Sovereign Wealth Funds could turn out to be the gorilla in the room, says Dr. Mukul Asher

Dr. Mukul Asher, Professor of Public Policy at the Lee Kwan Hew School of Public Policy at the National University of Singapore, speaks at the last meeting

Sovereign Wealth Funds (SWFs for short) is a new nomenclature and applies to a financial instrument that has become a rage in many parts of the world, in the same way that hedge funds and private equity firms are common in India.

Unfortunately, all three are growing in an uncontrolled manner and no one can put a figure to the humungous amounts of money that they control. While some call SWFs "sexy", others warn that along with hedge funds and private equity firms, "SWFs could be the gorilla in the room".

Does India need SWFs? The answer is both yes and no. Yes, because not going for SWFs would be an opportunity missed. But opting for them would, in a manner of speaking, label India a practitioner of "State capitalism" (which it vehemently insists it is not).

Besides, Indian politicians' (and policy makers') fetish for socialism (euphemistically described as political economy) would prove to be a major roadblock.

These and other interesting points came to the fore at the last meeting when Dr. Mukul Asher, Professor of Public Policy at the Lee Kwan Hew School on the subject at the National University of Singapore, spoke on "Sovereign Wealth Funds".

Dr. Asher, who graduated from the University of Bombay, obtained a Ph.D. in economics from Washington State University and served as a professor in the UK, Sweden, Japan, Australia and now Singapore.

A consultant on tax reforms and social security, he advises the government of India and the State of Gujarat. His forte is research on fiscal and pension reforms and he has worked with the World Bank, the IMF and the Asian Development Bank.

He is an adviser on the editorial boards of several journals, including International Social Security Review, Journal of Financial Regulation and Compliance, IIM-Bangalore Management Review and so on.

To start with, Dr. Asher defined SWFs as "separated pools of assets" which were primarily (though not exclusively) invested internationally. They were owned by governments and were formed for the fulfilment of certain economic, financial and strategic objectives.

Interestingly, just a day before (on April 28), Russia had stated that it would put monies received from the sale of oil into an SWF and try to become a global player of influence by using the fund for strategic purposes.

SWFs were separate from a country's foreign exchange reserves for which well-established norms for investment had been established. Foreign exchange reserves could only be invested in a conservative manner, under established channels. Any central bank that strayed from the path could be pulled up by the Bank of International Settlements, Sorbonne, at the cost of its reputation.

Dr. Asher said the International Monetary Fund (IMF) classified SWFs into five groups:

(1) Stabilisation funds: These were designed in a way that insulated the country's budget and economy against commodity price swings.

(2) Savings funds for future generations: These enabled the conversion of non-renewable assets into a more diversified portfolio of assets and helped mitigate the effects of "the Dutch disease" -wherein "if you've got a lot of resources, your exchange rate appreciates artificially, even though your real economy is not well diversified; and the appreciated exchange rate can then reduce the competitiveness of the rest of the economy".

Some "oil countries", such as Canada and Norway, were adopting this approach

(3) Reserve investment corporations: In such cases, the assets were still counted as reserve assets and were established to increase the returns on reserves, but at a higher risk.

(4) Development funds: Designed to help fund socio-economic projects and infrastructure, these funds usually had a large domestic component.

China had used this rationale to take a rather unusual course. It was using half the funds of the CIC (China Investment Corporation) in order to recapitalise its banks which had nonperforming loans of around 50%.

(5) Contingent pension reserve: The funds were used to finance social security and the health expenditure for rapidly aging populations.

Japan, which was aging very rapidly, had $1,200 billion in pension funds reserves but did not know how to invest it.

"In one of my articles," Dr. Asher said, "I had indicated that if Japan invests the money in such a way that it increases the real rate of return by just 1%, it can delay by about 20 years the exhaustion of $1,200 billion to finance its ageing population over the next four to five decades".

Turning to the vastly expanded scale and scope of activities of SWFs, he said this was a relatively new phenomenon, although the first ones were established many decades ago.

A few people had dubbed SWFs as an important symbol of state capitalism. This was an important point to note because India did not follow state capitalism.

"We have a situation where the private sector is far more dynamic and thanks to it, the country is making progress; the state sector has not always been as dynamic and is not always complementing the work being done by the private sector".

