Sovereign Wealth Funds as Development Funders

As debate about Sovereign investors rages in many OECD countries (see related RGE coverage), there has been less attention to their investments in emerging and developing economies – in part because to date reported investments in the US and EU have been much larger.

In fact investment by sovereign wealth funds and state owned enterprises of developing countries is part of a broader increase in South-South investment that also includes EM private multinationals. As these companies seek higher returns, fast growing emerging markets seem attractive.

A new OECD report looks at the effects of these new public sector investors on the EM sponsoring countries and the recipients. Javier Santiso suggests that SWFs might be better considered Sovereign Development Funds as their investment might soon exceed development aid from OECD countries. Should SWFs allocate 10% their portfolio to developing economies and rate of growth continue, they might invest $1.4 trillion over the next decade. The role of these actors from the emerging world – public and private – is a reason why G7 is not the only or even the best venue to talk about development.

The effects on developing countries haven’t been ignored exactly. – Back in September, Simon Johnson of the IMF noted that while SWF assets are small in comparison to global market capitalization and total financial assets, they are large in comparison to the market capitalization of emerging markets. Similarly, Gerald Lyons suggested SWFs would increase their stake in EM equity markets and many commentators have suggested that SWF strategy shifts would boost EM currencies and weaken the dollar and to a lesser extent the Euro. Vinay Nair warned that India should strike a balance between encouraging inflows needed for development and urging more transparency. Desmond Lachman noted that Latin America has not been a major focus of SWFs.

At present EM public and private sector companies might actually be more significant than SWFs per se, though they are part of a broader trend. Whatever the source, more interest in EM assets could have significant effects both on asset prices and on macroeconomic policy management. Since most developing countries already run net surpluses and many still control their exchange rates, a significant capital inflow from any source is a challenge for policy makers. This also implies that unless domestic investment really accelerates in recipient countries that capital will continue to flow to the net debtors (ie the U.S. – and some EU countries). The interest of investors – sovereign and private – in developing countries is likely a good sign. But developing countries need to take a close look to maximize the benefits from foreign investment. This might have the side benefit of increasing transparency, which might benefit citizens and foreign investors alike.

Some examples:

– GCC: SWFs especially investment companies are upping exposure to Asia – targetting of 10-30% of total portfolio – for its strong growth and dollar weakness hedge, but diversification is limited by the persistence of dollar pegs.

– IIF estimates 11% of GCC outflows were bound for each of MENA and Asia regions.

– In 2006, 14% of ADIA’s equity allocation was in Emerging markets, likely the highest of sovereign wealth funds at the time (via Euromoney and the FT)

– QIA is reportedly interested in Latin America. Few (Same goes with Asia) mention Eastern Europe, though it is likely included in EM portfolios.

QIA and KIA both have stakes in China’s ICBC. Others have stakes in Indian, Pakistani and African banks – and telecom licenses.

Asia: Asia (ex Japan and Singapore) makes up 40% of Temasek’s holdings – more than its Singapore holdings and twice that in the OECD. Though this may not include its stake in Merrill.

-Available targets suggest CIC will have significant EM exposure- mostly Asia.

– GIC has recent property joint ventures in a range of EMs – and significant exposure to EM Asia.

-Chinese state bank ICBC invested $5.6b in South Africa’s Standard Bank, the largest single investment by a Chinese firm abroad. Most of the funds will go to establish a joint fund to invest in African economies.

-Government pension funds of Taiwan, Korea may invest in energy sector abroad

– for now Kazakhstan and Russian SWFs invest only in the G-10 and US/EU15/Canada respectively. Though Russian banks and energy companies are investing in Emerging markets in Eastern Europeand Africa.

The Pros: In many ways sovereign wealth funds seem like an ideal investor for developing countries, long-term rather than short-term speculators, able to pass on knowledge to developing economies and probably less likely to impose political conditionality than development funders. Despite their tendency to use less leverage, some sectors (eg property development may be backed by more loans than others.

With their focus on economic returns and materials, EM investors may be more targeted towards the identified infrastructure needs of African countries. They also tend to privilege stability and access to resources rather than governance, democracy and human rights that are a focus of most development assistance. Yet, all investors may be hurt by poor governance or political uncertainty or nationalization. DAC countries are also changing how they deliver aid– more development priorities are being set with national governments and to meet their needs – though amount given is falling. And infrastructure is returning as a target – most recent millennium Challenge Corporation (MC
C) grants include infrastructure components.

Real estate, energy sector, utilities, telecoms and banks are key sectors of interest. Technology transfer is a key part of deals – some EM corporates and SWFs already have expertise in related areas and may be able to pass it on – to make higher returns. Unlike investments in flagship G-10 companies, technology transfers might be from the investing country to the target rather than the other way. These countries also provide a model for less developed economies.

