Crisis reshapes role of sovereign wealth funds

The global financial crisis has dramatically altered the investment and political environment facing sovereign wealth funds, according to State Street's latest report of SWFs. State Street released yesterday its latest Vision Series report examining the impact of the financial environment on sovereign wealth funds. Titled Sovereign Wealth Funds: Emerging from the Financial Crisis, the report assesses the funds' short- and long-term outlook, from investment opportunities to corporate governance issues.

Sovereign wealth funds attracted a lot of attention from late-2007 onwards when they embarked on a series of major cross-border equity investments. Their role has come under scrutiny mainly due to concerns over their growing size and their tendency in recent years to buy stakes in high-profile companies in other countries. In October last year, members of the International Working Group of Sovereign Wealth Funds (IWG) agreed on a set of 24 principles and practices and are planning to create a permanent SWF body.

SWFs have existed since the 1950s. Their asset size and clout in the investment community have grown dramatically over the past 10 to 15 years, however. Among the more prominent investments made by SWFs recently were those that involved the rescue of US banks that fell victim to the subprime crisis. For example, Singapore's Temasek Holdings bought a $5 billion stake in Merrill Lynch (it has committed a further $3.4 billion that is awaiting regulatory approval), while Abu Dhabi bought a $7.5 billion stake in Citigroup.

"The unprecedented events within the financial marketplace have significantly changed both the public perception of sovereign wealth funds and the way these funds perceive their own role as very large institutional investors," says Jay Hooley, president and chief operating officer of State Street. "The sizeable challenges and opportunities confronting sovereign wealth funds today compelled us to revisit the themes in our 2008 Vision report to assess the immediate and long-term implications of the crisis."

With renewed debate about the global financial structure and the need for a super-sovereign reserve currency, the Vision report notes that the post-crisis reality has created an excellent basis upon which sovereign wealth funds and the rest of the global financial community can further their cooperation and forge a mutually beneficial coexistence.

"The funds have experienced substantial declines in both their investment valuations and in the value of the commodities and exports that support their growth," the report says. "This downturn has prompted a reassessment not only of the funds' investment assumptions and approaches, but more broadly of their priorities and objectives in a new financial world order."

State Street notes in the report that growth estimates for SWF assets range from $12 trillion to $20 trillion by 2020. Market estimates place current SWF assets at close to $3 trillion.

Meanwhile, known as the Generally Accepted Principles and Practices (GAPP) for SWFs, the principles agreed on by the IWG serve as a voluntary framework for governance and accountability arrangements as well as the investment practices of SWFs.

The GAPP covers legal framework, objectives, and coordination with macroeconomic policies; institutional framework and governance structure; and investment and risk management framework.

The GAPP's purpose is to have in place a transparent and sound governance structure that: provides for adequate operational controls, risk management and accountability; ensures compliance with applicable regulatory and disclosure requirements in the countries in which SWFs invest; ensures SWFs invest on the basis of economic and financial risk and return-related considerations; and helps maintain a stable global financial system and free flow of capital and investment.

The IWG was established in May in Washington DC. Members of the IWG are Australia, Azerbaijan, Bahrain, Botswana, Canada, Chile, China, Equatorial Guinea, Iran, Ireland, Korea, Kuwait, Libya, Mexico, New Zealand, Norway, Qatar, Russia, Singapore, Timor-Leste, Trinidad and Tobago, the United Arab Emirates, and the United States. Oman, Saudi Arabia, Vietnam, the OECD, and the World Bank participate as permanent observers of the IWG.

The International Monetary Fund (IMF), which has been pushing for the best practices guidelines for SWFs since March 2007, organised a two-day meeting in Chile in September 2008 where the guidelines were created. The past few weeks were spent by governments of the IWG members reviewing the principles and practices. The IMF facilitates and coordinates the work of the IWG. Previous IWG meetings were held in Norway and Singapore.

Examples of the 24 guidelines in the GAPP include the following: Where the SWF's activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domestic fiscal and monetary authorities, so as to ensure consistency with the overall macroeconomic policies. There should be clear and publicly disclosed policies, rules, procedures, or arrangements in relation to the SWF's general approach to funding, withdrawal, and spending operations.

The need for the GAPP resulted from the increasing profile of SWFs in the global investment community. Concerns have been raised about these funds -- whose number and asset size have been increasing -- owning significant stakes in major corporations in other countries.

The IMF's own estimates place the total asset size of SWFs at around $2 trillion to $3 trillion, with the potential to grow to between $6 trillion and $10 trillion by 2013. Meanwhile, Merrill Lynch has a more conservative estimate of SWF assets rising to $8.5 trillion by 2012.

In February this year, consulting firm Financial Dynamics released the findings of a survey that showed SWFs are holding on to their cash and waiting for the markets to bottom before committing more money to investments. And even when they do decide to raise their holdings, they will remain passive long-term investors and have no desire to behave in an activist manner towards their portfolio companies.