Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia

Park, Donghyun Working Paper Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia ADB Economics Working Paper Series, No. 129 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Park, Donghyun (2008) : Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia, ADB Economics Working Paper Series, No. 129, Asian Development Bank (ADB), Manila, https://hdl.handle.net/11540/1786 This Version is available at: https://hdl.handle.net/10419/109319 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/3.0/igo ADB Economics Working Paper Series Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia Donghyun Park No. 129 | October 2008 ADB Economics Working Paper Series No. 129 Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia Donghyun Park October 2008 Donghyun Park is Senior Economist in the Macroeconomics and Finance Research Division, Economics and Research Department, Asian Development Bank. Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org/economics ©2008 by Asian Development Bank October 2008 ISSN 1655-5252 Publication Stock No.: The views expressed in this paper are those of the author(s) and do not necessarily reflect the views or policies of the Asian Development Bank. The ADB Economics Working Paper Series is a forum for stimulating discussion and eliciting feedback on ongoing and recently completed research and policy studies undertaken by the Asian Development Bank (ADB) staff, consultants, or resource persons. The series deals with key economic and development problems, particularly those facing the Asia and Pacific region; as well as conceptual, analytical, or methodological issues relating to project/program economic analysis, and statistical data and measurement. The series aims to enhance the knowledge on Asia’s development and policy challenges; strengthen analytical rigor and quality of ADB’s country partnership strategies, and its subregional and country operations; and improve the quality and availability of statistical data and development indicators for monitoring development effectiveness. The ADB Economics Working Paper Series is a quick-disseminating, informal publication whose titles could subsequently be revised for publication as articles in professional journals or chapters in books. The series is maintained by the Economics and Research Department. Contents Abstract v I. Introduction 1 II. Asia’s Excess Foreign Exchange Reserves: The Basic Facts 3 III. Underlying Nature of Asia’s Foreign Exchange Reserves and the Role of Reserves in Domestic Financial Systems 8 A. Fiscal Reserves versus Central Bank ReservesA. Fiscal Reserves versus Central Bank Reserves 9 B. Central Bank Reserves and the Balance Sheets of Commercial Banks 9 IV. Sovereign Wealth Funds in Asia 11 V. Risks Facing Asia’s New Sovereign Wealth Funds 13 A. Political Economy Risks 1A. Political Economy Risks 14 B. Risks Arising from Inadequate Institutional Capacity 15 C. Moral Hazard Risks 15 D. Fiscal Risks 16 E. Transparency and Accountability Risks 16 F. Financial Protectionism Risks 16 G. Risks Arising from Noncommercial Motivations 17 VI. Risks from Asia’s Sovereign Wealth Funds to Its Financial Systems 17 VII. Concluding Observations 19 References 21 Abstract Sovereign wealth funds (SWFs) are emerging as developing Asia’s main policy tool for handling the region’s excess foreign exchange reserves. SWFs represent a strategic shift of excess reserves from low-risk, low-return investments to high-risk, high-return investments, and are subject to a wide range of downside risks. The underlying nature of Asia’s reserves, which are the consequence of the central bank’s purchases of foreign exchange, means that those reserves have counterpart liabilities in the commercial banks that form the backbone of the region’s financial systems. This suggests that the realization of SWFs’ downside risks may have serious adverse effects on the region’s domestic financial stability. The broader implication is that the transformation of Asia into a major exporter of capital raises the possibility that capital outflows can also be a direct source of financial instability in the region. Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia | 7 There are two other well-known reserve adequacy measures: the reserves-to-M2 ratio and the months of imports that reserves can pay for. The higher the reserves-to-M2 ratio, the greater the extent to which the risks of crisis-provoking domestic capital flight are covered, and hence the lower the probability of a crisis. The suggested critical values range from 5% to 20%. Figure 5 indicates that the reserves–M2 ratio is either above or close to the upper limit of the 5–20% range for Asia’s biggest reserve holders. The import cover measure is based on the intuition that reserves reduce vulnerability to current account shocks such as higher oil prices for an oil importing-economy. The suggested critical value is usually 3–4 months. Figure 6 shows that reserves can cover well above 4 months of imports in the region’s biggest reserve holders. Figure 5: Ratio of Foreign Exchange Reserves to M2 in Developing Asia’s Top 10 Reserve Holders, 1990–2006 1990 1992 1994 1996 1998 2000 2002 2004 2006 1.0 0.8 0.6 0.4 0.2 0 Source: Asian Development Outlook database. China, People's Rep. of Hong Kong, China India Indonesia Korea, Rep. of Malaysia Philippines Singapore Taipei,China Thailand 8 | ADB Economics Working Paper Series No. 129 Figure 6: Imports Covered by Foreign Exchange Reserves in Developing Asia’s Top 10 Reserve Holders, 1990–2006 1990 1992 1994 1996 1998 2000 2002 2004 2006 20 16 12 8 4 0 Source: Asian Development Outlook database. China, People's Rep. of Hong Kong, China India Indonesia Korea, Rep. of Malaysia Philippines Singapore Taipei,China Thailand III. Underlying Nature of Asia’s Foreign Exchange Reserves and the Role of Reserves in Domestic Financial Systems In this section, we briefly look at the underlying nature of Asia’s reserve accumulation and its relationship with the domestic financial system. By and large, Asia’s reserves are the consequence of foreign exchange purchases by the central bank. Those purchases have an impact on the balance sheets of commercial banks. The link between the central bank’s foreign exchange purchases and commercial banks’ balance sheets is ultimately what explains the transmission of risks stemming from the activities of SWFs to the domestic financial system. Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia | 9 A. Fiscal Reserves versus Central Bank Reserves According to a conceptually useful dichotomy introduced by Hildenbrand (2007), foreign exchange reserve accumulation can be classified into two types: (i) accumulation based on government budget surpluses, profits of state-owned companies, or other government net income; and (ii) accumulation based on foreign exchange market interventions by central banks within the context of current account surplus and/or capital inflows. A classical example of the first type is oil revenues accruing to the governments of oilproducing countries such as Saudi Arabia. A classic example of the second type is the PRC central bank’s purchase of foreign exchange that the PRC companies earned by exporting manufacturing products. Let us define the first type of reserves as fiscal reserves and the second type central bank reserves. A critical difference separates fiscal reserves and central bank reserves in terms of the balance sheet of the consolidated public sector, i.e., government plus central bank. Fiscal reserves are net assets in the sense they do not have any counterpart liabilities in the balance sheet. By contrast, central bank reserves have counterpart liabilities in the form of bonds or currency. Asia’s reserve build-up reflects central bank reserves and thus do have counterpart liabilities. Whether the reserve build-up reflects fiscal reserves or central bank reserves, it reflects a balance of payments surplus. It is conceptually useful to distinguish among three main types of balance of payments surplus: (i) resource-based current account surplus based on natural resource export revenues; (ii) nonresource current account surplus based on exports of manufactured goods and services; and (iii) financial account surplus, i.e., capital inflows from abroad. For the region as a whole, the external surplus is predominantly Type 2, in some cases augmented by Type 3, rather than Type 1. B. Central Bank Reserves and the Balance Sheets of Commercial Banks To repeat, Asia’s foreign exchange reserves are the consequences of foreign exchange purchases by central banks. A hypothetical example will clarify the effect of central bank reserves on the balance sheets of commercial banks. Suppose that Hyundai, a Korean conglomerate, exports US$80 billion and imports US$50 billion. The firm has earned more than it spent, so it is in effect saving and thus adding US$30 billion to its net wealth. Korea’s national net wealth has unambiguously increased. In terms of Hyundai’s balance sheet, the US$30 billion is a foreign currency asset, as follows: Hyundai Assets Liabilities US$30 billion 10 | ADB Economics Working Paper Series No. 129 Instead of investing the US$30 billion abroad in assets such as a US dollar deposit