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How Are GCC (and Other) Sovereign Funds Faring? An Update

by rziemba
February 21, 2009

This post is by Rachel Ziemba of RGE Monitor where this post first appeared. Thanks to Brad for letting me fill in.

Recently,  Reuters reported that the assets under management of Kuwait’s sovereign wealth fund fell to 49b Kuwait Dinar ($177.6 billion) at the end of December from 58 billion Kuwait Dinar ($218 billion) in March 2008. – a face value decline of about $31 billion. Given that Kuwait had record oil revenues in 2008 (and a record fiscal surplus even if revenues tailed off in the second half) and KIA likely received record new capital, this implies that investment losses were even larger. It is significant for two reasons. One it shows that the estimates of fund performance (including those released in a recent paper by Brad Setser and myself) are on track and two, it could suggest that within limits there may be increasing amounts of transparency among sovereign investors. It also will provide an interesting test case of how the population and opposition react to the losses on the national wealth.

Unlike funds of its neighbors, Kuwait’s fund has to routinely report to its parliament and at such times information on its assets usually is released to the press. Doing so increases the robustness of estimates of their performance and may also open up channels to domestic pressure concerning how the national wealth is being managed. Domestic politics has influenced decisions in the past – Kuwait Petroleum’s deal with Dow Chemical was reportedly withdrawn under political pressure. So it will be a case to watch, as will the funds of Singapore which have also noted investment losses in response to legislative questioning.

The numbers seem to refer to Kuwait’s future generations fund, the larger of the two pools of money managed by KIA. The other, the General Reserve Fund,  is smaller, perhaps around  $40 billion. It is on the one hand more liquid as its name suggests but also holds the countries holdings in domestic equity and property markets. KIA itself though was also authorized to invest in the domestic equity market to prop up prices.

In out paper, Brad and I estimated that KIA’s foreign assets  (including the assets of the general reserve fund) fell to $228 billion in Dec 08 from $265b in March. Since evidence suggests that the GRF has an AUM of around $40b, that means we are pretty close, estimating face value losses of $33 billion.  Taking account of the net inflows received in 2008, the valuation losses on the equity and alternative asset-heavy portfolio might have been well over $90 billion – only partly offset by inflows of over $50 billion. This pattern manifested itself across most of the gulf funds as well as other funds with similar asset allocations like funds of Norway, Singapore and many university endowments.

Given the performance of risky assets in January and February (especially the deterioration of the last week) KIA has faced  further losses. In fact, based on our model the assets under management for the big GCC pools of capital (ADIA, KIA, QIA, SAMA) are estimated to have fallen to $1085 billion at the end of January from $1115 billion in December 2008 and $1165 billion in December 2007.  This takes the estimated total assets of GCC sovereign funds and central banks to $1.16 trillion by the end of January down from. $1.12 trillion in December. If asset prices end February where they closed yesterday (Feb 20), the AUM might fall to $1.13trillion at the end of this month.

All of these estimates assume no major changes in the asset allocation of these funds. This may not be correct. There is evidence that the funds of the gulf are increasing their allocation to liquid assets. This can be accomplished in two ways 1) not rebalancing to maintain an allocation share or 2) allocating new funds, if any, in a new way or selling one asset class to raise funds to buy another.

These valuation losses, come at a time when GCC countries (and many other sponsors of sovereign funds) are starting to need more liquidity and when oil prices have fallen below budget break even points even as oil production has fallen. Some governments may already be drawing on their savings to finance deficits. The foreign assets of Saudi Arabia’s central bank and pension funds fell around $5 billion in December, which may only be the start of the trend as Saudi Arabia runs a deficit at current oil prices and production.

The following charts update those in the paper, showing among other things that even if the oil price were to inch back up to $75 a barrel, GCC foreign asset purchases would fall far short of those in 2006 and 2007, when oil prices averaged slightly less.

Moreover, assuming modest investment returns, it would take a long time for the GCC’s portfolio to return to the peak of early 2008.

