Behavioral Finance and Economic development

Behavioral Finance and Economic development: Foreign Exchange Reserve Management, Sovereign Wealth Fund Investment decisions and Economic development.

Chapter 1: Background

Sovereign Wealth Funds (SWFs) are state-owned investment funds which are usually derived from the country’s foreign reserves, revenue from exports and fiscal surpluses as well as other official foreign currency operations. In other words, sovereign wealth fund can be defined as a large pool of assets or investment vehicles owned and managed by the State to achieve long-term economic development policy goals. These state-owned investment vehicles are increasing becoming popular in emerging markets largely due to their role of enabling a new paradigm in sovereign wealth management.Since the early 2000s, there has been a significant wave of new sovereign wealth funds entering the capital markets utilizing a range of investment strategies. Sovereign wealth funds investment aim to achieve positive return on assets under management making the sector more attractive to both policymakers and other institutional investors such as pension, mutual and hedge funds. Hence it can be argued that, these state-owned managed funds are increasingly becoming part of the financial system as they are active mainstream markets.Thus, Sovereign wealth funds (SWFs) are active in real estate, financial and alternative investment markets making them more attractive to both policymakers and investors. The source of funding for sovereign wealth funds largely emanate from through trade and budgetary surpluses and majority of countries are keen to set up or investing in the sector to achieve specific investment goals. However, majority of these State-owned funds are located in emerging markets holding excess foreign exchange reserves and the main participating countries are of oil exporting countries such as Russia, Qatar, Kuwait, Norway and United Arab Emirates (UAE).However, countries like China, India, South Korea and Malaysia which enjoy favorable economic growth have invested part of their foreign reserves into the sovereign wealth funds sector. For example, China Investment Corporation (CIC) a sovereign wealth fund which manages China’s $3.44 trillion in reserves has aggressively invested worldwide with a sole mandate of seeking higher returns and to increase diversification of the country’s foreign reserve.

Moreover, sovereign wealth funds employ various investment strategies which are specialist in nature to ensure positive return on assets under management, as such drawing large pool of foreign investment into the investing market. As a result, there has been a significant wave of new sovereign wealth funds entering the markets since the early 2000s and their investment strategies appear to target foreign markets. In addition to that, sovereign wealth funds are actively taking positions in other institutional investors such as pension funds, hedge funds as well as the banking sector. It is reasonable t suggest that, sovereign wealth funds play a major significant role in emerging market economies in all areas of economic development processes. Since its inception in the early 1950s, its size and asset under management has increased dramatically from about $500 billion in 1990 to nearly $4 trillion in 2009, Kotter and Lel, (2010). As of now the size of the sovereign wealth funds sector is believed to have surpassed the hedge funds industry by far making them vital player in global investment. Furthermore, sovereign wealth funds investment styles have been characterized by their tendencies to invest in foreign markets. The repaid expansion in terms of both asset under management and the size does appear to suggest that sovereign wealth funds now represent a new paradigm in finance for economic development.

Sovereign wealth funds (SWFs) into categories, that is, the macroeconomic stabilization funds whose principal role is to stabilize government and export revenues against external economic shocks. (ii) Development funds specialize in the promotion of industrial development or socioeconomic schemes to raise potential output of the domestic economy, (iii) Reserve investment strategies  of sovereign wealth funds are aimed at increasing the return on currency reserves and more commonly is (iv)  the intergenerational savings funds which aim to accumulate wealth for future generations.  Due to the nature of their investment styles, (SWFs) can provide stable source of capital for both investors and markets, making them vital part of the economic and financial system. For example, the Russian Reserve Fund (RRF) and the Russian Social Welfare Fund (RSWF), more recently opted to invest locally in order to address liquidity issues in domestic market. There is increasingly evidence that, these state-owned investment vehicles play a vital role in addressing liquidity issues and promoting economic development of emerging markets. In addition to that, majority of sovereign wealth funds invest in both traditional and alternative markets highlighting their growing importance in economic development.

Despite their perceived benefits, the operations of sovereign wealth funds continue to raise serious questions on corporate governance since they generate incidence of inadequacy level of transparency and accountability because of their secretive nature. Thus, majority of these sovereign managed funds do not disclose their actual size, their investment objectives and the source of funds making prone to counterpart risk exposures. Although investing in sovereign wealth funds seems to raise concerns among investors and policymakers, there is no doubt that these state-owned funds play a major significant role in macroeconomic stabilization. For example, empirical studies by Patton, J.R (2012), highlight the importance of sovereign wealth funds in terms of liquidity provisions in financial institutions. In addition to that,   Raymond.H, (2010) noted that majority of sovereign wealth funds were actively involved in bailing the banking sector during the recent financial crisis.  Therefore, it can be argued that sovereign wealth funds present emerging markets with greater opportunities to mitigate external economic pressure. The investment nature of sovereign wealth funds can help countries to counter the adverse effects of changes in business cycles. The research conclude that, developing countries such as those in Latin America, Asian economies and in the Sub-Saharan African region might have  benefited by investing part of their surplus into the sovereign wealth funds sector.

