset Allocation of the Abu Dhabi Investment Agency
Asset class Percentage
Listed equities 60
Fixed Income 20
Private Equity 10
Real estate 5
Alternative investments 5
By diversifying out of customary reserve investments as well as the established reserve currencies , SWFs are accepting a higher level of risk than traditional foreign reserve investments. This higher risk tolerance can facilitate international risk sharing , as SWFs move into different class of assets. Diversification allows SWFs to spread the risk in their portfolios across a variety of assets and currencies , thus reducing their reliance on one asset price ( such as oil prices) . They will also be able to rebalance in less volatile assets and better hedge their investments , reducing the negative outcome of a sharp drop in ( or an increase in the volatility of) the price of any given asset. In doing so, SWFs are building more balanced portfolios that will not only earn their higher returns, but allow them to protect themselves from volatility in any one market, thus stabilizing their revenues.
Addressing longer-horizon structural issues
Strategically investing “ excess” revenues can provide SWF states with a means to deal with future issues such as demographic pressure and economic development and diversification. Savings funds facilitate intergenerational transfers , allowing future generations to benefit from current favourable economic conditions. At the same time, increased profits on foreign holdings allow a larger cushion in the event of external shocks from falling commodity prices. Additionally , investing abroad allows SWF states to import knowledge and technical expertise that may help develop local industries and provide a basis for sustained growth as natural resources are slowly depleted. As such, strategic investments can allow SWF states to address structural weaknesses in their economies, reducing both macroeconomic and financial vulnerabilities in the future.
Providers of Liquidity
Large investors can play a stabilizing role by providing liquidity to financial markets. One of the commonly cited advantages of SWFs is that , due to their large scale, they are able to inject liquidity into global capital markets, thereby supplying capital to those who require( or demand) it. At the same time, their increased risk appetite allows them to provide capital to entities that risk-averse investors would shy away from them. This function was clearly exhibited recently , when SWFs invested heavily in Western financial institutions, allowing them to recapitalize after incurring losses due to the U.S. subprime mortgage crisis.
Long -term investment horizon
SWFs have an explicit mandate of long term investments and can withstand short-term fluctuations. SWFs are focused on long-term returns as well as other positive externalities that will arise from their investments, such as market access. Additionally , SWFs are not highly leveraged and have very little capital adequacy requirements, unlike other large institutional investors such as hedge funds. The focus on long term returns and the lack of specific capital requirements will decrease the risk of a rapid liquidation of investments and the ensuing impact on financial stability. Much like hedge funds, SWFs can act as contrarian investors , investing in times of market distress.
Facilitate unwinding of global imbalances
Moving out of official assets towards market-based assets facilitates the gradual resolution of global imbalances. Warnock and Warnock (2006) estimate that foreign official purchases of U.S. government bonds have lowered the U.S. 10-year Treasury yield by 90 basis points and that around two-thirds of this impact came from East Asia. This was due, in part , to the large sums of foreign exchange reserves that were housed at the central bank and invested in relatively safe assets, such as U.S. Treasury bills . Significant parts of money that would normally be invested by the monetary authorities have been and will continue to a gradual reversal of this effect. By diversifying across currencies, SWF investments may also contribute to a depreciation of the U.S. dollar ; this would contribute to a narrowing of the U.S. current account deficit, allowing a gradual unwinding of global imbalances that have been prevalent over recent years.
Other positive externalities
Strategic investments can allow SWF states to develop their domestic economies and provide a basis for sustained growth. Gaining access to international markets will allow states to nurture non-commodity sectors and diversify their economies in preparation for the eventual depletion of finite natural resources or to provide for other sources of income when commodity prices are low.
The experience with the 1980s less-developed -country also highlights a positive externality from SWFs . During that period , petrodollars arising from the 1970s oil shocks were deposited with money centre banks that lent freely to many countries in Latin America. This excess credit creation and lending was followed by sovereign defaults that crippled the balance sheets of many large financial institutions and destabilized the international financial system. Many of these countries experienced large inflation and output losses over the next decade. By investing their commodity wealth directly , SWFs have avoided this boom-bust scenario and its damaging side effects for the international financial system.
