Economics of Sovereign Wealth Funds
Chapter

Chapter 14 The Macroeconomic Impact of Sovereign Wealth Funds

Author(s):
Udaibir Das, Adnan Mazarei, and Han Hoorn
Published Date:
December 2010
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Author(s)
Julie Kozack, Doug Laxton and Krishna Srinivasan 

Sovereign wealth funds (SWFs) have come to play an increasingly large role in the global financial landscape. Their rise reflects, in part, the buildup of global current account imbalances in the run-up to the 2007–09 global financial crisis. In particular, large current account surpluses in several Asian and oil-exporting countries—reflecting their savings-investment imbalances and the sharp increase in oil prices between 2000 and mid-2008—translated into a rapid accumulation of foreign reserves by central banks (Figure 14.1). Coinciding with this accumulation of reserves was a reduction in these countries’ public debt, making them significant net creditors to the rest of the world. The combination of higher levels of international reserves and lower public debt, and often lower external debt as well, led to substantial improvements in the standard reserves adequacy measures for several of these countries.

Figure 14.1Emerging-Economy Reserves

Source: IMF, 2009.

Reserves accumulation reached a point that led many countries to believe they had sufficient cushions against financial or economic shocks. Notwithstanding enormous development needs, limited absorptive capacity meant that quickly spending much of the oil or export windfall was neither appropriate nor feasible. Moreover, policymakers in these countries were increasingly of the view that an important way to transfer wealth across generations would be to turn “resources in the ground” into financial assets. As a result, many countries sought to enhance the return on these large pools of funds. Instead of continuing to invest conservatively through sustained reserves accumulation with resources largely held in government securities, assets were transferred to SWFs with broader investment mandates, resulting in the sharp increase since 2000 in the number of SWFs and in the assets under their management (Figure 14.2).

Figure 14.2SWF Formation

Source: Market reports.

Note: Assets under management are the assets currently managed by the SWFs established in each time period.

Like most other financial institutions, SWFs were affected adversely by the global financial crisis. Before the crisis, given their size and projected growth, SWFs were seen to be well placed to play a more prominent role in global finance. In the context of low interest rates, market participants were of the view that SWFs were poised to move up the risk frontier in their quest for yield, including the increase of their exposure to emerging economies. The crisis, however, is believed to have had a sobering influence on SWFs’ investment behavior and focus; many SWF portfolios suffered large losses, and with home economies facing recession, their focus turned, at least temporarily, to domestic matters. Nonetheless, SWF assets are still sizable. Their estimated assets under management ranged from US$1.8 trillion to US$2.4 trillion at end-2008—down from a range of US$2 trillion to US$3 trillion at end-2007.2

This chapter discusses the growing role of SWFs and their potential effects on global financial markets. Thus far, SWFs have not been a destabilizing force in the global financial system. To the contrary, they made significant investments in global financial institutions in the early stages of the crisis, although these actions were overtaken by events as the crisis intensified in late 2008. Nonetheless, even benign shifts in the risk appetites and investment behaviors of SWFs, including changes in the currency composition of their assets, could have an impact on global capital flows and asset prices. This chapter analyzes the possible impact of shifts in SWF portfolios or strategic asset allocations on global capital flows and asset prices. Using illustrative scenario analysis and model-based simulations, the investigation gauges the effect of relatively modest shifts in SWF behavior on capital flows, major currencies, and global interest rates, as well as on key macroeconomic variables such as consumption and investment.

The first section of this chapter presents estimates of the potential growth of SWF assets. The second section discusses the impact of the global financial crisis on SWF assets and investment behavior. The third section explores the implications of the growing presence of SWFs for global capital flows and asset prices, and is followed by a concluding section.

