Sizing up the leviathan

UBS News for Banks, Spring 2008

High oil prices help many sovereign funds to boost their investment activity

Sovereign wealth funds (SWFs) are hardly new. Indeed, the Kuwait Investment Authority (KIA), Government of Singapore Investment Corporation (GIC) and Abu Dhabi Investment Authority (ADIA) can collectively point to more than a century of investment experience. But their rapid build-up in both number and size recast them in a new light – that of omnipotent financial heavyweights. It is time to ask how they will influence the global financial system, and how banks should respond to the opportunities and challenges they bring.

To understand SWFs, it is first necessary to define them. The catch-all definition – asset pools overseen by publicly-accountable officials – embraces thousands of funds with more than $12 trillion under management, much of it in the US. Market participants, however, tend to think of SWFs as non-US in origin, and beyond the scope of financial market regulation. To keep the discussion clear, publicly accountable investment pools can be categorized as follows:

Each of these categories employs specific similar mandates and investment patterns (see Table). Each can affect asset valuations in meaningful, though notably different ways. Each is growing at a different rate, some at the expense of others. The Chinese Investment Corporation (CIC), for example, was funded largely by the sale of bonds to the Chinese central banking authority, the State Administration of Foreign Exchange. If, as now debated, Japan establishes a federal investment corporation, it would likely be financed by the Japan’s Ministry of Finance in a similar way.

The six-category taxonomy outlined above shows that SWFs are a very heterogeneous group, with widely varying governance structures and investment characteristics. The implications for commercial and investment banks are clear; every sovereign client will need service tailored to their particular needs and objectives.

Some SWFs can alter their investment behavior very quickly, but more often they are subject to bureaucratic oversight and control. For this reason, only a few are really able to act tactically. Some provide complete transparency on what they do; others – indeed, most – are circumspect or even secretive about their activities. Some are hybrids within the six categories outlined above. ADIA, for example, started life as a stabilization fund but, outgrowing its original mandate, has morphed into a future generation fund as well as a statesponsored investment corporation. In a similar fashion, Russia is splitting its massive foreign exchange holdings between its central bank, an oil stabilization fund that is to be capped at 10% of GDP, and a future generations fund. To date, however, all Russian funds have been invested across currencies and asset classes rather as if they were traditional central bank reserves.

Most commentators tend to define sovereign wealth funds as a collection of federal, future generation or pension funds, stabilization funds, and government- sponsored investment corporations – excluding central banks, ministries of finance, multilateral organizations and state/local pension funds. Using this definition, UBS Public Policy recently estimated that SWFs now preside over assets worth some $2.7 trillion.

Institutions in this bracket include many that benefit from two of the most powerful forces now fostering SWF formation and growth, namely (1) rising commodity prices, principally for oil (see box), but also copper, gold, gas and phosphates; and (2) Asian trade surpluses and currency regimes. Recent high-profile investments by ADIA, CIC and GIC have attracted a special glare of publicity to these sub-categories of SWFs. However, the economic impact of these narrowly defined SWFs is easily overstated. At present, we estimate, they represent less than one quarter of all publicly accountable assets under management and less than 3% of total assets under management worldwide.

By comparison, central banks and finance ministries, together with state and local pension plans, preside over assets worth nearly three times as much. Because of their role in setting foreign exchange policies and their emphasis on high-quality fixed-income investments, central banks and finance ministries are particularly influential in foreign exchange valuations, official interest rates and high-grade credit spreads.

A further point needs to be stressed. The expansion of investment corporations in Asia – and probably soon in other developing countries with burgeoning FX reserves, such as Brazil – is a virtual necessity if the respective central banks are to avoid financial calamity. Why? Against their more than $4 trillion in foreign exchange assets, emerging-market central banks hold mostly local currency-denominated liabilities – that is, local money-market instruments issued to sterilize the effects of foreign exchange intervention.

As the remnimbi, Singaporean dollar, Korean won, Malaysian ringgitt and Brazilian real all rise in value against the US dollar, euro or yen, their central banks must mark-to-market a balance sheet loss. By putting more assets into investment corporations and simultaneously pursuing more diversified and return-oriented investment schemes, these central banks limit the amount of currency translation risk they bear while improving the risk/reward prospects of their assets.

Over the past three years, emerging market central banks have averaged a negative 180 basis point return in local currency terms on their multi-trillion reserve portfolios. Over the same period, multi-asset portfolios, such as those pursued by pension plans, have recorded positive returns of some 300-400 basis points per annum in local currencies. Fundamentally, the further growth of federal investment corporations in the developing world is favoured by the prospects for higher returns, reduced balance sheet risks and the desire to invest in strategically more significant assets than US treasury bonds. As these funds start to flow into riskier asset classes, they will influence financial markets more markedly. At the same time, those who expect these leviathans to lift all stock prices and tighten all credit spreads are likely to be disappointed.

Terry Keeley UBS Investment Bank,
Global Head, Central Bank Services