Sovereign Wealth Fund Institute

Central banks and official reserve institutions are in change mode. Investment returns are ranked lower on criteria as compared to safety and liquidity. For some central banks, liquidity has a higher priority than capital preservation. Reserve managers face a tough dilemma, find a safe haven to park funds but be concerned about the U.S. credit downgrade and future value of the U.S. dollar.

In the past few months, several central banks have lowered exposure to bank commercial paper, certificates of deposits, and time deposits. The European financial crisis has shaken the confidence of reserve managers and many want to limit exposure in the banking sector. The European monetary union is under pressure, while member countries try to deal with mounting public debt. Many countries have lived beyond their economic means. The global crisis has caused a flight to safe haven government bonds such as the United States, Japan, the United Kingdom and Germany.

Demand for safe haven sovereign debt has lowered yields, giving rise to opportunistic investors in second tier debt markets.

The Japanese yen is enjoying safe haven status as it jetted to an 11-year peak against the euro in January 2012. Despite loose monetary policy by the Federal Reserve, globally reserve managers see U.S. treasuries as the safest liquid asset in absence of a credible alternative. Some central banks are leaving Eurozone government bonds besides Germany, France, and the Netherlands.[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

China is trying to plan for a gentle landing for the economy as growth slows and inflation remains high.

The People’s Bank of China said it will decrease the reserve requirement ratio by 50 basis points from February 24, 2012. This is the first announced cut in three years, reversing a policy of ratio increases. The ratio cut will bring it down to 20.5% for the biggest banks. It will free theoretically around RMB 400 billion for new lending.

Banks with low loan-to-deposit ratios such as the China Construction Bank will have more capacity to stimulate loan growth.

Established in 2007, the China Investment Corporation (CIC) was created and originally had US$ 200 billion in registered capital from China’s Ministry of Finance.

China is deploying more reserves to the CIC to increase financial returns. After the Chinese New Year holiday, the China Investment Corporation received an undisclosed amount from the People’s Bank of China. Before the injection, the fund was around US$ 410 billion. The CIC has been seeking capital to expand its investment portfolio and generate higher returns.

According to the press release, “Given the EU’s serious and deepening concerns over the Iranian nuclear programme, the Council today broadened the EU’s restrictive measures against that country. Today’s decisions target the sources of finance for the nuclear programme, complementing already existing sanctions.

The Council banned imports of Iranian crude oil and petroleum products. The prohibition concerns import, purchase and transport of such products as well as related finance and insurance. Already concluded contracts can still be executed until 1 July 2012. A review of the measures relating to oil and petroleum products will take place before 1 May 2012. In addition, the Council outlawed imports of petrochemical products from Iran into the EU as well as the export of key equipment and technology for this sector to Iran. New investment in petrochemical companies in Iran as well as joint ventures with such enterprises are also no more allowed.

The Council also froze the assets of the Iranian central bank within the EU, while ensuring that legitimate trade can continue under strict conditions. Trade in gold, precious metals and diamonds with Iranian public bodies and the central bank will no more be permitted, nor will the delivery of Iranian-denominated banknotes and coinage to the Iranian central bank. A number of additional sensitive dual-use goods may no more be sold to Iran.

Finally, the Council subjected three more persons to an asset freeze and a visa ban. It also froze the assets of eight further entities.”

Source: Council of the European Union – Press Release

According to the press release, “The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.

These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.

As a contingency measure, these central banks have also agreed to establish temporary bilateral liquidity swap arrangements so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant. At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar, but the central banks judge it prudent to make the necessary arrangements so that liquidity support operations could be put into place quickly should the need arise. These swap lines are authorized through February 1, 2013.

Federal Reserve Actions
The Federal Open Market Committee has authorized an extension of the existing temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank through February 1, 2013. The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.”

Source: Federal Reserve

According to Japan’s Ministry of Finance, official reserve assets rose to US$ 1.209 trillion at the end of October. This is an increase of US$ 9.289 billion from September.

In addition, Japan is trying to increase private consumption and investment.

With Greece holding a bailout referendum, downside risk is growing among continental European nations. European leaders made it clear that Greece will give up all European aid if it votes against the agreed bailout package from last week.