A few recent trends to note in the world of sovereign wealth.
1)    Sovereign funds are likely to privileging liquid assets as their needs for it increase. Oil funds are particularly vulnerable as their new funds have dried up. However, the other many source of surplus funds has also tapered off with capital flows to emerging economies reversing.  China’s pace of reserve growth has slowed and most others have reversed. As a result these countries may be pickier about how they allocate their assets. Korea is unlikely to allocate more funds to a sovereign fund now that it needs a higher cushion of fx liquidity.  Data in Singapore’s balance of payments which appears with a lag suggests that GIC’s pace of portfolio investment began slowing in Q3 2008. With the Singapore economy contracting sharply, it plans to draw on its reserves, some of which are managed by GIC, to finance its fiscal deficit.

2)    Instead of Investing abroad many are investing at home. If they do invest abroad, they may prioritize sectors consistent with domestic development goals. The latter trend began in 2007/08 but may have been accentuated by the reduction in available capital. Funds like Mubadala may find it easier to attract funds than others. Domestic banks also require capital and many countries are implicitly guaranteeing the debt of their corporate sector. All in all fewer funds are available for investment and other domestic outward investors may win out. .See here for a list of domestic investment by sovereign funds or their parents.

3)    Uncertainty about valuations may be deterring investments. Despite losses, sellers may not be willing to take current prices, mean the gap between buyers and sellers in key resources is.

4)    When they do (return to) invest, the sectors of interest may be shifting. Consumer focused goods may not be so appealing. The investment in the banks is well under water. Resources and other real assets may return to being attractive for a range of sovereign investors, especially those in Asia. Chinese loans to cash-strapped resource companies are only one example.  Some sovereign funds are talking about adding to real estate holdings. Norway’s fund in is talking about finally beginning to implement its planned new allocation to property and CIC officials also raised the possibility. But with prices yet to bottom out in the U.S., Europe, China and elsewhere, this may not yet be the time.

5)   Those funds that maintained conservative asset allocation outperformed their more diversified colleagues in 2008.  Those funds that planned to give more cash to invest in a range of diversified assets may shift their plans. There are some exceptions. Libya seems now to be planning to use its cash to buy Italian companies and Banks (it owns stakes in ENI, Unicredit and announced a recent plan to co-invest with Mediobanco).

6)    Funds that were reliant on leverage or who needed to raise capital in order to make investments have gone silent and are trying to sell some items. The funds of Dubai are a prime example. Isthithmar was reportedly trying to unload Barneys, a rumor it sought to quash. Even if that is untrue, many of the purchases made at the peak are under water and the leverage involved makes them vulnerable. No wonder various of the funds have been merging and seeking out new strategies, seeking investments that will hold their value in the downturn.

As always, its very hard to generalize across sovereign funds, but in general with fewer funds available, expect them to continue to be less active than some of the more optimistic observers thought this time last year and focused much more internally.

18 Comments

  • Posted by Indian Investor

    @Rachel:
    I have strong objections to petrodollar recycling,crude price manipulations,and mainly to medium intensity wars over oil resources and logistics.
    The current system of funding entire governments from oil export proceeds by having a cartel called OPEC that is secured by the US military is unsustainable in the medium term.
    There’s plenty of oil and the break even price of oil should be determined in the same way as you might determine the break even price of tobacco or coffee… by adding a reasonable margin for the capital and technology involved to the basic production cost.
    In the interim it’s better these oil exporters have their own large sovereign funds and invest to develop their own economy. No point in sheikhs keeping billions of dollars in New York and London banks and having the money recycled for nefarious US oligarchy purposes.If the shiekhs transfer their personal funds to the sovereign funds, all the better.
    Oil is basically a smelly, dislikeable fluid, and the world can replace it with nuclear plants, or some other source of energy whenever it wants. Besides oil, like rocks, is infinite in supply. All the oil wells in the whole world aren’t worth shooting a single bullet over, let alone have oil geopolitics wars, oil based sovereign wealth funds, and all the crazy stuff that goes on around oil.
    The new theater they’ve opened up is for carbon emissions trading. The US hopes to holds its dollars up in the exchange market with CFTC manipulations of carbon trading and strict international carbon emissions norms.
    I hate oil!

