SWFs have experienced significant growth and are becoming some of the largest investors in traditional and alternative investments. Since 2008, SWFs’ assets increased by more than ____; and, in 2021, SWFs managed over ___ in assets (of which over ____ was in alternative assets), which exceeds the total assets under management of both the hedge fund and private equity industries.
$4.4 trillion
$9 trillion
$1.6 trillion
What is the balance of payments (BOP) of a country?
The BOP is composed of two accounts, what do they measure:
It is a record of its transactions and cash flows associated with its foreign transactions in a given period (e.g., over a quarter or a year).
- Capital account - measures investment flows (i.e., change in asset ownership) of purchases and sales of foreign assets and debt.
- Current account - measures trade in goods and services, investment income, and gifts (e.g., foreign aid). Components include commodities and manufactured goods and services.
A country with a capital account surplus has more ___
imported capital than exported capital
What is China’s and USA’s capital/current account make up?
China has a current account surplus and a capital account deficit since it exports more than it imports and uses the proceeds to buy foreign assets
U.S. has had a current account deficit and a capital account surplus for some time, since it buys more imported goods/services than it exports. The excess consumption is financed by U.S. residents selling assets or borrowing money.
In a country with a current account deficit, the value of imports of goods and services ___ that of exports, so more money ___
exceeds
leaves the country to buy goods/services than comes in from the sales thereof.
How are current account deficits typically funded?
with capital account surpluses
central bank’s reserve account maintains its
central bank’s reserve account maintains its foreign currency holdings and is the sum of the capital and current accounts.
Countries with floating exchange rates that have capital account surpluses generally have ___
The currency market brings the two accounts into equilibration by adjusting ____
offsetting current account deficits in a given year, keeping the reserve account stable.
currency prices to make imports of goods and exports of capital equally attractive.
Gwartney et al. (2003) explain that a country’s currency tends to appreciate in value when the country has the following 5 characteristics:
- Lower inflation rate than its trading partners
- Higher real interest rates than its trading partners
- Policies that attract capital inflow
- Slower income growth than its trading partners that reduces demand for imports
- Competitive or comparative advantage in export-oriented industries
What are the 2 potential risks for countries with a current account deficit (more imports than exports) combined with a capital account surplus (more foreign investment than domestic investment):
1) Foreign Investment Reliance: The country relies on continued foreign investment to maintain its capital account surplus. If foreign investors suddenly decide to withdraw their money, it could cause the currency to depreciate (lose value) and lead to financial difficulties.
2) Current Account Strain: A persistent current account deficit can put pressure on a country’s long-term economic health. If the gap between exports and imports isn’t sustainable, the country may eventually struggle to pay for its imports.
Revenues of many countries are closely tied to oil prices because either their oil companies are state owned or the state receives tax revenues on sales of energy commodities.
Commodity exporting countries have three key concerns regarding tax revenues.
- Volatile oil prices produce an unstable income stream, which is incompatible with generally stable government spending.
- Commodity revenues will eventually experience depletion since commodities cannot last forever.
- Governments prefer not to rely primarily on commodity revenues, but prefer to have a diversified economy that also generates tax revenues from other industries ( e.g., technology and tourism).
4 types of SWFs:
1) Stabilization Funds - countercyclical, accumulating excess revenues during
periods of high commodity prices and distributing the savings during periods of low commodity prices
2) Savings Funds - once a reserve adequacy standard has been met, a sovereign wealth savings fund with a total return objective is created. Also establish spending rates so that income can be available for future generations and the fund’s corpus can be maintained or increased.