The European Central Bank (ECB) is doing everything it can to prevent another recession. In addition, the ECB is also trying to contain an economic contagion that stems from the sovereign debt crisis. To combat this, under the command of new ECB President Mario Draghi, the ECB unexpectedly cut interest rates by 25 basis points to 1.25%. This was a reactionary move since Spanish and Italian borrowing costs climbed after the realization of a scenario of a Greek exodus of the European monetary union.

The ECB is under tremendous pressure to allocate more funds to purchase bonds of distressed European countries.

Libya is trying to get its feet of the ground when it comes to the economy.  Post-conflict, already banks have eased withdrawal rules.  The new administration in Libya is titled towards Islamist principles. Mustafa Abdel Jalil who heads the country’s National Transitional Council (NTC) says that Libya’s banking industry will be made Shariah-compliant. Libya is in restart financial mode and making a substantial move towards creating an Islamic banking industry. The Central Bank of Libya is in preparation to permit lenders and issuers to sell Islamic bonds. Local citizens have issues with conventional banks.

With regards to Libya’s assets abroad, foreign governments have begun to lift sanctions on them with France, Switzerland, and the United Kingdom leading the way.

This is public information released by the BIS.

Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the SWF (Sovereign Wealth Fund) Forum, Montreux, Switzerland, 24 October 2011

To download the full speech (BIS)
To download the full speech (SWF Institute)

Ladies and Gentlemen,

It is my pleasure and privilege to talk in front of this audience of experts and practitioners. I do thank the SWF Forum for this opportunity to share my thoughts on the current challenges of the sovereign debt crisis in Europe.

Montreux seems to be the perfect setting for a central banker to speak. Is there a better symbol for stability and long-term nature than the surrounding Alps? And Lake Geneva represents a perfectly balanced level of liquidity – while central bankers have to deal with the contradiction of abundant global monetary liquidity and a shortage of market liquidity in certain asset classes.

But without further ado, let me embark in today’s topic.

Need for clarification: the often forgotten strengths of the euro area

Some countries in the euro area face a combination of high levels of indebtedness, budget deficits and weak or absent growth. Amid growing market turmoil and the risk of contagion an increasing number of economists call for debt restructuring in the affected countries. These proposals often share an anti-Euro sentiment and seem to be in accordance with the naysayers who were taking potshots at the Euro even before its inception in 1999.

However, many critics ignore the euro area’s strengths. There is a need for clarification. Let me start by stressing some facts:

1. Since its inception almost 13 years ago, the euro area has experienced an unprecedented level of price stability.

2. The euro area has logged real per-capita income growth of around 1 percent a year since 1999, just below the U.S.’s 1.1 percent. Observers often look only at headline growth figures, where the difference is bigger. But the figures match once adjusted for population growth.

3. During the same period of time, the euro area has created 14 million jobs, six million more than the USA.

4. Contrary to common belief, the heterogeneity within the euro area is not significantly bigger than between U.S. states.

5. On a consolidated base public finances are in a much better shape than those of other major currency areas. The euro area as a whole will run a budget deficit of about 4.5 percent of gross domestic product this year. The International Monetary Fund (IMF) expects a U.S. budget shortfall of about 10 percent this year.

6. According to the IMF the aggregate debt-to-GDP for the euro area stands at 87 percent. For the US the debt-to-GDP ratio in 2011 is expected to be 100 percent.

7. The current account is broadly in balance, different from other advanced economies of similar size. For this year the IMF forecasts a current account deficit of 3 percent for the U.S.

Still, there is no room for complacency. The sovereign debt crisis in several Member States of the euro area and financial markets turmoil indicate that we are facing very challenging times.

To download the full speech (BIS)
To download the full speech (SWF Institute)

The Bank of Thailand and Thailand Ministry of Finance have agreed to not use the country’s foreign reserves to create a sovereign wealth fund. There was a significant internal debate among Thailand’s governmental financial bodies on if it was feasible to create a sovereign wealth fund. Including Thailand, the majority of Asian countries intervene to lower the value of their currency. By practicing currency intervention, Thailand and other countries that follow a similar activity, usually hastily accumulate international reserves.