Sovereign Wealth Infusion for Banks March 2007- April 2008
Investment value in US $ millions
Abu Dhabi Investment Authority
New convertible units
Government Singapore Investment Corporation
New convertible units
Kuwait Investment Authority
New convertible units
Kuwait Investment Corp.
New convertible units
Korean Investment Corp.
New convertible units
New common stock
China Investment Corporation
New convertible units
Qatar Investment Authority
Govt of Singapore Investment Corp
New Convertible Units
Saudi Arabian Monetary Agency
New Convertible Units
Total Cash Infusion from Sovereign Wealth funds $ 44938
Source: Sovereign Wealth Fund Institute, Official Press Release ( updated April 1, 2008)
5: POTENTIAL RISKS TO INTERNATIONAL FINANCIAL STABILITY
While SWFs may provide benefits to both domestic economies and global markets, significant outflows of capital from SWF states present potential risks to international financial stability. While most concerns are focused on what may be low-productivity events , an examination of their possible impact on international financial stability is merited.
Triggering “ herding” behaviour
SWFs present a risk to global financial markets due to the fact that large sums of capital are concentrated in the hands of a limited number of large actors. In the absence of SWFs , these surpluses would be distributed among domestic citizens. Then the decision to consume, save , or invest would be left to the discretion of (small) individual households, which can be assumed to be distributed along a continuum of risk preferences. Whereas central banks follow a conservative investment strategy, SWFs , while still conservative in nature, may demonstrate a significantly higher risk preference than traditional reserve managers. It can safely be assumed that the SWF managers will invest in higher risk assets than either the monetary authority or the average individual would have done.
The presence of a large player with a high-risk appetite can induce markets behaviour taht could lead to a negative outcome. Much of the existing literature on “ large players” focuses on the role of highly leveraged institutions , such as hedge funds, in the various exchange crisis.
While it is often found that large players have the potential to play a destabilizing role. Corsetti et al.() argue that the size of the impact depends on the information content of the move and the signal being sent to the smaller traders.
While the possibility of SWFs inducing “ herding” behaviour does exist, the risk that they would deliberately seek to destabilize or manipulate markets is minimal. First, SWFs are committed to diversifying their portfolios , reducing investment in one specific asset class. Second , if SWFs were to invest large sums of funds into any one asset, there is a possibility that the market would move against them , which is something they would try to avoid. Corsetti et al.(2004) stress that , if the larger actor has significant holdings of assets denominated in the currency under attack, their presence will actually make the attack less likely.
Corsetti et al.(2004) also conclude that being aware of the large player's initial portfolio positions is significant. In this case, the opacity of many SWF investment positions may contribute to short - term volatility in the markets . However, Corsetti et al. Note that , in order to avoid adverse price movements, large actors would have an incentive to avoid signalling or disclosing their position until the move was executed ( and possibly even beyond that)
Lack of transparency and short-term volatility
SWFs have the potential to destabilize small markets by inducing other traders to mine their strategies, leading to greater buying or selling on one side of the market. The impact of this behaviour may be exacerbated by the lack of transparency surrounding the investments and strategies of SWFs . Since SWFs have become more widely known , many analysts have tried to anticipate their strategies , based on the investment strategies of similar institutional investors. The lack of transparency about the holdings of SWFs introduces an element of uncertainty into two markets. If there is a belief that SWFs will follow a specified strategy , it may induce other market participants to anticipate the move, leading to destabilizing behaviour. If the investment preferences of SWFs are revealed by their actions, other agents may interpret their investments as signals and act accordingly.
Non-Competitive objectives and financial protectionism
While it is not necessarily a direct risk to international financial stability , some observers are concerned about a protectionist backlash against SWFs that would restrict cross-border investment and slow economic growth. The reaction of Western states to SWF investment may lead to the adoption of barriers, preventing the free movement of capital. This policy response may affect not only SWFs but also other institutional investors, such as national pension funds.
While the leading SWFs have stated that they are long-term , passive investors , they offer little transparency concerning their investment strategies and corporate governance structures. This lack of transparency leads to concerns regarding political motivations for investing. Increasing transparency would alleviate these concerns and provide for an atmosphere that is more attractive to foreign investment.
Virtually all countries have legislation in place that protects national industries and interests. However, the prospect of other states controlling domestic companies in sensitive industries has triggered a review of existing rules and may lead to the adoption of new and more onerous regulations. Although policy-makers state that these regulations are not specifically aimed at SWFs , there are special clauses that deal explicitly with SOEs.
