Philipp Hildebrand: The challenge of sovereign wealth funds
Speech by Mr Philipp Hildebrand, Vice-Chairman of the Governing Board of the Swiss
National Bank, at the International Center for Monetary and Banking Studies, Geneva,
18 December 2007.
I would like to thank Signe Krogstrup for her valuable support in drafting this speech. I also want to thank Rita
Kobel, Urs W. Birchler, Daniel Heller and Bertrand Rime for helpful comments and discussions.
* * *
1. Introduction
I am very pleased to be in Geneva. The International Center for Monetary and Banking
Studies (ICMB) provides a wonderful platform to discuss a wide range of economic and
monetary policy challenges. On behalf of my ICMB Foundation Board colleagues, I would
like to thank Charles Wyplosz for his successful and long-standing stewardship of the ICMB.
Tonight, I want to talk about Sovereign Wealth Funds (SWFs). Broadly defined, SWFs are
government-owned investment corporations. For the most part, they invest their funds in
foreign currency assets. SWFs are usually managed separately from central bank reserves.
Unlike other publicly owned pools of capital, such as social security funds or public pension
funds, SWFs have no explicit liabilities. As you can see in slide 1, the estimated assets
currently managed by SWFs exceed the combined pool of assets managed by hedge funds
and private equity firms. Total assets held by SWFs remain small, however, in comparison to
the combined assets managed by pension funds and mutual funds worldwide. The rise in
SWFs is closely linked to the global macroeconomic imbalances that have characterized the
world economy since the mid 1990s. Since these imbalances are unlikely to unwind in the
near term, SWFs are likely to keep growing disproportionably for some time.
The rapid rise of SWFs has undoubtedly brought a number of benefits. One of them has
recently become particularly evident. Against the backdrop of the current market turmoil,
SWFs have been a welcome source of capital, strengthening the vulnerable balance sheets
of some of the world's largest financial institutions. I will return to this important point at the
end of my lecture.
But the investments made by SWFs have also given rise to considerable political controversy
and media coverage. Slide 2 provides a sample of some of the most pertinent recent
headlines. The political controversy does not derive from the fact that SWFs are new. They
are not. Political leaders are anxious because the rapid rise of SWFs and their increasing
visibility as large investors in mature markets challenge some long-held assumptions about
how the global economy works. In the process, the investment decisions of SWFs run the
risk of triggering defensive reactions in mature countries. If left unchecked, this process could
feed financial protectionism, which would clearly be to the detriment of global economic
welfare.
To provide some context, I will first describe the rise of SWFs. I will then discuss in more
detail what I view to be the primary challenge arising from SWFs. Finally, I will briefly touch
upon a number of recent policy proposals. On the basis of these ideas, and drawing on the
history of central banking, I will then offer some personal reflections on what a simple but
effective policy response might look like. In closing, I will briefly comment on the Government
of Singapore Investment Corporation (GIC), one of the most prominent SWFs in the world.
As you know, UBS last week turned to the GIC for a substantial capital injection in
connection with losses in the sub-prime credit markets.
2. The rise in sovereign wealth funds
I noted at the outset that the rapid growth in SWFs is largely a by-product of global
macroeconomic imbalances. Slide 3 shows that the current account deficit of the US has
increased every year since 1992. The deficit surpassed USD 800 billion, or 6 percent of
GDP, in 2006. Such a large current account deficit is unprecedented in US history.1 This rise
in the US current account deficit has been mirrored almost one to one in the combined rise of
surpluses in South East Asian countries and oil exporting countries. I will refer to these two
country groupings as the surplus regions. By definition, the surplus regions are investing less
than they are saving, and hence, both regions are accumulating net financial claims on
foreigners. But the underlying reasons for the current account surpluses in the two regions
are distinct.
The South East Asian countries saw an increase in savings and a fall in investment in the
wake of the Asian financial crisis.2 Since then, these countries have generally continued to
pursue a macroeconomic policy mix in support of an export-led growth strategy which
sustains these savings-investment patterns. Meanwhile, in the oil exporting countries, export
revenues have been boosted by the increase in the price of oil since 2000. You can see this
in slide 4. Since domestic investments in these countries have not increased at the same
pace, the result has been a rise in net savings in the oil exporting countries.
