Executive Summary
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Sovereign wealth funds (SWFs) have generated great hype over the past couple of years. But the economic and financial forces that led to the rise in their importance were also responsible for the creation of unsustainable global financial imbalances whose painful and prolonged correction is now underway.
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SWFs will continue to exist, but they are unlikely to play a dominant role in the global financial system. If the existing global financial status quo is maintained and sovereign wealth funds are still causing the same hype in the next couple of years, economic policy in the SWF countries would be on the wrong track, risking a major global downturn.
Introduction
The hype about sovereign wealth funds began in early 2007, when China announced it was setting up such a fund and planned to invest $3 billion in US private equity group Blackstone. The realization that SWF assets had nearly doubled since the start of the decade, reaching $3.3 trillion by the end of 2007, while China had $1.2 trillion in foreign exchange reserves which could be channelled through its SWF in riskier assets, caused a quick escalation. Analysts tripped over themselves in projecting exponential increases in the wealth of SWFs, claiming that this marked a historic change or a paradigm shift in the global financial system. But although sovereign wealth funds will continue to exist, the hype about them is a transitory phenomenon. The global economic and financial circumstances that led to their rise in importance were also responsible for the creation of unsustainable global financial imbalances whose painful and prolonged correction is now underway. If SWFs still dominate the news headlines in the next couple of years, economic policy across the world will have failed.
SWFs’ History
Sovereign wealth funds are not a new phenomenon. The term has existed since 2005, but the first sovereign wealth fund was created as far back as 1953. SWFs are pools of assets owned and managed directly or indirectly by governments. For decades, sovereign wealth funds were the prerogative of the oil-producing countries. Their domestic nonoil economies tend to be dwarfed by the size of their oil revenues. At the peak of their cycle these countries run current account surpluses on average as high as 20–30% of output. Consequently, the pressure on their currencies to appreciate is massive, undermining the competitiveness of their nonoil domestic economies. A country can always keep its currency from appreciating by printing money, but at the expense of rampant inflation. To avoid the effects of extremely excessive liquidity, oil revenues can be set aside in a fund or funds that invest in foreign assets.
In most oil-producing countries most of the oil is in the hands of the state. Even if it is not, the intervention in the foreign exchange markets needed to keep the currency down siphons money into government hands. But, historically, the oil producers have invested their SWFs in search of high returns. More importantly, they have always used their oil revenues to smooth the global economic cycle. When global demand slumps and the price of oil falls, their current accounts tend to move from a huge surplus to a huge deficit. Oil revenues not only fall, but tend to be used up in an attempt to soften the cyclical blow to the domestic economy. The gigantic surge in oil producers’ SWF assets during this decade was the result of the prolonged global economic cycle, which was also accompanied by a spectacular commodity price boom.
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