Introduction of SWFs
Definition
There is no universally agreed definition of sovereign wealth funds (IMF, 2005). One of the most agreeable definitions is that "government investment vehicles funded by foreign exchange assets and managed separately from official reserves" (the US Treasury Department, 2005). This essay will adopt this definition mentioned above.
A Sovereign Wealth Fund is composed of financial assets such as stocks, bonds, real estate, or other financial derivative instruments funded by foreign exchange assets (SWF Institute, 2008). However, it is complicated to distinguish differences between SWFs and official reserves. Both of them are state-owned; while unlike the latter, SWFs have limited effects on monetary policy and are not directly relative to international balance of payment and policy of foreign exchange rate. Five characteristics involve in a SWF: sovereign; high foreign currency exposure; no explicit liabilities; high risk tolerance; and long investment horizon (Stephen Jen, 2007).
Background
In 1953 the first sovereign wealth fund, Kuwait Investment Authority, was established. After 1990s, the scale of SWFs expanded rapidly. According to the statistics of SWF Institute, the total amount of SWFs' assets has reached approximately $3.9 trillion until June 2010(SWF Institute, 2010). In a study of Morgan Stanley, it prospected that the world's SWFs could grow to $12 trillion by 2015 and could exceed the total size of the world's official reserves by 2011(Stephen Jen, 2007). Standard Chartered also indicted that SWFs would reach $13.4 on current trend in the next nine years (Gerard Lyons, 2007).
In recent years, SWFs have drawn a great deal of concern since an apparent increase in investment activities. SWFs obtained more assets in corporations of developed countries after financial crisis in 2008. As SWFs are state owned funds, they are significantly different with private investors. So it seems uncertain that their purpose of investment is political or financial. Particularly the purpose of investment from countries with political power, such as China and Russia has attracted primary attention. It was pointed out that SWFs may affect the development of domestic industries of host countries. A further argument against SWFs is that it may also threaten the stabilization of global financial market (Edwin M. Truman, 2010). However, Hany H. Makhlouf believed that the motives and hidden agenda of SWFs have been proved based on a false assumption (Hany H. Makhlouf, 2010).
Scope
This essay attempts to demonstrate that the purpose of SWFs' investments is more financial than political; furthermore SWFs enhance the stabilization of global economy.
This essay will first analyze the motives for establishment of sovereign wealth funds. Secondly, it will evaluate the investment strategies of SWFs in order to find the real purpose. Finally, it will list the advantages brought by SWFs.
Motives for establishment of SWFs
Origins of funds
The funding of SWFs comes from different sources. From Figure 1, one important source is domestic resources, such as oil and natural gas. Another one is non-commodity export, for example, labor. Sufficient sources cause surpluses of fiscal budget; therefore, SWFs were set up in order to alleviate risk of exchange rate fluctuation (a major currency of foreign exchange reserves is U.S. dollar) and increase returns on asset.
Figure 1: SWFs by funding source
Source from SWFs Institute, http://www.swfinstitute.org/fund-rankings/
Policy objectives
According to the distinction of policy objectives of SWFs, they can be divided to five types (IMF, 2007):
• Stabilization funds are set up by countries which possess of sufficient natural resources in order to alleviate the influences of volatile commodity prices (usually oil) on their economic stabilization.
• Savings funds are intended to share wealth across generations. For countries rich in natural resources, savings funds transfer nonrenewable assets into a diversified portfolio of international financial assets to provide for future generations, or other long-term objectives
• Reserve investment corporations are funds established as a separate entity either to reduce the negative cost-of-carry of holding reserves or to pursue investment policies with higher returns. Often, the assets in such arrangements are still counted as reserves.
• Development funds allocate resources for funding priority socioeconomic projects, such as infrastructure.
• Pension reserve funds have identified pension and/or contingent-type liabilities on the government's balance sheet.
Clearly, SWFs' polity objectives are primarily to maintain the stability of economic systems and acquire profits. Indeed, it seems that there are political reasons. However, these reasons merely contribute to establish a SWF; do not lead to decision-making of investment. Their directions of investment are determined by financial market, in other words, how they can harvest maximum money. Then they make use of this money to arrive at their political objectives. So SWFs are investors who pursuit pure benefits and this is same with other private investors or institute investors. To this extent, no political purpose is found in the process of investment.
Investment Strategies of SWFs
Strategic asset allocation
"The strategic asset allocation (SAA), which reflects the return objective, risk tolerance, and identified constraints (such as liquidity and financing needs, investment horizon, and legal and regulatory requirements)"(IMF, 2007).
There is a myriad of SAA of SWFs because of different considerations. Some SWFs invest a majority of assets, while others invest in publicly-listed financial assets, such as bonds and equities. Some SWFs seek the maximum of absolute benefits in a long term so that the asset classes they invest may alter related to marketing benefits, whereas others seek the diversity of investment so that they balance investments over a wide range. Thus, different investment strategies are determined by ratios between benefit consideration and risk consideration.
Management
A majority of SWFs uses actively external funds managers who are professional and famed investors. These investors have a large amount of experience in funds management which results in a good governance. Another way to manage SWFs is public officials who are elected from relevant governmental agencies.
