Development Finance and Markets International

Sovereign Wealth Funds: Asset or Liability?

A Sovereign Wealth Fund (SWF) is a fund managed by the state and comprised of income generated from the government’s surplus reserves. SWFs have been an important aspect of the economic landscape for almost two decades, and their numbers have increased dramatically since the 2008 Financial Crisis, with over 100 funds controlling nearly $8 trillion in assets globally.

Many Sovereign Wealth Funds have enjoyed great success, such as the Norwegian Government Pension Fund, which has invested the country’s revenues from the oil and gas industries in over $1 trillion in assets. It is roughly worth three times Norway’s annual GDP, with 69.6% of its investments in equities such as Alphabet and Apple, 27.6% in fixed income where the amount of interest received is constant e.g. government bonds, and 2.8% in property. The fund is carefully managed; only 3% of the fund’s value is spent each year, so that the wealth is available for future generations. The money generated is then employed to improve areas such as healthcare, energy, and education. Norway’s Sovereign Wealth Fund has played an important role in the economy for years, contributing to the country’s high standard of living, low debt, and high level of energy security.

However, although many SWFs have benefitted their countries, others have not experienced the same level of success, and some have even done more harm than good to their economies.  A number of high-profile failures and scandals have highlighted some of the issues that can arise, leading many to be concerned about whether the potential benefits are truly worth the consequences of a poorly managed fund.

The purpose of most Sovereign Wealth Funds is to diversify a resource-rich economy and ensure a sustainable source of wealth for future generations. Income generated from SWFs is reinvested into public services, which could create jobs, accelerate economic development, raise the standard of living, and lay the foundations for future economic growth. In addition, whilst the benefits of Sovereign Wealth Funds are primarily for the citizens of the country, the money can also be invested in areas where it will have a positive impact. Therefore, it is easy to see why a population would support the creation of a SWF.

For example, Saudi Arabia set up its SWF, the Public Investment Fund (PIF), in 1971, to diversify its oil-rich economy. The PIF is now worth an estimated $325 billion, investing in companies such as Boeing ($713.7 million), and Facebook ($522 million). Saudi Arabia has also used the money to develop ambitious “giga-projects”, which aim to stimulate economic growth. The first project is NEOM, a $500 billion mega-city. Announced in 2017, it is part of Vision 2030, a project to reduce Saudi Arabia’s dependence on oil and improve public service sectors. The second project, the Red Sea Project, is a luxury tourism venture being developed along 200 km of coastline. It will include 50 new hotels with approximately 8,000 rooms, a new airport, and a town for 35,000 inhabitants. The goal is to establish Saudi Arabia as a global tourism centre. Evidently, SWFs can be a valuable source of capital, which can then be used to develop the country.

Dubai, in the last 20 years, has undergone a similar transition to Saudi Arabia. The Investment Corporation of Dubai (ICD), with an annual revenue of $228 billion (2019), has enabled Dubai to transform in recent years from a small desert city to a global centre of tourism, finance, and architecture. The SWF has been essential in reducing the country’s dependence on oil, using the revenues to improve infrastructure, establish itself as a tourist destination, and become a trade centre of commodities such as gold. This has led to greater economic growth, and Dubai is considered one of the most developed cities in the world. Undoubtedly, the SWF has played an important role in this.                                           

SWFs are also beneficial for the companies they invest in by providing long-term capital (enabling companies to expand at their own pace). SWFs can have a great deal of influence on a firm, and their economic weight means that they can impact a company’s business dealings, such as increasing acquisition premiums (the amount paid to a firm in addition to its real value when acquiring it). When MidAmerican Energy Company attempted to buy Constellation in 2008, the Norwegian Government Pension Fund, which had a 4.8% stake in Constellation, brought MidAmerican Energy to court because it considered the price insufficient. Evidently, SWFs can be a great advantage for the companies they invest in, acting as a financial buffer and enabling the company to expand.  Greater success for companies would result in more jobs created which, over time, would result in further economic development.

Sovereign Wealth Funds can also invest in emerging economies throughout Asia, Africa, and South America, consequently aiding the development of those countries. This enables the SWF to expand its global presence, receive a higher (but riskier) return over the long term, and accelerate growth in the countries they invest in. For example, Norwegian Government Pension Fund has invested extensively in developing economies such as Egypt, (2.57% stake in Commercial International Bank Egypt worth roughly $150 million) and Bangladesh (3.45% stake in BRAC Bank worth an estimated $24 million).

However, there are issues with SWFs, especially considering that many are not as transparent and well-run as Norway’s. To understand why SWFs can be problematic, we must first understand their structure and asset allocation. After a country’s revenues are pooled into this fund, experts from investment banks and management consultancies are brought in to assess how to invest the fund. The reputation of these firms means they have a great influence over how the SWF is run. Whilst this is not always a bad thing, if left unchecked, the consequences for the country can be catastrophic. For example, Libya set up the Libyan Investment Authority in 2006 with $60 billion of its oil wealth and Goldman Sachs, a respected investment bank, was paid $200 million to manage the funds. $1.3 billion was invested into risky, but potentially lucrative derivatives, and the result was a loss of $1.2 billion, 98% of the initial investment. Libya sued Goldman Sachs for the losses, but lost at court in 2016.

Not only is there a risk of financial loss, but SWFs in some countries have also been used by corrupt officials as a way to siphon money. Most infamous is the scandal surrounding Malaysia’s Sovereign Wealth Fund (1MDB), again involving Goldman Sachs. In 2008, Malaysia established the 1Malaysia Development Berhad, or 1MDB, whose goal was to invest in Malaysia’s green energy and tourism industries. Its ties to banks such as Goldman Sachs and Deutsche Bank helped it to raise billions of dollars for projects. However, over time, the fund’s debt grew unmanageable, and the Malaysian government was forced to start secretly repaying 1MDB’s obligations. In 2015, 1MDB came under increased scrutiny as reports revealed that Prime Minister Najib Razak had received transfers of $681 million into his personal bank account. 1MDB was then investigated by the Department of Justice (DoJ), and in 2017 the DoJ released a document showing that funds were embezzled from 1MDB and used to buy real estate, precious artwork, and custom-made jewellery. 1MDB is now $10 billion in debt, making it one of the biggest corruption scandals in history. More importantly, Malaysia’s economy will take years to recover.

How can these risks be mitigated? Good governance and efficient checks and balances would decrease the risk of corruption and poor management. For a fund to be managed well, there must be transparency, responsible investment policies, and accountability. Transparency of the funds would ensure that any investments not accounted for would be quickly noticed, thus reducing the likelihood of a corruption scandal on the scale of 1MDB. Responsible investment would remind investors of the duty to do what is best for the citizens of the country; this is not to say that risky investments should be avoided, but simply that the risks and benefits of the investment should be weighed more carefully in future. This would decrease the chance of an event such as the Libyan Investment Authority losing 98% of an investment due to a high-risk trade. Finally, accountability and a strong internal structure of the fund would help to prevent misuse of the fund and make sure that no individual has too great an influence on the investments.

In conclusion, whether Sovereign Wealth Funds become an asset or liability ultimately comes down to the management of a fund. If a fund is managed efficiently, the possible benefits of setting up a Sovereign Wealth Fund are great, stabilising the economy, creating sustainable wealth, and improving the economic development of not just that country, but others as well. In theory a SWF – well managed, and corruption-free is an asset for all. However, there are many risks involved, which could have the opposite effect of the fund’s original purpose. Good governance is key to ensure that Sovereign Wealth Funds truly help the economies they were founded to benefit.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: