Economics of Sovereign Wealth Funds

Chapter 16 Sovereign Wealth Funds in the New Normal

Udaibir Das, Adnan Mazarei, and Han Hoorn
Published Date:
December 2010
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Mohamed A. El-Erian

The worldwide economy that emerges from the 2007–09 global financial crisis will differ in a number of important ways from what had prevailed in previous years. At a minimum, watchers and participants should anticipate lower steady-state growth in industrial countries, greater financial regulation, lower credit intermediation, simplified capital structures, continued migration of growth and wealth dynamics to systemically important emerging economies, higher protectionist pressures, and an even blurrier line between economic rationality and political exigencies.

This “new normal” will not materialize overnight. It will evolve over several years. The journey will be far from linear and will involve various head fakes, detours, and related market overshoots. Indeed, the global system has entered a more uncertain, more volatile, riskier phase that combines cyclical shocks with secular realignments. To navigate this bumpy journey successfully to a new normal, virtually every dimension—economic, financial, and sociopolitical—in the global system will be required to demonstrate a high degree of adaptability and agility (Sull, 2009b).

Among retail and institutional investors, sovereign wealth funds (SWFs) as a group enter this historic phase with the best set of initial conditions—at least on paper. They are well capitalized; their fiduciary responsibilities direct them to take a long-term view; and their standing in the marketplace is enhanced at a time when the private sector is in a general deleveraging mode and worries about the financing of ballooning public sector balance sheets are growing.

This powerful trio of conditions places SWFs apart when it comes to the strength of their self-insurance and their ability to be appropriately countercyclical and responsively secular. Yet they too face important challenges in this journey to a new normal.

Governance structures will be tested as SWFs seek to strike the right intergenerational equity and efficiency balances in a more fluid environment, and as a wider range of national claims compete with the institutions’ fiduciary responsibilities. For some SWFs, the appropriate investment positioning will require a degree of adaptability and agility that is a multiple of what has been pursued in the past—be it in adjusting asset allocation and risk management, or selecting the right investment vehicles. And communication needs will become even more important if SWFs are to maintain sufficient domestic and international buy-in.

The purpose of this chapter is to shed light on the opportunities and risks that SWFs face in the aftermath of the recent global financial crisis. Following the first section’s quick review of the immediate impact of the global financial crisis on SWFs, the second section outlines the potential components of the new normal that are directly relevant to SWFs. The third section illustrates some of the operational implications for SWFs. The chapter’s concluding remarks appear in the last section.


For the purpose of the current discussion (and abstracting from differences within the set of SWFs), three factors are important to the characterization of SWFs as a group in the run-up to the most acute phase of the global financial crisis, and the global economic and sociopolitical dislocations that followed (and that continue to materialize). These factors defined where the group stood on the eve of the major disruptions occasioned by the global financial crisis in general and, in particular, by the sudden stop experienced by the global economy in the last three-and-a-half months of 2008.1

First, and consistent with their long-term orientation, SWFs were gradually getting bolder in underwriting significantly greater liquidity and equity risk factors to allow them to deliver higher returns over time.2 Specifically, SWFs were opting for bigger allocations to public equities (relative to fixed income), to less liquid and levered investment vehicles (such as private equity and hedge funds), and to direct corporate holdings at the bottom of the capital structure (which, consistent with the insights of the behavioral finance literature, involved a focus on sectors that were historically most familiar to them, led by financials).

Second, SWFs showed growing awareness of some industrial countries’ sensitivities to foreign ownership and especially, when these countries bothered to make the distinction (which was not very often), control of domestic assets. Accordingly, they were more willing to participate in multilateral deliberations on a suitable code of conduct. Most notably, a leading group of SWFs agreed on a set of voluntary principles (the Santiago Principles) emphasizing “transparent and sound governance structures,” appropriate “regulatory and disclosure requirements,” and SWF investing on “the basis of economic and financial risk and return-related considerations” (IMF, 2008).

Third, SWFs operated in highly supportive domestic environments fueled by booming economic growth, continued large accumulation of international reserves, and ready availability of credit. As a result, they were major recipients of cash inflows, but were subject to little pressure to deploy their assets internally or even regionally. SWFs’ major operational stress involved finding ways to step up the pace of investment, but they worried less about potential cash flow issues.

Each of these factors was deemed consistent with delivering higher risk-adjusted returns over time. Most importantly, they reflected the majority perception at that time of a favorable (and durable) set of cyclical and secular conditions. Indeed, the predominant world view—in both the private and public sectors—romanced a “great moderation” in the economic and policy realms. Goldilocks (as in “neither too hot, nor too cold”) became the one-word bumper sticker for this period.

