from Follow the Money

So a Gulf sovereign fund still has 60% of its assets in dollars? And SAFE is a SWF ...

July 17, 2008

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My initial reaction to Henny Sender’s front page FT article was probably the opposite of most. I wasn’t all that surprised that sovereign funds are reducing their dollar exposure -- though cutting their dollar exposure when the dollar is under pressure does suggest that they, unlike central banks, haven’t been a stabilizing force in the foreign exchange market. I was, though, surprised that "one big sovereign fund in the Gulf" had 80% of its assets in dollars a year ago, and still has 60% in dollars now. 60% is substantially higher than I would have expected. It also is a bit higher than the IMF assumed in its modeling of sovereign funds: their well-established diversified fund was assumed to have 38% of its portfolio in dollars (see the appendix of the IMF’s recent SWF paper)

Moreover, if a major Gulf fund is 60% in dollars and the Gulf’s central banks have an even higher share of their assets in dollars (the UAE’s central bank recently indicated that 95% of its assets are in dollars), the Gulf as a whole has even more dollar exposure than Rachel Ziemba and I thought.

Sender’s article is full of interesting tidbits.

The obvious question to ask is which big sovereign fund in the Gulf had 80% of its assets in dollars until recently. I would assume that major excludes Oman and Bahrain -- and I would also assume that the reference to "sovereign wealth fund" excludes the Saudi Monetary Agency. If Saudis, who are widely thought to keep most of their foreign assets in dollars -- had cut from 80% to 60% that would truly be news. That leaves the funds of Abu Dhabi, Kuwait and Qatar. The Qataris seem to have a lot of exposure to the UK -- and a wildly diversified real estate portfolio -- so they don’t seem like the most probable candidate. Plus, they have previously indicated that about 40% of their portfolio is in dollars. ADIA’s reported portfolio* is also geographically diversified, and its holdings are pegged "to global economic growth." It is hard to see how a portfolio linked to expected growth could be so over-weight the dollar, though Sender reports that currency risk is all managed by a central trading desk. Consequently, some of the currency exposure implied by ADIA’s diverse equity exposure could have been hedged. But it is hard to see how ADIA could be anywhere close to its current rumored size if it had that much dollar exposure and thus missed out on currency gains from holding euros and the financial gains from holding non-American equities over the past few years.

That leaves Kuwait -- which hasn’t disclosed much about its portfolio. It was also fairly conservative until recently. But even there the fit isn’t perfect -- Kuwait has hinted in the past that its large stakes in BP and Daimler imply that its equity portfolio at least is geographically balanced.

* The data in Business Week indicating that North America accounts for between 40 to 50% of ADIA’s portfolio explicitly excludes ADIA’s investment in private equity, hedge funds, real estate, infrastructure and cash. It consequently could understate ADIA’s dollar exposure. And ADIA could have hedged out the currency risk on its European and Asian portfolio.

Sender’s article also notes that SAFE is seeking out European private equity firms -- and even encouraging "private equity firms with which it has relationships" to invest in natural resources companies.

China’s State Administration of Foreign Exchange (SAFE) has been looking to strike deals with private equity firms in Europe as a part of a strategy to reduce its dollar holdings. ...

By allocating money to Europe-based private equity firms, SAFE could diversify away from the dollar, at least at the margin, without spooking the currency markets and driving the dollar down in a disorderly manner. In addition, SAFE is encouraging the private equity firms with which it has relationships to make investments in natural resources companies in markets outside the US - in part, to hedge its exposure to the dollar.

SAFE, not the CIC. The central bank, not the sovereign fund. PE funds investing in natural resource companies aren’t exactly a standard part of a typical central bank’s reserve portfolio. Here though I would note that the enormous scale of China’s reserves means that even large investments in private equity firms could be overwhelmed by SAFE’s ongoing bond purchases. Still, it is interesting to know that SAFE is looking to invest not just in oil firms like BP and Total but also is encouraging PE firms to invest in natural resources.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy -- and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

Sovereign wealth funds have played a leading role in helping to recapitalise faltering US banks, but have lost money so far on such investments. Continuing market turbulence has further shaken their faith in US policy and policymakers. ....

Behind the scenes, fund officials are questioning the credibility of the Federal Reserve and US Treasury in defending the dollar and maintaining financial stability.

Reacting to last year’s collapse of structured investment vehicles, the head of one Middle East fund said: "I thought the problem of off-balance sheet had gone away with Enron."

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows. If the US economy spirals down along the lines that some are expecting -- and if the Fed cuts rather than raises rates -- there is at least a hint that a few important creditors might balk at providing even more financing to the US than they do now.

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