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Financial Institutions and Markets

Analysis and Discussion Of SOVEREIGN WEALTH FUNDS In the World Financial Markets

Submitted By: Sachin Pal Ritesh Khanna Karishma Khokhar Simran Preet Kaur 11FN-085 11IB-047 11FN-053 11FN-105

Chellu Chanakya Raja 11IB-015


18th Feb 2013

Outline of the Project

1. 2. 3. 4. 5. 6. 7. 8. 9.
Introduction to Sovereign Wealth Funds Types of Sovereign Wealth Funds Major Factors that impact the size of Sovereign Wealth Funds Comparing Sovereign Wealth Funds to other types of funds Investments of Sovereign Wealth Funds Concerns raised about Sovereign Wealth Funds Economic Implications of Sovereign Wealth Funds Impact of the recent Financial Crisis on the Sovereign Wealth Funds Major Sovereign Wealth Funds of the world 3 4 5 6 7 9 10 12

o China SWF o Singapore SWFs o Middle Eastern SWFs 10. 11. 12.
Analysis of Indian case for SWF and developing investment model Countries which can develop SWF References

14 15 17 18 21 23

Introduction to Sovereign Wealth Funds

The first Sovereign Wealth Fund was started in the year 1953 in Kuwait. Initially the Sovereign Wealth Funds were started mainly by the Oil Exporting countries. Sovereign Wealth Funds are state-owned investment funds. They invest

in financial assets such as stocks, bonds, property, precious metals or other financial instruments. Sovereign wealth funds invest globally. They are used by countries to maximize their long term returns on the foreign currency holdings. Instead of keeping the excess money in the central bank or plugging it back into the system, a country may choose a Sovereign Wealth Fund to put it into investments. Sovereign Wealth Funds are funded by foreign currency reserves but managed separately from official currency reserves.

Since 2000 the number and size of Sovereign Wealth Funds has grown at phenomenal rate. IMF, in 2008, had estimated them at about US$ 2-3 trillion and states that it expects the Sovereign Wealth Funds to reach around US$ 10 trillion over the next decade. Currently around 20 nations in the world hold a Sovereign Wealth Fund, with the top five funds holding about 70% of the assets under management. A comparison of global financial assets (in $ trillion) is given below that highlights the importance of Sovereign Wealth Funds in todays world (2008 figures).

$48.1 Retirement Funds AUM Projected Sovereign Wealth Foreign Exchange Reserves Sovereign Wealth Funds Hedge Funds AUM Private Equity AUM $23.6 $7.5 - $10.0 $5.4 $3.0 $1.9 $1.3

Types of Sovereign Wealth Funds

The following classifications are available for Sovereign Wealth Funds:

Commodities: These SWFs are either owned or taxed by the government and are created through surplus forex earnings through commodity exports. Over $2.5 trillion in value in 2008 NonCommodities: These SWFs are created by transferring assets from official exchange reserves, i.e. assets accumulated as a result of current account surpluses. $1.4 trillion in value in 2008

Stabilization Funds: To insulate the economy against the commodity price swings Savings Funds: To enable savings for future generation through a diverse portfolio of assets Reserve Investment Corporations: Have higher risk, but established for higher return on reserves Development Funds: To fund the countrys domestic socio economic projects Contingent Pension Reserve: For financing health expenditures and social security, especially in countries with an ageing population

Major Factors that impact the size of Sovereign Wealth Funds

1) Price of Oil Oil or commodity stabilization funds are largest subgroup of SWF Fast accumulation of foreign reserves by the oil exporting countries - Due to booming oil prices, cheap credit and momentum driven capital flows Keen not to repeat the mistakes of the last oil boom in the 70s, so they established Sovereign Wealth Funds to preserve oil wealth for future generations and/or to smooth consumption

a) b) c)


Contingent spending policies of oil stabilization funds (accumulating wealth when oil prices are rising and spending wealth to support the local economy when GDP is shrinking) it becomes important to understand the magnitude and the relative importance of oil price shocks relative to other sources of macroeconomic risk


Oil price innovations are the most important short and long-term economic drivers of local GDP for GCC (Gulf Cooperation Council) countries. Investment guidelines- Stress on the necessity to invest in assets with negative correlation to oil price movements to protect the total wealth


Fiscal Situation of a country If a country is facing fiscal difficulties and it faces large fiscal deficits, then it becomes very difficult for such countries to maintain the size of the government owned Sovereign Wealth Funds. The government usually needs money to help finance such deficits and improve the economic condition and so they need to liquidate a portion of these funds



