Defining a Sovereign Wealth Fund (SWF)
Monday, October 29, 2007 at 08:39PM Strictly speaking this is really an update to the post below but since I am still collecting notes, data and thoughts on a review and preview note on the economic outlook in Japan surrounding the next BOJ decision (as well as of course I need to be doing something on the ECB and FED decisions too) I am allowing place for this one above the fold. In this way, and hot in on the heels of my post below, Stephen Jen has an entry up over at MS' GEF entitled The Definition of a Sovereign Wealth Fund. Formally, my post posted before this one sets the game and discusses some of the sources and trends of global liquidity with respect to the mounting evidence of a potential change in the fundamentals of the imbalances as well as in the light of the emergence of the so-called sovereign wealth funds (SWF). According to Jen the following five aspects formally define a SWF ...
- Sovereign
- High foreign currency exposure
- No explicit liabilities
- High risk tolerance
- Long investment horizon
In general, we should also understand the the notion of SWFs essentially covers a more broad and diverse set of funds or as Jen puts it ...
Rather than being well-defined and distinct from other types of funds, there is a great deal of overlap between SWFs and their close cousins. Rather than coming up with a complicated definition of a SWF, I think it is more useful to highlight their distinguishing traits, as compared to the other types of funds.
Now, I don't think that I want to change this list but I would however like to add my own comments relative to what Jen remarks. The first point I would like home in on concerns the point about high foreign currency exposure which I think is an important point to take aboard in so far as it goes to show some of the potential links between ageing and liquidity. In this way and as a first point the existence of a SWF is a proxy for how an economy attempts and essentially needs to export capital/liquidity in order to earn a respectable return on its reserves. This furthermore naturally implies that the existence of a SWF tends to go hand in hand with a large and growing external surplus and this is of course where we get into the demographics since there is evidence to suggest that (apart of course to some extent the peggers) ageing leads to an external surplus. Furthermore, the SWF and most emphatically SPFs (sovereign pension funds) are proxies for the decline in home bias as investors and also governments with large savings/reserves on their hands moves their assets abroad precisely because the domestic economy by far cannot support the investment. The second point I want to note is the point about high risk tolerance and long investment horizon. Regarding the former point this is of course bit word salad since you could ask 'relative' to what? Yet coupled with the point of a long investment horizon I fundamentally agree with Jen that the SWFs themselves will tend to scout a much more broad portfolio of asset classes. Yet, I am unsure how this will change the fundamentals in terms of official reserve management in the sense that I still believe the surplus nations will end up with plenty of firepower to finance the few deficit nations. The point I think is that at any given points in time the search for yield which cannot be found in the domestic economy is what will drive the flows. In this way, we could ask whether the potential trend in home bias is going to be somewhat 'forced' simply as a result of necessity.
Finally and before I sign off in this small post I also want to note another remark made by Jen relating to the potential market stabilizing factor of the SWFs.
There is a presumption that SWFs could become a source of instability, disrupting and crowding out private capital flows. I disagree. We believe that SWFs could have a much longer investment horizon and a higher tolerance for swings in P/L. When the global equity markets corrected in 2000, Norges Bank was a heavy buyer of global equities. I would not be surprised if the SWFs already played a meaningful role in September, facilitating the recovery in EM equities and equities in general. Having such a different ‘temperament’ from private funds, SWFs should reduce the risk of ‘herd behaviour’.
This of course somewhat smells a bit of complacency but I also think that it is difficult to disregard the possibility entirely that the SWFs are going to step up with financing where other financial market participants will not. This all goes back to the fundamental driving forces for the SWFs' existence and their overall net contribution to the global supply of liquidity in the sense that this is not so much a case of channeling of a given non-growing slice of official reserves into a SWF but a question of the SWFs that already exist will get bigger and how new ones will be set up in other countries.
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