Bocconi University, November 17, 2011 PBC-CAREFIN Seminar “Curbing Volatility: Financial Markets,...

Bocconi University, November 17, 2011PBC-CAREFIN Seminar “Curbing Volatility: Financial Markets, Credit Rating Agencies, and Sovereign Investment Funds”

Taming Leviathan:a Regulatory Framework for Sovereign Wealth FundsVictoria BarbaryPaolo Baffi Center, Bocconi University

Bernardo BortolottiUniversità di Torino and Paolo Baffi Center, Bocconi University

Curbing Volatility SeminarBocconi – November 17, 20112

1. Background: the trade-off of sovereign ownership

SWF as a tool to address market failures in long term investment and domestic economic development

SWF as a politically oriented arm to assert the geopolitical ambitions of emerging countries

Benevolent dictator’s SWF Neo-mercantilist SWF

January 19-25, 2008


2. Facts: SWF history

IPIC, Abu Dhabi

1990

Government Pension Fund - Global, Norway

2008

GIC, Singapore

BIA, Brunei

National Social Security Fund, ChinaKNF, Kazakhstan

CIC, ChinaEmirates Investment Authority, UAEADIC, Abu Dhabi

National Wealth Fund, Russia

QIA, QatarKIC, KoreaTimor-Leste Petroleum FundRIA, Ras Al KhamahState Capial Invest. Corp., Vietnam

LIA, LibyaFuture Fund, AustraliaInvestment Corp., DubaiState Oil Fund, AzerbaijanBahrain Holding, BahrainOIF, OmanDIFC, Dubai

2000

IPRF, IrelandNew Zealand Superannuation Fund, NZ

Mubadala Development Company, Abu Dhabi

Istithmar World, Dubai

KNB, Malaysia

Revenue Equalization Fund, Kiribati

National Oil Account, Sao Tomé

KIA, Kuwait

1953

Temasek Holdings, Singapore

ADIA, Abu Dhabi

1980

State General Reserve Fund, Oman

Source: Sovereign Investment Lab

1960 1970


2. Facts: the largest SWFs by AUM, 2010

Country Source of Funds Fund Name Assets Under Management

Founding Date

Norway Commodity (Oil) Government Pension Fund-Global $560,5bn 1990

United Arab Emirates Commodity (Oil) Abu Dhabi Investment Authority $342bn 1976

China Trade Surplus China Investment Corporation $332,4bn 2007

Kuwait Commodity (Oil) Kuwait Investment Authority $296bn 1953

Singapore Trade Surplus Government of Singapore Investment Corporation $220bn 1981

Singapore Govt Linked Companies Temasek Holdings $133bn 1974

China Trade Surplus National Social Security Fund $132bn 2000

Russia Commodity (Oil) National Wealth Fund $94,3bn 2008

Qatar Commodity (Oil&Gas) Qatar Investment Authority $80bn 2005

Libya Commodity (Oil) Libyan Investment Authority $53,3bn 2006

Australia Commodity (Various) Future Fund $77,2bn 2006

United Arab Emirates Commodity (Oil) International Petroleum Investment Company $49,7bn 1984

Kazakhstan Commodity (Oil&Gas) Kazakhstan National Fund $41,9bn 2000

Republic of Korea Trade Surplus Korea Investment Corporation $37,6bn 2005

Brunei Commodity (Oil) Brunei Investment Agency $39,3bn 1983

Total Oil & Gas $1.599,1bn

Total Other $1.079,6bn

Grand Total $2.678,8bn

Source: DB Research; Peterson Institute for International Economics; SWF Institute; Nadim Kawach, “UAE’s overseas investment income to rebound in 2009,” Emirates Business 24-7, April 2009; Hadfi eld, “Kuwait Investment Authority loses $31bn in nine months,” Meed Middle East Business Intelligence, February 11, 2009; Mubadala Annual Report 2008; Brad Setser and Rachel Ziemba, GCC Sovereign Funds: Reversal of Fortune, WP, January 2009 (Council on Foreign Relations, New York: 2009).


2. Facts: SWF Investment from MENA, 2000-2010

Since 2000, MENA SWFs have invested $172,6bn primarily in Europe (42%), within MENA (26%), and in North America (23%). Contrary to Asia, MENA balance domestic investment with international diversification.

