IMF paper sounds red alert for SWFs over domestic investment

Sovereign wealth funds (SWFs) should stay away from local market, and focus on their stabilisation role in foreign markets as domestic investment could drive prices up, according to an IMF working paper.

Although SWFs domestic investment could support growth in their home countries, the invested funds at home should be part of the budget to avert mismanagement of funds and damage to public spending, the paper said.

It also urged SWFs to choose a basket of currencies in their investment abroad and shun those to which their own currency is pegged. "The decision of investing part of the assets domestically depends on the purpose of the SWF. If the SWF has developmental objective, it could invest domestically. However, its operation must support and be consistent with the country's macroeconomic policy framework," the paper said.

"Using assets in SWFs to purchase domestic inputs could stimulate domestic demand and put upward pressure on prices.

"This may result in an appreciation in the real effective exchange rate, with adverse consequences for exports and growth… on the other hand, sterilisation of domestic input financing could lead to higher interest rates and crowd out private sector investments.

It said that while the new domestic project could add to output, it may also through the real exchange rate undermine private exports and domestic investment, often the real sources of growth.

"Even if SWF financing is utilised for domestic projects which would clearly augment growth prospects with positive externalities, it is arguable that these projects should be formed in the government fiscal policy and budget," it said.

"If spending is allowed to take place outside the budget, issues of fiscal accounting and transparency could emerge, which could undermine budgetary control, imply unequal treatment of different types of spending, and could lead to mismanagement of funds and waste," it said.

The paper followed calls on the Abu Dhabi Investment Authority (Adia) and other SWFs in the Gulf to pump funds into the domestic market after the region was hit by a severe liquidity shortage because of the global financial distress.

While they have remained reluctant to undertake that role, the global crisis is gradually pushing Adia and other funds to look for investment opportunities in the Arab world after suffering from massive losses in jolted global markets.

According to the US Council on Foreign Relations, the combined losses of SWFs in the six-nation Gulf Co-operation Council (GCC) were estimated at around $350 billion (Dh1.3 trillion) in 2008 but they were partly offset by a massive financial surplus spawned by a surge in their oil export earnings.

The council put the net flow into those funds at nearly $273bn last year, resulting in a decline in their total assets to about $1.2trn at the end of 2008 from $1.28trn at the end of 2007.

Adia, believed to be the world's largest SWF, suffered from the biggest loss of around $183bn.

Losses were estimated at $94bn by the Kuwaiti Investment Authority, $27bn by the Qatari Investment Authority and nearly $46bn by the Saudi Arabian Monetary Authority.

Although some of these sovereign funds lack transparency, the bulk of their assets are believed to be concentrated in the West in bonds, bank deposits, real estate and equity.

"The choice of currency composition depends on the objective and the liability structure of the SWF.

In the case of managing sovereign wealth with a stabilisation objective, a sharp drop in commodity export prices and revenues may require a withdrawal of fund which entails short investment horizon and high liquidity constraints," the IMF paper said.

"As a result, sovereign wealth with stabilisation objective implies choosing a currency composition that is negatively correlated with the commodity price. This is most likely to weigh the basket in favour of the countries that import the most [relatively] of the commodity," said the paper

It advised SWFs not to invest their assets in the currency to which its own currency is pegged. "The reason is that the risk is then passed on to another part of the sovereign's own balance sheet [the central bank] and thus not laid-off.

"Managing sovereign wealth with liabilities need to consider the correlation of the liabilities with the foreign currencies."

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