Central banks are known to be conservative “investors” and usually invest in assets with low default risk and high liquidity, thus yielding very low returns. This negative carry has been pushing some central banks into yearly losses.

Left and right, Thailand observes its Asian peers creating sovereign wealth funds to deal with excess foreign reserves.

Thailand Finance Minister Thirachai Phuvanatnaranubala wanted to see if it was possible to invest around US$ 180 billion in foreign reserves in higher-yielding assets. The big concern was government interference or meddling in the central bank over the excess foreign exchange assets.

Giulio Tremonti

Like other Southern European nations, Italy is suffering from severe sovereign debt issues. The Italian Ministry of Finance met with the China Investment Corporation to discuss possible scenarios. Recently, investors wanted greater returns and drove up the bond auction. Italy is trying to lower soaring interest rates and introduce austerity measures. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Regardless of having a budget surplus or deficit, a number of countries in Sub-Saharan Africa are developing or have developed sovereign wealth funds including Nigeria, Ghana, Botswana, Zimbabwe, and now Uganda. Uganda is in midst of creating a commodity-based sovereign fund to manage potential excess oil revenues.  [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Thirachai Phuvanatnaranubala

This isn’t the first time the Government of Thailand has thought of creating a sovereign wealth fund. The previous Thai administration did not move forward. The Bank of Thailand has been instructed by the Thailand Ministry of Finance to study the creation of a sovereign fund and its feasibility. Finance Minister Thirachai Phuvanatnaranubala is giving the central bank a month to finish the study. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Hugo Chavez

Venezuela is fortunate enough to be the largest oil producer in Latin America being courted by several economic powers such as China, Russia, and Brazil.  The country is highly dependent on oil revenues and the price of oil. Nearly 95% of export earnings stem from oil revenues. With the excess petroleum wealth, the country had the ability to take on a myriad of socialist policies, increase military expenditures, and fund infrastructure projects. Venezuelan President Hugo Chavez has transformed the country in a matter of a decade to nearly a centrally planned economy. In fact, numerous foreign companies, especially in the oil sector were forced to be nationalized. Venezuelan President Hugo Chavez also made a statement to nationalize the gold industry in his country.

Recently, the South American nation approved plans to shift money and gold held abroad back to Banco Central de Venezuela. Sources believe $6.3 billion in cash reserves and at least 211 tons of gold are held internationally and are being moved.

What is the reason for the shifting of money and gold?[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Western central banks and monetary authorities have less wiggle room in the current environment. In 2008, the global financial system was operating under terrible economic conditions with numerous financial institutions failing. At that time, the United States was fortunate to have the flexibility to act in terms of using the Federal Reserve, authorizing TARP, and relying on outside capital coming from sovereign funds. Now, the opposite is occurring as economic conditions have gradually improved since 2008; however, fiscal deficits are plaguing governments across Europe and in the United States. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Sovereign wealth funds and other governmental investors will likely continue to hold positions in U.S. treasuries, at least in the short-run. Last Friday, Standard & Poor’s downgraded the United States, while Moody’s and Fitch Ratings affirmed their AAA status for the United States. This downgrade is unlikely to cause any mandatory sell-off of treasuries or massive dump by central banks, governmental pension funds, and sovereign funds since treasuries remain the most liquid asset. At this point in time, the United States is not facing the exact same dilemma that Greece is currently dealing with.

Around the globe, government officials publicly did not state there would be a massive sell off of treasuries from their respective countries.

From a practicality stance, treasuries remain safe as other major Western nations with sovereign debt issues are in similar or worse shape than the United States.

Asian countries are major holders of U.S. treasuries, especially China and Japan. Unlike Japan, in China there is a strong growing consensus from government officials of the need for the United States to curb its addiction on borrowing.

South Korea’s vice finance minister, Yim Jong Yong, told reporters in Gwacheon, “Our faith in U.S. Treasuries has not changed,” after a meeting with counterparts from the central bank and financial agencies.

Major Foreign Holdings of U.S. Treasury Securities in Billions – End of Period

Source – U.S. Treasury

* Includes Channel Islands and Isle of Man
**Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria.

