Since the beginning of the financial crisis in the summer of 2007, financial stability has been at the forefront of policy discussions. At the same time, sovereign wealth funds have become dominant players during the past two years, as they have injected significant capital in major financial institutions. Research on the financial stability implications of these funds has been slowly emerging, hampered by lack of data on their asset allocations. This article summarizes the results of some recent studies about sovereign wealth funds and their implications for financial stability.
Sovereign wealth funds (SWFs) are defined as special-purpose investment funds or arrangements owned by the general government. They are often established out of balance of payments surpluses, official foreign currency operations, proceeds of privatizations, fiscal surpluses, or receipts resulting from commodity exports. Their total size has been estimated at $2 trillion to $3 trillion, but many of them have probably seen unrealized losses from the ongoing financial crisis combined with a sharp reduction in oil prices.
There have been many arguments put forth regarding the potential positive and negative effects of SWFs on global financial markets. For example, some argue that SWFs can play a stabilizing role in global financial markets. First, many commentators point out that as long-term investors with no imminent call on their assets, and with mainly unleveraged positions, SWFs are able to sit out longer during market downturns or even go against market trends. In particular, the capital injections by SWFs into systematically important financial institutions in late 2007 and 2008 have augmented the recipients’ capital buffers and have been helpful in reducing various bank-specific risk premia, at least in the short term. This provides initial evidence that SWFs could have a potentially volatility-reducing impact on markets. Second, large SWFs may have an interest in pursuing portfolio reallocations gradually so as to limit adverse price effects of their transactions. Third, SWFs could, as long-term investors and by adding diversity to the global investor base, contribute to greater market efficiency, lower volatility, and increased depth of markets.
Although SWFs appear to have been a stabilizing force thus far, given their size, there are circumstances in which they could cause volatility in markets. Having large and often unclear positions in financial markets, SWFs—like other large institutional investors—have the potential to cause a market disturbance. For instance, actual or rumored transactions may affect relative valuations in particular sectors and result in herding behavior, adding to volatility. Such effects could be especially pronounced in shallower markets. To the extent that SWFs invest through hedge funds that rely on leverage or are subject to margin requirements, such investments may inadvertently magnify market changes. For markets to absorb flows from any major investor class without large price fluctuations, it helps if they can anticipate the broad allocation and risk-preference trends of such investor classes. Opacity about such trends can lead to inaccurate pricing and volatility. As regards the financial stability implications of SWFs, both theoretical and empirical research has been implemented.
Given the lack of publicly available data on SWF asset allocations, a strand of IMF research has been on the theory side. Lam and Rossi (forthcoming) develop a theoretical model that aims to examine the impact of SWFs on global financial stability during periods of stress. Their findings indicate that SWFs have a risk-sharing role in financial markets. As part of the IMF-coordinated process of the Santiago Principles that provide generally accepted principles and practices for SWFs, Hammer, Kunzel, and Petrova (2008) examine the asset allocation and risk management frameworks of SWFs based on a detailed survey. The results show that SWFs have specific investment objectives in place, adopt an asset approach (mean-variance style) in determining their asset allocation strategy, utilize common risk measures (e.g., credit ratings, value-at-risk models, tracking errors, duration, and currency weights) for their risk management, and have explicit limits in their investment classes and instruments.
Simulations of SWFs’ asset allocations have been undertaken by Kozack, Laxton, and Srinivasan (forthcoming). Specifically, they create two stylized diversified portfolios, one mimicking Norway’s SWF and the other representing some well-established SWFs, and they conduct a scenario analysis of the impact from a diversification of sovereign assets. While the calibrations are highly sensitive to the underlying model assumptions, the findings indicate that advanced economies will see lower capital inflows, while emerging market countries will be the primary beneficiaries. Their quantitative results are consistent with the back-of-the envelope calculations of Beck and Fidora (2008), which imply a net capital outflow from the United States and the euro area and net inflows to emerging market countries. In the same vein, Hoguet (2008) points out that there is scope for the global equity risk premium to fall and for real bond yields to rise if SWFs allocate their assets to equities. In addition, as SWFs increasingly diversify into global portfolios, their activities may place some pressure on the dollar.
