Sovereign wealth funds and financial stability

Tao Sun, Heiko Hesse, 30 March 2009

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Sovereign wealth funds (SWFs) are defined as special-purpose investment funds or arrangements owned by the general government. They are often funded by balance of payments surpluses, official foreign currency operations, proceeds of privatisations, fiscal surpluses, or receipts resulting from commodity exports. Their total assets have been estimated at $2-3 trillion, but many of them have suffered unrealised losses stemming from the ongoing financial crisis.

There have been many arguments put forth regarding the potential positive and negative effects of sovereign wealth funds on global financial markets. Some argue that SWFs can play a stabilising role in global financial markets. First, as long-term investors with no imminent call on their assets and mainly unleveraged positions, SWFs are able to sit out longer during market downturns or even go against market trends. For example, the SWFs’ capital injections into systemically important financial institutions in late 2007 and 2008 augmented the recipients’ capital buffers and helped reduce risk premia for some banks, at least in the short term. This provides initial evidence that SWFs may reduce volatility in financial markets. In addition, SWFs in some countries, particularly in the Middle East, have recently supported domestic equity markets and financial institutions. Second, large SWFs may pursue portfolio reallocations gradually in order to limit adverse price effects of their transactions. Third, as long-term investors that add diversity to the global investor base, SWFs could contribute to greater market efficiency, lower volatility, and increased depth of markets.

Although sovereign wealth funds appear to have been a stabilising force thus far, there are circumstances under which they could cause volatility in markets. Given their large and often opaque positions, sovereign wealth funds – like other large institutional investors – have the potential to cause market disturbances. For instance, actual or rumoured transactions may affect relative valuations in particular sectors and result in herding behaviour, adding to volatility. To the extent that sovereign wealth funds invest via hedge funds that rely on leverage or are subject to margin requirements, such investments may inadvertently magnify market changes. For markets to absorb flows from any major investor class without large price fluctuations, it helps if they can anticipate changes in those investors’ asset allocations and risk preferences. Lack of such transparency can lead to inaccurate pricing and volatility.

The evidence

What are the merits of these arguments about sovereign wealth funds’ impact on financial stability? We consider both theoretical and empirical research.

Lam and Rossi (IMF, forthcoming) develop a theoretical model that examines the impact of sovereign wealth funds on global financial stability during periods of stress. Their findings indicate that SWFs perform a risk-sharing role in financial markets. As part of the research backing the IMF-coordinated Santiago Principles, which provide generally accepted principles and practices for SWFs, Hammer, Kunzel, and Petrova (2008) examine the asset allocation and risk management frameworks of funds based on a detailed survey. They find that SWFs have specific investment objectives in place, adopt an asset approach (mean-variance style) in determining their asset allocation strategy, utilise common risk measures (e.g., credit ratings, value-at-risk models, tracking errors, duration, and currency weights) for their risk management, and have explicit risk limits in their investment classes and instruments.

Simulations of SWFs’ asset allocations have been undertaken by Kozack, Laxton, and Srinivasan (forthcoming). Specifically, they create two stylised diversified portfolios, one mimicking Norway’s fund and the other representing other prominent funds, and conduct a scenario analysis of the impact of diversification by the funds. While the results are highly sensitive to the underlying model assumptions, the findings indicate that advanced economies will see lower capital inflows, while emerging market countries will be the primary beneficiaries. Their quantitative results are consistent with the back-of-the envelope calculations of Beck and Fidora (2008), which imply a net capital outflow from the US and the euro area and net inflows to emerging market countries. In the same vein, Jen and Miles (2007) and Hoguet (2008) note that there is scope for the global equity risk premium to fall and real bond yields to rise if SWFs shift their holdings to equities. In addition, as funds increasingly diversify into global portfolios, their activities may place pressure on the dollar.

Empirical results

Empirical research, using equity market indicators and an event study approach, has examined the role of SWFs as major institutional investors. In Sun and Hesse (forthcoming), we assess whether and how stock markets react to the announcements of investments and divestments by SWFs. Based on over 160 publicly observable investments and divestments by major sovereign funds from 1990 to 2009, we evaluate the short-term financial impact of SWFs’ activity on selected public equity markets in which they invest. We analyse the impact across sectors (financial and non-financial), actions (purchases and disposals), market types (developed and emerging markets), countries, and corporate governance levels. We calculate the abnormal returns by differencing the actual returns due to the SWF action and the estimated normal returns in the absence of SWF action.

