Ashby Monk

I’ll be honest, I’m jealous of Joshua Aizenman. Not only does he write some very sensible things on foreign reserves and SWFs, but he gets to live in Santa Cruz, CA while doing it. Can you think of a better life? I can’t. I used go surfing there when I was a kid (I grew up 30 miles inland), so I can assure you it is an amazing locale. So if you’re reading this Prof Aizenman, I’m a free-agent in September and am open to relocating…just say the word.

Anyway, why are we talking about Aizenman again? Well it’s because he has just released two new papers that are definitely worth a read.

1) “Macro prudential supervision in the open economy, and the role of central banks in Emerging Markets.” This paper uses the recent liquidity crisis to evaluate the prudential supervision role of central banks. I learned a lot reading this paper, but one specific insight is worth repeating here:

“Diversification by means of Sovereign Wealth Funds exposes the economy to the risk that value of the fund may collapse precisely at the time when hard currency is needed to fund deleveraging as has been the case during the 2008-9 global liquidity-crisis.

It’s a good point, which is why SWFs should only be comprised of “excess reserves” (i.e. those not needed for precautionary purposes).

2) “International reserves and swap lines: substitutes or complements?” with Yothin Jinjarak and Donghyun Park. This paper examines whether “swap lines” between central banks of larger economies and their counterparts in smaller economies can reduce the need for reserve accumulation. Again, I learned quite a bit from this paper; here is an excerpt:

“One way to reduce such costs is to use reserves more productively via sovereign funds and more generally, by active reserve management. Although the global financial crisis has inflicted heavy losses on Asian sovereign funds and temporarily dampened their risk appetite, they provide an important channel for more productive use of reserves in the medium- and long-term. There are already signs that the funds are returning to the financial markets, and there are indications that China may inject up to US$250 billion of fresh capital into CIC. However, investing surplus reserves more efficiently after they have already been accumulated is a second-best solution. The first-best solution is to avoid building up such large reserves in the first place. Furthermore, if we view reserves as insurance against unexpected shortage of international liquidity and financial crisis, pooling risks is more efficient than individual risk bearing. That is, collective insurance is always less costly than self insurance. The seemingly irrational behavior of reserve hoarding can partly be explained by the region’s loss of confidence in the IMF during the Asian crisis. In principle, the IMF pools the risks of all countries and thus offers the most efficient collective insurance. In practice, a region wide perception that the IMF has mishandled the Asian crisis, compounded by a broader region wide perception that the IMF does not serve the interests of Asian countries, has eroded the region’s confidence in IMF. Regardless of the validity of the perceptions, the perceptions themselves have contributed to a marked preference of self-insurance over collective insurance.”

I totally agree. As such, this paper explores innovative mechanisms that would reduce countries’ demand for precautionary reserves in the first place, such as swap agreements. It’s worth reading in its entirety.

(Photo by Jim Whitehead)

]]> http://oxfordswfproject.com/2010/03/12/weekend-reading-joshua-aizenman/feed/ 0 Ashby Monk View from Aizenman's office...maybe http://oxfordswfproject.com/2010/03/12/alabama-eyes-change-to-constitution-to-tap-swf/ http://oxfordswfproject.com/2010/03/12/alabama-eyes-change-to-constitution-to-tap-swf/#comments Fri, 12 Mar 2010 16:37:44 +0000 Ashby Monk http://oxfordswfproject.com/?p=4128 ]]> Ashby Monk

The Alabama Senate (led by the state’s Democrats) yesterday passed a constitutional amendment that will allow the government to tap the state’s SWF for an “Alabama stimulus program.” The idea is to take $1 billion from the Alabama Trust Fund for road and bridge building over the next ten years–$100 million will be drawn from the fund each year and invested in construction works so as to create local jobs.

Because the bill calls for drawing down on the SWF’s principal (and requires a constitutional amendment), it has not been well received by everybody.

“People are treating the Alabama Trust fund like free money,” according to Sen. Scott Beason, R-Gardendale.

Indeed, the states’ Republicans see this bill as a breach of the SWF’s original intention and rationale.

The Alabama Trust Fund was launched in 1985 as an “an irrevocable, permanent trust fund”. The plan was to sequester a portion of revenues from offshore drilling rights and royalties in an intergenerational savings fund. Indeed, the trust receives 99% of all oil and gas payments paid to the State (the remaining one-percent goes to the Department of Conservation-Lands Division). In turn, the government only gets a portion of the interest from the Fund’s investments (which is used to fund prisons, health programs, elderly care, among other things).

