One of the great economic changes of our age has been the dramatic surge in the external accounts of developing nations. Since the early part of this decade, developing nations have run giant surpluses of at least $500 billion (Rs23 trillion) a year. China, South Africa, Russia, the United Arab Emirates, Singapore and Kuwait are among the owners of giant claims against several of the Organisation for Economic Co-operation and Development (OECD) countries. Some of these such as Abu Dhabi’s investment in Citigroup Inc. and the China Investment Corp. Ltd’s acquisition of a stake in Morgan Stanley take the form of equity. This trend is not unusual.
Mohamed El-Erian, fund manager at Pacific Investment Management Co. Llc, demonstrates in his book When Markets Collide how once the novelty of being currency rich wears off, creditor countries focus on making strategic investments through sovereign wealth funds (SWFs) to avoid low returns from safer investments. A debate on the use of sovereign wealth assumes a certain moment for India because the next few years appear uniquely apposite for making such strategic investments. Given the gloomy consensus about the next few years for much of OECD, there may exist opportunities for investment in several sectors.
There need be no moral ambivalence about the propriety of assertive resource acquisition by a sovereign entity. In the 16th century, the city-states of Venice and Florence issued tradable public debt to fight wars. The British crown was not averse to using the fund-raising skills of the Rothschilds to defeat Napoleon at Waterloo. History is, therefore, entwined with the story of opportunistic investment. Governments in the 21st century, too, must protect strategic economic interests through intelligent market plays.
As India invests its substantial reserves in somewhat marginal securities, the question that inevitably comes to mind is whether a small fraction of this ought to be diversified into a more strategic form through a sovereign wealth fund with explicit criteria to manage sustained investments for the future.
Among the concerns that seem to have held back a greater level of sovereign investment has been the lack of research about how well investments of SWFs have worked. In the absence of any real evidence of their success, there has been no real framework within which a potential fund could be created. This issue appears to have been addressed finally through an excellent paper titled The Investment Strategies of Sovereign Wealth Funds by Shai Bernstein, Josh Lerner and Antoinette Schoar published this year. The authors, who have been affiliated with Harvard Business School and Massachusetts Institute of Technology, have after examining several sovereign wealth funds come to some interesting conclusions.
They observe that SWFs seem to invest when price-earnings multiples are relatively high; they seem to follow trends rather than create them. This is not unusual given that many sovereign funds are in the public eye and may feel the need to be seen to be following popular sectors rather than totally new ones where a poor investment might be questioned. The paper also observes that SWFs invest at a lower price to earning levels when investing at home and at higher private equity (PE) levels when investing abroad. This might suggest a willingness to undertake less promising but socially sensitive investments at home and more economically valuable investments overseas. It was also observed that when politicians were involved in fund management, SWFs tended to invest at home while professional fund managers tended to invest abroad, also consistent with the thesis that politicians may use SWF for non-economic ends—some of which may be quite valuable for the country. Finally and not surprisingly, the PEs of firms where investments were made by professional investment managers rose in the year after the investment, while for funds where politicians were involved, the opposite happened. Ideally, the governance structure of SWFs should separate political ownership from day-to-day investment management. Further, while the asset classes in which investments are made may be broadly guided by the governments’ priorities, the specific timings of investments and their mix should be generally chosen by professional fund managers. The quality of these decisions can be measured by means of the so-called Linaburg-Maduell index, which measures the transparency of a sovereign fund.
As the wealth of developing economies increased, there has been a sustained demand for a broad range of commodities. The Morgan Stanley MSCI global commodity index has grown from around 1,000 a few years ago to 2,500 today. Moreover, developing countries not only increase real current consumption but also seem to go in for the same kind of commodity security that their developed counterparts used to indulge in by buying commodity assets in advance. Chinese and the West Asian funds appear to be consciously increasing their access to a variety of assets and increasing the concentration of ownership in a few industries.
India is unique among large nations in not having an SWF policy. In the past few months we are again seeing substantial capital flows into the country. Given this background, it is surprising that there is so little discussion on whether we need to utilize a fraction of our sovereign wealth towards some form of resource insurance. There is no time like now for this debate to commence.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes every other Friday on issues related to governance. The views expressed here are personal.
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