Sovereign Development Funds

What are the consequences of developing economies’ growing influence in the global market?

March 21, 2008

What are the consequences of developing economies' growing influence in the global market?

Sovereign wealth funds have been grabbing the headlines of newspapers around the world. The debate is raging over their potential global financial impact and their investment policies. Strangely, the development dimension is missing from the debate.

This is a striking omission, as sovereign wealth funds are arising from emerging and developing countries. Beyond their spectacular emergence, however, lies promising news for the wealth of (developing) nations: sovereign wealth funds are (or could be) major actors in development finance, not only in their homelands but also abroad, in other emerging countries.

From this perspective, we may have to rename them using more appropriate terminology: sovereign wealth funds are above all sovereign development funds.

Firstly, sovereign wealth funds (SWFs) are the byproducts of a major economic and financial rebalancing of global power. Their emergence is controversial because of the fear of politically induced investments, lack of transparency, and other arguments relying more or less on sophisticated conspiracy theories.

More importantly, however, they are causing unease in the West because they symbolize a much deeper and bigger phenomenon that is reshaping the world's economy and finance: Emerging markets are taking an unusual lead, becoming massive creditors to industrialized countries in particular.

Since the early 2000s, the emerging world as a whole is, for the first time, running current account surpluses and exporting capital to the rest of the world. Emerging countries are now key engines of the world economy.

When the OECD was created five decades ago, its 20 members accounted for nearly 75% of world GDP. Now, with 30 members, it represents a relatively meager 55%. In 2007, the engines of growth were located in emerging countries. We have also witnessed, for the first time, major outward foreign direct investment coming from emerging countries.

The emergence of SWFs should therefore be put into this broader perspective: For the first time, financial actors from developing countries are playing with other OECD financial giants as equals. The novelty is that the new global financial players are no longer headquartered in the City of London or New York's financial district — but rather in more "exotic" places like Beijing, Singapore or Dubai.

They already represent sizable global financial players. The largest SWFs — from the United Arab Emirates, Kuwait and China — have reached a scale in line with the largest global asset managers or the biggest hedge funds and private equity firms.

By the end of 2007, these new power brokers altogether had amassed more than $3.1 trillion, according to Morgan Stanley. This amount is nearly equal to the total value of traded securities in Africa, the Middle East and emerging Europe, which is, combined, about $4 trillion.

This is also roughly the size of these markets in all of Latin America. If their growth trends remain steady, they could reach $17 trillion over the next decade, topping more than 5% of the total global financial wealth.

Secondly, and most interestingly, SWFs are not only major new financial institutions arising from emerging countries — but are above all becoming major players in the development of other emerging countries.

Their recent spectacular stakes in big Western banks may have dominated newspaper headlines. Their bailouts of traditional Western financial institutions are rather impressive, totaling $35 billion by the end of 2007.

But not less interesting are their bets on emerging economies. Some of their biggest investments are already located in developing countries in Asia, Africa or Latin America — and the sums might continue to increase in the future.

Some SWFs like, for example, Temasek of Singapore — a veteran institution established in 1974 — already have large stakes and investments in Asian companies, contributing to the development of these countries.

All in all, Asia (excluding Japan and including Singapore) already accounts for 40% of its portfolio, which is more than its total holdings in Singapore (38%) and double those realized in OECD countries (20%).

Better yet, these financial engagements are already paying: Kuwait Investment Authority (KIA), the $215 billion Middle Eastern sovereign wealth fund, has already made juicy profits on its stake in the Industrial and Commercial Bank of China. Both the Qatar Investment Authority and Dubai International Capital are pursuing important investments in the Middle East and North Africa.

One of the blue chip investments of ADIA (Abu Dhabi Investment Authority) is the Egyptian investment bank EFG Hermes (where it holds a stake of 8%). It also has stakes in North African companies like Tunisia Telecom (17.5%).

The future will bring more investment towards emerging and developing economies. KIA is already cutting the portion of its portfolio invested in Europe and in the United States from about 90% to less than 70%.

Emerging markets in Asia (and other regions) are attracting more and more attention: In the end, why bother to invest in low-growth OECD economies when you can access nearly double-digit growth rates in emerging countries?

Dubai International Capital is willing to pursue its moves towards emerging Asia, a region where it intends to raise its portfolio to reach levels of 30% of the total. For the moment, its portfolio is still concentrated in Europe (70%), with the remainder being in the Middle East.

All of this is good news for developing countries. SWFs — pardon me: sovereign development funds — will contribute to boosting equity investments, injecting capital into local companies and emerging countries' projects.

They are building long-term portfolios — and will therefore contribute to reducing volatility, as they are less subject to the constraints of more immediate returns on investments and short-term gains that are typical of traditional Western portfolio asset managers.

Most interestingly, because of their mandates and objectives, they tend to look for secure investments and long-term returns. Ironically, to date, this has led them to invest the bulk in OECD countries. However, portfolio allocation considerations and infrastructure needs suggest that they will benefit by extending more into Africa, Asia and Latin America.

This might also be good news for the African continent — and offer an unexpected helping hand in achieving the Millennium Development Goals.

If sovereign development funds choose to allocate, let's say, 10% of their portfolio towards other emerging and developing economies over the next decade, this could generate spectacular inflows of $1.4 trillion — or, in other words, a yearly amount superior to all OECD countries’ aid towards developing economies.

For all the donors interested in contributing to the achievement of development, their funds' emergence might therefore be a blessing in disguise. They could also become potential development finance partners.

Takeaways

For the first time, financial actors from developing countries are playing with other OECD financial giants as equals.

Developing countries are building long-term portfolios — and will therefore contribute to reducing volatility.

Sovereign development funds might be good news for the African continent — and offer an unexpected helping hand in achieving the Millennium Development Goals.

The largest SWFs — from United Arab Emirates, Kuwait and China — have reached a scale in line with the largest global asset managers or the biggest hedge funds and private equity firms.

We may have to rename sovereign wealth funds as sovereign development funds.