The Design and Governance of Sovereign Wealth Funds
I’ve got a couple of good articles this week. First, Foreign Affairs has an article by C. Fred Bergsten on how Washington can prevent the future crisis. It’s entitled, “The Dollar and Deficits.” Second, Seeking Alpha has a short article detailing China’s voracious appetite for commodities in 2009. Both are worth a read.
Enjoy your weekend.
Corporate Financing Week has an article out this week in which it compares GCC SWFs to Asian SWFs. According to the article, the former look like ”sleepy giants” when compared to the “story of growth” experienced by the latter. This seems like a bit of a stretch. Nonetheless, if you compare Istithmar to the CIC, you can see their point.
However, I don’t think the issue here is really about GCC vs. Asia, it is more about leverage. Those funds that were levered are struggling; with Istithmar we may end up seeing the first SWF to be liquidated. Those funds with unconstrained cash, such as the CIC, are well positioned to grab deals in the aftermath of the crisis. This was a point made by Rachel in her post last week.
Anyway, CFW’s point appears to be based more on future sources of capital than on current investment activities:
“The big difference between Asian and GCC SWFs is the sustainability of their growth model. Regardless of short-term oil price action, SWFs whose resources are based on a commodity, which is propped up in part by Opec’s continued supply management instead of sustainable demand, are unlikely to flourish in the medium-term.”
Given that China continues to set forex reserve records, this seems a fair point to make.
IRRCi and Risk Metrics have just published a huge research report on SWFs. Weighing in at 154 pages, there is enough there to keep any SWF wonk busy for a few hours. The most significant claim is that many SWFs remain GAPP non-compliant:
“One year after the introduction and adoption of the Santiago Principles, while a few funds have achieved a comparatively high level of disclosure, the public disclosure levels of a number of SWFs have not yet met the Principles’ standards.”
If this is the case, why are SWFs concerned about too much transparency?
The inaugural meeting of the International Forum of Sovereign Wealth Funds (IFSWF) wrapped up on Friday. The two day meeting ended in an agreement to further promote compliance with the Santiago Principles as well as work to prevent protectionism. This is pretty much what we expected to come out of the final communique. However, I was interested to see two SWF complaints surface in interviews with the IFSWF leadership after the meeting:
The first had to do with reporting. It seems there was agreement that quarterly reporting drives SWFs’ asset managers towards short-termism, which contradicts SWFs’ nature as long-term investors: “This kind of practice encourages the management to seek short term, high profit, to the detriment of long term returns. We don’t want to do that,” according to Jin Liquin, Chairman of the Board of Supervisors at CIC and Deputy Chair of the IFSWF. I would be more sympathetic to this complaint if it was based on experience. As far as I know, the CIC does not and has not reported quarterly, so any complaints being voiced are purely theoretical. Moreover, the fact that SWFs have no outside shareholders (beyond the government) and are not traded entities implies that quarterly reporting should have little impact on SWF operations. Ostensibly, the political elite who are responsible for the funds have bought into the mandate and are in fact being kept up to date on operations. So this is really a complaint about keeping the countries’ citizens informed as to what the SWFs are up to, which seems off to me. But this is an increasingly common refrain these days, as the formerly secretive SWFs begin to understand how difficult it can be to acheive domestic legitimacy.
The second complaint was also about transparency. According to David Murray, Chair of the IFSWF, front running has become a real problem for SWFs: “Because we are generally large institutional investors, there is the whole community of investment banks, brokers, analysts and others who want to front-run our investments in the market.” In short, he worries that becoming overly transparent will allow these other investors to jump into certain investments before the SWFs, which will in turn erode returns. Since most SWFs are secretive, I didn’t think this was a problem. That said, I acknowledge that the greater transparency associated with the Santiago Principles may allow other investors to guess what the big SWFs are interested in. But this, too, seems a bit of a stretch. Large investors of all kinds deal with similar issues, and there are many ways to keep this type of information secret all the while reporting on operations regularly. Backing away from reporting due to the threat of front running would be, in my opinion, misguided.
Anyway, the first IFSWF meeting was interesting! The next meeting will be in May 2010 in Sydney.
I’d just like to thank all my guest bloggers from last week for their interesting posts. All have been added to the Resources section of the website.