Economic Cycle The financial crisis of 2008 had a negative impact on all the SWFs in the world. Depression causes lower global trade reducing the current account surplus of countries like China, etc. This negatively impacts the size of Sovereign Wealth Funds



Current Account Balance

a) b) c)

Established by countries which enjoy a current account surplus Have led to a build-up of foreign currency reserves in these countries Since 1995, reserves have more than doubled but the currency reserves in developing economies have increased sevenfold Asian exporting countries combined current account surpluses grew from $53 billion in 2000 to $443 billion in 2007. The U.S. dollar accounted for slightly less than two-thirds of total central bank foreign reserve holdings of all the countries as of the first quarter of 2008


Foreign Exchange Reserves of a Country

a) Major exporting nations or natural resource (like oil, etc) providers may accumulate large
amounts of FOREX reserves

b) Nations invest their foreign exchange reserves in assets such as the sovereign debt of
other countries, including securities issued by US Treasury

c) Some countries invest a portion of their excess foreign currency reserves in assets which
would earn higher returns, such as the equity shares d) These especially include countries that are major exporters of commodities or natural resources, such as oil, as well as those, like China, that are exporters of manufactured goods.


In contrast US, the worlds largest importer of goods and natural resources, has run increasingly large current account deficits since the early 1990s

Sovereign Wealth Funds vis--vis other type of funds

The key aspect in which Sovereign Wealth Funds differ from other type of funds (Hedge funds, Pension funds) is the objective of the investment:

1. Accumulate sufficient assets, through contributions and investment income 2. Satisfy all pension obligations of the contributors on a timely basis 3. Primary aim of most hedge funds is to reduce volatility and risk 4. Preserve capital and deliver positive returns under all market conditions

Unlike the aforementioned objectives of different funds, the aims of SWFs are as follows

Comparison of investment vehicles

1. SWFs exceed the size of hedge funds (around US$1.7 trillion), but comparison is
somewhat misleading because of leverage

2. SWF Portfolios are more diversified than traditional reserves holdings 3. Greater Stakes in Equities and Wider Geographical Dispersion than other forms of
investment funds 4. Market Participants expect SWFs Portfolios to look like those of the larger Public Sector Pension Funds

5. Some SWFs are also exploring Alternative Investments, including Hedge Funds,
Private Equity, and Real Estate The following are the risks involved in SWFs which could culminate into a National Security Risk

Investments of Sovereign Wealth Funds


The Investment Behavior of Sovereign Wealth Fund is determined by the investment objectives. The objectives determine the Investment Horizon and the Risk/Return Trade-offs. Singapore SWFs are the most active internationally - oriented funds and the Chinese fund has focused on the home market front. Norways Government Pension Fund-Global is the worlds second largest SWF. The fund subcontracts out all of its investments to asset managers, and so the fund is never listed. SWFs favor investing in the financial industry. The 376 financial firm investments account for 30.9% of all deals, by number, and over half (54.6%) of the value of all acquisitions. Singapore receives the largest number of SWF investmentsmostly from Singaporean SWFs total value of investments ($13.23 billion) yields sixth place ranking. United States is the most popular target for SWFs with 10.9% of the number and 22.2% of the total value of SWF investments being channeled to US headquartered companies. China is the second most popular target nation, though almost all of the 79 deals worth $31.0 billion are domestic investments by the China Investment Corporation Apart from investing in a few home-country firms, it seems clear that SWFs prefer to purchase stock and real estate in the capital markets of the principal English common law countries: America, Britain, and Australia.

Temporal Distribution OF Sovereign Wealth Fund Investments, January 2000-Dec 2008 Source: SOVEREIGN WEALTH FUND INVESTMENT PATTERNS AND PERFORMANCE (Apr 2009) by Bernardo Bortolotti, Veljko Fotak, William Megginson and William Miracky

The graph shows the massive spike in SWF investment in 2007 (and 2008) versus previous years, as well as the rising share of financial deals in aggregate investment value

Concerns raised about Sovereign Wealth Funds

Transparency/ Poor Accountability

1. Distinct policy concerns about the effects of SWF investment 2. May pursue political objectives or policies that are not strictly financial 3. Few publish information about their assets, liabilities, or investment strategies 4. Rogue traders have taken large speculative positions and lost heavily. Traders acted without
the approval of the appropriate credit risk managers.

5. Largest share of assets is with the countries in which the state has played a dominant role in
the society and the economy; and where representative institutions are relatively less established Global Macroeconomic Stability

1. 2. 3.

