Economics and politics of reserves and sovereign wealth funds

Kelvin Teo

Since the 1997 Asian Financial Crisis, central banks of Asian countries have taken a precautionary measure to accumulate foreign exchange reserves. There are two main reasons for accumulation – firstly, it serves as a precautionary move against future financial crises, and secondly, to bring about domestic currency devaluation to increase the competitiveness of exports, especially in a move to provide a boost to the export sector. Thus, how does accumulation of foreign reserves protect an economy from financial crises? A financially open economy that is open to international financial flows is also vulnerable to the rapid outward movement of financial capital besides inwards capital flow. This can precipitate volatile boom-bust cycles and financial crisis. Thus, for policy makers who opened their economy to capital flow, accumulating foreign exchange reserves will provide them with a war-chest to battle future financial crises.

How then does a government undervalue its currency? The currency value is a reflection of supply and demand. A government that wants to undervalue its exchange rate relative to another currency must sell its own currency and buy up the target country’s currency. Hence, this process involves accumulating foreign reserves in order to keep the domestic currency under-valued. The under-valued currency will in turn promote exports. Exporters from the agricultural and manufacturing sectors, for instance, will thus benefit from the under-valued currency. Improved exports subsequently lead to economic growth and employment.

David Leblang, the J Wilson Newman Professor of Governance and Chair of the Department of Politics at the University of Virginia together with colleague, Thomas Pepinsky, Assistant Professor at the Department of Government, Cornell University both co-authored a paper arguing the role of political institutions in exerting two types of pressure towards foreign reserves accumulation – precautionary and mercantilist. According to the pair, precautionary pressures are what drive autocratic regimes to accumulate reserves, i.e. hoarding foreign reserves is a precautionary decision. Authoritarian regimes are more vulnerable to capture by organised business interests who tended to enjoy greater political access. Such business groups may benefit from an economy open to capital flow where they can easily access international capital but they also dislike volatile capital flows which may stop or reverse in direction to their disadvantage. Consequently, representatives of such groups will want to advocate for foreign reserves accumulation to shield the economy from exogenous shocks.

Democratic systems on the hand tend to respond more to mercantilist pressures, according to Leblang and Pepinsky. For mercantilist behaviours, it is pretty self-explanatory when the raison d’etre is to undervalue currencies by storing foreign reserves with the goal of becoming competitive in and promoting exports. However, regardless of mercantilist or precautionary pressures, the decision to accumulate foreign reserves is in essence a political one.

Foreign reserves may be held by central banks in the form of not only foreign currency, but also gold, which is usually expressed as a certain percentage of the foreign reserves. The excess foreign reserves are channelled to entities known as sovereign wealth funds (SWFs). The latter is conventionally a savings fund controlled and managed by the sovereign government. In fact, authors have observed that SWFs have especially emerged in developing Asia as a policy response to the unprecedented accumulation of foreign exchange reserves since 2000 after the financial crisis. The role of SWFs it appears is to diversify their portfolios by investing in a broad range of assets that can generate higher returns.

Researchers have scrutinised the nature of East Asian SWFs in tandem with an observation of their respective economies, which have yielded interesting insights. Professor Helmut Reisen, Head of Research at the OECD (Organisation for Economic Co-operation and Development) Development Centre described SWFs from East Asia as products of dynamic inefficiency, citing the examples of Singapore and China. An economy is considered dynamically efficient if the country invests more than what it is making for future consumption. This means that the financial sector is draining is draining more resources from the economy, when the whole point of investment is to augment future consumption, especially that of an aging population. It may sound counter-intuitive but it is dynamic inefficiency nonetheless.

The sources of funding for SWFs not only come from foreign reserves, they can also come from natural resources or oil and gas revenues. The Abu Dhabi Investment authority (United Arab Emirates), Government Pension Fund (Norway), Kuwait Investment Authority (Kuwait) and Stabilisation Fund of the Russian Federation (Russia) are examples of SWFs whose funding source came from oil revenues. Israel, which recently discovered the Leviathan gas field in 2010 is looking to create an SWF for excess gas revenues, with the intention of investing outside of Israel. The fund is projected to be up and running by next year. Thus, broadly speaking, SWFs can be placed into two categories – commodities and non-commodities. The source of funding of non-commodities SWFs come from foreign reserves as mentioned earlier. Singapore’s Temasek Holdings and Government of Singapore Investment Corporation (SGIC) are non-commodities SWFs. The SGIC manages Singapore’s foreign reserves.