Like virtually every sector of the financial and policy complex, the group of SWFs as a whole was caught off guard by the disruption in global payments and settlements occasioned by the manner in which Lehman Brothers failed. Virtually overnight, and as a cascading number of markets seized up, investors around the world experienced a dramatic repricing in all risk factors—particularly liquidity.

With the global financial services sector at the center of the storm, SWFs’ direct holdings in financial companies came under intense pressure. Meanwhile, rather than remaining on the receiving end of large new inflows, some SWFs found themselves under pressure to support other national (and, in some cases, regional) entities that were facing sudden and acute cash needs.

As a result, the six-month period that ended in March 2009 constituted a dramatic regime change for SWFs (similar to the experience felt by many others): investment returns turned dramatically negative; cash, collateral, and counterparty management became more of an issue; some isolated liquidity pressures emerged; and forward-looking decisions were postponed pending greater clarity on the global financial system.

More generally, the sudden stop experienced by the global economy served to pause the longer-term evolutionary process in the asset-liability management (ALM) of emerging economies—a process that had seen a number of systemically important countries and regions evolve from delayed recognition of their improving circumstances through to liability retirement and more sophisticated asset management (detailed in El-Erian, 2007). Pending clarity on the changes to the global economy, several countries felt it best to wait and see before embarking on the subsequent stages of their own evolution.

SWFs also experienced a significant shift in how they were being perceived in many industrial countries. Most notably, countries that had warned against SWFs taking direct stakes in their domestic companies were now actively seeking SWF funding as a means of countering the highly disruptive impact of the deleveraging by these countries’ private sectors. The tables had turned, with SWFs now being urged to help recapitalize struggling companies, either through new cash injections or by accepting an exchange of existing claims for other instruments lower down in the companies’ capital structures.

This striking change was captured well in an April 2009 editorial in the Financial Times entitled “From Vultures to White Knights.” The editorial observed, “A year ago, sovereign wealth funds were portrayed in the U.S., Europe and Japan as vultures bent on gaining political influence through their investments. These days, in a welcoming change of attitude, governments and companies cannot throw their doors wide enough” (Financial Times, 2009).


Thanks to a massive injection of public sector capital and liquidity, undertaken in a dramatic “whatever it takes” crisis-management mode, the global financial system began normalizing in 2009. Key financial markets—particularly in the short-term complex—are operating smoothly again; companies are able again to access new funds via bond issuance; and trust has been restored to a range of counterparty relationships that underpin the orderly functioning of the global payments and settlements system.

The core of the global financial system has overcome the massive cardiac arrest experienced after September 15, 2008. That is the good news, and it has come as a result of bold and imaginative policy responses. Yet, the policy reactions were not sufficiently effective to fully offset the damage to other parts of the global economy. In addition, such policy responses inevitably entailed risks and unintended consequences that, in themselves, are subsequently becoming important drivers of markets and economies.

The best analytical framework to put all this in perspective may be one that characterizes the recent disruptions not as a crisis within the global system but, rather, as a crisis of the global system. After all, the epicenter was in the most economically important country in the world (the United States, which is also the provider of important global public goods) and, by massively disrupting the financial sector, it ruptured long-standing operational links among sectors nationally, as well as across borders.

Faced with a crisis of the system, internal circuit breakers lacked potency. Rather than getting stopped in its tracks, the crisis spread from one balance sheet to another (starting with U.S. housing and proceeding to banks, nonbank financial institutions, the consumer, and ultimately, the rest of the world). As the crisis intensified, authorities around the world had no choice but to step in with their own balance sheets, and do so in a massive and historically unprecedented fashion.

The failure of circuit breakers is not even the biggest concern. Policy responses to a crisis of the system had to be undertaken in the context of limited information and broken transmission mechanisms; they required the deployment of new tools that had not been properly tested; and they risked collateral damage that is hard to see beforehand and counter appropriately.

Thus, the global financial crisis has now given way to serial economic, institutional, and political dislocations. As an example, the bulk of 2010 will witness the delayed reactions of nonbank actors. In the process, the secular landscape will be further redefined, resulting in a new normal (El-Erian, 2009). Indeed, as Reinhart and Rogoff (2009) observe in their book on the history of crises, this “is a transformative moment in global economic history whose ultimate resolution will likely reshape politics and economics for at least a generation” (p. 208).

Although it is too early to predict every component of the new normal, certain elements are already clear at this early stage, and they mainly affect industrial countries (the United States and the United Kingdom, in particular).

The list of consequential changes for the next three to five years includes

  • a dramatic shift from unfettered market activities to greater government involvement;
  • a notable, regulatory-led derisking of the financial sector;
  • a massive jump in public indebtedness, in absolute terms and as a percentage of GDP, with related concerns about sovereign risk;
  • a significant increase in unemployment, followed by a slower reversion to what will be a higher natural rate; and
  • a reduction in the trend rate of economic growth.

