Sovereign Wealth Fund Institute

The U.S. inflation-linked bond sector has experienced major outflows since the start of 2013. Treasury Inflation Protected Securities also called Tips performed well in recent years. With regard to Tips, there is concern that real yields can increase along with nominal bond yields without inflation growing. The theory behind inflation-linked bonds is to allow investors the chance to hedge risk on negative yields on government bond portfolios. In the 1950s, many emerging market economies issued inflation-linked bonds.

In 2012, Norway’s Government Pension Fund Global (GPFG) sliced inflation-linked bond holdings by 73% – reduced to 42.2 billion NOK. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

The Federal Reserve’s balance sheet has mushroomed more than US$ 3.3 trillion. During the last week of April at the Federal Open Markets Committee, the Federal Reserve maintained their US$ 85 billion a month asset purchasing program with conditions. Interest rates remain at historic lows to accommodate a loose monetary policy.

According to the May 1st reserve statement, “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”

Current Federal Reserve policy is targeted to boost asset prices. The Federal Reserve believes current fiscal policy of the United States is partially restraining growth. Federal tax increases and government spending cuts are affecting the job market. According to the ADP National Employment Report, service-providing jobs increased by 113,000 in the United States, the weakest pace of growth in seven months.

In mid-April 2013, there was a massive sell-off in the world gold market. Strategists at Goldman Sachs informed clients to short gold, targeting US$ 1450 an ounce. At the time gold was trading around US$ 1570 per ounce. Several of the large bullion banks had major short positions in precious metals in early January. A myriad of commodity research reports predicted a gold peak, partly due to “risk-off” and investor gravity toward public equities.

Fluctuations in the value of assets are a normal market function. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Inflows are heating up; China’s foreign reserves recorded their largest quarterly increase since the second quarter of 2011. Foreign reserves sprouted up by US$ 130 billion, totaling US$ 3.44 trillion in the first quarter of 2013. The foreign reserve increase is a reversal from 2012 when money exited China.

Augmenting credit growth occurred in China in the first quarter of 2013. Over the past two months, the People’s Bank of China increased liquidity withdrawals to mollify the inflationary influence of capital inflows. The inflows are partly caused by mega bond-buying initiatives by the Federal Reserve and the Bank of Japan which are expanding their monetary supplies.

Occidental countries maintain employment of quantitative easing (QE) programs to fend off another financial drop. To prevent fallout in asset prices, central banks have played an important role in reflating risk assets. A negative spiral down in the value of assets would be catastrophic. In recent board minutes, most Federal Reserve board members believe asset purchases should continue at least till the middle of 2013.

In the era of fiat currency, there is change in conviction in central banking in which remarkably low interest rates are the new normal.

Mega policy stimulus from global central banks has benefited equity markets at the expense of savers in fixed income. On April 10, 2013, the S&P 500 topped its 2007 trading record high, climbing to 1585.65. With that being said, how long will the U.S. equity market rally last? Is it sustainable? The linkages between quantitative easing policies and stock market movements are complex to say the least. Since the Federal Reserve is buying mortgage-backed securities (MBS) in relation to QE policy, essentially they are driving down mortgage rates. These mortgage rates have augmented housing market activity, coupled with investors buying foreclosures, pushing up the value of housing.

Mature public companies that are flush with cash on their balance sheets and pay dividends are likely contributing to the surge in U.S. equity markets. Dividend-paying companies provide alternative relief from corporate bonds.

In the long-run, the Federal Reserve will eventually exit their QE policies. Central banks and monetary authorities have been accelerating leverage risk to the future as large debt-to-GDP rations in old, developed economies will put severe strain on the world economy. Public funds are weary of this surge in equity prices. High volatility in the equity markets have been a turnoff for public investors, especially when allocated to active strategies.

S&P 500 Index

Over the past decade, the American-centric base of economic power has been shaken. Mounting deficit spending, a financial meltdown, lackluster sustainable GDP growth and growth of the Federal Reserve’s balance sheet have negatively affected the long-term economic health of the United States. During the late 1920s, the U.S. dollar surpassed the pound as the world’s dominant currency. When will the United States give up the currency crown? Across the Pacific Ocean, the government of China is patiently adamant on efforts of internationalizing their currency.

China has a tight grip on the renminbi (RMB). If China desires faster internationalization of their currency, the People’s Bank of China (PBOC) will need to deregulate and reform policies such as capital controls. China’s financial markets must be deep, liquid and open to attract RMB demand for expansion. China has made some progress which includes allowing Chinese entities with approvals to use RMB for direct overseas investments and reforming their QFII program.

