“Sovereign wealth funds may actually be more beneficial to most countries than commonly made out to be.”

By Prabhod Mudlapur

 

What are Sovereign Wealth Funds

Sovereign wealth funds get a bad rap. In the Middle East, they are seen simply as a way to park oil money and in China and Asia, they are seen as investment instruments at the hands of their governments. But what are sovereign wealth funds, and why do countries need them?

Sovereign wealth funds are “state-owned investment funds that invest in real and financial assets, such as stocks, bonds, real estate, precious metals, foreign exchange, or in alternative investments such as private equity or hedge funds.” Sovereign wealth funds vary widely in their management structures, source of revenues, usage and size. However the general story for most sovereign wealth funds goes something like this:

Country A discovers a large quantity of some resource, let’s call it ‘Shiny’, in remote hinterland region -> major industrial area. A extracts Shinies, sells it on the international market and earns profits. Now Country A hires some very smart economists, who tell them that they must avoid succumbing to Dutch Disease (foreign-exchange linked decline in export-competitiveness) and spiking inflation (sudden influx of money into the system leading to runaway inflation (a la Zimbabwe). To deal with the sudden increase in money supply, the average government makes ‘targeted investments’ in ‘key industries’, (read: subsidies), in order to ensure that it wins re-election campaigns forevermore. The smarter government listens to its smart economists, and starts a sovereign wealth fund, which accumulates the extra money earned from selling ‘Shinies’ and invests it in assets the world over.

From investing in the global markets, our Country A is able to hedge against declines in the prices of the resources it extracts (oil in 2015-16), market downturns (2008 financial crisis) or any systemic risks (terrorists attacking pipelines) deriving from its heavy dependence on this industry. Sovereign wealth funds also allow a nation to make investments in industries that are up-and-coming and will take capital to become profitable, or are experiencing slow growth due to external factors. But now you ask, “Pray, if the SWF invests in weak industries to help them, what difference is there between the SWF’s balance sheet and the national budget?” Well, the difference is that SWFs are able to invest globally, and hence reduce the risk that a market downturn in its own country will risk the savings of the entire nation. According to the Sovereign Wealth Institute, the main institute tracking such data, of the five largest sovereign wealth funds, which, by the way, hold more than 3.7 trillion USD worth of assets, four are oil-derived while the fifth manages a bulk of China’s foreign exchange reserves.

When we compare the size of SWFs to their GDPs, we see that for most of these countries, the size of their SWF is appreciable to the size of their annual GDP, and in some case, a multiple of the same*.

SWF-holding states	GDP(bil USD)	GDP Growth Rate % (2015-16)	SWF size (bil USD)	SWF-size to GDP as %
Norway	376	1.6	885	226
China**	391	6.9	2038	17
UAE	375	3.8	1262	336
Saudi Arabia	673	3.5	736	109
Kuwait	110	1.8	592	538
Singapore	296	2	530	179
Qatar	156	3.6	335	214
South Korea	1466	2.6	108	7.3
Australia	1256	2.2	92	7.3
Russia***	1276	-3.7	123	9.6

*While Canada, USA and Mexico all have large sovereign wealth funds, the SWF-size to GDP ratio for each of these countries measures less than 0.008% and is hence mostly negligible.

**For the purposes of this calculation, the China-Africa Development Fund has been ignored as its focus is mostly international

***Russia is an aberration to this chart, however its economy’s weakness has more to do with international sanctions pertaining to Crimea.

Let’s take a look at Norway, a country that for the most part can do no wrong. A country which holds the largest SWF in the world (885 billion USD; almost 1.5 percent of the entire global equity market), Norway has a ratio of SWF assets per capita of more than 170,000 USD. With such a large interest in the global markets, there are going to be complaints everywhere. Analysing the general complaints from the detractors of sovereign wealth funds, we see a few major themes, which will be address in-line.

