Whatever happened to sovereign-wealth funds? Eighteen months ago SWFs were destined to acquire swathes of Western companies for foreign governments, not all of which always passed the smell test. They then had a brief cameo as the saviours of Western banks, piling in where few other investors dared to tread. But lately things have gone quiet. That partly reflects the big losses that many funds are sitting on. But there is also a suspicion that the funds are a little passé; that their importance was as exaggerated as the merits of leveraged buy-outs or originate-to-distribute banking.
It is easy to see why they rose to prominence. As the current-account surpluses of oil exporters and Asian countries were recycled, foreign financial assets controlled by governments soared, reaching about $9.5 trillion in late 2008, according to Alex Patelis, an economist at Merrill Lynch. That is equivalent to roughly 15 percent of the value of all publicly traded shares and bonds worldwide. A quarter of this is held by SWFs. They take more risk than the central banks that manage foreign-exchange reserves, by investing in shares and even hedge funds and private equity.
Assuming a high oil price and a long global boom, the boldest forecasts suggested that the total amount of foreign assets held by governments could double in under a decade and that the proportion invested through SWFs would rise to over half. It was just about plausible that SWFs could become as influential in stockmarkets as hedge or pension funds.
Like most things financial in the past year, nothing has gone according to plan. The sovereign funds that hold shares have suffered large losses. A recent paper by Brad Setser of the Council on Foreign Relations and Rachel Ziemba of RGE Monitor, a research firm, estimates that Gulf foreign-reserve funds and SWFs (the distinction is often blurry) lost $350 billion last year, or 27 percent of the value of their assets. That is a similar fall to a typical pension fund. High-profile investments in struggling Western banks have been disastrous.
Meanwhile the crisis has shifted priorities. Some countries, such as Russia, have depleted their reserves to defend their currencies from capital outflows. And just as Western governments are borrowing to fund bail-outs and stimulus packages, so many surplus countries are tapping their reserves of extra cash. China Investment Corp., a $170 billion SWF which invests at home and abroad, has been buying shares in domestic Chinese banks at the same time as Western firms such as UBS, Royal Bank of Scotland and Bank of America have been selling theirs. The $50 billion Qatar Investment Authority has also been buying stakes in local banks to shore them up.
Heavy losses are hardly unique. But the hunger to buy assets may well fade, too. This is easiest to show for oil exporters. Mr. Setser and Ms. Ziemba estimate that with oil at $50 a barrel (comfortably above its current level), Gulf states’ net purchases of foreign assets are likely to be close to zero, from a peak of over $300 billion annually, taking into account likely domestic government spending. With oil at $25, foreign assets would probably have to be sold (see chart). As well as its currency and corporate woes, Russia is expected to face a budget and current-account deficit this year, which may lead it to draw on its surplus cash.
The picture is less clear for Asian countries, which, led by China and Japan, account for about half of the world’s foreign-exchange reserves and sovereign-wealth assets. Few expect China’s current account to balance even in the medium term, but the country’s surpluses are likely to stop growing so quickly and may even shrink before too long.
Even if the SWFs do not become as big as some had projected, might they become more gung-ho, gradually moving out of safe investments like American Treasury bonds into riskier equities and alternative assets? Here the picture is clear: since the credit crisis began, they have become more risk-averse. Among the most cautious is China, which has been selling American agency bonds since their main issuers, Fannie Mae and Freddie Mac, the two mortgage giants, flirted with default in mid-2008. Instead it is buying Treasuries. The Saudi Arabian Monetary Authority, with $500 billion-odd of assets, is being run even more conservatively than usual: between June and November the share of its funds held in gold, cash and deposits rose from 22 percent to 31 percent. The similarly sized Abu Dhabi Investment Authority has been cutting its equity allocation to the lower end of its target band of 40-55 percent of assets, and giving more to index-trackers and less to expensive active managers.
This caution is not particularly surprising. As Mr. Setser puts it, at times of crisis “the only thing you want from your foreign portfolio is not to have to worry about it.” Nor is it universal: Singapore has said that its two investment vehicles are now poised to “take advantage” of opportunities thrown up by the slump. But there are good reasons why surplus countries may think hard now before shifting their portfolios into riskier assets.
Stephen Jen of Morgan Stanley points out that the crisis has reminded some economies, such as Russia and South Korea, of how large capital outflows can be; that makes it especially important to buffer reserves with risk-free liquid assets, preferably in dollars, which can be readily used for currency interventions. And it seems likely that large capital inflows contributed to the overvaluation of Western assets. If and when oil exports and trade imbalances next reach a cyclical peak, it may make sense to park surpluses in low-risk assets until the boom subsides.
The China Investment Corporation’s website still says it is looking to hire investment professionals who it can offer “exciting” opportunities in a “fast-growing and dynamic institution” that runs “a global portfolio.” From being an understatement that now looks like an exaggeration.