In short, the Alabama Trust Fund was never meant to be a stabilization fund. As such, using it to pay for a stimulus package to create jobs–while politically expedient–is quite a departure from the fund’s original purpose.

In times of crisis, politicians around the world must be tempted to put SWF assets to work in their communities; even if the fund has a mandate that explicitly prohibits that type of behavior. So, how do you set up an intergenerational savings fund with appropriate checks and balances to ensure the assets aren’t misused?

• In Canada, the CPPIB’s mandate is harder to change than the Canadian constitution. The idea being that, while past governments can’t tie the hands of future governments completely, they can make it very difficult to change the fund’s mandate (so as to access to these assets).
• When Ireland tapped its National Pension Reserve Fund to bolster the country’s banks, new legislation was required that changed the fund’s mandate.

And so, Alabama is currently following a similar path through the state’s checks and balances. Indeed, this bill requires both the approval of the House and voters (since it’s an amendment to the constitution). If all agree that this is in the best interest of the state, then who’s to say they are wrong?

In the current lackluster M&A market, SWFs are starting to stand out. In fact, according to an article in Emirates Business, Middle Eastern SWFs are emerging as the world’s most active strategic investors.

“The region’s largest SWFs, particularly in Qatar and Abu Dhabi, are emerging as major investors, interested in sectors ranging from financial, commodities to real estate.”

Apparently it isn’t that these funds are doing more; it’s that other types of investors are simply doing less. Still, SWFs seem to have been able to do as they please in global financial markets. This is remarkable given the widespread “national security” concerns of 2007/08, which led to the IWG and the Santiago Principles.

This got me thinking, to what extent have recipient countries’ fears affected SWFs’ investments and deals. We all remember the Dubai Ports debacle. Is anything like that still going on?

Fortuitously, Paul Rose of Ohio State University just posted a paper to SSRN entitled, “Sovereign Wealth Fund Investment in the Shadow of Regulation and Politics.” The paper considers how recipient country public sentiment and regulatory burdens affect SWF deal-making. Drawing on a series of detailed case studies, he concludes:

“There is no evidence to suggest that SWF investment suffers from significantly higher transaction costs than other foreign investment. Indeed, the fact that other domestic and foreign investors are investing on the same terms as SWF investors in the Merrill Lynch and Citigroup transactions provides compelling evidence that transactions costs are not higher.”

In short, the article suggests that SWFs are not being constrained more than their private sector cousins (i.e. are not incurring higher transaction costs). In other words, national security concerns aren’t having an appreciable impact on SWF deal-making. This conclusion jives with the Emirates Business’ article.

That said, Rose goes on to acknowledge that his case material could be temporally biased. After all, he draws his conclusions from transactions that took place during the financial crisis:

“…the extraordinary pressures on the banks at the time of the investments may also suggest that the banks were willing to absorb higher transactions costs (perhaps by agreeing to terms that would not have accepted from only private investors) in order to secure investment from what were essentially lenders of last resort.”

So, while SWFs have had free reign during the financial crisis, Rose raises the possibility that this will end once target firms regain their footing.

I came across a rather surprising statistic this morning. Apparently, one out of every two SWFs is today investing in private equity, real estate or infrastructure:

“55 percent of the funds are known to invest in private equity, 51 percent in real estate and 47 percent in infrastructure,” according to Preqin.

I’m a little bit shocked by this. This implies that a significant portion of SWFs have no exposure to these assets.

Remember, these are the longest-term investors in the world. With no liabilities, they are perfectly suited to these types of illiquid investments. In fact, in our survey of SWFs’ own asset managers, we asked, relative to the 55% equities, 35% debt, and 10% alternatives standard, which asset class should be overweighted. Most of our respondents chose to overweight alternatives; i.e. SWFs (in the eyes of professional asset managers) should have more than 10% of their assets in alternatives.

And yet, some SWFs have 0% of their assets in alternatives? Why? It’s tough to pin it to any one thing. Perhaps the government employees running the SWF are just too conservative? Perhaps they don’t have the necessary internal competencies to make these types of investments? Perhaps their original mandate forbade these types of transactions? Perhaps the funds avoid these illiquid assets so as to be able to act quickly if the government has need for the money?

Whatever the reason, it’s a missed opportunity for SWFs.