China has a long journey ahead toward RMB internationalization.

[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Amando M. Tetangco, Jr.

Philippines – Total Reserves includes Gold

Source: World Bank

Cyprus is another economic contagion Eurozone members are seeking to mollify. Facing national bankruptcy, the Mediterranean island nation has few options. The financial sector of Cyprus is nearly eight times the size of the economy. Eurozone officials developed a unique package to salvage Cyrus’s popular banking industry. The proposed bailout would help save the country’s financial sector, but the long-term damage would negatively affect the banking industry. In a drastically different approach from previous country bailout programs, Eurozone finance ministers demand Cyrus’s bank depositors forfeit a percentage of their deposits. In return, Cyprus would receive a €10 billion bailout.

To be precise, the bailout proposal levies on deposits are 9.9% for deposit accounts greater than €100,000 and 6.7% on anything below that threshold. Depositors would be compensated with bank shares, taking bank equity risk. In addition, the levy does not apply to Cypriot banks overseas.

Capital flight among EU periphery nations is a major risk.

[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

In general, when people think of sovereign funds what usually comes to mind is a mega pool of government capital that wants to purchase something big. Categorizing sovereign funds is a difficult task, since many vary in size, scope, mandate, investment style and origin.

From funding perspective, sovereign funds receive their initial capital through various means. Fiscal stabilization funds often receive trickles of money flow initially, thus limiting investment options. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Occidental central banks have printed their way out to temporarily avert the financial crisis and economic contraction risks. Before the financial crisis, central banks were net sellers of gold; this trend has clearly reversed regarding Eastern central banks. Central banks still hold a very minute percentage in gold. With Germany repatriating gold back and foreign governments taking physical control of gold, there is a legitimate movement in which governments are slowly stockpiling gold. Russia and China have added hundreds of metric tons of gold to their central banks as financial insurance against Westernized currency regime frameworks. Russia has been buying gold bullion and the Russian Central Bank has a sense the western central banks have been undermining the gold market to the detriment of the developing world. Russia has first-hand experience in currency crises. In 1998, Russia defaulted on US$ 40 billion in domestic debt.

Eastern central banks are not the only group amassing gold. Some sovereign funds have been purchasers of gold.

The State Oil Fund of Azerbaijan (SOFAZ) purchased 17.4 metric tons of gold bullion as of March 1, 2013. 3 tons of gold have been delivered into Baku, the capital of Azerbaijan.

In a Bloomberg telephone interview in Moscow, on February 10, 2013, Russian lawmaker Evgeny Fedorov stated, “The more gold a country has, the more sovereignty it will have if there’s a cataclysm with the dollar, the euro, the pound or any other reserve currency.”

In the fifth occurrence in nine years, the government of Venezuela has devalued their currency again. The Venezuelan government is attempting to mitigate the shortage of dollars in the economy. In addition, the devaluation of the bolivar can assist in narrowing the government’s fiscal budget.

Venezuelan Finance Minister Jorge Giordani said the government will weaken the exchange rate by 32% to 6.3 bolivars per dollar from 4.3 bolivars per dollar. The new exchange rate will start on February 13, 2013. The Sistema de Transacciones con Títulos en Moneda Extranjera (SITME), the central bank-administered currency market, will be eliminated following the change.

Venezuela is a member of Organization of the Petroleum Exporting Countries (OPEC) and is fourth biggest source of imported oil for the United States.

Korea’s foreign exchange reserves touched a record high in January 2013.

Foreign reserves touched US$ 328.91 billion in January 2013, up US$ 1.94 billion from December 2012. The Bank of Korea attributed this to higher conversion values of non-dollar assets and an increase in investment profits.

Japanese Prime Minister Shinzo Abe desires the central bank to ease monetary policy to counter deflation and encourage export-led growth. Trillions of yen are to be pumped into the Japanese economy from asset purchases. Tokyo’s foreign-exchange policy could be a catalyst for a future Asian currency war. The Bank of Japan (BOJ) announced an open-ended easing plan and a 2 percent inflation target to stimulate growth. Many economists are worried about the Bank of Japan losing independence and caving to executive political pressure.

The government of Japan is adamant that the reason for this is to combat deflation and revive growth.

