There is less than meets the eye in this hoopla about SWFs!

 

Doubling of money managed by SWF in ten years is just 7 per cent more pa on average and that is both from return on investment and additional funds. So how rapid is it really and how good a return is it? In both cases, not very. Are SWFs really going to invest in risky assets on those assumptions of returns? Not really, especially given their losses in stock markets and alternative investments since 07.

 

 

Francois Pages is absolutely right! There is LESS to this hoopla about more SWF and more money in them than meets the eye. The telling points are the French and Japanese examples. If Kern is right and funds under management by SWFs double to $7 trillion, that will represent in part a return on investment, If no new funds flowed in, the return would be barely over 7%. So how much more money are we talking about? Let us say it is 50:50. And given recent performance can it reasonably be expected that SWF that seek 3.5% pa returns will go into risk assets versus government securities? Hardly.

 

There have also been some points of confusion.

 

SWF are not funded by SHIFTING assets from a central bank which must maintain adequate reserves (e.g., to cover X months of imports). Rather SWFs are ALLOCATED assets for long term investment when the country's FX reserves are (and are for the long term expected to remain) in excess of an acceptable level of reserves for the country's transaction and precautionary purposes (e.g., above 3-6 months of imports).  Francois is right to point out the conflicting practice of governments when making such allocations as many considerations come into play.

 

As such excess reserves are allocated to SWF when FX holdings rise reliably and persistently above transactional and precautionary purpose demand for reserves, the allocations per force depend on the outlook of the country's external accounts and its overall economic situation. If balance of payments position is persistently strong and positive as has been the case for Japan, Norway and  China, such allocations can be significant. But if external accounts are volatile as they are for countries like Nigeria, their allocations are likely to be smaller and may need to be reversed if commodity prices drop sharply. 

 

One reason to assign management of such excess reserves to SWFs as distinct from central banks is to limit the potential for and the impact of such SWF investments in the domestic economy. Such investments of FX into a local economy require converting it to local currency thus adding to the monetary base and to inflationary pressures. In times when the economy is weak, some such monetary pump priming might be carried out but otherwise SWFs do not represent a long term source of investments in domestic infrastructure. I have been struck by how often media in emerging market countries - such as India among others -  blast policy makers for investing reserves in foreign securities. They do so for a sound monetary reason. 

 

For this reason, I believe that the potential for domestic investment by Nigeria, Scotland or others of their SWF assets is very limited - barring extenuating or exceptional circumstances such as in the case Chinese investment in local bank stocks. Recall that Hong Kong also made similar investments in HK stock markets over ten years ago in the Asian financial crisis and -- if I recall right -- after the stock market crash of 1987.

 

In sum, the issue is - how much new money do SWFs really represent and will they invest in risky sectors such as coroporate equity and debt and structured finance products as well as other alternative investments when they have been badly burned by the stock market as well as their PE investments in the financial sector and otherwise since 07? 

 

My view is - once burnt, twice shy.  A case in point is a small emerging markets central bank. I was recently laughed at by a former senior official of that central bank  for having suggested in 05 that they make a small allocation to AAA rated agency paper. They took a lot of other advice I gave them then but not this piece. I think that if they had, their advisor or I or both would have told them to bailed out early last year before the US government took Fannie and Freddie into conservatorship. But the bottom line is that neither this bank not most other central banks / SWFs are likely to to take up additional so called triple A MBS or agency paper, or much investment grade corporate paper anytime soon nor much in alternative investments any time soon. 

 

I hope I am wrong and ten years is a long time. Ten years ago, Asia was recovering from the Asian financial crisis. Now we are wondering about how much risk we can sell to Asian and other SWFs!!