account, Hyundai brings its US dollars home and exchanges them for Korean won at a commercial bank, e.g., the Korea Exchange Bank (KEB), and opens a won deposit account at KEB. Hyundai’s transactions affect KEB’s and its own balance sheet as below. Hyundai may have opened a dollar deposit account instead, but that does not affect the analysis. KEB Assets Liabilities US$30 Korean won deposit 30 Hyundai Assets Liabilities Korean won deposit 30 The Korean central bank, the Bank of Korea (BOK), decides to add to its stock of foreign exchange reserves by purchasing US$30 billion from KEB. BOK initially purchases the US dollars with Korean won it issues. The US$30 billion dollars’ worth of won expands the monetary base and is thus inflationary. Central banks typically try to sterilize the inflationary expansion of the monetary base by selling bonds, and BOK is no exception. For the sake of simplicity, let us assume that BOK sells those sterilization bonds to KEB. In effect, BOK has borrowed US dollars from KEB, and their balance sheets are affected as below. In most Asian countries, commercial banks do in fact play a central role in the foreign exchange market. KEB Assets Liabilities Sterilization bonds 30 Korean won deposit 30 BOK Assets Liabilities US dollars 30 Sterilization bonds 30 The central bank may manage all foreign exchange reserves, including excess reserves, on its own. However, as noted above, the regional trend is toward establishing SWFs to manage at least part of the reserves. The following section describes this trend in more detail. The transfer of reserves from the central bank to the SWF usually takes the form of the SWF’s borrowing the reserves. This is purely an internal transaction within the public sector, so it does not affect commercial banks’ balance sheets. Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia | 11 KEB Assets Liabilities Sterilization bonds 30 Korean won deposit 30 BOK Assets Liabilities KIC bonds 30 Sterilization bonds 30 KIC Assets Liabilities US dollars 30 KIC bonds 30 IV. Sovereign Wealth Funds in Asia Section II showed evidence that supports the conventional wisdom that the level of foreign exchange reserves has now surpassed all plausible estimates of what the region needs for precautionary insurance purposes. There is thus ample justification for the popular notion that investing the region’s excess reserves in traditional reserve assets such as US government securities is a costly waste of national resources. For example, if the rate of return on traditional reserve assets is only 3% but the rate of return on higherreturn assets is 10%, the central bank is incurring a loss of 7% of foregone investment income. This suggests that the optimal use of the region’s excess reserves is to invest them abroad to maximize risk-adjusted returns.2 In fact, state-owned SWFs have a long history of using publicly owned foreign exchange to pursue commercial profits.3 These institutions provide a natural institutional blueprint for more active, profit-oriented management of Asia’s excess reserves. Despite their relatively long history (the oldest, the Kuwait Investment Authority, was set up in 1953) the term sovereign wealth fund was coined only in 2005 by Andrew Rozanov (2005a and 2005b). Table 2 lists the major SWFs of the world. Well-known sovereign funds include Norway’s Government Pension Fund (GPF), the Abu Dhabi Investment Authority and other Gulf oil funds, and Singapore’s Temasek Holdings and Government of Singapore Investment Corporation (GIC). Most well-established and biggest funds are based on export revenues from oil and other natural resources. The two defining characteristics of SWFs are (i) ownership and control by the government and (ii) pursuit of risk-adjusted returns rather than liquidity as the central objective. 2 It is also possible to invest them at home on domestic-currency projects but doing so entails a number of macroeconomic complications. See Park (2007) for an extended discussion. 3 Johnson-Calari and Rietveld (2007) provide an excellent overview of sovereign wealth management. 