John Gieve: Sovereign wealth funds and global imbalances
Speech by Sir John Gieve, Deputy Governor of the Bank of England, to the Sovereign
Wealth Management Conference, London, 14 March 2008.
* * *
Introduction
Much of the debate on sovereign wealth funds (SWFs) has focused on political questions: do
they reintroduce the failings of public ownership into market economies by the back door, will
SWFs use their ownership rights to pursue political ends, and will resistance to foreign
ownership lead to a new wave of protectionism. I want to concentrate today on some
economic issues: why have they become so prominent recently, how does that relate to
imbalances in the world economy, how are they affecting financial markets and what are the
policy implications of their growth.
Background
But first let me set out some of the background.
There is no off the shelf definition of an SWF. What I have in mind is a government
investment vehicle that manages foreign assets with a higher risk tolerance and higher
expected returns than for central bank foreign currency reserves.1 The size of such funds is
hard to measure, but may be in the $2-3 trillion range.
Origins of SWFs
Investments by SWFs are one type of capital flow between countries so they have always
been closely related to global imbalances in trade. When countries run surpluses on their
current account, they generate equal and opposite net capital outflows of one sort or another
and those capital flows produce an investment income.
That has been the story of the UK economy over the last 150 years. We ran continuous
surpluses in the 50 years before the first world war (Chart 1) and built up a large stock of
foreign assets. Partly as a result of that, we benefited from a surplus on our investment
account for most of the period since the 1870s.
There are two key differences between that period of the UK's investment abroad and the
situation today. 100 years ago the developed countries were investing in emerging markets
(at the time in the Americas and Australia) which had abundant land and natural resources
but scarce capital and so the returns were high. Currently, capital is flowing "uphill" from
emerging to mature economies. Secondly, the investors before were mainly in the private
sector and were seeking out the best returns on capital. Today the investors are mainly EME
central banks and governments and the build up of foreign assets reflects their policy
choices.
Modern sovereign wealth funds are not new, in fact the first - the Kuwait Investment Office -
was set up here in London in February 1953 - just as Edmund Hillary and Tenzing Norgay
were setting out to climb Everest.2 And the number of funds has been increasing since then
like the traffic on the slopes of Everest.
The next wave were set up by other oil producers after the price increases in the 70s and
80s for persuasive reasons (Chart 2). First oil is a non-renewable resource so it can make
sense for governments to spread the benefits of this endowment across generations by
investing part of today's income in assets that will provide an income tomorrow. That would
be so even if the path of oil prices was predictable but in fact it is not. That uncertainty about
future income provides a second case for saving today. In the late 1970s, some oil exporters
increased spending to match higher incomes and faced a painful adjustment when prices fell
back again. Third, even if the rise in income was permanent there would be a case for
phasing the growth of domestic spending and investment to prevent supply bottlenecks
leading to inflation.
Recent growth of SWFs
Since the millennium at least 10 new SWFs have been set up and there are reports of plans
for more for example in Brazil, Japan and India.
This reflects the remarkable shift of emerging-market economies from debtors to creditors.
Ten years ago - at the time of the Asian crisis - emerging markets as a whole were running
a current account deficit. Since then they have been running progressively bigger current
account surpluses reaching an estimated $685 billion last year (1.3 % of world GDP).3 The
counterpart to this is that developed countries as a group have been running progressively
bigger current account deficits not just in the United States but also in a number of other
developed countries including the UK.4 Of course there are some notable exceptions in each
group: Canada, Japan and Germany for example are still creditors while many countries in
central and eastern Europe and Africa are running large deficits. But maps 1 and 2 show how
much the pattern has changed in the last 10 years. Most of South America and South East
Asia have swung from deficit to surplus. Perhaps as important, the scale of the differences
has grown with more countries running surpluses or deficits of over 5% of GDP.
Oil and other commodity inflation is part of the story, of course, but that does not account for
the large current surpluses in most of East Asia. Here strong manufacturing growth resulting
from higher labour productivity has not been matched by higher domestic spending so
savings have grown ahead of even dramatic investment growth. A deliberate policy of
fostering export industrial growth has slowed the rise of exchange rates that would reduce
these imbalances.