Since there were no robust databases that monitored the financial flows of the SWFs, estimates of their size varied widely. But it was not size that mattered; rather, the order of magnitude and where the money was going to go, that was the crucial factor.

Already, SWFs were worth about $4 trillion ($ 4,000 billion); the Abu Dhabi Investment Authority alone had SWFs of $1 trillion that the State could invest.

Dr. Asher, who had initially described SWFs as .separated pools of assets., said that another identifiable pool was foreign exchange reserves.

'MANY SWFS ARE CONTROLLED BY COUNTRIES THAT DO NOT FAVOUR OPEN
SOCIETIES'

Already, there are SWFs worth $4 trillion and Abu Dhabi owns 25% of them, says Dr. Mukul Asher

This pool was already worth $9 trillion. With governments controlling this massive amount, it was natural for the RBI to be apprehensive about their impact on the international financial system and on the financial stability of a country like India.

Over time, however, the oil-exporting countries" share in SWF would decline and the share of non-oilexporting countries, especially China, would increase. As recently as 2001, China's foreign exchange reserves were a modest $200 billion. Today, China had $1 trillion "all accumulated over the last five or six years".

Putting various figures in perspective, Dr. Asher pointed out that the world's GDP (Gross Domestic Product) was about $48 trillion; the world's stock market capitalization was about $50 trillion; debt securities $70 trillion; bank assets $71 trillion; and bonds, equities, bank assets and everything else, $190 trillion.

Of the $190 trillion, North America alone had $61 trillion and the European Union $70 trillion. Thus, out of $190 trillion, $140 trillion was controlled by the EU and the USA.

Making a passing reference to the "SWF scorecard", Dr. Asher said that as expected from government-run agencies where commercial and economic objectives were not always the most dominant ones, many had a poor ranking in terms of governance, structure, transparency, accountability, communication with the public, and so on.

What were the advantages of SWFs? Why were they becoming popular? They had many benefits. For home countries:

(a) They facilitated inter-generational transfer of proceeds from nonrenewable resources and helped in stabilization;

(b) They permitted consumption and "smoothening" of tax across generations;

("If Japan cannot invest it properly to get a higher rate of return, it will have to levy much higher taxes on the current generation . this will reduce their consumption basket".)

(c) They potentially enabled prudent diversification of assets;

(d) In some countries, a national holding company managed state enterprises and oversaw their acquisition of a strategic stake in key foreign companies, while ensuring that domestic state enterprises and other strategic companies were not acquired by foreign interests ("China is already doing that, so are Singapore, Abu Dhabi, Dubai and so on").

Dr. Asher said that this was where, unfortunately, asymmetry and lack of reciprocity entered the scene.

Many SWFs were controlled by countries that were not very participative or open societies and which placed tremendous restrictions on business within their own borders.

For example, in the Middle East and other countries, it was mandatory to enter into a partnership with a local company. The difficulties foreign companies faced while investing in China.s financial and other resource sectors were also well known.

(f) SWFs could enable a portion of excess foreign exchange reserves to be segregated for pursuing a higher risk appetite and thus obtain higher returns. This could help reduce "the cost of sterilization".

And what was this "cost of sterilization"? When India got more foreign exchange reserves, these had to be invested under established norms and could yield a return of 3 to 4%. However, higher foreign exchange reserves also increased liquidity in the domestic economy. Therefore, the RBI had to issue bonds to soak up the additional liquidity. But on these bonds it had to pay 7 to 8%- and this at a time when the rupee was appreciating! Thus, it was a thoroughly bad bargain . higher foreign exchange reserves fetched 3 to 4%, but the RBI had to finance it by paying 7 to 8% in a currency that was appreciating.

Dr. Asher said this was called the .quasi-fiscal cost.; already, by some accounts, the "quasi-fiscal cost" was close to 1% of GDP "and rising" Both the Ministry of Finance and the RBI were worried about it. But what were the benefits of SWFs for international financial markets?

(i) They facilitated a more efficient allocation of revenue from commodity surpluses across different countries;

Thus, if some countries had a large pool of reserves and if they invested it elsewhere, it allowed for the allocation of revenue. "Unfortunately, the US, by far the richest country, was, because of its macro-economic imbalance, soaking up the rest of the world.s savings". The point to note was that many SWFs were not from high-income countries but low-income, commodity-producing countries like Nigeria.

