Sovereign Wealth Funds - Coursework Example

Sovereign wealth funds Introduction: Sovereign Wealth Fund or SWFs is a well known and not so recent international financial strategy which involves the investment of national foreign currency reserve on foreign markets with little or no regard to where the currency originates. The IMF’s October 2007 Global Financial Stability Report states that there are five major types of SWFs namely; the stabilization funds, savings funds for future generations, reserve investment corporations, development funds and contingent pension reserve funds, where each serve a distinctive and well defined purpose. These funds’ management is separated from official management of foreign currency reserve. The aim of SWFs among others is to manage government wealth so that funds do not remain static thus balancing investment with savings. The SWFs as a government-based investment strategy may involve the buying of shares in profit making organization or the taking over of a foreign based company, foreign direct investment, purchase of stakes in financial firms, long-term government bond amongst others. This process has resulted in a well recognized trend in monetary trade, foreign currency policy, and new international finance strategies. But, much debate subsists on the legitimacy of these policies and their ethical parameters. There are considerable economic and social issues associated to fairness of competition and possible political non-commercial hidden agenda, which come to the surface seriously. Various institutions are starting to feel greatly concerned by the issue of SWFs especially because these investments are taking considerable proportions. Causes for increased SWFs While many countries are facing important turnabouts and recession in their economy others are continuously sustaining their considerable economic rise. Some major states are facing recurrent financial crises due to external parameters which are out of their control for instance the oil crisis, financial globalization which results in accumulation of wealth in term of foreign currencies and financial asset by some countries. While there was the 800 billion U.S dollars deficit in 1996 in the United State’s current account, export-oriented economies of South East Asian countries were enjoying incessant growth. It is universally recognized thus, that the subsequent rise in SWFs is a result of large global macroeconomic impairment and imbalances. These major discrepancies have resulted in some countries possessing high relative ratio of foreign currency reserve which has boosted considerably the event sovereign wealth funds. Major states involved in SWFs are Kuwait, Singapore, Saudi Arabia and Norway among others and are termed as surplus countries. “The estimated combined assets of the worlds 14 largest SWFs now constitute nearly half the size of the world’s total official foreign exchange reserves”(Hildebrand, 2007, p.5) The largest sovereign wealth funds thus,seeks at broadening their economic base by investing in usually very risky business which logically yield in higher return on investment whether in short or long term. These states usually absorb foreign currency in large quantity on domestic market which in parallel stabilizes the local currency. Also, by implementing sovereign funds government seeks at decreasing costs associated to reserve holding although the persistent discussion on the optimal reserve level remains unanswered. The implications of SWFs: Broadened Market and diversification of wealth Some major implications of SWFs the opportunity for investing state to diversify their economic base and taking advantage upon the subsequent profit made on the bond or securities bought from foreign country. The ideal case is to have a major currency evaluation during the period and earn maximum revenue at maturity of bond. But, the risks associated to these bonds are numerous. The SWFs have broadened economic bases for many countries like South Africa as government-controlled foreign investment provides funding to countries which help in mitigating some of the adverse effects of globalization on the weaker economies. Hildebrand agrees that, “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” (2007, p.2). It is undeniable thus, that SWFs have been seen as a symbolic source of ‘fresh water’ for thirsty souls. Thus, for companies being purchased more capital means more money for research and development, possible expansion and diversification, and more money to pay salaries. Many countries have seen their economy being boosted considerably as a result of SWFs where per capita income has known a non-negligible rise. The investing government sometimes uses the SWFs in order to stabilize the balance of payment preventing the flooding away of capital obtained on commodity items exported. Next generations wealth is therefore guaranteed in the simple sense that profit incurred and return on invested amount can be escalated over years, as investment are usually on a long term basis Financial stability implications: Major changes in international investor base and their behavioral changes will predictably result in alteration and modification in the global financial market. “SWFs should have the ability to absorb a greater degree of short-term asset return volatility and may be prepared to buy during periods of asset price weakness, thereby providing market liquidity in times when it is most needed”( Devlin, Brummitt, p. 128). In this context there should be an effort to mitigate possible attempt to weaken financial market as aimed to be able to introduce sovereign funds. Thus it is necessary to take great care of seeing that the inherent agenda of sovereign funding process is not solely for commercial purposes, and market structure will not suffer and become volatile. Although much debate persist over the market stability issue, most delegates in the world economic forum in Davos in January 2008, reached consensus on the issue that “SWFs represent a valuable pool of stable, long-term capital, and have reduced, rather than increased, capital market volatility”, and also agreed on the fact that “SWFs not only contribute to domestic economic stability but to the stability of the global economy as well”. Furthermore, most economist and experts point out that with the shown trends over oil prices, surpluses in foreign currency will be directed solely in the pockets of exporters. This will inevitably result in increased sovereign investment, which will put these countries in the forefront as key partners on the global financial market. SWFs and ethics: The event of sovereign wealth funds has given rise to ethical financial issues which results from a lack of visibility of financial transaction and put a black spot over the controversial question of good governance. Simple issues of political nature can very well be a hindrance to the free flow of invested capital in SWFs,if motivation behind investment is vague. As soon as the question of hidden political objectives emerges the fundamental behind