As a result the build-up in EME foreign assets have been held mainly as central bank
reserves especially in Asian countries (Chart 3). In total the foreign assets now held by EME
central banks and governments is about $7 trillion dollars, which compares with only $60
billion gross foreign assets held by the UK government. Many emerging economies
concluded after the Asian crisis a decade ago that they needed bigger liquid reserves in
traditional government debt to defend themselves against volatility in financial markets even
when that carried the likelihood of a negative return (taking account of expected exchange
rate movements). But when the reserves outstripped the levels needed for that purpose, it
was natural to look to increase the returns on investment by widening the range of
investments.5
And in the next few years, these current account surpluses are likely to remain high and the
build up of foreign assets by governments in oil exporting and Asian countries is likely to
continue. According to the IMF's forecasts, the combined current account surplus of China
and oil-exporting countries will be around $800 billion over the next 3 years. And the
IMF estimates that sovereign wealth fund assets could grow to $6-10 trillion within the next 5
years.
The impact of SWFs on financial markets
These are huge numbers and SWFs have become prominent and important players in many
financial markets. But we should not exaggerate their impact on the global financial system.
In aggregate, their assets under management are currently only less than one-twentieth of
those held by private sector participants such as pension, insurance and mutual funds as
well as hedge funds and private equity (Chart 4). And they account for about 2% of the total
size of equity and bond markets globally. Even in five years time - and on some of the
fastest growth projections - assets under management by sovereign wealth funds are
projected to reach only about 6% of global financial assets.6 Moreover, though they have
more assets under management than hedge funds they have smaller investments since they
are not leveraged.7
It is not difficult to identify positive effects on the world's capital markets. Sovereign wealth
funds have long investment horizons and generally have no commercial liabilities. Therefore,
in periods of market stress they are likely to face less pressure than most private investors to
reduce the size or increase the liquidity of their investments. They are well placed to play a
contrarian role and help to stabilise markets by investing in times of stress. For example,
when the global equity market fell sharply between 2000 and 2002, the Norwegian
Government Pension Fund was a large buyer of global equities. And a number of sovereign
wealth funds have played an important and welcome stabilising role during the current
turmoil by providing around $40 billion of new capital since November to some of the world's
biggest commercial and investment banks (Table 1).8
Taking a broader view, the switch of some reserves from government debt into SWFs which
invest in a wider range of instruments should help to improve the allocation of resources if
these investments are based on commercial criteria. Investing in equities may also help to
reinforce and bring to the surface the common interest that EMEs and the advanced
economies have in the good performance of the companies involved and the markets they
operate in. It may thus help to integrate EMEs into the global financial system and encourage
them to participate more in global policy making.
From a parochial point of view, the prospective increase in demand for equities relative to
bonds could have a positive impact on London and sterling. Whereas the value of the UK
market for public debt securities is only 3.3% of the global market, UK equities account for
71⁄2% of the value of global equities. The rapid growth in sovereign wealth funds is also a fillip
for London as a leading international financial centre.
SWFs and transparency
The main doubts concern their objectives and how far their investments will be driven only by
financial returns.
Public sector owners might have other objectives including national political interests, such
as, accessing military technology, controlling strategic resources or markets, and influencing
public opinion.9 There are often complaints that sovereign wealth funds lack transparency.
Decoded, this is a request for reassurance about their investment policies.
I am certainly not going to argue against more transparency (except in the very special case
of the market operations of central banks). More openness from SWFs may help to alleviate
concerns in recipient countries - and thus reduce protectionist pressures. And it may
improve the dissemination of information to market participants and to their own citizens. I
know many SWFs are working with the IMF to produce a voluntary code of conduct that is
based on best practices for the governance and transparency of sovereign wealth funds. For
example, it would be helpful if all sovereign wealth funds were transparent about their overall
strategies, objectives and broad investment guidelines. Norway's Government Pension Fund
is a good example in this respect.
But there should be a level playing field applied to all investors. The case for greater
transparency applies to other investors too. SWFs may take some comfort that they are not
being singled out and that there are equally powerful pressures for transparency on hedge
funds and private equity investors. In this respect, two recent initiatives are particularly
welcome. First, a report under the chairmanship of Sir Andrew Large - my predecessor as
Deputy Governor for Financial Stability at the Bank - on voluntary standards, including on
disclosure, for hedge funds. And, second, a report by Sir David Walker - a former Executive
Director of the Bank - on guidelines for disclosure and transparency by private equity
funds.10
And transparency should not be one sided among countries. I know SWFs themselves are
often keen for more transparency from recipient countries on whether and how far they are
welcome and the rules of engagement.
The UK in recent years has been unusually open to foreign investors and foreign ownership
both in comparison to our past and in comparison to most other developed (and emerging)
countries today. We have relied on regulation of infrastructure industries and on competition
law to prevent the abuse of market power and most of our utilities, much of the financial
sector, as well as an increasing number of our leading football clubs have come into foreign
ownership. In its latest survey of international direct investment trends, the OECD ranked the
UK as having one of the least restrictive regulatory environment for foreign direct investment
across all OECD member countries (Chart 5). And the UK has welcomed a number of SWFs
to London as a base for international operations.
