Veljko Fotak & William Megginson
Two years ago, sovereign wealth funds (SWFs) were the bogeymen of world finance. Then came the global financial crisis, and worries about them seemed to vanish. Now that the crisis is abating, concerns about the SWFs and their behavior are returning.
SWFs like to portray themselves as politically independent, commercially motivated investment vehicles. But the last couple of years have proved that, in a crisis, they are not immune from political pressures to re-focus their portfolio allocations towards domestic investments. This tendency at times of economic downturn suggests that SWFs are not the long-term, stable shareholders of foreign firms that they (and some commentators) claim themselves to be.
In the years following 2000 but before the financial crisis hit, the proportion of SWF equity investments allocated to foreign markets had been increasing, reaching a peak of 90% during the second quarter of 2008. During the second half of 2008, however, a clear retreat of SWFs towards domestic markets became visible. Indeed, as the financial crisis spread to the emerging markets that host most SWFs, the proportion of foreign investments within SWF portfolios fell to about 60%.
Over the second half of 2009, with the world economy recovering, this trend reversed. But the message is clear: when domestic economies require stabilization, SWFs will shift their focus to domestic investments. In case of a worldwide economic event, such as the recent crisis, this can mean pulling out of foreign markets when they are most vulnerable.
It may seem plausible that a “domestic retreat” could be justified by a contracting range of opportunities in foreign markets, rather than by a desire to stabilize domestic economies. After all, developed markets, the favorite targets for SWF investments, were the first to be hit by the 2007-2008 financial crisis.
But this argument is flawed because of two distinct facts. First, we have seen multiple examples of domestic investments by SWFs clearly aimed at sustaining and stabilizing domestic economies. After the Doha Securities Market lost one-fifth of its capitalization between January and October 2008, the Qatar Investment Authority injected $5.3 billion into its own domestic banking sector by buying a 20% stake in each of the five banks listed on the domestic exchange.
Similar losses at the Kuwait Stock Exchange prompted the Kuwait Investment Authority to invest $5.4 billion in a new fund meant to provide liquidity to the local market, and to purchase a 24% stake in Gulf Bank for $1.5 billion. China injected more than $46 billion into the China Development Bank and the China Everbright Bank through investments by its national SWF, the China Investment Corporation. Other examples of domestic stabilization by SWFs abound.
Second, not only have new foreign-equity investments declined during the financial crisis, but SWFs have also recently engaged in an unprecedented wave of divestments, especially of foreign holdings. While news of SWF divestments has historically been extremely rare, we identified 23 SWF divestments during 2009, worth more than $14 billion. Eighteen of those divestments, worth approximately $13 billion, involved foreign targets.
This increased domestic focus at the expense of foreign investments is compounded by a contraction in assets under management during times of crisis. Low returns on SWFs’ earlier investments reduced their existing assets, while low commodity prices and a contraction in international trade reduced the accumulation of foreign currency reserves that usually constitute the bulk of new capital flowing into SWFs. In times of crisis, SWFs not only invest a smaller proportion of their portfolios abroad and divest from some foreign holdings, but the total value of their investments tends to shrink as well.
Incidentally, it is plausible that the cyclical behavior of the SWFs is responsible for the underperformance of their holdings. SWFs tend to invest in foreign markets more when times are good and security prices are more likely to be inflated, and to divest during market downturns, when divestment offer implies lower-than-fundamental-value security prices. Accordingly, the underperformance of SWF equity portfolios might be a consequence of unfortunate, but constrained, timing, rather than a result of poor stock picking.
Overall, what has happened over the past two years was a temporary retreat by SWFs from foreign, mostly developed-country, markets. SWFs like to portray themselves as independent institutions, yet it is clear that, once domestic economies falter, they cannot ignore the combined pressures of the media, public, and politicians at home, all of whom question the wisdom of investing domestic wealth abroad in times of crisis.
Yet, this trend cannot last forever, as many of the economies hosting SWFs simply do not offer sufficient attractive investment opportunities to absorb the bulk of SWF investments. Moreover, domestic economies do not provide the diversification benefits that countries dependent on single-commodity revenue streams seek.
As a result, no domestic retreat by SWFs can be expected to persist. Indeed, the first signs of new growth in SWF foreign investments could already be seen towards the end of 2009. At the same time, the expected benefits of having SWFs as shareholders – that is, of having a long, stable investor – might simply be a mirage, which disappears precisely when that stability is most needed: during a global financial crisis.