What is a Sovereign Wealth Fund (SWF)?

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1 What is a Sovereign Wealth (SWF)? A sovereign wealth fund (SWF) is a state-owned investment fund that invests globally in order to achieve objectives generally relating to intergenerational wealth, industrial policy, the management of state assets and/or monetary policy. Depending on the extent to which it also invests in especially infrastructure bonds in developing nations, it can also called a sovereign development fund, Motivation for a SWF According to Sovereign Wealth s: A Critical Analysis (Balin, 2008): Sovereign wealth funds are established for four principal reasons. Firstly, most funds held by natural resource exporters act as intergenerational transfer mechanisms, where future government pensions, asset liquidity, and fiscal revenues are guaranteed by today s export earnings. When the country s natural resources are exhausted, therefore, future generations can continue to live prosperously using the earnings of their forefathers. Next, most sovereign wealth funds of all country types are created to diversify a country s income so that it can respond to shocks to the country s comparative advantages. When a country is faced with a competitiveness crisis, it can call on its sovereign wealth fund assets to reinvest in new sectors of the economy that can revive the country s competitive advantages. Thirdly, countries establish sovereign wealth funds to increase the return on assets held in their central bank reserves. By investing in securities other than U.S. or European sovereign bonds, they can raise returns above the 3-5% annual returns garnered by most foreign exchange reserve holdings. With rapidly expanding foreign exchange stocks in many emerging markets and the decline of the U.S. dollar and thus lower returns on dollar-denominated debt this desire has become increasingly prevalent in recent times. Some sovereign wealth funds, whether in word or practice, also seek to promote investment from multinational corporations and technological transfer to domestic industries. To accomplish this goal, a fund would have to acquire a majority stake in a company or form a coalition with other shareholders. Mandates and asset allocation The same paper notes that: There is much variation in the types of equity, bond, and other investments held by sovereign wealth funds. To meet the objective of smoothing out pension fund obligations and government revenues, for example, countries tend to invest counter-cyclically, taking stakes in industries and countries that perform best when the SWF holding country s economy is performing poorly. Examples of this strategy include the holdings of Norway and Saudi Arabia, where investments are primarily made in banking, technology, and industrial companies, and natural resource investments are discouraged. On the other side of the countercyclical strategy is Singapore and Malaysia: they tend to invest strongly in natural resource plays. Also, smaller stabilization funds oftentimes seek higher allocations of lowerrisk equities and bonds because it is likely that they will be called upon during times of worldwide economic slumps because only low-risk securities hold their value during global slumps, investments in high-risk assets are of little use to these funds. Additionally, countries such as Singapore and South Korea that are seeking to develop specific industries and encourage the transfer of technology to native firms target the equity of companies that can carry out their goals. On average their asset allocation is split between fixed income securities (35-49%), equity securities in listed corporations (50-55%) and the remaining (8-10%) in alternative investments such as hedge funds, private equity companies or other products (Fernández and Eschweiler, 2008).

