With the increasing volatility in the global economy, driven by the increasing frequency and intensity of negative externalities (such as climate change), the demand for robust economic support systems has grown rapidly over the past few decades. In response, governments have started focusing on building state-backed financial cushions to safeguard their countries from economic shocks. Sovereign wealth funds (SWFs), have been one of the most significant developments as a result of these mounting concerns that countries have had to face in the past two decades. The first SWF was established in Kuwait in 1953 called the Kuwait Investment Authority, with the sole purpose of investing the surplus revenues from oil exports.
What are sovereign wealth funds?
A Sovereign wealth fund, also known as a social wealth fund, refers to the pool of money that a country has accumulated over a period of time through surplus revenues. Whenever a country is in a situation where it has excess revenues, it uses the SWF mechanism to channelise the money into areas where it is needed the most and invest some portion of it.
The primary motive behind the creation of an SWF is to protect the country’s economy from unforeseen or unpredictable events, such as the COVID pandemic. However, even though the broad objective is the same, the reasons for establishing sovereign wealth funds vary from country to country. For example, for oil-rich countries, the surplus revenues generated by their oil export activities become the key input for their respective SWFs; in turn, these state-supported pools of money help protect these countries’ economies from external shocks that may have a direct or an indirect bearing on the global oil industry.
Types of sovereign wealth funds
Social wealth funds can exist in different forms and sizes. Some funds are created with a specific purpose, while others can be set up to serve as general contingencies in times of crises. Broadly, SWFs can be categorised as follows:
- Stabilisation funds - True to their name, these funds are established to simply stabilise the economy in case of any negative external events, such as extreme weather events, outbreak of war, or a sudden and sharp decline in oil and gas prices. These types of funds ensure that during crisis times, the damage to national economic growth is minimal and the recovery is quick.
- Pension reserve fund - This kind of a fund is used by the government to finance its pension system, without taking on too much of the burden on itself. Unfortunately, a large number of countries do not have such funds and those that do are usually rich countries with a sizable geriatric population.
- Future generation fund - Such sovereign wealth funds are created to cater to the needs of the current and the future elderly population in the country. They also ease the pressure on government budgets in the forthcoming years.
- Reserve investment funds - As the name suggests, these funds are established primarily for investment purposes. Governments set up such SWFs with a view to tap investment opportunities and generate long-term revenue for the country.
- Commodity funds - Another category of social wealth funds is commodity SWFs, which are replenished through the export of commodities. For instance, if Country A specialises in the production and export of semiconductors and the price of chips rises in the global market, then this country stands to make enormous surpluses. On the other hand, a fall in global chip prices will lead to a deficit for Country A.
- Non-commodity funds - These funds are mainly financed by a country’s foreign exchange reserves. To maintain these SWFs, a country will need to have a current account surplus, which is a complex undertaking.
Top Sovereign wealth funds in the world
Sovereign wealth funds hold massive sums of money, and some of these have grown exponentially since their inception. Today, the three largest SWFs are:
- Government Pension Fund Global - This was set up by the Norwegian government in 1990 and currently, it owns assets worth US$ 1 trillion or more.
- Abu Dhabi Investment Authority - Created in 1976, this body holds nearly US$ 900 billion in assets
- China Investment Corporation - It was established to direct China’s excess foreign exchange reserves into different investment areas. At present, it holds assets worth US$ 800 billion or thereabouts.
Investment areas for sovereign funds
Operating as wealth funds, it is very natural to question where the money in the SWFs actually goes. The most preferred investment areas for governments include foreign direct investment (FDI), bonds, and equities. Within these broad categories, SWFs funnel large amounts of money into more specific asset classes and financial assets. In recent times, a significant number of sovereign wealth funds have been exhibiting a proclivity toward alternative investment channels, such as private equity and hedge funds. Furthermore, state-backed funds that invest in private corporations can also assume a greater degree of control over the entities’ investment strategies, pushing them to direct capital responsibly or in the social welfare sector.
Risks involved in Sovereign Wealth Funds
While SWFs have obvious economic benefits, they also entail risks. According to a report by the International Monetary Fund (IMF), central banks are likely to increase the allocation of their excess reserves to higher risk-higher return markets, risking the stability of the SWFs in the process. Sovereign wealth funds are also playing an essential role in the aftermath of global financial crises, such as the 2007-08 subprime crisis in the US. SWFs helped the US government rescue several of the so-called “too big to fail” financial institutions, such as Morgan Stanley, from imminent bankruptcy. Experts believe that these funds are now having way too much control over domestic economies, which, if left unregulated, can result in long-term economic damage and political turmoil.
Key Takeaways
Social wealth funds provide governments opportunities to diversify their investments and explore and open new revenue channels to boost economic activity. As they are backed by the government, SWFs are also highly attractive investment areas for large investors, such as MNCs and foreign governments. However, the dangers posed by SWFs to the international trade system are palpable and policymakers need to take a cautious approach toward these funds to ensure that they do not harm domestic economies.
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