Foreign-Exchange Reserves and Sovereign Wealth Funds

Søren Schrøder and Esben Humble Slotsbjerg, Financial Markets

INTRODUCTION

Over the last 20 years, markets for goods and financial assets have become more globalised and integrated. Purchase and sale of goods and financial assets such as stocks and bonds increasingly take places across national borders, and business enterprises and banks operate internationally. This has led to larger global flows of trade and capital, but has also enabled financial imbalances. The USA, for example, has reported substantial current-account deficits, while a number of Asian and commodity-producing countries have recorded large surpluses, cf. Chart 1. Consequently, the US current-account deficit is to a large extent financed, directly or indirectly, by South East Asian emerging market economies and oil-exporting countries.

This not only shows that capital flows have increased in volume, it also reflects a new pattern with industrialised countries as net capital importers.

Furthermore, growing current-account and capital-account surpluses have resulted in mounting foreign-exchange reserves in the surplus countries, cf. Chart 2.

As their foreign-exchange reserves have accumulated, a number of countries have transferred "excess" foreign-exchange reserves to sovereign wealth funds (SWFs), separating them from the central banks' traditional foreign-exchange reserves. In a broader context, an SWF can be seen as an alternative investment opportunity for foreign-exchange reserves, but the growth and investment patterns of these funds attract considerable attention in the media, in political institutions and among financial institutions.

SWFs are not a new phenomenon. The first such entities were established in the 1950s, e.g. in Kuwait. The reason why they have now come more into focus is that they have grown dramatically in size, and at the same time new SWFs have been set up in countries such as Russia and China. Moreover, as the funds build up wealth they have begun to invest in stocks and private equity. Recently, SWFs have been active during the financial crisis.

SWFs thus differ from traditional foreign-exchange reserves in terms of management and risk profile, resembling other investment institutions such as pension funds.

The primary difference between the investment strategies of central banks and SWFs is that central banks have to take monetary and foreign-exchange policy into account, whereas SWFs typically seek to achieve high returns and therefore have a greater risk appetite.

This article looks at the scope of SWFs and compares their asset management with central banks' management of traditional foreign-exchange reserves.

FOREIGN-EXCHANGE RESERVES

An increasing inflow of foreign exchange can be channelled into foreign-exchange reserves in central banks or into SWFs. This section outlines the reasons for and implications of rising foreign-exchange reserves in central banks, while the subsequent sections discuss the impact of accumulation of foreign-exchange reserves in SWFs.

In countries with current-account surpluses the exchange rate tends to strengthen, as evidenced in China. The same applies to countries with considerable capital inflows, either as direct investments or as foreign portfolio investments, as in India. If such a country wishes to curb the appreciation of its currency, its central bank must intervene in the market to purchase foreign exchange, thereby increasing the foreign-exchange reserve. The alternative is to ease the upward pressure on the exchange rate by lowering the interest rate, but this may be less compatible with domestic stability considerations.

The South East Asian economies pursue an exports-led growth strategy, and in order to remain competitive they do not want their currencies to appreciate too much. Consequently, they have purchased foreign exchange. In connection with crises it has also proven to be valuable to have sufficient foreign-exchange reserves to support the exchange rate as well as the domestic financial sector. Large foreign-exchange reserves can thus be seen as a buffer against sudden capital outflows, as witnessed by several Asian and Latin American economies in 1997-98.^[1]

Central banks cannot build up foreign-exchange reserves without financing them. If the central government accounts for the build-up, it typically deposits the income with the central bank, thereby increasing the balance of its account with the central bank. If the private sector accounts for the build-up, the central bank typically issues domestic debt instruments or sells domestic claims in order to finance purchase of foreign-exchange in the market, cf. Chart 3.

In neither case the foreign-exchange reserve represents wealth for the central bank. However, it may reflect growing central-government wealth or, in a broader sense, growing national wealth.

In oil-exporting countries, mounting foreign-exchange reserves reflect both foreign-exchange revenue and government budget surpluses. Foreign-exchange proceeds from sale of oil, which accrue to the Treasury, either directly via ownership of oil companies or indirectly via taxes, are not exchanged in the market, but are typically deposited with the central bank. This adds to the foreign-exchange reserve, and an equivalent amount is credited to the central government's account at the central bank. As long as the central government does not use its deposit in the central bank, no upward pressure will thus be exerted on the domestic currency and on inflation from this source. Norway is a case in point.

In the South East Asian countries, on the other hand, the foreign-exchange reserves primarily reflect foreign-exchange revenue in the private sector, and the central banks finance the increasing foreign-exchange reserves by selling domestic securities and/or raising loans via issuance of domestic debt instruments.