2 This is an average estimation and obviously strategies diverge importantly between institutions. In the case of Norway, equities accounted in 2007 for 40% of the fund s strategic benchmark portfolio and consisted mainly in Europe-listed equities (50%), Americas and Africa (35% and Asia/Oceania (15%). Fixed income accounted for the remaining 60%, denominated mostly in currencies from Europe (60%), Americas and/africa (35%) and Asia/Oceania (5%) (Kjaer, 2008). In the case of the National Oil of Kazakhstan, inspired by Norway s experience, assets were split into stabilisation and savings portfolios. The stabilisation portfolio has been mainly invested in high liquid money market instruments while the savings portfolio has been invested mostly in fixed income instruments (75%) but also equities (25%) (Sartbayev, Izabasarov, 2008). ing a SWF SWFs have been funded in various ways: from central bank reserves (China, Singapore); the export of state-owned resources (Botswana, Chile, Abu Dhabi, or Kuwait); taxation of exports (Russia, Alaska); fiscal surpluses (Korea, New Zealand); or from privatization receipts (Malaysia, Australia). Growth of SWFs globally SWFs have proliferated in the first decade of the 21 st century. Value $bn Sovereign Wealth s Inception year. Balin estimates that 35% of all SWFs were established over the five years leading up to However, some are far older, investing since the 1960s and 1970s and by now extremely diversified (see González Cid, 2008). The Kuwait Investment Authority, for example, the oldest, was created in 1953, Singapore s Temasek Holdings in 1970, the Abu Dhabi Investment Authority (ADIA) in Singapore, with a powerful export base but a relatively small economy, was one of the very first in Asia to create a fund, establishing Temasek in 1974 and then the Government Investment Corporation of Singapore (GIC) in 1981, with the aim of increasing the return on investment of its external surpluses by targeting international portfolio investments since the very inception. It was the commodity boom of the 2000s and the rise of emerging markets economies which boosted the new wave of SWF creation, with China, Russia and Dubai creating their own sovereign wealth management institutions.

3 For a complete list of SWFs globally, their value, their inception year and their main funding source, see Appendix A. Governance of SWFs One of the reasons SWFs are controversial is the potential for opaque governance of significant amounts of public money. s differ markedly in the extent to which investment mandates, investments and returns are open to public scrutiny. Another reason is the degree to which SWFs that are funded by excess reserves diverge from traditionally conservative central bank management through higher-risk approaches. State Street Global Advisors made the following observation in 2005: In December 2003 the South Korean government announced plans to use around $20 billion-worth of central bank reserves to launch a separate government investment arm called Korea Investment Corporation ( KIC ). The plan initially met with criticism and open resistance from the Bank of Korea, as it was no doubt concerned with this being seen as government interference with monetary and reserve policy, and central bank independence in general. However, the government managed to persuade the central bank of the benefits of its proposal. It also helped that an agreement was reached that the Bank of Korea would retain the option to recall these assets in case of an emergency, meaning that the funds would effectively be retained by the central bank as international reserves while being entrusted to the KIC for management. Retention of reserve status also meant diversification of assets would be limited to liquid public instruments, ruling out investment in real estate or private equities. On the other hand, there are some potential pitfalls to keeping everything in the central bank. For example, liquidity management and wealth management are two very different disciplines. Even if both can be separated at the operational level, to the extent that both are managed within one organisation, the reporting lines will feed into the same group of senior managers and board members. Whatever the actual shape or form, the general trend is unmistakable: a major part of official reserves is gradually moving from classic risk-averse liquid assets to more broadly diversified and risk-tolerant sovereign wealth. This gives investment specialists in government a larger risk budget and a much wider choice of asset classes, instruments and tools to construct more efficient portfolios and extract better risk-adjusted returns. But it can do more than that: it can provide new and sophisticated tools to economic and monetary policymakers as well. Wealth fund or development fund? In a 2008 report titled Sovereign Development s: Key financial actors of the shifting wealth of nations, Javier Santiso of the OECD highlights the potential role of SWFs in achieving developmental outcomes beyond their traditional roles. The report recommends that SWFs could act as Sovereign Development s by allocating part of their investment to developing nations. If only 10% of SWF holdings were directed in this way, it would amount to $1 400 billion more than the official development assistance of all OECD countries combined.