MENA to Asia Pacific50 deals, $7.5bn

MENA to Sub-Saharan Africa27 deals, $4.4bn

MENA to Russia & Central Asia

16deals, $1.7bn

Within MENA145 deals, $45.2bn

MENA to Latin America5 deals, $0.5bn

MENA to North America60 deals, $40.2bn

MENA to Europe124 deals, $73.0bn

Source: Sovereign Investment Lab Transaction Database


2. Facts: Barbarians at the Gate?


Utilities, 7%

Transport, 1%

Natural Resources, 11%

Banking, Insurance, Trading

40%

Other16%Automotive

10%

Real Estate13%

Telecoms, 1%Aircraft, 1%

21% Strategic Sectors

SWFs foreign investment by sector, 2000-2010


2. Facts: SWF activity by type of political regime

Percentage of SWF Assets under Management by Political Regime, 2010

Authoritarian Regime

54%

Hybrid Regime17%

Full Democracy

27%

Flawed Democracy

2%

Source: Sovereign Investment Lab; 2010 EIU Democracy Index

SWF Investment Flows, 2000-2010

$-

$10.000

$20.000

$30.000

$40.000

$50.000

$60.000

$70.000

$80.000

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

US$ Mn

AuthoritarianFlawed DemocracyFull DemocracyHybrid



2. Facts: Foreign exchange reserves and political regimes

$0

$1.000

$2.000

$3.000

$4.000

$5.000

$6.000

$7.000

$8.000

$9.000

$10.000

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

2006

M1

2006

M5

2006

M9

2007

M1

2007

M5

2007

M9

2008

M1

2008

M5

2008

M9

2009

M1

2009

M5

2009

M9

2010

M1

2010

M5

US$

Mn

Total Global ReservesFull DemocraciesFlawed DemocraciesHybrid RegimesAuthoritarian States

Source: International Monetary Fund, International Finance Statistics Database; EIU Democracy Index 2010


3. SWF investment and political risk

Does it matter?Yes. Political risk could affect the risk and return properties of SWF targets via:

Upheaval risk, transforming the country’s wealth management from savings towards divestiture and public spending to assuage protestors

Geopolitical risk, events could trigger the use of targeted financial sanctions freezing SWF assets (e.g. Libya)

SWF metamorphosis: from patient, long-term investor providing capital over the business cycles to a short-term player with unpredictable liquidity needs.


3. The financial performance of SWF targets

Source: Bortolotti et al. (2010), “Quiet Leviathans: Sovereign Wealth Funds Investments, Passivity, and the Value of the Firm”, mimeo.

0,00%

-1,67%

-3,96%

-6,25%

-11,83%

0,00%

-2,15%

-1,51%

-8,35%

-10,47%

-12,00%

-11,00%

-10,00%

-9,00%

-8,00%

-7,00%

-6,00%

-5,00%

-4,00%

-3,00%

-2,00%

-1,00%

0,00%

Investment 6 months 1 year 2 years 3 years

Adju

sted

Per

form

ance

Abnormal Return

Return-on-Equity


3. The EUI Index of political unrest for SWF countries

% OF POPULATION

UNDER 25

GOV'T YEARS IN POWER

CORRUPTION INDEX

DEMOCRACY INDEX

CENSORSHIP INDEX

GDP PER CAPITA PPP ILLITERACY RATES

INTERNET PENETRATION

RATE

TOT.

COUNTRY % share yrs share indexval share indexval share indexval share value share % share % share

Norway 31,90 0,81 n/a - 6,80 0,09 - - - - 52.013 0,18 - - 94,80 1,25 2,33

Singapore 29,80 0,76 6,00 0,18 - - 51,90 0,65 79,50 1,00 56.522 0,17 5,60 0,45 77,80 1,03 4,24

Malaysia 47,80 1,23 n/a - 38,30 0,48 44,90 0,56 73,40 0,91 14.670 0,64 8,10 0,65 64,60 0,85 5,32

China 36,80 0,94 7,00 0,21 53,40 0,66 86,00 1,08 94,20 1,17 7.519 1,25 6,70 0,54 34,40 0,45 6,30

Korea 29,80 0,76 n/a - 26,70 0,34 12,70 0,16 34,90 0,44 29.836 0,31 - - 81,10 1,07 3,08

Bahrain 35,00 0,89 12,00 0,36 32,80 0,41 77,20 0,96 79,60 1,00 26.852 0,35 11,20 0,90 88,80 1,17 6,04

Libya 49,00 1,25 42,00 1,25 100,00 1,25 100,00 1,25 100,00 1,25 13.805 0,68 13,20 1,06 5,50 0,07 8,06

Oman 49,00 1,25 41,00 1,20 28,00 0,35 90,50 1,13 79,60 1,00 25.439 0,37 15,60 1,25 41,70 0,55 7,10

Qatar 28,00 0,71 16,00 0,48 13,00 0,16 86,00 1,00 76,00 0,95 88.559 0,11 6,90 0,56 60,90 0,79 4,76

