Reading 4.4

Question 1

SWFs have experienced significant growth and are becoming some of the largest investors in traditional and alternative investments. Since 2008, SWFs’ assets increased by more than ____; and, in 2021, SWFs managed over ___ in assets (of which over ____ was in alternative assets), which exceeds the total assets under management of both the hedge fund and private equity industries.

Answer 1

$4.4 trillion

$9 trillion

$1.6 trillion

Question 2

What is the balance of payments (BOP) of a country?

The BOP is composed of two accounts, what do they measure:

Answer 2

It is a record of its transactions and cash flows associated with its foreign transactions in a given period (e.g., over a quarter or a year).

1. Capital account - measures investment flows (i.e., change in asset ownership) of purchases and sales of foreign assets and debt.
2. Current account - measures trade in goods and services, investment income, and gifts (e.g., foreign aid). Components include commodities and manufactured goods and services.

Question 3

A country with a capital account surplus has more ___

Answer 3

imported capital than exported capital

Question 4

What is China’s and USA’s capital/current account make up?

Answer 4

China has a current account surplus and a capital account deficit since it exports more than it imports and uses the proceeds to buy foreign assets

U.S. has had a current account deficit and a capital account surplus for some time, since it buys more imported goods/services than it exports. The excess consumption is financed by U.S. residents selling assets or borrowing money.

Question 5

In a country with a current account deficit, the value of imports of goods and services ___ that of exports, so more money ___

Answer 5

exceeds

leaves the country to buy goods/services than comes in from the sales thereof.

Question 6

How are current account deficits typically funded?

Answer 6

with capital account surpluses

Question 7

central bank’s reserve account maintains its

Answer 7

central bank’s reserve account maintains its foreign currency holdings and is the sum of the capital and current accounts.

Question 8

Countries with floating exchange rates that have capital account surpluses generally have ___

The currency market brings the two accounts into equilibration by adjusting ____

Answer 8

offsetting current account deficits in a given year, keeping the reserve account stable.

currency prices to make imports of goods and exports of capital equally attractive.

Question 9

Gwartney et al. (2003) explain that a country’s currency tends to appreciate in value when the country has the following 5 characteristics:

Answer 9

1. Lower inflation rate than its trading partners
2. Higher real interest rates than its trading partners
3. Policies that attract capital inflow
4. Slower income growth than its trading partners that reduces demand for imports
5. Competitive or comparative advantage in export-oriented industries

Question 10

What are the 2 potential risks for countries with a current account deficit (more imports than exports) combined with a capital account surplus (more foreign investment than domestic investment):

Answer 10

1) Foreign Investment Reliance: The country relies on continued foreign investment to maintain its capital account surplus. If foreign investors suddenly decide to withdraw their money, it could cause the currency to depreciate (lose value) and lead to financial difficulties.

2) Current Account Strain: A persistent current account deficit can put pressure on a country’s long-term economic health. If the gap between exports and imports isn’t sustainable, the country may eventually struggle to pay for its imports.

Question 11

Revenues of many countries are closely tied to oil prices because either their oil companies are state owned or the state receives tax revenues on sales of energy commodities.

Commodity exporting countries have three key concerns regarding tax revenues.

Answer 11

1. Volatile oil prices produce an unstable income stream, which is incompatible with generally stable government spending.
2. Commodity revenues will eventually experience depletion since commodities cannot last forever.
3. Governments prefer not to rely primarily on commodity revenues, but prefer to have a diversified economy that also generates tax revenues from other industries ( e.g., technology and tourism).

Question 12

4 types of SWFs:

Answer 12

1) Stabilization Funds - countercyclical, accumulating excess revenues during
periods of high commodity prices and distributing the savings during periods of low commodity prices

2) Savings Funds - once a reserve adequacy standard has been met, a sovereign wealth savings fund with a total return objective is created. Also establish spending rates so that income can be available for future generations and the fund’s corpus can be maintained or increased.

