Globally, countries hold over $6 trillion of assets in forex reserves. These are managed either by their central banks or their sovereign wealth funds (SWFs). For example, India alone has around $250 billion in forex reserves, currently managed by RBI. However, SWFs are not one of the larger players in global financial markets. SWF asset holdings ($3.1 trillion) amount to much less than those of mutual funds, pension funds and insurance companies ($20-30 trillion) but more than the $1.9 trillion assets of hedge funds and $1 trillion of private equity groups.
The growing size of these reserves prompt many questions on optimal management. Many of these focus on the advantages/disadvantages of forming an SWF and the merits/demerits of having a central bank versus an SWF- managed reserves. Joshua Aizenman and Reuven Glick of the IMF answer some of these questions in a working paper. They explore three specific questions?what are the institutional and political factors that lead to the formation of SWFs, what are the main differences in the management of forex reserves by a central bank versus an SWF and which form of management is more advantageous. ?
Using a sample of 29 SWFs across the world, they identify the main factors that drove the formation of SWFs to be the rise in commodity prices and current account surpluses in emerging economies. They make a distinction between commodity funds (SWFs that are funded by commodity exports, either owned or taxed by government, such as Norway?s Government Pension Fund) and non-commodity funds (SWFs that own assets directly transferred from forex reserves, such as the China Investment Corporation or Singapore?s GIC).
Interestingly, they also find a statistically significant relationship between indicators of national governance and SWFs. They use indicators such as ?voice and accountability?, ?political stability?, ?government effectiveness?, ?regulatory quality? and ?rule of law? sourced from the World Governance Indicators. Countries with greater effective governance indicators but lower democratic accountability are more likely to have sovereign wealth funds. For examining the second question, they look at the composition of assets when reserves are managed by a central bank versus by a sovereign wealth fund. Broadening the time horizon of their sample, they find that composition of assets was more conservative during central bank management of reserves than during SWF management. Central banks were investing in instruments such as US treasury bills, sub-sovereign bonds and other highly rated asset classes, while SWFs have a much more diversified portfolio which includes agency and asset-backed securities, corporate bonds, equities, commodities, real estate, derivatives and FDI. Also, given this diversification, SWFs typically make little use of leverage and tend not to have explicit liabilities such as workers? pensions.
This finding, compounded with the earlier insights into lack of democratic accountability in countries that have SWFs, leads to the third question about optimum management . Given the lack of rigorous international transparency norms for SWFs, is it more optimal to retain forex management with the central bank? The authors provide a nuanced argument for why the answer depends on country-specific factors. Apart from the potential gains of higher returns by SWFs, they find that for low levels of public foreign assets, assigning portfolio management independence to the central bank is advantageous in the sense of preventing ?sudden stops? or rapid outflows of capital. However, for a large enough foreign asset base, the opportunity cost associated with low returns from ?safe? foreign assets provides enough impetus for establishing a SWF. This finding is also dependent on whether the central bank holds the responsibility for financial stability (such as in India). They find that the ?threshold? of the foreign asset base that justifies setting up of a SWF falls considerably if the central bank is also mandated to ensure financial stability.
?The author is consultant, NIPFP. These are her personal views