POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise APRIL 2010 · Number 8 53915 Sovereign Wealth Funds in the Next Decade Stefano Curto A prolonged and multispeed recovery period, its associated policy response, and the new global financial landscape might have important bearing on the size and allocation of sovereign wealth funds (SWFs) assets. SWFs could become a driving force in South-South flows, boosting global wealth by helping recycle large savings in surplus countries toward more productive investments. Whereas they indeed represent a new opportunity for developing countries, they also carry challenges for both home and host countries. In recent months, data across the globe indicate that the SWFs Assets and Portfolio global recovery is under way. However, many analysts antic- ipate that the recovery will be particularly uneven: strong Precrisis estimates of SWFs assets were in the range of $13.4­ growth will resume in developing countries, with emerging 17.5 trillion by 2017.1 If the foreign assets under SWF man- Asian economies leading the way out of global recession; and agement were to be invested under the reasonable assumption developed countries will continue to struggle with a fragile of a mix between the portfolio allocations of Singapore and situation and no appetite by the central banks to raise rates Norway,2 at least $2.7­5.0 trillion of total assets theoretically in the near future. could be invested in developing countries by 2017 (equally Interest rate differentials can only be expected to widen split between equities and bonds). Excluding the regions --creating carry trade opportunities that produce a resur- where these funds originate (that is, Asia and the Middle gence of unsustainable capital flows to developing countries, East), these assets could represent 8­16 percent of the com- exacerbate exchange rate pressure and sterilization policies, bined GDP in developing countries in Latin America, Africa, and intensify global imbalances and reserve accumulations. and Eastern Europe; 1­2 percent of their market capitaliza- This macroeconomic and financial landscape is set to create tion of traded companies; and 10­19 percent of the total mounting incentives for emerging markets' central banks to debt securities in these regions. allocate even more foreign reserves into SWFs to release the However, no one knows with certainty the pace of re- pressure on money supply; reduce the cost of sterilization; serves accumulation and the size of SWF increases at the and use reserves in excess of prudential levels more produc- margin. On one hand, external imbalances are expected tively, away from low-yield, dollar-denominated securities. (hoped) to somehow diminish in the medium term because 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise surplus countries may be under pressure to increase internal the G-7 is definitely going to be more gradual and incremen- demand. On the other hand, the crisis and its associated pol- tal. SWFs will avoid a further depreciation of U.S. dollars; and icy response actions to support the global economy might that, in turn, could generate large revaluation losses for the create mounting incentives for central banks to allocate even central banks' dollar-denominated assets as well as a slow- more foreign reserves into SWFs, and for the SWFs to seek down in future reserves accumulation. As long as countries higher alpha and lower beta. in which SWFs are fed by reserves' accumulation resist the Quite naturally, where SWFs invest is also going to be appreciation of their currencies, a full diversification away governed by a number of considerations. Although devel- from the dollar will be difficult.7 oped countries, and the United States in particular, have been the main recipients of SWFs' investments to date, a Opportunities and Challenges for Host shift in attention toward developing countries' securities is Countries likely to increase because of the economic prospects of de- veloped countries in the medium and long terms. Despite Over the next decade, SWFs have the potential to boost differences in investment strategies and appetite for risk and global wealth by helping recycle large savings in surplus liquidity--reflecting different objectives, liabilities structure, countries toward more productive investments, particularly and so forth--the desire to diversify their portfolios in the in the developing world. Over the medium term, many de- hope of maximizing returns for acceptable levels of risk is a veloping countries will continue to depend on external sav- common feature of all SWFs and will support such a shift ings to finance critical investment.8 On the supply side, major (albeit gradually).3 fiscal stimulus packages in advanced economies are likely to In addition to maximizing portfolio performance, portfo- result in a general repricing of sovereign debt risk and the as- lio allocations may also have strategic considerations, like fu- sociated cost of borrowing; and in more limited access to and ture access to commodities.4 Before the crisis, for instance, a crowding-out of credit for developing-country borrowers, East Asia accounted for more than a quarter of global de- forcing some of them into fiscal austerity if they don't find mand for commodities and a significant portion of demand alternative resources. for agricultural commodities (Lyons 2007). Gaining access In this context, SWFs could bridge the gap between the to strategic commodities and resources will require not only growing investment needs and the reduced supply of exter- contracts, but also mergers and acquisitions. In this regard, nal resources,9 thereby sustaining growth, accelerating it has been reported