Observers have this burning question in mind – what is the raison d’etre of SWFs? Well, we can address this question by choosing to take a macroscopic view of things, i.e. looking at the global financial ecosystem as a whole. Revenue surpluses from exports of natural resources and thanks in part to soaring oil prices meant that SWFs expanded in terms of size. However, countries who have enjoyed such surpluses do not have desire to spend their money. They rather set the money aside and invest with it to generate greater returns, in the hope to provide aging and future generations with some form of stability. In addition, domestic retention of the money gained from exports may result in inflation, which some countries want to avoid. Hence, the decision to invest the money outside of the country. And just as well, since the banks in America lack capital, and investments by SWFs from overseas will provide much needed capital injection. There is also a rarely discussed motivation for SWFs to invest within America – they enjoy special tax treatment which are special provisions given their status as foreign government-owned entities. It was estimated that the total value of financial assets held by SWFs across the globe hit the USD$4 trillion mark last year.

Reciprocally, beleaguered financial institutions have lost no time in wooing SWFs. Way back in 2008, the UK bank Barclay’s needed to raise 4 billion pounds. They courted the China Development Bank and Temasek Holdings. Temasek acquired a near 2% stake, and subsequently sold it. Citigroup managed to raise USD$22 billion from a number of investors which included the Kuwait Investment Authority. A Citi banker declared at the World Economic Forum:”I would make an argument today that the greatest single benefit to the longevity of the US and UK financial structure is investment made by sovereign wealth funds into financial institutions.”

And thus, it appears there are those who welcome SWFs with open arms, especially financial institutions who have received much needed cash injection to rebuild their balance sheets. However, the pertinent question is what is the impact of SWFs on financial markets? Much will depend on the strategies adopted by SWFs. If they adopt a buy and hold strategy, they will have a stabilising effect on markets. However, there are also evidences of SWFs investing in hedge funds. Gains made by hedge funds typically rely on one thing – borrowing or leveraging, and borrowing in large amounts. Indeed, the world of hedge funds can be perilous, yes you win big, but you can also lose big. It is believed that hedge funds can have a destabilising effect on the market when bets go wrong. This is due to the fact the total assets managed by hedge funds are well in excess of USD$1.3 trillion worldwide. That sum is larger than the gross domestic product of many countries and thus, has the potential to move markets.

How much do we know of how SWFs operate? Sadly, not much. Much of what we know come from the transparent SWFs of which the Norwegian Government Pension Fund (GPF) comes to mind. The fund is where excess revenues from oil exports are channelled into. GPF’s investments are solely abroad. This is a move to insulate funds from political interference, for example, pressure to back companies and projects of friends, supporters and relatives of politicians or office holders. The GPF is transparent in terms of its investment strategy. The Ministry of Finance, owner of the GPF, reports regularly on the fund’s goals, investment strategies, results and ethical guidelines. The Norwegian Central Bank also publishes quarterly and annual reports on the fund management, including its performance, and annual listing of all investments. The fund also has to follow a set of ethical guidelines in its investments; companies that have poor and irresponsible conduct, in addition to not respecting human rights and the environment are excluded from receiving investments by the GPF. The purpose of the GPF is to fund public pension expenditures in Norway, given its aging population. The GPF is widely considered to be the exemplary role model in the way SWFs should conduct themselves in terms of governance, transparency and accountability.

The topics of reserves and SWFs have political undertones both within the sovereign nations and destinations abroad who are targets of investments. Just earlier this year, Singapore held its General Elections and Temasek Holdings, unsurprisingly was featured in a debate between opposition candidate Mr Tan Jee Say and the ruling People’s Action Party. Tan came up with a ‘National Regeneration Plan’, which required up to SGD$60 billion to implement. The plan covered 6 different areas in which $10 billion will in invested in one of each. When quizzed on how to raise the sum, Tan suggested that the money can be taken from Singapore’s reserves or by getting Temasek Holdings to sell a portion of its assets to raise the sum.

Now, currently Singapore is the midst of a build up to its next Presidential elections, which will become an eventuality if all the Presidential hopefuls receive approvals in the form of Certificates of Eligibility from the authorities that will allow them to contest the elections. What is particularly unique about Singapore is that its President is by constitution the custodian to its national reserves. The prospective candidates each have a different take on how the President should approach the country’s reserves. Mr Tan Kin Lian, a Presidential hopeful, opined that the elected Presidential office should produce an annual report on the reserves of Singapore showing the financial assets held by relevant bodies expressed in terms of their book and market values. However, the latter cautioned against becoming fixated on the market value of assets given its volatility. Dr Tan Cheng Bock, another Presidential hopeful, adopted a more cautious approach. The latter, in a video interview with a citizen journalist site The Online Citizen warned of the dangers of disclosing the exact sums of Singapore’s reserves, which may result in Singapore ‘watchers’ outside, who have been ‘eyeing the nation’s reserves, coming after the nation’.

