Financial Crisis, SWF Investing, and Implications for Financial Stability
In this column Joonkyu Park and Han van der Hoorn introduce readers to sovereign wealth funds - the topic of their recent co-authored article for Global Policy Journal available here.
Sovereign wealth funds (SWFs) play an important role in modern capital markets as large providers of stable sources of funding. From a policy perspective, they are particularly interesting because they combine financial and macroeconomic objectives. SWFs are created for macroeconomic purposes, yet hold, manage, or administer assets to achieve financial objectives.
The global financial crisis caused tremendous volatility in the financial markets and SWFs have not been shielded from the consequences. SWFs’ responses to the crisis show that SWFs, in many cases, maintained their overall investment framework and asset allocation. However, some SWFs deployed resources to support domestic banking systems by depositing their assets in domestic banks, and others helped with bank recapitalizations. Some SWFs showed patterns of a flight to quality, increasing their exposure to high-quality sovereign assets while reducing their credit exposures.
Several SWF types, notably savings and pension reserve funds, have—at least in theory—long investment horizons. The long maturity of their implicit liabilities allows them to hold longer-dated securities in less liquid markets, and reap the associated risk premia. However, the crisis response of several countries and their SWFs raises the question whether SWFs are truly long-term investors and, subsequently, whether lessons for their investment strategies can be drawn.
Sovereign ownership can reduce the investment horizon of SWFs. In extreme scenarios, country authorities may use their SWFs as a second line of defense—complementing the official reserves held by the central bank—if the net benefits from using them domestically short-term exceed the benefits of holding long-term illiquid foreign assets. The possibility that funds may be needed for domestic support at short notice has implications for the investment strategy, including strategic asset allocation, of SWFs. Overestimating the investment horizon leads to a suboptimal asset allocation, especially if it includes many illiquid assets. As fire sales tend to be costly, this paper discusses how they can be avoided or minimized.
The first step towards preventing fire sales is a systematic approach for identifying and quantifying implicit liabilities. A sovereign asset and liability management (S¬–ALM) approach that incorporates all assets (reserves) and liabilities owned or controlled by the sovereign, can help derive the true investment horizon of the SWF.
Moreover, SWFs should seek asset classes in which a long investment horizon gives them a competitive advantage over short-term investors. Long-term investors like SWFs are in principle well positioned to ride out temporary price volatility. Mean-reversion of asset prices is an important condition for the success of such strategies.
It is important—and difficult—to align incentives of staff with the long-term interests of the fund. Performance targets that are defined over longer periods may help avoid short termism in investment behavior.
In 2008, 23 countries agreed on a set of ‘Generally Accepted Principles and Practices’ for SWFs, known as the Santiago Principles. The Santiago Principles aimed, among other things, to alleviate fears that SWF investment decisions were driven by political motivations.
One of their guiding objectives was that SWFs ‘invest on the basis of economic and financial risk and return related considerations’. Another guiding objective was ‘to help maintain a stable global financial system’. The crisis has shown that these two objectives can sometimes be at odds with each other, as some SWFs had to make the difficult trade-off between protecting their own financial assets and safeguarding financial stability.
The paper argues that conflicts arose mainly from a wrong interpretation of the principles, not from the principles themselves. Ultimately, stable financial markets are in each SWF’s self interest, also from a narrow financial perspective. In stable markets, SWFs can truly benefit from their long investment horizons and pick up the risk premia that short-term investors cannot. In this respect, financial stability and financial risk ⁄ return can be mutually reinforcing objectives.
Han van der Hoorn, is a technical assistance advisor in the Sovereign Asset and Liability Management Division of the International Monetary Fund. In that position, he works with and advises central banks and sovereign wealth funds on strategic asset allocation and risk management.
Joonkyu Park, is working for the Monetary and Capital Markets Department of the International Monetary Fund (IMF), mainly covering foreign exchange reserves, sovereign wealth fund (SWFs), capital flows, and international monetary system (IMS) issues.