The two surplus regions have one thing in common. In both cases, foreign assets are
accumulated almost entirely by the official sector. In the oil exporting countries, oil revenues
primarily accrue to governments. Higher oil revenues therefore translate into higher
government budget surpluses. In South East Asia, where the currencies shadow the dollar,
foreign assets are accumulated primarily by the central banks in the form of official foreign
exchange reserve accumulation. Slide 5 shows that the global macroeconomic imbalances
have led to a rapid accumulation of global official foreign exchange reserves.3 Let me now
leave you with five stylized facts about SWFs.
First, as I already pointed out, SWFs are not a new phenomenon. With its Caisse des Dépots
et Consignations, France set up a SWF in 1816.4 Slide 6 shows the year of establishment of
each of the 14 largest SWFs currently in operation. The Kuwait Investment Authority was
established in 1953. Since then, SWFs have been set up essentially in two waves. The first
one occurred in the second half of the 1970s. The second wave began in 1996 with the
setting up of Norway's Government Pension Fund - Global. The steep increase in oil prices
since 2000, the widening of global imbalances and the resulting accumulation of foreign
exchange reserves suggest that other countries will follow suit. By applying a simple rule to
identify which countries potentially hold excess reserves, we can readily identify the countries
that are obvious candidates for future SWFs. Slide 7 shows a list of countries that meet the
following two conditions.5 They have no SWF at present and, judging by the
GreenspanGuidotti rule, they hold excess reserves of at least USD ten billion.6
1
Note that according to SNB staff calculations, the US current account deficit currently absorbs about 60
percent of the world's aggregate current account surpluses. The remaining deficits are located largely in a
handful of EU countries (Spain, Italy, Greece, France and the UK, 30 percent), in Central and Eastern Europe
(8 percent). The final 2 percent originate in developing countries.
2
The exception is China, which has attracted even more investments since the Asian crisis, while savings have
also increased faster. See, for example, Genberg et. al. (2005).
3
In some countries, the reserve accumulation has been further magnified by private capital inflows.
4
I am grateful to Benoit Coeuré of the French Treasury for this comment (see Coeuré, 2007).
5
Summers (2007) has a similar table which also includes countries that already have SWFs.
6
The Greenspan-Guidotti rule is based on the definition of a sufficient level of reserves as equal to the level of
short-term foreign currency debt of the country. Excess reserves are calculated as reserves in excess of this
level.
BIS Review 150/2007
Second, in terms of size, SWFs have become important financial market participants. The 14
largest SWFs are estimated to have approximately USD 2.2 trillion under management.7
Some market estimates put combined assets as high as 3.5 trillion dollars.8 The estimated
combined assets of the world's 14 largest SWFs now constitute nearly half the size of the
world's total official foreign exchange reserves.9 As I pointed out at the beginning, however,
the assets of the world's SWFs are still much smaller than the assets invested in mutual
funds (USD 19.3 trillion) or global pension funds (USD 21.6 trillion).10
Third, SWFs are likely to grow substantially in coming years. Market forecasts, which assume
that high oil prices and the large current account surpluses in South East Asia will persist,
project that SWFs will increase three to fivefold in nominal dollar terms over the next five to
ten years.11 My own view is that such simplistic linear forecasts will likely prove to have been
flawed. Nonetheless, it is difficult to argue with the basic direction of these forecasts. The
fundamental dynamic behind the recent rise of SWFs will not disappear over night. As I
mentioned, estimated excess reserves are very large.12 In all likelihood, at least some of
these excess reserves will be transferred to SWFs in coming years. Moreover, even if global
imbalances were to unwind quickly, for instance in association with a sharp and protracted
recession in the United States, the power of compound return will continue to be a
substantial source of growth for SWFs that already exist.
Fourth, SWFs have so far been initiated predominantly in the Middle East and in Asia. Slide
8 shows that these two regions account for 77 percent of the assets of the largest SWFs.