With all things being said, many countries with non-commodity sovereign funds have large allocations to treasuries. For central banks, this is a result to prevent the unwanted appreciation in their currency against the U.S. dollar. If their currencies appreciate over the U.S. dollar it would hurt their export competiveness. Already, Japan has indicated they are willing to intervene again after selling currency on August 4th. Asian central banks are not thrilled about the American downgrade, but they are willing to hold out.

China possesses nearly $3.2 trillion in foreign exchange reserves, mostly in U.S. dollar assets. U.S. treasuries are one of the most actively traded financial instruments on the planet and most liquid. Unwarranted volatility and market uncertainty would weaken the already fragile stability of the international financial system. A short term crisis has been averted; however it seems that Russia and China are not totally pleased. Basically, confidence has not been fully restored. In fact, a prominent Chinese rating agency, Dagong Global Credit Rating Company, has already downgraded the United States from A+ to A.[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

According to the Emirates News Agency, “Due to the controversy at the legislative authorities in the US, around the public debt of the US Government, we have received some questions from local and foreign media entities, said the Central Bank of the UAE in a statement.

It added that the Central Bank of the UAE currently possesses no U.S. treasury bonds or any other financial instruments issued by the U.S. government due to the very low return on holding these instruments.

“We believe that the debate on the U.S. public debt ceiling issue will end with a compromise solution before the deadline date”, the statement added.

It indicated that “We do not believe that it is necessary to imagine that the U.S. government may default on its debts given its enormous potential, and we had seen in the past under President Clinton, the U.S. economy’s ability to reduce its public debt.”

The statement noted that no fear on the U.S. dollar, although it is exposed to price fluctuations as it happens with all the major currencies. Despite the fact that the Central Bank foreign reserves are mostly denominated in U.S. dollars, they are invested mostly in non-US assets. Eventually these investments are not obligations on the U.S. government.

It added that there is no direct link between the dollar-denominated assets and the U.S. Government debt. The peg of the Dirham to the U.S. dollar is steady and consistent.”

Read more: Emirates News Agency

As a tool, central banks often intervene in the foreign exchange market when the buy or sell currencies to influence exchange rates. On Thursday, Japan acted alone to curb the yen’s strength in a unilateral intervention. This was the first time since Japan’s March tsunami that the Bank of Japan intervened in the foreign exchange market to limit their currencies appreciation. On Wednesday, the Swiss National Bank amended their key lending rate to a smaller range near zero. Lastly, the Bank of Japan is contemplating an increase in its ¥10 trillion asset-purchasing program.

Since the end of June 2011, Korea has the 7th largest foreign reserve holdings in the world. The Bank of Korea’s official reserves at the end of July 2011 totaled to $311.03 billion dollars. In addition, the Bank of Korea bought gold holdings worth $1.24 billion. The total gold amount owned is at $1.32 billion. Central banks, sovereign funds, and other governmental investors are using gold as a hedge against western currencies. This was the greatest purchase of gold for the Bank of Korea since the Asian debt fiasco of 1997. Gold prices continue to rise around the world.

Korea also has a sovereign wealth fund called the Korea Investment Corporation.

Korea’s Foreign Reserves Split (July 2011)

• Dollar Securities – 88.5%
• Deposits – 9.2%
• Special Drawing Rights 1.2%
• IMF Reserve Position – 0.7%
• Gold – 0.4%

Source: Bank of Korea

With the increased risk profile of sovereign bonds and other fixed income instruments, many central banks are rethinking their asset allocation for reserves. In addition, government bonds have yielded historic lows in recent months. A decade ago, a majority of central banks wouldn’t even contemplate investing reserves in equities, besides central banks like the Saudi Arabian Monetary Agency.

By the end of 2011, the Bank of Israel plans to invest a portion of its reserves in the stock market. The investments will be based on indexing rather than active equity management. Beta strategies are becoming widely accepted by conservative investors such as central banks.

Another bit of news is that the Bank of Israel plans to utilize external managers for this equity pilot program.

The Bank of Israel has around US$ 77 billion in reserves. There has been no formal announcement on what percent will be allocated to equities in the future.