In many cases, increasing foreign-exchange reserves entail rising costs and risk for central banks. If the reserves have been financed by issuing domestic debt, the rate of interest payable is typically higher than the rate at which the reserves can be placed. This reflects how monetary policy in surplus countries is often aimed at dampening inflation. At the same time, surplus countries typically experience underlying upward pressure on their currencies. In that case, foreign-exchange reserves may also entail large exchange-rate losses for the central bank.

SOVEREIGN WEALTH FUNDS – SWFS

Many countries now transfer their growing foreign-exchange reserves to SWFs. While larger foreign-exchange reserves involve higher financing costs and increased risk for central banks, the establishment of an SWF implies that risk and financing is undertaken by the central government, not the central bank.

Previously the South East Asian emerging market economies and the oil-producing countries primarily invested in US government bonds. As wealth has accumulated, these countries seek higher returns and increasingly invest in stocks, business enterprises and real estate, also outside the USA. SWFs thus differ from traditional foreign-exchange reserves in terms of management and risk profile, resembling other investment institutions such as pension funds.

Size and development
With a few exceptions, SWFs do not publish the size and composition of their foreign assets, which must thus be estimated.^[2] The IMF estimates that the global value of SWFs has risen from around 500 billion dollars in 1990 to a current level of somewhere between 2,100 and 3,000 billion dollars, cf. the Appendix.

Compared with other players in the financial markets, these funds still seem modest, cf. Table 1. SWF assets thus correspond to approximately one seventh of pension fund assets, less than 5 per cent of bank assets and around half of the total foreign-exchange reserves of central banks.

SWFs are characterised by a high degree of concentration in that the largest 10 funds hold 80 per cent of the wealth. The largest SWF, Abu Dhabi's ADIA, is the 11th largest institutional investor worldwide.

In the longer term, the value of SWFs may constitute a considerably larger share of the financial markets, particularly in view of the higher commodity prices and the sustained high growth in the South East Asian economies. According to IMF (2008b), the global value of SWFs will grow to somewhere between 6,000 and 10,000 billion dollars in 2013.

Financing and objectives
SWFs differ in terms of their sources of financing and their objectives. Around three quarters of the assets are proceeds from sale of commodities, typically oil.

This applies to e.g.Saudi Arabia and Norway. For both the central government and the nation as such, the assets are genuine wealth without corresponding debt. In these cases, SWFs can be seen as a means of smoothing or redistributing income over time.

Approximately one quarter of the assets relate to current-account surpluses or government budget surpluses. An example is Singapore. In such cases, an SWF can be seen as a vehicle for increasing the expected return. The question is whether the assets in these cases represent genuine wealth since the central bank or the central government has financed them by raising debt. This particularly applies to funds such as those contemplated in India and Brazil; both these countries have posted current-account deficits or only modest surpluses and have considerable foreign debt.

The objectives of SWFs may differ. The IMF operates with five types:

• Stabilisation funds, where the primary objective is to reduce the exposure of government finances to fluctuations in e.g. oil, copper and diamond prices.
• Savings funds for future generations, which aim to convert revenue from commodities into more stable, permanent income from financial assets.
• Reserve investment corporations, which seek to achieve a higher return on the foreign-exchange reserves.
• Development funds, typically aimed at supporting socioeconomic projects or domestic industries.
• Contingent pension reserve funds to save up for general pension liabilities of the central government.

The objectives may be a combination of the above and may change over time.

TRADITIONAL FOREIGN-EXCHANGE RESERVES AND SWFS

Like other financial institutions, central banks and SWFs are exposed to a number of financial risks. The following provides an overview of how SWFs and central banks differ in terms of management and how this is reflected in their return and risk profiles.

Central banks' management and portfolio structure
The primary objectives of a central bank are typically to issue banknotes and coins, to conduct foreign-exchange and monetary policy and to ensure financial stability. As a result of these tasks, central banks have claims in foreign exchange.

Typically, the size of a central bank's assets, including the foreign-exchange reserve and domestic assets, does not reflect the central bank's net capital (wealth). The reason is that the assets of a central bank are offset by liabilities. Purchase of foreign exchange for the foreign-exchange reserve thus entails an equivalent increase in debt to e.g. banks or in central-government deposits with the central bank. Chart 3 shows an illustration of the assets and liabilities of central banks.

In a net perspective, i.e. if both a central bank's assets (the foreign-exchange reserve) and its liabilities (loans) are considered, the central bank's risk may be considerable in relation to its net capital. The risks incurred by a central bank typically reflect the risks arising from its role as monetary policy authority.

If a fixed-exchange-rate policy is pursued, the foreign-exchange reserves may increase in periods with upward pressure on the exchange rate. At the same time, sufficient liquid foreign-exchange reserves must be available if the exchange rate is under downward pressure. Consequently, the central bank may need to release invested assets at short notice. It must be possible to sell, pledge or settle investments abroad quickly and easily without incurring substantial costs. This usually involves large foreign portfolios in short-term securities such as short-term money-market deposits and liquid short-term government bonds.