Nonetheless, we should not lose sight of the fact that 16 percent of the assets of the 14
largest SWFs are held in developed countries.13
Fifth, SWFs will increasingly attempt to diversify their holdings. They will do so gradually,
given the prevailing size and liquidity constraints. Like central banks, SWFs have traditionally
been investors in highly rated fixed income assets. Going forward, SWFs will increasingly
look for investments in equity markets, both public and private ones. Several of these
investments have recently produced headlines in the global financial press. Slide 9 depicts
some of them.
3. The challenges
In my introductory comments, I suggested that much of the anxiety surrounding SWFs stems
from the fact that their increasing presence in mature markets presents a challenge to some
long-held assumptions about how the global economy works. Let me elaborate a little bit on
three such assumptions. As you will see, they are very much interlinked.
7
This is shown in table 1 in the appendix. Sources: Truman (2007a, 2007b), IMF, Morgan Stanley, FT.
8
Morgan Stanley, Standard Chartered, Deutsche Bank and Merrill Lynch all recently produced estimates,
ranging from USD 2.5 to 3.5 trillion.
9
Global reserves amounted to USD 4.7 trillion in the second quarter of 2007, according to IMF's COFER
database.
10
2006 estimate by Mckinsey Global Institute. The size of pension fund assets held by OECD countries is
estimated at USD 13.2 trillion by the OECD.
11
The estimates of Merrill Lynch, Deutsche Bank, Morgan Stanley and Standard Chartered are, respectively,
that SWFs will grow to USD 7.9 trillion by 2011, USD 9 trillion by 2015, USD 12 trillion in 2015 and USD 13.40
trillion by 2017.
12
According to SNB calculations, excess reserves of developing countries according to the Greenspan-Guidotti
rule reached USD 2.5 trillion in the second quarter of 2007.
13
These are located in the US (Alaska Permanent Reserve Fund), Australia and Norway.
BIS Review 150/2007
First, since the early 1980s, we have witnessed broad-based and sustained political
momentum to deregulate and liberalise economic structures, enhance the role of market
forces and attempt to reduce the role of governments in the global economy. Looking back,
Ronald Reagan's confrontation with the air traffic controllers union in 1981 marks the
beginning of this process. Most of you in this room would probably concur with the premise
that the secular trend to strengthen the role of free markets and competition as the
overarching organising principles of the global economy has contributed significantly to the
long period of prosperity that the world economy has enjoyed. In this context, SWFs
represent a potential threat. Sizeable state-sponsored foreign investments in mature
economies can be perceived to be a threat to free market forces.14 Moreover, such
investments run the risk of triggering protectionist reactions in the recipient countries.
Second, one of the basic premises of open global capital markets is the idea that capital
flows freely worldwide in search of investment opportunities that yield optimal risk-adjusted
rates of return. The fact that large and government-controlled investment companies make
substantial investments in privately owned companies in other countries raises concerns
about the validity of the hypothesis that capital seeks optimal risk-adjusted rates of returns.
Governments of recipient countries may have doubts about the motivation behind such
investments. Are SWFs in pursuit of a variant of the traditional motive to maximise returns?
Or could a particular government be tempted to use its SWF as a financial instrument in
pursuit of a particular political objective? The mere fact that such questions arise could serve
as a trigger for protectionist policies in recipient countries, thus again undermining the proper
functioning of free markets.
Third, as a general rule, capital has historically tended to flow from the core of an economic
system to its periphery.15 Most recently, global capital flows from the periphery to the core
are clearly on the rise. SWFs play a potentially important role in what appears to be a
reversal of global capital flows. The economics students here will recognise that this
apparent reversal in capital flows is not really a new phenomenon, but a new and
unexpected variant of the Lucas Paradox which Bob Lucas described in a seminal paper in
1990.16 Nonetheless, the sense that capital increasingly flows from the periphery to the core
is raising a variety of political sensitivities in the core countries. I fear that many of these
sensitivities will likely be protectionist in nature.
As you can see, in all three cases, the real or perceived activities of SWFs play a role in
challenging these deeply held assumptions about the world economy. In my view, the most
important challenge associated with the rise of SWFs is therefore to ensure that the policy
reactions in the recipient countries of potential and actual SWF investments do not
degenerate into what ultimately amounts to financial protectionism.