Results suggest that average abnormal returns are positively associated with SWFs’ share purchases but not significantly negatively associated with their divestments. Moreover, preliminary results indicate that significant share price responses to SWFs’ investments are confined to developed economies. In addition, SWFs’ investments in the financial sector have a larger impact on share prices than in the non-financial sector. These differences in responses may be due to the relatively more liquid equity markets in developed economies as well as in the financial sector.

In another event study, Chhaochharia and Laeven (2008) find that the announcement effect of SWF investments is positive. They report that share prices of firms respond favourably when SWFs announce investments, partly because these investments often occur when firms are in financial distress, but the long-run performance of equity investments by SWFs tends to be poor (see Fotak, Bortolotti, and Megginson, 2008, for similar results). Kotter and Lel (2008) show that the cumulative abnormal return of SWF investments has an announcement effect similar to the effect of investments by hedge funds and institutional investors on stock returns. In addition, investments by more transparent SWFs have about a 3.5% larger cumulative abnormal return suggesting that voluntary disclosure might serve as a signalling device to investors. Kotter and Lel (2008) also obtain a significant negative but small announcement impact from SWFs’ divestures. Beck and Fidora (2008) conduct a case study of Norway’s SWF and ask whether its divestiture of companies that violate the ethical guidelines of the Ministry of Finance exhibits price pressures on those companies. Their findings suggest no significant negative impact.

Overall, these event studies find little destabilising effect of sovereign wealth funds on equity markets. The studies do not, however, address overall global and regional financial stability or stability in markets other than equity markets. Additional empirical examinations of the impact of SWFs would require more detailed knowledge of their investments – data that is presently not available. Determining market responses to SWFs’ investments requires a thorough understanding of how asset allocations are constructed and the size, depth, and breadth of the corresponding markets.

Sovereign wealth funds as a stabilising force

To summarise, existing research on sovereign wealth funds suggests that they can be a stabilising force in global financial markets. Event studies do not find a destabilising impact from SWF investments and divestments in equity markets, while simulations of SWF asset allocations imply only modest economic effects. With SWFs improving their transparency and disclosure over time, the availability of historical SWF transactions will provide researchers with the necessary data to examine further their implications for financial stability.

The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the authors.

References

Beck, Roland, and Michael Fidora, 2008, “The Impact of Sovereign Wealth Funds on Global Financial Markets,” ECB Occasional Paper Series No. 91 (Frankfurt: European Central Bank).

Chhaochharia, Vidhi, and Luc Laeven, 2008, “Sovereign Wealth Funds: Their Investment Strategies and Performance,” CEPR Discussion Paper No. 6959 (London: Center for Economic Policy Research).

Fotak, Veljko, Bernardo Bortolotti, and William Megginson, 2008, “The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies” (unpublished; University of Oklahoma).

George R. Hoguet, 2008, “The Potential Impact of Sovereign Wealth Funds on Global Asset Prices,” Vision, Vol. 3, Issue 2, pp. 23–30.

Hammer, Cornelia, Peter Kunzel, and Iva Petrova, 2008, “Sovereign Wealth Funds: Current Institutional and Operational Practices,” IMF Working Paper 08/254.

Jen. Stephen and David K. Miles, 2007, “Sovereign Wealth Funds and Bond and Equity Prices,” Morgan Stanley Research (31 May, 2007).

Kotter, Jason, and Ugur Lel, 2008, “Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the Price of Keeping Secrets,” International Finance Discussion Papers No. 940, Board of Governors of the Federal Reserve System.

Kozack, Julie, Douglas Laxton, and Krishna Srinivasan, forthcoming, “Macroeconomic Implications of Sovereign Wealth Funds,” IMF Working Paper.

Lam, Raphael W., and Macro Rossi, forthcoming, “Sovereign Wealth Funds—Risk Sharing and Financial Stress,” IMF Working Paper.

Sun, Tao, and Heiko Hesse, forthcoming, “Sovereign Wealth Funds and Financial Stability—An Event Study Analysis,” IMF Working Paper.

Topics: International finance
Tags: sovereign wealth funds

Heiko Hesse

Economist, Monetary and Capital Markets Department, IMF

Economist in the Monetary and Capital Market Department at the International Monetary Fund