While states feel that these regulations are critical to protecting national and economic security , they may impede the efficient allocation and free flow of capital, undermining the advances thus far made in liberalizing capital flows, and they may even reduce or redirect investments to another state.
Investor activism and monitoring of managers
In the finance literature on principal-agent problems, large stakes by outsiders are seen as a mechanism that improves the monitoring of managers ( Jensen and Meckling 1976) . In their investments , many SWFs have done their utmost to prove that they will be passive investors, including forgoing any voting rights. While this may ward off protectionist sentiment, it may also impede the monitoring of managers. When a company experiences large capital losses , more active investors ( whether they are large institutional investors or individual shareholders) will usually push for some sort of reform to avoid losses in the future. By giving up voting rights , SWFs are less able to protect themselves ( and other shareholders) from mismanagement and prevent the same practices from occurring in the future. This weaker oversight may result in the continuance of poor investment strategies or lax risk management , which that can lead to further instability
Triggering a disorderly unwinding of global imbalances
Gradual portfolio rebalancing through SWFs can reduce current account imbalances in the global economy. However large scale and rapid portfolio diversification can trigger a disorderly unwinding that would provoke volatility in international markets . Since SWF states have been large investors in the traditional reserve instruments of the U.S. Treasury and U.S. dollars , there is a concern that assets will put pressure on Treasury bond yields. Furthermore , rapid currency diversification away from U.S - dollar assets could spark a rapid depreciation of the U.S. dollar and thus put upward pressure on other major currencies.
Diversification will probably affect both U.S. Treasury prices and the U.S. dollar, but only at the margin. It is in the interest of SWF states to diversify gradually, so as not to influence the value of their own assets and risk incurring capital losses. Asset diversification implies that SWF states will move out of the traditional reserve instruments ; this does not, however, necessary entail moving entirely out of the U.S. dollar - denominated assets. Rebalancing between government bonds and equity investments will still involve a substantial amount of monies flowing into U.S companies and stock exchanges.
While diversification may also be associated with a weaker U.S. dollar at the margin , a wholesale divestment of U.S. dollars is unlikely, thus reducing the risk of a sharp depreciation of the U.S. dollar. A weakening of the U.S. dollar translates into a decrease in the value of a state's net foreign assets , resulting in significant valuation losses. Thus, SWF states themselves would be negatively affected by a large U.S-dollar depreciation , reducing the likelihood that they would intentionally act to bring about this outcome.
Furthermore for those countries not pegged to the dollar, a large U.S.-dollar depreciation would effectively cause their currencies to appreciate, weakening their competitive position as goods exporters . Several SWF countries fix their exchange rates to the U.S. dollars , including China and many of the oil exporters. Defending a strict dollar peg or a basket peg would still involve purchases and holding of dollars , further reducing the risk of a strategic divestment of dollars. In short, a serious off-loading of U.S. dollar assets would do SWF states more harm than good.
Leaving aside the issue of rebalancing official reserves , transfers of national wealth to SWFs that invest in global markets will necessarily involve investments in a variety of currencies. Although the majority of investments will be in U.S. dollar assets , capital will also flow to assets denominated in other currencies , such as the euro and the U.K. pound , exacerbating the upward pressure on their exchange rates.
6: RULES FOR AN OPTIMAL POLICY RESPONSE
Based on the above considerations , it is clear that in economic terms an optimal policy regime should be characterised by the following broad characteristics.
* Openness of national and regional markets to foreign investments by SWFs as a general rule.
Reciprocity of market access
* Reciprocity of open market access- as opposed to reciprocity in protectionism
* Political intervention in SWF transactions - as in any other foreign investment deal- must be a last-resort option , and should only be applied in cases where national security is under threat.
* Political decisions leading to such interventions should be based on asset of pre-defined principles for protective measures and thorough analysis by the authorities of each individual case of foreign investment in the course of a well-structured , calculable review process that takes into account the time sensitivities of major capital market transactions.
* Optimally , the design of measures and instruments for last -resort political intervention should be harmonised at the EU level in order to avoid further fragmentation of investment rules and corporate governance provisions across the member states , thus protecting the integrity of the Internal market and ensuring a level playing field.