government-controlled investment as being to, obtain optimal risk adjusted rate of return of investment becomes secondary. Any attempt to raise this issue is considered as a hindrance to freed markets. The cross-border investment initiative according to some opinions brings to surface concerns of investing countries trying to gather operational details to be used in locally based rival companies. This can hardly be noticed and no action can be taken against this issue as, there are any regulatory bodies to regulate policies of government-controlled investment in SWFs. Therefore, there is no compulsory need for financial reports in whatsoever form. No comprehensive agreement surrounds the questions of who controls these funds; where transparency frames of funds are usually vague and poorly defined. SWFs have given rise to major discussions both in the media and by politics, where the great concern on how the deployment of sovereign fund might alter the way global economy functions. The pertinence of such reactions is varied and touches grounds of global economic welfare at its broadest possible parameter. Moreover the generated profit or return on invested capital in SWFs may not at all benefit the population of the host nation, as these incomes shall be directly deposited on the account of some kingdom remotely situated. Thus, a country which has high financial investment from foreign destinations either directly or indirectly does not necessarily guarantees a misery-free society. Furthermore citizens and opponent policy-makers argue that, because government has many alternatives as to the holding of funds for instance state-owned enterprises, international reserves and public pension fund, is not necessarily the best option and its genuineness and relevance compared to other opportunity should be looked into. The argument suggests that in the short term, it is a better option to invest in the state-owned enterprise that would provides immediate employment instead of risking huge sums of money in remote places where there are no guarantees where change in political configuration and monetary policies might cause major loses. Global economic challenge: There have been since decade attempts from many governments and politics to allow the market to auto-regulate itself. In this view, the economic structure would be free from governmental intrusion in any form whatsoever, and the market forces would exert pressure on economies. With the event of SWFs, this issue comes to surface again as government investment in foreign markets can be view as an attempt to control a market and become a serious danger to market force from being freely exerted. Similarly, in the January 2008 world economic forum bankers point out that sovereign wealth funds have been “ideal investors, taking only small stakes and serving as silent, long-term investors. Moreover, their investments help ensure that some of the money spent on oil and electronics finds its way back to the US. Nonetheless, scepticism has emerged about whether the funds owners - particularly those that are non-democratic governments - would refrain from interfering if their national interests were at stake” SWFs and its regulation Although sovereign funds know an incessant rise, some shadow areas still exist in relation to how the ethical issues can be dealt with. Some experts however remain optimistic to the effect that certain government will be able to control and regulate the deployment of sovereign wealth. This can be particularly true as many countries possess regulatory framework that surrounds banking transactions and commercial activities. Moreover, the International Monetary Fund is praising efforts to create a ‘best practice’ code for sovereign wealth, also aiming thus, at bringing political concerns to that issue. As a result of the rising importance of SWFs, concerned countries as well as the IMF find it of utmost importance to see into this issue seriously and seek to understand sovereign funds and regulate the possible policies underlying such investment. The strongest of fears resides in the fact that SWFs may take majority shares in strategic companies that would allow them to control market parameters. Similarly, it is more and more accepted that there is a need to prevent fragmentation of regulation to ensure harmonization after regulatory reforms have been initiated. There is thus, the need for proper standards to be adopted. The standard would set out norms for transparency and accountability with respect to four different aspects which are objectives and investment strategy, governance, actual investment portfolios and fund management behavior. This imply mutual understanding of participating countries. One of the proposed regulations is thus, “the principle of reciprocity” which states that a country will be able to invest in other countries if and only if it allows free investment facility to the country it is investing in and opens its economic space. Conclusion: The observed tendency and fundamental behind the rise in SWFs brings us think that this dynamic will not come to an end abruptly. If the opinions on the issue are divided consensus will be reach on the effect that there is an urging need balance the imperfections and imbalance in global economy. One possibility to bring equilibrium to global financial sector is to remove all possible hindrances to inflows and outflow of investment. The authority which controls the fund should be the secondary concern whereby private investment or government control investment will have the same weightage and consideration of in the balance of making and keeping the global market opened. Keeping in mind that some elements of market discipline should be respected imperatively, SWFs regulatory bodies should be implemented to look into ethical and practical parameters and genuineness of financial policies, absence of politically-oriented objectives but rather the win-win situation behind SWFs. In this context, the IMF shall have to play a vital role in the intermediation process to ensure franc communication, clarified objectives which would ensure the well-being of its member states and maintaining coherent best practices for overall good functioning of the global economy. Bibliography Hildebrand P., 2007, The challenge of sovereign wealth funds. [Online] available at http://www.bancanationalesvizzera.ch/en/mmr/speeches/id/ref_20071218_pmh/source/ref_20071218_pmh.en.pdf [accessed 29 March 2008]. Devlin W. & Brummitt B.,A few sovereigns more: the rise of sovereign wealth funds available at http://www.treasury.gov.au/documents/1329/pdf/07_ A_few_ sovereigns_more_the_rise_of_sovereign_wealth_funds.pdf [accessed 29 March 2008] International Monetary Funds. 2008 IMF Intensifies Work on Sovereign Wealth Funds available at http://www.imf.org/external/pubs/ft/survey/so/2008/POL03408A. htm[accessed 30 March 2008] World Economic Forum. 2008. Economics and Finance: Addressing Economic Insecurity. available at http://www.weforum.org/pdf/summitreports/am2008/ economics.htm [accessed 30 March 2008] Read More