(ii) SWFs helped recycle current account surpluses and enhanced market liquidity;

In the current scenario of global financial stress, when Citibank, UBS and others needed large funds very quickly, the SWFs were there. A large part of Citibank was now owned by Kuwait and Saudi Arabia; and UBS by Singapore.

iii) They had longer time horizons which could bring stability;

Many SWFs were from countries that were not very accountable and could potentially hold on for a long period.

(iv) They permitted more diversified partnerships with other players such as private equity and hedge funds;

Thanks to the current liquidity issues, private equity and hedge funds were under stress and SWFs had come in very handy; a lot of partnerships had been formed with private equity and hedge funds.

Already, Dr. Asher said, the world .s regulators were concerned about what to do with the private equity and hedge funds that were not very transparent or accountable.

"Now, along comes another very big animal, SWF- and they all partner each other and produce exotic financial products which make the regulator's job even more difficult".

Having enumerated the benefits of SWFs, Dr. Asher listed four major areas of concern:

(A) Global macro-economic stability and sustainability:

Over-consumption by the USA and the mercantilist policies of North- East Asian countries like China had resulted in global macro-economic imbalances.

The continued acquisition of excess reserves by them, combined with policies to keep their currencies undervalued, perpetuated the imbalances and adversely impacted on the financial stability of the rest of the world.

Further, as global micro-economic imbalances rose (inflation was one of the results of that), the burden of adjustment was falling on weaker states- even as countries like China and Japan continued to maintain their undervalued exchange rates.

Dr. Asher said he admired the steps taken by RBI (as a guardian of the conservative financial policies) to maintain financial stability, though it was finding it much more difficult to pursue the goal.

"The Ministry of Finance and the fiscal policies have in many cases not been very responsible and have neither contributed to stability nor to improving the results from the budgetary outcomes. A lot of the money has not been used very effectively".

(B) Transparency and accountability:

The largest share of SWF assets was with countries in which the state played a dominant role both in the society and the economy; moreover, representative institutions for checks and balances were not well established. In these countries, information was regarded as a strategic resource rather than a public good.

Hence, the transparency and accountability concerns were also relevant for the domestic population of SWF countries as these could adversely impact on their welfare.

For example, Nigeria received about $500 billion in oil revenues in three decades, but it had little to show by way of improvement in infrastructure or the social services sector.

This concern was also present in the case of other financial players such as hedge funds and private equities.

(c) Commercial vs. strategic use of SWFs:

There was a perception that not all SWFs had (or would have in future) only portfolio investment on a commercial basis as their main investment objective.

Such perceptions were important, particularly when there were emerging countries requiring adjustment from the current dominant powers.

"We know that the current power balance in the world is undergoing readjustment. This readjustment, history teaches us, has always been a period of stress. Most countries with large SWFs have significant barriers for foreign investors in sectors such as finance, mineral resources and telecommunications.

"Reciprocity is therefore an issue, though some argue that providing SWFs access to recipient countries is advantageous- just as unilateral liberalization is advantageous," Dr. Asher pointed out.

Financial 'innovations' are now very difficult to regulate

(D) Conflicts of interest, potential insider trading and regulatory effectiveness:

Being government agencies, SWFs had access to commercial and security- sensitive information. This could also lead to insider-trading.

In fact, it had already led to massive insider trading around the world and the regulators were unable to check it.

Besides, since SWFs were controlled by governments, prosecuting the officials of foreign governments could pose a diplomatic dilemma, reducing the effectiveness of domestic regulation.

The Chairmen of the US Federal Reserve, the European Central Bank, and even the Bank of England, all of them were wringing their hands over the fact that there was no regulation or supervision over several large financial transactions. Financial "innovations" had moved so far ahead that it was difficult to regulate them.

"Once SWFs become involved- and these are government officials- it's going to be very difficult to prosecute because it becomes a political situation; and when power shifts occur, they could be even more dangerous".

Dr. Asher then turned his attention to recent developments in the field of sovereign wealth funds.

It was becoming clear, he said, that SWFs would become important players in the international financial and capital markets; hand-wringing would not change the reality. Therefore, a code of governance was needed.

Since data on SWFs was not systematically collected, national and international efforts were needed in this direction. Similar data gathering efforts were also needed for hedge funds and private equity.

