Sources of Financing of Sovereign Funds

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Sovereign wealth funds are often criticized and rather opaque, and remain a source of hypothesis and doubt. Governments, investors and citizens are wondering about the real investment intentions of these funds or the means by which they have built up their foreign exchange reserves. We will see here how they obtain these large foreign exchange reserves.

If sovereign wealth funds are often perceived as aggressive and dangerous, it is mainly for reasons of origin. Indeed, their geographical distribution is more than unbalanced. We can see that the majority of them, 75%, come from two regions, Asia and the Middle East. (Source: www.swfinstitute.org)

The question then arises as to why these regions have more funds than Europe or the Americas. This will primarily involve reserves of raw materials, mainly oil. These reserves of raw materials will be the source of financing for Africa and especially the Middle East.

Asia’s foreign exchange reserves will come not from a mining rent but from a wage rent since this region of the world is much less exposed to raw materials than other regions (though…). Thanks to the very valuable website, www.swfinstitute.org, which has gathered an impressive amount of information on sovereign wealth funds, we were able to determine the distribution of funding sources and the results are surprising.

In fact, 70% of the resources come from raw materials, including 51% from oil. Next comes gas with 9% while the rest represents no more than 3%. Non-mining or oil resources are nevertheless important with 30% of the total and therefore come from the wage rent thanks to the sale of technological products (South Korea), consumer goods (China) and even real estate (Singapore).

Note also that the sources of funding for the funds do not come exclusively from a single resource. For example, Botswana’s sources of funds come from both diamonds and mining rent, while East Timor’s resources are gas and oil. But then, how did they manage to obtain foreign exchange reserves?

Following the Asian crisis of 1997, Asian developing countries decided to change their growth strategy towards a need to accumulate trade surpluses with the sole purpose of accumulating the foreign exchange reserve. This new strategy has been the cornerstone of their growth policy and this through exports.

However, these exports could only have been possible through a very limited appreciation of their currency. As Asian currencies are weaker than the US Dollar or the Euro, exports can only increase. Countries devalue their currencies voluntarily to make them more competitive.

This competitiveness being positive, it promotes exports of goods and services. Thus, the Asia zone is very attractive for importing countries. When a company makes the decision to import, it is simply because this method is much more cost-effective than domestic manufacturing.

Factors such as very cheap labour or low production costs abroad increase Chinese exports and thus its trade surplus. In this way, since 1998, Asian countries have experienced annual trade surpluses of between 12 and 4% of their GDP. The Trade Balance as a percentage of GDP of emerging Asia and Latin America (Source: NATIXIS Economy Flash of 23/01/2012: “What happens if emerging countries protect their domestic demand)

In terms of mining rent and more precisely oil rent, the most important producers are the United Arab Emirates (UAE), Iran, Kuwait and Saudi Arabia in first place with the impressive figure of more than 10 million barrels of oil produced per day (BP Statistical revenue of world energy June 2011). This region alone represents the largest oil reserve in the world and therefore the largest liquidity reserve more commonly referred to as “petrodollars”.

Petrodollar is defined as a financial asset paid to governments by oil companies through royalties. However, it is not clear exactly how much money these countries have, what state banks or special purpose vehicles have in their assets. However, there are two major problems with oil rent, namely:

  1. The unequal distribution of the latter due to the disparity that exists between countries in the supply of fossil fuels

  2. Due to the considerable mass of petrodollars generated and managed, some funds do not publish their financial statements. This raises questions about their opacity and strategies.

It is thanks to the strong increases in foreign exchange reserves from mining and wage rents that sovereign funds have seen their growth. These huge reserves, which were not very dynamic at the base, were the subject of a revaluation of their strategy and this by being entrusted to State funds in order to have a higher profitability. From a general point of view, state funds are investment funds with high potential and still under-exploited.

Due to a certain lack of transparency and this latent power, these investment vehicles inspire fear. Especially since some funds come from countries with strong geopolitical and strategic characteristics, such as China or Russia. We have only developed a tiny part of the world of sovereign wealth funds here. An exciting world when you take a closer look and each event is to be taken into consideration.

Guillaume BARDON

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