Granted that Singapore’s SWFs are tasked with investing its reserves, e.g. in the case of SGIC investing Singapore’s foreign exchange reserves, the likely ‘watchers’ are supposedly institutions who are in need of capital injection like those mentioned earlier who are turning to SWFs to bail them out. However, the issue is more complicated than just ‘watchers’ coming after large SWFs. Much has to do with the external (political) perception of SWFs. SWFs, at least the majority of them, barring the Norwegian and Chilean ones, suffer from the lack of transparency. Thus, when an SWF, especially one that is non-transparent about its investment decisions, goals and agendas acquire an asset from another country, the chief suspicion is whether the fund has any political agenda behind its investment. Thus, even though the balance sheets of financial institutions have benefitted largely from SWF bail outs, banks have also warned that such will come at the price of independence if foreign governments decide to wield their political influence. This is especially so if the assets are of strategic interest, e.g. military contractors.

Thus, what if for example, the company was a defence contractor like Lockheed-Martin which produces the current generation of F22 Raptor Stealth fighters, and a Chinese SWF, the China Investment Corporation wishes to acquire the company? The other possible motive behind SWF’s investment in certain companies is for governments to gain access to certain technologies, and in this case, stealth technology. However, it is also not in America’s interest to have cutting-edge military technology transferred to another country, especially not when China is trying to develop a stealth fighter on its own. Obviously, the American government will intervene and stop any attempts at acquisition, and it has done so before. CNOOC, which is technically a state-owned oil company from China and not an SWF once attempted to take over a small American oil company. However, the US congress intervened and the take-over was unsuccessful because oil was considered a strategic resource.

With suspicion of political motives, SWFs are placed in an awkward position. This is why to allay any fears of political interference, SGIC refused a board seat offered by UBS after injecting 10 billion swiss francs into the embattled swiss bank which suffered multi-billion dollar losses from the US sub-prime, high risk mortgage investments. In yet another example, a Chinese SWF, the Chinese Investment Corporation refused a seat on the board of Blackstone Group after acquisition of a USD$3 billion stake. At least such anecdotal evidences indicate that SWFs are passive investors as opposed to having a political agenda.

However, current developments have provided indications that domestic politics have ramifications on the reactions of the international community to SWFs. An extreme example that occurred earlier this year involved the Libyan SWF, the Libyan Investment Authority (LIA). Its source of funding comes from excess oil revenues. Muammar Gaddafi, the Libyan dictator received worldwide condemnation after his violent crackdown on protestors against the backdrop of “Arab Spring”, a revolutionary wave of demonstrations and protests that swept though the Arab world. Gaddafi and his family, plus a close associate of his son who goes by the name of Mustafa Zarti, are in charge of the LIA, which controls an estimated capital of USD$70 billion. LIA’s investments include a 226 million pounds stake in Pearson, the owner of Financial Times, in addition to a major European soccer club, Juventus FC. The fund has assets in both American and European institutions. A damning charge by the prosecutor of the International Criminal Court states:”Gaddafi makes no distinction between his personal assets and the resources of the country”, in reference to his personal and familial control of LIA. As a result of Gaddafi’s atrocities, his family faced international sanctions and an asset freeze was imposed which included LIA’s assets held by the dictator and his family. The US, UK and EU implemented the asset freeze in a move to incapacitate Gaddafi. It is hoped that such a move will lead to his stepping down from power.

Another far more benign but relevant example pertaining to the impact of domestic politics on the function of SWFs comes from Chile. The country has largely benefitted from high copper prices that resulted in a huge surplus of revenue. Instead of spending the money domestically, Chile has chosen to invest abroad. The Chilean Economic and Social Stabilization Fund is the SWF responsible for investment. The fund is considered by observers to be transparent, and its purpose is to serve as a war-chest to bolster domestic government spending during periods of crisis. Hussein Kalaoui, then a candidate at Wharton’s MBA programme emphasised on the importance of domestic politics on the management and strategies of the Chilean SWF. He noted how the Chilean government has gone to lengths to create the fund that represented legitimate use of the tax payer’s money, and more importantly, establish the domestic purposes that they should serve.

From the very outset, the accumulation of foreign reserves serves a political purpose, whether we are looking at a democratic or autocratic regime. The excess foreign reserves are channelled into what is known as non-commodities SWFs, although for other countries with natural resources, they may set up commodities SWFs from excess revenues gained from exports. Domestic politics may influence the evolution of SWFs, and in more extreme cases like in the case of LIA, influence how the international community responds to them. Domestically, aging issues and welfare of the future generation determine current and projected government spending, and this will inexplicably involve political debate on how proceeds from the SWFs can be best utilised. This is especially so in instances when there is increased political pressure on the government to invest in education, healthcare, welfare for the aged and other aspects of the national development, and this will call for utilisation of SWF funds. Indeed, there is much economics and politics surrounding a country with accumulated reserves and an SWF (s).

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Photo courtesy of Wendy, Flickr Commons.