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Corporate Sep 8, 2011

Sovereign Wealth Funds: Who, what, where and why

By Firstbiz Editors

Recently, media reports suggested that India was debating the pros and cons of creating a sovereign wealth fund (SWF). Earlier this month, Thailand's finance minister also suggested that the country could use some of its $189 billion in foreign reserves to set up a SWF to invest in regional infrastructure deals.

But what exactly are SWFs? While they handle billions in public money, very little is known about these funds. For example, can you name the world's biggest sovereign wealth fund? How about their funding sources? Or, what is the region that accounts for the maximum number of sovereign funds?

For answers to these questions and more, here is an our quick guide to SWFs.
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What are sovereign wealth funds?

A sovereign wealth fund is an investment fund owned by the state. Typically, these funds put money in different financial assets such as stocks, bonds, real estate and gold. The money of SWFs comes from different sources. Some funds invest wealth from fiscal (government) surpluses or foreign currency reserves, while the wealth of other SWFs can be from revenues generated from oil and other commodities.

Are SWFs a new phenomenon?

Not really. Singapore's Government Investment Corporation (GIC), which has been around since 1981, is often acknowledged as the pioneer of SWFs. Government-created funds have existed for a long time. However, the modern-day versions differ from the older versions such as Calpers, which is a US government pension fund investing in long-term assets. The difference between Calpers and other SWFs like GIC is that the proceeds go to pensioners, not governments.

What are the goals of SWFs? How different are they from foreign exchange reserves?

SWFs aim to generate returns over maintaining liquidity, so they are able to tolerate higher levels of risk than traditional foreign exchange reserves. Reuters

A country's central bank manages foreign exchange reserves, but these are conservatively invested and aimed at providing liquid funds for crisis management and market intervention rather than good long-term returns. In contrast, SWFs aim to generate returns over maintaining liquidity, so they are able to tolerate higher levels of risk than traditional foreign exchange reserves.

In addition, SWFs may also have other goals such as protecting and stabilising the budget and economy from excess volatility in revenues or exports, diversifying from non-renewable commodity exports and ensuring sustainable long-term capital growth.

What are the implications of SWFs?

To some experts, the emergence of sovereign wealth funds represents a fundamental shift in the reasons governments invest money. "To the extent governments have traditionally held investment assets, it was to protect domestic currencies and banks from crisis," the Economist magazine said some time ago.

However, today's SWFs act far beyond this agenda. In the past, finance ministries have typically invested in their foreign currency reserves in US Treasury bills and other risk-free bonds issued by wealthy countries. SWFs provide countries with a broader range of investment options. This, experts say, could facilitate a gradual shift away from investments in US government-backed assets like Treasury bills and in the dollar.

What are the biggest concerns about SWFs?

SWFs are, in general, not very transparent about their dealings, as a result of which they arouse both suspicion and concern about their investing intentions among the public. One of the biggest fears is whether the investments of SWFs are driven purely by commercial sense or partly by political agendas. For example, in the US, any investment by Chinese state-owned companies or funds has often been thought as an attempt by the Chinese to gain indirect exposure to advanced Western technologies. There are also fears about the power they wield if they start exercising the power they have as shareholders in foreign companies. Over the past few years, however, they have made some efforts to convince people that they are not acting on behalf of their governments.

Are SWFs governed by any international law?

In 2008, operating principles were created for wealth funds to assure countries that they would act for economic gain, and not on behalf of their governments. Called the Santiago Principles, they are a set of rules that dictate that funds should invest on the basis of financial returns and have transparent structures. However, these rules are voluntary for the members of the forum.

What are the biggest SWFs?

More than 40 percent of SWFs originate in Asia, while about 35 percent of them hail from the Middle East. The largest SWF in the world is the UAE's Abu Dhabi Investment Authority, with a whopping $627 billion in assets. That is followed byNorway's Government Pension Fund - Global ($517 billion) andChina's SAFE Investment Company ($568 billion).

In late 2007 and early 2008, particularly as the price of oil and other commodities surged, many sovereign wealth funds swelled.Overall, the total reported assets of the top SWFs are currently more than $4.7 trillion, according to the Sovereign Wealth Fund Institute.

What are the implications of SWFs for governments and businesses?

The gradual rise of sovereign wealth funds could, in theory, be broadly positive. More efficient government investment potentially means more government money.For the companies being purchased, and the countries in which they are located, capital inflows can also be a net positive. As a policy paper published by the University of Pennsylvania's Wharton Business School pointed out, Abu Dhabi's November 2007 investment in the US banking giantCitigroup was widely cheered as a boon--much needed liquidity at a time when global credit was stretched thin and the financial sector was struggling.

by Firstbiz Editors

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