Capitalism and the State: Nothing New and Always There
I’d like to use this opportunity to reflect on the crisis of legitimacy faced by SWFs over the past few years. This crisis led to the Santiago Principles and various new regulations in western countries, and, in my view, was a drastic over-reaction and a misinterpretation of what capitalism really is.
The oft made claim made by some skeptics of SWFs or any accumulation of financial power by some public entity (e.g. a public pension fund), is that such entities that are intrinsically linked to the state (or some center of political power) are incompatible with free market capitalism. Such skeptics fear that state-linked entities (even if there is a high degree of political separation from the decision-makers of these funds) will ultimately contravene ‘free’ market processes of exchange to the benefit of the political will, and such interference in a space that ‘should’ be limited to only private actors is ultimately inefficient. In other words, it goes against the ‘spirit of capitalism’, and as such, SWFs are dangerous.
Unfortunately, such skeptics seem to forget or ignore that markets are inherently political: in the history of capitalism over the last 150 years the state has had a key role — whether explicitly or implicitly — in ensuring capitalist processes. The state sets many of the rules of the game and is usually there to support those areas of the economy that can’t go it alone but are necessary for the rest of the capitalist system to operate. No successful developed market economy is without a relatively strong state. The recent financial crisis has reminded us that even in the most so-called free markets of global capitalism, the state is always waiting in the shadows to rescue capitalism from its excesses and failures — and the state is likely to continue to do so even to the chagrin of free-market purists, because it always has done and, politically, no one is willing to sit back and see what happens if it doesn’t.
Following the collapse of Lehman Brothers in September 2008, it wasn’t uncommon to hear fearful pronouncements that capitalism could soon be replaced, that the emerging markets that had embraced capitalism as a means to organize their economies over the last several decades would revert to their old ways. The specter of socialism was knocking on the door… Or was it? Like most economic crises, many forget to remind themselves that capitalism oscillates between booms and busts (to varying degrees), as it always has done. Moreover, it wasn’t so much a fear of socialism, but a fear of a return of the state (there is a difference). The state is already an inherent part of the capitalist process (even in the most free markets), so a more visible state is not necessarily counter to a properly functioning free market, or the continuing existence of one. The state may have to periodically show its face, but it is still firmly on the side of capitalism.
That the majority of SWFs are in emerging markets is not just a product of global imbalances and high commodity prices of the last decade, they are an expression of these political economies’ embrace of market capitalism and globalization. As has been suggested by some commentators, such as Ashby Monk, this crisis may engender the development of new SWFs and the extension of others (just have a look at all of the “varieties of capitalism” that have decided to join the SWF bandwagon). Given SWFs are by nature capitalist entities in pursuit of the profits of global capitalism, such a reaction would be another confirmation that the embrace of capitalism remains strong, with states (not surprisingly) leading the embrace.
Are Sovereign Funds Back? A Roundup
It certainly seems so—at least in terms of new purchases. At least two of the conditions that contributed to SWF’s rapid rise in 2007 and early 2008— a rally of equities and alternative assets, as well as the growth in foreign exchange reserves—have resumed, to some extent. Yet future growth might be more muted—the third condition – large oil surpluses – no longer exists.
The revival of equity and commodity prices has contributed to the rise of sovereign funds’ assets under management, allowing them on average to make back half of the paper losses sustained in the 2008/09 price correction. Equity-heavy SWF portfolios have reflated along with the market. At current oil prices, most oil funds are again receiving some new capital, albeit much less than inflows of 2007 and 2008. Most also face new domestic competition.
My estimates suggest that the foreign assets under management by the 10 or so largest sovereign funds rose to an estimated US$1.7 trillion by the end of September 2009. Excluded from this total are domestic holdings of funds like China’s CIC, Singapore’s GIC and several of the Abu Dhabi funds. This total reflects an increase of almost US$300 billion in assets from the end 2008/early 2009 lows, but remains well below the highs of mid 2008. It also assumes the funds’ returns roughly tracked established benchmarks—an assumption that may not provide a totally accurate picture given the changes in asset allocation and management strategy since the crisis. (A past working paper with Brad Setser has more methodological details.)
New Actors?