Macroeconomic imbalances - Over-consumption by the United States, and mercantilist policies of North-East Asian countries, particularly China. Continued acquisition of excess reserves and policies to maintain under-valued currencies, perpetuate imbalances and adversely impact on financial stability Mitigated by provision of liquidity that the SWFs can potentially provide

Conflicts of Interest, Potential Insider Trading and Regulatory Effectiveness

1. 9

When governments which are regulators become investors

2. 3.

SWFs as government agencies could have access to commercial and security sensitive information. Could also lead to insider-trading Prosecuting officials of foreign governments - Diplomatic dilemma


Protectionist reaction by the investee country government Countries pick and choose who can invest in what

Exercising Influence as a Shareholder

Shareholders with even seemingly small ownership percentages could exercise influence disproportionate to their shareholding Use their influence in a company to:

extract technology protecting their national industries from competition

Disguised Political Objectives

If the governments will use the SWFs simply as financial tools or to implement political power Political objectives might influence their management Use funds to create artificial monopolies Transfer of strategic assets Key industries and technologies Trade & state secrets Natural resources

Economic Implications of Sovereign Wealth Funds

Increase in demand for capital market products

1. SWFs enjoy considerable freedom in their investment decisions and are expected to
maximize performance, hence a substantial inflow of funds from SWFs in emerging economies expected


2. In their asset management, SWFs behave similar to investment, pension, hedge or private
equity funds; therefore, they are seeking to diversify across a wide range of asset classes in different countries. 3. This suggests that SWF growth will likely lead to an increase in demand for stocks, private and public bonds, as well as real estate, but also private equity, possibly also funds or hedge funds, as well as the use of derivative instruments. Substitution effects on asset classes

1. The investment of official central bank reserves in liquid assets will be replaced by
investments in assets with higher expected returns, i.e. stocks or private bonds

2. This may have a perceivable impact on market demand and yields

Demand for asset management and investment services

1. SWFs have the choice of outsourcing all or a part of their funds to outside fund
managers; can purchase parts of the asset-management value chain from independent suppliers

2. Market analysis and investment evaluation, portfolio construction and monitoring,

securities trading, clearing and settlement, hedging and risk mitigation are services which will pick up

3. Complex investment banking services like advisory, valuation and due diligence, legal
and accounting advice, placement and distribution, and settlement services will incresae

Impact on exchange rates and asset prices 1. Impact asset prices and exchange rates through price pressures or a change in risk
aversion 2. A direct impact on asset prices or exchange rates through price pressures triggered by SWF demand (e.g. equities) or supply (e.g. government bonds)

3. Impact on asset prices through a rise in global risk aversion, given their return-orientation
and longer-term investment horizon. Potential risks to international financial stability 1. Triggering herding behavior


Large sums of capital are concentrated in the hands of a limited number of large actors. In the absence of SWFs, these surpluses would be distributed among domestic citizens The presence of a large player with a high-risk appetite can induce market behaviour that could lead to a negative outcome. 2. Lack of transparency and short-term volatility Inducing other traders to mimic strategies, leading to greater buying or selling on one side of the market Since SWFs have become more widely known, many analysts have tried to anticipate their strategies, based on the investment strategies of similar institutional investors. The lack of transparency about the holdings of SWFs introduces an element of uncertainty into markets 3. Non-economic objectives and financial protectionism A protectionist backlash against SWFs would restrict cross-border investment and slow economic growth. The reaction of Western states to SWF investment may lead to the adoption of barriers, preventing the free movement of capital 4. Investor activism and monitoring of managers Many SWFs have done their utmost to prove that they will be passive investors, including forgoing any voting rights. While this may ward off protectionist sentiment, it may also impede the monitoring of managers. When a company experiences large capital losses, more active investors usually push for some sort of reform to avoid losses in the future

Impact of the recent Financial Crisis on the Sovereign Wealth Funds


Not all SFWs suffered equally, Libya's SWF ($50.6 billion) returned profits of about $2.4 billion since 2006, (78% of the portfolio invested in short-term financial instruments and only $8 billion in equities, spread mostly across North Africa and Asia.)