Foreign-exchange reserves naturally entail a foreign-exchange risk. Evidence shows that exchange-rate fluctuations can impose large losses on central banks. The risk on foreign-exchange positions is often great and the expected return is typically very low in relation to the risk. However, the foreign-exchange risk depends on the exchange-rate policy pursued.

In addition to the foreign-exchange reserve, a central bank often has a stock of gold. The price of gold is characterised by large fluctuations and central-bank gold thus entails considerable risk in relation to the other investments of a central bank. At the same time, there are current opportunity costs for holding gold, as the rate of interest on gold is close to zero and thus lower than on alternative investments, but rising gold prices act as a safeguard against inflation. In spite of the strong increase in the price of gold in recent years, the risk-adjusted return seems to be relatively low in a historical perspective.

Typically a central bank also assumes interest-rate risk, often relating to a bond portfolio. If the yield on bonds is higher than the rate of interest on a placement in the money market, an excess return ("carry") is obtained. The overall outcome from assuming interest-rate risk also depends on the price of the bond, however. If the price falls (rises) as a result of higher (lower) interest rates, an interest-rate-driven capital loss (gain) is achieved. The overall result thus comprises a "carry" plus any capital loss or gain. Central banks typically seek to achieve an acceptable return on interest-rate risk in order to increase revenue.

As the size of foreign-exchange reserves reflects equivalent financing and not genuine wealth for central banks, the risk of a central bank should not be assessed in relation to the size of the reserve. It is more relevant to relate it to the size of the bank's net capital, possibly supplemented with the value of banknotes and coins in circulation, which is a source of revenue for the central bank.

The aggregate risk incurred by a central bank may thus often be relatively high in relation to its net capital. Furthermore, it is concentrated on a few areas such as exchange rates and gold.

Separation of SWFs from core central-bank tasks
The establishment of an SWF draws a clear line between management of typical central-bank tasks and national asset management.

The separation of SWFs from central banks means that fluctuations in SWF assets do not have any impact on the central bank's risk. In a worst-case scenario this would otherwise potentially entail quite substantial losses and thus affect the solvency and credibility of the central bank. By establishing an SWF, the central government can increase the risk-adjusted return without increasing the central bank's risk of incurring large losses not related to its role as monetary policy authority.

Expected return and risk
The different objectives and liquidity considerations, etc. mean that the asset allocation in an SWF may differ substantially from that of a typical central bank. The reason is that an SWF need not consider financing of the foreign-exchange reserves (liabilities side), and that from a risk-management perspective it might be appropriate for an SWF to diversify in the same way as e.g. pension funds do.

A gain may be achieved by spreading investments on other assets than those which contribute most to central-bank risk: exchange rate, interest rates and gold price. However, it is very difficult to assess future return and risk. Chart 4 provides a historical overview of return and risk for various asset classes.

The asset allocation in both central banks and SWFs is based on a trade-off between risk and expected return. For central banks, high revenue is not in itself the primary objective. In contrast, SWFs can be expected to seek the best possible return on a given risk, without taking any liabilities side into account.^[3]

Chart 4 shows that US money-market deposits have entailed the lowest risk since 1980, while the risk on bond investments^[4] has been slightly higher, but so has the return. It is also seen that stocks have entailed a lower risk and yielded a higher return than e.g. investments in gold and oil.

Past developments are not necessarily a good proxy for future risk/return ratios. Nevertheless, it must generally be assumed that investors require a higher return when taking a greater risk. Against that background, SWFs with a long investment horizon have invested large sums in stocks and other, more risky assets in the expectation of achieving a higher return in the long run.

Finally, it should be mentioned that differences in asset allocation between central banks and SWFs may also indicate that the countries in question have become more affluent and feel that they can afford to take a greater risk via an SWF that invests in other assets, such as stocks, thereby also achieving greater diversification. If, for example, SWF wealth is accumulated via income from commodities, this is "genuine" wealth not immediately set off by liabilities that must be financed.

Other issues
The asset allocation and risk tolerance of SWFs can vary considerably, depending on their objectives, and are not necessarily based purely on maximising the expected return.

For example, oil prices have historically fluctuated considerably, and oil reserves are, of course, limited. This means that oil revenue will cease at some point. Via an SWF, the limited resources in the underground can be transformed into more stable and permanent financial revenue.^[5] At the same time, this will curb the strengthening of the domestic currency, which might otherwise reduce competitiveness in other industries.

If oil reserves are seen as a financial asset, it might, from a risk perspective, make sense to invest profits in assets with a low or negative correlation with oil prices. This can reduce the aggregate risk on the portfolio, including the oil reserves, while also increasing the expected return.

Investments in SWFs can also be used to counter specific risks that the countries are exposed to. For example, a number of Asian economies are highly dependent on changes in commodity prices. Investments in commodity companies, etc. may therefore be a means of hedging against rising commodity prices.