12 | ADB Economics Working Paper Series No. 129 Table 2: Sovereign Wealth Funds of the World Economy Name of Fund Assets (US$ billion) Year of Inception Type United Arab Emirates Abu Dhabi Investment Authority 875 1976 Commodity: Oil Singapore Government of Singapore Investment Corporation 330 1981 Noncommodity Norway Government Pension Fund 300 1990 Commodity: Oil Saudi Arabia Various types 300 n/a Commodity: Oil PRC China Investment Corporation 200 2007 Noncommodity Kuwait Kuwait Investment Authority 160–205 1953 Commodity: Oil Singapore Temasek Holdings 100 1974 Noncommodity Hong Kong, China Investment Portfolio (Hong Kong Monetary Authority) 100 1998 Noncommodity Australia Future Fund 50 2004 Noncommodity Qatar Qatar Investment Authority 40 n/a Commodity: Oil State of Alaska, USA Permanent Reserve Fund 35 1976 Commodity: Oil Russia Oil Stabilization Fund 32 2003 Commodity: Oil Note: Due to lack of official information from the funds themselves, asset sizes are largely estimates from unofficial sources such as Jen (2007). Sources: Jen (2007), Rozanov (2005a), Setser and Ziemba (2007), Government of Singapore Investment Corporation (2007), Temasek Holdings (2007), Rietveld and Pringle (2007), United States Treasury (2007). Within Asia, by far the most well-established SWFs are Singapore’s Temasek and GIC. Unlike most of the other well-established funds, the two Singaporean funds are not based on oil export revenues. Instead, their underlying income base is government budget surplus and profits of government-owned companies. A common characteristic of SWFs, with the notable exception of Norway’s GPF, is their relative lack of transparency. Despite the lack of transparency and information, there is a fairly robust consensus that the two Singaporean funds have been highly successful investors. For example, the market value of Temasek grew on average by a remarkable 18% per year on a compounded basis between 1974 and 2006. It is this kind of commercial success by SWFs right in their own backyard that has encouraged many Asian countries to plan their own SWFs. Indeed many Asian governments are looking toward the two Singaporean funds as models for their own SWFs, and seeking to replicate their success. It was in this context that Korea established the KIC in 2005 with initial assets of US$20 billion, and the PRC established the CIC in 2007 with initial assets of US$200 billion. Table 3 lists the major SWFs of Asia. Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia | 13 Table 3: Sovereign Wealth Funds of Developing Asia Economy Name of Fund Assets (US$ billion) Year of Inception Type Singapore Government of Singapore Investment Corporation 330 1981 Noncommodity PRC China Investment Corporation 200 2007 Noncommodity Singapore Temasek Holdings 100 1974 Noncommodity Hong Kong, China Investment Portfolio (HKMA) 100 1998 Noncommodity Brunei Darussalam Brunei Investment Agency 30 1983 Commodity: Oil Korea, Rep. of Korea Investment Corporation 20 2005 Noncommodity Malaysia Khazanah Nasional BHD 15 1993 Noncommodity Kazakhstan National Oil Fund 15 2000 Commodity: Oil, gas, metals Taipei,China National Stabilization Fund 15 2000 Noncommodity Azerbaijan State Oil Fund 1.6 1999 Commodity: Oil Timor Leste Petroleum Fund 1.22 2005 Commodity: Oil and gas Uzbekistan Fund for Reconstruction and Development 0.5 2006 Commodity and noncommodity Kiribati Revenue Equalization Reserve Fund 0.47 1956 Commodity: Phosphate mining Nauru Nauru Phosphate Royalties Trust 0.07 1968 Commodity: Phosphate mining India To be named n.a. n.a. Noncommodity Thailand To be named n.a. n.a. Noncommodity Note: A number of trust funds in the Pacific region, which have been financed by government and donor funds, are not included in the above list and have an aggregate size of about $500 million. Due to lack of official information from the funds themselves, asset sizes are largely estimates from unofficial sources such as Jen (2007). Sources: Jen (2007), Rozanov (2005a), Setser and Ziemba (2007). V. Risks Facing Asia’s New Sovereign Wealth Funds As discussed earlier, the risks of Asia’s SWFs for Asia’s financial systems are primarily risks arising from the investments of SWFs. Section III showed that Asia’s foreign exchange reserves originate from foreign exchange market interventions by the central bank. Analytically, such interventions amount to the central bank’s borrowing foreign exchange from the commercial banking system. The central bank then on-lends the borrowed foreign exchange to the SWF, which uses them to finance investments abroad. Therefore, if those investments sour, commercial banks will also suffer the consequences. That is, the investment performance of Asia’s SWFs will have repercussions for the stability and efficiency of Asia’s financial systems. The principal risks to the investment performance of SWFs originate from a number of sources. 