* All foreign investments are subject to domestic markets and competition rules. This applies in particular to the maintenance of free and fair competition.
* Economically sensible instruments for addressing potentially sensitive foreign investments include the establishment of a formal review process along the principles defined above , as well as reporting requirements regarding investment transactions beyond a certain size.
* Some policy instruments should not be used , owing to their distortionary effects on the economy. These primarily include the holding of golden shares by the state as well as the establishment of “ defensive funds” to acquire stakes in domestic companies to protect them against foreign investments. Both of these instruments bear the danger of an inefficient use of funds and the risk of domestic state intervention . similarly , states should refrain from defining critical or strategic sectors and the promise of granting them specific protection. This provides adverse incentives to the” ins” as well as the” outs”.
· Global financial market stability should be reinforced through higher transparency of SWFs on the basis of an internationally agreed code of conduct , underscored by a set of best-practice yardsticks , to be defined in the context of the IMF.
· For the prevention of contagion effects , SWF transparency should entail a minimum of timely information on the size of funds, broad strategy of management and investment objectives.
A code of conduct should establish minimum requirements regarding the formal mandates and statutes of SWFs , financial reporting at least on an annual basis an independent auditing of the accounts and financial reports of the funds. In addition, such a code should include a commitment to the adherence by funds to the relevant national and international financial market and corporate governance rules as well as to the pursuit of financial objectives.
7: PUBLIC POLICY INITITATIVES ON SWFs
OECD approach in regard to SWFs is that international cooperation can build mutual trust and keep markets open. The OECD Investment Committee and its non-OECD partners have agreed that over the coming period they will follow a two-track approach to these issues. First track would involve dialogue among governments. SWFs and the private sector to improve understanding of both home and host country approaches to foreign investment. The second track would involve exchange of experiences in relation to national security protection, developing shared views on investment policies that observe the principles of proportionality, transparency and predictability , accountability, and that also avoid unnecessary restrictions to international investment by SWFs.
The OECD released report on April 4 , 2008 , which is intended to develop a guidance for recipient country policies towards investment from SWFs . The OECD has also proposed to work on how governments can maintain their commitment to open international investment policies- including for SWFs - while also protecting essential security interests. The resulting framework is expected to foster mutually beneficial situations where SWFs enjoy fair treatment in the markets of recipient countries and these countries can confidently resist protectionist pressures.
The European Commission ( EC) is proposing a common EU approach to respond to concerns over SWFs and enhance the transparency , predictability and accountability of SWFs ‘ investments while maintaining an open investment environment. It has laid out the principles which should shape that approach. These are ( a) commitment to an open investment environment . It has laid out the principles which should chase that approach. These are (a) commitment to an open investment environment . It has laid out the principles which should shape that approach. These are (a) commitment to an open investment both in the EU and elsewhere , including in third countries that operate SWFs b) support of multilateral work , in international organisations such as the IMF and OECD c) use of existing instruments at EU and Member State Level (d) respect of EC Treaty obligations and international commitments , for example in the WTO framework and \(e) proportionality and transparency.
The recent joint released by United states , Abu Dhabi and Singapore sets out Policy Principles for the SWFs as well as the countries receiving SWF investment . The responsibilities enjoined upon SWFs mainly relate to greater transparency in areas such as purpose, investment objectives , institutional arrangements and financial information , strong governance structures , internal controls , and operational and risk management systems and the need to respect host-country rules by complying with all applicable regulatory and disclosure requirements of the countries in which they invest. The prescriptions for the SWF host countries stress on transparent inward investment rules , which are publicly available , clearly articulated , predictable , and supported by strong and consistent rule of law and favour non-discriminatory treatment for SWFs vis-a-vis other foreign investors.
Of particular interest from a host country perspective is the Media Release of the Treasurer of the Commonwealth of Australia in February 2008, which illustratively lays down a set of principles to enhance the transparency of Australia's foreign investment screening regime. The principles set out the main factors that are considered during the screening which include determining on a case by case basis and consistency with national interest , while assessing the national interest in any given case , a balanced view against the principles is proposed. The principles set out the additional factors that need to be considered in relation to investment proposals by foreign governments and their agencies , over and above those that apply to normal private sector proposals.
