Conference on “Sovereign Wealth Funds in an Evolving Global Financial System” ANU Centre for Applied Macroeconomic Anal

1. Sovereign Wealth Funds: Stylized Facts about their Determinants and GovernanceJoshua AizenmanUniversity California at Santa Cruz and NBERReuven GlickFederal Reserve Bank of San Francisco Conference on “Sovereign Wealth Funds in an Evolving Global Financial System” ANU Centre for Applied Macroeconomic Analysis  Sept. 25-26, 2008 The views expressed are not those of the Federal Reserve Bank of San Francisco or the U.S. Federal Reserve System

2. Outline of Paper • Determinants of SWFs • Oil export • Current account surpluses • Other • Role of governance • National • Fund Specific • Determinants of SWF asset size • Interaction of SWF asset and official reserve holdings • Implications for world financial markets

3. Standard Stylized Fact #1:SWFs are small, but growing, class of global investors

4. Standard Stylized Fact #2 Some individual SWFs hold a lot of assets

5. Why do some countries have SWFs? • Compare characteristics of countries with and without SWFs • Graphs • Probit regressions • Data • SWF countries: Truman (2008) • Macro and finance data: World Bank World Development Indicators • Governance data: • National Governance: Kaufmann, Kraay, and Mastruzzi (2007) • SWF Governance Scores: Truman (2008)

6. SWF Sample Source: Truman (2008)

7. Countries with SWFs tend to have large current account surpluses. Note: current account/GDP ratios defined as averages over 2002-2006

8. Trade of countries with SWFs tend to be concentrated in fuel exports.

9. SWFs established in countries with low, middle, and high incomes.

10. Some countries with SWFs have high foreign reserve levels, others have relatively low levels.

11. Role of National Country Governance and Sovereign Wealth Fund Governance • National Governance (Kaufmann, Kraay, and Mastruzzi, 2007) • Government Effectiveness • Political Stability and Absence of Violence • Voice and Accountability = DEMOCRACY • Regulatory Quality • Rule of Law • Control of Corruption • Governance Average • SWF Governance (Truman, 2008) • Fund Accountability and Transparency • Fund Structure -- • Fund Behavior – approach to management • Fund Management – role of govt. • Total Score (42% weight for Fund Accountability & Transparency)

12. No clear association between SWF countries and national governance.

13. SWF countries, particularly oil exporters, have “less” democracy.

14. Governance in industrial countries is “highest.”Governance in SWF countries is “higher” than in other developing countries,except democracy which is “lower” in SWF countries. SWFs on average have “less” democracy than other developing countries GE = govt. effectiveness PS = political stability VA = voice and accountability, ROL = rule of law RQ = regulatory quality COC = control of corruption

15. Governance of oil-exporters with “older” SWFs is higher than other SWF countries (except Norway), except democracy Countries with “older” SWFs have higher overall governance, “less” democracy, than other countries with SWFs (except Norway) GE = govt. effectiveness PS = political stability VA = voice and accountability, ROL = rule of law RQ = regulatory quality COC = control of corruption Oil-exporters with “older” SWFs, include Brunei, Kuwait, Oman, and Saudi Arabia

16. Weak correlation of national and SWF governance measures Strong correlation of democracy with SWF scores. Better democracy = Better fund governance & transparency

17. Weak positive correlation between national and SWF governance. “Older” oil exporters “Newer” oil exporters

18. Strong correlation of democracy with SWF scores. “Older” oil exporters have lower democracy and lower SWF scores. “Older” oil exporters “Older” Oil-exporters include Brunei, Kuwait, Oman, Qatar, and Saudi Arabia; VA = voice and accountability, i.e. democracy

19. Correlation of democracy with SWF accountability score. “Newer” oil exporters have lower democracy, but more accountability & transparency “Newer” oil exporters “Newer” Oil-exporters include Russia, Khazakistan, Azerbaijan, Timur-Leste VA = voice and accountability, i.e. democracy

20. Governance of sovereign pension funds (SPFs) is highest. Governance of SWFs in “older” oil-exporters is “lower” than in other SWF countries (except Norway). “Older” Oil-exporters Asia include Brunei, Kuwait, Oman, Qatar, and Saudi Arabia

21. Effect of SWF asset accumulation on official reserve holdings? • Accumulation of assets by SWF assets implies lower holdings of official foreign reserves? • Takes time to adjust portfolio behavior

22. Countries with “older” SWFs have more sovereign assets relative to reserves

23. Panel estimates of Reserve/GDP determinants Random effects of panel regression over 1985-2006. Sig. at 1%, 5%, 10% indicated by ***, **, * SWF “older” oil-exporters include Brunei, Kuwait, Oman, Qatar, and Saudi Arabia

24. Summary of stylized facts about SWFs • Incidence of SWFs positively related to fuel exports and current account surpluses. • National governance quality • lower in SWF countries and other developing countries than in industrial countries, • higher in SWF countries than in other developing countries, • though SWF countries (particularly oil exporters) display lower degree of democracy development • National and SWF governance quality are positively (though weakly) correlated • Governance quality of individual SWFs • lower in “older” SWFs in oil-exporting countries than for other SWFs (except Norway) • lower in “older” SWFs in oil-exporters than for SWFS in “newer” oil-exporters • i.e. older SWFs are relatively less transparent than newer oil-exporting SWFs. • Countries that have only recently begun to develop their fuel resources have greater incentive to foster more global integration by establishing institutions, such as SWFs, with more transparency and accountability. • Easier to change the level of transparency of fund than to change country’s political system • Largest SWFs are fuel exporters and have been around a long time • Evidence that countries with “older” SWFS hold lower levels of official reserves

25. Implications of SWFs for World Financial Markets • Long investment horizons, not highly leveraged, •  Stable source of investment capital that may help stabilize markets • Possess large pool of liquid assets •  Recent source of new capital to foreign banks and investment firms • Concern about size of SWFs in global markets • Asset allocation shifts may move markets unintentionally • May use market power strategically, leading to greater financial instability • Concern about possible motivation by political objectives • May lessen market efficiency by not seeking to maximize returns • May use controlling positions in foreign firms to gain proprietary knowledge and help state-owned enterprises • Increase control of strategic resources abroad (telecommunication, energy, ports, etc.). • Compromise national security

26. Announcement Effects of SWF investments Figure plots cumulative abnormal returns from day -5 before to day + 20 after the announcement of an investment by a SWF. Sample consists of 163 investments in 135 firms. Source: Kotter and Lel (2008)

27. Recent Gulf Country Sovereign Financial Investments

28. Recent Asian Sovereign Financial Investments

29. SWF Policy Proposals • More regulation • E.g. ban controlling stakes by SWFs (Buiter) • E.g. lower threshold foreign ownership share (now 10%) that triggers review by Committee on Foreign Investment in the US (CFIUS) • Require countries with SWFs to support reciprocal arrangements, opening up of own financial markets • More transparency and disclosure about investment strategy, composition of portfolio, etc. • Voluntary code of conduct (Truman, Summers, IMF working group) • Accommodate SWF desire for more diversification • “Encourage” investment thru intermediary asset managers, as is case with endowments and pension funds • “Encourage” investment thru well diversified country index instruments (Aizenman& Glick) • IN ALL CASES AVOID FINANCIAL PROTECTIONISM