The nature of the new normal’s inflation dynamics is more difficult to specify. On the one hand, the enormous size of the output gap during the journey will serve to dilute inflationary pressures. On the other hand, the journey will almost certainly involve a large degree of destruction of productive capacity, including in areas that are unlikely to recover for quite a while, if ever. This includes activities that relied on a seemingly endless ability to borrow cheaply.

Ultimately tilting this balance toward a world of higher and less stable inflation is the call on the U.S.-specific component. The new normal is likely to involve an important gradual shift in the analytical characterization of the United States—away from an economy that operates essentially as large and closed and toward one that is more open and more heavily affected by developments in the rest of the world. This shift comes as part and parcel of the process of a slow and gradual erosion in the valuation of the public goods provided by the United States, as well as the country’s reliance on foreign capital associated with its rapidly increasing public sector borrowing requirement and debt levels.3

Clearly, these national changes will have important international implications. Yet the global consequences go well beyond this. After all, the global financial crisis has undermined the credibility of the Anglo-Saxon model, which hitherto acted as an important global convergence magnet. Moreover, the United States is no longer in a position to press other countries to deregulate, liberalize, and globalize.

Simply put, a dominant financial services sector—as measured by contributions to economic activity, employment, and profitability—is no longer deemed to legitimately constitute the highest level in economic maturation. Given the absence of an alternative convergence magnet, the risk of global economic fragmentation in the new normal is not immaterial. Protectionist threats will prevail, as will a slow process of partial erosion in two important public goods: the role of the U.S. dollar as the global reserve currency, and the attractiveness of the U.S. financial system as the totally dominant destination for intermediation outsourced by other countries.

Together, these factors constitute an important change in the operational landscape for investors, including SWFs. They call for a retooling of investment strategies and risk management, as well as business and other operational strategies. They involve adaptations in human resources, technological systems, and processes. And they require a higher degree of communication with economic and political stakeholders, as well as with national and international counterparties.


SWFs have an important advantage in managing the road to the new normal: Their capital characteristics and the long-term nature of their objective function are key enablers when it comes to the potential to capture first-mover advantages. Indeed, the question should not be whether this pool of patient capital is able to pursue a first-mover strategy—it is. The question is whether it is willing to do so. The process will test the responsiveness of SWFs’ governance structures, the robustness of their investment processes, and the effectiveness of their internal and external communication activities.


Governance structures will be called on to respond to the combination of cyclical and secular changes, appropriately shifting the emphasis over time from defense to offense. At the most fundamental level, this response will require that the institutions obtain overall guidance from their governing bodies—directly, and by those bodies’ shielding SWFs from distractions—that enables the SWFs to (1) adopt forward-looking secular asset allocations that are (2) anchored by solid cash, liquidity, counterparty, and collateral management; and (3) supplemented by appropriate exposure to cyclical dislocations. Implementation will (4) require using investment-savvy vehicles that (5) reside in robust institutional platforms. All this must be (6) accompanied by holistic risk-management frameworks that (7) supplement conventional asset class diversification with targeted and cost-effective tail risk management.

Having set the overall principles to guide a favorable outcome on these seven points, the governing bodies of SWFs will need to rely on management and staff for effective execution. The governing bodies must also play a more important role in protecting SWFs from pressures to become subservient in funding noncommercial activities—domestically, regionally, and internationally.4

Given the fluidity of the global system, governing bodies will also need to provide more frequent assessment and verification with an open mind toward midcourse correction as needed. Policy portfolios will inevitably be subject to greater variability over time, and traditional backward-looking indices for specific asset classes will have to become more forward-looking.

Investment Processes

Adaptability and agility in investment management cannot be created overnight. They require that significant and sustained efforts be devoted to processes and structures that are able to dynamically develop responsive frameworks and, as a result, ensure that investment decisions are made in the context of a relatively high degree of conviction and foundation. Several SWFs are well advanced in internalizing such processes and structures. Their effectiveness will be tested in how well they enable the institutions to navigate the journey and to position for the new normal.

Superior navigation of the journey requires, first, a strong defense in the form of prudent cash, liquidity, and counterparty and collateral management. Once this is achieved, investors can pursue with more confidence opportunities that mesh well with SWFs’ greater ability to underwrite liquidity risk factors. These involve situations where (1) valuations are already disrupted; (2) price appreciation is consistent with the realities of the new normal; and (3) there are identifiable short-term catalysts that allow for the price appreciation to occur, closing the valuation gap between technicals and fundamentals.