If one approached the RBI for inflows into SWFs, private equity, hedge funds and so on, it would cut a sorry figure because it was not collecting such data.

The IMF, the World Bank and the OECD had now been asked by G-7 to examine SWF issues and to draw up broad guidelines for both the home and the recipient countries.

In March this year, the IMF set up a work agenda for fund surveillance and for developing a draft on SWF principles and practices, including disclosure, reporting, transparency and governance. India had an important stake in how this process unfolded.

Similarly, the US Treasury had reached an agreement with the SWFs of Abu Dhabi and Singapore on policy principles for SWFs and for countries receiving SWF investments.

In the UK, a "hedge fund working group" and a "private equity working group" were now developing transparency and disclosure codes on a voluntary basis.

But a lot would depend on how the plans were implemented. It would not be easy because there was no enforcement agency.

Germany had taken a novel approach. It had created an agency similar to the Committee on Foreign Investments in the US which would have the right to review and even veto acquisitions by SWFs that could pose a threat to national security or public order.

Acquisitions involving a stake in a German company of more than 25% would come under scrutiny.

But the German law excluded SWFs from other European Union countries. The OECD concurred with this approach, arguing that it struck a reasonable balance between the need to protect strategic sectors from investors with non-commercial objectives and the need to keep markets for investments open.

In India, on the other hand, the regulatory regime governing capital inflows did not recognize SWFs (or even hedge funds and private equity funds) as a distinct category. Their investments were subject only to the overall prudential supervision of the RBI, the FIPB and other agencies.

Which brought Dr. Asher to the crucial question .should India establish SWFs?

He pointed out that India.s foreign exchange reserves as on April 4, 2008, were $312 billion . about 25% of the GDP of 2007.

The reserves had grown primarily through the capital account, for India had been running large trade and fiscal deficits. She also had a negative international investment position (IIP) with liabilities far exceeding assets. These factors made it even more difficult to determine the excess reserves.

Capital flows constituted liability and trade surpluses were the country's real earnings. As such, the capital flows coming in, whether from FIIs, remittances or others, could easily reverse themselves. Hence it was not easy to decide what was an excess reserve and what was a comfortable one.

Thus, India's situation was different from that of commodity-exporting countries and some Asian exporters running large trade surpluses.

India also needed to substantially upgrade its physical infrastructure and invest in agriculture and human resources.

The "quasi-fiscal costs" (the difference between interest earned on foreign reserves and the domestic costs of sterilizing them) were substantial and unlikely to be reduced significantly as it would require aligning India's interest rates with global interest rates.

Thus, while India had to act urgently to reduce its trade deficit (without compromising growth) and tighten fiscal policies, was it desirable to set up a small SWF?

Some analysts believed that India already had one . the India Infrastructure Finance Company (IIFC), a government-owned firm that had set up a subsidiary in London (after acquiring regulatory approval from the UK). It had borrowed $250 million from RBI in foreign currency by issuing it 10-year governmentguaranteed bonds at LIBOR.

IIFC would lend to Indian companies to import capital goods for infrastructure projects in India or cofinance ECBs (external commercial borrowings) in selected areas.

This did address the concern that using reserves domestically could create adverse liquidity and have an inflationary impact. But it could also adversely impact the domestic capital goods sector; and the government guarantees could create a severe "moral hazard problem".

But, Dr. Asher asked, would IIFC's governance be prudent enough to ensure that government guarantees were not misused and the "moral hazard problem" would not ultimately have to be borne by the taxpayer?

He then listed the case for, and against, establishing SWFs in India.

The case for was mixed: If the RBI pursued a more aggressive investment strategy, setting aside 3 to 5% of the reserves (between $10and 15 billion) in SWFs, it could provide enough scale for professional mandates and for development of investment expertise.

It would also make monitoring of investment performance easier. Operating an SWF would enable greater understanding of its complexities and assist in devising measures to better monitor and safeguard foreign SWFs operating in India (giving India the learning curve effect). India would also be able to better participate in international discussions concerning a governance code for the SWFs.

Since India's need for capital was huge and many of its needs would be filled by SWFs, private equities and hedge funds, India had every reason to be part of the main table and the discussions- "but we can only go there if we can say that we have our own SWFs".

