Risk of Investment of Sovereign Wealth - Research Proposal Example

?Risk of investment of sovereign wealth and strategies that can be used to mitigate the risks Table of Contents 3 Background 4 Research objective 5 Research question 5 Significance of the research 6 Literature review 6 Magnitude of risks that sovereign wealth bears to the national economy 8 Magnitude of risks that a country exposes by investing its sovereign wealth 9 Strategies to mitigate risk associated with investment of sovereign wealth 10 Political influences on investment on sovereign wealth fund 11 Methodology 12 Conclusion 13 Reference List 14 Abstract In the 21st century, Sovereign wealth funds (SWF) have become one of the key factors that affect the international financial scenario. The world is undergoing a phase of transition since the beginning of this century. The financial crisis of 2008 has aggravated the reasons of this transition. The developed nations have suffered heavily from the financial breakdown of the most powerful institutions of the world and are still striving hard to overcome the effects of recession that followed after the great financial crisis. Reports published by OECD reveal that government-driven mergers and acquisitions reached the peak (almost 20 percent of the total international value) level immediately before the financial crisis struck the Euro zone in 2009. In the subsequent year, this value declined sharply to half. The bulk of this international investment originated in few countries, China, the Middle East and North Africa (MENA) region and few other Asian economies. Recently, SWFs have gained serious attention from the governments of countries around the world on the issue of risk associated with the holding of such wealth and its investment. In this paper, the impact of such risk on the economy is studied and the ways to mitigate risks have been discussed. Background Sovereign wealth funds are funds that are controlled by the government of a country. The government of a nation used this fund to make investments in other economies. Governments make investments in other countries by acquiring the assets located in those countries (Keefe, Fournier and Torys, 2003). The developing nations have also been affected hard by the crisis. However, research shows that due to the fact that these countries are developing, growth rate of these countries are higher than the growth rate of the developed nations (Manganelli and Engle, 2001; Mehta et al., 2012). A gradual but steady shift in power is visible from the West to the Eastern countries. The West is traditionally the centre of economic and financial power and the developed countries of the United States of America and European countries, until now enjoy the maximum economic power and therefore hold the highest political position in the global economy. The ongoing shift in traditional position and power from the western developed countries to the emerging economies in the east, such as China, is associated with higher levels of investment of SWF (Waki, 2010; Saunders and Cornett, 2011). These investments are mostly made in the emerging market economies. Different levels of risks are associated with the SWFs depending on the pattern of investment made with these funds. Economists and policymakers have made different recommendations and suggested divert ways to mitigate such risks (Seagal, 2013). After the Euro zone crisis took place in late 2009, the issue of risks associated with sovereign wealth has been receiving greater importance (Jost, 2009; Saunders, 2013). Through further research it has been identified that the emerging economies are at lower levels of growth but showing higher growth potential than the developed countries (Smith, 2003). Hence investment of SWF is migrating fast towards the emerging economies. Research objective The objective of this research paper is to analyse the risk of investment of sovereign wealth and strategies that can be used mitigate these risks. The researcher aims to check whether risks of investing sovereign wealth adversely affect the economic variables in a country, such as employment level, per capita income and asset prices. This research objective would be fulfilled by studying the magnitude of risks that sovereign wealth bears to the national economy and the magnitude of risk that a country undertakes by investing its sovereign wealth. The research objectives are: To critically evaluate the theories pertaining to risk involved in holding sovereign debt To investigate the political impact on sovereign wealth To evaluate the risks entailed in the investment of sovereign wealth funds Research question The research questions depend on the intention and motivation of the researcher to conduct this particular research. The research questions are as follows: What are the government regulations with regard to the sovereign wealth fund investments? What are the impacts on asset prices due to investment of sovereign wealth funds? What are the impacts on the economic factors such as, employment, national income and per capita income due to these investments? How to mitigate the risks that arise due to investment of sovereign wealth? Significance of the research SWFs are only one of the vectors that sovereign entities choose for making foreign private investments. The other vectors that the sovereign governments use to make investments are by purchasing state-owned enterprises and by making foreign direct investments through foreign exchange stocks (IMF, 2011). Some of the multinational companies are controlled by the government and they make investments in the foreign lands by acquiring enterprises that are operating in those countries domestically. Governments of some of the Asian countries, such as Thailand, Indonesia and India are investigating or have already implemented the plans to “diversify their foreign exchange holdings into private fixed income products or liquid international equity securities” (Balin, 2008, p. 4). This makes it important to study the sovereign wealth holdings and risks associated with the investment of these funds. Significance of this research paper lies in the fact that the issue is discussed in detail and the researcher is successful in covering every aspect of the topic of research. The problem would be discussed in the paper from all angles and every feasible solution would be considered for making recommendation. It is not aimed at identifying the single best solution, but the importance of the study rises when it provides an in-depth analysis of the topic of research. This study would help in understanding the riskiness of these funds; it would shed light on the impact of the SWFs on the economic and social