that a number of Chinese companies progress toward the Millennium Development Goals, in- already have been securing strategic assets in energy and raw creasing economic integration, and helping build the foun- material supplies in Africa and Latin America, with the dations for a multipolar world. Africa, in particular, may backing of China's government5--the Industrial and Com- benefit most from SWFs' resources, given its relatively weak mercial Bank of China's investment in Standard Chartered starting point in trade, regional integration, infrastructure, was seen by many market analysts as China's strategic entry and private sector development. point into the African continent, using the bank as the prin- Although SWFs could help recycle large savings gener- cipal investment agent. In February 2010, the oil industry in ated in surplus countries toward the developing world India called for the government to use parts of the $278 bil- where capital might be socially and economically more pro- lion in foreign exchange reserves to create an SWF to com- ductive, several concerns remain and the memory of the pete with China in the race to secure global energy assets. 1980s debt crisis fueled by the recycling of oil countries' sav- The current levels of the stock markets in developed ings is still vivid. countries may slow down the process of portfolio rebalanc- ing as many investment opportunities might materialize in Debt Run-Up the European Union, Japan, and the United States.6 More- The current global savings glut may have similarities with over, at a recent Official Monetary and Financial Institutions the recycling of oil countries' savings that fueled the debt Forum, attendees also emphasized the role that SWFs could crisis in the 1980s. In the 1970s and early 1980s, these wind- play in purchasing government bonds being issued by coun- falls were deposited in the West's banks and eventually on- tries of the G-7 (projected by the International Monetary lent to developing countries in Latin America and elsewhere. Fund to rise from precrisis levels by an average 40 percent Today, these windfalls may take the form of SWFs directed, of GDP by 2014). for example, to African countries that are becoming increas- A gradual shift toward developing countries' investments ingly attractive investment destinations; are growing at the may be the most likely outcome. As reserves accumulate, fastest rates in the past four decades; are reforming institu- SWFs' strategy will focus initially on a rebalancing from low- tions and improving governance; and, most important, have yield assets into high-yield equities. Diversification away from had their government balance sheets virtually wiped free of 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise external debt as a result of the Heavily Indebted Poor Coun- ecdotal evidence that SWFs farm out part of their as- tries and Multilateral Debt Relief initiatives. sets to highly leveraged funds. For instance, a quarter Three important considerations should be well consid- of Singapore's SWF is believed to be channeled and ered. First, even though their external debt may have been invested through hedge funds that use this strategy.11 slashed, many countries are burdened by domestic debt and contingent liabilities related to loss-making state-owned Opportunities and Challenges for Home companies or possible banking system problems. Second, the Countries institutional capacity of countries to select high-rate-of- return projects is often limited. Besides, the projects have to The idea behind SWFs is quite simple: divert reserves in ex- be implemented, monitored, and maintained. In other cess of those needed for short-term current and capital ac- words, the paucity of investment funds may not be the bind- count requirements12 or for stabilizing exchange rate ing constraint to growth and development. Third, portfolio movements toward long-term diversified portfolios of equi- shifts by SWFs may put some upward pressure on the prices ties and bonds.13 This is more risky than investing in U.S. of riskier asset classes, such as equities, and downward pres- Treasury bills in the short run, but is also likely to yield sure on bonds, thus increasing yield. Again the impact on higher returns over the long haul. However, although the developing countries will not be negligible in terms of cost idea is appealing and some benefits are undeniable, the fol- of borrowing, for instance, and of inflated equity prices.10 lowing challenges are worth mentioning. Financial Stability Net Wealth, Repatriation of Assets, and Dutch Disease There are also concerns about the impact of SWFs' in- When a substantial amount of the reserve buildup has been vestment on the financial stability recipients, particularly the counterpart of central banks' sterilization,14 SWFs' assets those that have more shallow financial markets. Limited in- can be considered as a purchase with government debt. formation about SWFs' objectives, strategies, institutional Therefore, a careful analysis of government whole balance structure, and investment management may reinforce the sheet effects is necessary to assess real net wealth, which clouds around how SWFs' behave: may not be as large as it first appears. The joint balance sheet · Pro-cyclicality and herding--SWFs are believed to be of government and the central bank actually would worsen countercyclical in supporting prices and markets, as with domestic currency appreciation and high domestic in- they have traditionally been on buy-and-hold strate- terest rates. gies. However, a pro-cyclical behavior cannot be ex- A potential currency mismatch is of particular concern cluded. Single individual transactions