I can’t read Norwegian. But I can read maps. And the map that Norway’s Aftenposten has put together to illustrate the geographic dispersion of GPF-G’s investment portfolio is definitely worth a gander. The map, for which the data is drawn from the 2009 annual report, includes all of the fund’s 10,288 investments aggregated and sub-divided into countries. (Thanks to these guys for a description of this in English.)

In large part, the map confirms what we already know about the GPF-G; that it is a traditional portfolio investor. Accordingly, concentrations of investments are in jurisdictions with large financial markets. Still, one aspect of this map was particularly interesting; it appears that the African continent has been almost entirely passed over. As best I can tell, the GPF-G has only invested in South Africa and (to a much smaller extent) North Africa.

Are there no profits to be had in Sub-Saharan Africa? Isn’t this a region with some benefit for a highly diversified institutional investor? After all, we are all used to hearing about SSA’s uncorrelated returns. For example, during the global sell-offs due to the sub-prime crisis, several of the SSA stock markets, such as Ghana’s, were up. Shouldn’t the biggest investors in the world be interested in this type of exposure? And yet, the GPF-G, one of the biggest investors in the world (full stop), has decided to take a pass on the region; either they don’t have the capacity or they lack interest.

There are good reasons for avoiding Africa, namely high levels of risk and uncertainty. It’s a very difficult environment to try to invest in for profit (remember, investors aren’t philanthropists). It’s for this reason that I initially felt that only emerging market SWFs would take the plunge into Africa. The south-south link gives them considerable experience operating in difficult legal and regulatory environments that are characteristic of this region.

In my view, this just reinforces the importance of some of the initiatives to bring SWF assets into Africa. Specifically, I think the World Bank’s Sovereign Funds Initiative is attractive. (It seeks to direct 1% of SWF capital into Africa via the International Finance Corporation). By acting as a skilled intermediary, the IFC can help overcome some of the constraints above and bring SWF cash into this under-served market. This would be to the benefit of both Africa and the world’s largest institutional investors.

Over the past year or so, I’ve been watching with interest the evolution of the “entity” that is now known as “Invest AD”. Its origins go back to 1977 with the creation of the Abu Dhabi Investment Company. One of the UAE’s first SWFs, ADIC had an explicit mandate to invest on behalf of the government. However, ADIC was given a new mandate in 2007 to attract and manage third-party assets with a view to facilitating regional development. And in order to reflect this new focus, ADIC changed its name to Invest AD in mid-2009. In a sense, the fund was changed from a SWF into a “private” regional asset manager; albeit with a new mandate that remained closely aligned with Abu Dhabi’s plans and policies. Indeed, Invest AD plays into a broader plan (i.e. the “Abu Dhabi 2030 Vision”) to develop UAE’s financial services industry.

Today, Invest AD attracts cash from all over the world for investment almost exclusively in the MENA region. For example, it announced last week that it was launching a second PE fund targeting MENA. The government will invest $75 million and Invest AD expects to raise $325 million from outside investors. In addition, Invest AD is planning to list on a major stock exchange in the next few years. If successful, this would would represent a remarkable transformation; one of the oldest SWFs, which is to this day owned by the Abu Dhabi Investment Council, may soon be a publicly traded asset manager, akin to State Street or JP Morgan.

Part of the reason I’ve been so interested in Invest AD’s evolution is because I think Singapore may be copying the UAE’s moves.  In the same way that the Abu Dhabi Investment Council has spun off Invest AD, so to has Temasek spun off Seatown. Both Invest AD and Seatown are “private” institutional investors that are (or will be) open to third-party investors. I can see a variety of reasons for why these SWFs are setting up these new companies:

1. They are trying to drop the SWF stigma.
2. They are attempting to use external assets to achieve sovereign objectives.
3. They want to have their investment strategies “blessed” by private and commercial investors (this will help with domestic legitimacy).
4. They are trying to implement private sector compensation and rewards systems that might be irreconcilable with ‘public service’.
5. They are looking to set up an institution that can engage in risky or politically sensitive investments abroad.
6. And maybe…just maybe…they are actually trying to make some money on asset management fees.

Whatever the case, the evolution of Invest AD and the unveiling of Seatown have been interesting developments over the past year that are worth paying watching.

Elvira Sojli and Wing Wah Tham have a new paper out entitled, “The Impact of Foreign Government Investment: Sovereign Wealth Fund Investments in the U.S.” It’s a paper with an interesting conclusion; it shows that SWF investments, in the long-run, outperform hedge fund investments. As the authors explain:

“Our results point to the benefits of long-term, large, and foreign investors for shareholders.”

