Sovereign Wealth Funds - Essay Example

SOVEREIGN WEALTH FUNDS Student’s name Course title Instructor’s name Date of submission Introduction In simple terms, a sovereign wealth fund (SWF) refers to a collection of funds set aside by a country from its reserves for the purpose of financing investment ventures for the benefit of the citizens and overall economy (Castelli & Scacciavillani, 2012). These pools of cash arise from a country’s budget and trade surpluses. The SWFs may also accumulate from the money that a country generates from the exports of naturals resources such as oil. For example, the Asian Gulf nations boast of huge oil deposits thereby the country’s rich natural deposit translate to huge revenue gains from the sale of oil across various global. These countries, therefore, have loads of money that they can put to extra usage such as the creation of SWFs to act as some form of hedge for the economy. This paper will attempt to give some perspectives into SWFs while shedding light on resource rich nations such as Australia. The rationale for SWFs, benefits, drawbacks and some relevant issues will be looked at appropriately. Rationale (need) for sovereign wealth funds The aftermath of the global financial crises was characterized by major blows to international markets that left nations grieving and staring down the barrel of depression. The dependency of nations on the common the oil industry as one of the catalysts of world economies became evident. In the United States of America, the financial crises was coupled with a housing bubble that left countless big corporations at the brink of bankruptcy. Fry, McKibbin & O'Brien (2011) note that the Obama administration was forced to put in substantial efforts to save corporate finance giants such as AIG Insurance. The ripple effects were also felt across Europe in nations such as the United Kingdom and governments came out to bail out key corporations such as banks to prevent a total decline of the economies. The need for liquidity during such times of economic crises came out clearly. Looking back, SWFs and other pools of state-backed capital act as important policy options that help in stabilizing global markets (Fry, McKibbin & O'Brien, 2011). In fact, SWFs acted as integral forces that helped in offsetting the early phases of the crisis. Thus SWFs act as important policy instruments for providing urgent financial liquidity during financial crises. Some nations create the SWF’s as a way of diversifying their sources of revenue (Carson and Litmann, 2009). For example, the oil-rich nations such as the United Arab Emirates (UAE) develop their economies based on revenues streams from the sale of oil. As a measure to diversify their economy and reduce overdependence on oil revenue, the government sets aside some portion of the national reserve to a given SWF. Such an SWF undertakes investments in other sectors of the economy such as the tourism industry. These countries, thus, enjoy some vibrancy in other sectors of the economy thanks to the SWFs. The changing dynamics of trade and capital flows provide a clear rationale for resource-rich nations such as Australia to seek ways to manage their earnings. Such measures would act as preventive mechanisms that would assist these nations to minimize any disruptions caused by unexpected currency or commodity price fluctuations. Other options such as receiving aid from the International Monetary Fund (IMF) come along with various conditionality conditions. Such conditions may have intense socio-political as well as economic implications (Castelli & Scacciavillani, 2012). SWFs, thus, provide a legitimate alternative to these nations without having to worry about conditional requirements in case of a financial crisis. Benefits As highlighted under the above discussion on rationale, the creation of SWFs aims to meet a given set of objectives. The accomplishment of these objectives results in a number benefits for the respective nations from which the SWFs arise. SWFs act as vehicles for managing public sector financial asset, for example, in countries such as Australia. Their advantage lies in the possibility of employing them with or without specific policy objectives. Moreover, SWFs are predominantly utilized to facilitate cross-border investments (Castelli & Scacciavillani, 2012). As a result, they assist in boosting international trade between nations leading stronger international ties between nations engaging common trading activities. Such ties ensure greater economic growth and development and improves diplomatic ties tremendously. On another front, SWFs provides investment opportunities that aim at achieving higher returns than short-term risk-free investment options (Castelli & Scacciavillani, 2012). In the long-run, SWFs tend to result in higher returns meaning that they are worth the risk (Bolton, Samama & Stiglitz, 2012). The countries that set aside some parts of their