14 | ADB Economics Working Paper Series No. 129 A. Political Economy Risks It is important to remember that the region’s sovereign funds are partly a policy response to growing calls from the general public to use the region’s burgeoning reserves more productively so that they can make a bigger contribution to welfare. There are concerns that Asian SWFs may pursue geopolitical or strategic objectives and that those objectives may complicate their pursuit of profit maximization. While there is some element of truth to this, such concerns tend to be overdone. The primary impetus behind the creation of SWFs in Asia is a popular belief that a potentially valuable national resource is being wasted. More specifically, the primary concern among both policymakers and the general public is that the rate of return on traditional reserve assets is “too low” and that Asia is incurring a large opportunity cost by foregoing higher-return assets. In short, the central focus of Asian SWFs is likely to be largely, or even purely, commercial for the simple reason that their raison d’etre is to make more money out of reserves. Contrary to conventional wisdom, operational independence and commercial orientation does not guarantee freedom from major investment risks. Indeed it may be argued that precisely because SWFs are tasked with making as much money as possible that they may be tempted to take risks they are ill-prepared to manage. SWFs manage a public resource and hence the performance of their investments will be subject to a great deal of public scrutiny. In principle, public scrutiny is beneficial since it promotes transparency and accountability. At the same time, however, public scrutiny may lead to public pressure for unrealistically high returns given the limited capacity of the SWF. A classic example of such outcomes is CIC’s purchase of a US$3 billion stake in Blackstone, a US private equity firm, in May 2007. The turmoil in US financial markets in the wake of the subprime mortgage crisis has taken a heavy toll on Blackstone. As a consequence, the book value of CIC’s investment in the firm has dropped by almost 50% as of the end of March 2008. The price of Blackstone shares has plunged from US$29.61 to US$15.45. The huge loss in book value has provoked a major uproar among the PRC general public infuriated by the loss of “their money”. The example of CIC’s so far disastrous investment in Blackstone highlights the political economy risks stemming from the fact that SWFs are state-owned institutions. The SWFs are in a no-win situation in the following sense: while they are motivated to pursue high-risk, high-return investments because of political pressure to make better use of excess reserves, they face popular criticism and anger when investments go wrong. Conversely, the general public will always insist on having it both ways—to pressure the SWF for higher returns, but to blame the SWFs responsible when the downside risks are realized. Pursuing a conservative investment strategy reduces the likelihood of big losses but also reduces the likelihood of high returns. On the other hand, pursuing an aggressive investment strategy increases the likelihood of high returns but also increases the likelihood of big losses. While private sector financial institutions also face such Capital Outflows, Sovereign Wealth Funds, and Domestic Financial Instability in Developing Asia | 15 dilemmas, SWFs, unlike those institutions, are ultimately answerable to the entire country rather than just a group of shareholders for their performance. Therefore, regardless of which investment strategy they choose, SWFs will be subject to a much greater deal of scrutiny, criticism, and second-guessing from the general public. B. Risks Arising from Inadequate Institutional Capacity Political pressures for earning higher returns from the region’s large and growing excess reserves has induced Asian countries to set up their own SWFs to emulate the success of Singapore’s Temasek and GIC. The commercial success of the Singaporean funds is ultimately the consequence of high-risk, high-return investment strategies. However, the new Asian SWFs simply do not yet have the institutional capacity to effectively manage a portfolio of high-risk, high-return investments. Temasek and GIC are financially sophisticated investors with large investments in alternative asset classes such as private equity, venture capital, and real estate. Furthermore, they are often active investors seeking to control or at least influence the management of companies. It is not only unrealistic but downright dangerous for Asian countries to believe that it is possible to build a Temasek or a GIC overnight. In the absence of adequate investment management capacity, including risk management capacity, pursuing Singapore-type investment strategies creates dangerously high levels of risk. Nevertheless, popular pressures for profits may encourage SWFs to