Types and Characteristics of Sovereign Wealth Funds - Coursework Example

COURSE TITLE: SOVEREIGN WEALTH FUNDS NAME: INSTRUCTOR: INSTITUTION: DATE: Introduction Sovereign Wealth Funds are owned by the state and consist of a pool of resources derived from countries budget surpluses, the proceeds of trade and government reserves set aside for purposes of investments so as to improve the economy of the country. The fund is financed by the central government through the central bank reserves that accumulate from budget and trade surpluses and the proceeds of trading in natural resources of the particular country. These wealth funds are managed directly or indirectly by the central government of the country for the purpose of meeting the objectives of national interest set by the government. The general objective of setting up these funds is to diversify wealth of a country through investment in different wealth generating projects and improve the returns of foreign exchange reserves and shield the economy from fluctuations of prices of commodities. Other objectives of the sovereign wealth funds are to provide for pension in the future, to provide for future generations when natural resource reserves have been depleted, to promote strategic industrialization so as to unlock the economic potential of the country and to help in promoting political agenda of the country. For example Russia has developed large pools of sovereign wealth funds and has used it to promote industrialization in the region together with driving a strategic political agenda in the region. These funds have been mixed views from economists with concerns being raised about the financial stability, corporate governance and political interference and protectionism. This paper focuses on the benefits and the need to develop Sovereign wealth funds by a growing economy like Australia and any drawbacks of the funds thereof in helping the country to achieve its economic goals. Types of Sovereign Wealth Funds Sovereign wealth funds take different forms depending on the objective they are formed to achieve. Stabilization Funds These are state owned funds which are mainly established to insulate the economy from influxes of revenue for economies which rely on a particular industry such as the oil and gas industry. Savings Fund These are funds which are established to save for future generations during times of budget surplus. These funds are aimed at distributing nonrenewable resources across generations by transforming the resources into diversified financial assets. Abu Dhabi Investment Authority Pension Reserve Funds These funds are established by governments to support social welfare of the county together with servicing of pension. Reserve Investment Funds These are established to reduce the risks involved in holding excess funds by a government. This is achieved by allocating high investments in equities to generate higher returns. Strategic Development Sovereign Wealth Fund These are sovereign wealth funds that are established to promote national economic development goals and allocate funds to socio development projects Characteristics of Sovereign Wealth Funds Investment Period Sovereign Wealth Funds are invested for a pre-determined period of time. Stabilization funds are a meant to caution against the uncertainty associated with government income, spending and the economy. These funds are meant to be accessible as and when the need arises and therefore invested for a short term. Savings funds on the other hand are intended to cover the funding needs required by future generations and are hence invested for a longer term. Investment composition Sovereign funds are invested in varying asset forms depending on the type. Stabilization funds, owing to their short investment period, are composed of highly liquid assets. Saving funds are composed of more composite asset classes of both liquid and illiquid assets. Performance basis Stabilization funds are meant to maintain a stable liquidity in the economy by managing expenditure volatility. This is what they are set to achieve. Savings funds are meant to provide for future returns in the long run. They are meant to maintain the long term purchasing power of wealth. Degree of risk Stabilization funds are the most risk averse. They are invested in low, almost zero risk ventures, due to the need to be able to acquire returns with a reasonable degree of certainity. As such, the returns from stabilization funds are usually low. Savings funds are more risk friendly. They are invested more aggressively in high risk ventures. This enables them to acquire high returns within the investment period. Sovereign wealth funds are differentiated by on the basis of macro fiscal policy objectives that were established to achieve and general asset allocations. The objective of these funds depends on the specific goal an economy wants to achieve with rich countries coupling multiple objectives to one type of fund. The decision of investing and the type of portfolio to invest in solely is determined by the stated objective and the governance structure. There are many important benefits of sovereign wealth funds can create to a rich economy which contribute to wealth distribution and resource allocations. Generally, sovereign wealth funds are important in any economy as they help to control and regulate macro and micro economic aspects to ensure there is smooth growth of economies. Below section discusses various the key benefits an economy can gain by establishing sovereign wealth funds. These benefits are selectively applicable across economies because every economy has its own investment plans or objectives and political and socio economic environment the fund will be exposed to is unique to each economy. Increased Foreign Currency Reserves Countries which have sustained increase in foreign exchange reserves can create an incentive to create sovereign wealth funds. China, South Korea, Russia and Brazil have accumulated substantial foreign exchange reserves in excess of $ 100 billion. All these accumulated reserves can be used to multiply economies returns by investing the funds in income generating portfolios which will be used by future generations. Strong economies with large foreign reserves have used sovereign wealth funds as a way of saving for their future generation through investments and multiplying their wealth. Economy such as Australia can adopt sovereign wealth funds as a way of regenerating and increasing their foreign currency reserves by investing in foreign portfolios which will generate returns