national reserves are poised to get massive returns from their present sacrifices. The UAE, for instance, has managed to develop a strong tourism industry and over the years the nation has created a name for itself as a major tourist destination due to its high-class hospitality and tourism industry. Truman (2010) notes that SWFs act as contingent pension reserve funds that acts as a government’s mechanism for supporting pension funds for its citizens. Drawbacks Pacific Island Countries (PICs) boast of a diversified and long-standing experience with SWFs (Le Borgne and Medas, 2007). These countries set up SWFs with the aim of managing uncertainty and volatility of revenue. They also hoped that SWFs would assist them in their quest to achieve a log-term sustainable fiscal path. However, these countries faced some challenges in their efforts to set up SWFs. Their experiences provide vital insight on the probable challenges that countries may face while making attempts to set up SWFs. A key challenge for the PICs lay in the struggle to manage fiscal policy despite the highly volatile and uncertain revenue streams it experienced. In addition, some of these nations faced the reality of a possibility of depletion of natural resources or a total decline in the production volumes. As a result, these countries faced the challenge of getting assured revenue streams that they could continually channel to the SWFs. Every nation that forms SWFs faces a similar drawback could pose a significant blow to their quest to achieve certain objectives using SWFs (Carson and Litmann, 2009). The concern for long-tern sustainability of SWFs also remains an area that attracts significant concerns thus posing some challenges. Moreover, PICs have very large public sectors yet they face significant governance issues such as effectiveness and controlling corruption (Truman, 2010). The government’s struggles have a ripple effect on the success of the SWFs as the government’s move to set aside funds for long-term projects may be hampered by governance issues. As a result, the issue of governance relates closely with the challenge of political interference that curtails the overall performance of SWFs (Balding, 2012). The issues of governance also highlight the concerns on regulation of SWFs that will be discussed under the contemporary issues sub-heading below. Contemporary issues SWFs have existed for several years leading to an influx in the number and range of state-backed pools of capital. Therefore, a large number of institutions have been born under the SWFs and the question on common policy options for these institutions raises concerns. Policies that suiting one institution may be unsuitable for another. As a result, there is need to conduct a deeper situational analysis into the operations of different types of SWFs before looking at the threats that the diverse nature of asset pools pose to the international economies. Therefore, there is need to understand not only the rationale for SWFs but also critical factors such as source and degree of funding, size and capacity for growth, and relative transparency and accountability (Fry, McKibbin & O'Brien, 2011). As opposed to traditional stabilization funds, large SWFs tend to adopt longer time horizons for investment. These SWFs arise thanks to government backing meaning that political perspectives come into play. For example, political considerations that determine the growth of SWFs with regard to the share of foreign currency inflows preferred for SWFs in nations such as China. In addition, the debate on realism also portends the concerns under international relations theory. Shemirani (2011) observes that the perspectives on realism mainly look at the concept of power. The elite political groups, such as those from the USA, maintain undeterred concerns and viewpoints on the realist view. They voice their concerns on the potential for manipulation of economic and financial power by nations wielding significant power thanks to their large SWFs (Shemirani, 2011). The large SWFs act as tools for acquiring giant stakes in various economic sectors abroad and they may effectively gain controlling power over such economies (Xu and Bahgat, 2010). The impact of SWFs on the trajectory of global equity markets remains an insignificant factor. However, it is prudent to take note of the threat and the underlying opportunities that arises out of the interaction between the global equity markets and financial intermediaries, mainly composed of private equity and hedge funds. A number of hypothesized risks manifest concerning the growth of SWFs. The first risk is that of transmission of financial market shocks. Second, the exercise of soft political power also takes center stage (Clark, Dixon & Monk, 2013). Lastly, the need to manage and maintain national security also comes up as a major area of concern. For the purpose of this paper, these underlying hypothesized risks will