conditions of the countries and would develop the stage for making further research on this issue in future. Literature review Sovereign wealth is the wealth of a country, which is controlled by the government of the country. There is significant risk associated with the possession and investment of sovereign wealth. The 2009 sovereign debt crisis in the Euro zone was a result of the combined effect of sovereign debt crisis, banking system failure and lack of competitiveness among the firms (SEIC, 2013). SWFs have been existent in the countries of the Middle East, Europe and the United States for several decades now. But it has developed newly in the countries like, Russia and China. Some of the governments of countries in the Middle East have accumulated these funds by selling natural resources, such as, oil. Others have accumulated such funds in the form of trade surplus (Das, 2010). The SWFs are large sums of money, which the governments seek to invest. Some of these investments are made with the purpose of fulfilling commercial objectives of the governments. For example, Peninsular and Oriental Steam Navigation Company (P&O) has been acquired by the state-owned enterprise, Dubai Ports World Corporation. IBM’s computer hardware business has been acquired by the Lenovo Group, which is controlled by the Chinese government (Gajek, Ostaszewski and Zwiesler, 2005). However, other investments are not made with the aim of earning returns on investment, like other general investments made by private investors. Rather, some SWFs are invested with the aim of achieving political or non commercial goals of the government (Glassman, 2009; GARP, n.d.). There are mixed perspectives about the SWFs. Some experts consider that SWF can cast positive impact on markets because of the long term nature of the investments and also the nature of the investor. Between 2007 and 2009, SWFs have invested heavily into the European and US markets. Some market observers consider that these investments are the cause of disruptions in the subprime mortgage loan market. Critics have pointed out that one of the major drawbacks of the SWFs is that there is lack of transparency in the transactions made by the sovereign funds. Risks are associated with the holdings of the SWFs as well as the strategies of investment (ECB, 2011). Due to investment through these funds, large amount of funds are moved into or out of these countries (or markets), which is capable of affecting the asset prices adversely. Magnitude of risks that sovereign wealth bears to the national economy Four prime reasons can be identified as the causes of establishing a wealth fund by the name SWF. Firstly, these funds act as “intergenerational transfer mechanisms” (Balin, 2008, p. 4). These funds are the source of asset liquidity, future revenues to be earned and government pensions to be provided to the pensioners in future. These funds are earnings of the forefathers that allow the economy to support its future generations, such that they would be able to lead a prosperous life. The SFWs allow the country to diversify its investment decisions and helps it to respond to any shock to economic and financial structure of the economy. The country can reinvest its SWFs in order to revive its sectors during any form of crisis. Additionally, SWFs also help in increasing “the return on assets held in their central bank reserves” (Balin, 2008, p. 4). Finally, investment of the SWFs also helps in promoting transfer of technology to the domestic industries due to investment made by the foreign multinational corporations (Davis and Zhu, 2004). However, this has led to the creation of a new paradigm globally. Some market observers are of the notion that the sovereign funds are in effect huge pools of financial assets that are owned by authoritarian governments (Barbary and Bortolotti, 2012). These governments are often found to be undemocratic and they are not always accountable for their activities. Many governments that hold large amounts of sovereign wealth do not have solid accounts of their activities related to the maintenance of human rights and freedom of the people living in these countries. Often these governments take the process of development for granted. They consider the amount of sovereign wealth held by the government as an indicator for the level of economic performance of the country. In this process, the level of economic development of the country might be overestimated. SWFs can potentially warp the existing economic structure in the domestic as well as international economies, disturb the economic balance in the economy and reduce or eliminate competition in the marketplace. It might also put substantial influence on the enterprises working individually in the domestic and international economies by affecting the management structure and human resources of these individual firms (Demson, n.d.). Magnitude of risks that a country exposes by investing its sovereign wealth Some countries in the Middle East, Europe and Asia are owners of large trade surpluses. These are funds that the countries seek to “invest outside their home markets” (Barbary and Bortolotti, 2012, p. 310). Such investments are mostly associated with varied degrees of risks. These investments might be made with the aim of politically blackmailing a company or making espionage on the company. If a foreign multinational enterprise invests in an enterprise running in another country and own a certain percentage of shares of that company, it would become knowledgeable about the inner activities and strategies of the company. If there is a case of breach of trust, the domestic firm would become vulnerable to the foreign company. Strategic purchase of company shares delivers a portion of the company’s ownership to the company that purchases it. On the other way round, if the SWFs are invested to such enterprises that do not have reliable market record of performance, the investor is faced with significant risk; it might be difficult to earn returns on that investment or even recover the principle amount. Besides, there also remains the threat of manipulation of the political positioning of the governments by way of strategic investment of some types of SWFs (Balin, 2008). This is mostly possible in case of investment in the strategic sectors in the economy, such as oil and gas, telecommunications and transportation system, for example, the national airlines. The top ten SWFs in the globe have signed a treaty that would prevent them from getting involved into any political associations and have agreed not to make investments in the sensitive sectors of the economies. Strategies to mitigate risk associated with investment of sovereign