Not all sovereign funds shy away from strategic stakes
If oil stays in the 60s — and if China isn’t willing to buy Agencies, let alone riskier assets — sovereign funds are not going to be the kind of force in the global economy that many forecast earlier this year. The investment banks are now busy revising their forecasts for the growth of sovereign funds down.
Nonetheless, sovereign funds are not going to disappear entirely, so understanding their various investment strategies remains important. In my view, the common argument sovereign funds are inherently passive, long-term investors interested mostly in financial returns oversimplifies.
For a recent example of this argument — one that happened to catch my attention — consider a recent column from Bloomberg’s Michael Sesit:
These funds represent the excess reserves of countries with large current-account surpluses and/or major oil exporters. They are overwhelmingly invested outside their domestic markets and so far have been managed passively, without political bias, to achieve enhanced returns.
No doubt some sovereign funds are invested passively and without political bias. Norway’s fund certainly invests passively, and its “political bias” is very transparent. The Abu Dhabi Investment Authority, Singapore’s GIC and the Kuwait Investment Authority all seem to focus primarily on managing a passive external portfolio — though in all three cases a lack of transparency makes it hard to know for sure. The KIA is certainly under pressure to do more to support Kuwait’s own market. The scale of the GIC’s investments in the financial sector also at least raises the question of whether the GIC’s strategic is evolving to include taking strategic states that might help to support Signapore’s own ambitions as a financial hub.
But many other funds invest both at home and abroad. Any many aren’t just passive investors either.
Singapore’s Temasek, for example, originally had some similarities to France’s proposed sovereign fund: it managed the Signapore’s strategic stakes in its large domestic firms. And it clearly takes large strategic stakes when it invests abroad.
Many new funds also invest at domestically as well as external stakes. The CIC is still a work in progress. But it certainly has large stakes in a sector that China considers strategic (i.e. the state banks) as well as a foreign portfolio. It recently took a significant stake in the Agricultural Bank of China as part of that bank’s recapitalization. In that sense it doesn’t seem all that different from the French fund Sesit criticizes.* The CIC’s external investment strategy isn’t clear from the investments it has made to date, as most of its portfolio apparently remains in cash. But so far it hasn’t shied away from doing big “deals” that involve taking significant stakes in key companies. It hasn’t limited itself to investing in passive index funds.
Some of the new Gulf funds also seem rather keen on doing strategic investments — and in blurring the line between foreign and domestic investment.
For example, the Qatar Investment Authority owns Qatar National Bank, and it recently took large stakes in Qatar’s other banks as part of their recapitalization. Its real estate arm Qatari Diar is active in Qatar as well as abroad. And it clearly isn’t adverse to large strategic stakes; just look at its current investment in Barclays. Or for that matter, just look at its website.
Most of Abu Dhabi’s new funds also seem rather more keen on taking strategic stakes that ADIA. Mubadala is an obvious example. Part of its mandate is to make strategic investments that help develop and diversify Abu Dhabi’s economy. Look on its web site: it describes itself as a business development firm as well as an investment firm and its mandate as economic diversification as well as financial return. Some of Abu Dhabi’s large state-owned firms are increasingly taking large stakes abroad as well — leading some to consider them mini-sovereign funds.
And then there is Russia’s sovereign fund. It might initially have been designed as a vehicle for making passive investments abroad. But it looks more and more like it will be used to pay off the external debts of key Russian companies, and thus keep them out of the hands of their foreign creditors. It certainly has been given permission to invest in the local stock market to help offset sales by foreign investors.
In a lot of ways it seems — at least to me — that if anything the trend in the sovereign investing world is away from the passive diversified style of some of the older more-established funds and toward the deal-making style of some of the new funds.
Here I may be focusing too much on Abu Dhabi and Qatar. Then again, if oil prices stay low and a host of emerging economies remain cut off from international capital markets, Abu Dhabi and Qatar may be among the few countries that still have the cash flow needed to be adding assets to their funds.
Setting China aside of course.
China could create a much bigger CIC quite easily. All it needs to do is hand the management of more of its current stockpile of reserves over to the CIC. That though seems unlikely to happen in the near term, if for no other reason than the fact that the CIC still hasn’t invested most of its initial allocation.
I suspect that the reduced pace of growth of key sovereign funds over the next year will reduce the attention that they receive. But if the debate on sovereign funds continues, it would be nice to debate sovereign funds as they are — in their full diversity — rather than focus on a model that only applies to some funds. France’s proposed new fund no doubt reflects France’s own penchant for state capitalism. But most of countries that have large sovereign funds that invest abroad also have something of a penchant for “state capitalism.” Their domestic economies look a lot more like the Anglo-Saxon stereotype of the state-guided French economy than the French economy itself.
There are concerns that come even with sovereign funds that have passive investment strategies. For example, even passively managed sovereign funds can emerge from policies — like excessive intervention in the foreign exchange market — that inhibit needed adjustments in the global economy.
But much of the concern about sovereign funds arises because governments that invest strategically at home seem interested, on occasion, in taking strategic stakes abroad.