undertaken by for developing countries in light of repatriation of returns an SWF may disrupt more shallow financial markets on investments because a country's future needs (SWFs' li- either because the funds may mirror hedge fund strate- abilities) are denominated in domestic currency while SWFs' gies of portfolio rebalancing against possible losses or assets are denominated in foreign currencies. Real conver- because perceived shifts or rumors and second-guessing gence and catching up in emerging markets inevitably would about SWF investment decisions may cause volatility force domestic currencies to appreciate in real terms relative and herding. For instance, the Singaporean SWF Tema- to those of developed currencies (Balassa-Samuelson effect), sek Holdings' sale of shares in two big Chinese banks reducing the real (and/or nominal) value of repatriated (Bank of China and China Construction Bank) and in funds. In addition, as SWFs' returns are repatriated, the in- Asia's largest container-shipping group Cosco created flux of dollars cannot avoid the need for an adjustment rumors about the health of the banking sector or the when dollars are spent putting additional upward pressure belief that several areas of the Chinese economy had on their currencies and undermining the competitiveness of reached their cyclical peak. That occurred despite the traded goods sectors.15 Temasek's statements that the sale was just "part of In the long run, it seems that some form of Dutch disease our ongoing rebalancing of the portfolio against new is unavoidable for oil-exporting countries whose intention in opportunities" (Burton 2007). setting up SWFs is to avoid real exchange rate appreciation. · Short positions--We also cannot assume that undertak- ing short positions in quick win-win situations will not Opportunity Costs occur in the future, rather than waiting to step in when The issue of investable surplus and real net wealth hints that asset prices fall. For instance, The Economist (2008) there are opportunity costs attached to the alternative uses mentioned that, four years ago, Norway's SWFs began of SWFs' assets. The opportunity costs arise from the fact to sell short the bonds of Iceland's banks when a slow- that in countries with underdeveloped social and economic down of the economy was foreseen. There is also an- infrastructure, social and economic return on investment at 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise home may exceed the return on investing foreign reserves billion railway in oil-rich Nigeria was announced, as were abroad, regardless of the nature of that investment and in- joint China-Africa plans to explore energy development. tergenerational preference of the government.16 6. An example is Abu Dhabi's decision to buy 9.1 percent Since 2003, China has used foreign exchange reserves to of Daimler through Aabar Investments in March 2009. support domestic policies with Central Huijin Investment 7. At the consolidated level (including central banks' pur- Company to absorb Central Huijin Investment Company chases), there is already some evidence of portfolio rebal- and to recapitalize the Agricultural Bank of China and the ancing. The recent announcement about the sale of Chinese China Development Bank, including dealing with bad loans. holdings of U.S. Treasury debt in December 2009--ceding Russia has taken advantage of the recent run-up in oil prices its place as the world's biggest foreign holder of U.S. debt to to pay down its external debt, and some other governments Japan--provides clues about China's appetite for loaning (such as Brazil) have considered the possibility of using a money to the United States. China pared its Treasury hold- share of their international reserves in a fund geared toward ings by $34.0 billion, to $755.4 billion. Japan's holdings total the promotion of industrial policy. $768.8 billion, according to U.S. Treasury estimates. For commodity SWFs, the issue of investing foreign re- 8. Excluding China and major oil exporters, developing serves domestically is also a fiscal policy issue because for- countries are (on average) net importers of capital; this eign currency accrues directly to the government and is not makes them dependent on external financing for critical in- converted into domestic currency unless it is spent by the vestment. government. 9. Global Economic Prospects estimates that most of the 53 developing countries that faced an external financing gap Notes in 2009 had current account deficits of 5 percent or more, with private-sourced net-debt inflows financing equivalent 1. Projections by Morgan Stanley, Standard Chartered, to about 2.2 percent of GDP (0.8 percent if Central Asia Merrill Lynch, and the International Monetary Fund esti- and Europe are excluded). mated that foreign assets under the management of SWFs 10. Warnock and Warnock (2005) underscore that total could reach US$12 trillion by 2012. foreign buying (private and official) of U.S. bonds in the 2. We assume that SWFs could invest 20­30 percent of years leading up to 2005 kept the 10-year Treasury yield 150 their assets in developing countries, with 45 percent allo- basis points lower than it would have been without foreign cated into equities; 45 percent into bonds; and 10 percent inflows. The same study estimates that without foreign offi- into private equity, real estate, and commodities. cial buying, long-term rates would have been 60 basis points 3. In September 2009, the move by China Investment Cor- higher. Miles and Jen (2007) estimate that, all other things poration (CIC) to take a $1 billion minority stake in the Hong being equal, the emergence of SWFs could push up "safe" Kong, China­based Noble Group, a commodities trading/ bond yields over the next 10 years by 30­40 basis points and supply chain manager, was a step in this direction. J.P. Mor- could reduce the equity risk premium by 80­110 basis gan calculates that other deals worth $50 billion of invest- points. ments are likely to materialize between the CIC and 11. Jen (2008) estimates that SWFs may outplace 20 per- companies in developing countries. cent or more of assets with external investors. 