SUMMARY

Sovereign wealth funds (SWFs) are investment funds owned and managed by national governments. Such funds currently manage between $1.9 and $2.9 trillion and are expected to grow to over $12 trillion by 2015. This is due to the rapid growth of commodity prices and large trade surpluses in several emerging market economies. During the second half of 2007, interest in SWFs increased as Asian and Middle Eastern SWFs, fueled by surging foreign exchange reserves, invested large sums of capital in U.S. and other Western companies. Policy makers in the United States have raised two broad policy concerns about SWFs: (1) their lack of transparency and (2) their possible misuse for political or other non-commercial goals. Hearings have been held by several congressional committees including the House Financial Services Committee and the Senate Foreign Relations and Senate Banking Committees. SWFs pose a complex challenge for policy makers. investment vehicles looking beyond quarterly results and therefore serve as stable funding sources during financial turbulence. On the other hand, however, there are operational concerns stemming from government control (i.e., lack of transparency and possible non-commercial investment goals).Without transparency, it is difficult to attain a clear picture of SWF investment activity. A lack of SWF transparency can also obscure governance and riskmanagement On one hand, SWFs are long-term. Many are also concerned that countries will use SWFs to support what one analyst has called state capitalism, using government-controlled assets to secure stakes around the world in strategic areas such as telecommunications, energy and mineral resources, and financial In response to these concerns, many analysts and policy makers are evaluating the operations of existing SWFs and are looking to the international financial institutions such as the International Monetary Fund, World Bank, and the Organization for Economic Cooperation and Development to establish guidelines for SWF operations. All of these institutions are currently developing proposals that will be deliberated during 2008. This report will be updated as events warrant.

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What are SWFs?

Sovereign Wealth Funds (SWFs) are part of a countrys foreign exchange reserves that have been separated to invest in global equity, infrastructure, commodities and other financial instruments. Your country holds several billion dollars in forex reserves. Normally, these would just lie there, growing at a paltry interest rate. SWFs are a way to improve the countrys finances as well as hedge against future crises.

Whos using SWFs?

SWFs are not new; Kuwait and Kiribati have had them since the 1950s. Today there are 30 such funds in the world. Abu Dhabi, Norway, Yemen, Qatar, Saudi Arabia, China, Russia and Singapore are some countries that are successfully using this instrument. Abu Dhabi has the biggest, with over $600 billion being managed. Norway in fact has a fund of funds of sorts; it helps other countries invest their money. SWFs became famous when China bought up 10% of the American Blackstone Group for $3 billion out of its SWF. Soon after, Qatar bid to buy J Sainsbury, a British retailer. The West fears that emerging economies could buy out firms in sensitive sectors or take over their infrastructure. Also financial services firms are scrambling to position themselves as Sovereign Wealth Managers.

Nature and Purpose

SWFs are typically created when governments have budgetary surpluses and have little or no international debt. This excess liquidity is not always possible or desirable to hold as money or to channel it into consumption immediately. This is especially the case when a nation depends on raw material exports like oil, copper or diamonds.

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Other reasons for creating SWFs may be economical, or strategic, such as war chests for uncertain times. For example, the Kuwait Investment Authority during the Gulf War managed excess reserves above the level needed for currency reserves (although many central banks do that now). The Government of Singapore Investment Corporation is partially the expression of a desire to create an international finance center. The Korean Investment Corporation has since been similarly managed. There are several reasons why the growth of sovereign wealth funds is attracting close attention. First, as this asset pool continues to grow in size and importance, so does its potential impact on various asset markets. Second, and relatedly, some critics worry that foreign investment by sovereign wealth funds raises national security concerns because the purpose of the investment might be to secure control of strategically- important industries for political rather than financial gain. Third, sovereign wealth funds are not nearly as homogeneous as central banks or public pension funds. Fourth, are central bank reserve managers at least those among them who have accumulated massive foreign exchange reserves in recent years starting to act more like sovereign wealth managers?