CURRENT AND FUTURE SIZE OF SWFs

Although SWFs have been around for decades, few attempts have been made, until recently, to estimate the size of their assets under management. This chapter estimates these assets using data provided by SWFs through their regular reporting and, where such data are not available, approximations by market participants. Taken together, these various sources suggest that SWF assets under management currently total US$1.8 trillion to US$2.4 trillion (Table 14.1). Assets under management are highly concentrated among the five largest SWFs, which account for about two-thirds of estimated total assets. Looking across regions, nearly 40 percent of SWFs are located in the Middle East and North Africa, with another 25 percent in non-Japan Asia and about 20 percent in industrial economies. The remaining 15 percent are concentrated in the Commonwealth of Independent States (CIS), with a small share in Latin America (Figure 14.3). Commodity exporters account for roughly three-fourths of estimated assets under management (Figure 14.4).

Table 14.1Estimated SWF Assets Under Management, End-20081
CountryName of fundDate establishedAssets (range)
LowerUpper
(US$ billions)
Oil and gas exporting countries
UAE (Abu Dhabi)Abu Dhabi Investment Authority1976250627
NorwayGovernment Pension Fund–Global21990330330
KuwaitKuwait Investment Authority1953228228
Russian FederationReserve Fund32008137137
Russian FederationNational Wealth Fund320088888
QatarQatar Investment Authority20056070
LibyaLibyan Investment Authority20066565
United StatesAlaska Permanent Reserve Fund19763030
Brunei DarussalamBrunei Investment Authority19833035
KazakhstanNational Fund20002727
CanadaAlberta Heritage Savings Trust Fund19761212
OmanState General Reserve Fund198088
BahrainReserve Fund for Strategic Projects200611
MexicoOil Income Stabilization200066
AzerbaijanState Oil Fund19991111
Timor-LestePetroleum Fund200544
Trinidad and TobagoHeritage and Stabilization Fund200733
Other commodity exporters
ChileEconomic and Social Stabilization Fund2006220
ChilePension Reserve Fund200633
BotswanaPula Fund199377
Asian manufacturing exporters
SingaporeGovernment Investment Corporation198170300
SingaporeTemasek19748484
ChinaChina Investment Corporation2007190190
Korea, Rep. ofKorea Investment Corporation20052525
MalaysiaKhazanah Nasional BHD19931616
Pension reserve funds
AustraliaFuture Fund20064242
IrelandNational Pensions Reserve Fund20012323
New ZealandSuperannuation Fund200177
Total1,8002,400
Sources: Annual or quarterly reports of SWFs; SWF Web sites; analyst reports; media reports.

Does not include reserve assets. Does not include estimates for the Islamic Republic of Iran or Equatorial Guinea.

Formerly know as the Petroleum Fund.

The Reserve Fund and National Wealth Fund were funded initially with transfers from the Stabilization Fund of the Russian Federation, after which the Stabilization Fund ceased to exist.

Sources: Annual or quarterly reports of SWFs; SWF Web sites; analyst reports; media reports.

Does not include reserve assets. Does not include estimates for the Islamic Republic of Iran or Equatorial Guinea.

Formerly know as the Petroleum Fund.

The Reserve Fund and National Wealth Fund were funded initially with transfers from the Stabilization Fund of the Russian Federation, after which the Stabilization Fund ceased to exist.

Figure 14.3SWFs by Region (Percent Share)

Source: Authors’ calculations.

Figure 14.4SWFs by Type (Percent Share of Assets under Management)

Source: Authors’ calculations.

SWFs have the potential to grow rapidly over the next decade, although the crisis has clearly affected key revenue sources through reduced capital inflows and lower commodity prices. Based on projections of the size of external surpluses in SWF countries—along with assumptions about annual returns and the share of the external surplus allocated to the SWF (rather than continued reserves accumulation)—a range of estimates for the future size of SWFs is calculated (Figure 14.5).3

Figure 14.5SWF Projections by Region, 2014

Source: Authors’ calculations.

Note: The black bars in panel b illustrate the upper and lower bounds of the projected range.