What was the case against? There were several challenges to be faced squarely:

(I) The high initial cost of staffing specialized and efficient front and back offices; it could not be left to the civil service or to the RBI" It had to be done by a specialized agency which would have to be paid market rates. Whether the "political economy "would permit market rates to be paid to hire professional staff had to be seen.

(II) Sustaining a governance structure that ensured transparency and accountability.

There was no point in setting up a structure where there was a lot of money, lest it attracted people who were more interested in rent-seeking rather than in performing the mission of the organization.

(III) Managing .the political economy .. India was not a state capitalist economy; it had checks and balances.

Dr. Asher recalled the furore over the privatisation of Centaur Hotel near Bombay Airport. Even though it was all above board and nothing untoward was found, "it wasted a lot of energy because the political economy is so immature".

(IV) It could distract from the urgent need to address trade imbalances, fiscal consolidation and infrastructure and human resource development needs.

When something was touted as "sexy", people thought that it was the panacea for all ills. If SWFs were indeed set up, then it was likely that problems would be addressed. But would that really be the case?

Therefore, Dr. Asher suggested, it was best to think of creating SWFs as part of a conscious effort; and after accepting that India, in a dynamic sense, was a rising power and had a need to understand SWFs; then, it would be easier to get on the learning curve, be at the table, learn some more risk appetite and use some of it.

India would face a problem of plenty in another 25 to 30 years when its pension sector assets would grow from 15% of GDP to 50% of GDP. It would yield a huge amount of assets which the country would not be able to absorb domestically. India had to understand how to invest it properly elsewhere in the world, perhaps through SWFs.

"Our mindsets and our political economy can act as constraints," Dr. Asher added.

Answering questions, he told PP Arun Sanghi that some estimates about the investment in hedge funds placed it at $2 to $3 trillion. But in many cases leveraging was done on a very small capital base (this was at the root of the sub-prime crisis).

'Don't worry, India is not going to fall apart tomorrow'


Putting his point across. Dr. Mukul Asher answers questions at the end of his talk at the last meeting. At right is President Dr. Rumi Jehangir

Private equity and hedge funds had grown very big in size, but the element of secrecy allowed even insiders to make only guess-estimates. But it was true that the "gearing ratio" and leveraging had been huge.

"We have these two players about whom we don.t understand enough and now we've got a new player who's going to be a gorilla in the room in terms of the amounts we are talking about. when these three get together and create sophisticated products, the kind of leveraging and the kind of impact they have will be huge.

"That's what is happening right now; these companies are acquiring some of the icons among western banks and others. When a private equity firm wants to acquire some of the icons, it goes to an SWF in Abu Dhabi, Qatar, Kuwait or Saudi Arabia.. someone will write a cheque.

"We are trying to put them under some sort of perspective, some international responsible governance code. The game has gone too far to do anything else except to start setting up a code for responsible behaviour and to ensure that if something were to happen, then they would also lose in terms of their reputation and commercial viability".

PDG Manibhai Doshi wondered how India could set up SWFs with its foreign exchange reserves which, after all, were borrowed. How could one invest other people's money?

Dr. Asher asked him to keep in mind one fact . "India is not going to fall apart tomorrow. India's story is a good one. We have to keep on making efforts to make it a better one".

In 1991, India had $1 billion in reserves; today, it had $312 billion "and growing" The RBI was doing everything it could to prevent it from going very high.

This was the effect of liberalisation on companies, on individuals, of investing abroad and so on. Besides, RBI had the right approach, that of not growing too fast. But India faced other problems as well, viz., that a lot of things were no longer in the central bank's control, the 'quasifiscal costs' were growing and new players were coming in.

After the Pokaran N-blasts of 1998, the India Development Bonds had raised $5 billion almost overnight. Today, raising $10 billion would not be difficult. Therefore, setting aside $9 to $15 billion (3 to 5% of reserves) as a conscious "learning tool" would go a long way in coping with the problems of tomorrow.

The RBI Governor had said in Washington that SWFs could be set up; but he did not want RBI to handle it, he favoured a specialised agency.

"We have to work our own organisational problem, money is not our problem".

When Pranay Vakil asked what the rupee-dollar parity rate would be a few years down the line, Dr. Asher said he would be very rich if he could predict that.