try to run before they can walk, to pursue high-risk, high-return investments without adequate capacity to handle risk. Succumbing to such pressures entails a clear risk of large, even catastrophic, investment losses. C. Moral Hazard Risks All state-owned institutions, including SWFs, are subject to a moral hazard risk arising from government support in case of unfavorable contingencies. For example, state-owned enterprises tend to be less efficient than private sector firms because they believe that the government will bail them out if they suffer losses. A similar moral hazard arises for SWFs, which may take unduly high risks in pursuit of high returns in the belief that the government will bail them out if their investments go bad. This type of moral hazard, in combination with the inadequate risk management capacity of Asia’s new SWFs and popular pressure for high returns, creates a dangerous Molotov cocktail of excessively risky investment behavior. Precisely because SWFs are state-owned institutions entrusted with managing public funds, governments will have to take the ultimate responsibility if they suffer heavy losses or go bankrupt. This is true regardless of the SWF’s degree of operational autonomy and freedom from political interference. As such, governments will be tempted to shore up poorly performing SWFs with financial support. The secure belief that government will not allow them to fail will embolden SWFs to focus on returns without due regard for risk, increasing the likelihood of large investment losses. 16 | ADB Economics Working Paper Series No. 129 D. Fiscal Risks The foregoing has demonstrated that the prospect of government support for SWFs may encourage excessive risk-taking. The flip side of this argument is that using SWFs to support the government will also create serious risks for SWFs. In particular, there has to be a clear-cut separation between the foreign exchange assets controlled by the central bank and those controlled by the SWFs. There must be clear ground rules for ensuring that SWF resources will not be used to supplement the central bank’s traditional reserves in the event of a financial crisis. Otherwise, having to liquidate long-term assets, which are likely to be a major part of a SWF’s portfolio, at short notice will bring about major losses for SWFs. More generally, serious financial risks for SWFs will ensue if the government views their assets as free fiscal resources to be used ad hoc to meet various fiscal needs. The vast majority of Asia’s reserves are not fiscal reserves but central bank reserves with counterpart liabilities. The balance sheet of even the best-run Asian SWF will suffer if the government views SWF assets as fiscal assets to be used freely at its own discretion. E. Transparency and Accountability Risks A vocal demand from western governments to the SWFs of emerging markets, including those from Asia, is that they become more transparent and accountable. In this connection, they often hold up Norway’s exceptionally transparent GPF as a blueprint for all SWFs. Therefore, greater transparency and accountability will help to diffuse financial protectionism in industrialized countries.4 Furthermore, it may be argued that greater transparency and accountability will prevent corruption and promote good governance within SWFs. On the other hand, it is not clear whether transparency is beneficial or harmful for investment performance, e.g., hedge funds are notoriously opaque but some of them are remarkably successful investors. More generally, transparency and accountability are not without significant risks for Asian SWFs, especially in conjunction with the political economy risks outlined above. Transparency will increase public scrutiny and the political pressures stemming from public scrutiny. A more specific risk associated with transparency is short-termism in investment strategy associated with political pressures to deliver short-term results. A long-term investment horizon that ignores shortterm volatility can deliver significant benefits in terms of investment performance. F. Financial Protectionism Risks The biggest external risk faced by Asia’s new SWFs is that of financial protectionism, especially from industrialized countries. The cross-border investments of SWFs not only affect the legitimate interests of home countries but also those of host countries. As such, foreign investors, whether state-owned or not, have to conform to host-country laws and regulations. However, host-country governments and citizens are sometimes 4 Diffusing financial protectionism expands the SWF’s universe of possible investments.