Raising Capital: The Role of Sovereign Wealth Funds

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This article describes what sovereign wealth funds do, where their funding comes from, and what drives their investment strategies. It also highlights some of the policy issues that their activities raise.

In their efforts to weather the subprime crisis and shore up balance sheets, many commercial and investment banks have been raising new capital. One important source of new capital has come from sovereign wealth funds (SWFs). For example, Morgan Stanley received $5 billion from the Chinese SWF China Investment Corporation. The United Arab Emirates' SWF Abu Dhabi Investment Authority purchased a 4.9% equity share in Citibank, and Merrill Lynch received $5 billion from Singapore's Temasek Holdings.

While there is no generally agreed upon definition of an SWF, the U.S. Department of the Treasury defines SWFs as government investment vehicles funded by foreign exchange assets that are managed separately from official reserves.1 More colloquially, SWFs are investment funds controlled by governments. One example is the Norwegian Government Pension Fund; much of its funding comes from oil revenues. Other SWFs such as the Government of Singapore Investment Corporation are funded through foreign exchange reserves.

In addition to their recent investments in global financial institutions, SWFs are of interest because of their size and their potential to grow even larger. Figure 1 lists the ten largest funds, their sponsoring countries, their estimated value in U.S. dollars, their source of funds, and the year when each fund was established, according to a recent study.2 The largest funds are quite large. For example, Abu Dhabi's fund manages $875 billion in assets, and Norway's fund has $380 billion assets under management. There are approximately 40 SWFs in total, and collectively they are estimated to manage $3.6 trillion dollars. Assets under management are projected to reach $10 trillion by 2012 if recent trends continue.3 To put this in perspective, approximately $1.4 trillion is managed worldwide by hedge funds, $15 trillion by pension funds, $16 trillion by insurance companies, and $21 trillion by investment companies.4

Why would a country start an SWF?

First of all, the country typically has substantial funds to invest. One prominent source of funds is commodities. Many oil-exporting countries started commodity stabilization funds in the 1970s and 1980s as a way to reduce the impact of changes in oil prices on government budgets. Over time, especially when oil prices increased, the balances in the commodity stabilization funds grew beyond what was needed for commodity stabilization. Other countries generated substantial foreign exchange reserves from large net exports. Given these funds, the countries that control them have decided to create SWFs that use global financial markets to help them meet their investment goals.

For the sponsoring countries, SWFs can perform several useful functions. A recent International Monetary Fund (IMF) report5 lists five potentially overlapping functions of SWFs:

* Stabilization funds established by commodity-rich countries to insulate federal spending from commodity price fluctuations;

* Savings funds that share wealth across generations by investing the proceeds from nonrenewable assets (often oil) into a variety of assets to fund long-term objectives and future generations;

* Reserve investment corporations that are designed to increase the net returns to holding foreign exchange reserves;

* Development funds that are designed to fund infrastructure and other socioeconomic projects; and

* Pension reserve funds that invest to fund the government's pension-like liabilities.

Like other investors, SWFs hope to achieve these goals by using financial markets to diversify risk, to transfer funds through time, and to maximize returns.

SWF investments in financial firms

One reason that SWFs have received a lot of attention in the popular press is because of their recent high-profile investments in developed countries' financial institutions. …