Sovereign wealth funds and global imbalances
However, the emphasis on transparency and the politics of SWFs risks missing a bigger
policy issue: the recent rapid growth in SWFs reflects large and persistent global imbalances
which are a continuing threat to the stability of the world financial system and the global
economy.
Global imbalances and financial crises
While there are many examples of countries which have run deficits for many years such as
Australia and New Zealand, history also shows how painful the eventual adjustment can be.
There are many examples in which capital flight has resulted in a huge fall in GDP growth
and broader financial crises - for example in Latin America in the early 1980s, in the Nordic
countries in the early 1990s and the east Asian economies a decade ago - which, in turn,
weakened global GDP growth or global financial institutions.
Countries with large deficits are vulnerable to a rapid reversal of capital flows. If investors are
no longer willing to finance the deficit, domestic spending will need to be cut relative to output
through a combination of reducing spending and switching production to the tradable sector.
A recent IMF study reviewed 42 episodes of large reductions in current account deficits in
developed countries over the past 40 years. In a quarter of the cases, which were mainly
countries with limited real exchange rate depreciation, annual GDP growth fell by 31⁄2
percentage points on average.11
There are dangers too for surplus countries. Large foreign exchange inflows are not easy to
sterilise. They tend to contribute to asset price bubbles and higher inflation which itself can
undermine economic and financial stability. The effect of such inflows into China and
oilexporting countries have been compounded recently by their exchange rates being pegged
or managed against the falling dollar. This has contributed not just to the build up of reserves
and SWFs but also to the build up of inflationary pressures within these countries.
No one would blame EMEs for the current turmoil in Western financial markets. It has been
generated at home by the widespread mispricing of financial assets; this has been most
obvious among the assets based on the US housing market but it is not confined to that
sector. However the way that the boom developed did owe a great deal to global imbalances.
The "savings glut", to quote Ben Bernanke12, that developed in the oil exporting countries
and China contributed to the fall in real long-term interest rates.13 In the UK, for example, real
long-term interest rates, measured by the difference between the nominal 10-year
government bond yield and the annual rate of inflation, fell from around 3.9% in 1997 to 1.6%
in 2005. A similar pattern was also evident in the US (Chart 6). In particular, interest rates on
safe assets fell since the build up in foreign assets were invested mainly in government
bonds.14 That both discouraged saving and boosted asset prices. In order to maintain their
traditional returns, the private sector sought higher yielding strategies and were too ready to
believe that these could be attained through new products without running bigger risks. We
are now dealing with the consequences of that mistake.
Global imbalances - where to from here
Looking forward, the unwinding of global imbalances requires some combination of a
slowdown in the growth of domestic demand in deficit countries and an increase in domestic
demand in surplus countries. If the slowdown is not to dominate, we need to see a shift in
relative prices to rebalance demand - that is a gradual real exchange rate depreciation of
deficit countries against surplus ones.
The rise of SWFs may play a part in this dynamic. Their emergence is a sign that surplus
countries may be less willing in future to accept such low yielding assets. That should put
pressure on exchange rates to adjust and contribute to a reduction in global imbalances. So
while SWFs may be a product of global imbalances, they may also play a part in the
adjustment.
There are signs that in the United States, at least, imbalances are beginning to adjust. The
US current account deficit now looks past its peak and the marked fall in the dollar - about
25% in real traded-weighted terms - since its peak in early 2002 should help in the
adjustment. However, the decline in US relative demand is coming about mainly through
slower domestic demand growth at home rather than faster demand growth abroad while the
dollar has fallen less against currencies with the largest current account surpluses (Chart 7).
There is a risk, therefore, that the fall in the US current deficit will not be matched by a fall of
surpluses in high surplus countries but a rise in deficits in other deficit countries. The
imbalances could be transferred not reduced.
So it is important that the current large gap between savings and investment in the Far East
and oil exporting countries narrows. In the near term, the ability to increase spending will be
constrained by the recent increase in inflationary pressures in these countries. But more
exchange rate flexibility should be helpful on both fronts. And over the medium-term, in oil
exporting countries, government spending is likely to increase further in response to past
increases in incomes since part of the rise in the oil price looks to be permanent. This gives
oil exporters the opportunity to spend more on diversifying production in their economies. It is
encouraging also that in China the government has plans to increase its own expenditure on
the infrastructure, encourage higher spending by households through speeding up financial
sector reform and improving the safety net as well as allowing more flexibility than in the past
in the exchange rate.