While the Australian Government welcomes foreign investment , the purposes of Australia's foreign investment screening is to ensure consistency with their national interest. The Treasurer can reject proposals that are deemed contrary to the national interest . The Treasurer can reject proposals that are deemed contrary to the national interest or impose conditions on them to address the national interest concerns . The examination includes implications for other government policies, competition and operations of Australia's businesses.
Recent reports suggest that Germany is contemplating a legislation which will enable it to block” unwanted” investments by SWFs . The proposed law is expected to enable scrutiny of all investments where the investor's stake in the investee entity is likely to exceed 25 per cent , even up to three months after the investment has been made . This concern seems to stem from the suspicion that some of the SWFs may be driven by political and other motivations and not purely by economic and commercial considerations.
8: SOVEREIGN WEALTH FUNDS - INDIAN PERSPECTIVE
India as a host country
In India, the regulatory regime governing capital inflows does not recognise SWFs as a distinct category. Hence their investments are subject to normal regulations governing capital flows under the category of Foreign Direct Investment ( FDI) and Foreign Institutional investment ( FII) . In regard to some sectors , such as banking and financial market infrastructure companies there are limits on individual holdings and the investment proposals are subject to an element of due diligence processing with regard to fit and proper requirements . For this purpose , no discrimination is made between a domestic investor and foreign investor or between SWFs and others as long as the policy criteria are met.
The existing FDI policy permits investments under the “ automatic route” and the “ approval route” in most, though not all, of the activities. Under the automatic route , the investors are allowed to invest in the identified sectors up to the threshold specified for those sectors, without the need for a prior approval from regulators or the Foreign Investment Promotion Board ( FIPB) . In respect of the other sectors , the investors will need a prior approval of the FIPB before undertaking any investment. The FIPB is functioning under the aegis of the Ministry of Finance and comprises representatives of various government departments who are expected to ensure that the proposed investment addresses the administrative and other concerns before allowing investments in the concerned activity. Similarly under the FII route , the FIIs registered with the securities market regulator ( the Securities and Exchange Board of India- SEBI) can invest in the secondary market , without prior approval , subject to certain limits on individual FIIs , as a category , as well as the sectoral thresholds and other conditions applicable to FDI. SWFs can also invest directly as an FII or indirectly as a “ sub-account” of a registered FII , which include hedge funds and investment funds. Accordingly , any SWF can invest under the FDI route( automatic or approval routes as the case may be) or under FII route either directly or indirectly. Thus , on the inflows , there is generally no discrimination on the basis of country of origin of the foreign investor or on the basis of category of foreign investors.
The policy , however, does provide for a framework in regard to ownership and management of the entity investing in some sectors , particularly the financial sector, which is applicable equally to resident as well as non-resident investors.
In respect of banks, acknowledgement from the Reserve Bank for acquisition / transfer of shares which will take the aggregate holding ( direct and indirect , beneficial or otherwise ) of an individual or group to equivalent of 5 per cent or more of the paid-up capital of the bank. The relevant factors for “ fit and proper” assessment of the investor include the source of funds for the acquisition and where the investor is a body corporate its track record of reputation for operating in a manner that is consistent with the standards of good corporate governance , financial strength and integrity . The process also envisages a higher level of due diligence when the share holding of the investor exceeds 10 per cent in the investee bank's up capital , which includes fit and proper status of the investor entity.
An amendment to the Banking Regulation Act has been proposed which envisages prior approval of the reserve Bank for acquisition of more than five per cent of the paid up share capital of a bank by any investor “ directly or indirectly , by himself or acting in the concert with any person.” The approval will be accorded after ensuring that the investor would be “ fit and proper” from the perspective of public interest , interest of banking and financial system in India.
In the case of investments in financial market infrastructure companies such as stock exchanges the guidelines stipulate a desirable dispersal of ownership. Investment by individual entities , including investments by persons acting in concert is subject to a threshold of five per cent of the equity in these companies.
In regard to securitisation and Reconstruction Companies (SRC) the Reserve Bank conducts due diligence on the sponsors/ investors before giving a certificate of registration to the SRC. Any subsequent investment by any individual entity in excess of 10 per cent of the paid up equity capital of the SRC also acquires the status of a ‘sponsor' and requires prior permission of the Reserve Bank which ‘ as the regulator, is required to satisfy itself , among other things , of the “ fit and proper” credentials of the investor.
