SOVEREIGN WEALTH FUNDS: Market Making

04/10/2009 | George Hoguet, Emerging Markets Investment Strategist, Global Active Equity

Sovereign wealth funds could use their growing clout to kickstart a private market for SDRs, as part of wider efforts to manage global liquidity, writes Global Active Equity's George Hoguet

Despite their recent losses, sovereign wealth funds (SWFs) remain crucial participants in and observers of the evolving debate over a new global financial architecture; they are also large and growing official financial institutions. As such, they are in a unique position to promote the private use of Special Drawing Rights (SDRs) as a unit of account and store of value.

By buying SDR-denominated bonds and securities, these institutions could develop a private market for SDR-denominated instruments. Such a market would be a step towards promoting the greater official use of SDRs as a medium of exchange; it would also help advance the debate on developing a super-sovereign reserve currency.

In this context, the IMF’s recent issuance of SDR-denominated bonds, which were placed with official institutions, could be the precursor of future SDR-denominated bond issues by official institutions and private issuers.

As Chinese central bank governor Zhou Xiaochuan expressed it in a March essay, a super-sovereign reserve currency is a stated objective of China’s government, the world’s largest holder of foreign exchange reserves (roughly $2.1 trillion). Russia, the world’s third-largest holder of reserves (roughly $396 billion), has also suggested expanding the use of SDRs and including gold in the basket of currencies that constitute the SDR. India and Brazil have also supported studying a larger role for the SDR in international finance.

SWFs may decide to purchase SDR-denominated instruments to: 1) diversify their currency risk; 2) create more efficient portfolios; or 3) promote the SDR as an alternative to the dollar as a reserve currency.

For technical, political and other reasons, SWFs might not pursue such a course. But, given the tremendous uncertainty over the future of the world economy – not to mention official institutions’ portfolio choices – global investors should construct strategic asset allocations that are highly diversified by asset class and, in particular, by currency.


The China factor

China’s desire for a super-sovereign reserve currency is particularly important, given the country’s growing clout. If any nation’s relative financial position has been enhanced by the crisis, it is China’s. In a stark illustration of its growing financial prominence, consider that if China decided to use just half of its $2.1 trillion in official assets (reserves plus sovereign wealth fund assets) to purchase global equities, as of September 14, 2009 it would be in a position to purchase roughly 5% of every company in the FTSE All World Index.

China’s sovereign wealth fund, the China Investment Corporation (CIC), controls some $300 billion in assets. While the CIC currently ranks as the world’s sixth-largest SWF, given the size of China’s reserves as a percentage of its GDP and its continued pace of reserve acquisition (roughly $400 billion in 2008), the CIC may well emerge as the world’s largest SWF.


Private SDRs

SWFs, such as CIC, could expand the private market for SDRs as part of wider efforts to manage global liquidity.

The SDR is composed of a portfolio of currencies whose weights are reviewed every five years. The currencies included in the SDR are those issued by IMF members, the size and value of whose exports of goods and services during the five-year period ending 12 months before the review, had the largest value and are “freely useable”. SDR weights are based on the value of exports and the amount of reserves denominated in the respective currencies. At the latest review in 2005, the Fund established the weights for the SDR as: US dollar 44%; euro 34%; yen 11%; pound sterling 11%.

In 1981, US Federal Reserve economist Dorothy Sobol reviewed the private use of the SDR and observed: “The official and private SDR are two distinct instruments. The public SDR exists in the framework of the IMF.”

She also noted that public holders of SDRs can exchange their SDRs for currencies such as dollars or yen. Private holders cannot do so. But they can denominate private contracts in SDRs, thereby providing investors currency diversification.

Private markets in SDR-denominated instruments first emerged in 1975 and included commercial bank deposits, syndicated credits, Certificates of Deposit (CDs), floating rate CDs, Eurobonds and floating rate notes. Sweden issued an SDR-denominated credit in 1981, and several other borrowers followed.

The private use of the SDR has not grown substantially, even though analysts noted more than 20 years ago that “the variance of the SDR exchange rate will always be lower than the weighted average of the variances of the component currencies in the basket.” They suggested that SDR-denominated securities had a role to play in the construction of efficient portfolios.

SDR contracts may suffer from technical handicaps that, although they can be addressed in legal frameworks, might prevent SWFs adopting them. Such handicaps include: safeguard clauses that specify what happens if the IMF changes the composition of the SDR; currencies used to repay interest and principal; the absence of clear market-making and liquidity provisions; and other constraints.

However, by virtue of their origin, ownership structure, and investment and political objectives, some sovereign funds are uniquely positioned to promote the private use of the SDR. SWFs, among other measures, could advance the private use of SDRs by agreeing to buy bonds and loans in SDRs, encouraging dealers to make markets in SDR instruments, and potentially denominating their financial accounts in SDRs. The topic could be discussed at the International Working Group (IWG) of Sovereign Wealth Funds, established last year.



Evolving monetary regimes

Even though the international monetary regime evolved over the course of the 20th century, the dollar will remain the world’s principal reserve currency for the foreseeable future. It is unlikely that the US will make the same policy mistakes today that led to Japan’s “lost decade”, which followed the collapse of its asset bubble at the start of the 1990s. Nor is it likely that the dollar will suffer the fate of the pound sterling, which lost its principal reserve currency status in the first half of the last century.

Nevertheless, the debate on international monetary arrangements is likely to increase in pitch over the coming months. In this context, it should not be forgotten that, in 1978, the US issued bonds (albeit non-marketable) denominated in deutsche marks and Swiss francs, so-called “Carter Bonds”.

Indeed, the debate on the international financial architecture is already gaining momentum. Nobel Laureate economist Joseph Stiglitz argued earlier this year that the proposal for the SDR as a new global reserve currency is a “good idea for many reasons”. As chair of the UN Commission of Experts on Reform of International Finance and Economic Structures, Stiglitz also suggested – controversially – that replacing the dollar with a new global currency is “very much in the interest of the US”.



New architecture

Meanwhile, the political impetus for revised and enhanced global and national financial regulation is growing.

While the notion of a super-sovereign reserve currency may seem far-fetched, it is useful to remember that the European Currency Unit (ECU) preceded the euro by 20 years. The ECU served as a unit of account for target European food prices under the Common Agricultural Policy and also served in 1979 as a unit of account for the currency area designated as the European Monetary System.

Both private and public ECUs existed at one point, as is the case today with SDRs. By 1992, more than $250 billion in private financial assets were denominated in ECUs. Over time the role of the ECU evolved and, eventually, euro notes and coins began to circulate.

Despite the losses they suffered following the 2008/9 recession, SWFs are still estimated to hold between $2.5 and $3 trillion in assets, though well below global reserve assets.

Although SWFs vary greatly in objectives and governance, their goals include diversifying national wealth and enhancing returns. As such, they are well placed to shape and react to the debate on the international financial architecture in general, and specifically the role of SDRs.

George Hoguet is a senior emerging markets portfolio manager and global investment strategist at State Street Global Advisors in Boston. The views expressed here are his own

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