4 The New Growth Path Framework contemplates an African development fund which can promote investment in the region (by buying regional infrastructure bonds at a higher yield than developedcountry bonds) and, at the same time, function as a sovereign wealth fund. A Development of this nature has also been considered as an alternative means for dealing with revenues from the SACU revenue-sharing agreement (i.e. by employing shared revenues towards supporting infrastructure development in member countries rather than providing direct transfers). Hedging against South Africa s carbon intensity and oil dependence SA currently provides a safe haven for carbon-intensive companies, with historically low electricity prices based on large-scale, cheap coal. In fact, only 60% of SA s production-based emissions are attributable to the consumption of South Africans. In many ways, not taxing something is equivalent to subsidising it. In the absence of a price on greenhouse gas emissions (and conversely, carbon in its non-combusted form), carbon intensive production and exports receive a de facto subsidy. A tax on carbon would be a way to tax a form of rent (or excess profit) that currently goes to carbon intensive users. A carbon tax would also represent an additional source of revenue, not previously budgeted for. The extent of carbon tax revenues could be significant. If a tax covers 400MtCO 2 of the country s overall annual emissions at a rate of R75/tCO 2, annual revenues would amount to R30 billion. Initial modelling suggests a low, but negative (static) impact on GDP from a carbon tax recycled into reductions in VAT, company income tax (CIT) or personal income tax (PIT), or into direct transfers (like social grants). On the other hand, investment of the revenues could yield a significant, positive impact on GDP.

5 Specific proposal for SA A South African SWF could build on two areas where South Africa is rated as a world leader: governance in the financial sector and openness of its budgeting process. A decision to pursue a Sovereign Wealth for South Africa should be based on a prioritization of real and lasting wealth across all of the nation s capitals or factors of production economic, social and natural. It should also contribute to the control of inflation, which erodes economic wealth. Such a fund would have to compliment other key elements in a package of measures directed at preserving and growing the country s wealth and sustainability. Such a package could include complimentary measures that support: A) The roll-out of green infrastructure (particularly low-carbon infrastructure and including infrastructure for the Knowledge Economy) which decouples the economy from the volatility and inflation attributable to rising global commodity and/or carbon prices. B) A social wage which protects and builds social capital (people and skills), underpinned by universal access to basic services, including not just housing, water, sanitation and electricity, but also mobility (transport and communication), health and education. This is achieved through: 1. A set of policy instruments that internalize social costs associated with minerals extraction and pollution (just as a social wage internalizes the social benefit of equitable access to basic services), as well as instruments that reduce the finance costs for essential infrastructure. 2. A sovereign wealth fund, which uses revenues from these taxes to hedge the country s income from mineral- and carbon-intensive industries. It does this by capitalizing on global growth in the Green and Knowledge Economy sectors, while also supporting local Green Economy and Knowledge Economy-related projects and infrastructure. The following diagram provides a depiction of an interconnected set of solutions deriving from and contributing to a real wealth approach. Economic elements are shown in blue, social in red and environmental in green (or a combination of these where appropriate) to demonstrate the extent to which these instruments are based on a triple bottom-line of public good(s).

6 Based on this framework, some specific design features could be considered for a South African SWF: Source of funding Investment goal(s) Carbon and resource rent tax revenues (rather than foreign reserves) The primary goals would be developmental and inter-generational: Hedging carbon- and resource-based export revenues (carbonintensive and raw mineral exports) and import (especially oil) costs; Exposure to global growth in strategic industries; and/or Providing support for local infrastructure development through infrastructure bond investments and for local industrial development through equity investment. A complimentary set of goals focus on economic stabilization and include: Annuity income for co-funding social spending (the social wage); Currency stabilization (possible if the fund is held off-shore); A source of funding for emergency stabilization; and/or Support for the state/public sector balance sheet. Note: The investment strategies for an intergenerational/development fund and a stabilization fund would differ significantly and the mandate would have to select from these or be split between high liquidity/low risk and low liquidity/high risk assets, biased towards higher liquidity and lower risk investments. Investment mandate 70% high liquidity/low risk: International listed equity in strategic industries (Green and education) infrastructure bonds in developing nations (including SA) 30% low liquidity/high risk: Subordinate equity in strategic local industries Private equity in strategic global industries Accelerated technology diffusion through acquisition or majority share-holding of foreign companies in strategic industries Non-controlling shares (partial nationalization) in mineral deposits strategic to the Green and Knowledge economies (e.g. rare earths, lithium and copper). Strategic industries include industries in: the Green Economy (renewable energy, energy efficiency, alternative transport, biotech); and the Knowledge Economy (ICT, electronics, pharmaceuticals) Governance Independent entity, with joint oversight from government (Treasury) and the central bank (each with half of the voting rights each) Conclusion Sovereign wealth funds are an example of financial innovation which provides a vehicle to direct revenues from (Pigovian) taxes on carbon and/or resource rents into developmental investments. Such a fund, located in and connected to a wider set of complimentary measures, including the building of Green infrastructure and the provision of a adequate and sustainable social wage can be a powerful tool for South Africa in pursuit of a New Growth Path.

