from Follow the Money

Sovereign bailout funds, sovereign development funds, sovereign wealth funds, royal wealth funds …

May 11, 2009

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The classic sovereign wealth fund was an institution that invested a country’s surplus foreign exchange (whether from the buildup of “spare” foreign exchange reserves at the central bank or from the proceeds of commodity exports) in a range of assets abroad. Sovereign funds invested in assets other than the Treasury bonds typically held as part of a country’s reserves. They generally were unleveraged, though they might invest in funds –private equity funds or hedge funds – that used leverage. And their goal, in theory, was to provide higher returns that offered on traditional reserve assets.

To borrow slightly from my friend Anna Gelpern, sovereign wealth funds argued that they were institutions that claimed to invest public money as if it was private money, and thus that they should be viewed as another private actor in the market place. Hence phrases like “private investors such as sovereign wealth funds”

This characterization of sovereign funds was always a bit of an ideal type. It fit some sovereign funds relatively well but the fit with many funds was never perfect. Norway’s fund generally fits the model for example, except that it seeks to invest in ways that reflect Norway’s values, and thus explicitly seeks to promote non-financial goals.

And over time, the fit seems to be getting worse not better.

Governments with foreign assets have often turned to their sovereign wealth fund to help finance their domestic bailouts – and thus investing in ways that appear to be driven by policy rather than returns. Bailouts are driven by a desire to avoid a cascading financial collapse – or a default by an important company – rather than a quest for risk-adjusted returns. That is natural: Foreign exchange reserves are meant to help stabilize the domestic economy and it certainly makes sense for a country that has stashed some of its foreign exchange in a sovereign fund rather than at the central bank to draw on its (non-reserve) foreign assets rather than run down its reserves or increase its external borrowing.

Of course, a country doesn’t need foreign exchange reserves to finance a domestic bailout. Look at the US.

Foreign exchange cannot be used to finance domestic bailouts directly – only to meet a need for foreign exchange that arises in the context of a domestic bailout.* In the past countries like China with more reserves than they really needed and undercapitalized banks had to find creative ways to use their foreign exchange reserves domestically. China handed some of its foreign exchange reserves over to the banks to manage and getting equity in the banks in exchange. Critically, the foreign exchange remained abroad; it was just invested by the state banks rather than the central bank.** The state’s resulting stakes in the domestic banks were then transferred to the CIC, creating an institution that from the start necessarily had to mange to support goals that went beyond simple returns.

Right now though it hasn’t been hard to find troubled domestic banks and firms that need foreign exchange. It turns out that a lot of private (and quasi-sovereign) banks in major oil exporting economies were borrowing large sums from the world even as their governments were building up foreign assets and investing abroad. After a period when foreign asset and foreign debts were both rising, many are now seeing both assets and debts fall – think of Russia, for example. And in some cases a fund providing emergency hard currency loans to a troubled bank or firm may also end up with an equity stake.

But the need to supply foreign exchange to overleveraged domestic firms hasn’t been the only factor changing the shape of sovereign funds. Last week, the FT highlighted large changes inside Abu Dhabi, changes that do not seem to have been driven exclusively by a need to draw on Abu Dhabi’s no doubt considerable (though in my view not as large as some claim) foreign assets. Dubai has a huge need for foreign exchange – but to date, most of that need seems to have been met by the Emirates central bank rather than Abu Dhabi directly (though the visible flow from the central bank to Dubai may be matched by other less visible flows). And no doubt some Abu Dhabi firms and banks have also needed a bit of help.

But much of the change seems to have been driven by a desire by a new generation of princes to invest in new ways. ADIA seems to have been viewed as a bit dowdy. Rather than investing in private equity funds, a new generation in Abu Dhabi wanted to, in effect, run their own private equity funds. Dubai, Inc was their model –

That has meant the creation of sovereign funds that use leverage, that invest at home and abroad and that in some cases have a mandate that explicitly includes support Abu Dhabi’s own development. No doubt they hope for a return too – but their mandate isn’t just returns.

Lines though have gotten blurred, as theoretical differences between the mandates of different funds sometimes don’t seem to have been held up in practice. And – at least in some cases -- the line between the wealth of the state and the private wealth of the ruling family has gotten a bit more blurry. The FT reports:

Just a few years ago, ADIA - thought to be the world’s largest sovereign wealth fund - was the focal point of businessmen and political delegations who headed to the wealthy emirate in search of a deal. But as the emirate has embarked on a massive development plan it has cloned its best creation, to produce a multitude of investment vehicles hungry for overseas deals. The conservative ADIA takes small stakes in largely listed companies and rarely creates noise about its deals - the exception was its ill-fated $7.5bn investment in Citigroup in November 2007. Some of the newcomers are bolder.