Issues with SWFs

 

1.    Under what conditions can the state spend SWF money? – The best argument here would be either in a severe market downturn, or when either the availability of the resource funding the SWF, or its viability as a future source of revenue is in question. This question might also be dealt with in terms of inflation, as there are trains of thought which contend that SWF money that is invested outside the country, when ‘repatriated’ into the domestic economy has an inflationary effect, which must be taken into account when considering the rate of ‘repatriation’. Norway’s government is allowed to use up to 4% of SWF assets per year to help balance the budget.
2.    Should SWFs invest in safe assets (real estate, gold) or seek yields from stocks, corporate debt and more risky investments? – Here, it depends on the risk-profile of the fund. Although you can never know for certain how long an investment decision will continue to generate justifiable returns, and there is always a chance for premature rejection (the global aversion to diesel today after the VW scandal), this falls down to the management of the fund. Most countries can either operate their SWFs like a pension fund, in which case you go for safety, or like a hedge fund, in which you take risk designed for maximum returns. The decision is up to the country.
3.    Are sovereign wealth funds morally justified? – The discussion here leads into two separate moral arguments, both with valid points. The first has to do with the understanding that the government should always prioritise ameliorating the conditions of its citizens by whatever means possible, including spending all the money it earns. To this, I say, ”But what about tomorrow? Do our kids not matter?”. The main rebuttal is that if the SWF functions like a pension, the pieces all fall in place. If the government is paying an annual ‘premium’ to the SWF based on its ‘work’, then when the government ‘retires’, it receives monthly or yearly ‘pension payments’ that help the government balance the budget or keep from relying too much on sovereign debt. The second issue is that if a small proportion of SWF money is used to invest in high yield instruments, the government might be investing indirectly in evil companies that exploit (insert victim here) to chase a bottom line. The answer to this issue is even simpler: Mandate that the SWF not invest in ethically dubious companies. Problem solved.

While traditional economic theory holds that investments in human capital (education, health and welfare, etc) last forever, there are specific and prevalent demographic and social issues that can negate these gains. In many countries today, ageing populations pose systemic risks to the economy, increasing burdens on the working class. Similarly, political risk as it pertains to the development of human capital (read: the current debate about Betsy Devos, the American Secretary of Education’s views on educational policy) is ever an issue. Human capital must be nurtured, and is likely the most-lasting investment that a state can make, but even human capital can decline. An educated workforce requires a growing and stable economy with available skilled jobs in order to continue growing.

The Advantages of SWFs

Sovereign wealth funds could have helped immensely during the 2008 financial crisis. With the failures of major American institutions together employing tens of millions of people, including AIG, GM and Fannie Mae & Freddie Mac (still owned by the government), the orderly purchase, capitalisation, overhaul and dispension could have been accomplished more efficiently, and with less political backlash through SWFs. During a crisis, if there are systemically significant institutions that are failing, and a SWF is able to identify the intrinsic value in the continued functioning of these enterprises to the national economy, then the privately organized and managed purchase and structural overhaul of such institutions, avoiding the need for issuance of sovereign debt or large central bank price stimulus is beneficial. The funding of sovereign wealth funds need not come only from resource funding, but also from divestitures and one-off bumps in tax collection due to policy. Saudi Arabia plans to sell up to 5% of its flagship enterprise, Saudi Aramco, to use that money to bolster the Public Investment Fund, Saudi Arabia’s main sovereign wealth fund, and is in the process of hiring international banking executives and building up its human capital to manage the growth of that fund. India is embarking on a campaign of divestitures of state utilities and other national assets; a well-managed sovereign wealth fund with an eye on targeted investment for the future would be a smart step for the nation. Sovereign wealth funds can also be used as instruments of foreign policy. The China-Africa Development Fund is a SWF solely funded by the China Development Bank to help Chinese companies invest in Africa, generating jobs in both regions and growing economies.

What does it all mean…

The decision to form sovereign wealth funds to manage national assets will at the end of the day, be one made by lawmakers and policy experts in each respective nation. However, a smart move would be greater awareness and consideration of this form of national institution as a means of facilitating intergenerational savings, safeguarding national interests and building for the future.

 

Sources

Bianchi, S. (2016, May 25). The Key Questions Asked About Saudi Arabia’s $2 Trillion Fund. Retrieved from https://www.bloomberg.com/news/articles/2016-05-25/key-questions-raised-by-the-2-trillion-saudi-wealth-fund-plan

Pothan, R. (2017, January 18). CPSE ETF: A promising ETF for your portfolio. Retrieved from http://economictimes.indiatimes.com/mf/analysis/cpse-etf-a-promising-etf-for-your-portfolio/articleshow/56640352.cms 

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Campbell, P. (2016, October 24). Diesel sales fall to lowest level in seven years after VW scandal. Retrieved from https://www.ft.com/content/f3e59748-978f-11e6-a80e-bcd69f323a8b

Sovereign Wealth Fund Rankings. (2016). Retrieved from http://www.swfinstitute.org/sovereign-wealth-fund-rankings/

The World Factbook: NORWAY. (2017, January 12). Retrieved from https://www.cia.gov/library/publications/the-world-factbook/geos/no.html