Let me simply mention that there are other potential challenges associated with SWFs, such
as concerns that SWFs could pose a risk to financial stability.17 A related concern is that
asset allocation changes by some of the larger SWFs could result in disorderly market price
adjustments.18 While it is impossible to rule out such effects, these risks are clearly not
unique to SWFs. Moreover, they strike me as being second-order problems, compared to the
threat of the activities of SWFs unleashing a vicious cycle of financial protectionism.
4. Policy response
Let me now turn to the question of how to respond to the risks associated with SWFs. As I
said in my introduction, I would like to provide you with my own judgment on what kind of
policy response will likely be required to address adequately the risks I have tried to outline.
But before I do so, let me briefly touch upon four policy ideas that are currently being
circulated.
First, a number of European politicians are calling for increased transparency requirements
relating to actual portfolio positions of SWFs.19 A more far-reaching development are the
calls for legislation that would block SWFs from taking major stakes in companies in any
strategic sectors.20
Second, a number of politicians have proposed the principle of reciprocity as a guiding
principle for granting market access to SWFs.21 For example, Jean-Claude Juncker, the
Luxembourg Prime Minister and Euro-group president, has stated, "Countries that protect
their own markets cannot expect to be allowed to make unimpeded investments in Europe."22
In a strict sense, the principle of reciprocity means that SWFs are only allowed to invest in a
foreign country if companies in that country are allowed to invest freely in the home country
of the SWF. Since many SWFs are located in countries which are financially less open than
a typical OECD country, a strict application of the reciprocity principle would place strong
limitations on SWF investments.
Third, Larry Summers has suggested that if SWFs were to invest through intermediary asset
managers, most risks associated with SWFs would be mitigated, if not avoided.23
Incidentally, Summers argues that the added benefit of such an indirect investment
philosophy is that it generates a better risk-return profile.
Fourth, there is now considerable political momentum behind the idea of a code of conduct
or a set of guidelines for SWFs. The idea that is emerging is that SWFs would adopt such a
code on a voluntary basis in an attempt to alleviate concerns in the most important mature
market. At the October 2007 IMF/World Bank Annual meetings in Washington, the finance
ministers and central bankers of the G7 countries discussed the issue in a private meeting
with a number of leading SWFs. They subsequently stated that they "see merit in identifying
best practices for sovereign wealth funds in such areas as institutional structure, risk
management, transparency and accountability."24 Since then, G7 treasury officials have
continued to engage with a number of leading SWFs. The US has called on the International
Monetary Fund to try to identify possible best practices, noting that these should be modeled
on best practices for managing international reserves.25 So far, Ted Truman has developed
19
For example, Joaquín Almunia, the EU Commissioner for Economic and Monetary Affairs summarised the
general position of the European Commission as calling on SWFs operating in EU member countries to
increase the transparency of their operations and investments. Interview with the Financial Times on 28
September 2007.
20
In Germany, legislation has been drafted that would enable the German government to veto any foreign
investors intending to take a stake of 25% or more in a German company that may threaten national security;
Süddeutsche Zeitung, 30 September 2007.
21
Reciprocity has also been raised by Alistair Darling in response to SWFs, see, for example, "Chancellor backs
The
G7 move to get tough on sovereign wealth funds", Guardian, 20 October 2007.
22
Germany's Handelsblatt newspaper, 19 October 2007.
23
Larry Summers on SWFs, Financial Times, 30 June 2007. See also Summers (2006).
24
Statement by G-7 Finance Ministers and Central Bank Governors, Washington, DC.
(http://www.mof.go.jp/english/if/g7_071019.pdf)
25
The US policy stance has been relayed to the public by US Undersecretary for International Affairs, David H.
McCormick, in testimony before the Senate Committee on Banking, Housing and Urban Affairs on 14
BIS Review 150/2007
the most extensive set of proposals for best practices for SWFs.26 He calls it a "standard to
guide the activities of SWFs". The standard sets out norms for transparency and
accountability with respect to four different aspects. They are: objectives and investment
strategy, governance, actual investment portfolios and fund management behaviour.