One of the most notable changes has been the activity of IPIC, an old fund that once quietly invested in energy-related businesses but has taken on a new face. Displaying a new aggressiveness, it has spent billions of dollars on investments, including the €1.95bn acquisition of a 9.1 per cent stake in Daimler that it bought through Aabar, another investment company IPIC controls. It also claims the $3.5bn investment in Barclays, even though officials at the time said it was a private investment by Sheikh Mansour. That investment, however, is expected to be soon moved away from IPIC, according to Moody’s, which rated the company this week, and understands that IPIC was merely the vehicle chosen to do the transaction. But to some the IPIC/Barclays deal illustrates the difficulty understanding the relationships between individuals, the ruling family and the government.

Officials argue that investment vehicles should not be judged as like-for-like entities …. Abu Dhabi’s development, the officials say, requires at times more active and nimble vehicles, particularly as the emirate tries to tap into the expertise of international groups and import their technology.

Not all sovereign funds now fit the image of diversified, largely passive, unleveraged external investors. More and more have large domestic stakes in strategic companies – stakes that presumably are managed to achieve goals that go beyond just financial return. A country like Abu Dhabi now has a large fund that generally doesn’t use leverage directly – and a host of smaller funds that do use leverage. And in many cases the line between a sovereign fund, a state bank, a state holding company and a state enterprise (especially one used as vehicle for a host of strategic investments abroad) is getting harder and harder to draw.***

There are a lot of models for sovereign funds now that don’t look all that much like an unleveraged funds that invests primarily in diverse portfolio of foreign securities and generally seeks to avoid taking large, visible stakes in any individual company.

In a world where sovereign funds’ external assets aren’t growing very fast – new inflows are very low – this shift doesn’t raise the same kind of issues that came up back when sovereign wealth funds were expanding at a rapid clip. Especially in a world where many sovereign funds need to raise foreign currency just in case demands at home surge.

But there is one exception to the general rule: the CIC isn’t getting any bigger, but it does seem a bit keener than in the past to put its existing funds to work. That means some of the questions about exactly what kind of sovereign fund the CIC was going to be – and just how its investments will relate to China’s efforts to encourage state firms to go forth, China’s desire to jump start its own economic development and China’s desire to try to assure a secure supply of resources by investing abroad – will need to be clarified. As long as the CIC was just sitting on a pile of cash, these questions could be put on hold. But they cannot be deferred forever.

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* This is true for reserves as well as the foreign assets of a sovereign fund. Reserves can be used to make up for a shortfall in export receipts – i.e. to cover a trade deficit associated with a faster fall in imports than exports. Or to cover capital outflows, including those outflows related to the repayment of external debt. The first point is complicated when export proceeds from commodity sales traditionally finance a large part of the budget. In normal times – at least in a country with a peg -- those export proceeds would be converted into domestic currency at the central bank, and the domestic currency would be spent. This usually leads to a rise in demand for imports, and thus a rise in the number of private citizens selling local currency to the central ban for foreign currency. The rise in demand for foreign currency, not the provision of local currency to the Treasury in exchange for foreign currency, is what causes reserves to fall. A shortfall in commodity receipts not matched by a fall in spending would lead to a fall in foreign currency inflows to the central bank (as the government would be selling less foreign exchange to the central bank) but no change in outflows. That shortfall can be met by running down central bank reserves, running down treasury reserves that are not counted as central bank reserves, selling more debt to the rest of the world to raise new cash or by transferring some foreign currency from a sovereign fund to the central bank.

** If the banks had to draw on their equity buffer to cover losses, they would actually need RMB – not dollars. Consequently, they would need to sell their foreign exchange to the PBoC before the funds could actually be put to use domestically. The sale would push the PBoC’s reserves back up, as the foreign exchange that was handed to the banks would come back into the PBoC’s hands. Then the PBoC would have – in effect – have gotten equity in the banks in exchange for RMB cash … or least it would have but for the creation of the CIC, which adds another layer to the transaction (the PBoC sells fx to the CIC which hands the fx to banks and gets equity in return; if the banks need to draw on their equity, they would sell fx to the PBoC, handing the PBoC back some of the foreign exchange bought by the CIC)

*** More detail from the FT:

" Analysts consider the more traditional investors, such as the Abu Dhabi Investment Authority (ADIA), as falling under Sheikh Khalifa bin Zayed al-Nahyan, the president of the United Arab Emirates and Abu Dhabi’s ruler. ‘The more interventionist funds are more closely associated with his younger half- brother and crown prince, Sheikh Mohamed bin Zayed. He is considered the architect of Abu Dhabi’s more ambitious development in recent years, including in tourism and culture, and is dubbed the chief executive officer of Abu Dhabi Inc. He is chairman of Mubadala, a highly visible investment vehicle, and the executive council, the emirate’s key policymaking body.

Meanwhile, Sheikh Mansour, the ambitious 38-year-old full brother of the crown prince, appears to be acting at times in his personal capacity but at others as part of Abu Dhabi Inc. He bought Manchester City and is chairman of the International Petroleum Investment Company (IPIC) - the most active of the funds recently.”

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