Get it here.

Back in January, I reported that the State of Oklahoma was considering a new SWF that would mitigate financial fallout from volatile oil and natural gas prices. Yesterday, the new fund was overwhelmingly approved in the House (86-4) and is expected to soon pass in the Senate.

This new policy will see gross production tax collections above a three year average sequestered in the new stabilization fund. If collections drop below the three year average, the fund will deposit the difference into the general revenue fund. This fund will join the pre-existing “Rainy Day Fund” in Oklahoma, which already has around $600 million.

It is quite interesting to see a single US state with two SWFs. What is it about Oklahoma that makes SWFs so appealing? I see two factors:

• It is rich in natural resources; the state is the second biggest producer of natural gas in the US and fifth in crude oil. As such, its economy is dependent on commodity prices, which explains the stabilization fund.
• Politically, the state leans Republican in national elections. Also, the House Speaker (who proposed the new SWF) is a Republican. However, the state has had a Democratic governor since 2003. So, perhaps the new SWF represents a policy tool implemented by Republicans (i.e. fiscal conservatives) to discipline the spending of a Democratic governor?

Whatever the case, Oklahoma now joins Alaska, Alabama, New Mexico and Wyoming as US states that sponsor SWFs.

When it isn’t re-evaluating the very foundations of active financial management, Norway’s Ministry of Finance apparently likes to shake things up by re-conceptualizing active ownership policies and responsible investment practices for its SWF. Earlier this week the MoF unveiled a new set of ethical guidelines that will replace the original guidelines set up in 2004:

“The general conclusion was that the ethical guidelines had worked well and could largely be continued. With a view to bolstering the Fund’s responsible investment practices, the Ministry of Finance also announced plans to introduce a number of new measures and changes linked to active ownership and exclusion of companies.”

In short, the new guidelines take a two pronged approach focusing on “exclusion and observation” and “responsible management and exercise of ownership rights.” The immediate result is the addition of tobacco companies to the exclusion list. More broadly, the new guidelines seem to be an attempt to consolidate and combine the above “prongs” into a more coherent ethical mandate (more akin to, say, what a CalPERS does). These new guidelines afford policymakers more flexibility on exclusions, allowing instead for use of “active ownership” policies in certain cases:

“We are increasingly attaching importance to Norges Bank’s active ownership,” says Minister of Finance Sigbjørn Johnsen.

While active ownership and engagement with portfolio companies may have an important impact on corporate governance, this specific policy strikes me as potentially problematic. It appears that the decision-making for this revamped ethical process is still housed entirely within the MoF. Indeed, the press release says explicitly that:

“The Ministry will in this context consider use of other measures.”

As such, this new policy puts in the hands of politicians quite a bit of authority over investment decisions and financial operations (albeit under the advisement of the Council on Ethics). In short, Norway’s SWF seems to be adding another layer of politicization to what was already a complex governance structure.

CIC has $110 billion dollars in its international portfolio. So, where is it? The fund has been pretty tight-lipped on the subject. Nonetheless, we got a small glimpse from a recent SEC filing, but that represented less than 10% of the fund’s assets. Interestingly, our friends at Z-Ben have just written a report on this subject; they break down the CIC’s international investments as follows (in their words):

USD 9.6bn of investments can be seen in the 13-F filing.

An equal sum invested in other markets seems to us a reasonable guess.

USD 6bn in PE, hedge funds and alts we believe is another reasonable guess, given long lead times to assemble a portfolio.

USD 20bn in money market funds (of whatever currency but likely primarily USD) is the kind of low-yield barbell component we would expect to find in any Chinese institutional investor’s portfolio.

USD 10bn in cash is the minimum likely reserve with which CIC would feel comfortable.

That leaves USD55bn. All of it, we judge, is currently invested through third-party mandates.

If true, this would mean that only around $25 billion of the CIC’s international portfolio is “strategic” and the rest is in cash, money markets or managed by others. You could even knock that down further if you discounted the PE, HF, alternatives portion, since that is likely managed externally as well. So we’re talking about less than $20 billion in CIC’s “strategic portfolio”. That doesn’t seem like much to me.

However, that may be set to change in the weeks ahead, as the CIC is reportedly set to receive a large cash injection. When?

“We’d bet dollars to donuts that State Council has already decided to go forward and only the amount and the process are in the final stages of debate… Keep your eyes open for a new round of RFI/RFP requests, likely in early Q2.”