The effort by the authorities of the largest industrialised countries and the leading SWFs to
develop jointly a set of "good governance guidelines" is timely and clearly sensible. There is
a risk, however, that these efforts will fail, or will prove to be counterproductive if the
demands from the industrialised countries are too ambitious, or if such guidelines are
ultimately motivated by the desire in mature markets to impose veiled barriers to foreign
investments.
In my view, a future code of conduct or a set of guidelines must cover two central issues if
they are to be effective. First, to quell the concerns of recipient countries with respect to
politically motivated investments, a code of conduct must contain governance prescriptions
that ensure that the investment decisions of SWFs are not driven by political objectives. I
believe the institutional design of modern central banking can offer some clues as to the
appropriate form of these governance prescriptions. Central banks and SWFs obviously
pursue fundamentally different objectives. But, in principle, they are both at risk of being
hijacked by governments for political aims. In the case of central banks, this problem has
been successfully addressed by the adoption of an institutional design based on two
powerful features. Central banks have a clear mandate, typically focused on or around price
stability. Moreover, they have generally been given statutory independence from
governments in pursuing their mandate. This simple institutional design has become best
practice and has made an important contribution to keeping politics largely out of monetary
policy.
Second, to preclude a resurgence of state ownership in our economies, SWF guidelines
need to spell out upper limits to investment stakes in foreign private companies. It is difficult
to determine what such limits should be. As I alluded earlier, it is not just a matter of
preempting majority stakes of SWFs in foreign companies. "Cross-border nationalisation" of
private companies is simply the most extreme version of a broader unwelcome trend.27 For
this reason, I believe that to alleviate fears about excessive meddling of governments in
private companies, a SWF code of conduct will have to set the limit for individual stakes at a
level significantly below the typical threshold of a controlling minority, let alone an absolute
majority.
As long as a recipient country can be confident that a particular SWF operates in accordance
with these two paramount guidelines, there is no reason to demand intricate levels of
portfolio transparency from SWFs. Transparency is an attractive answer to intractable
problems. But it is unlikely to solve the problems I have tried to outline here. Indeed, I fear
that, in some cases, extensive transparency requirements for SWF portfolios could actually
end up triggering protectionist reactions in mature markets. It is also important to remember
that most stock exchanges already impose various disclosure requirements for large equity
holdings in listed companies.
There are, of course, a host of reasons why SWFs should, over time, become more
transparent. Many of these reasons have to do with the presumed desire of the citizens of a
SWF country to demand accountability. Once again, the history of central banking may
provide some valuable insights here. The more independent central banks have become, the
more they have recognised their obligation to be accountable to the public. Typically, more
accountability has meant more transparency. An independent central bank is therefore likely
to be transparent about how it pursues its mandate. The same may turn out to be true for
SWFs.
There are a number of difficult questions that need to be addressed before a set of SWF
guidelines can become operational. What exactly do we mean by a non-political investment
mandate? How do we gauge to what extent there might or might not be political interference
in the pursuit of such a mandate? Will there be a need for a referee to determine whether a
SWF complies with a particular set of guidelines? What happens if a SWF initially signs up to
a code of conduct but subsequently fails to comply with its guidelines? As you can see, much
work remains to be done and the timeframe is tight. Ideally, a first set of guidelines will be
agreed upon jointly between the G7 countries and the most prominent SWFs by the 2008
spring meetings of the IMF and the World Bank. If well designed and agreed upon, such a
set of guidelines could serve as a basis for determining which SWFs will continue to enjoy
full market access in mature economies.
5. Conclusion
Before I conclude, let me say a few words about the capital participation of the GIC in UBS
that was recently announced. As you know, the GIC recently committed to subscribe to
CHF 11 billion of a mandatory convertible bond which will be issued by UBS in an effort to
raise capital in the aftermath of losses on large sub-prime mortgage positions. Subject to the
UBS shareholders' approval, the GIC will in due time become a significant shareholder in
UBS. In the process, UBS will significantly strengthen its balance sheet and thereby maintain
a substantial capital cushion relative to the regulatory minimum. A strengthened capital
cushion is to be welcomed. First and foremost, it serves as a confidence-building measure.