  • Posted by Twofish

    Investor: But the US Treasury secretary is scared to act to change the management of these institutions.

    No he isn’t. All of the top executives of AIG, Lehman, Freddie, Fannie, Washington Mutual, and Bear-Stearns lost their jobs. So far Treasury hasn’t fired the heads of the megabanks, but there are good reasons for that. JPMorganChase and Wells Fargo have managers that seem competent. Bank of America is in trouble because it bought Merril-Lynch and it was strongly encouraged to do that by Treasury. That leaves Citigroup, and the new CEO has only been there for a short time, and most people think that he is part of the solution and not part of the problem.

    As far as the non-bank institutions, you have much bigger problems because there is no obvious legal way that Geither could fire the head of General Motors without forcing it into bankruptcy. GM can create a hostage situation in ways that banks can’t.

    Investor: While the US Government itself displays the height of irresponsibility, it isn’t even in a strong position to call these firms to account.

    This is the sort of thing that really ticks me off. Yes, lots of people made mistakes and did really stupid and perhaps even immoral things. But if you want people to help put out the fire, it helps that you wait until the fire is out before bashing them.

    I really should have a thicker skin against this armchair quarterbacking, but I am human, and after spending lots of time and effort trying to fix the problem, I do have my limits at being bashed.

    Investor: What I find curious about people like Brad Setser is that they spend their time fiddling with minor data from the rest of the world, and not focusing on the bleeding head of the Wall Street Bull that lies on the table.

    Will you please kindly knock this sort of questioning of motives off. It’s really annoying to people that are actually trying to fix the problem rather than just be on the sidelines.

    It helps a lot in getting through this mess, if we assume that everyone else is trying to do their best.

    In the case of financial messes, they are *huge* problems with lots of different and complex interactions.

    Brad and Rachel aren’t focusing on Wall Street because they don’t work there so they are focusing on issues that they do have deep knowledge on rather than blathering on about things that they don’t.

    I have more street level knowledge about what happens on Wall Street since I spend much more of my time near or on a trading floor than Brad and Rachel do, and I think I understand more than anyone else on this list the details on how toxic assets are bought, sold, and priced (even though by Wall Street standards my knowledge is at the kindergarten level). I don’t have the knowledge of trade statistics or macroeconomics that Brad and Rachael do, which is why I’m interested in what they write.

    The thing about finance is that there is no such thing as “minor data.” Every scrap of information that you can get means something, and getting it right means zooming in on the details.

    Personally, I think that everything that is happening in Wall Street is more or less a sideshow and the big problem is employment.

  • Posted by Twofish

    Investor: The current system of funding entire governments from oil export proceeds by having a cartel called OPEC that is secured by the US military is unsustainable in the medium term.

    It depends on what you mean by the “medium term.” Everyone knows that the cheap oil is going to run out in about 20 years, which is why all these oil sheikdoms are investing furiously in SWF’s so that they have something once the wells run dry.

    As far as US military intervention. It’s quite sustainable. Unlike the 1970′s the Middle East does not face any external threats like the Soviet Union. The only threats are those that the US military is more than enough to deal with.

    The two major uses of the US military in the Middle East (Iraq and Afghanistan) really have very little to do with oil. Iraq was to “spread freedom” and Afghanistan is for revenge.

    Investor: There’s plenty of oil and the break even price of oil should be determined in the same way as you might determine the break even price of tobacco or coffee… by adding a reasonable margin for the capital and technology involved to the basic production cost.

    The cost of production varies wildly from place to place, and because most of the cheap reserves are in Saudi Arabia and Russia, the cost depends on how much oil the two are willing to put out, and in doing so, they tend to be profit maximizers.