3) Reserve Funds - used to meet future obligations (pension reserve fund or reserve investment fund)
4) DEVELOPMENT FUNDS - established to allocate resources to socioeconomic
projects
Central banks use the reserves from their Stabilization funds for 3 purposes:
i. To implement monetary policy by changing interest rates by trading fixed-income securities.
ii. To intervene in the foreign exchange market, either to keep a currency at a fixed rate or to move a floating currency toward a desired level.
iii. To provide liquidity to prevent crises in the banking system
3 types of rules on the amount of commodity revenues transferred into SWFs by Alsweilem et al. (2013)
i. Fixed percentage rule - fixed percentage of commodity revenues (e.g., 15%) is transferred to the SWF. This transfer is procyclical (i.e., the government receives higher revenues during times of higher commodity prices and lower revenues during times of lower commodity prices) and the easiest rule to implement.
ii. Hurdle price rule - all commodity revenues above a hurdle price (e.g., $65 per barrel for oil) are transferred to the SWF.
This approach saves windfall revenues received during good times (it does not necessarily release stabilization funds into the government budget during periods of low commodity prices).
iii. Deviation from moving average rule - Commodity revenues that exceed a moving-average revenue are transferred to the SWF, while revenues below a moving-average revenue move proceeds out of the SWF into the government budget.
Describe the 2 potential conficts that Development funds may face:
What is the solution to the conflicts?
1) government agencies responsible for developing infrastructure may not advance projects, expecting instead a SWF to develop the infrastructure.
2) Development funds should select projects or investments based on financial assessment, only financing projects/investments with the greatest chance of success or profit potential; selections should not be made based on personal relationships.
They should be separated from government agencies and any political pressure.
There are 4 common motivations that may result in a SWF being established:
- To protect a country’s economy from a decline or volatility in revenues.
- To help monetary authorities counter unwanted liquidity.
- To grow for future generations, particularly if the surplus was driven by a condition that may reverse or become depleted.
- To invest in infrastructure or economic growth projects to improve a sector of the economy or grow an industry (particularly to diversify away from commodity revenues).
According to Preqin (2016), more than ___% of SWFs invest in alternative investments.
Due to the SWFs’ size and long holding period, investors tend to make direct rather than pooled investments, especially in ____ .
75%
infrastructure and real estate
Asset Allocations of SWFs by type of fund
Converting proceeds from large commodity sales into the local currency
may have two adverse effects:
- Inflation - if the money supply grows faster than the availability of goods in the local economy.
- Dutch disease - a large foreign currency inflow (e.g., from a commodity sale) that negatively affects a country’s other sectors (e.g., manufacturing or agriculture) by making them less price competitive on the market
Discovery of a tradable natural resource (dutch disease) or a significant rise in the price of a natural resource has 2 major effects that result in making the manufacturing and export sectors less competitive and may result in their de industrialization:
i. It increases wages by shifting workers from other sectors to the commodity sector. It may also shift the focus of entrepreneurs and industry leaders to opportunities related to the export of the commodity.
ii. The value of the local currency increases due to large inflows of cash.
What is Sterilization?
It is a macroeconomic policy used by many countries that involves countering the effects of an economic event (e.g., commodity boom) and a BOP surplus on the country’s economy.
There are two forms of sterilization:
- Sell domestic currency & buy foreign currency: The central bank of a country with a trade surplus that wants to prevent its currency from appreciating can sell its domestic currency and buy foreign currency to meet the increased demand for domestic currency by foreign importers of its products.
- Invest revenues abroad - A country may accumulate significant reserves from revenues from sales of natural resources that are controlled by the government. Since spending the revenues in the local economy may disrupt the economy and appreciate the currency, the government may invest a portion of the commodity proceeds abroad. For example, Norway may invest some of its sovereign assets in German euro-denominated securities so as not to disrupt its local economy and to prevent the appreciation of its currency
What is a conservative investment opportunity cost, how can it occur in a SWF and what are the solutions to the problem (which can only be done after what)?
After a period of high commodity prices, a stabilization fund may end up being unnecessarily large and subject to a sizeable conservative investment opportunity cost due to its concentration in cash and liquid fixed-income investments.
The solution would be to start investing in risky assets and creating a total return portfolio, however, only after its reserves reach a reserve adequacy level.
How is a reserve adequacy level measured?
The appropriate size of the reserves is measured relative to the size of potential shocks (e.g., changes in commodity prices, trade or investment flows, or losses in the banking sector).
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