Testing times for SWFs

As the world’s stock markets start the year in much the same mood as they ended 2008 – the S&P 500, the main US market index, ended last month lower again at just 825, in touching distance of its lowest point 6 years ago – investors across the globe face difficult times.  Should they capitulate and sell, or hang on in the hope of a recovery?

For those minded to sell, there is the nagging fear that they will be relinquishing good assets at fire sale prices:  when the recovery comes, the current market may turn out in retrospect to have been the greatest buying opportunity for years.  But the key is that little phrase “when the recovery comes”:  at the moment the world’s financial authorities are still very much in fire-fighting mode, and they have enough to do to prevent further shocks after last autumn’s banking collapses.  For most central banks and their finance ministries, it is still too early to be turning their minds to the long term, and to the reconstruction of the global financial system.  Building the recovery can come later;  at the moment they have more pressing issues on their plate.  And so the markets continue their downward path.

But one part of the official sector is very much considering the longer term.  This is the Sovereign Wealth Fund (SWF) sector, whose interests are those of the asset owner and whose mindset is by nature long term.  They have been suffering like any other investor, and the depth of the recent market fall – nearly halving since its all time high in October 2007 – has caused a number of SWFs to revisit their core purposes and fundamental objectives.

It might be useful to revisit the origins and rationale for SWFs, state-owned investment vehicles.  The oldest SWF is widely considered to be the Kuwait Investment Authority, which traces its roots back to the Kuwait Investment Board, set up by the British authorities in 1953 when it became clear that the territory’s oil revenue would soon greatly exceed its needs and even its ability to spend it sensibly.  This feature – of revenues vastly in excess of that needed – became the main driver for subsequent SWFs as well:  when a state reaches a level of income that cannot be spent sensibly, there is no alternative but to save it, and investment funds for Abu Dhabi, Singapore and Norway followed.

In every case, the creation of an SWF has at least one positive objective, and also several defensive ones.  The positive objective is easily stated;  it is usually posed in the form of a question, such as “How can this money be best used to benefit future generations?”  Inherent in this question is the understanding that revenue from eg a commodity resource does not belong solely to the current generation, but also to generations to come.

Even to such a simple question there are a range of possible answers.  At one extreme, some countries decide not to use the funds at all for current expenditure, but to set up a fund for future generations to benefit from the income they generate.   This – the equivalent of wealthy parents setting up trust funds for their children – requires considerable restraint from the current generation;  it is probably only societies that are already wealthy that can contemplate such an approach, and even in the richest of countries it is rare that the electorate is so satisfied that it cannot think of any expenditure (on infrastructure, health etc) that is worthwhile.

Even Norway, one of the richest countries to have a substantial SWF, still allows its finance ministry to draw a (limited) amount from the national oil fund (since 2006 renamed the Government Pension Fund – Global) each year to supplement the national budget.

At the other extreme, many countries decide that the best way to help the next generation is to improve the economy they will inherit.  Poorer countries may well gain more overall from developing their own economy than from investing their wealth overseas in more mature economies:  other things being equal the return on each dollar invested should be higher in less developed countries than in those which already have a high standard of living and development.

It is here, when poorer countries start to have large sums of money to invest, possibly for the first time, that the other side of SWFs, their defensive qualities, comes strongly into play.  There are, broadly speaking, five dangers that a country in this position can face, and a well-constructed and well-run SWF can provide the authorities with a structure and governance system to meet them.

The first danger is public expectations.  The public will not be unaware of the country’s good fortune and the prospects of new wealth and ideas for how to spend it will mushroom rapidly.  Grandiose infrastructure schemes will be promoted as “absolutely essential” and if the authorities are not careful, the public will in their own minds spend the new wealth many times over.  The most dangerous period is ironically probably just before the money starts to flow into the national coffers:  at this point is it still a vague enough concept and an imprecise enough amount to be almost infinite in the electorate’s minds.

It is a good rule of thumb that if one visits a country on the verge of such revenue and finds the average man in the street talking about “the oil money” or whatever, and how it should be spent, then the authorities are already on the back foot and the task of managing public expectations is an urgent one!

The second danger is that as the money starts to flow into the Exchequer and starts to meet the existing onshore economy, it creates large distortions between goods and services in the new sector and those in the existing economy[1].   If these are left unchecked it can lead to a two-tier economy in which anything outside the new sector is starved of money, employees and much else.

The worst case of such a two tier economy in recent history was possibly the Dutch economy.  When the Netherlands discovered and started pumping North Sea gas in the 1960s, they brought the revenue onshore into the domestic economy.  Not only did this create the distortions described above, but the resulting inflows into the Dutch Guilder also caused the currency to appreciate and the existing economy to become uncompetitive.  The phenomenon has since been called the Dutch Disease;  for many countries the creation of an offshore (foreign currency) SWF is directly designed to avoid a similar fate.

The third danger is closely allied to the first two, and is that the ready availability of much larger sums of money undermines the authorities’ budgetary discipline.  If it is hard enough for a finance minister to resist his or her colleagues’ demands for expenditure when money is not plentiful, it is doubly hard when it is not only plentiful but abundant.

The last two dangers flow from the fact that most newly wealthy governments, especially those in poorer countries where some expenditure on development and infrastructure is clearly both useful and justified, are not initially used to handling such flows of money or to interacting with the suppliers of the services they seek to buy.  This leads firstly to the risk of being overcharged – experienced infrastructure construction firm meets naïve finance minister and takes advantage – and secondly to the risk of bribery and corruption.  This is by no means limited to the poorer and less developed parts of the world, but in the third world especially, the strength of governance and public sector openness and accountability required to combat such temptations is not always as high as might be hoped.

A well-constructed SWF, with clear objectives, open governance, sound rules for the interaction of SWF income and the national budget, and accountable officials running it will go a long way to countering these five dangers.  And, to return to current markets and the travails of those investing SWF assets, it will also assist them in keeping in mind the long term objectives of the fund, and looking through the current market turbulence.

When the market will turn, we do not know.  But that it will turn, that even this bear market will end, we do know.  And like any other long term investors, SWFs who have held their nerve and remembered their core principles will then benefit from the upturn.


[1]              As an illustration of this, the author remembers visiting Shetland, the centre of the UK’s North Sea Oil industry, in 1979 and seeing two job advertisements next to each other in a shop window.  One was for a trainee butcher at £25 a week, the other was for a cleaner on the oil rigs at £200 a week.   One can guess which job was filled first;  the more worrying question for the local authorities was whether traditional jobs paying traditional wages would ever be filled at all.