Asian SWFs are among the most significant for political reasons as much as economic. Concerns are often raised about the strategic objectives of the major funds in China in particular, while understanding the complexities of the internal politics driving their own formations and subsequent investment strategies can be a challenge.
Edwin Truman at the Peterson Institute of International Economics finds five areas of concern over the impact of the activities of SWFs:
Mismanagement of investments by SWFs to the economic and financial detriment of the citizens of the home country of the fund.
Pursuit of national political or economic power objectives via SWFs.
Exacerbation of financial protectionism inspired by actual or perceived threats from foreign SWFs.
The potential for financial market turmoil and uncertainty associated with SWF activities.
Conflicts of interest between countries with SWFs and countries in which they invest.
Yet how valid these concerns are is debatable. Often, the distrust of SWFs may be more due to a lack of understanding of what drives their strategies than any underlying unacceptable behaviour. Indeed, a recent paper by academics Saadia Pekkanen and Kellee Tsai, “The Politics of Ambiguity in Asia’s Sovereign Wealth Funds”, highlights the fact there can often be a large gap between some of the alarmist views expressed by western observers and the realities of the domestic politics driving investment strategy, giving rise to behaviour seen as ambiguous in objectives.
China attracted the most concern and the country has a total of four major SWFs. The State Administration of Foreign Exchange Investment Company (SAFE) set up in 1997, the National Social Security Fund (NSSF) in 2000 and the China-Africa Development Fund in 2007. Most prominent is the China Investment Corp. (CIC), which was also set up in 2007, with an initial capital of $200 billion and a mandate to increase returns on China’s then $1.5 trillion of foreign exchange reserves.
As Pekkanen and Tsai argue, the controversy surrounding CIC stemmed from concerns, especially in the US, that it would be acting as an arm of the Chinese government in ways seen as unacceptable, such as securing energy resources or purchasing strategic assets for geopolitical purposes, obtaining access to sensitive technology or information, and giving financial institutions with CIC investment preferential access to China’s financial markets.
Pekkanen and Tsai believe the popular image of China deploying its $2.4 trillion or more in reserves for geostrategic motives is mainly alarmist. The actual proportion of CIC’s funds invested abroad is far more modest than the total size of its fund, 27.5% as of October 2009, which in itself is only a small fraction of its total reserves. Instead they see CIC has been characterised by conflicts among the Chinese institutions that led to its creation.
Asia versus the world
To understand the issues that face CIC and other Asian SWFs, it is necessary to realise they cannot be compared with most global peers. The major Asian SWFs are fundamentally different in one critical respect - the source of their funds is foreign exchange reserves, unlike SWFs in the Middle East and the Norwegian Government Pension Fund Global.
While the politics and objectives of the Asian SWFs can differ dramatically, the common source of their funding does have a profound impact on their behaviour. They also form a peer group whose members do compare themselves with each other.
As John Nugée, senior managing director of SSgA’s Official Institutions Group points out, the commodity-driven SWFs in the Middle East and Norway are more like endowment funds, managing net wealth with an indefinite, and in many cases essentially infinite life-span.
For the major Asian SWFs, the main driver of the build-up of sovereign wealth is current account surpluses, which are first brought into the authorities’ hands through the central banks as they intervene to manage their currencies. This is a considerable and profound difference, Nugee agues.
In Asian countries the central bank receives the cash first, not the SWF. In Abu Dhabi, the central government gets the funds and immediately passes it on to ADIA. If the funds are received as a result of forex intervention, it is the central bank that receives it, and it is then a separate decision as to whether and how much to pass on to a SWF.
Moreover, the central bank is a bank, and each of its assets has a liability attached to it. Transferring assets from one entity to another creates liabilities and assets. CIC, like its Asian peers, is essentially managing a balance sheet.
The Asian SWFs also differ considerably among themselves in the extent to which funds and autonomy on investment is passed on from the central banks to the SWFs.
Challenges for Asia
In Singapore, there is a well-established route to passing on cash from the central bank to Temasek Holdings and the Government of Singapore Investment Corp. (GIC), which are among the longest established SWFs in Asia.
Nugée sees Hong Kong as standing at the opposite end of the spectrum, adding the Hong Kong Monetary Authority (HKMA) manages the Exchange Fund, or forex reserves, which is more than $200 billion. “This is much more than Hong Kong needs for the currency requirements of its currency board. There is a definite amount of surplus capital there. Unlike Singapore, Hong Kong has decided the surplus should be managed by the HKMA so they do not need to explicitly define the surplus assets.”
Korea stands somewhere between the two extremes, he says. “In Korea, they are building up foreign exchange through the central bank and then it is a second decision as to how much is surplus and can be put into an investment vehicle.”
The challenge for central banks in Asia, particularly when they remember the experience of the 1998 regional financial crisis, is that they can only be wrong one way.
In Korea the money is passed to Korea Investment Corp. (KIC), but the central bank has the ability to call it all back, so it represents a halfway house. Thus, the KIC does not have complete confidence that it will not be asked at some stage, to provide liquidity.