Yet, differences among funds have widened. The richest countries, either in terms of unused reserves (China) or lower domestic spending needs (Abu Dhabi, Norway, Qatar), are the most active. Those funds and countries that are the most leveraged (Dubai, Russia) are facing challenges. The need for liquidity and offsetting revenue shortfalls has contributed to withdrawals from some funds (Russia, Saudi Arabia). Yet domestically focused investors such as state holding companies or resource companies seem to have gotten a bigger piece of a smaller pie.
Yet, much of the new sovereign wealth activity stems from China. After almost a year of no new foreign investments, the CIC seems to have received the go-signal beginning in July. It has subsequently launched an advisory board, allocated billions of dollars to a number of asset managers and made a handful of investments (for instance, it purchased a stake in the Canadian mining company Teck Resources, several Asian resource companies, the Kazakh oil and gas company Kazmunaigaz and is eyeing U.S. property). The investments have spanned a number of sectors, but resources have dominated—mirroring a generalized stampede of Chinese government investors into in resources this year.
New Sectors:
It’s always difficult to assess the exact portfolios of sovereign funds, as many purchases (or divestments) are not publicly reported. However, there is some evidence that sovereign funds are rebalancing away from the financial sector.
In the boom years many sovereign funds over-weighted financials. Singapore’s Temasek was a case in point—financials accounted for a whopping 40% of its portfolio in early 2008 but fell to 33% a year later. Financial stakes were likewise attractive to other funds, even if the allocation was lower. Previous RGE research suggests that the bulk of identifiable purchases by GCC sovereign wealth funds in 2007 and 2008 were in financial institutions. This “overweight” reflected several trends including the outperformance of financial institutions relative to other sectors, as well as opportunities to buy into global players at what seemed like cheap prices. Similarly, domestic financial sector holdings may have encouraged funds to buy what they knew.
Several funds that provided capital to cash-strapped global financial firms have sold their stakes—in many cases at a profit. These moves, however, are likely to shift most financials to neutral weight rather than underweight. Even Temasek’s 33% is a large allocation to the financial sector. Most sovereign funds increased their exposure to domestic financial institutions in 2008/2009 as part of their effort to support domestic banks so adding foreign exposure might not be the smartest idea.
Some funds could end up overweighting some other sectors, most notably commodities. In terms of optimal asset allocation on a national basis, this is a bigger concern for oil funds. Investing in resources would be like doubling down for an oil, gas or resource rich nation. Doing so might increase the volatility of returns even as doing so could facilitate an increase in the national government’s (or national oil company’s) market share.
Responding to Losses:
Most sovereign funds—like most investors—have been reassessing their investment strategies as they process the volatile market moves of the past year and ask how their risk models went awry. Some funds have replaced key managers (Norway) or reshuffled/combined operations (Dubai World). Clearly as with private asset managers, strategy and hedging shifts are likely. Of course this is a rather opaque area so details are fuzzy.
The other more significant asset management shift—to more domestic holdings—has been ongoing for some years. This shift could potentially reduce investor independence and further blur the ultimate investment goals of some SWFs.
With the emergence of new goals come new responsibilities. The jury is still out on the effectiveness of the Santiago Principles, a voluntary code of governance principles that aim to increase transparency. In part, the need for capital changes the concerns of target countries. International scrutiny has in some cases heightened domestic pressures. Many countries—particularly those that are more democratic—are under great pressure not to squander national wealth and to use it as seed capital to support growth.
Slower Growth Ahead?
Absent a transfer from China’s central bank to the CIC, the investment pace of “sovereign wealth funds” may slow given the reduction in new capital. Such a transfer should not be ruled out, especially as the CIC is one of several outward investment vehicles being promoted by China. However, other countries might be wary of allocating more funds to equities. Russia’s spending needs mean it will spend all of its reserve fund over the next year—its value has already almost halved to US$76 billion since January—and prior plans to invest the wealth fund in equities seem off the table for now. Other funds might take the lesson that a reserve is more useful than a number of high profile investments.
Oil funds have roughly maintained their share of about 75% of total sovereign wealth fund assets under management. They are also receiving new funds, yet new capital transfer levels are well below 2007 levels in most cases. Norway’s fund is perhaps an exception, as Norway’s spending has climbed more slowly than that of oil exporters in the Gulf and elsewhere. Aside from Kuwait, which continues to show a reluctance to spend, even the GCC funds are now saving less. Production cuts and higher spending have eroded the surpluses of the UAE, Qatar, and especially Saudi Arabia.