7 Appendix A: Sovereign wealth funds in 2010 (Source: Wikipedia) Country Abu Dhabi Assets $Billion Abbreviation Inception ADIA Abu Dhabi Investment Authority Oil Norway GPF Government Pension - Global Oil Saudi Arabia SAMA SAMA Foreign Holdings n/a Oil Origin China SAFE SAFE Investment Company 347.1** 1997 Non-commodity China CIC China Investment Corporation Non-commodity South Korea NPS National Pension Service Non-commodity China Hong Kong HKMA Hong Kong Monetary Authority Investment Portfolio Singapore GIC Government of Singapore Investment Corporation Non-commodity Non-commodity Kuwait KIA Kuwait Investment Authority Oil China NSSF National Social Security Non-commodity Singapore TH Temasek Holdings Non-commodity Russia RNWF National Welfare 142.5* 2008 Oil Qatar QIA Qatar Investment Authority Oil Australia AFF Future Non-commodity Libya LIA Libyan Investment Authority Oil Algeria RRF Revenue Regulation Oil Abu Dhabi IPIC International Petroleum Investment Company Oil Kazakhstan KNF Kazakrhstan National Oil South Korea KIC Korea Investment Corporation Non-commodity United States of America Alaska APF Alaska Permanent Oil Malaysia KN Khazanah Nasional Non-commodity Ireland NPRF Natironal Pensions Reserve Non-commodity Brunei BIA Brunei Investment Agency Oil France SIF Strategic Investment Non-commodity Iran OSF Oil Stabilisation Oil Chile SESF Social and Economic Stabilization Copper Azerbaijan SOF State Oil Oil Dubai ICD Investment Corporation of Dubai Oil

8 Canada Alberta United States of America New Mexico Abu Dhabi AHF Alberta's Heritage Oil NMSIOT MDC New Mexico State Investment Office Trust Mubadala Developmrent Company New Zealand NZSF New Zealand Superannuation Non-commodity Oil Non-commodity Bahrain MHC Mumtalakat Holdring Company Oil Australia BAF Building Australia Non-commodity Brazil SFB Sovereign of Brazil Non-commodity Oman SGRF State General Reserve Oil & Gas Botswana PF Pula Diamonds & Minerals Template:Country data ETMTimor Leste TLPF Timor-Leste Petroleum Oil & Gas Australia EIF Education Investment Non-commodity Saudi Arabia PIF Public Investment Oil China CADF China-Africa Development Non-commodity Australia HHF Health and Hospitals Non-commodity United States of America Wyoming PWMTF Permanent Wyoming Mineral Trust Minerals Trinidad & Tobago HSF Heritage and Stabilization Oil Ra's al Khaymah RIA RAK Investment Authority Oil Venezuela FEM FEM Oil Vietnam SCIC State Capital Investment Corporation Non-commodity Nigeria ECA Excess Crude Account Oil Kiribati RERF Revenue Equalization Reserve Phosphates Indonesia GIU Government Investment Unit Non-commodity Mauritania NFHR National for Hydrocarbon Reserves (Federal) Oman Abu Dhabi Oil & Gas EIA Emirates Investment Authority X 2007 Oil OIF SGRF * This includes the oil stabilization fund of Russia. ** This number is a best guess estimation. Oman Investment State General Reserve X ADIC Abu Dhabi Investment Council X 2007 Oil Oil