* There is one difference: China often has used foreign exchange reserves to help recapitalize its domestic banks. This though is a reflection of the fact that China has a lot reserves. It is perfectly possible to recapitalize domestic banks without having any foreign exchange reserves. Just ask Hank Paulson.
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Hi Brad,
I don’t know if I understand correctly the difference between active and passive investors: In my view, active investors use their ownership rights to influence the behaviour and decisions of companies.
The doubts about the intentions and the possibility that SWF invest on political grounds for non-financial reasons are well understood.
But international best practice, as for example outlined in the Principles for Responsible Investment, ask explicitly for active ownership. The challenge for SWFs, maybe with a longer perspective, is not to remain simply passive investors, but to adopt tranparent investment policies. The Norwegian Government Pension Fund – Global is a good example.
This would also be in the interest of the “west”, as we need active owners that promote the environemntal, social and corporate governance agenda. Our challenge is thus not to hope that SWFs will remain passive investors, but to convince them that it is in their own interest to adopt transparent investment policies and international best practice. The IMF did valuable work with its Santiago Principles, the Principles for Responsible Investments would provide a further opportunity for SWFs to gain credibility and trust among western policy makers.
one of the roles of SWFs, presumably, is to help CBs diversify their FX reserves away from dollars; while it may be too much to ask the US to loosen its grip on reserve currency status, i wonder if reconstituted SDRs might provide the anchor for BWIII?
Nice article as always. How do you recapitalize banks without using foreign reserves. Is it through printing/selling treasuries?
Brad,
Once again a hyped up subject (the Triffid-like SWF phenomenon) seems to become less spectacular. Time to revisit those projections against a background of much more balanced trade, a couple of decades of zero growth and a high degree og home state ownership (as well as little green men looking over our economic shoulders).
However, there is still time to revisit the phenomenon before SWF becomes a nationalistic tool for mnaging portfolios of nationalized industries (a bit like the original temasek and (in my humble opinion) CIC. Mexico once had (and may still have, not my field) something called Patrimonio Nacional. Believing that these things might be a sound way to manage a portfoio pf businesses, or the national wealth for that matter would probably not get you an economics degree in either Mexico or Singapore, but thre are politicians and polities that sems to have a tolerance and posibly a (learned) preference for them. Small countries tend to believe in economic nationalism. Smart small countries hide their beliefs and can achieve abnormal national “returns” (in terms of living standards) by fre riding the international relations systems in ways big countries cannot. Th same goes for EU members, the country with capacity for unpunishable free riding is selling its citizens shorth if it does not do so, despite propaganda to the contrary distributed by the big ones who pay the bill. Poland is a fine example of a country where the people understand this, but throw out governments that overplay their hand.
Re banks, bank capital ans nationalization: nationalized banks do not need capital, but they do need a mechanism that makes them disciplined lenders. If the government allows non-nationalized lenders to compete with nationalized ones (neither endowed with overwhelming market share initially) a wide range of strategic developments can follow, also depending on the breadth of banking charters and ease of entry by well capitalzed foreigners. However, in general, state-owned banks might lend too little to politically unimportant and risky firms (pricing differentation is difficult without private capital monitoring management) while large, politically connected firms would tend to get overtly generous terms.
But theoretically, it would not be difficult to structure an incentive set for management around fictitious capital (dynamic in terms to cost and availability to management), based on refence mrkets (for bank capital and bank managers) that may exist in countries with private banking systems and a comparable economic profile.
A real problem for small economies in this respect is that nationalized banks have inherent problems in achieving optimally internationally diversified loan portfolios.
In a nutshell, nationalized banking is not very good idea but probably better than banking systems run by idiots or crooks, although nationalized systems may attract those too…
Jason — the standard way to recapitalize banks is by issuing treasuries. sometimes the treasuries are just handed to the banks. sometimes they are sold in the market raising cash that is used to buy equity (i.e. the current use of the tarp). domestic currency resources are actually better than fx reserves here — as the banks need domestic resources, not foreign currency.
Rien — the current trend seems to be to give even state banks some real capital. see the agricultural bank of china …
bsester: “China could create a much bigger CIC quite easily. All it needs to do is hand the management of more of its current stockpile of reserves over to the CIC. That though seems unlikely to happen in the near term, if for no other reason than the fact that the CIC still hasn’t invested most of its initial allocation.”
What does “most of its initial allocation” mean specifically? What percentage has been invested? Maybe you have already talked about this in a previous post?
reuters reported that about 90% of the CIC’s external assets (i.e. excluding the banks) are in cash, which implies it never selected fund managers/ never did anything much other than the big headline grabbing deals we know of (morgan stanley, blackstone, etc). I have no way of confirming this but it generally seems true, and consistent with the anecdotes i have heard.
bsetser: In my view, the common argument sovereign funds are inherently passive, long-term investors interested mostly in financial returns oversimplifies.
I think the notion that SWF’s really have *anything* in common with each other is a flawed assumption. There’s no particular reason why a Norwegian SWF should look anything like a Qatari or Singaporean one, any more than the politics and economy of Norway look anything like the politics and economy of Qatar or Singapore.
