As the number and scale of operations of sovereign wealth funds (SWFs: a portion of the country's reserves set aside for investment in risky assets), like GIC and Temasek of Singapore, keep growing rapidly, their role is increasingly being debated. As it is, the SWFs' aggregate size is estimated at $2.5 trillion, and Morgan Stanley has forecasted it to go to $6.5 trillion by 2011. At that rate, SWFs would exceed the aggregate reserves of the central banks! So long as smaller countries like Norway, UAE, Singapore, Brunei, etc. were sponsoring such funds, western countries were not too worried. China's joining the SWFs list, with an initial contribution expected at about $ 300 billion, has added to the intensity of the debate, given its reserves of $1.3 trillion and growing at $1 billion a day!
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| There are several reasons underlying the growth of SWFs: The first and foremost is that, in recent years, reserves of East Asian and oil exporting countries have gone up rapidly, as a proportion both of their GDPs, and of the world reserves. The level is much in excess of their foreseeable balance of payments needs, and there is every prospect of the reserves growing further. For quite some time now, interest rates for major currencies, typically forming part of the reserves, have been low and therefore the reserves had given a meagre return (our own reserves gave a return of barely 4.7 per cent in 2006-07). | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Seventy to eighty per cent of the reserves are still invested in dollars, which retains its status as a reserve currency notwithstanding that, given the gargantuan US deficit on the current account, there is a possibility of a further sharp depreciation in the medium term. The way reserves are growing, even as fiscal deficits (including in the notoriously profligate United States) come down, the supply of government paper may fall short of the reserves in the next few years! | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Overall, both from a return and capital protection angle, a review of the way reserves are traditionally invested, has become more imperative. In fact, the issue is important for us in India as well. Traditionally, reserves have always been invested in a basket of major currencies, and in instruments which are liquid and entail no credit risk; in other words, in government paper of countries like the US, Euro-zone, UK, Switzerland and Japan. Inevitably, low risk means low rewards. The only way to increase returns is to invest in riskier assets like equities as the existing SWFs have done. China's first foray in risky investments was to contribute $3 billion to the equity of Blackstone, the private equity investment management firm. Almost by definition, private equity is a high-risk, high-reward business. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| While so far most of the equity investments by SWFs have been in the form of portfolio investments, in recent times, there is a discernible move towards strategic or direct investments, involving a measure of control over boards and therefore company policies. And this is what is raising political hackles in some of the western countries. It may be recalled how Dubai's attempt to take over the management of some US ports attracted political flak, and had to be abandoned; so was that of the attempted takeover of oil major UNOCAL, by CNOOC, a Chinese oil major. While, strictly speaking, both these investments were not by sovereign wealth funds, but by public sector corporate entities, the political opposition, particularly in the US, is an indicator of what could happen when SWFs go beyond the role of silent, portfolio investors. Already, there are calls for greater scrutiny and transparency of the investment policies and portfolios of SWFs, and the issue is also likely to be debated in the forthcoming annual meeting of the International Monetary Fund, later this month. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| But this apart, just imagine the impact on equity prices of a few trillion dollars of fresh money coming into the market! | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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