wealth There are various types of risks that might occur from the investment of SWFs. The most common methods of mitigating these risks are diversification of investment in many countries, making greater levels of background check before making new investments, avoiding making investments in some countries (that are politically unstable or that have unfriendly relations with the investor countries and decreasing the size of risky investment. These methods are mostly employed for mitigation of the risks arising from the investment of sovereign wealth. However, there are certain other methods that have recently been found to be more effective in mitigating risks. Geopolitical risks are complicated and it is difficult to determine the causal relationship among the factors that cause this risk (Glancy, 2012). There is no basic standard methodology that might be prescribed for mitigating any particular risk (BIS, n.d.). In every industry, risk mitigating practices are diverse depending on the type of geopolitical risk. Institutional investors are required to spend considerable amount of time as well as resources before adopting a risk mitigating method (Alexander, 2009). Geopolitical risk analysis is a method of analysing risk that allows senior managers in multinational corporations to make strategic decisions about investment. Managers should include political risk in the process of budgeting, since it allows investors to understand the downside risks of investment better. On gaining better understanding of the downside risks, they would be capable of diversifying their investments. Geopolitical analysts help in making scenario planning, so that it highlights the possibility of development of a political crisis and also portrays the way in which asset prices in the economy is affected. If the path of movement of asset prices can be forecasted with minimum error, the chances of risks are minimised. Political influences on investment on sovereign wealth fund Over the period of the last decade, size of sovereign funds has undergone vast changes. The scope of these funds has also changed significantly. Sovereign wealth holdings are increasing not only in the developed economies of the West and the oil countries of the Middle East, but also has spread to the other emerging economies of the world, such as China, Thailand as well as some of the African nations. This is a result of increased political influence on these funds. The size of SWFs has doubled in ten years time, between 2000 and 2011. It is also apprehended that, given the rate at which the sovereign funds are growing, it might surpass the size of foreign exchange reserves. Investments of SWFs are made without much commotion and the government enterprises are careful enough to keep these activities out of limelight, such that they do not become the topic of public scrutiny (BIS, 2012; 2013). This is done to ensure that the objective with which the investment is made is achieved successfully. However, it might become the cause of the lack of transparency in the financial transactions. Due to the secretiveness of the SWF transactions, there might appear a motivation lag in making proper background check on the enterprises in which investments are made (PWC, 2011). Since SWFs are very secretive about the investments that they make, there is no record whether investments are made deliberately in the rival countries or those countries that are considered as ‘obvious’ enemies. Research shows that Saudi Arabia has adopted a policy of not investing in Iran and China has declared that it would not make any investment in Taiwan (Balin, 2008). Methodology This paper would present a comprehensive study of the issue of sovereign funds; the risk of holding the fund from the point of view of the economies and also the risk associated with the investment of these funds with respect to countries in which these are invested. Therefore, the paper would make use of qualitative as well as quantitative data. Secondary sources of data would be use for collecting information. Qualitative data would help the researcher to gather a broad understanding of the issue at hand and help to develop a solid platform of knowledge regarding the nature of sovereign funds, their variability, investment options and risks associated with the funds. Qualitative data would be gathered through the study of existing literature and other resources that reveal the history of sovereign funds, the pattern of investment of these funds and the impact of risks that have been faced by the economies that have made huge amount of transactions through the SWFs. Quantitative data would also be collected for the study. This would help in evaluating the current scenario sovereign funds. Considerable amount of debate has been made on the positive and negative effects of the SWFs. The European crisis has been one of the results of SWF investments. Various government agencies publish elaborate quantitative data on the performance of the different SWFs of the European countries. Quantitative data would be collected from different sources that would be analyzed statistically to assess the riskiness of the sovereign funds. These results are then sued to evaluate the position of SWF in the current global economic scenario. These would be helpful in finding out alternative solutions to the risks, which would lead to ways for mitigating the risks associated with holding sovereign funds and investing them. Conclusion This is a distinctive trend that points towards the fact that there is a profound swing in power and hence importance of the countries in the global economy. This shows that the act of holding sovereign wealth is significant for the economic, financial and political status of the nation that holds it. Some of the Asian countries have generated huge surplus from trade with the Western countries and some of the countries in the Middle East have generated surplus from sale of oil to the rest of the world, which have been the source of sovereign wealth for these countries (Glancy, 2012). Investment of sovereign wealth is also held responsible for the Euro zone crisis. Hence the study of sovereign wealth, its investment opportunities and its risks is important in the current global business scenario. Reference List Alexander, C., 2009. Market risk analysis, value at risk models. New Jersey: John Wiley & Sons. Balin, B. J., 2008. Sovereign Wealth Funds: A Critical Analysis. [pdf] Available at: < https://jscholarship.library.jhu.edu/bitstream/handle/1774.2/32826/Sovereign%20Wealth%20Funds%20A%20Critical%20Analysis%20032008.pdf > [Accessed 24 September 2013]. Barbary, V. and Bortolotti, B., 2012. 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