Role and risks of sovereign wealth funds
S. Venkitaramanan
The latest issue of Finance & Development, an official publication of the International Monetary Fund, has an authoritative article on the rise of sovereign wealth funds — funds owned by State Governments of countries.
It is significant that the IMF has chosen to recognise the issues regarding the role of sovereign wealth funds, modelled on Singapore Government Investment Corporation’s experience — mostly formed out of current account surpluses and invested in debt and equity stocks of other countries, mostly richer economies.
The article, authored by Mr Simon Johnson, Counsellor and Director of the IMF’s Research Department is a cogent summary of the issues posed by sovereign wealth funds on the global financial scenario.
Size of the pool
As the article points out, sovereign wealth funds have existed since the 1950s, but their size worldwide was $500 billion. The current level is $2 to $3 trillion. Based on current expectations of current account surpluses of various countries, including raw material exporters, the size may well cross $10 trillion by 2012.
At present, more than 20 countries have set up these funds. A dozen more have expressed interest in establishing them. Still, the holdings are mostly concentrated with the top five funds, accounting for more than 70 per cent of the total assets under management.
Over half of these assets are in the hands of countries that export a significant amount of oil and gas. Countries ranging from Norway to Trinidad, including Russia, China and Australia figure in this list. More than a third of these assets are held by Asian and Pacific countries, including Australia, China and Singapore.
Whether the current pool of sovereign Funds is too large or of tolerable size depends on the basis of comparison. In relation to the US’ GDP of $12 trillion, $3 trillion is not too large. The total value of debt and equity securities denominated in US dollars is expected to be more than 50 trillion.
The global value of traded securities is about $165 billion. In this context, 3 trillion is not huge. The fear of sovereign wealth funds forming a threat to the financial stability of global markets may, therefore, be far-fetched.
Their size is, however, significant in relation to the size of emerging country markets estimated at around $4 trillion — that too only for Africa, West Asia and emerging Europe. As against the assets under management of sovereign wealth funds, the assets under management by private hedge funds and private equity funds is estimated at around $2 trillion.
The hedge funds factor
The debate about the risks and opportunities of sovereign wealth funds is similar to that ongoing in the US and the EU about hedge funds. One of the problems about hedge funds is that their operations are opaque and they are not regulated by any single authority.
The same could apply, with some modification, to sovereign wealth funds, except that Singapore publishes its balance-sheet and details of assets under management periodically. One may also ask whether a Sovereign who owns the funds can be meaningfully regulated by any authority other than a multilateral organisation.
It is clear that sovereign wealth funds also operate through hedge funds, and in one or two cases, through private equity companies. They invest their resources in these high-return entities. They also leverage their resources by raising debt against their contribution.
If this leverage — borrowed funds against the sovereign wealth fund’s assets — is taken into consideration, the impact of sovereign wealth funds can be considerably higher than the $3 trillion mentioned earlier. Estimates range up to a much higher order of magnitudes. Given this background, the order of magnitudes of resources managed through Sovereign Wealth Funds also becomes more serious in its implications.
In this context, the debate about regulation of hedge funds is relevant. (This has, incidentally, some relevance to the recent Indian debate regarding Participatory Notes.) The Finance & Development article points out that while there is a degree of doubt about regulating hedge funds, the establishment opinion is veering round to the view that it is the banks that lend to them that need to be regulated!
This is stated to be a solution of choice in the interest of innovation associated with hedge funds, although the price of innovation is higher risk to the financial markets.
As regards the Indian debate on Participatory Notes, the doubts of the regulator are centred on the anonymity of contributors to funds, which end up in Participatory Notes. It may well be that Sovereign Wealth Funds are themselves among the sources of funds for hedge funds. This adds yet another piquant element to the question of what funds Participatory Notes.
Two sides to the tool
It is interesting that apart from the risks posed by sovereign wealth funds, the article in Finance & Development raises the issue of what risks sovereign wealth funds face. The risks are endemic to the design of hedge funds.
The article cites that one sovereign wealth fund was involved in the historic debacle of Long Term Capital Management, an episode that took place in the eighties. Involvement of sovereign wealth funds in hedge funds is, indeed, an important issue that the article mentions. Not much information is, however, given about the extent of irregularities of sovereign wealth funds as compared with those that occurred in hedge funds.
In general, the article is fair to sovereign wealth funds, in so far as it goes on to say that these funds have a good tendency to go long on securities, that is to say, they buy and hold or stay invested for longer periods. This way, they may be a more stabilising influence on stock markets. The same cannot be said for the hedge funds through which some of them operate.
The article raises the question of what dangers lie ahead and what the IMF can do about it. The piece mentions the dangers of rogue traders, who may take risky positions using their command over Sovereign Wealth Funds.
This requires great care in fund governance. Apart from this, the author points out that sovereign wealth funds may lead to emergence of financial protectionism, in the sense that various countries may try to pick and choose what fund can invest where. Further, there are questions of national sovereignty.
Here to stay
The article, however, dismisses the need for any dramatic action. That is all to the good. It points out that sovereign wealth funds are a throw-back to the end of the nineteenth century, when large pools of capital moved around the world with unregulated ease and generated a global boom, rapid productivity growth, and a fair number of crises.
The author rhetorically asks, referring to sovereign wealth funds, what happens when the twenty-first century State-owned funds meet the nineteenth century private sector.
He misses the fact that the twentieth century innovations of hedge funds and private equity funds have intervened between the two eras.
The solution lies in not targeting the Sovereign Wealth Funds but in handling the demons of the markets’ own design.
My conclusion on perusing the Finance & Development article is: “Blame not the sovereign wealth funds. They are here to stay and rule the roost”. Their writ will run in the financial world of the twenty-first century, whether the IMF likes it or not.
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