Should sovereign wealth funds (SWFs) invest in domestic markets?
The Middle East is home to some of the largest SWFs in the world, and they have earned a reputation in global financial markets as deep-pocketed, shrewd international investors.
But as political unrest sweeps across the region, many SWFs have been called upon to cast an eye on investment opportunities at home.
"The emergence of SWFs with domestic investment mandates represents a shift of emphasis on the role of natural resource rents in development towards domestic investments," according to a report for the World Bank by Alan Gelb, Silvana Tordo, H?vard Halland, Noora Arfaa and Gregory Smith.
"About 20 sovereign funds now have at least some specific mandate in this area, including some that traditionally have invested abroad. As resource markets stay strong and more countries make discoveries, more domestic investment mandates are being established," the report noted.
SWFs, of course, were originally created by resource-rich countries to diversify their revenues. Many of the resource-rich states especially in the developing world are highly dependent on their natural gas or crude oil revenues, and it seemed prudent to apportion a part of that revenue in a fund that would invest abroad and create a new revenue stream that is not dependent on the domestic economy.
Of course, SWFs investing domestically are not as unusual as one might expect, as domestic holdings constituted 16% of total investments in a sample of 60 SWFs.
"But domestic infrastructure investment remains uncharted territory for most SWFs. In light of the pressing infrastructure needs, several resource-rich developing countries have established, or are in the process of establishing, SWFs with an expanded role as a national investor," the authors said.
A CHANGE IN FOCUS
The strategy of creating a diversified sovereign wealth fund that primarily looks abroad for returns has largely been a successful policy for many Gulf Arab states. Abu Dhabi Investment Authority is the world's second largest second sovereign wealth fund - after Norway's Government Pension Fund - and has amassed assets of USD 773 billion.
SAMA Foreign Holdings (assets of USD 675.9 billion), Kuwait Investment Authority (USD 410 billion) and Qatar Investment Authority (USD 170 billion) are among the world's top 10 sovereign wealth funds in terms of assets, according to the Sovereign Wealth Fund Institute.
Over the decades, Gulf sovereign funds have picked up trophy real estate assets in the poshest areas of London and New York. They have bought stakes in blue-chip financial services companies, German car makers, major oil companies and even dabbled in the global media and IT sectors.
But as the regional economies grow, some governments have looked to divert some of the SWF funds into the domestic market.
Abu Dhabi launched the Investment Council fund in 2007, Bahrain developed Mumtalakat in 2006, and the United Arab Emirates' Mubadala has a strong domestic mandate.
BOOM-BUST CYCLES
But the World Bank argues that many resource-exporting countries have launched investment programs "to little effect".
Very few resources exporters have managed to sustain countercyclical fiscal policy in the face of large swings in resource markets. This leaves their economies vulnerable to destructive 'boom-bust' cycles, which have a direct impact on investment quality and returns.
"On the upside of the cycle, spending outruns management capacity, raising the prospect of poor-quality spending as well as creating bottle-necks that raise costs for all investors. On the downside, sharp fiscal consolidation leaves partly completed projects in limbo and may also cut the utilization of completed investments by constraining operational spending."
If SWFs create a domestic unit, it could further increase those risks, fragment public investment programs and may even provide an avenue to bypass parliamentary or cabinet scrutiny of spending.
"With its resources provided from resource rents and not from the capital market the SWF is not subject to oversight by market actors and institutions," the report warned.
Furthermore, even if the fund is restricted to commercial investments or investments with near-commercial returns, "it could exacerbate macroeconomic and asset-price cycles by investing heavily when resource prices are booming."
Therefore, it can only offer potential benefits relative to alternative approaches if, as a high-capacity expert investor, it operates in coordination with the government's macro-fiscal policy.
In addition, heavy-weight SWFs may start competing with local banks and private equity institutions for market share and disrupt the organic growth of capital markets.
SWFs should also not try to replace poorly run development banks that are built precisely to focus on the domestic economy.
Instead, the funds should seek to partner with other institutions and multilateral development banks.
"For example, the Oman-India Joint Investment Fund (OIJIF), a co-investment vehicle between the Oman State General Reserve Fund (SGRF) and the State Bank of India, was set up in 2010 to strengthen infrastructure investment in both economies through equity investments in various sectors."
However, the recent trend toward more liberal politics in some SWFs states characterized by the Arab Spring may also lead to increased demand for domestic oversight over SWF activity, according to Jeremy Leong, in a report for The Tufts University.
"Hence, a domestic-oriented analysis of SWFs would be relevant as the heighten sensitivity for international or cross-border discipline of SWF activity has waned somewhat, and domestic demands for discipline and stronger governance of SWFs increase over time."
FIVE GUIDELINES
SWFs learn fiscal and investment discipline by investing abroad, but they often don't import those skills when investing in domestic markets as they may be driven by political pressure, or forced to prop up an entity that is of national importance, such as a bank.
The authors argue that if governments insist on apportioning some funds to domestic investments, they must follow five key guidelines:
1) Ensure that its investments are not destabilizing to the macro-economy,
2) Limit the scope of domestic SWF investments to those appropriate for a wealth fund;
3) Invest through partnerships with entities that bring credible standards for project quality and governance;
4) Establish credible governance arrangements to ensure that the SWF operates with independence and professionalism, and clear accountability mechanisms;
5) Mandating full transparency, particularly on each domestic investment and its performance.
As political pressures increase, many Arab states are likely to divert more of the SWF funds to the domestic market. But they need to place proper checks and balances to ensure that the scope of their investments are properly mandated and are subject to a higher level of scrutiny.
That would help ensure some capital discipline in local markets and not crowd the sector.
The feature was produced by alifarabia.com exclusively for zawya.com.
Zawya 2014
