Sovereign Wealth Fund

The rapid globalization of international finance is a salient feature of the early 21st century. The phenomenon has been promoted by technological innovation, substantial elimination of restrictions on international capital flows, and the conviction that those flows reflect individual decisions of multiple private investors responding to market forces.

One of the most striking developments over recent years has been the emergence of dedicated government investment vehicles as an important investor class. These so?called ‘sovereign wealth funds’ (SWFs) have grown rapidly both in size and number, fuelled by a sharp and sustained rise in energy and commodity prices and by large current account surpluses among the export?oriented economies of East Asia.

2. Concept of Sovereign Wealth Funds.

 

At its broadest level, the term sovereign wealth fund (SWF) refers to any government?controlled fund that manages and invests government savings, regardless of the revenue source. A narrower definition focuses on government investment vehicles which are funded by foreign exchange assets, but which manage those assets separately from official reserves. These foreign exchange?based SWFs generally fall into two categories based on the source of the foreign exchange assets: 

• commodity funds are established from the proceeds from commodity exports, either owned or taxed by the government; and

• non?commodity funds are typically established through transfers of assets from official foreign exchange reserves.

Truman (2007a) has defined “Sovereign Wealth Fund” as a pool of domestic and international assets owned and managed by governments to achieve a variety of economic and financial objectives, including the accumulation and management of reserve assets, the stabilization of macroeconomic effects and the transfer of wealth across generations.

3. Current Scenario.

The researches conducted by International Monetary Fund (IMP) have identified 32 active Sovereign Wealth Funds in 29 countries. Their international assets total about $2 trillion. Five countries have funds with holdings of more than $100 billion. The first fund was created by Kiribati in 1956 to manage revenues from its phosphate deposits. A number of them were established in the mid-1970s. Ten have emerged since 2000. As the proportion of cross?border capital flows directed via these funds continues to grow they are also becoming an important part of the debate over broader global saving and investment imbalances.

Many of the commodity?based SWFs — such as the Abu Dhabi Investment Authority, the Norwegian Government Pension Fund?Global and the Kuwait Investment Authority — have been in existence for many years. They were originally created for the purposes of stabilising fiscal revenues, intergenerational wealth transfers, or for balance of payments sterilisation. However, given the sharp and sustained rise in commodity prices over recent years, many funds initially established for fiscal stabilisation, but now have the ability to absorb a greater  degree of short-term asset return volatility and may be prepared to buy during periods of asset price weakness, thereby providing market liquidity in times when it is most needed.

Three important drivers of the recent growth in East Asian SWFs can be identified:

• the accumulation of ‘excess’ foreign exchange reserves in the course of defending hard (or soft) currency pegs;
• the desire to seek higher returns on reserves to cushion actual and anticipated increases in reserve funding costs; and
• the quantity of outstanding mature market bonds is increasingly insufficient to meet demand from official reserve investors, including SWFs.

 4. Key Concerns.

 

Sovereign wealth funds and other substantial government holdings of international assets pose many challenges for the citizens and governments of the owners of the assets, for the citizens and governments of the countries in which they are invested, and for the smooth functioning of international financial markets. Many of those challenges flow from the fact that the operations of sovereign wealth funds are often obscure. They lack structures that are transparent and management processes that are domestically and internationally accountable. This contributes importantly to additional potential concerns.

The scope and scale of sovereign wealth funds also increase the potential for deliberate or accidental financial disruption. In a period of global financial turmoil such as we have witnessed in the past few months, would the managers of those funds can be counted upon to act in a stabilizing manner or not will be of key concern.

Good Corporate Governance of sovereign wealth funds a key issue. It provides the check and balances that ensures that organizations are running effectively and in accordance with the stated objectives of their owners. The government-run investment pools are not new, but their scope and scale are expanding rapidly. Consequently, they are a source of uncertainty and potential instability for the countries sponsoring the funds as well as for the international financial system. Policymakers can ignore them no more and leading to calls for the funds and their government masters to clarify their practices and intention. In view of the importance of SWFs, the International Monetary Fund (IMF) has recently set up an International Working Group of SWFs to formulate a set of principles to reflect investment practices and objectives.

5. Possible Best Practices for addressing key concerns.

 

The best practice in the management of cross-border investments by SWF and similar entities should cover four basic elements:

 

• First, best practice should establish clearly stated policy objectives for the international investment activities of governments. Their fiscal treatment should be specified, including how the funds are incorporated into the investment portfolio, and how the earn­ings on and/or principal of the investments should be spent or redeployed. At the same time, principles of sound public policy suggest that the structure should not be modified frequently or capriciously.

 

• Second, best practice should clearly establish the roles of the government and of the managers of the investment mechanism. How are the policies set? Who executes polices? What types of assets should be included in portfolios? How should the assets be managed? Accountability arrangements should be in place at each stage of the process. To the extent that the international investments are anything other than passive investments in financial assets (bank deposits, government notes and bonds, or nonvoting shares), guidelines for corporate governance should be established along with responsibility for ensuring compliance.

 

• Third, the operations of the investment mechanisms should be as transparent as possible. Transparency promotes horizontal accountability among the interested parties and stakeholders (domestic and international) as well as vertical accountability within the policy process. In practice, transparency should involve at least annual reports and preferably quarterly reports. The activities of investment mechanisms should be subject to published, independent audits.

 

• Finally, depending on the type of mechanism, its size, and the scope of its activities, behavioral guidelines for its management should be established. For example, they should cover the scale and rapidity with which the entity adjusts its portfolio.

 

The agreed set of best practices should be applied flexibly. The basic case for the proposed approach rests on two principal considerations: accountability and protection.

 

Accountability is important to the citizens of the home country as well as to the citizens of the host country (who may distrust the motives of the foreign government). Protection is important for the managers of the investment entity. The broader the investment strategy of the entity in terms of the risk-reward tradeoff, the more likely it is that losses will be made from time to time along with higher overall returns.

6. Indian Scenario

 

The concerns where pushed into headlines when Finance Minster P. Chidambaram said in Rajya Sabha on May 7, 2008 that “The government has no plans to establish a sovereign wealth fund at present” as the Prime Minister’s Council on Trade and Industry has, in its meeting held on December 18, 2007, suggested that there is need to create a sovereign wealth fund of $5 billion to begin with for financing acquisition of companies abroad. Even Reserve Bank Governor Y.V. Reddy had said, “India is watching with great interest the development of global codes, standards and practices in regard to SWFs, both in view of the presence of SWFs in the Indian financial market and the ongoing debate on establishing an Indian SWF”. Sovereign Wealth Fund of foreign countries can be register as Foreign Portfolio Investors with Securities Exchange Board of India (SEBI), as the capital market regulator have moderate the norms to invest in Indian stock market.

7. Conclusion

 

As sovereign wealth funds assets fall out of reserves, even if perfectly appropriate from a statistical perspective, they also risk falling out of mechanisms that the international financial system has for reserves transparency. The challenge of sovereign wealth funds can be met best by the governments of the countries that own them acting together to establish a set of best practices for the management of their funds and similar holdings. SWF may be prepared to buy during periods of asset price weakness, thereby providing market liquidity in times when it is most need. They have played a somewhat unexpected stabilizing role, by providing the funds that have helped to stabilize the developed countries’ banking system during the current world financial turbulence. And they have also generated an important opportunity to increase financial cooperation among developing countries, both on a regional basis but also on a broader scale.