3) Reserve Funds - used to meet future obligations (pension reserve fund or reserve investment fund)

4) DEVELOPMENT FUNDS - established to allocate resources to socioeconomic
projects

Question 13

Central banks use the reserves from their Stabilization funds for 3 purposes:

Answer 13

i. To implement monetary policy by changing interest rates by trading fixed-income securities.

ii. To intervene in the foreign exchange market, either to keep a currency at a fixed rate or to move a floating currency toward a desired level.

iii. To provide liquidity to prevent crises in the banking system

Question 14

3 types of rules on the amount of commodity revenues transferred into SWFs by Alsweilem et al. (2013)

Answer 14

i. Fixed percentage rule - fixed percentage of commodity revenues (e.g., 15%) is transferred to the SWF. This transfer is procyclical (i.e., the government receives higher revenues during times of higher commodity prices and lower revenues during times of lower commodity prices) and the easiest rule to implement.

ii. Hurdle price rule - all commodity revenues above a hurdle price (e.g., $65 per barrel for oil) are transferred to the SWF.

This approach saves windfall revenues received during good times (it does not necessarily release stabilization funds into the government budget during periods of low commodity prices).

iii. Deviation from moving average rule - Commodity revenues that exceed a moving-average revenue are transferred to the SWF, while revenues below a moving-average revenue move proceeds out of the SWF into the government budget.

Question 15

Describe the 2 potential conficts that Development funds may face:

What is the solution to the conflicts?

Answer 15

1) government agencies responsible for developing infrastructure may not advance projects, expecting instead a SWF to develop the infrastructure.

2) Development funds should select projects or investments based on financial assessment, only financing projects/investments with the greatest chance of success or profit potential; selections should not be made based on personal relationships.

They should be separated from government agencies and any political pressure.

Question 16

There are 4 common motivations that may result in a SWF being established:

Answer 16

1. To protect a country’s economy from a decline or volatility in revenues.
2. To help monetary authorities counter unwanted liquidity.
3. To grow for future generations, particularly if the surplus was driven by a condition that may reverse or become depleted.
4. To invest in infrastructure or economic growth projects to improve a sector of the economy or grow an industry (particularly to diversify away from commodity revenues).

Question 17

According to Preqin (2016), more than ___% of SWFs invest in alternative investments.

Due to the SWFs’ size and long holding period, investors tend to make direct rather than pooled investments, especially in ____ .

Answer 17

75%

infrastructure and real estate

Question 18

Asset Allocations of SWFs by type of fund

Answer 18

Question 19

Converting proceeds from large commodity sales into the local currency
may have two adverse effects:

Answer 19

1. Inflation - if the money supply grows faster than the availability of goods in the local economy.
2. Dutch disease - a large foreign currency inflow (e.g., from a commodity sale) that negatively affects a country’s other sectors (e.g., manufacturing or agriculture) by making them less price competitive on the market

Question 20

Discovery of a tradable natural resource (dutch disease) or a significant rise in the price of a natural resource has 2 major effects that result in making the manufacturing and export sectors less competitive and may result in their de industrialization:

Answer 20

i. It increases wages by shifting workers from other sectors to the commodity sector. It may also shift the focus of entrepreneurs and industry leaders to opportunities related to the export of the commodity.

ii. The value of the local currency increases due to large inflows of cash.

Question 21

What is Sterilization?

Answer 21

It is a macroeconomic policy used by many countries that involves countering the effects of an economic event (e.g., commodity boom) and a BOP surplus on the country’s economy.

Question 22

There are two forms of sterilization:

Answer 22

1. Sell domestic currency & buy foreign currency: The central bank of a country with a trade surplus that wants to prevent its currency from appreciating can sell its domestic currency and buy foreign currency to meet the increased demand for domestic currency by foreign importers of its products.
2. Invest revenues abroad - A country may accumulate significant reserves from revenues from sales of natural resources that are controlled by the government. Since spending the revenues in the local economy may disrupt the economy and appreciate the currency, the government may invest a portion of the commodity proceeds abroad. For example, Norway may invest some of its sovereign assets in German euro-denominated securities so as not to disrupt its local economy and to prevent the appreciation of its currency

Question 23

What is a conservative investment opportunity cost, how can it occur in a SWF and what are the solutions to the problem (which can only be done after what)?

