Akash Prakash: Here come the sovereigns

The government needs to shed its risk aversion and be willing to trade higher risk for higher long-term returns.

In recent times countries increasingly are beginning to appreciate the need to manage their large foreign exchange holdings in a more strategic manner. Be it Korea, Russia, China and now maybe even Japan, countries with very large foreign exchange reserves are realising the opportunity costs of keeping these reserves invested only in G-3 government debt or, worse still, bank deposits. They are beginning to carve out a portion of these reserves and setting up specialist investment organisations to manage these long-term pools of capital. These dedicated investment organisations are following one of two models. Either they can be modelled on the GIC (Government of Singapore Investment Corporation) and invest in all types of financial assets globally, and become effectively multi-asset fund managers, or they can be more like private equity, focused on buying strategic stakes in select companies""like Singapore's Temasek Holdings.

Whichever model is followed, the end objective is clear""the organisation has a clear mandate to focus on returns, broaden the asset allocation and accept higher risk.

These changes are being driven by the huge surge in global foreign exchange reserves, which, at $5 trillion, have increased by almost a trillion dollars in the last 12 months alone. This spike in reserves, which shows no signs of abating, has been accompanied by a realisation that most countries are already holding reserves way in excess of what they need for liquidity purposes. An additional factor driving this trend is the acceptance by many countries that oil stabilisation/windfall funds initially set up to smoothen out the impact of fluctuating oil prices may be more permanent in nature than thought previously. Being more permanent in nature, these oil funds can also be managed as long-term pools of capital like the FX reserves.

Setting up these sovereign long-term pools of capital is a new development that investors and policy makers need to understand and track.

As Stephen Jen of Morgan Stanley has pointed out in numerous articles on the subject, the size of these so-called sovereign wealth funds is already nearly $2.5 trillion. These long-term pools of capital, which over time will look more and more like multi-asset mutual funds, are distinct from and already almost half the size of the total quantum of foreign exchange reserves (approximately $5 trillion). Mr Jen also makes the prediction, using realistic assumptions, that these sovereign funds will increase to over $12 trillion in size by 2015, surpassing the total size of the world's FX reserves. In fact he predicts that by 2011 itself, the sovereign funds will equal and then surpass global FX reserves at $6.5 trillion.

While currently the three largest sovereign pools of capital are ADIA (Abu Dhabi Investment Authority, with a rumoured size of $800 billion), GIC (Government of Singapore Investment Corporation) and Norway's global fund (to handle windfall oil profits), China's SFIC (State Foreign Exchange Investment Corporation) will soon join this club and eventually become among the largest pools of capital in the world.

Such a large and growing long-term pool of capital, which is moving away from government bonds into riskier equity""corporate bonds and real estate assets""has investment implications for all asset classes and markets.

First of all, it creates a large and sustained incremental demand for risky assets like emerging market debt and equity and equities more broadly. Even if one assumes that only 40 per cent of these funds are invested in equities, as these funds increase in size to over $6 trillion over the coming five years, that creates an incremental demand for $1.6-2 trillion of equities, not a trivial amount. This is a new and more structural demand for risky assets. Given the nature of the countries running these surpluses (mostly Asian, including West Asian), one can expect them to be comfortable holding emerging market assets, and thus the impact of this new long-term and structural demand will be even more significant for the emerging markets.

Secondly, to the extent that some of these reserve pools adopt a more private equity approach and attempt to buy real assets, we run the risk of financial protectionism rearing its ugly head. The experience of Dubai ports in dealing with the US authorities is a case in point. Issues of this type will recur as economic nationalism prevails on both sides.

A movement of funds of this quantum away from risk-free government securities into riskier equities and corporate bonds also has the potential to impact bond yields and even currencies.

All of the above once again leads one to ask as to why India has still not thought about or implemented a plan to better manage our own burgeoning reserves. We are already at $200 billion and counting, and surely the RBI cannot think we need this entire corpus for liquidity purposes. Even if we want to be conservative and assume that $150 billion is needed for liquidity and only $50 billion can be carved out into an investment pool, an additional return of 4 per cent per annum on this pool will generate an incremental $2 billion of national wealth per annum.

This investment pool can also be used strategically to acquire real assets globally, in case the government retains an allergy towards higher-risk financial assets. It can be turned into an energy security fund, for example, and used to supplement the efforts of ONGC Videsh in acquiring energy assets globally. If we as a country aspire for global leadership in certain sectors or technologies, can this investment pool not be used strategically to fulfil this ambition in partnership with corporate India?

To the extent that management of this investment fund is farmed out to global investment advisors (till adequate skills are developed in-house), it can also be an effective tool to develop Mumbai into a global financial centre. Mandates can be strategically handed out to only those organisations that set up full-fledged offices and operations in Mumbai. As global fund management mandates begin to be run out of Mumbai, this will create its own eco-system of service providers and put us on the global map as a source of capital.

The government needs to shed its risk aversion and be willing to trade higher risk for higher long-term returns. We are now the only economic power in Asia still unwilling to go down this road. Given that Korea, China, Taiwan and now most probably even Japan have seen wisdom, what is holding us back?