SWFs invest in emerging markets

Emerging markets

With their strong growth as mentioned earlier, emerging markets are now very attractive as a place for investment. Abu Dhabi Investment Authority (Adia), a strong believer in the growth of such markets, is making significant investment, especially in Asia. The amount is known to be far greater than the amount of US biggest pension fund, as stated by Jean-Paul, head of Adia’s investment strategy. Qatar Investment Authority ‘s (QIA) intention to expand its investment in Asia is another example.

Kenneth Shen, Head of strategic and private equity of QIA explained that this is because they see the attractive risk/return profiles of these countries. Besides, their portfolio is mainly focused on North America and Europe, thus a further exposure to Asia is necessary. Of all emerging markets, China appears to be most attractive and is now the target for a lot of funds. There would be no better example for this than the record-breaking $19. 1 billion IPO of the Industrial and Commercial Bank of China last year, which attracted a number of funds from Middle East including ADIA and QIA to participate.

In the end, more than half of the top 15 allocations belonged to Middle Eastern investors. According to Richard Gibb, Asia Pacific Head of financial institutions group at Merrill Lynch, the demand from Middle East investors for US or European IPOs has been historically limited, compared to the huge amount they are putting in Asia. Besides that, it is seen that Asian funds are big supporters of their own region, mostly because of its growth prospects.

An example would be Temasek of Singapore. Temasek has considerable investments in Thailand, China, Indonesia, Korea as well as at its hometown, Singapore.

Recently, it increased its stake in Vietnam by acquiring a 10% share in Minh Phu Seafood, the country’s largest shrimp processor and exporter. Nevertheless, it is noticed that SWFs are now evaluating its investments mostly based on economic opportunity. Sector or geography do not play as important a role. This assessment method is similar to other major asset managers. In the current market situation with Europe and US stocks stumbling, bad credit markets and M&A activity drying up, these funds’ influencing power has become more apparent than ever.

Dino Kos, a Federal Reserve Bank of New York former senior official and a managing director at Morgan Stanley Investment Management in Hong Kong, said “At a time when deleveraging is taking place and potential providers of capital, such as banks, hedge funds and insurers, are reducing their risk levels, sovereign wealth funds, by keeping their powder dry, can undertake a deal when others cannot. “With the emergence of sovereign wealth funds as “power brokers” in the global capital markets, financial institutions are trying to understand their movements.

Wealth funds

The analysis is toughened due to the lack of uniformity in the way these funds manage their money, which differ from central banks. According to John Nugee, head of the official institutions group at State Street Global Advisors in London, most central banks follow the general principles of reserves management which is to seek security and liquidity first and returns only come in later. On the contrary, there is no common standard about how sovereign wealth funds should manage their money. In fact, treating different funds as if they were the same is one problem in the analysis of these funds.

These funds are not an homogenous group moving in the same direction and acting in the same way. As Cynthia Sweeney Barnes, HSBC’s global head of sovereigns and supranational in London puts it, SWFs are not a pack that operates in the same way with exactly the same needs. There are variations in the sophistication and risk levels. Within the investing countries, a poor management of SWF investments could lead to decreasing efficiency and transparency of resource allocation and cash management due to fluctuating availability of money for governmental spending (IMF, 2008).

Another negative aspect of badly managed funds would be the increased riskiness of investments related to probable losses. This would decrease assets for fiscal policy as well (IMF, 2008). Moreover, the monetary policy could be affected as currency exchange transactions are involved with the system of investing abroad and repatriating returns (IMF, 2008). So, SWFs impact the demand for and supply of home and foreign currencies which can also be used as a political tool.

This concern is mainly valid for the investing countries. But SWFs are a means of increasing government income and hence indirectly supporting monetary and fiscal policy. Consequently, this is a valid but not often fulfilled concern for most SWFs. As the majority of big SWFs is investing strategically rather than passively12 to amplify their returns, there is higher risk involved (IMF, 2008). This effect is increased if additional capital is borrowed to increase returns because with loan-financing risk increases.

Moreover, the shift of more money out of more secure financial assets into SWFs increases on the one hand the return possibility, on the other hand the risk exposure (IMF, 2008). However, this depends on the objective of the individual funds. For example, there is only a very small percentage of borrowing by SWFs. The validity of this scrupulosity is the same as the one of fiscal and monetary concerns: SWFs are basically generating further income for their home countries so they will not take on risks so high as to outset their investment.

Hence, this concern might be valid but not commonly experienced. By their nature, SWFs can play a stabilizing role in global financing markets for both, investing and receiving countries. SWFs as long-term investors and mainly unleveraged positions are able to sit longer in the market during market downturns or even go against market trend in recipient countries. Therefore, SWFs’ investments enhance the depth and breadth of markets and contribute to greater market liquidity and lower volatility.

In case of the credit crunch, investments of SWFs into banks such as Bear Stearns can be seen as a balancing factor. However, they refused to invest further into these banks so that this stabilizing role is only fulfilled to a certain degree. Moreover, having large and unclear positions in financial markets, SWFs also have potential to cause market disturbance. For example, any actual or rumoured transactions may result in herding behaviour and affect assets’ valuation (IMF, 2008).

Furthermore, the shift away from reserve assets to SWFs due to a more strategic than passive investment strategy will affect the future patterns of global capital flows 13. Firstly, there is estimation of net capital outflows out of US assets due to large reduction in demand for US bonds, which partly offset by an inflow into US equity market. Secondly, there is also suggestions of net capital outflows out of euro area asses due to net inflow into euro area equities is far offset by capital outflow of euro are bonds.

Thirdly, the destination of net capital outflows from US and European area are mainly Japan and emerging economies. This anxiety is reasonable considering the strategic investment strategy as well as the current downfall of the US$ and decreasing American economy. With a market capitalization of US$3. 3 trillion, the size of SWFs raises concerns about its market moving ability. Although this is a rather small part of overall market capitalization of investments in the world, SWFs are able to considerably move markets, especially smaller or less liquid ones (Cohen, 2008).

Because of their size, even rumours concerning SWF investment can influence market behaviour resulting in a procyclical impact despite their already mentioned stabilizing nature (IMF, 2008). Apart from their big impact today, SWFs are growing fast. Reinvestment of today’s returns, further exploitation of resources such as oil and minerals and growing tax and other receipts due to growth of most SWF countries will increase the overall wealth captured in SWFs. Although estimates range widely, they all project a huge SWF growth in the close future resulting in a value of US$12 trillion by 2012 according to the IMF (2008).

With their growing size, the impact of SWFs will increase even more stressing the importance of concerns. The issue of big size of SWFs disturbing markets and fortifying other topics of anxiety is valid but only to the extent that SWFs invest without responsibility and view towards the effects of their investments. Considering the mainly long-term investment strategies, markets might not get too volatile in the short time. Moreover, the big size of SWFs is rather a foundation for other concerns than a single concern itself.