If developed economies raise more barriers to state-backed investors or private , emerging markets might seem even more attractive. Several sovereign funds have announced a hold on investment in the US either because of fear that deals may be blocked or a (belated) realization that their dive into the financial sector may have been too soon. Many EMs, especially in the MENA region have been actively courting investment from SWFs

The investment climate in many African countries is improving as investors seek other opportunities. Many are developing their capital markets, seeking sovereign ratings, and bond and equity offerings are increasing. Growth is up and inflation is down. To protect against the risk of illiquid bond issues, institutions like the AfDB and the EIB are sponsoring a series of local currency bonds that are attractive to investors seeking higher yields.That being said, many emerging markets – especially those sponsoring SWFs retain significant barriers to investment, even beyond sectors deemed strategic but some are opening more sectors.

But it may not all be rosy

Investments are not altruistic. They are commercial, and perhaps in some cases strategic motivations (especially resources). Furthermore they, like any investor will privilege some countries over others. There will still be a need for funds targeted towards improving health and social outcomes and poverty reduction. This development assistance and loans need not come from developed economies. China, India, Kuwait and Saudi Arabia are among those that have increased development assistance or loans – often with political implications. And economic growth triggered by the removal on infrastructure bottlenecks and improvements in revenue collection might make domestic governments better placed to invest in such sectors.

SWFs may be more likely to take majority stakes in developing countries – this may equally be a positive as they may be in a place to make positive corporate governance roles and transfer technology. In fact the nature of direct investment by SOEs and MNCs implies they would want a management role – not just the financial benefits. But it also means that developing countries will need to think about some of the issues preoccupying g-10 policymakers. Passivity is not necessarily a panacea –willingness to take a passive (especially non-voting stake) may only open up speculation about implicit influence and quid pro quos. But it raises a key question for recipients. After all, Temasek had political problems in its investments in South East Asia and Standard Chartered may soon lose its status as a HK$ issuing bank as Temasek’s stake breaches 20%.

Investment by foreign governments might increase the role of the state, both domestic and foreign. In many developing countries, the state does not have a good track record in picking winners. Perhaps a weakening of institutions is a greater risk. Investment could influence political and regulatory processes in recipient countries, especially if such foreign countries are less bound to regulations in home countries or shareholders to corruption and related practices.

Reverse nationalization could be as significant for developing countries as it is for developed and perhaps more given nascent institutions and regulations. At a time when some developing countries are privatizing key sectors, they may not want a foreign government to control significant sectors.,

As with aid, there is a question absorbing increased flows, especially short-term speculative flows. Many small emerging markets, especially in Asia, already run current account surpluses, meaning that they ultimately have net outflows. New investment – from SWFs other EM investors among – may put more pressure on EM currencies. Should countries continue to try to limit upward movement, reserve accumulation might continue and possibly trigger even more sovereign wealth funds as reserves exceed needed levels. Furthermore challenges of sterilizing the effect on the money supply would be high. Though the reserves of African countries are far from excess levels.

It may be easier to identify target countries than to find opportunities to invest. SWFs have a lot of competition and they are competing with each other There is already a lot of investment flowing into China Investment opportunities in some of the more exotic markets may be dominated in a small number of flagship companies. Portfolio investors may be offput by the small size of offerings – ADIA for one apparently rarely invests in small bond issues. The size and liquidity of these markets may continue to be a limiting factor to investment – as breakingivews notes.

Returns in other developing countries may not be as uncorrelated to those in home countries of SWFs as Santiso suggests. Firstly, commodity prices – which have contributed to growth in Africa, most of Latin America and the Middle East – themselves have tended to be correlated. Standard Chartered though suggests that government spending – in part facilitated by debt relief – is a bigger growth driver especially among non-oil exporters. Should investment help diversify away from commodities and respond to the infrastructure gap, that could lead to more sustainable sources of growth and returns.

Correlation among emerging markets is up also. Though EMs with healthy surpluses have tended to outperform those with deficits, many EMs were tainted with a similar risk aversion brush. Although African markets have been largely sheltered from credit market turmoil (south Africa is a notable exception) Asian markets have not been – and all may be vulnerable to shifts in commodity prices and global demand. And if African economies open more to foreign investment, they might also be more susceptible to global trends. Indeed, by some accounts, more money has been invested in frontier markets since the beginning of the subprime crisis in the search of a sector less correlated to EM and developed country equities. Given that the goal of most sovereign funds is to be to rainy day fund, investing in a broad range of countries – including Emerging markets – and sectors is the best way to diversify. But it should not obscure the risks in what are now illiquid markets. An SWF in a position to buy and hold may be better placed than a private fund manager but even SWFs can only endure so many losses.

PS. interestingly Norway, one of few donors exceeding the 0.7% GNI target agreed at the UN in 1971 – with development assistance reaching 0.89% of GNI in 2006, has very little exposure to emerging market equities in its pension fund. this is a reflection of the GPF-G’s role as a financial actor, they invest in more liquid markets and that Norway uses other vehicles for its development assistance, which tends to focus on governance issue. Its benchmark portfolio requires that EMs make up less than 5% of the equity portfolio – and the latest data implies exposure of under 4% – most of it in countries like Hong Kong, Singapore as well as Brazil, Mexico, and South Africa (data from Norges bank). Its exposure to Canada, Australia and New Zealand is higher than that to emerging Asia. But its recent launch of an office in Beijing may imply a shift in the future and upping its equity allocation will also slightly boost EM exposure.