Sovereign Wealth Funds
The flip side of our current account deficits these past 25 years has been an inflow of foreign savings. These funds have been quite beneficial: They helped to keep real interest rates lower than they otherwise would have been, thereby promoting interest-sensitive sectors of the economy, like investment and consumers’ durable spending. But would we be so sanguine about the economic benefits of these financial inflows if foreign governments directed the placement? Foreign governments are increasingly interested in earning higher returns on their large and growing reserve portfolios.
Most governments maintain portfolios of foreign exchange reserves as insurance funds against temporary shortfalls or reversals in their foreign currency receipts. Countries’ ability to sell their foreign exchange reserves in the face of short-lived problems with their balance of payments helps them avoid currency depreciations without either imposing restraints on imports and financial outflows or immediately adopting deflationary macroeconomic policies. Countries acquire foreign exchange reserves by managing their exchange rates; they traditionally invest their reserves in low-risk liquid assets like foreign government securities, interest-bearing deposits, or repurchase agreements. The U.S. dollar is the key international reserve currency, accounting for about 65 percent of the world’s total portfolio. The euro, with approximately 25 percent of the total, is a distant second, and the British pound comes in third with 5 percent. The Japanese yen also plays a noteworthy role as an official reserve currency.
A sharp increase in official holdings of foreign exchange reserves began in the early 1990s and accelerated after 2001, probably in response to the global financial crises of 1997 and 1998 and the sustained rise in oil prices. The gains seem large, not only in an absolute sense but also relative to traditional rules of thumb for reserve needs like countries’ imports or their outstanding short-term debts. The sharpest increase in reserve holdings has occurred among the developing countries, although Japan’s portfolio expanded rapidly through 2003. China, which tightly manages the renminbi–dollar exchange rate, holds the largest reserve portfolio, approximately $1.2 trillion.
Traditionally, reserve portfolios’ low yield has made them rather expensive insurance funds, particularly for developing countries where the rate of return on domestic infrastructure and the interest cost of foreign loans can be rather high. Concerns about the opportunity cost of holding large and rapidly growing reserve portfolios have prompted some developing countries to seek higher yields.
In doing so, they have turned to sovereign wealth funds. These are government investment vehicles that seek a higher yield on official foreign exchange receipts by diversifying into a broad range of assets, including long-term government bonds, corporate bonds and stocks, derivatives, commodities, and real estate. These funds have a higher tolerance for risk than do traditional official reserve portfolios. To the extent that the financial resources contained in sovereign wealth funds are not readily available to monetary authority for exchange rate stabilization or balance-of-payments purposes, they are distinct from official foreign exchange reserves.
Sovereign wealth funds have been around since at least 1956. Countries that either owned or taxed exported commodities—like oil—initially established them, effectively replacing real assets taken from the ground with high-yielding financial assets and thereby creating a revenue source for future generations. Norway’s Government Pension Fund-Global is a prominent example of a commodity-based sovereign wealth fund. Such funds account for an estimated two-thirds of all sovereign wealth funds.
The emergence of reserve-based sovereign wealth funds is fairly recent. Singapore created the first—the Singapore Global Investment Corporation—in 1981. Korea started a reserve-based sovereign wealth fund last year, and China recently completed the process of setting one up. Japan, Russia, and India reportedly are also considering reserve-based sovereign wealth funds.
Little is known about the aggregate size of sovereign wealth funds, but the U.S. Treasury estimates that they control approximately $1 trillion to $2.5 trillion. Including official foreign exchange reserves, governments now control a portfolio of $6.3 trillion to $7.8 trillion. Many observers believe sovereign wealth funds will continue to demonstrate strong growth, particularly if oil prices remain high, and they project that such funds will eventually become the single most important factor in global financial markets.
The growing clout of sovereign wealth funds has left a lot of anxious people wondering if state-controlled investment funds will act like privately owned investment funds. With the exception of Norway’s, sovereign wealth funds’ operations are notoriously opaque, which has given rise to many questions: Will they invest for non-economic or strategic reasons? Do they raise national defense and security issues? Will they provide the firms in which they hold a stake unfair access to their home markets? Will they be subject to as much market discipline as private investment funds?
And what may be the biggest concern: Will they encourage financial protectionism? Germany recently announced plans for establishing an agency to review investments by sovereign wealth funds for national security reasons. The United States has maintained a similar mechanism since 1988. While these are legitimate concerns, they also could offer individuals who simply do not appreciate competition—domestic or foreign—another means of seeking protection. How far, after all, might security issues extend?