not be looked at into detail. In retrospect, large SWFs such as Tamasek Holdings of Singapore, have made spirited efforts to highlight the quality of their internal controls and external advice. The large SWFs have made strides towards obtaining high-profile international advisory. In addition, they have made progress in developing controls and recognized the need for regulatory restraint (Castelli & Scacciavillani, 2012). National governments, through the ministries of finance have the capability to monitor to ensure that they invest in a wide array of assets in accordance to prior settings of risk tolerance levels. Another area for concern lies in the complex nature of the relationship between SWFs and financial engineers. The IMF broadly accepts the advent of SWFs and welcomes their emergence in global economies. On the contrary, the IMF maintains its prediction of the possibility for SWFs to degenerate in to a collection of unregulated intermediaries that may or may not channel future investments in hedge funds (Bolton, Samama & Stiglitz, 2012). The financial engineers may potentially take part in market manipulation using SWFs. However, there is little evidence to support such reservations. The debate about the policy mechanisms for SWFs also gains traction. SWFs represent a shift in paradigm by bringing up a blend of commercial and political imperatives. Some analysts contend that SWFs may be used as tools to destabilize the market based on political inclinations. For example, Fry, McKibbin & O'Brien (2011) suggest the notion that Chinese SWFs played some role in the global financial crisis of 2008/2009. Such concerns further the concerns about the regulation of SWFs. In light of all these concerns, there are grounds for greater transparency within the SWF sector. Furthermore, the immense benefits that SWFs provide as stabilization mechanisms cannot be overlooked. As mentioned earlier, SWFs act as macro-fiscal management options that allows countries to deal with financial crises effectively. The presence of SWFs would greatly reduce the potential effects of financial crises (Castelli & Scacciavillani, 2012). In fact, SWFs assisted in the alleviation of the initial effect of the 2008/2009 financial crisis. Additionally, the SWFs may also act as mechanisms for countries to accumulate savings for future use and provide funds for long-term objectives. Conclusion In a nutshell, SWFs serves as important economic tools that governments utilize to achieve various objectives. Despite the underlying drawbacks, the underlying benefits of implementing SWFs far outweigh the costs. Countries stand to meet various objectives thus improving the state of the economy and raising the welfare for its citizens. In fact, the rationale for SWFs highlights both the internal and external drivers for the growth and development of SWFs. The rationale for setting up SWFs serves as a strong indicator for nations to seriously consider using SWFs as fundamental economic stabilization tools or developmental catalyst. The examples of nations such as the UAE provide appropriate examples of the benefits of SWFs to national economies. Furthermore, the inadequacy of evidence to support the claims that inform contemporary issues affiliated to SWFs acts as a motivating factor to propel success of SWFs especially in resource-rich nations such as Australia. However, there is need to conduct extensive research in order to address concerns surrounding SWFs and develop the necessary frameworks for success in the future (Clark, Dixon & Monk, 2013). References Bottom of Form Top of Form Bottom of Form Top of Form Top of Form Bottom of Form Top of Form Bottom of Form Top of Form Top of Form Bottom of Form Bottom of Form Balding, C 2012, Sovereign wealth funds: The new intersection of money and politics, New York, Oxford University Press. Bolton, P., Samama, F & Stiglitz, J. E 2012, Sovereign wealth funds and long-term investing, New York, Columbia University Press. Carson, T and Litmann, W 2009, Sovereign wealth funds, New York, Nova Science. Publishers.Bottom of Form Castelli, M & Scacciavillani, F 2012, The new economics of sovereign wealth funds, Hoboken, N.J: Wiley. Clark, G. L., Dixon, A. D & Monk, A. H 2013, Sovereign wealth funds: Legitimacy, governance, and global power, London. Fry, R., McKibbin, W. J & O'Brien, J 2011, Sovereign wealth: The role of state capital in the new financial order, London, Imperial College Press. Le Borgne, E and A. Medas, P 2007, Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages, Washington D.C., International Monetary Fund, pp.3-10. Shemirani, M 2011, Sovereign wealth funds and international political economy, Surrey, England, Ashgate. Truman, E. M 2010, Sovereign wealth funds: Threat or salvation? Washington, DC, Peterson Institute for International Economics. Xu, Y and Bahgat, G 2010, The political economy of sovereign wealth funds, New York, NY: Palgrave Macmillan. Read More