The Saudi Arabian Monetary Agency (SAMA), did not lose much due to its conservative dollar-and-bond-heavy portfolio. Lessons learned : Spurred SWFs to rebalance their portfolios within individual asset classes,

o Moving developed market investments away from equities and towards bonds. 13

o Allows SWFs to increase their holdings of more liquid bonds, without sacrificing
their other developed and emerging market investments; perhaps showing that SWFs believe the prospects for growth among higher-risk and higher return equities are highest outside the US. Despite global crisis, SWFs have continued to follow two core investment mantras (1) Capitalising upon short-term market lows for long-term gain (2) Investing in industries that help build the comparative advantage of the home country

These mantras may not be the best strategy. : Sovereigns are more likely to call upon
SWFs for domestic stabilisation purposes.

SWFs will need to hold a large share of counter-cyclical assets to avoid realising large

Real estate, commodities and direct investments in firms that enhance a sovereigns
comparative advantage tend to move pro-cyclically with the SWFs domestic economy.

Hence SWFs face a pull between market opportunities, and core investment

Lastly, sovereign governments have re-evaluated the management and oversight of


Slowdown may only be transitory. - High commodity prices return and large global
imbalances will increase the volume of their inflows. Strong inflows into SWF is very likely: (1) Unwillingness of Chinese policymakers to alter their currency peg (2) Continued rise in commodity demand (3) Nascent stage of renewable energy technologies


Major Investments:

1. Implications for Chinas economy: a. New vehicle for managing forex reserves; soak up excess liquidity b. Prevent domestic inflation or speculative bubble in China due to excess money supply c. Reduced pressure to appreciate currency (allegedly undervalued) d. Accumulation of US debt with excess money not very profitable; gives the government to earn a positive rate of return on investments

2. Implications for Global Financial Markets and the US Economy:

a. Types of investments made is a critical issue b. Shift in portfolio from US treasury to other assets could lead to upward pressures on the interest rate (currently Fed trying to bring them down) c. Purchase of strategic assets for geopolitical purposes will raise security concerns


Singapore Sovereign Wealth Fund

Portfolio Investments by Geography Majority of the holdings are in the emerging economies of Asia, a large part is in Singapore itself.

Portfolio Investments by Sector It has a diversified portfolio with investments in varied fields. Government of Singapore Investment Corporation


It is a global investment management company founded in 1981. Its main aim is to manage Singapore's foreign reserves. It invests in equities, fixed income, natural resource, treasury & currencies, real estate, private equity and infrastructure. GIC Investment Process The aim is to construct a diversified multi-asset class portfolio alternative real estate. In 2009-10 the Portfolio underwent a loss of more than 20%. by increasing investments

such as private equity and



GIC had invested in UBS and Citigroup to a large extent. During the financial crises GIC converted its preferred stock holding to common stock at a price of USD 3.25/ share to reduce their loss.

Middle East Sovereign Wealth Fund

Structure of Sovereign Wealth Funds (mid 2008)
Structure of SWFs (mid-2008) USD bil. Oil and commodities 1,752 Other 1,009 Own funds Borrowed funds Pure SWFs Stabilisation funds Saving funds Emerging markets Other Middle East Emerging Asia Advanced economies Other 2,365 395 2,297 277 186 2,236 525 1,061 928 525 246 % 63 37 86 14 83 10 7 81 19 38 34 19 9

Investment Strategy & Objectives The Kuwait Investment Authority is a long term investor. Objectives include Maintaining the real value of the funds entrusted to the Office for the Future Generation Fund, Achieving a fair return over the long-term Increase the favorable reputation as an expert and progressive institution in the international financial markets. Investment Strategy and Objectives The Abu Dhabi Investment Authority invests in a variety of asset classes. Benchmarks can range from the MSCI Index to the S&P 500 Index. Some of their asset allocation consists of: Equities Developed Markets


Equities Emerging Markets Hedge Funds Futures Sovereign Debt Corporate Debt Real Estate (Funds or Direct Investments) Private Equity Infrastructure

Analysis of Indian case for SWF

Major reasons for building Sovereign Wealth Funds: Excess Foreign Reserves: India needs to park their excess reserves as there is a cost involved in maintaining such reserves/ liquidity which is the loss of possible returns. Better Management of foreign Reserves: The foreign reserves could be invested for long term in slightly risky and illiquid assets which can provide better returns. The Sovereign Wealth Funds of Singapore has managed to gives returns in excess of 15% for many years. Acquiring Strategic Assets: SWF help the domestic companies to arrange the necessary funds to acquire these assets. The China Investment Corporation (CIC) is mainly investing in the Power Sector trying to acquire strategic assets abroad. Major arguments against creating a Sovereign Wealth Fund: Indias reserves are built from capital account inflows and are hence assets that are subject to capital flight:

India has huge merchandise trade deficit and current account deficit whereas reserves of other countries have been built up from huge current account surpluses.