Moreover, in uncertain times, a solid capital cushion provides insurance against a further
potential deterioration in the global macroeconomic environment.
Who is this new Asian investor in the largest Swiss bank? The GIC was set up in May 1981
with an original seed capital of several billion dollars from the Monetary Authority of
Singapore (MAS).28 The central bank reserves had grown steadily throughout the 1970s as a
result of public sector surpluses. The GIC's objective was to invest the portion of foreign
reserves, which was surplus to the needs of the central bank for its monetary policy
management, in longer-term assets. The mandate of the GIC is to preserve at a minimum
the international purchasing power of its assets against inflation and global exchange rate
risk. The objective of the GIC is commercial, focusing on long-term investment returns. In
many ways, it is similar to the objectives of the large European public pension funds. In fact,
the GIC has exceeded that mandate and has generated an average return of 9.5 per cent in
US dollar terms since inception. The size of the assets managed by the GIC is not publicly
known. The GIC has stated that it manages more than USD 100 billion but some estimates
have put their assets under management at over USD 300 billion. The assets of the GIC are
invested in ten asset classes - developed market public equities, emerging market public
equities, private equity, infrastructure, nominal bonds, inflation-linked bonds, real estate,
commodities, hedge funds and short-term assets including currency overlay. Geographically,
its investments are concentrated in the US, Europe and Japan, but span almost 50 countries.
Based on what is known about the GIC, and judging by the reasoning I have outlined in my
lecture this evening, there is little cause for concern about the UBS equity stake the GIC will
likely acquire. Over the past quarter century, the GIC has gained a solid reputation as a
global investor. With regard to the specific topic of my lecture this evening, I expect the GIC
to demonstrate leadership in the coming months to help shape an agreement with the
governments of the most important mature countries on a set of guidelines for SWFs that will
hopefully help to address the challenges I discussed this evening.
To summarise, SWFs have become an important source of capital flowing from the periphery
to the core of today's global economy. As such, they can play a constructive role in mature
markets. At the same time, SWFs pose a challenge to the international community. The
challenge is to preclude an outcome where the activities of SWFs trigger policy responses in
mature markets that ultimately lead us down the path of financial protectionism. It is in the
interest of mature markets and developing countries alike to avoid such an outcome. A set of
guidelines addressing the threat of politically driven investment decisions and resurging state
involvement in the global economy represent the best currently available option to respond to
the challenge of SWFs.
Let me close with a broader Swiss perspective. Switzerland has in absolute terms the sixth
largest current account surplus in the world. Last year, foreign investments by Swiss
companies and Swiss individuals generated net income receipts equivalent to 12 per cent of
our GDP, or approximately CHF 60 billion. In other words, we are experts at making
profitable cross-border investments. This means that we have as strong an incentive as
virtually any country in keeping global financial markets open.
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Appendix
Table 1. Sovereign Wealth Funds with assets estimated above 20 billion US dollars
Region Country Name Year of Establishment and Estimated Size
Year Size, bn USD, 2007.
Asia Singapore Temasek
1974c 100b
Singapore GIC
1981c 100-330b,c
China China Investment Co. 2007
200b
Brunei Brunei Investment Authority
1983c 30b
Japan Announced intension to n.a. n.a.
create one
South Korea Korea Investment
2006c 20b
Corporation
UAE ADIA (Abu Dhabi)
Middle East
1976c 250-875b
and Africa
Saudi Arabia Various n.a.
250+b
Kuwait Kuwait Investment Authority
1953c 160-250b
(KIA) and Futures Generation
Fund
Algeria Revenue Regulation Fund
2000c 43c
Libya Libya Investment Authority
2007a 40a
Qatar Qatar Investment Authority
2005c 50c
Other Russia Stabilization Fund
2003c 127b
Emerging
Markets
Developed Norway Government Pension Fund -
1996c 308b
Countries Global
US (state of Alaska) Alaska Permanent Reserve
1976c 35b
Fund
Australia Australian Future Fund
2004c 42b
Totald:
2227.5
a) Source: Financial Times on 18th October 2007, interview with the executive director of the Liby