TYPES OF SWFs:
The IMF divides SWFs into several categories based on their stated goals. In practice, however, many SWFs combine elements of the following three categories. The three primary types of SWFs, according to the IMF, are as follows: (1)Stabilization funds Volatile international market prices are a primary concern for resource- and commodity-intensive economies. fluctuations of an average of 20%-25% per year. To mitigate this volatility, several countries have established funds to sterilize capital inflows and stabilize fiscal revenues. Because stabilization funds serve a more immediate function than long-term savings funds, they tend to be more conservative in their

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investment decisions, focusing on fixed income rather than equity investments. Examples include Russias Stabilization Fund of the Russian Federation and Kazakhstans National Oil Fund. (2)Savings funds Savings funds are intended to share wealth across generations. For countries rich in natural resources, savings funds convert nonrenewable natural resources into a diversified portfolio of international financial assets to provide for future generations or other long-term objectives. According to the IMF, while newer oil funds predominantly focus on stabilization objectives, the recent increase in oil prices has allowed SWFs to emphasize savings objectives. Because savings funds have longer investment horizons than pure stabilization funds, they invest in a broader range of assets, including bonds and equities, as well as other forms of alternative investments, such as real estate, private equity, hedge funds, and commodities. Examples include the Abu Dhabi Investment Authority, Kuwait Investment Authority, Singapores Government Investment Corporation, and the China Investment Corporation. (3)Reserve investment corporations Reserve investment corporations are funds established to reduce the opportunity cost of holding excess foreign reserves or to pursue investment policies with higher returns. Reserve investment corporations adapt more aggressive investment strategies, including taking direct equity stakes. These funds typically seek higher returns than other SWFs and use leverage (i.e., debt) in their investments. Historically, theses vehicles tend to be more secretive than other SWFs that are primarily portfolio investors. Examples of such funds are Singapores Temasek, Qatars Investment Authority, and Abu Dhabis Mubadala. Among funds, there are substantial differences in risk-return profiles, investment horizons, asset allocation, eligible instruments, risk tolerances, and constraints. Because each fund is different and has varying goals and objectives, it is difficult to generalize about the investment strategies of SWFs as a class. For example, an oil-exporting economy may initially establish a SWF for stabilization purposes. However, if the assets under management by the SWF grow to exceed the levels needed for stabilization, the country may either change the priorities and investment strategy of the fund or establish a separate fund with a more aggressive investment approach. Thus, several countries have multiple sovereign wealth funds. For

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example, the United Arab Emirates primary fund, the Abu Dhabi Investment Authority (ADIA), was established in 1974 to invest surplus cash in assets that provide steady gains and returns over a long time-horizon using a portfolio investment strategy. In 2002, the United Arab Emirates established Mubadala Development to pursue direct investment projects targeted at higher returns.

Importance of SWFs:
A solution to the resource curse:
SWFs provide a natural solution to Resource curse problem. They could convert finite expendable natural assets into financial assets that generated returns in perpetuity. SWFs allowed resource exporters to switch from an unpredictable cash inflow that is limited in time to a well-diversified and a more stable cash inflow in perpetuity through a portfolio of financial and real assets. SWFs help to maintain export competitiveness as well. In an environment of high commodity prices, a sudden inflow of cash from export earning or fiscal surpluses into the real economy could overheat the economy through consumption bubbles and rising inflation.

Protection against domestic economic shocks:

SWFs particularly stabilization funds helped government of resource rich countries manage rapid fall in commodity prices and smooth out economic cycles. SWFs provide the necessary financing for fiscal stimuli and ensuring boost in demand, saving jobs and protecting against speculative attack on national currencies.

Bolstering national security:

SWFs could be a mechanism of national defense for smaller countries in politically unstable regions since their assets were difficult to seize. Investment abroad represented a reliable insurance policy against hypothetical foreign attack. These funds provide

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considerable assistance to the local government in rebuilding the national economy after the end of war.

A Caterpillar of Global financial Markets:

The global scope and connections of SWFs with institutional investors in particular entails greater exit opportunities for companies and lower the transaction costs in deals. Large investors can also benefit its shareholders as they are able to enter investment opportunities with illiquidity discounts. The larger the size of the capital deployment the fewer investors can afford it. This leaves SWFs as a sole potential investor in some opportunities resulting in favourable acquisition prices. An investment by SWFs in a firm can positively affect the firms value through signalling. SWFs played an important role in enabling the survival of financial services system in many incumbent centres during the financial crises by capital infusions.