At the 2013 World Economic Forum in Davos, Bader Al-Sa’ad, the managing director of the Kuwait Investment Authority (KIA) informed news sources that, “the only fear is the decline of the yen. The decline of the yen could trigger a currency war in the countries of Southeast Asia; this is the only fear we have at the moment.”

Japanese public officials quickly countered that far and few complaints regarding trade advantages were brought up when U.S. and European economies embarked on quantitative easing policies. There is possible political consequences with China, a weakened yen might provide fuel for China to slow down renminbi appreciation. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

For the first time in history, the Federal Reserve has grown its balance sheet passing US$ 3 trillion. To bring this into perspective, the Federal Reserve’s balance sheet on September 10, 2008 was US$ 924 billion.

The bond buying program (quantitative easing) is designed to add tinder to the economic recovery by undertaking open-ended purchases of Treasuries and mortgage-backed securities. The US$ 85 billion monthly purchases will cease once the U.S. labor market substantially improves upon determination of the Federal Reserve. The Federal Reserve is counting on the excessive slack in the U.S. labor market which is pushing out inflation to future years.

Germany’s Bundesbank is planning on relocating some of its gold in New York (New York Federal Reserve) and Paris (Bank of France) back home. Germany is the number two holder of gold reserves. Only the United States holds more gold.

The Bundesbank plans to move a small portion of its gold reserves back to Germany, some people see it as a sign of a central bank trust breakdown. Debt limit standoffs, quantitative easing, and social unrest in some regions of Europe, make a strong case for repatriation. The printing of money and balance sheet growth of central banks have made some governments uneasy.

During the Cold War, Germany moved the bulk of its gold reserves abroad in case of an attack from the Soviet Union.

China’s State Administration of Foreign Exchange (SAFE) has created a new investment body named SAFE Co-Financing. This extension of SAFE will assist Chinese companies invest overseas by providing credit loans backed by foreign exchange reserves. Instead of allocating capital to a sovereign fund and then to a fund manager or asset, SAFE Co-Financing will allocate capital through Chinese financial institutions. These institutions will provide financing opportunities for Chinese companies in overseas investing and trade.

SAFE is trying to diversify their investment strategy in their massive pool of foreign exchange holdings. In addition, they want to maximize efficiency.

[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

At the close of 2012, official foreign currency reserve assets of Hong Kong amounted to US$ 317.3 billion. The end of November 2012, foreign currency reserve assets tallied to US$ 305.2 billion.

Hot money continues to flow into Hong Kong. According to the Hong Kong Monetary Authority (HKMA), US$7 billion of funds entered Hong Kong since the Federal Reserve began a third round of quantitative easing (QE) in September 2012. The HKMA continues to intervene in currency markets to weaken the Hong Kong dollar.

Central bankers from around the globe, especially in Asia are concerned about the possible effects of relying too much on quantitative easing (QE) policies. This comes after the Federal Reserve embarks on an ambitious buying program of mortgages and treasuries. Quantitative easing poses risks for investors as the man-made increase of asset prices creates market distortions. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

In October 2012, the foreign ownership level of U.S. Treasuries rose to a record level. According to the U.S. Treasury Department, total foreign holdings of U.S. Treasuries grew to US$ 5.48 trillion in month of October. This is 0.1% up from September.

Largest Foreign Holders

• China – US$ 1.16 trillion
• Japan – US$ 1.13 trillion
• Brazil – US$ 255.2 billion

Since the global financial crisis, the Federal Reserve has been buying treasuries and agencies at around US$ 500 billion per annum. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Since 2003, global reserves have more than doubled. There has been a gradual shift from U.S. dollars to euros over this time period; however, U.S. dollars still dominate in proportion at greater than 60% of total world reserves. In addition, emerging markets’ accumulation of reserves has outpaced advanced economies. Exports have contributed to emerging markets’ massive current account surpluses. In addition, capital inflows in emerging markets will magnify due to economic growth and interest rate differentials between Western and emerging market economies.

With massive amounts of reserves, currency diversification will be inevitable, but at a snail’s pace.

The good news is that during the global financial crisis, the magnitude of the devastation was partially mitigated by the growth of emerging market reserves playing a greater role in the world economy. Once recovery in the United States takes a stronger hold, the U.S. savings rate decline will continue that will restore the process of global imbalances. As long as the U.S. dollar remains the world’s reserve currency and continues wear the badge of being a safe-haven country, the United States will be able to finance large current account deficits.