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Global economic crisis has implications for sovereign wealth funds too

Wednesday, 4 February 2009 - 2:05am IST | Place: Mumbai | Agency: DNA
With forex reserves shrinking, the urgency of setting up one has reduced for India

The ongoing global economic crisis is the severest the world has experienced in decades. The IMF expects world growth to stagnate in 2009, while global trade is expected to fall by about 3%. Other indicators of the severity of the crisis: the global stock market capitalisation declined by 41% during 2008, from $55.2 trillion to $32.6 trillion; and the International Labour Organisation has predicted that 50 million jobs may be lost globally during the crisis.

A factor complicating the path to global economic recovery is the significant loss of confidence in the competence and credibility of economic policy makers and financial institutions, including the central banks and the sovereign wealth funds (SWFs).

The crisis will have long-term geo-economic and geo-strategic implications. The probability of rebalancing power and the emergence of a multi-polar world have increased substantially though the dynamics of process and the precise contours of the transition to a new global order remain unclear.

In the just-ended relatively brief era of financial capitalism, SWFs acquired considerable prominence. SWFs represent one of the separated pools of assets, primarily but not exclusively internationally invested, controlled by governments to achieve economic, financial and strategic objectives.

The foreign exchange reserves are another separated pool of assets controlled by the governments. In countries with a significant state enterprise sector, their investments and other decisions represent additional leverage for the governments. In some countries, those controlling the state also own substantial personal assets arising from commodity exports.

These pools of assets are fungible, and governments may pursue their objectives through any of them. It is for these reasons that the term ‘SWF’ remains analytically imprecise and regulating SWFs as an entity is difficult.
Commodity producers, particularly the oil producers and the mercantilist export-oriented countries such as China, account for much of the assets of SWFs and foreign exchange reserves. Merrill Lynch estimated that in August 2008, the top 20 central banks held $7 trillion in reserves; while the largest SWFs had assets of $2.5 trillion. Thus, the combined assets controlled by relatively few countries were $9.5 trillion, approximately 15% of the value of total global publicly traded shares and bonds.

SWFs, along with hedge funds and private equity firms, have been key players in the so-called “shadow banking system,” which has been able to largely escape national regulations and financial oversight by taking advantage of the fundamental inconsistency between globalisation of finance on the one hand and primarily nation-state based financial regulation on the other. Weakening of hedge funds and private equity firms due to the crisis will, however, provide lesser opportunities to SWFs to partner them in exercising leverage.

The current global economic crisis will impact both the stock and the flow of SWF assets (and foreign exchange reserves).
It is estimated that combined foreign reserves and SWF assets of the Gulf countries fell by $350 billion or 27% of their total in 2008. Declines in real estate, and other assets in which the SWFs have also invested will also reduce the existing stock of SWFs assets.

Near zero rates on government bonds in the US and Japan suggest that SWFs (and foreign exchange) investments in treasury bills and money market funds may, however, lead some SWFs to invest in riskier assets such as commodities. Most, however, would prefer safer assets, creating potential distortions, such as in the US Treasuries and valuation of Japanese yen.
Negative growth for industrial countries in 2009 and rebalancing of the household portfolios in the United States are reducing trade surpluses of the export dependent countries such as China, Japan and Korea.

Sharp decline in oil prices from a peak of $140 per barrel to about $40 per barrel currently, if persistent, will significantly reduce fiscal and trade surpluses of oil exporting countries. Thus, it is estimated that at $50 per barrel of oil, the Gulf countries’ purchases of net foreign assets are likely to be negligible. Fiscal stimulus packages will further adversely impact budgetary balances. Some countries with large SWFs such as Saudi Arabia and Kuwait are already experiencing budgetary deficits.
Credit crunch and the need to ensure financial stability and viability of the banking system will require some of the countries with large SWFs, such as Qatar and Kazakhstan, to turn towards domestic priorities, such as recapitalising the banking system and unfreezing domestic credit flows.

Even countries with traditionally strong fiscal positions such as Singapore have announced that they will use drawing down foreign exchange reserves to help support domestic economic activity.

Some countries find their currency under pressure. Thus, the value of Russian’s currency per US dollar fell from 24.7 to 32.8 between January 2008 and January 2009, while its foreign exchange reserves declined to $396 billion in January 2009, from their 2008 peak of $590 billion.

With the end of the era of financial capitalism, many of the assumptions, particularly light regulation of new financial products, and forbearance of new financial players, including the SWFs, are unlikely to hold. Effective nationalisation of the banks in the industrial countries has also altered the business environment for the SWFs.

The acceptance of the state-market balance shifting in favour of the state is, however, likely to make the role of the SWFs more acceptable to the recipient countries in ideological terms. But greater uncertainty and lower global growth prospects for some years will reduce opportunities. Trade and financial protectionism, exemplified by preferences given to domestic industries in allocation of capital, will also reduce opportunities for the SWFs.

Citizens of the SWFs’ originating countries are also likely to demand greater transparency and accountability from their SWFs. Without these, SWFs seeking greater acceptance of their role in reforming the international financial architecture will lack credibility internationally. The global crisis has increased the importance of implementing the Santiago principles for the governance of SWFs.

For India, the urgency of establishing an SWF has decreased considerably as its reserves at $248 billion on January 23, 2009 — down $41 billion from a year ago — no longer appear to be excessive in the current global environment.

On balance, the crisis has made the SWFs ideologically more acceptable, but has led to reduced value of their assets, and diminished inflows. The crisis has also made the investment climate for their operations less hospitable.

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