    Investor: In the interim it’s better these oil exporters have their own large sovereign funds and invest to develop their own economy. No point in sheikhs keeping billions of dollars in New York and London banks and having the money recycled for nefarious US oligarchy purposes.If the shiekhs transfer their personal funds to the sovereign funds, all the better.

    The sovereign funds are all managed in New York and London. The Arabs would like to get a financial center started in Dubai and the Western banks are all helping them. But financial centers take decades to develop. One problem that the major oil producers have is just lack of population, which means that it is tough to put together any diversified industries.

    You seem to have some very deep and very basic misunderstands of how money works. All money is are bookkeepping entries in an electronic database.

  • Posted by Twofish

    Investor: Oil is basically a smelly, dislikeable fluid, and the world can replace it with nuclear plants, or some other source of energy whenever it wants.

    No, it can’t. The thing about oil is that it has extremely high energy density which means that you can create mobile engines from it.

    How do you create a nuclear car? Well you can do it with electric power, which is why everyone is interested in hybrid vehicles. But just replacing all of the gas powered vehicles with electric generated ones is going to take a few decades.

    And that’s not counting the four billion people that want cars.

  • Posted by bsetser

    Indian investor — this is your final warning. Please address your comments to the post, address the argument (and not the person). this is a blog that focuses primarily on the int. balance of payments and global flow of funds — which may or may not be the issue that interests you. Rachel put up valuable work on one aspect of the global flow of funds– namely the repatriation of the gulf’s foreign investment to cover current spending/ domestic investment/ domestic bailouts at current oil prices. your comments questioning her personally (and me too) was absolutely unacceptable.

    i hope subsequent comments by all parties will return to the theme of the post.

  • Posted by Rachel

    Thanks all –

    Indian investor – we can discuss issues of peak oil and oil depletion elsewhere, however I think most petroleum engineers would argue that oil per se is not infinite, ie it is not regenerated. hence. but you and I had this debate on my post on China’s resource buys.

    twofish – apologies for not making the link to wall street explicit. one of my reasons for focusing on how countries like oil exporters and other sovereign investors like China are managing their funds is to understand how their investment decisions affect domestic and global markets. The challenges of managing a vast increase in funds over recent years, added to domestic and international distortions. Furthermore decisions on spending and saving also influence how much is being absorbed at home ie how much consumption is being increased.

    However, the influence of GCC funds on asset prices is lower than now given the reduction in flows of funds. some evidence would suggest that they were never that high. However, I do think it is significant that the most risk-seeking (in terms of interest in equities, alternative assets) sovereign investors may now be becoming conservative (a point Brad and I highlight in the paper).

  • Posted by Rachel

    twofish –
    good to point out the varying cost of production, eg the cost of production is much lower in Saudi and Kuwait. It can also vary significantly within countries, eg the cost of extracting Libya’s offshore oil is much more expensive than some of its onshore supplies.

    Furthermore the fiscal regimes of these countries vary, having an influence on investment in exploration and extraction. Many oil companies in Russia (especially IOCs) had mixed incentives to export given the export taxes.

  • Posted by Off the boil

    bsetser responds:
    Indian investor — this is your final warning. Please address your comments to the post, address the argument (and not the person). this is a blog that focuses primarily on the int.

    Could you pls show us where he is mudslinging on the person ? I dont see a mention in this thread . Are you referring to an old thread ?

  • Posted by Jen H

    Hi Rachel–

    Great post. Learned alot. Two questions for you:

    - My sense is that what were once important economic steam valves to release either currency or commodity pressure, SWFs might now become bets of last resort for maintaining adequate liquidity (or solvency in the case of Dubai)… if this is a fair assessment, how might it change the management? Will these governments become more attentive / take a more active interest?