As Sull (2009a) points out, institutions that seize such opportunities do so because of their ability to collect and process “rush data,” as well as to “use simple rules for a complex world.” Critically, “rather than match market complexity with complicated strategy,” these institutions are able to “apply a small number of heuristics to critical processes.”

Positioning for the new normal also requires adaptability and agility. Once again, SWFs dominate most other investors when it comes to enabling structural attributes. For example, lacking the home bias trap of many other investors,5 several SWFs are already well advanced in formulating and implementing forward-looking asset allocations.

Three elements will stand out for those SWFs that end up securing a remunerative first-mover advantage in positioning for the new normal:

First, these SWFs will have relatively larger, and carefully differentiated, exposures to equity and credit risk factors in those parts of the world that are likely to account for an even higher percentage of growth in the global economy. They will also be able to invest in activities that complete markets, be they in the rapidly developing segments of the mortgage complex in Brazil or the still-lagging components of the corporate bond arena in east Asia.

Second, these SWFs will be among the first to protect against the potential medium-term resurgence of higher and less stable inflation. Such protection will involve a range of asset classes, starting with appropriately priced inflation linkers (such as Treasury Inflation-Protected Securities in the United States) to utility-oriented infrastructure investments and commodity baskets.

Third, these SWFs will actively clip their tails through the use of more focused risk-management techniques. Such tail hedging must treat the task as equivalent to managing a distinct asset class using an active, responsive, and cost-effective approach. The critical inputs will come from scenarios that take their cues from the underlying risk factor exposures (rather than conventional asset classes) and the appropriate mix of self- and external insurance.6


SWFs operate in a complex sociopolitical context, at home and abroad. They must, therefore, achieve a sufficient degree of trust from the political masters and from society at large. Indeed, this is an inherent part of successfully meeting the implicit contract that comes with setting up an investment management operation in the public sector.

Communication is increasingly recognized as crucial to ensuring the appropriate amount of buy-in—in both the good times and the bad times. The global financial crisis has highlighted the importance of establishing a proper context for politicians and others to evaluate what is taking place in the portfolios of SWFs.

Appropriate communication is also key to minimizing the risk of improper capture of SWFs by narrow interests. Yet, with the exception of some SWFs (most notably Norway’s Government Pension Fund–Global), implementation of adequate communication is still evolving. The key lies in aiming for greater clarity in disseminating timely information on SWFs’ objective setting, on their overall strategy, and on medium-term evaluation metrics.

The operational effectiveness of some SWFs is challenged by domestic and external confusion about their objectives. This lack of clarity renders these funds’ decisions more vulnerable to misunderstandings, to a misspecification of underlying motives, and accordingly, to disruptive interference.

The situation becomes even more troublesome when paired with limited transparency into how SWFs pursue their objectives. Individual actions can be easily misinterpreted if viewed in isolation rather than as part of a series of mutually consistent steps. This is particularly the case for individual investment decisions that often are viewed as unique events as opposed to integral to an overall portfolio strategy that involves the effectiveness over time of many potential return engines.

Finally, these risks can be easily compounded by a lack of subsequent evaluation mechanisms. The bumpy journey to the new normal calls for even greater dissemination of results. Critically, and consistent with the mandate of SWFs, reported results should be placed in a medium-term context. Evaluations should involve both the absolute numbers, and those numbers in relation to internal and peer-group benchmarks.


In the aftermath of the 2007–09 global financial crisis, the world is in the midst of both major cyclical dislocations and large secular realignments. The bumpy road to the new normal is a consequential phenomenon that requires retooling by virtually every segment of the global economy.

Although SWFs were not able to sidestep the global financial crisis, they are well placed as a group to navigate the journey and position for the destination. Indeed, the patient characteristics of their large capital pools result in the best set of enabling conditions among virtually all investors.

Exploiting these enabling conditions is far from ensured or automatic. Success requires continuous improvement in the institutional responsiveness of SWFs, which, as argued in this chapter, brings to the fore issues of governance, investment processes, and communication.

Such improvements are not easy to deliver. They may take some SWFs out of their operational comfort zones, and they involve risks. Yet, given the scale of ongoing and prospective changes in the global economy, the alternative of maintaining a business-as-usual approach could involve even greater risks.


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Specifically, following the manner in which Lehman Brothers failed on September 15, 2008–an event that disrupted the global payments and settlements system, resulting in cascading market failures, acute pricing anomalies, and a series of emergency (and experimental) policy responses.


For a contextual discussion, see Summers, 2007.


The United States also starts from a position where the average maturity of its outstanding debt has fallen to a more vulnerable level—a level not seen since the early 1980s.


Such funding is best undertaken in the context of explicit budgetary appropriation.


For a related discussion, see French and Poterba, 1991.


For additional information on this topic, see Bhansali, 2008.

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