A sovereign wealth fund (SWF) is an organisation that manages financial and other assets on behalf of a government or nation. But what about the holdings of foreign exchange reserves by central banks? These assets, often much larger in size, are not regarded as SWFs. So what’s the difference? This question arose for me last week from meetings in Thailand and China, each of which has a central bank but only China has a SWF – in fact it has three.
The difference is in what the assets are held for. A SWF typically has a long term investment horizon, possibly generations in length, and aims to maximise some risk-adjusted return, accepting some risk and illiquidity along the way. A central bank that manages foreign exchange reserves usually puts the emphasis on safety and liquidity, since these reserves are held against the risk of a sudden loss of foreign investor confidence of an abrupt shortage of foreign exchange liquidity. Returns are secondary or irrelevant.
Foreign exchange reserves
Most central banks hold some assets in the form of foreign reserves, meaning financial assets denominated in foreign currency, plus gold. These assets are held as precautionary savings, to manage the risk of a shock or disruption to the foreign exchange market. If for some reason a country suffers a sudden shortage of foreign currency, it can use its reserves to carry on buying essential imports and to stabilise the exchange rate, while buying time to deal with the underlying cause of the disruption (such as a loss of foreign confidence arising from an overheating economy).
Countries’ demand for foreign reserves dramatically increased after the Asian financial crisis of 1997. Several countries, starting with Thailand, suffered an abrupt loss of confidence by foreign lenders and investments, who withdrew funding. Many Asian fast growing economies depended on foreign funding for their banks and had borrowed heavily in foreign currency, so the region saw a disastrous combination of bankrupt banks and a huge increase in the cost of servicing the debt as the domestic currency plummeted. Indonesia saw a fall in GDP of about 20% on top of a huge increase in the cost of foreign debt.
Determined not to let this happen again, emerging economies around the world started building foreign exchange reserves over the next decade. The only way to do this is to run a persistent balance of payments surplus, because this means more foreign exchange flowing in than flowing out, with the surplus going into reserves. And since a surplus must imply somebody else is running a deficit, this increase in reserves had as its counterpart the large balance of payments deficits run by the US in the decade leading up to financial crisis of 2007-09.
Since these reserves need to be available at short notice to manage any disruption in the foreign exchange market, whether caused domestically or by global crises, they are held in safe, liquid assets such as the bonds of the rich economies, chiefly the US, some Eurozone countries, the UK and Switzerland.
Those countries like the US and UK which can borrow in their own currency need not hold foreign reserves and typically don’t intervene in the exchange markets any more, though Japan has been known to do so. The US holds very little in foreign exchange reserves but it does hold a lot of gold, which could be converted into foreign exchange though it is clearly not as liquid as government bonds. (Whether gold is as safe as bonds is a controversial issue.)
The largest foreign exchange reserves in the world are those of China, currently in the region of $3.3 trillion. China was only slighly affected by the Asian financial crisis because it controlled foreign financial flows (and still controls does even now), though it did suffer the bankruptcy of the provincial government-owned Guangdong International Trade and Investment Corporation (GITIC) in 1999. These reserves represent the accumulation of years of balance of payments surpluses, and the deliberate holding down of the RMB currency value until recently, to keep China’s exports competitive. The reserves are held by China’s central bank, the People’s Bank of China, and managed by its subsidiary the State Administration of Foreign Exchange, nicely abbreviated to SAFE.
SWFs are mostly set up by countries with natural resources. The aim is to save some of the income from the taxes levied on the oil, copper, iron ore or whatever to shift consumption into the future. This is done for efficiency and equity reasons. The efficiency reason is that the economy may not be able to safely handle all of the income at present and there is a risk of a “Dutch disease” crowding out of other parts of the economy. The equity argument is that it is not fair for the current generation to enjoy all the benefits of the natural resources. By investing some of the proceeds for the future, later generations may also benefit.
