Sovereign wealth funds and financial stability (Registration required)

Publication date 30th March, 2009,http://www.voxeu.org/index.php?q=node/3360.
The present financial crisis has placed financial stability at the forefront of policy discussions. At the same time, sovereign wealth funds have become much more significant players over the past two years. This column summarises the results of some recent studies about sovereign wealth funds and their implications for financial stability. Overall, the existing research on SWFs suggests that they can be a stabilising force in global financial markets.

Sovereign wealth funds (SWFs) are defined as special-purpose investment funds or arrangements owned by the general government. They are often funded by balance of payments surpluses, official foreign currency operations, proceeds of privatisations, fiscal surpluses, or receipts resulting from commodity exports. Their total assets have been estimated at $2-3 trillion, but many of them have suffered unrealised losses stemming from the ongoing financial crisis.

There have been many arguments put forth regarding the potential positive and negative effects of sovereign wealth funds on global financial markets. Some argue that SWFs can play a stabilising role in global financial markets. First, as long-term investors with no imminent call on their assets and mainly unleveraged positions, SWFs are able to sit out longer during market downturns or even go against market trends. For example, the SWFs’ capital injections into systemically important financial institutions in late 2007 and 2008 augmented the recipients’ capital buffers and helped reduce risk premia for some banks, at least in the short term. This provides initial evidence that SWFs may reduce volatility in financial markets. In addition, SWFs in some countries, particularly in the Middle East, have recently supported domestic equity markets and financial institutions. Second, large SWFs may pursue portfolio reallocations gradually in order to limit adverse price effects of their transactions. Third, as long-term investors that add diversity to the global investor base, SWFs could contribute to greater market efficiency, lower volatility, and increased depth of markets.