FINANCIAL MARKETS AND FINANCIAL STABILITY

For several years, countries with current-account surpluses have primarily invested in US government bonds. This has contributed to downward pressure on long-term interest rates, cf. ECB (2006), Warnock and Warnock (2006) and Andersen, Fick and Hansen (2007). Likewise, SWF investments have supported the dollar during periods when the US current-account deficit has put the currency under pressure.

The increasing wealth managed by SWFs can affect the financial markets in two ways: via a savings effect and via a portfolio effect.

Firstly, the high propensity to save in surplus countries will make a positive contribution to global savings and exert downward pressure on interest rates.

Secondly, increasing wealth may also affect the prices of e.g. stocks and bonds, partly because return-risk preferences may be different in surplus and deficit countries, partly because risk aversion usually declines with rising wealth. All other things being equal, this may lead to substitution from e.g. more secure bonds to stocks. This may exert upward pressure on yields and on the price of assets with a higher return-risk profile, such as stocks.

Increasing SWF wealth can be expected to weaken the savings effect and strengthen the portfolio effect. This is in accordance with two tendencies in SWF portfolio restructuring.

The first tendency reflects diversification away from dollars. The second is restructuring from liquid, less risky investments into assets with a higher return-risk profile such as stocks, private equity and real estate.

Although the overall effect on price formation in the financial markets is by no means clear, growth and portfolio restructuring will entail that ownership of financial assets, business enterprises and real estate may change in the coming years.

In a number of countries this has led to concerns that wealth is being used for strategic business acquisitions, notably in France, Germany and the USA. Such concerns are often rooted in national security considerations. At the same time, a number of countries with SWFs are concerned that their investments abroad are subject to a higher degree of restriction and protectionism, which could impede the free flow of capital. It should, however, be noted that a number of countries with SWFs traditionally have various restrictions on foreign investments.

In view of the above and to ensure financial stability, the IMF is preparing a general code of conduct for e.g. the governance and transparency of SWFs. This code of conduct will set targets for best practice in areas such as guidelines for public governance of SWFs, distribution of responsibilities, accounting policies, independent audit and degree of transparency about objectives, risk management and investments.

The code of conduct should help to ensure that SWFs are governed on business terms. In addition, it may contribute to greater transparency concerning the risks and investment patterns of SWFs.

Financial stability
As the SWFs accumulate wealth and diversify into more asset classes, their investment decisions will have a greater impact on financial stability.

Concerns could be that the funds are not governed in an adequate way, that they are not subject to regulatory supervision and that they are rather closed.

These concerns are less pronounced in relation to the global foreign-exchange markets. It should nonetheless be borne in mind that even small portfolio shifts may trigger large changes in the financial markets.

Owing to the increasing importance of SWFs, market participants try to predict their next moves. With a few exceptions, SWFs are characterised by a pronounced lack of transparency, which may give rise to more or less reliable rumours about their investments. Such rumours may, in turn, lead to unnecessary turmoil and herding effects in the financial markets, which is not conducive to financial stability. It should be noted, though, that today there are far more players in the financial markets than previously. This means that an individual player is less able to influence the markets than e.g. during the financial turmoil in 1992 (EMS) and 1998 (Long-Term Capital Management).

On the other hand, SWFs may be a stabilising element in that they operate with a longer investment horizon and are less governed by liquidity considerations. With their deep pockets they thus have resources to withstand the stampede in the market. This is also the case in connection with the subprime crisis. Most recently, two banks, Citigroup and UBS, have received considerable capital injections from Abu Dhabi and Singapore, respectively.

LITERATURE

Andersen, Thomas Barnebeck, Sofie Nedergård Fick and Frank Øland Hansen (2007), Petrodollars, Portfolio Restructuring and Long-Term Interest Rates, Danmarks Nationalbank, Monetary Review, 3rd Quarter.

Deutsche Bank (2007), Sovereign Wealth Funds – State Investments on the Rise, Deutsche Bank Research,10 September.

ECB (2006), The Accumulation of Foreign Reserves, Occasional Paper Series, no. 43.

IMF (2007), Global Financial Stability Report, October.

IMF (2008a) World Economic Outlook (2008), April.

IMF (2008b) Sovereign Wealth Funds – A Work Agenda, IMF, February.

Knut N. Kjær (2007), Turning oil wealth into financial assets: the case of Norway, Sovereign Wealth Management, Central Banking Publications.

Toloui, R. (2007), Petrodollars, Asset Prices, and the Global Financial System, PIMCO Capital Perspectives.

Warnock, Francis E. and Veronica C. Warnock (2006), International Capital Flow and U.S. Interest Rates, update of Federal Reserve Board International Finance Discussion Paper 840.

APPENDIX