A few countries without natural resources also have SWFs, chiefly Singapore and China. A persistent balance of payments surplus means these countries have large amounts of foreign exchange which could either be used to buy more imports now (a consumption and investment boom) or invested for the future. Arguably in both cases the surpluses reflect an underlying undervalued exchange rate. The rise in the RMB and move to a more neutral balance of payments means that China’s reserves are no longer rising and in the longer term may fall if the government allows more offshore investment by Chinese residents (which would also threaten the property market, but that’s a different story).
Accurate data on SWFs is not always available. The consensus is that the largest fund is probably the Government Pension Fund Global of Norway, at about $700bn, though Abu Dhabi Investment Authority (ADIA) is of broadly similar size but doesn’t disclose its asset total. Norway is uniquely transparent in the way its SWF operates and provides long term projections of the fund, based on investment performance and on the amount of new oil and gas revenue that will go into it. On its high scenario, the fund will have $3.3 trillion in 2030, about $650,000 per person. Even adjusting for inflation, this would provide a reasonable modest income for the entire population without anyone having to do any actual work. So my pension advice to anyone is marry a Norwegian. There is an interesting analysis of the Norway model, contrasted with the Yale investment model, by my colleagues David Chambers and Elroy Dimson here. (Some key differences are that Norway avoids all “alternative” investments, minimises transactions costs and sticks to rigid rebalancing of assets. It seems to work.)
China has three SWFs. The “official” one is China Investment Corporation (CIC) which has around $500bn invested. The National Council for Social Security fund has around $150bn, which is to provide future pension returns. But most of this money is invested domestically. Lastly there is the SWF part of the State Administration of Foreign Exchange (see above). This is where the definitions get blurred. SAFE manages in total about $3.3 trillion. A part of this, which is estimated by various people to be in the range of $500bn, is separately invested in a SWF.
But even the “reserves” part of SAFE is now apparently looking at assets other than the traditional safe government bonds that are normally held in foreign exchange reserves. The government is shifting the priority from safety and liquidity to seeking a higher return on its assets. This implies a shift from government bonds to equities, corporate bonds, lower quality government bonds and real estate. The actual asset allocation is not disclosed but there are apparently well sourced press articles that document SAFE investments in UK real estate.
If the Chinese government had decided that only a part of its $3.3 trillion need be managed as traditional foreign reserves then SAFE could mutate into by far the world’s largest SWF. China’s foreign reserve management needs are much less than $3.3 trillion. China’s imports are about $150bn a month (recent months have been distorted by the lunar new year). So even if China stopped exporting and had no net foreign investment, it could keep paying for imports for nearly two years from its reserves. Just six months of imports would be a very safe level of reserves, so three quarters of the total reserves could be invested in SWF assets without any risk to China’s foreign exchange management needs. If that were to happen, then SAFE would become a SWF with assets in the region of $2,500bn, or more than three times the size of the Norwegian SWF. If you add China’s other SWF assets it’s clear that China in total has by far the largest amount of assets managed by or on behalf of a state. (And this excludes the large and growing funds being lent by other state owned and directed financial institutions such as China Development Bank, subject of a forthcoming blog).
The significance of this shift would be that even if the foreign exchange mix of assets didn’t change (i.e. the proportion held in dollars was maintained) the asset mix would. Instead of investing around $1,000 billion in US government bonds, China might invest a similar amount in US equities, corporate bonds and real estate. That shift would potentially be good for the US, though it might lead to some interesting price movements.
Thailand doesn’t currently have a SWF but apparently the government thinks it would be a good idea, though perhaps for the wrong reasons. The central bank, the Bank of Thailand, is resisting the idea of diverting some of its $178bn into a separate SWF. It may have reason to be concerned. In China, where the central bank is admittedly far less independent of the government than it is in Thailand, CIC was created in 2007 by diverting a portion of PBOC’s reserves. CIC, though part of the government sector, reports into the Ministry of Finance, not to PBOC. So, while there are perfectly good reasons for arguing about the correct asset allocation for a government, there are also institutional rivalries around the formation of new centres of financial power.