Answer 23

After a period of high commodity prices, a stabilization fund may end up being unnecessarily large and subject to a sizeable conservative investment opportunity cost due to its concentration in cash and liquid fixed-income investments.

The solution would be to start investing in risky assets and creating a total return portfolio, however, only after its reserves reach a reserve adequacy level.

Question 24

How is a reserve adequacy level measured?

Answer 24

The appropriate size of the reserves is measured relative to the size of potential shocks (e.g., changes in commodity prices, trade or investment flows, or losses in the banking sector).

Question 25

What are the findings on the impact that SWFs have on the companies they invest in?

Avendano and Santiso (2011) & Megginson and Fotak (2015)

Answer 25

1) Avendano: most SWFs have little interest in controlling their portfolio
companies

2) Megginson:
- Public stocks purchased by SWFs exhibit positive abnormal returns around the acquisition announcement date, but the returns decline over subsequent years.
- SWFs’ investments in distressed firms trigger a decline in the firms’ credit risk. This may be due to the assumption that, if necessary, SWFs’ governing countries will bail out the distressed firms to prevent them from declaring bankruptcy

Question 26

10 principles of the Linaburg-Maduell Transparency Index:

What is the minimum rating out of 10 to be considered adequately transparent?

Answer 26

1. Provides history including reason for creation, origins of wealth, and government ownership structure.
2. Provides current, independently audited annual reports.
3. Provides ownership percentage and geographic locations of company holdings.
4. Provides total portfolio market value, returns, and management compensation.
5. Provides guidelines for ethical standards, investment policies, and enforcement of guidelines.
6. Provides clear strategies and objectives.
7. Identifies subsidiaries and contact information, if applicable.
8. Identifies external managers, if applicable.
9. Manages its own website.
10. Provides main office address and contact information (e.g., telephone).

Minimum rating is 8/10

Question 27

Santiago Principles consist of generally accepted principles and practices (GAPP) of good governance of SWFs, with which 24 countries have voluntarily agreed to comply. The Principles, established by the International Working Group of SWFs (2008), promote good governance, transparency, accountability, careful investment practices, and more thorough understanding of SWF activities

What are the 9 principles?

Answer 27

1. Clear investment policy
2. Diligence, prudence, and skill in investment practices
3. Robust risk management framework
4. Refraining from pursuit of objectives other than maximization of risk-adjusted returns
5. Public disclosures of general approach to voting and board representation
6. Not seeking advances of privileged information
7. Description of use of leverage or disclosure of other financial risk exposure measures
8. Execution of ownership rights consistent with the SWF’s investment policy
9. Transparent and sound operational control and risk management system

Question 28

Card 1 (Front): What is the purpose of Norway’s GPFG?

Answer 28

Card 1 (Back): To save oil revenues from the North Sea for the benefit of future generations of Norwegians.

Question 29

Card 2 (Front): How does Norway’s GPFG differ from some other SWFs?

Answer 29

Card 2 (Back): Norway’s oil revenue is not its main income source, so the GPFG focuses on long-term savings, not stabilizing the economy like some SWFs heavily reliant on oil.

Question 30

Card 3 (Front): How is the GPFG’s investment strategy unique?

Answer 30

Card 3 (Back): The GPFG is a large, diversified fund with a high percentage of liquid assets managed internally at low costs. It mainly invests in stocks and bonds but plans to increase real estate holdings.

Question 31

Card 4 (Front): Why does the GPFG invest abroad?

Answer 31

Card 4 (Back): To avoid conflicts of interest and the challenges of managing large domestic investments.