A bulk of SWFs restricts the proportion of shareholding of corporations and institutions that they invest on. They do not care about the management control of a company, but the potential profits in long term. "On average, Sovereign Wealth Funds take 0.74 per cent of the shares outstanding in a company" (Bris and Fernandes, 2009). As a result, they would not influence decisions of host companies by limited voting rights. Besides, many governments create barriers of investment due to political concerns. SWFs prefer corporations of countries which provide a legal protection to foreign investors and have a favorable investment environment.
Concerns
A massive anxiety of host countries is that SWFs hold strategic stakes in important corporations of key industries and affect, even control, decision of these fields. These key industries may be energy, media, telecommunication, financial sector and so on. "In 2007, Singapore indicated that it would not invest in iconic companies that host countries would rather keep in the hands of individual or non-governmental institutional investors due to cultural, nationalistic, or political considerations " (Financial Times, 12 December, 2007). The solid evidences illustrate that SWFs are passive and patient investors without political purpose to impact decisions.
To decrease the nervousness of host countries and boost the regulation of SWFs, a negotiation was reached through International Monetary Funds (IMF). This is called as Generally Accepted Principles and Practices (GAPP)-Santiago Principles. It provides Sovereign Wealth Funds with a framework of accountability, transparency and governance. Specially, one principle formulates that SWFs should not hold stocks of one company more than five per cent in order to minimize the political impacts of their investments (International Work Group of SWFs, 2008). On the basis of GAPP, it demonstrates that SWFs present an active willing to operate with international organizations and ease considerations about their political purposes. Moreover, it is a significant stage in the process of SWFs' development and indicates a correct direction for SWFs in the future.
A case study: China Investment Corporation (CIC)
Choosing CIC as an example is based on an enormous number of concerns about this SWF from China, a country which has a socialism political system.
According to the annual report of CIC (2009), it can be seen that its investment is based on economic and financial objectives and do not attempt to influence other companies' operations. Moreover, the overseas investment portfolio of CIC is mainly composed of equity, fixed in come and alternative assets, in both developed and emerging markets. Besides, these investments are primarily managed by professional external fund managers (CIC, 2009).
This source comes from a report of CIC itself, so it may be not tell all the truth. However, it still illustrates that CIC has a complete system to operate its investment activities and govern internal structure. It also shows a high transparency of CIC because of its open report.
Benefits of SWFs
Benefits in home countries
SWFs are an effective measure to diversity the origins of national revenue. They invest different countries and industries by different asset classes, thereby, easing the risk of single revenue.
SWFs make the utmost of the surplus of foreign reserve to create returns of benefit. If the foreign reserve is idle, its opportunity cost would be lost. Hence, investments are not only increasing wealth, but also decreasing loss at the same time.
Benefits in host countries
SWFs markedly help companies which are lack of capital by injecting money into them. Barclays, for example, have received capital from SWFs of Qatar, China, Singapore and Kuwait, which solves the problem of capital flow.
Investments of SWFs positively advance the value of companies since the investments are mostly long-term and responsible.
An investment of SWFs may contribute to a slight increase in stock price as a result of strengthening confidence. So they bring interests to shareholders.
Due to investments of SWFs, companies gain sufficient capital to enlarge their market and adjust their industrial structure. This is a key factor which influences the successful development of a company.
Benefits in global financial market
SWFs have an inevitable impact on global financial market (Edwin M. Truman, 2010). Indeed, SWFs play a stabilizing role in global financial market. They have large capitals, long investment circles and strong responsibility. All of these can maintain the stability of global market.
SWFs enhance the flow of funds between countries. This is beneficial for efficient allocation of resources over the world. If one nation cannot absorb the surplus capital in domestic market, this capital can be transferred to another short-capital market.
Nations swift their foreign reserves to SWFs which diversify the measures of surplus reserves. It can be seen as a creative evolution to solve the imbalance between exporting and importing payment.
Conclusion
In conclusion, there is no accurate evidence which can point out the political motives hidden behind investment activities of SWFs; whereas mass analyses illustrate that the purpose of investments is primarily based on economic benefits. To be specific, the evaluation of investment strategies explains the innocence purpose of SWFs which is similar with other institutional investors; and the case of China Investment Corporation also provides a reasonable evidence for this statement. SWFs, as mentioned before, result in a variety of positive effects on their owners, host countries and global financial market. Clearly, SWFs has become an active power which contributes to the stabilization of global finance.
The world economy has been continuing to recover from the downturn of financial crisis in 2008. Consequently, the increasing investments of SWFs may promote the recovery of global economy in the future as well as in the past. Since more regulations and principles related to SWFs are established, host countries may change their attitudes to SWFs. SWFs themselves should improve their governance and transparency in order to gain others' trust. Moreover, host countries and SWFs would gradually adjust to each other. As a result, the investment environment of SWFs will be more friend and welcome. This might accelerate the expansive pace of SWFs and advance the force of SWFs in the global stage. Yet a further research is still demanded to find out a best appropriate pattern to regulate SWFs and deal with the relationship between SWFs and host countries.
Even though there are some limitations of the work. For instance, the data of a small group of countries is incomplete because of a low transparency. Overall, "Sovereign wealth funds investors invest in countries because it is financially rewarding, regardless of political regime" (Avendaño, Rolando and Javier Santiso, 2009).