  • Based on these calculations, SWFs could grow to between US$4 trillion and US$6 trillion by 2014. This is about a third lower than previous estimates, given revised projections of the size of external surpluses in these countries.4
  • Funds of commodity exporters could grow by 75 percent, to reach US$2.75 trillion to US$3 trillion, while other funds could increase by between four and five times to US$1.5 trillion to US$3 trillion, led by China and Singapore.
  • Geographically, SWFs located in East Asia—led by China—could grow tremendously, although the ultimate outcome depends on the share of foreign currency inflows allocated to SWFs instead of reserves. In the Middle East and industrial economies, SWFs are projected to grow to nearly twice their current size, while those in the CIS and Latin America would remain roughly flat over time because the sharp deterioration in current account balances would reduce amounts available to SWFs.

HOW HAVE SWFs COPED WITH THE 2007–09 GLOBAL FINANCIAL CRISIS?

Against the backdrop of ample global liquidity and low interest rates in the run-up to the financial crisis, SWFs had moved up the risk spectrum in search of yield. This increased appetite for risk was increasingly reflected in a rebalancing of their portfolios by geography, asset class, and leverage. Geographically, SWFs gradually had begun to shift assets away from investments in industrial economies and toward those in emerging economies. With respect to asset class, SWFs increased their exposure to equities and alternative investments, including real estate and private equity, and, in some instances, used leverage (either directly or indirectly) to amplify returns.

The limited data available on SWF investments provide evidence of these shifts. For instance, Temasek’s investments in industrial economies had declined, albeit modestly, from nearly 85 percent of total assets under management in 2006 to less than 80 percent in 2008, matched by greater exposure to emerging economies, notably in South Asia. Similarly, Norway’s Government Pension Fund–Global decided in 2007 to increase investments in equities, while reducing exposure to fixed-income assets. As a result, investments in equities increased from 40 percent in 2007 to 52 percent in the first quarter of 2009, matched by offsetting changes in exposure to fixed-income assets.

The investment behavior of SWFs in the context of the crisis can be viewed as reflecting a combination of opportunism and sensitivity to international and domestic political economy considerations. In the initial phase of the crisis, extending from the summer of 2007 through the spring of 2008, SWFs played an important role in efforts aimed at alleviating financial market strains. Their actions included capital injections into major industrial-economy financial institutions—these investments were large, privately negotiated rather than executed in public markets, and often in the form of bonds that were to be converted to equity stakes in the future. In making these investments, SWFs were attracted by below-average valuations of equities in crisis-hit financial markets that provided them with a window of opportunity to increase their exposure to the global financial sector. At the same time, however, one could speculate that—against the background of simmering discontent with the growing role of SWFs—these investments may have also been motivated by political economy considerations, given that they were seen as having a stabilizing influence on industrial-country financial markets. Regardless of the reason, SWFs invested about US$80 billion in U.S. and Western European banks over this period; investments in the financial sector of the industrial economies accounted for about 50 percent of SWFs’ total investments in 2008 (IMF, 2008a).

As the crisis deepened during the first half of 2008, SWFs were soon subject to large losses on those investments in major financial institutions. At the same time, prospects in emerging economies appeared more promising, with some observers arguing that these economies may have decoupled from the industrial economies. In light of the differentiation in economic prospects, investments by SWFs from the spring of 2008 through the intensification of the crisis in the fall were, in large part, targeted at emerging economies. In particular, while investment in Organisation for Economic Co-operation and Development (OECD) countries declined sharply, from an estimated US$37 billion in the first quarter of 2008 to about US$17 billion in the next two quarters combined, investment in emerging economies increased by about US$23 billion, and accounted for more than 50 percent of the U.S.-dollar value of transactions over this period (Monitor Group, 2008). Moreover, there was also greater differentiation in SWF investments within the group of emerging economies, possibly reflecting their differing growth prospects. In particular, emerging economies in the Asia Pacific, Middle East, and North Africa regions accounted for 65 percent of the publicly reported transactions undertaken by SWFs in the third quarter of 2008, representing nearly 50 percent of the U.S.-dollar value of those transactions.