China versus rest of Asia
By contrast, the money passed over to CIC is final. There is no assumption that SAFE can call the money from CIC. It is more of a one way transfer. The central bank could in theory ask CIC to return cash, but whether it does so or not would be a decision for the political authorities. What this means is that the central government in China is very cautious on how much they give to CIC.
But CIC and GIC don’t face liquidity challenges unlike the KIC. “CIC may have a liability which gives a hurdle rate but the cash is unlikely to be called. If they make losses, they have the time to be able to recover them,” says Nugée.
It is interesting to examine how different national authorities within Asia address the issue of how much of their forex reserves should be passed onto an autonomous SWF and its impact on the investment strategy.
As Nugée points out, Singapore decided 30 years ago a regime for how much they needed in forex reserves at the Monetary Authority of Singapore and anything extra is moved outside of the central bank’s reserves. While Temasek was initially set up in 1974 as an investment company to manage assets in local industry, GIC was explicitly set up in 1981 to generate higher returns on its foreign reserves with a global portfolio with 43% in the Americas, according to Pekannen and Tsai. In contrast, the HKMA policy managing the Exchange Fund from within the HKMA, is to have a maximum of 25% in equities as a target and according to their website, they are currently underweight.
Having passed funds over to a SWF with varying degrees of autonomy, the question then arises as to how that SWF should be steered towards developing its investment strategy. In this respect, CIC is interesting. CIC was capitalised by a $200 billion loan which means the fund has to generate a 7.3% minimum return to meet its funding obligations. There is a strong incentive to invest in profit maximising assets.
Asian SWFs are more aware of hurdle rates and liabilities and so are cognizant of the healing qualities of time. “A great asset of all SWFs, particularly those with net wealth such as the Middle Eastern ones and Norway’s, is that if there is a bad quarter, they have time to make it up. CIC has a liability which details what returns they have to make. With the luxury of time, they have a long cycle in which to earn more than the hurdle rate,” says Nugée.
Still, it remains challenging to make the case that CIC is solely a profit-maximising SWF when much of its portfolio is tied up in investments in China’s domestic financial sector. This is attributed to a political compromise that the very establishment of CIC would be contingent on its responsibility for supporting state-owned banks.
The financial crisis provided an enormous stress test and Nugée sees the more sensible SWFs used it as a test of their own fundamental philosophies.
“There is an association of infinite life with a long investment horizon,” Nugée says. “The assumption is SWFs with infinite lives should like long investment horizons. The assumption is the longer the better and the only limitation is how much you have to invest. That assumption has been challenged.”
Perhaps this should not come as a surprise since central banks also have infinite horizons but their investments are very short term.
The Norwegians came to the view that there is an advantage in having long term horizons but that the best place for this was in the equity markets, not the fixed income: “So long term fixed income does not reward you more than medium term fixed income. So you should load up on equities. The Norwegians put this into practice and at the bottom of the market, they changed their allocation from 40% equities/60% fixed income to 60% equities and 40% fixed income and recouped all their losses!”
Asian SWFs, because of their liabilities, have had less freedom to manoeuvre. Coming out of the 2008/09 volatility, they became much more aware of reputational risk. It matters not only how much money you lose but how you lost it.
If you lost $1 million because of a corporate default in a bond the fund had and was meant to be monitoring, that is more serious than if you lost the same amount because of movements in interest rates. If the loss arose because a structured product blew up, that would be even more serious.
While the national media in Asia are generally deferential to authority, in Korea the newspapers did criticise the government so the taboos have been broken and raised the issue of reputational risk for SWFs.
Thus, the funds are much more urgently seeking to protect themselves against unavoidable loss. There was a search for tail risk insurance in 2010 and Nugée attended a number of meetings where people wanted that: “Given the public sector is the final guarantor of the private sector in times of crisis, it doesn’t seem to make sense for the public sector to look to the private sector for help. There is just not the scale in the private sector to do that.”
It leads the SWFs to be less adventurous and by that, it means more reliant on sticking close to their peer group. They do look at the average asset allocations. For an individual SWF, what may matter most, is not being seen to be out of alignment with their peer group.
Asian central banks do face an issue that Nugée describes. The countries have built up reserves sterilised with bonds and find low interest rates in the US and Europe are giving them running losses. What they pay out in sterilised bonds is more than what they receive from their reserves as the sterilised bonds are in the local currencies with higher interest rates. The usual get out in this situation is that the local currency is depreciating. But in Asia, the pressures are for currencies to appreciate.
The way out is for more intervention but that creates more reserves and it becomes costly. The policy of building up reserves leads to a discussion of global imbalances and the deflationary input of saver nations. Of the four big economies, three are saver nations.
But there is neither a market nor a moral mechanism to deter a determined saver. In contrast, for determined borrowers there is a moral idea that it is not good to be too much in debt. There is no equivalent for savers and so no corresponding pressure.
The Asian SWFs provide a mechanism, albeit less liquid than bond investments, to generate higher returns from their foreign currency reserves. Perhaps the issue is to what extent should they try to emulate the Norwegian fund’s stance on having 60% of its assets in equities to take advantage of an illiquidity premium.