In an economy with a sovereign wealth fund (SWF), the government may draw on the fund to supplement other government revenues. If the fund is invested in risky assets, this introduces a new stochastic element into the government’s budget. We analyze the interaction between the draw from and risk taking in the SWF. Using non-expected utility preferences, we distinguish between intended changes and stochastic changes in the SWF draws over time. We show that the desire for smoothness in taxes and public services translates into smoothing of SWF draws and lower risk taking. It can even lead to procyclical rebalancing of the SWF portfolio. Future interest rates are associated with interest-rate risk. We show that this risk may lead to a higher optimal equity share in the SWF portfolio. Policy makers can use the draws from the SWF to smooth over time variation in risk-free rates.
Many profound transformations are taking place in the global economy. Ten years ago, a large number of emerging economies were engulfed by financial and economic turmoil, and afflicted by balance of payments crises. In response, most of the affected countries acted decisively. Many of them significantly strengthened their budgetary and monetary policy discipline—often through difficult and stressful efforts. In many cases, national balance sheets were bolstered by debt reduction.
One result of the efforts was the restoration of economic stability and investor confidence. In fact, emerging economies in the aggregate quickly resumed their relatively rapid growth trajectory. At the same time, they began to run current account surpluses, thereby accumulating international reserve assets. In other words, these economies became net capital exporters to the rest of the world, in particular to the advanced economies.
More recently, this trend became high-powered: strong global growth in the past few years sharply boosted energy and commodity prices. The well-known result has been a striking increase in the foreign currency receipts of many energy and commodity exporting economies. These countries include some of the richest and most developed economies, but also many emerging ones, as well as some developing economies.
With many governments assuming—either by design or by circumstance—the role of guardians of substantial amounts of their countries’ financial assets, effective wealth management has become an important public sector responsibility. Many countries have responded by creating sovereign wealth funds.
Of course, the formation of SWFs is not a new phenomenon. However, almost two thirds of the existing Funds were established in the past decade. As a result, the importance of Sovereign Wealth Funds has grown not only within their own countries, but their relevance also has increased for the international financial system. For example, market participants’ estimates suggest that assets under management of Sovereign Wealth Funds currently total between US$2-3 trillion, thereby exceeding assets managed by hedge funds (US$ 1.9 trillion). In fact, such Funds today account for between ¼-⅓ of all foreign assets held by sovereigns. SWF assets are projected to surpass the stock of global foreign exchange reserves in the not so distant future and to top US$7-11 trillion by 2013.