The dramatic intensification of the crisis after the collapse of Lehman Brothers in September 2008, and the abrupt slowing of economic activity in emerging economies, led to yet another shift in the focus of SWF investments. From large investments in major financial institutions in industrial economies in the early phases of the crisis to a greater focus on emerging economies, the fallout of the Lehman collapse on global trade and commodity prices led SWFs to focus greater in their domestic financial sectors as they came under strain. For instance, the Qatar Investment Authority purchased 5 percent stakes in the Commercial Bank of Qatar, Al Ahli Bank, and Qatar International Islamic Bank as part of efforts to strengthen the banking system in the wake of the global financial crisis. Similar investments in their domestic financial sectors were also made by other SWFs, including the Kuwait Investment Authority, the China Investment Corporation, and the Abu Dhabi Investment Authority. Moreover, SWFs in countries hit hard by the crisis—such as Kazakhstan and the Russian Federation—are facing significant drawdowns as their “rainy day” resources are being used to finance fiscal stimulus.

With clear signs in late 2009 that the global economy is now emerging from the most severe recession since the Great Depression, and with financial conditions gradually improving, SWFs appear to have regained their appetite for exposure to the industrial economies.

Although the growth rebound is most widespread in emerging Asia, there are also indications that activity is starting to turn around in the United States and Western Europe. Although total SWF investments in the first quarter of 2009 were at their lowest point since 2005, the share of investment in OECD countries appears to have rebounded during that quarter (to about 65 percent) from its precipitous decline the previous year. More specifically, investments in these countries amounted to 94 percent of total SWF investments in the first quarter of 2008—largely reflecting investments in major industrial-economy financial institutions—before plummeting to 27 percent of total SWF investments by the fourth quarter of 2008 (Table 14.2).

Table 14.2Gross Value of SWF Transactions (US$ billion)
2008
Indicator20072008Q1Q2Q3Q42009:Q1
Total101.7127.767.89.515.335.16.8
OECD60.086.863.74.98.79.54.4
Emerging economies41.740.94.14.66.625.62.4
Source: Monitor Group.
Source: Monitor Group.

IMPLICATIONS FOR GLOBAL CAPITAL FLOWS AND ASSET PRICES

Against this background, a critical issue concerns the impact of SWF investment decisions on the pattern of global capital flows and asset prices. SWFs typically have medium- to long-term investment horizons, suggesting that they are less likely to make abrupt portfolio shifts that could affect market stability. Indeed, as noted above, SWFs were a source of initial capital injections into systemically important financial institutions, suggesting that they can play a stabilizing role in global financial markets. Nonetheless, even a gradual shift toward greater portfolio diversification of reserve assets by sovereigns, including through SWFs, could have implications for the flow of funds between countries and for the absolute and relative prices of assets.

From a global macroeconomic perspective, three factors point to the possibility of a more subdued outlook for net capital flows to the United States in the coming years as investors seek to diversify their portfolios.

  • A shift in risk appetite for U.S. assets. The global financial crisis has been associated with a safe-haven dynamic, which has dramatically increased demand for U.S.-dollar assets, particularly government securities. As this dynamic fades, investors may view U.S. assets as riskier—particularly given the sharp losses on credit and equity instruments since the crisis erupted. Investors may also come to view government debt as increasingly risky, given the very large issuance already in the pipeline to finance the fiscal expansion and the longerterm fiscal pressures associated with entitlements. Both of these factors could lead to an increase in the country risk premium on U.S. assets.
  • Lower world demand for U.S. assets. Independent of risk-return considerations for global portfolios, global demand for U.S. assets could contract sharply if national savings in U.S. creditor countries, such as China, fall as a result of global rebalancing triggered by an increase in private-sector demand. This could reduce capital inflows into the United States.
  • Global diversification of foreign exchange reserves. Global demand for U.S. dollars relative to other currencies, which had already begun to ease in recent years, may decline further over the long term, as investors seek to diversify the currency exposure of their portfolios. This could put downward pressure on the U.S. dollar.

Taken together, these shifts in investor sentiment and behavior could have an impact on the U.S. dollar and U.S. interest rates, as well as on capital inflows to other countries, particularly emerging economies.