4. Despite its early, visible stakes in Blackstone, Morgan 12. This means six months of imports or equal the Stanley, and other financial institutions in the United States, amount of short-term external debt (Guidotti-Greenspan the CIC has also focused in other areas--namely, natural re- rule). sources (Wei 2007). 13. In line with long-standing tradition, reserves are in- 5. In addition to $1.6 billion of acquired assets at the end vested in safe but low-yield U.S. Treasury bills; when con- of 2005, an additional $2.3 billion has been invested by verted into local currency terms, the return could be close China National Offshore Oil Corporation in Nigerian oil and to zero or negative because of the depreciation of the dollar. gas exploration (Trinh 2006; Broadman 2007). China Devel- This might be aggravated by sterilization policies intended opment Bank also has launched a $5.0 billion China-Africa to maintain price and exchange rate stability. The Bank for Development Fund to finance Chinese companies' invest- International Settlements has estimated costs of sterilization ment in Africa, following up what was agreed at the Beijing to be roughly 0.5­2.0 percent of GDP for 14 emerging mar- Summit of the Forum on China-Africa Cooperation. Accord- kets. Similarly, Summers (2006) suggests that central banks' ing to China's Xinhua News Agency, Chinese and African portfolios have earned around 1 percent real returns annu- companies and governments at that summit signed 14 agree- ally over the past 60 years, in comparison with about 6 per- ments worth $1.9 billion for projects in infrastructure, cent for a portfolio diversified in stocks and bonds. With telecommunications, and other fields. A deal to build an $8.3 foreign exchange reserves at 50 percent of GDP, in a country 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise like China, a difference of 500 basis points on the returns to References reserves amounts to 2.5 percent of GDP a year. 14. An analysis conducted by the Bank for International Bourdet, Yves, and Hans Falck. 2006. "Emigrants' Remittances and Dutch Disease in Cape Verde" International Economic Journal 20 (3): 267­84. Settlements suggests that, during the period from January Broadman, Harry G. 2007. Africa's Silk Road: China and India's New Eco- 2000 to May 2006, sterilization might have offset as much nomic Frontier. Washington, DC? World Bank. as 85-95 percent of changes in net foreign assets in India, Burton, John. 2007. "Temasek Sale a Fresh Sign of China Doubts." Financial Korea, Malaysia, Singapore and Taiwan (China), and over 70 Times, November 30. percent and 60 percent, respectively, in the case of China Jen, Stephen. 2008. "How Much Assets Could SWFs Farm Out?" Briefing Note, Morgan Stanley, New York. and Russia. Lyons, Gerard. 2007. "State Capitalism: The Rise of Sovereign Wealth Fund." 15. Real appreciation in the case of an exchange rate peg; Standard Chartered Bank, London. nominal appreciation in the case of floating or renouncing Miles, David K., and Stephen Jen. 2007. "Sovereign Wealth Funds and Bond of a peg. Bourdet and Falck (2006) studied the effect of and Equity Prices." Morgan Stanley, Global Economic Forum, June 1. Cape Verde remittances on the traded goods sector. As local http://www.morganstanley.com/views/gef/archive/2007/20070601-Fr incomes have risen with a doubling of remittances from i.html#anchorf40f6046-419e-11de-a1b3-c771ef8db296. Rodrik, Dani. 2006. "The Social Cost of Foreign Exchange Reserves." Inter- abroad, the Cape Verde real exchange rate appreciated 14 national Economic Journal 20 (3): 253­66. percent during the 1990s. The export sector of the Cape Summers, Lawrence. 2006. "Reflections on Global Account Imbalances and Verde economy suffered a similar fall in productivity during Emerging Market Reserve Accumulation." Speech delivered at the Re- the same period--a fall caused entirely by capital flows. serve Bank of India. 16. Recently, several authors have attempted to measure The Economist. 2008. "Asset-Backed Insecurity." January 17. Trinh, Tamara. 2006. "China's Commodity Hunger: Implications for Africa the opportunity cost of reserves accumulations. For instance, and Latin America." Deutsche Bank Research, Frankfurt am Main, Ger- Rodrik (2006) shows that there is a "social cost" to reserves many. accumulation to the extent that the private sector borrows Warnock, Francis E., and Veronica C. Warnock. 2005. "International Capital at a higher rate than what the central bank earns on its for- Flows and U.S. Interest Rates." International Finance Discussion Paper eign currency assets. Similarly, Summers (2006) suggests 840, Board of Governors of the Federal Reserve System, Washington, higher costs based on the forgone return on infrastructure DC. Wei, Tan. 2007. "China's CIC Likely to Diversify Away from Further U.S. projects. Banking Sector Investments." Financial Times, December 30. About the Author Stefano Curto is a senior economist, Poverty Reduction and Economic Management (PREM), World Bank. To learn more about PREM, please visit http://www.worldbank.org/prem. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. It is produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at www.worldbank.org/economicpremise.