Foreign investment in an Indian company in the financial services sector through acquisitions , requires prior permission of the Reserve Bank which allows such investments only after ensuring that the regulatory concerns , if any, are appropriately addressed and that the bonafides of the overseas investors are satisfactory . Wherever necessary , the clearance or comments of the home country regulators of the investing entity are also sought while examining the requests.
In case of investments by foreign investors in activities other than the financial services sector , where there are security or other administrative concerns , for instance , in defence and strategic industries and print media and broadcasting sectors , investments are allowed only under the “ approval route”.
In order to assess the eligibility of an entity to be registered as FII or as Foreign Venture Capital Investor , SEBI takes into account all factors relevant to the grant of a certificate and in particular the applicant's track record , professional competence , financial soundness , experience , general reputation of fairness and integrity as well as the fact whether the applicant is regulated by an appropriate foreign regulatory authority.
In brief , India is yet to consider a policy addressing investments by SWFs except as a part of due diligence in regard to all investors.
India as a Home Country
In India, the foreign exchange reserves areb on the balance sheet of the Reserve Bank of India (RBI) and are managed as per the provisions of the RBI Act , consistent with the global best practices . The Reserve Bank adheres to appropriate prudential norms and the transparency and data dissemination standards in regard to reserves management.
Given the significant increase in the level of foreign exchange reserves, there is an increasing expectation in regard to returns. The returns on the foreign exchange reserves under the present framework are constrained by the mandate to the Reserve Bank of India , which understandably lays a greater emphasis on safety and liquidity.
It may, however, be possible to argue that a part of the reserves , which may be considered to be in excess of the usual requirements, be managed with the primary objective of earning higher returns. Given the limitations placed on the central bank by its mandate, it can be held that it will be appropriate to bestow this responsibility on a different sovereign entity. If and when the country considers setting up of a SWF for the purpose, one of the methodologies could be to fund SWF by purchasing the foreign exchange from the central bank , to the extent required. These foreign currency funds could then be used by the sovereign entity for seeking higher returns by investing in assets which a central bank's mandate may not permit. As the SWF will be a public enterprise , it will be required to conform to the applicable governance , transparency and disclosure standards.
While it is possible to make a case for an Indian SWF , there are also weighty arguments for caution in this regard . First , it would be very difficult to reckon in the Indian context- as is the case with many other countries , the “ reserve adequacy” in a dynamic setting and on that basis divert a part of “ excess” reserves for a higher return from riskier assets. The current reserves management policy recognises this , based on experience during periods of both net inflows and outflows and therefore the overall approach to the management of India's foreign exchange reserves takes into account the changing composition of the balance of payments and endeavours to reflect the “ liquidity risks” associated with different types of flows and other requirements.
Second , while most other countries that have set up SWFs have amassed large reserves either on account of persistent current account surpluses or due to revenue gains from commodity exports , in particular of oil and gas , the Indian economy has twin deficits as also a fiscal deficit . India's export basket is diversified and does not have any dominant “ exportable” natural resource output , which might promise significant revenue gains at the current juncture.
Third , India has experienced consistent but manageable current account deficits barring very few years of a modest surplus. India is also having a negative international investment position ( IIP) with liabilities far exceeding the assets . The large reserves have been built over time mostly on account of capital inflows like foreign direct investments ( FDI) , portfolio flows through foreign direct investments ( FDI) , portfolio flows through institutional investors ( FII) , external commercial borrowing ( ECB) and short term credit. Further , the increasing reserves also reflect , in part , the lower absorption capacity of the economy , which may pick up with the economy moving on to a higher growth trajectory. In brief the public policy is yet to take a conscious view on the desirability of establishing a SWF.
