Sovereign Wealth Funds and Financial Stability

• Author: Tao Sun/Heiko Hesse
• Pages: 1-5

Page 1

Sovereign Wealth Funds and Financial Stability

Sovereign wealth funds (SWFs) are defined as special-purpose investment funds or arrangements owned by the general government. They are often established out of balance of payments surpluses, official foreign currency operations, proceeds of privatizations, fiscal surpluses, or receipts resulting from commodity exports. Their total size has been estimated at $2 trillionPage 4 to $3 trillion, but many of them have probably seen unrealized losses from the ongoing financial crisis combined with a sharp reduction in oil prices.

There have been many arguments put forth regarding the potential positive and negative effects of SWFs on global financial markets. For example, some argue that SWFs can play a stabilizing role in global financial markets. First, many commentators point out that as long-term investors with no imminent call on their assets, and with mainly unleveraged positions, SWFs are able to sit out longer during market downturns or even go against market trends. In particular, the capital injections by SWFs into systematically important financial institutions in late 2007 and 2008 have augmented the recipients' capital buffers and have been helpful in reducing various bank-specific risk premia, at least in the short term. This provides initial evidence that SWFs could have a potentially volatility-reducing impact on markets. Second, large SWFs may have an interest in pursuing portfolio reallocations gradually so as to limit adverse price effects of their transactions. Third, SWFs could, as long-term investors and by adding diversity to the global investor base, contribute to greater market efficiency, lower volatility, and increased depth of markets.

Although SWFs appear to have been a stabilizing force thus far, given their size, there are circumstances in which they could cause volatility in markets. Having large and often unclear positions in financial markets, SWFs-like other large institutional investors-have the potential to cause a market disturbance. For instance, actual or rumored transactions may affect relative valuations in particular sectors and result in herding behavior, adding to volatility.

Such effects could be especially pronounced in shallower markets. To the extent that SWFs invest through hedge funds that rely on leverage or are subject to margin requirements, such investments may...