Kuwait 37,00 0,94 5,00 0,15 37,00 0,46 72,10 0,90 60,00 0,75 37.849 0,25 5,50 0,48 39,40 0,52 4,45

UAE 34,00 0,87 7,00 0,21 19,00 0,24 93,60 1,17 79,60 1,00 56.580 0,17 10,00 0,80 75,90 1,00 5,46


3. The stock return of SWF targets: assessing political instability

Variable: Buy and Hold Adjusted Returns |

1 Year from Investment

2 Years from Investment

Political Unrest Index | -.31309864 -.32604307| 0.0284 0.0747

Govt Involvement | .05410613 -1.4061047| 0.9327 0.3018

SWF passivity | -.19614493 -.50469912| 0.2138 0.1473

Strategic Target Dummy | .020129 .04296757| 0.7333 0.7322

SWF Age | -.01018229 -.07029254| 0.6413 0.1436

Capital Infusion | -.62466721 1.9326637| 0.7566 0.4157

SWF Stake | .21320963 -.8246279| 0.8604 0.1488

Foreign Target Dummy | -.62759119 -1.1820403| 0.0000 0.0000

Target Market Value| -3.622e-06 -.00001155| 0.3285 0.0173

Target Leverage | .10698612 -.23162654| 0.4606 0.2909

Target Liquidity | .01115337 -.00152727| 0.2823 0.9656

SWF in the Board| .13625312 .04482498| 0.2150 0.7342

Buy and Hold Returns | -.05082958 -.05358762(previous year)| 0.0090 0.0104

Constant | 19.691.506 4.4301511| 0.0237 0.0119

Number of Obs | 293 144R2 | .04359465 .22252844


4. Pecunia non olet? Market failure considerations

Under laissez faire, increased political risk will restrict capital flows and investment opportunities in recipient countries. Contraction of international SWF investment will cause excessive FOREX accumulation, inflationary and exchange rate pressures in emerging countries, impinging economic development.

Political stability in emerging countries is a global public good. Decentralized, market-based systems will not provide efficient solutions. Market sanctioning by SWF targets will not trigger a socially efficient democratic transition abroad.

Market failure considerations provide a rationale for SWF regulation


5. Towards a smart regulation of SWF

The current regulatory framework on foreign investment Not targeted to SWF, varies by countries, generally protects

national security and strategic sectors US: mandatory clearance by CFIUS in case of acquisition by

sovereign investor EU: free movement of capital enshrined in Treaty, but legal

barriers are widespread in most member countries

The Santiago principles 24 (voluntary) Generally Accepted Principles and Practices (GAPP)

on governance, accountability and transparency Sponsored by IMF, OECD, and World Bank, undersigned signed by

23 SWF



The current regulatory framework at the national and multilateral level generally fails to address political risk

Targeted sanctions: the UN can adopt resolutions involving restrictive measures (such as asset freeze) to target the political elite in case of violation of international laws

Financial targeted sanctions are extreme solutions and operate ex post, not effective in preventing and mitigating ex ante political risks



Complementary non-legal measures

GAAP 25: "While members consider being in the mutual interests of recipient countries and sovereign investors to maintain free movement of capital, they also realize that social inequality and political instability in the investing country represent critical risk factors in the international allocation of capital. Upon these considerations, members agree that sovereign investment abroad will be associated with commitments to foster economic prosperity, social progress and political reforms in the investing country".

Amendment of the code of conduct of stock exchanges inviting listed companies to disclose SWF presence as a risk factor



Complementary legal measures

A CFIUS-style preventive mechanism, requiring a mandatory clearance of SWF acquisitions of the basis of a case by case review of countries' political outlook.

Establishment of the Sovereign Investment Office within a recognized international organization. On the basis of independent assessments, the Office could publish a list of “politically risk neutral” SWFs with a blanket authorization to operate globally, or establish a conditionality on investments based on case-by-case undertakings in the space of human rights, political freedom, constitutional reform and democratic transition.


5. Conclusions

Recent revolts in the Arab region are causing a metamorphosis of SWF from long-term, patient investors to short-term operator carrying political risk, affecting negatively the performance of target firms.

SWFs assets subject to political risk are worth $2 trillion and thus systemic.

Market failure considerations suggest that a SWF-specific regulatory framework may be desirable.

Self-enforcing solutions could be agreed upon at the multilateral level, given the countries’ mutual interest in open capital markets, peace and security.

Bocconi University, November 17, 2011 PBC-CAREFIN Seminar “Curbing Volatility: Financial Markets,...

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