  • Effect on the U.S. dollar. A shift into riskier assets by SWFs could lead to less demand for U.S.-dollar assets. At the same time, however, it could simply lead to a shift in the composition of dollar assets—away from U.S. government securities and into equities or alternatives, with minimal effect on the dollar.
  • Effect on U.S. interest rates. A shift from a conservative line of investing to one of greater risk-taking could lead to an increase in U.S. interest rates, as demand for U.S. government securities declines.
  • Effect on emerging economies. The rising presence of SWFs in global capital markets could be favorable to emerging-economy and high-yield corporate assets. As SWFs look to diversify their holdings and seek higher returns, capital could flow into riskier asset classes, including those of emerging economies.

Stylized Portfolio Analysis

This section estimates the potential impact of a diversification of sovereign reserves through SWFs on global capital flows using scenario analysis. In the scenario, SWFs diversify their assets across two spectra: asset class and geography. First, SWFs could diversify away from low-risk, low-return assets, such as government securities, into equities and other higher-risk instruments, such as private equity and real estate. Second, SWFs could also focus more on emerging economies, with attendant implications for capital flows to industrial economies, particularly the United States. This geographic shift may be increasingly likely if the significant deterioration in the fiscal positions of many industrial economies gives rise to longer-term sustainability concerns, thereby shifting perceptions of riskreturn trade-offs.

Any such estimation exercise is challenging because of the lack of reliable information for several large SWFs, especially information about their asset allocations. To examine the possible implications of the growing presence of SWFs, illustrative scenarios of asset allocations were constructed for countries that are in the process of shifting away from holding reserves to holding more diversified assets through SWFs.

  • Two stylized, diversified portfolios—one replicating Norway’s Government Pension Fund–Global and the second representing a more diversified SWF—were calibrated and compared with a stylized portfolio of foreign exchange reserve assets (Figure 14.6), with a view to assessing likely changes in the pattern of global capital flows and the impact on asset prices.5
  • To complement this scenario analysis, the exercise also estimates the impact of a modest shift away from U.S.-dollar assets in the current stock of reserves for the 10 largest emerging-economy reserves holders. Such a shift is within the realm of possibility, especially given recent statements by officials from some emerging economies raising concerns about the dollar’s future as a reserve currency (Financial Times, 2009). The analysis assumes that countries that have either recently established SWFs or announced their intention to establish one will channel a portion of their prospective foreign exchange inflows to their respective SWFs. Countries that have established SWFs over the past half decade or so include Bahrain, Chile, China, the Republic of Korea, Libya, Qatar, the Russian Federation, Timor-Leste, and Trinidad and Tobago.
  • The prospective foreign exchange flows are calculated as the sum of each country’s current account balance and net private capital flows, based on World Economic Outlook projections for 2009–14 (IMF, 2009).6 The analysis provides for a lower bound, which assumes that countries that have recently established SWFs will transfer 50 percent of newly available foreign currency inflows to their SWFs, and an upper bound, which assumes that in addition, countries that are contemplating setting up SWFs transfer 100 percent of newly available foreign currency inflows to their SWFs. The upper bound also assumes that 15 percent of the stock of the existing reserves of the top 10 emerging-market reserves holders is shifted from reserves to SWF holdings over the period 2009–14. All new flows into SWFs are assumed to be invested abroad.

Figure 14.6Currency Composition of Stylized Portfolios

Source: Authors’ calculations, based on COFER data.

As in many illustrative exercises, the results are highly sensitive to the underlying assumptions. For instance, by focusing largely on new sovereign investments, the exercise provides only a partial picture of the possible magnitude of the impact on capital flows and asset prices arising from the diversification strategy. Moreover, other sovereigns (and not just the top 10 emerging-market reserves holders, as assumed in the exercise) may choose to diversify their existing reserve assets. Nevertheless, this limited exercise provides a sense of the direction and magnitude of the possible impact on markets.

The analysis suggests that the pattern of global capital flows could change significantly, with the United States facing lower capital inflows and emerging economies attracting substantially larger inflows (Figure 14.7). Relative to reserve assets, which are predominantly dollar-denominated and generally held in the form of U.S. treasury or agency securities, the stylized SWF portfolios are more diversified across both asset classes and currency exposures. This suggests lower inflows into government bond markets, with attendant implications for interest rates. The shift away from reserve assets could have the most significant effect on markets in the United States, if countries diversify away from U.S.-dollar holdings.