Indias reserves are driven by capital account surpluses rather than the current account. Hence they is need to maintain reserves in liquid and lower-yielding assets Sovereign Wealth Funds usually make illiquid, long term investments.

Political Independence in Management and formation: Control of the RBI or the Ministry of Finance. Fund will be managed too cautiously affecting the returns of the fund. If the investments are not made for a long term horizon in some slightly risky assets then the entire purpose of creating such a fund will be defeated. Concerns about accountability and fiscal indiscipline Direct investment in strategic assets by a Sovereign Wealth Fund will invite severe criticism for its alleged non-commercial and political objectives. Santiago Principles Difficulty in acquiring Strategic assets:

Possibility of huge losses:

No guarantee that the investments made by the Indian Sovereign Wealth Fund will be

During the global financial crisis, Sovereign Wealth Fund from West Asia, Singapore, China and Norway suffered huge losses in their investments in Western banks and private equity funds. Global SWFs China CIC AUM Source of Countrys SWF Additional Capital Investment Strategy $ 200 Bn Current Account Surplus Middle East Gulf Cooperation Council More than $ 2000 Bn Oil and commodity based SWF Low proportion of funds borrowed from outside Different investing strategy - LT to Singapore Temasek $ 186 Bn Current Account Surplus Funded through dividends, divestment earnings Asia focused fund ; in the sectors of Singapore GIC $ 124 Bn Current Account Surplus Funded through dividends, divestment earnings of PSU Focus on diversifying and

Special bonds issued worth $ 207 Bn 2/3 Capital in US


Treasury Bills Focus on real Estate, natural resources and telecommunications

speculative and hedging purposes Asset Allocation consists of equities, futures, sovereign debt

financial services, telecom , media and transport

investing in alternative investments like real estate and private equity

Is India setting up a Sovereign Wealth Fund? In a recent report by SEBI in 2009, the SEBI has recommended the government not to set up a Sovereign Wealth Fund. According to the Indian express July 20, 2010, a proposal for setting up a sovereign wealth fund (SWF) is expected to be put before a group of ministers. It was reported in the newspaper that the Sovereign Wealth Fund will be created with an investment of $10 billion. An Indian Sovereign Wealth Fund would be a pool of money, controlled by government, which will be used to purchase overseas assets. This idea is weighed down with difficulties in the context of poor governance in India. The main reason quoted for setting up this fund was to help Indian companies acquire overseas assets. Size and Investment Strategy of the Indian Sovereign Wealth Fund

Close to 1015%of Reserves should be used

Part of the Reserves

Invest Through PSU

Strategic Assets EgOVL

Invest in equities , Asian companies


Size of Investment: India should use only 15% of reserves for investment. This is because India has current account deficit and does not want to take the risk of a heavy loss.

Mode of Investing:


Indirect: Acquiring strategic assets is a bone of contention among many a nation, PSUs

can be use in this purpose. Like Temasek, can run them professionally and divest them Investments:

The eastern European and African countries are mineral rich. China has already acquired natural resource asset in most of Africa. India through its PSU s like OVL needs to use the funds of SWF to acquire natural resources like oil fields, coal fields

India should not invest so heavily in alternative investments. This is because Private equity companies are not transparent; hence there is no knowledge of what India is investing in

India should invest in long term projects, similar to CIC like European power plants and renewable energy plants.

In case India wishes to invest in corporations, India should follow Tamasek and focus on the Asian corporates as their growth prospect is very strong

India should diversify as much as possible to increase return India should try to establish an independent management and accounting system

Countries that can develop SWFs

We have tried to analyze which other countries can develop a Sovereign Wealth Fund. The following procedure has been followed for the analysis: 1. We started with a list of countries without SWFs and proceeded towards collecting their reserves, imports, short term debt and long term debt figures 2. 12 month imports and short term debt figures were directly subtracted and those countries falling short and ignored for further analysis 3. Long term debt is amortized for 10 years and interest is calculated using 1y LIBOR and those countries found unable to service these liabilities are further removed from the study (assuming 50% of LT debt is being serviced through reserves) 4. After deduction, 15% of remaining amount is taken as the corpus for a potential SWF


Limitations of the study 1. Country Macro-economic parameters are not taken into account. These may restrict forming SWF or may facilitate it 2. We have not taken fiscal deficit and the source of reserves into account in the analysis 3. Volatility of reserves is also not taken into account. This may affect the sustainability of the SWF



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