Successful removal of capital constraints:

The amount of capital available with SWFs made them very suitable for large risky investment with expected late returns which would otherwise remain outside the scope of most of the funds. Large infrastructure projects in particular were in particular preferred domain of some funds. The capital available with SWFs vastly exceeded that of traditional sources of financing in emerging market like World Bank and the Asian Development bank.

Not at fault for their size:

Even though the size of SWFs indicated problem in the global economy, their prominence were more of a symptom that a root cause. It was pointed out by Goldman Sachs that the rise in the imbalances in the global economy and the SWFs investment in the world market restored balances.

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Criticisms Against SWFs

Bad investment managers:
As other state owned institutions SWFs are poorly run and generate less value than the private sector alternative would do. The $127 million investment of SWF investment in publicly listed companies suffered close to 57 billion in mark to market losses. SWF agreed to buy minority holding at $32 per share only to see the stock price fall below the dollar within a year. The disclosure by some of the biggest SWFs indicates that they are fulfilling their mandates with at least moderate success.

A cause of asset bubbles:

SWFs were accused of being partially responsible for financial bubbles. For instance During the oil price hike in 1970s, SWFs from the oil exporting countries invested their money with global investment bank which channeled a lot of capital in Latin American government debt. In response to high inflation caused by oil price increase the European central bank and US Federal Reserve raised their interest rates in 1980s. Latin American government saw their currency depreciate against US dollars and ended up in untenable debt payments.

Too big to fail.too:

SWFs justified their use of debt financing with a very favorable interest rate they could obtain. In addition debt financing had clear benefits in bringing market discipline to the funds, forcing them to improve corporate governance and solidify their risk management practices. However an appropriate level of leverage for SWFs remains a subjective decision for fund managers or by government officials. SWFs could become indistinguishable in capital structure from hedge funds, but their much larger size bore greater systemic risk.

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Political Motivation behind investment:

Empirical studies confirm that there is no statistical difference between investments of publicly known SWF investment and a control group of mutual fund. However some evidence support that SWF has political motivation behind investments for example in recent investment transaction Chinas state Administration of foreign exchange agreed to purchase $300 million in bonds from Costa Rica on the condition that Costa Rica switch diplomatic ethics. recognition from Taiwan to Peoples Republic of China. SWF deals also came under scrutiny for placing too little and too much importance on

Insufficient Transparency:
SWFs was accused for the of lack of transparency but earlier GPF had praised SWFs that it is more transparent, more accountable and has clearer governance structures than many private institutional investors. But the fear that transparency might diminish long term returns. It may also discourage fund managers from taking up good investment opportunities if they involved short term risk and subsequent pressure from the public. Recently SWFs had welcomed the idea that greater transparency was desirable. Most published annual reports and an increasing number were reporting the size of assets under management. Very few of the largest one though disclosed all their investments.

A trigger of financial protectionism:

Free market advocates that SWFs might inadvertently encourage capital account protectionism, through which countries Pick and choose who can invest in what. Financial protectionism could hurt the effectiveness of global capital markets and result in inefficient capital allocations thus slowing global growth. However critics blame that greater transparency would go a long way in fending off protectionism.

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Conclusion
To bid for strategic resources across the world, a system of coordination and cooperation between ministries and public sector undertakings, standardized legal and financial structures should be in place. This does not suggest a need for an Indian sovereign wealth fund it suggests the need for broad-ranging reform on strategic investments by public sector companies, their financial capabilities and strategic coordination across different ministries. This could very well be served through an empowered group of secretaries of relevant departments and ministries, than set up a new institution by way of the proposed fund. Last but not the least there are three elements that define an SWF: Ownership: SWFs are owned by the general government, which includes both central government and Sub- national governments. Investment: The investment strategies include investment in foreign financial assets, so it excludes those funds that solely invest in domestic assets. Purpose and objectives: SWFs are created to invest government funds to achieve financial objectives and have liabilities that are only broadly defined thus allowing SWFs to employ a wide range of investment strategies with medium to long term timescale. While SWFs may include all reserve assets the intention is not to regard all reserve assets as SWFs.

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