Figure 14.7Change in Pattern of Capital Flows, by Currency

Source: Authors’ calculations.

Estimates in this analysis show that inflows into the United States could decline by 0.5–0.75 percent of U.S. GDP per year on average, depending on the number of countries in the sample and the assumption made about the currency composition of reserves for the 10 largest emerging-economy reserves holders. The results also hinge on the asset allocation strategy used to model investments by the prospective SWFs. Portfolios more weighted to emerging economies—such as the stylized diversified portfolio—would result in lower flows into both U.S.-dollar and euro assets, while flows to emerging economies would tend to increase substantially. However, the adverse effect on demand for euro assets fades as large emerging-economy reserves holders shift out of U.S.-dollar assets and into euros and other currencies. By contrast, a portfolio similar to Norway’s SWF, which is heavily weighted to investments in Europe, would suggest a somewhat lower investment in U.S.-dollar assets even before the reserves shift is taken into account and a less sizable, but still positive, inflow to emerging markets.

Model Simulations

To quantify the implications of potential changes in the pattern of capital flows on interest rates and exchange rates, simulations were undertaken using an annual version of the Global Integrated Monetary Fiscal Model (GIMF).7 The change in the pattern of capital flows is modeled as a shock to portfolio preferences, as investors shift out of U.S. assets in favor of more diversified portfolios. Within the mechanics of GIMF, the shock is modeled as an increase in the country risk premium on U.S. assets (reflecting lower demand for U.S. assets). Figure 14.8 presents three variants based on different magnitudes of the shock—low, moderate, and high. The low case assumes a 50-basis-point permanent increase in the U.S. country risk premium and is associated with the lower bound of the change in the pattern of capital flows. The high case assumes a shock that is 150 basis points, representing a more extreme shift in portfolio preferences than those presented in the previous section. The text below focuses on the moderate variant, which assumes a 100-basis-point shock and is associated with the upper bound of the change in the pattern of capital flows computed in the previous section.

Figure 14.8Model Simulations, Deviations from Baseline

Source: Authors’ estimates.

Note: ______ Low; __ __ __ Moderate; ______ High.

The model results point to significant, but manageable, effects on exchange rates, current account balances, and trade balances in three economic regions—the United States, the euro area, and emerging Asia (Figure 14.8).8 All results are shown as deviations from a baseline.

  • The increase in the U.S. country risk premium would induce a temporary depreciation of the U.S. dollar in real effective terms and an improvement in the current account balance. The U.S. dollar would immediately depreciate by about 7 percent in real effective terms. This would induce an improvement in the current account balance in the United States of about 0.5 percentage points of GDP in the first year (panel a of Figure 14.8). Intuitively, in the short run, the U.S. real effective exchange rate must depreciate to generate an improvement in the trade balance consistent with savings behavior and capital flows. Over time, the depreciation in the real effective exchange rate would result in a further improvement in the current account balance, which would eventually stabilize at a value that is 0.75 percent higher than in the baseline (panel a of Figure 14.8). However, this longer-term improvement in the U.S. current account would result in a significant improvement in the net foreign asset position, reducing U.S. interest obligations to the rest of the world. To equilibrate this process, the real exchange rate must therefore appreciate in the long run (relative to the baseline) to generate a decline in the trade balance (panels c and f of Figure 14.8). Essentially, the composition of the current account changes over time—the initial improvement would arise from an improvement in the trade balance, while the long-run improvement would arise from lower interest payments as the stock of net foreign assets increases (or becomes less negative).
  • The shock to the U.S. country risk premium would induce a temporary real effective appreciation of the euro and emerging Asian currencies (panel c of Figure 14.8). The euro would appreciate in real effective terms, initially by about 3 percent and by smaller amounts over time. In emerging Asia, the dynamics are more rapid, given the region’s openness to trade. Currencies initially appreciate by 0.5 percent in real effective terms, but relatively quickly begin to depreciate. In the long run, current account balances deteriorate by less in the euro area and in emerging Asia—by about 0.5 and 0.25 percent, respectively, than in the United States. As in the United States, the composition of the current account balance would change over time, reflecting the impact of the real exchange rate path on the trade balance and the associated change in the net foreign asset position. Thus, over time, the exchange rate must depreciate in real effective terms to induce an improvement in the trade balance to offset the decline in interest earnings on net foreign assets. In these simulations, the real exchange rate has to adjust by more in the euro area than in emerging Asia because the latter (as a region) is more open.