    - If not consumer goods, then what sort of recession proof investments do you foresee? I’ve long advocated soliciting SWF investment in US infrastructure, which by its nature, seems to carry less of the CFIUS-style risks that might trip SWF investment ( executing a surprise financial attack where infrastructure is concerned would seem to amount to blowing up a bridge or a dam; far more mutual destruction than simply pulling out of a massive holding overnight). The obvious problem with this is the liquidity point that you mentioned, but perhaps some of this could be mitigated through playing with the bond offerings? Or channeling it into an infrastructure fund — perhaps run by the IFC or some other intermediary– that could allow for a little more liquidity if / as needed.

    - what sort of M&A activity with SWFs are you referring to? Does this portend more clubbing deals with some of the major pension and PE funds in the US?

  • Posted by bsetser

    off the boil — i took down the comment. it said something to the effect that rachel ziemba falls in the same category as brad setser (focusing on small issues rather than corruption on the street). that is disrepectful to rachel, who graciously has been filling in for me – as it resorts to name calling rather than argumentation.

    and in the past indian investor has called me a “sadist individual” and a few other things, no doubt hoping for reaction. most of these comments have been taken down as well. I don’t mind having my arguments challenged; in fact, i would be disappointed if there weren’t challenged. But the tone on this blog needs to be civil, and not personal.

    now, we should discuss the content of rachel’s posts …

    Rachel — agree that some risk seeking sov. investors have become conservative. but china now seems to be seeking risk again — or rather moving toward a bimodal portfolio of safe treasuries and potentially risky $ loans to Chinese SOEs looking to expand abroad, without much in the middle.

    indeed, i suspect a host of sov. investors — not just the known (former) risk seekers in the gulf — took on a bit more risk in the first part of 07 (notably by dabbling in equities and non-SDR currencies like the Aussie dollar) and subsequently have gotten burned.

  • Posted by bsetser

    jen H — treasury bonds seem to have been negative correlated with oil in the most recent downturn. equities not so much — even some stocks that might be thought to benefit from lower oil. a global downturn is bad for oil and bad for equities but good for bonds … may be that is too conservative (and it may overgeneralized based on correlations of the past few years) but it is one answer to the question of what oil exporters should hold.

  • Posted by Cedric Regula

    Interesting to see that Libya was allowed to buy Italian companies by the Italian government. Especially typically sensitive companies like a bank and Italy’s only oil company…

    If there is any truth to the rumored size of European bank exposure to a crumbling economy in Eastern Europe, large parts of Europe could be on fire sale by this time next year. With euro sovereign bond issues failing, it looks like they may have much more trouble than the US in recapitalizing the euro economy. Then Trichet will be under real pressure to fix things up again the only way Central Banks know how.

    So next year they may have a smorgasbord of things to pick thru, ranging from Spanish banks to Berlin office buildings, to maybe even whole countries like Luxembourg, or at least the post office.

    But of course it would be wise to wait and look for signs of the global economy stabilizing and asset prices and currencies to stop falling.

    So until then they can join the crowd in short term treasuries or US government insured commercial paper. Maybe even do a little carry trading in the 10 year to juice up returns a bit.

  • Posted by locococo

    Perhaps they bimodal portfolio model calculated that the risk of risky treasuries outweighs the risk in potentially safe $ investments through Chinese SOEs to expand in tanginble assets, without nymex / comex in the middle.

    Brad, welcome back.

  • Posted by Cedric Regula

    Here’s brand new e-mail newsletter from John Mauldin. He looks into the Euro & Swiss bank vs Eastern Europe problem some more. The dynamics of the situation look like it’s sure to blow. Euro commercial banks are leveraged 30:1 compared to 12:1 for our commercial banks. Makes them more like IBs.

    Usually the Middle East is more tuned in to Europe than we are, so I’m sure they see it coming too.

    Get the whole article here. It’s free.

    While Rome Burns
    http://www.frontlinethoughts.com/gateway.asp?ref=reprint

  • Posted by Twofish

    bsetser: Rachel — agree that some risk seeking sov. investors have become conservative. but china now seems to be seeking risk again — or rather moving toward a bimodal portfolio of safe treasuries and potentially risky $ loans to Chinese SOEs looking to expand abroad, without much in the middle.