Conclusion
Given the growth of the foreign currency reserves in many EMEs, the emergence of
SWFs making long term investments on financial criteria in a wider range of instruments is a
transparency the
positive development. Some increase in the both of strategy and objectives
and recipient countries' inward investment
of the funds of approach to should help dispel
concerns and ensure they are a force for greater global financial integration rather than a
prompt for a new wave of financial protectionism. SWF's recent investments in global
financial institutions have been helpful in easing the current financial market turmoil. And the
fact that they, and their central banks, are looking for higher returns and greater asset
diversification should be beneficial both to the EMEs and to the recipient countries since it
should improve the efficiency of global asset allocation.
But that positive story should not conceal that the growth of SWFs is also a result of
persistent global imbalances in trade. These imbalances have helped create vulnerabilities in
financial markets and in the wider economy. Our current experience is one more illustration
of how painful the unwinding of such imbalances can be.
Chart 1: Current account balances in Chart 2: Number of sovereign wealth
the first wave of financial globalisation funds since the 1950s
Per cent of own GDP Number of SWFs
United Kingdom
30
Germany 15
France Western Europe
10
25
5
0
20
-5
-10 15
-15
10
-20
-25
Canada
5
Australia 'New World' countries
-30
Argentina
-35 0
1870 1877 1884 1891 1898 1905 1912 1950s 1960s 1970s 1980s 1990s 2000s
Source: Taylor, A (2002), "A century of current account Source: Morgan Stanley, Deutsche Bank
dynamics", Journal of International Money and Finance, pp
725-748.
Global map 1: Current account positions (% of own GDP) in 1997
Global map 2: Current account positions (% of own GDP) in 2007
Source: IMF, World Economic Outlook, 2007
Chart 3: Global holdings of fx reserves
(excluding gold), 1995-2007
China US$tn
Japan
7
Russia
Other Asia (a) 6
Other EMEs
5
Developed countries (b)
4
3
2
1
0
Chart 4: Assets under management by
SWFs relative to other investors and
size of capital markets, 2006(a)
EME
Size of equity and
bond markets
US
Global
Private equity
Hedge Funds
SWFs
Assets under
FX reserves (a)
management by
Insurance assets
type of investor
Mutual Funds
Pension Funds
0 25 50 75 100 125 150
US$tn
(a) FX reserve holdings and estimates of SWF assets
under management are for 2007.
Source: IMF GFSR September 2007, McKinsey and Co.,
International Financial Statistics, various estimates of SWF
assets under management.
Table 1: SWF capital injections in financial institutions since November 2007
Date of Financial Amount
Sovereign Wealth Fund
announcement Institution (US$bn)
Abu Dhabi Investment
26/11/2007 Citigroup 7.5
Authority
10/12/2007 GIC - Singapore UBS 9.8
19/12/2007 China Investment Corporation Morgan Stanley 5.0
24/12/2007 Temasek - Singapore Merrill Lynch 4.4
GIC - Singapore 6.9
15/01/2008 Citigroup
Kuwait Investment Authority 3.0
Korea Investment Corporation 2.0
15/01/2008 Merrill Lynch
Kuwait Investment Authority 2.0
TOTAL 40.6
Source: Press releases, market reports.
Chart 5: OECD FDI regulatory restrictiveness
index, 2006
OECD regulatory restrictiveness score
0.4
0.3
Less restrictive More restrictive
0.3
0.2
0.2
0.1
0.1
0.0
US
UK
Rep.
Italy Rep. Zeal.
Japan Spain
Korea
France Greece
Ireland Poland
Austria Sweden Turkey Finland Canada Iceland
Mexico
Norway
Belgium
Portugal Hungary
Germany Australia
Denmark
New
Czech Switzerland
Slovak
Netherlenads
Source: OECD
Chart 6: Real long-term interest rates(a) Chart 7: Nominal exchange rate
in the UK and the US, 1987-2007 adjustments since 2002(a) and current
account balances(b)
Per cent Appreciation against the US$
US UK
8
80
Australia
Euro Area Norway
7 70
60
6
Canada Switzerland
50
5
40
UK
Russia Singapore
4 30
20
China Kuwait
3
2
100
-10
1
-20
Mexico
Other Middle East oil exporters
0
-30
-1
-10 0 10 20 30 40
1987 1990 1993 1996 1999 2002 2005
Current account balance (% of own GDP), 2007
(a) Nominal yields on 10-year government bonds minus the Source: IMF, Bank calculations.
12-month rate of inflation. (a) February 2002 to January 2008.
Source: Bloomberg, International Financial Statistics, Bank (b) Estimated current account balance in 2007.
calculations.