According to the model results, real interest rate differentials between the euro area and emerging Asia versus the United States would fall (panel b of Figure 14.8). When real effective exchange rates stabilize at their long-run values, a permanent increase in the country risk premium of 100 basis points would also be reflected in a 100-basis-point decline in real interest rate differentials between the rest of the world (in this case, the euro area and emerging Asia) and the United States. However, over the transition path, during which the real exchange rate is still adjusting to generate a path for the trade balance that is consistent with portfolio preferences, real interest rate differentials in the rest of the world (relative to the United States) would decline by less than 100 basis points.9 Higher interest rates in the United States and lower interest rates in the rest of the world would shift production to the rest of the world. As a result, investment would decline in the United States and rise in the euro area and emerging Asia (panel e). This would lead to lower levels of permanent income and consumption in the United States, and higher levels elsewhere (panel d).

While these simulations provide important analytical support to the qualitative assessment made earlier in the chapter, it is important to note that they deliberately abstract from a number of real-world issues. First, they assume that nominal exchange rates are flexible and adjust instantaneously to be consistent with risk-adjusted asset returns and fundamentals. Second, the model assumes that there is only one type of bond traded internationally and that it is denominated in U.S. dollars. Third, valuation effects that would be associated with a sudden decline in the value of the U.S. dollar are not taken into account. Including valuation effects in the analysis would require extending the model to include different types of asset classes. For example, modeling emerging Asia as a net-creditor country would tend to weaken its consumption responses because a depreciation in the U.S. dollar would result in a negative valuation effect on emerging Asia’s stock of financial assets denominated in U.S. dollars.

CONCLUSION

Although the global financial crisis has generally taken SWFs out of the headlines, they are still key players in global finance. Given their size and scope, their actions plausibly would have implications for global capital flows and asset prices. Even a gradual shift toward greater portfolio diversification of foreign assets by sovereigns, including through SWFs, could have implications for the flow of funds between countries and the absolute and relative prices of assets.

Using illustrative scenario analysis combined with model-based simulations, this chapter attempts to further the understanding of the implications of portfolio-allocation decisions of SWFs on global capital flows and asset prices. The analysis suggests that the pattern of global capital flows could change significantly if countries shift away from U.S.-dollar assets, including through more diversified SWF portfolios. In the scenario analysis, industrial economies would face lower capital inflows and emerging economies would attract substantially larger inflows. The results of the model-based simulations show that such a change in the pattern of global capital flows would lead to higher U.S. interest rates (lower interest rates elsewhere) and a depreciation of the U.S. dollar (an appreciation of other currencies). These findings are consistent with the economic intuition prevailing before the crisis and may yet come to pass as the global economy gradually recovers and risk appetite returns.

REFERENCES

    Financial Times2009“China Urges Switch from Dollar as Reserve Currency”March24.

    International Monetary Fund2008a“Box 1.2. Do Sovereign Wealth Funds Have a Volatility- Absorbing Market Impact?” in Global Financial Stability Report (WashingtonApril).

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    International Monetary Fund2008b“Sovereign Wealth Funds—a Work Agenda” (Washington).

    International Monetary Fund2009World Economic Outlook (WashingtonApril).

    KumhofMichael and DouglasLaxton2007“A Party without a Hangover? On the Effects of U.S. Fiscal Deficits,”IMF Working Paper 07/202 (Washington: International Monetary Fund).