    I think in this situation saying that “China seeks” is not a good idea since the risks are spread among the different actors within China.

    Having said that I think that the loans that are being made to the SOE’s are medium risk, at least from the point of view of the people making them. As debt obligations, they have to be paid before anyone else, and if the investments go bad, the SOE is forced to either pay for the loans from other operations or go bankrupt. The types of corporate expansions that the SOE seem to be wanted to undertake are standard variety corporate expansion activities that would be classified as medium risk in the West.

    What would be considered high risk are either straight bets on commodity prices or high technology venture capital start ups. Neither of which I see the Chinese government doing much of.

    Also in conversations I’ve had about the priorities for the Chinese financial system, there are three issues that always come up….

    a) the need for more funding to small and medium enterprises,
    b) the need for some mechanism similar to Silicon Valley venture capital to fund high risk high technology growth companies,
    c) the need for some mechanism to encourage small and medium business growth in rural areas

    One big problem in banking is that its relatively easy to make 2 US$1 billion loans, but really difficult to make 2 million US$1000 loans. As a result, SWF’s often have this bias toward funding (and over funding) large capital intensive enterprises, but an inability to find small businesses.

    Chinese banks tend to be awful at lending to small businesses. So what has happened is that small manufacturing businesses in the coast get their money from overseas, partly through foreign direct investment, but more often through loans from ethnic Chinese through Hong Kong and Taiwan. This I think had two effects:

    1) it increased exposure to international banking crises since the HK and Taiwan money came from investment banks, and

    2) it biased investment toward exports, If you are a non-PRC investor, you just can’t easily invest in a small non-export factory in rural, central China, because there is no easy way you can convert the profits of that factory back to US dollars. If you are going to put money in something, it’s going to be a factory that you can make goods that you can exchange for dollars.

    So the bias toward exports was as much a result of state non-policy as it was a result of state policy.

  • Posted by Twofish

    One big problem with the Chinese governments efforts to “go global” is that I suspect that there is going to be a huge amount of capital protectionism now. I’m not too worried about trade protectionism, but capital protectionism may be the wave of the future.

    One consequence of recent events is that it has caused companies to be more strongly associated with governments and this will have some interesting impact. The US government has bailed out GM, but there is no way at all that it will bail out Toyota or Nissan. Once GM gets money, then the US government will be rather upset of GM uses this to money plants to China or Mexico.

    One other thing to note is that the US government is going to make a series of extremely crucial decisions in the next two months, namely what to do about the banks, and what to do about General Motors and Chrysler.

    The constant statements that the US intends to continue with a private economy reminds me a lot of the Chinese leadership in 1978 insisting that the experiments in market economics and private ownership where just small scale experiments, and that they would be kept limited like a bird in a birdcage.

    What is going to happen is that once some crucial decisions are made, this forces you to make other decisions until you get somewhere that you never intended.

    If the Federal government decides to nationalize GM and the banks, it may eventually return them to private control, but it’s going to take some years before that happens. Right now, I sense that people are under the impression that the Federal government will maintain control of the banks and auto companies for a few months, and then privatize them, and this seems very unrealistic to me.

    Once you get to the point where you see Federal ownership as a semi-long term situation (i.e. 3 to 5 years), then it becomes essential to set up an SWF structure rather than having things done ad-hoc.

  • Posted by JD

    Does anyone know if oil rich sovereign fund use derivatives to lock in the future price of oil. Also, do oil rich countries/state run firms negotiate long term contracts with large buyers? If so, is it enough to have any significant impact on their profits?

  • Posted by Twofish

    JD: Does anyone know if oil rich sovereign fund use derivatives to lock in the future price of oil.

    I very much doubt it. There is too much oil and too few derivatives and anyone that is willing to be on the other side of a trade with an oil producer is an idiot, since they can adjust the price of oil and wipe you out.