in foreign currency. This way the count will enhance and accumulate its foreign reserves Stabilization With price volatility of commodities, sovereign wealth funds can be established by economies to help to regulate and stabilize the revenues in the economy. For example funds can be moved from the countries budget when the revenues are high to establish these funds and be returned9 from the funds) when the revenues in the economy are low with an aim of minimizing fluctuations of revenue and stabilizing the prices. For example Russia is planning to deplete its $ 38 billion reserve fund to cover revenue fluctuations brought about by falling oil prices. Australia as a rich nation can adopt the same strategy to create these sovereign wealth fund reserves when their revenues are high and use the revenues when the revenues are low in their economy. Combating Inflation Surpluses from foreign trade increase domestic prices and interest rates in an economy. The economy can use the surpluses to create sovereign wealth fund hence removing the excess funds from the budget hence absorbing the excess liquidity in the economy and reducing inflation. Inflationary gap in an economy can be managed by the government removing excess money from the economy. This is often done through the government issuing bonds to the public and using the proceeds to purchase foreign exchange. Usually the bonds are offered at an interest rate which is higher than the current market interest rate consequently attracting foreign investors to buy the bonds hence increasing the sterilization costs. This way the economy is deprived of the excess money and inflation is controlled. Australia can apply the same concept to control inflation rate which often affect economies. Development Sovereign wealth funds facilitate saving and provide savings which can be used for specific economic developmental projects and transfer of surplus funds from one generation to the other. Saving funds for specific developmental projects like health, education, pension and infrastructure is a common developmental agenda of any economy. For example, China Investment Corporation (CIC) which focuses on developing the banking industry has made investments of $ 200 billion in China development Bank and $40 billion in Agricultural bank of China and other investments in other banks (Martin, 2008). Development of the banking, health, education and infrastructure of an economy like Australia can propel the economy to be very competitive and gain competitive advantages. Diversification An economy can use sovereign wealth funds to diversify its investments so as to spread the financial risks involved in investment. Depending on the holding of government assets these funds can provide an avenue for the government to invest in different offerings, instead of putting on the investments under one portfolio and in any case they fail the government loses major part of its wealth. Rich economies like Australia can invest their wealth in sovereign wealth funds in different sectors. These investments in these funds can be used in future to fund government projects or be earmarked for use during tough economic times. Political influence Economies like China uses sovereign wealth funds in the international finance market to acquire key foreign infrastructural projects hence enhancing their political influence outside their territory. For example, china has used these funds to finance major infrastructural projects in Africa like in Kenya china has financed the Standard Gauge Railway project. The gained political mileage can be used to convince other states to adopt or support Chinese agenda. According to Financial Times (2008) China convinced to switch ties to Beijing from Taipei. Sovereign wealth funds have drawbacks in achieving the objective and goals with these funds drawing criticism from developed countries. Excessive Government Ownership and Management Excessive government control of resources can inhibit continuous growth in the private sector and create a capitalist economy where the government controls everything. Sovereign wealth funds can give a government this control which can be detrimental to the development of the economy. Some critics of sovereign wealth funds believe that the government cannot be more efficient than the private sector to handle these investments. Generally the mandate of these funds is controlled by central banks which usually operate to the benefit of the current regime. Creates policy Conflict Generally the policies of sovereign wealth fund policies may undermine the policies of their regulator hence undermines the government when not integrated with other policies. When these conflicts arise the citizens of the country stand to lose their wealth (Ashlund, 2007). Risks involved When governments starts to invest its public wealth with no clear structures and policies in place to regulate the level of investment, loses can be incurred as a result of uncontrolled appetite to invest. Most economies have lost wealth through sovereign wealth funds and it generally to the detriment of the common citizen when such loses occurs. Criticisms argue that countries should not be in a rush to form these funds when a clear objective has not been set. Conclusion As globalization has allowed free flow of goods and services across economies and trading blocks, Sovereign wealth funds should provide countries with the ability to wealth around the world. These funds can benefit economies around the globe in many ways with an ultimate goal of creating wealth and securing the future of generations to come. Australia as well can accrue these benefits as discussed above and it’s my opinion that the country should consider this as it strides to be a developed economy. References Ashlund, Anders, (2007).The Truth about Sovereign Wealth Funds, Foreign Policy. Ficova, A. (2015). Analysis of Sovereign Wealth Funds: From Asset Allocations to Growth. Global Journal of Management and Business Research, Vol 15, Issue 9. http://www.hacienda.cl/english/sovereign-wealth-funds/economic-and-social-stabilization-fund.html Chambers K (2016). A new Global Investment Power. Martin, Michael (2008), “China’s Sovereign Wealth Fund”, Congressional Research Service Report to Congress, Washington DC. Simon & Johnson, (2007). The Rise of Sovereign Wealth Funds, Finance & Development International Monetary Fund, (2011). Global Financial Stability Report. Sovereign Wealth Fund Institute. (2016, October 13). What is a SWF. Retrieved from http://www.swfinstitute.org/sovereign-wealth-fund/ Read More