Pranay changed tack and said he was asking because 56% of the GDP was coming from the services sector and IT and ITEs were playing a major role in it. Since they were dependent for nearly 70% of their earnings on dollars, fluctuations in the US currency could work either for India or against it.

Dr. Asher begged to differ on some facts. .Services. was a large, heterogeneous basket, he said. India.s international trade in goods and services together was about $520 billion and could soon reach $1 trillion. The new credit policy had set a target of $200 billion in just merchandise trade.

In the "services" sector, IT services earned between $35 and $45 billion. Therefore, it was not right to say that it was 56% of GDP . India's GDP was $1.2 trillion.

Even in employment, the number of people working in the entire IT industry was less than two million, after taking into consideration those indirectly employed. India.s labour force was 500 million people.

The rupee exchange rate was not driven by IT considerations, though some policies of RBI took into account the impact on the IT sector.

"IT is very visible... it is significant qualitatively in giving confidence in terms of what we can do. But we need to be competitive and competent across a wide range of manufacturing, services and, above all, in agriculture. That will give us a far more solid base.

"Besides, the IT sector is resilient" Look at where they were five to seven years ago and where they are today and how globalised they have become. They will find new niches; they will find new ways.

"The idea that India means cheap"  we've got to get that out. We've also got to start earning our unit value to that, because the indirect effect of thinking of India as cheap also means that our people don.t always get their due when they are canvassing for professional work, either within the country or outside".

Burjor Poonawala wondered why all transactions were invariably linked to the dollar which was depreciating all the time; with the fluctuations in all currencies, did it not result in a loss to the funds?

Dr. Asher said historically the US dollar and the UK pound had coexisted, with the latter going down and the former rising. But they played a significant role. The predominance of the US currency was an unusual post-World War II phenomenon which was being corrected only now.

"But, reserve currencies do not just disappear overnight. They take decades . There are different ways in which the correction is likely to occur, different people will take different views and the US itself has selfcorrecting tendencies. So it is very premature to write off the US and say that it is going down.

"It is good that at least with respect to the rupee we now have a two-way expectation.... that the rupee can appreciate or depreciate against the dollar. Five or ten years ago, at every business meeting (the first comment was that) the rupee will depreciate by 5 to 7% against the dollar. That was our baseline expectation. The fact that that is not the case any longer, is progress .

"Yes, people are worried about what is happening to their assets, if they are in dollars. But increasingly we must look at hedging possibilities. Part of the problem is the low negative interest rates around the world".

Dr. Asher revealed that in China fixed deposits gave a return of 2%; in Singapore, 1%. But the inflation rate was 7 to 8%. Therefore, there was a huge 7 to 8% negative rate of return- this had to go somewhere, it had to chase after a different type of asset.

These and other fundamental macro-economic global imbalances had to be worked on. It would take some time, perhaps a decade or more. It was not going to be easy, he added.

In proposing the vote of thanks, Subrata Mitra struck a somewhat cynical note.

He seemed upset with the shenanigans of politicians who wasted their time over trivialities. In the midst of their absurdities, he said, if Dr. Asher talked about sovereign wealth funds being "sexy", there was a fear that these would be equated to cheerleaders and bar dancers.

"They are experts in that" I don't think SWFs will be allowed by our ethical and political standards". Subrata recalled that he wrote about the appreciating rupee and the new opportunities that it had spawned in a leading financial business magazine six months ago.

He wrote against the spoonfeeding and molly-coddling resorted to earlier and suggested that it was time to take a serious look at sovereign wealth funds in view of the huge foreign exchange reserves.

Strangely, the Editor-Publisher chopped off some of his lines, saying he did not agree with the views. At this, Subrata said, he had told him, "It's none of your business to agree. Let the readers judge".

Upset with that Editor-Publisher, he had written another article on private equity and alternative investments; it had appeared in a Hong Kong magazine- which paid serious money and did not chop words.

Knowing the decision-making process in the country, he said, he could guarantee that no decision would be taken on SWFs.

"We are working backwards in every way in reforms and the political process for reforms. Indecision and the lack of leadership on many fronts, at various levels including the central bank which has slowed down reforms seriously in the banking industry" I don't think SWFs will come. I can take a bet on that".

He also expressed regret over the fact that most of the public sector companies, the Navratnas with huge resources and surpluses, had lost out on several international opportunities which the private sector was now taking.