Bernardo Bortolotti, SIL Director
SWF have never managed as much money as they do today. In a relatively short time span, SWF have gained magnitude, power, and reputation. All that is undeniable but the big question before us today hints at something more transformative. Have we entered a new era of sovereign wealth? Are the new global macroeconomic fundamentals and political climate challenging the conventional models of sovereign wealth management? If so, how should SWF adjust behavior and strategies in order to thrive and prosper in the 21st century?
There is no “one true answer” to these questions but we can confidently claim that the end of extrapolation has been reached: the outlook of sovereign wealth cannot be drawn with lines from the past.
The rapid accumulation of foreign exchange reserves over the last two decades has been an uncommon phenomenon from a historical point of view. Since the early 2000s, sovereign wealth grew by more than 10 per cent per year and by the end of 2014 it had reached an all-time-high of USD 17.3 trillion. SWFs account for 15 percent of the global fund management industry, closing quickly the gap with other institutional investors such as pension funds, mutual funds or insurers.
But in 2014, a tipping point was reached, associated with a structural break in the dynamics of sovereign wealth accumulation. Two related factors triggered this change, derailing the heavy train. First, the oil shock and the slowing down of global trade turned the two engines of SWF growth into a spent force. Second, governments started to tap assets to equalize lost revenues and to stabilize their domestic economies, scathing sovereign wealth for the first time in recent history.
These shocks were not short-term cyclical phenomena to be quickly absorbed. In fact, they proved being structural issues, which are still looming large today. Let us start with oil. After reaching a historical low in mid 2015, oil prices have stabilized, but absent major geopolitical events, supply and demand arguments suggest at high level of confidence that oil prices will remain reasonably low in the foreseeable future.
But it is not just the commodity supercycle being over: global trade is also going south, and at a quite rapid pace. According to a recent WTO release dated August 9, trade expansion is slowing and will likely slow further as we reach the end of 2018. This loss of momentum reflects weakness in export orders and automobile production and sales, which may be responding to the ratcheting up of trade tensions.
Let us now turn to the second critical (related) factor. The terms of trade shock curbed revenues and swept current account surpluses in commodity exporting economies. With oil prices averaging current levels or slightly higher, Middle Eastern oil-exporting economies will strive to maintain a balanced budget for the rest of this decade. Some countries had and will have to tap into sovereign wealth in order to fill their budgets’ shortfall.
What happened in the Gulf occurred to some extent also in China and Asian emerging markets. In 2015, for the first time in many years, central banks liquidated FX reserves in order to stem currencies devaluation and avoid a balance of payments crisis.
The data speak for themselves: from the all-time high recorded in 2014, today global foreign exchange reserves are worth 11.8 US trillion. For some countries, the drop has been dramatic: Saudi Arabia is down 33%, Qatar almost 40%, China 21%, Russia 15%.
These new economic fundamentals set off profound, structural, and long lasting repercussions in the SWF community, and that is why I claimed that we reached the end of extrapolation. The future will not be as we thought it could be.
The fundamental regime change is the collapse of the belief the SWF being “liability free” economic entity. Amongst practitioners but also in the academic literature, SWF were often referred to as funds without any explicit liability stream to cover, as opposed to pension funds or insurance companies. In the last years, implicit liabilities (a.k.a. distressed governments’ request to become lender of last resort) abruptly materialized, causing painful portfolio adjustment and capital impairment. Furthermore, some funds have started to issue plain debt, or sophisticated debt instruments. Nigeria Sovereign Investment Authority Infrastructure-related bonds are a case in point.
So how will the new era of sovereign wealth look like? More precisely, how can our fellow SWF thrive and prosper in this new, challenging scenario?
Up to now, the SWF community showed an impressive degree of resilience. With a few exceptions, SWFs weathered the storm quite well, with their capital unscathed, or even increased, in spite of the recent headwinds.
I see three main possible directions of change regarding i) risk management, ii) investment strategy, and iii) investment governance.
Most funds have made great progress in risk management recently, SWF may think about embracing strategic sovereign asset and liability frameworks (SSAL), endowing the organization with state-of-the-art risk management tools, and streamlining mandates within funds, central banks and other state entities to ensure better macro-fiscal policy coordination. In some cases, reorganization and restructuring may be required, and I see progress in some funds that have recently chosen to merge to fulfil better their mission.
Second, SWFs should seek internal growth leveraging upon their quintessential features of long-term, patient investors. In an environment characterised by lower inflows or even outflows, the return on accumulated wealth can be an important source of funding for the sponsoring government. SWFs should rely on illiquid assets classes and strategic direct investments to capture long term, above market returns. The enhanced focus on developmental aspects and investment to address market failures will be a key feature of the new strategy.
Third, and finally, SWFs should leverage upon one special characteristic, which is genuinely unique in the institutional investor industry. SWFs are a very small group of players relative to the size of the assets they manage. This massive concentration of financial wealth allows unprecedented direction and coordination of investments. By teaming up with fellow SWFs and engaging private partners, they can develop transformative coinvestment projects across the board. Importantly, these ventures will deepen gov-to-gov relations, strengthen economic diplomacy, and promote international capital mobility against the mounting protectionism tide.