I have some second thoughts about the “sovereign” bit in the term “Sovereign Wealth Fund”. If the term “wealth” talks about the amount of money that these funds manage, the term “fund” suggests that there is an administration in place to manage that wealth, the term “sovereign” speaks to the way its owner arranges his political relations to international and domestic stakeholders. An idea how he does, provides a classic, straightforward definition of “sovereignty”, suggesting internal sovereignty to constitute supremacy over all authorities within a state’s jurisdiction; external sovereignty as the state’s independence of outside authorities.
Many of the countries that own SWFs are still comparatively young modern states. After having gone through a sometimes painful nation state building process, they have difficulties to give up their sovereign claims to manage their wealth the way they want. This makes it so tricky to develop a convincing case for SWF transparency and accountability. Who, they might ask, is the authority that believes to supersede our sovereign right to manage our fund the way we believe is best for our country?
This thought might be part of the explanation of the, in my view, slow implementation process of the “Santiago Principles”. Why should a SWF take more than symbolic steps to accept the authority of a code of principles that substantially restricts the owners of SWFs to execute sovereign rights? To “placate” SWFs’ critics, as David Murray, Chair of the International Forum of SWFs, recently claimed, might not be good enough.
It appears that a convincing case that would motivate SWFs and their owners to balance their legitimate claims to exercise their sovereignty with the legitimate concerns about broader system efficiency has not yet been produced.
As the number of CIC’s public overseas investments increases, it becomes easier to identify the organization’s purchasing patterns and the investment preferences they express. In our view, CIC are doing exactly what they were expected to do when the outlines of their investing intent were made clear more than a year ago. Indeed, we have come to think of CIC as the beige Volvo of SWFs: both are unlikely to surprise you. Here’s the pocket checklist we use when asked, after a CIC purchase is made public: “Is this a new direction for CIC?”
1. Will the target benefit directly from China’s faster-than-anybody economic growth? For Noble Group, Teck Resources, Bumi, and Goodman Group, this box is easy to tick: all either supply China with key long-term resources, take a commission on the movement of those resources, or manage valuable assets in the countries that supply those resources.
2. Does the target have positional value for CIC? Again, ticks are obvious for Morgan Stanley and Blackstone. Both firms have opened a number of doors for CIC, introducing mandate managers, advising on market conditions, speeding entry into fast-closing products and contributing to CIC’s portfolio design.
3. Is the target’s market capitalization greater than USD5bn? Your hand will cramp from ticking this box: CIC prefers passive minority stakes of less than 20%, which limits the investable universe to roughly 1800 companies.
4. Was CIC’s investment greater than USD800m? By our reckoning, CIC has about USD25-35bn left to spend before it exhausts its initial funds. Putting that sum to work USD200m at a time, while possible, would conflict with the organization’s goal of getting fully invested quickly, so more cash can be transferred from PBoC’s USD2.13tr foreign reserves.
5. Was the investment made with one of the world’s fifty largest fund managers? We estimate than between USD15-30bn of CIC’s supposedly unspent cash has, in fact, been committed to (if not already invested in) a wide range of funds. These mandates were agreed in spring 2008, although many were left unfunded until market conditions improved. Reports of a USD1bn alt-assets mandate awarded to Oaktree may show only the tip of the iceberg. And, when shopping for managers which can swallow USD1bn+ mandates with ease, only fifty or so candidates are available.
The overwhelming majority of CIC’s overseas investments tick at least three of these boxes and, in combination, offer a cameo of a predictable, well-organized investment process. Financials and resources appear to dominate the direct investments so far but it is unclear to what extent this is counterbalanced by other sector biases achieved through mandates. Our suspicion is that CIC’s overall portfolio is both more balanced and less volatile than its publicly-known direct holdings would suggest. Moreover, given the recent acceleration of CIC’s stake-taking, we believe the fund will all but empty its coffers by year-end, and accept a healthy top-up from PBoC early in 2010. Say what you like about beige Volvos – they usually get where they’re going.