SPV for Use of Reserves
In the context of growing development needs , particularly of the infrastructure sector, a step in the direction of using a small part of reserves for development has recently been taken after considerable deliberations. An announcement was made by the Finance Minister in the budget Speech 2007-2008 on February 28, 2007 to “ use a small part of the foreign exchange reserves without the risk of monetary expansion “ for the purpose of financing infrastructure development projects. Accordingly a scheme has been finalised which envisages the Reserve Bank investing in tranches , up to an aggregate amount of USD 5 billion in fully Government guaranteed foreign currency denominated bonds issued by an overseas SPV of the India Infrastructure Finance Corporation Ltd. ( IIFCL) a wholly owned company of Government of India. The funds thus raised are to be utilised by the company for on-lending to the Indian Companies implementing infrastructure projects in India and/or to finance the ECBs of such projects for capital expenditure outside India without creating any monetary impact . The lending by the SPV under the arrangement would be treated as external commercial borrowings (ECB) and would be subject to the prescribed reporting and disclosure requirements . The bonds will carry a floating rate of interest. The investment by the Reserve Bank in the foreign currency denominated bonds issued by the SPV will not be reckoned as a part of the foreign exchange reserves , but will be a foreign currency asset on the Reserve Bank balance sheet. It is noteworthy that this arrangement is distinct in the sense that India is both a home and a host for the IIFCL's subsidiary , as it is basically a SPV for channelizing foreign exchange funds for meeting the requirements of the Indian private sector for infrastructure projectas in India by drawing upon the foreign exchange reserves of the country available with the central bank.
To sum up, India has not yet considered regulatory initiatives specifically addressing SWFs . Existing provisions in regard to fit and proper or take-over code are however applicable to all investors , including all SWFs . Currently, the pros and cons for the establishment of an Indian SWF as generally understood now are still under debate . India is monitoring recent development in regard to enhancing transparency and disclosure in respect of hedge funds, private equity and SWFs . In particular , India is watching with great interest the development of global codes , standards and practices in regard to SWFs both in view of the presence of SWFs in the Indian financial markets and the ongoing debate on establishing an Indian SWF.
Sovereign wealth funds have been investing governments' foreign assets for decades. However , it is only in recent times that such funds have emerged as managers of large “ excess reserves “ and other foreign assets. A transfer of sizeable amounts of traditional foreign exchange reserves to these investment vehicles may have an impact on the global financial landscape since such funds are likely to pursue an investment strategy that differs considerably from that of central banks.
Whether a change in the global financial structure will have a significant impact on financial stability will depend critically on the motives underlying the investment decisions of such funds. In fact , SWFs may contribute to a widening of the long-term investor base for risky assets such as stocks, corporate bonds , emerging market assets , private equity and real estate. In this regard , such funds could exert a stabilising effect on financial markets , in particular as SWFs are typically not leveraged . In addition , SWFs may contribute to a more efficient sharing and diversification of risk at the global level.
On the other hand , other investment motives ( e.g. when SWF acquisitions are driven by political considerations) could potentially lead to excessive risk-taking and a distortion of asset prices. For instance, some observers have expressed a concern that certain SWFs may be prone to an abrupt selling of assets , thereby contributing to market volatility. Other observers have warned that some SWFs may acquire stakes in companies of sensitive industries , and possibly bail out or support local firms for non-economic reasons. However, there is so far no firm evidence of such investment patterns which would also negatively impact market integrity.
On balance, several potential channels through which the emergence of SWFs as large global players may affect the global financial system can be identified. In this respect , it is of particular importance that SWFs be sufficiently transparent on their size , asset allocation and investment motives so as to assuage concerns about potentially distorting the effects of SWFs and to reduce uncertainty in financial markets.
.APPENDIX 1: Abu Dhabi Investment Authority
Established in 1976, the Abu Dhabi Investment Authority's (ADIA) main funding source is from a financial surplus from oil exports. ADIA replaced the Financial Investments Board created in 1967 part of the then Abu Dhabi Ministry of Finance. It is rumoured to be the largest of the Sovereign Wealth Funds. It is wholly owned and subject to supervision by the government of Abu Dhabi. The fund is an independent legal identity with full capacity to act in fulfilling its statutory mandate and objectives. As much as 75% of its assets are administered by external managers which includes around 60% that is passively managed through tracking indexed funds.
ADIA's funding sources derives from oil, specifically from the Abu Dhabi National Oil Company (ADNOC) and its subsidiaries which pay a dividend to help fund ADIA and its sister fund Abu Dhabi Investment Council (ADIC). About receiving 70% of any budget surplus is sent to ADIA, while the other 30% of surplus goes to the Abu Dhabi Investment Council (ADIC). Established in 2006, The Abu Dhabi Investment Council has a slant towards a local and regional focus and holds stakes in two large state owned banks, Abu Dhabi Commercial Bank and the National Bank of Abu Dhabi.