Question 32

Card 5 (Front): How does Norway use the GPFG’s income?

Answer 32

Card 5 (Back): The government transfers 4% of the fund’s value each year to the budget, aiming for a balanced budget with this income as a stable source.

Question 33

Card 6 (Front): What is the long-term goal for the GPFG?

Answer 33

Card 6 (Back): To generate a 4% real return, allowing the fund’s real value to be maintained indefinitely for future generations even after oil reserves are depleted.

Question 34

Card 7 (Optional, Front): What is the current status of Norway’s oil production?

Answer 34

Card 7 (Optional, Back): Production has declined since 2000 and may be exhausted in about 20 years.

Question 35

Card 8 (Optional, Front): How is the GPFG a model for transparency and governance?

Answer 35

Card 8 (Optional, Back): It publishes detailed annual reports on its investments, risk management, governance, and responsible investing practices.

Question 36

Card 9 (Optional, Front): Does the GPFG have any investment restrictions?

Answer 36

Card 9 (Optional, Back): Yes, it is prohibited from investing in certain industries or companies deemed unethical or environmentally harmful.

Question 37

Question 1: What is the main purpose of China Investment Corporation (CIC)?

Answer 37

Answer: The CIC functions as a reserve investment fund for China, aiming to earn higher returns on the country’s foreign exchange reserves.

Question 38

Question 2: How does the CIC’s investment strategy differ from Norway’s GPFG?

Answer 38

Unlike Norway’s GPFG with a diversified, liquid portfolio, the CIC focuses on concentrated investments with a large private equity allocation and significant exposure to external management. It also prioritizes real assets for inflation and currency hedge purposes, and invests more in private equity and direct investments (resources, infrastructure) compared to public equities.

Question 39

Question 3: Briefly describe the roles of China’s three export-based SWFs.

Answer 39

1) State Administration of Foreign Exchange (SAFE): Acts as a stabilization fund, seeking high returns with riskier investments and offering little transparency.

2) China Investment Corporation (CIC): Functions as a reserve investment fund, aiming for higher returns on foreign exchange reserves.

3) National Social Security Fund: Presumably invests funds for social security purposes (details not provided in the passage).

Question 40

Question 4: What are some concerns regarding CIC’s investment practices?

Answer 40

Answer: Global concerns include potential political influence in its investments (e.g., oil and gas) and potential conflicts of interest. For instance, the CIC has hired firms it previously invested in to manage some of its holdings, and it holds board seats in some corporations.

Question 41

Question 5: When was the CIC established, and how does it compare to SAFE in terms of asset size?

Answer 41

Answer: The CIC was established in 2007 and manages considerably more assets than SAFE ($747 billion vs. $474 billion).

Question 42

Question 1: How does Temasek Holdings differ from Singapore’s other SWF, the Government Investment Corporation (GIC)?

Answer 42

Answer: GIC focuses on maximizing returns through a globally diversified portfolio of liquid assets, while Temasek Holdings is a development fund prioritizing job growth and economic development in Asia through targeted investments.

Question 43

Question 2: What is the funding source for Temasek Holdings, and what are its main objectives?

Answer 43

Answer: Temasek Holdings is funded by proceeds from private sales of government assets. Its primary objective is employment creation and economic development in Asia, with some investment returns paid as dividends to the Singaporean government.

Question 44

Question 3: How does Temasek’s investment strategy differ from a typical SWF?

Answer 44

Answer: Unlike most SWFs that hold minority stakes, Temasek has a geographically concentrated portfolio with significant investments in Singapore and Asia. It focuses on public and private equity, including owning entire companies (e.g., Singapore Airlines) and holding large stakes in others

Question 45

Question 4 (Optional): Briefly describe the investment focus of Temasek Holdings based on the passage.

Answer 45

Answer: Temasek prioritizes sectors that drive a knowledge-based economy, with a focus on financial services, transportation, industry, consumer goods, real estate, and technology, media, and telecommunications sectors.