Other empirical research, using equity market indicators and an event study approach, has examined the role of SWFs as major institutional investors. Sun and Hesse (forthcoming) assess whether and how stock markets react to the announcements of investments and divestments to firms by SWFs using an event study approach. Based on over 160 publicly traceable events collected on investments and divestments by major SWFs during 1990–2008, they evaluate the short- and long-term financial impact of SWFs on selected public equity markets in which they invest. The impact is further analyzed on different sectors (financial and nonfinancial), actions (buy and sell), market types (developed and emerging markets), countries, and transparency (more transparent and less transparent). In particular, following the estimation of a market model and the prediction of a “normal” return during the event window, the abnormal return is calculated.
Results suggest that average abnormal returns are positively associated with SWFs’ buy actions and not significantly negatively with SWFs’ sell actions in the full sample. Moreover, preliminary results suggest that the share price responses to SWFs’ investment in developed economies are significant, while those in emerging economies are not. In addition, SWFs’ investments in the financial sector have a larger impact on share prices than in the nonfinancial sector. These differences in responses may be due to the relatively more liquid equity markets in developed economies as well as in the financial sector.
Similarly, in an event study, Chhaochharia and Laeven (2008) find that the announcement effect of SWF investments is positive. They report that share prices of firms respond favorably when SWFs announce investments, in part because these investments often take place, and also because the long-run performance of equity investments by SWFs tends to be poor (see Fotak, Bortolotti, and Megginson, 2008, for similar results). Kotter and Lel (2008) show that the cumulative abnormal return of SWF investments has an announcement effect similar to that of investments by hedge funds and institutional investors such as CalPERS on stock returns. In addition, investments by more transparent SWFs have a larger cumulative abnormal return by an order of 3.5 percent, suggesting that voluntary SWF disclosure might serve as a signal device to investors. Similar to Sun and Hesse (forthcoming), Kotter and Lel (2008) also obtain a significant negative but small announcement impact from SWFs’ divestures. Beck and Fidora (2008) conduct a country case study of Norway’s SWF and ask whether its exclusion of companies that violate the ethical guidelines of the Ministry of Finance exhibit price pressures on those companies. Their findings suggest no significant negative abnormal returns following the divesture of these companies.
Overall, these event studies do not find any significant destabilizing effect of SWFs on equity markets. It will be hard to draw conclusions for overall global and regional financial stability or stability in markets other than equity markets from these event studies. Other methods to examine the empirical impact of SWFs would require more detailed knowledge of SWFs’ investments and their timing and amount—data that is presently not available. Hypothetical market responses to SWFs’ investments require a thorough understanding of how asset allocations are constructed and the size, depth, and breadth of the corresponding markets.
To summarize, existing research on SWFs suggests that they can be a stabilizing force in global financial markets. Event studies do not find a destabilizing impact from SWF investments and divestments in equity markets, while simulations of SWF asset allocations only imply a gradual shift with modest economic effects. With SWFs improving their transparency and disclosure over time, the availability of historical SWF transactions would provide researchers with the necessary data to further examine their implications for financial stability.
BeckRoland and Michael Fidora2008“The Impact of Sovereign Wealth Funds on Global Financial Markets”ECB Occasional Paper Series No. 91 (Frankfurt: European Central Bank).
ChhaochhariaVidhi and LucLaeven2008“Sovereign Wealth Funds: Their Investment Strategies and Performance,”CEPR Discussion Paper No. 6959 (London: Center for Economic Policy Research).
FotakVeljkoBernardoBortolotti and WilliamMegginson2008“The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies” (unpublished; University of Oklahoma).
GeorgeR. Hoguet2008“The Potential Impact of Sovereign Wealth Funds on Global Asset Prices,”VisionVol. 3Issue 2 pp. 23–30.
HammerCorneliaPeterKunzel and IvaPetrova2008“Sovereign Wealth Funds: Current Institutional and Operational Practices,”IMF Working Paper 08/254.
KotterJason and UgurLel2008“Friends or Foes? The Stock Price Impact of Sovereign Wealth Fund Investments and the Price of Keeping Secrets,”International Finance Discussion Papers No. 940 Board of Governors of the Federal Reserve System.
KozackJulieDouglasLaxton and KrishnaSrinivasanforthcoming“Macroeconomic Implications of Sovereign Wealth Funds,”IMF Working Paper.
LamRaphael W. and MacroRossiforthcoming“Sovereign Wealth Funds—Risk Sharing and Financial Stress,”IMF Working Paper.