Strategy & Objectives:
The Abu Dhabi Investment Authority invests in a variety of asset classes. Benchmarks can range from the MSCI Index to the S&P 500 Index.
Some of their asset allocation consists of:
Equities - Developed Markets
Equities - Emerging Markets
Real Estate (Funds or Direct Investments)
ADIA's Board of Directors is the supreme body having absolute control over ADIA's offices and the control of its business. It is comprised of a Chairman, Managing Director and other board members, all of whom are senior government officials appointed by Ruler's Decree. Key decisions are made by various committees
APPENDIX 2: Government Pension Fund - Global
US$ Billion: 445
Entity Structure: Fund
The Government Pension Fund is a sovereign wealth fund where the surplus wealth produced by Norwegian petroleum income is held. The fund changed name in January 2006 from its previous name The Petroleum Fund of Norway. The fund is commonly referred to as The Petroleum Fund (Norwegian: Oljefondet). As of the valuation in October 2008, it is the largest pension fund in Europe and the second largest in the world with a value of NOK 2.09 billion, although it is not actually a pension fund as it derives its financial backing from oil profits and not pensioners. It is among the most transparent of the SWFs in its holdings & investments.
The Norwegian Ministry of Finance is responsible for the management of the Fund, and has delegated responsibility for the operational management of the Fund's international assets to NBIM.
Investments have to be in line with the ethical guidelines based on sector and company behaviour. The companies that the Fund invests in are closely monitored by a Council of Ethics. If companies are operating in conflict with the guidelines the Fund will consider withdrawal. Several companies have been excluded:
* Singapore Technologies, Singapore
* BAE Systems, UK
* Vedanta Resources plc, UK
* Serco Group plc, UK
* EADS (Airbus), Netherlands
* Finmeccanica, Italy
* Alliant Techsystems, US
* General Dynamics, US
* L-3 Communications, US
* Lockheed, US
* Raytheon, US
* GenCorp Inc, US
* Boeing, US
* Honeywell, US
* Northrop Grumman, US
* Textron, US
* United Technologies, US
* Safran, France
* Thales, France
* Wal-Mart Stores Inc, US
* Wal-Mart de Mexico S.A.
* Freeport McMoran, US
* Poongsan Corporation, South Korea
* Hanwha Corporation, South Korea
* Barrick Gold, Canada
* Rio Tinto plc, UK / Rio Tinto Ltd, Australia
* Sterlite Industries Ltd, India
* Madras Aluminium Company, India
* DRDGOLD Ltd, South Africa
(Source: Norges Bank Investment Management. Annual Report 2006).
The guidelines restrict investment where there is a risk that a company is involved in activities that can contribute to violation of human rights, corruption, environmental damage or ‘other particularly serious violations of fundamental ethical norms.'
The petroleum fund is investing parts of the large surplus generated by the Norwegian petroleum sector, generated mainly from taxes of companies, but also payment for license to explore as well as the State's Direct Financial Interest and dividends from the partial ownership of StatoilHydro.
It is predicted that revenue from the petroleum sector is now in its peak period and will decline over the next decades. The Petroleum Fund was established in 1990 after a decision by the legislature assembly Stortinget to counter the effects of the forthcoming decline in income and to smooth out the disrupting effects of highly fluctuating oil prices.
The wealth fund is administered by Norges Bank Investment Management (NBIM), a division of the Norwegian Central Bank.
Strategies and Objectives
The purpose of the Government Pension Fund-Global is to facilitate government savings necessary to meet the rapid rise in public pension expenditures in the coming years, and to support a long-term management of petroleum revenues. The fund invests a large portion of assets in fixed income and equities. They currently do not invest in private equity.
 This is the case for many oil producers who, in order to avoid sharp adjustments of fiscal policy once oil reserves are depleted , accumulate financial assets during the period in which they produce oil. Thus, oil wealth is gradually transformed into financial wealth, leaving the country's overall wealth unchanged and preserving it for future generations
 For details see “ Sovereign Wealth funds- state investment on the rise” Deutsche Bank Research, September 2007