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    Monitor Group2008Sovereign Wealth Fund Investment Behavior: Analysis of SWF Transactions During Q2 2008 (Cambridge, Massachusetts: Monitor Group).

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1The authors are grateful to Chanpheng Dara, Ashwin Goyal, and Susana Mursula for excellent research assistance. The authors are also grateful for comments and suggestions from participants at the Conference on Sovereign Wealth Funds in an Evolving Global Financial System, hosted by the Centre for Applied Macroeconomic Analysis and the Lowy Institute for International Policy, Sydney, September 2008, as well as for useful discussions with Simon Johnson, Udaibir S. Das, Adnan Mazarei, Alison Stuart, and David Hofman.
2For the purposes of this chapter, SWFs include the 23 IMF member countries with SWFs that constituted the International Working Group of Sovereign Wealth Funds (IWG); the three countries that were permanent observers to the IWG; plus Brunei Darussalam, Kazakhstan, Malaysia, and Oman. IWG member countries were Australia, Azerbaijan, Bahrain, Botswana, Canada, Chile, China, Equatorial Guinea, the Islamic Republic of Iran, Ireland, the Republic of Korea, Kuwait, Libya, Mexico, New Zealand, Norway, Qatar, the Russian Federation, Singapore, Timor-Leste, Trinidad and Tobago, the United Arab Emirates, and the United States. Permanent observers of the IWG were Oman, Saudi Arabia, Vietnam, the Organisation for Economic Co-operation and Development, and the World Bank.
3The range is based on projections of foreign currency inflows over 2009–14, calculated as the sum of each country’s current account balance and net private capital flows less reserve accumulation, drawn from the IMF’s April 2009 World Economic Outlook. It is assumed that all new flows into SWFs are invested abroad, earning the London Interbank Offered Rate (LIBOR) rate of interest (lower bound of range) or LIBOR + 200 basis points (upper bound of range). For countries with relatively new SWFs (i.e., those established after 2003), new flows are calculated as the sum of the current account balance and net private capital flows. From the sample, these countries include Bahrain, Chile, China, the Republic of Korea, Libya, Qatar, the Russian Federation, Timor-Leste, and Trinidad and Tobago. For these countries, it is assumed that 50–100 percent of new resources flow to their SWFs, with the 50 percent assumption forming the lower bound of the range estimates and the 100 percent assumption forming the upper bound. For China, prospective foreign exchange inflows are assumed to be equal to the sum of the current account balance and net private capital flows less half of the current projected reserve accumulation.
4See IMF (2008b), which projected that SWF assets under management could reach US$6 trillion to US$10 trillion by 2013.
5The stylized portfolio of a diversified SWF is based on market reports concerning asset allocation and currency composition. The Norway-like portfolio is based on publicly available data from Norges Bank Investment Management (which manages the Government Pension Fund–Global) as of end- December 2008. The reserves portfolio is based on the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) database, which records end-of-period quarterly data. Aggregate COFER data are used to derive a stylized reserves portfolio, assuming that assets are allocated exclusively to government bonds according to the COFER currency composition.
6For China, prospective foreign exchange inflows are assumed to be equal to the sum of the current account balance and net private capital flows less half of the current projected reserve accumulation.
7GIMF is a multicountry, dynamic stochastic general equilibrium model designed for studying macroeconomic policy issues that emphasize stock-flow consistency. The model is based on an overlapping generation setup, which produces a well-defined steady state in which countries can be either net creditors or debtors, depending on their savings behavior (Kumhof and Laxton, 2007). The simulations are based on an extended version of the GIMF model that includes separate models for the United States, the euro area, Japan, emerging Asia, and “remaining countries.” For the code used to produce these simulations, see www.douglaslaxton.org.
8The results focus on emerging Asia rather than emerging economies as a group because of the model’s structure, which does not (at this time) contain a separate block for emerging economies as a group or by regions outside of Asia.
9The model has an overlapping generation structure, which allows it to have a well-defined steady state in which countries or economic regions can be either net creditors or debtors. This feature is critical because it is possible to consider permanent shocks to study the transition from one steady state to another.

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