I also don’t think that it makes any sense to talk about “international best practice” at all, since that presumes that we know a lot more about economics than we do. A lot of the assumptions that I’ve seen in “best practices” documents are things that have become discredited or obsolete in the last two months.
Stempel: . The IMF did valuable work with its Santiago Principles, the Principles for Responsible Investments would provide a further opportunity for SWFs to gain credibility and trust among western policy makers.
Why is “credibility and trust among Western policy makers” a particularly important consideration?
Also the Santiago Principles seems to be your standard “useless and silly bureaucratic document intended to convince people that we’ve really done something when we haven’t.” The problem is that if you get SWF managers to agree to something, they go home, and now what? Just because you have SWF managers agree to something doesn’t mean that the people that they report to will care about any of this.
bsetser: That though seems unlikely to happen in the near term, if for no other reason than the fact that the CIC still hasn’t invested most of its initial allocation.
It’s unlikely to happen in the near or possibly at all because CIC was billed as bringing Wall Street fund management expertise and ideas to China, and right now things are on hold because people aren’t sure if this is a good idea or not.
The original idea was that CIC would have had fund managers announced in Q1 2008 and there were RFP’s send out. This has obviously stopped dead because of the financial crisis.
The other thing that is a very pressing issue right now is what the United States government wants to do with General Motors, Ford, and AIG. Rather than talking about last years SWF issues, I think it’s better to come up with the pressing issues right now. I haven’t even seen any list of what are the possible options that the US government has with respect to General Motors.
This all is relevant to the topic of SWF’s, since I would not be surprised if in five years, the US ends up with a huge SWF that owns large parts of General Motors, Chrysler, AIG, and several banks. The reason I see this happening is that I while the US government might try everything is can to avoid nationalizing General Motors, it may come up with the reality that GM either gets nationalized or liquidated.
So maybe there are steps other than nationalizing General Motors, but I haven’t heard of any public discussion listing them.
Brad,
The current trend may be to give even state banks some real capital, but that my be for four reasons: (1) as a mechanism to harden budget constraints and reinforce managerial incentives (2) rating agencies do not like to give high ratings to nationalized industries unless they are explicitly guaranteed (or use some mechanism to guarantee claim holders automatic recourse to the state itself (3) international activities may require Basle I or II compliance and (4) posibly to provide an earnings cushion, which would of course amount to a subsidy, unless there was a dividend obligation attached.
The key thing remains that nationalized banks have to function like well-managed private banks, i.e. like banks that can maintain sufficient capital to absorb reasonable unexpected losses whilst offering competitive returns to providers of risk capital. The current, near-manic environment in mainstream capitalist systems makes that difficult for anyone, private or state, so capital has basically lost its managerial incentives function, hopefully temporarily. Capital within the Chinese environment (clearly not a mainstream capitalist system) is different. The market has a pretty unique “logic” and raising capital from the state is, like everywhere else, a political activity and hence follows rules specific to the political culture (connections, accountability, transparency, contestation etc) the stated rationale may even be similar to that used in the “west” but the real balance betwen the 4 reasons may be very different
Twofish,
As usual excellent comments but:
Why should the US automakers not go the way of US shipbuilders? Why van Toyota, Honda, BMW and Daimler Benz produce conomically in the US whilst GM and Ford cannot? Why then should the US gvt bail the shareholders and creditors out? Pension liabilities?
2fish: “the US ends up with a huge SWF that owns large parts of General Motors, Chrysler, AIG, and several banks.”
if so, they’ll have to change the acronym from SWF to SDF.
Huizer: Why should the US automakers not go the way of US shipbuilders? Why van Toyota, Honda, BMW and Daimler Benz produce economically in the US whilst GM and Ford cannot? Why then should the US gvt bail the shareholders and creditors out? Pension liabilities?
The fact that Obama is President-elect in part because he won Michigan and Ohio. A lot of real world economics cares very little about ideological consistency.
The US and others will have domestic bailout funds; that is a bit different though than a fund that invests surplus fx abroad.
the net effect tho will be that the US does own financial assets abroad through say its ownership of AIG. but i would still disintguish among SWFs that have a BoP/ XR management function and those that do not.
2fish — i have a lot of sympathy for your point that SWFs are more different than alike , as they tend to be reflections of the politics of their home country.
Twofish,
This political economist and investor likes ideologies, but does not like to favor only one. Theoretical economics is not ideological as long as you do not let it become too influential in policy making (of course there is abuse of economic theory by politicians, as there is of religion or fear of epidemics). I see it as an interesting and not too difficult branch of applied mathematics, and a source of inspiration for politicians. But this blog is about economics and it does not do any harm to adopt mainstream economics reasoning occasionally for comical effect, despite being aware that the good people of Michigan etc do not like to default to subsistence wages because their output is no longer overwhelmingly attractive. Rather than hanging their managers (past and present), union bosses, and themselves they would like someone to give them a break and that could only be a very great fool like Uncle Sam, but, let’s face it that is precisely what politics is all about, you take from the commons what you gan get away with. Physicists do not know these things, of course.