The expansion of the global economy brought mixed fortune and policy curses for majority of developing countries. There is policy dilemma among emerging economies whose economies rely on export markets. The central dilemmas appear to be on the notion of how best to safeguard sovereign wealth generated through trade in the world economy. However relying on global markets means that majority of emerging markets are exposed to commodity markets demand deficit. As such more recently developing countries have been or are in the process of setting up government investment vehicles commonly known as Sovereign Wealth Funds. These Funds are established to manage their home countries’ foreign reserves to achieve a wide range of economic objectives, but investing national resources into Sovereign Wealth Funds a sound policy objective? For this reason, the research seeks to examine some of the behavioural financial aspects faced by emerging economies in seeking to manage sovereign wealth. The research seek to examine whether majority of developing countries investing part of their foreign reserve portfolio in sovereign wealth funds suffer from some form of investor behavioural biases. As conventional macroeconomics models failed to explain emerging markets crisis in the past. Given the macroeconomic dilemma in emerging countries, does investing in Sovereign wealth funds help in reducing economic exposure? Hence, incorporate behavioural economic model into this matter would enable me to investigate if developing countries suffer from behavioural biases in managing Sovereign wealth.

1.1Research objectives

Sovereign wealth funds (SWFs) are increasingly becoming important institutional investors and many developing countries have created or are in the process of setting these state-owned investment vehicles in recent decades. So the research seeks to examine the role of behavioral finance and Sovereign Wealth Fund investment decisions and how they can affect economic development. The research focuses on the relationship between behavioral finance and sovereign wealth fund investment in emerging economies. The Research, also examine the link between behavioral finance and Sovereign Wealth Investment decisions, how such choices may affect economic development. Throughout, the research seeks to exploit the contribution of behavioral finance in understanding investment motives among Sovereign wealth investors.

1.2 Research questions

Ø  To investigate the impact of behavioral macro finance biases on Sovereign wealth management.

Ø  Do behavioral biases influence Sovereign wealth investment choice?

Ø  What are the impacts of behavioral biases on Sovereign wealth asset allocation?

Ø  Do Sovereign investor behavioral biases play a leading role in macroeconomic management in emerging markets?

Ø  How do Sovereign wealth investors make investment decisions?

1.3 Research merit

Over the last four decades the global economy has expanded more rapidly driven by openness and new economic fortunes were created among developing countries. There were upsurge in foreign capital flows to developing countries and according to Calvo,G.A, Leiderman.L and Reinhart,C.M,(1996), foreign capital inflows to emerging markets rose to  about $670 billion between 1990 and 1994. So, in the event of excess capital inflow or outflow sterilization was a common monetary policy tool used to stabilize the money supply in the economy of all major markets. However, acquiring excess foreign capital could be detrimental as it may cause domestic currency to appreciate thereby making local produced goods to expense in export markets. This could lead to slowdown in global demand for exports in the event of a strong currency, and may also affect growth rates of export-oriented economies. The fact that economic liberalism increased the macroeconomic volatility, sovereign wealth funds can be a major source for long-term capital in emerging markets. Therefore, there is no doubt that these funds represent a new paradigm in sovereign wealth management. As such, the merit of the research topic is that it shed light on the role of sovereign wealth funds on macroeconomic stabilization processes. 

 Furthermore, sovereign wealth funds have been in operational since the early 1950s, but they were little known investment vehicles until more recently when increased their role in capital markets. In addition to that, sovereign wealth funds are increasingly becoming attractive to both investors and policymakers in recent years making researching into this topic an important area. Given the growing popularity of the sector, there are still little empirical studies regarding these state-managed wealth funds` on economic development. This largely due to the fact that, a lot of empirical studies have been focusing on macroeconomic stabilisation purpose, reserve investments and intergeneration saving funds. Also there has been a traditional assumption within the research community that only oil rich countries could invest part of their foreign exchange earning into the sovereign wealth funds sector. However, I think sovereign wealth funds can be central in managing sovereign debt burdens in developing countries. Furthermore, sovereign wealth funds can be a stable source of development finance for the majority of developing countries since they utilise various investment strategies linked to macroeconomic objectives of an investing country. As such, the research acknowledge the contributions made so far, but accept with caution the general perception among academics that only oil rich  countries have the upper hand to invest in sovereign wealth funds. How can one explain the rapid growth of these state–owned investment vehicles in last decade in non-oil exporting countries? For this reason, it appears as though there is a research gap in relation to the role of sovereign wealth funds in macroeconomic policies. So the merit of the research topic is that it contributes to knowledge and understanding of the impact of sovereign wealth funds on economic development. The research also argues that, sovereign wealth funds are part of macroeconomic stabilization forces safeguarding countries against adverse effects of changes in business cycles.

2. Methodology

Research on sovereign wealth funds is still on its early stage and majority of these sate-owned funds tend to be very secretive making it difficult to obtain data concerning their investment styles and objectives. However several empirical studies appear to agree that sovereign wealth funds are financed through trade and budgetary surpluses. So the research methodology focuses on economic performance in emerging markets of Latin American economies from 1960 to 2013. The research methodology uses time series data analysis extracted from the World Bank to measures changes in GDP growth rates over time. Time series modelling and forecasting is fundamental importance to various practical statistical analysis in the areas of finance and economics. In this regards, the use of time series methodology in the study enables me to investigate the impact of sovereign wealth fund investment on economic development in emerging markets. Given that, the gradual opening up of domestic economies particularly in emerging markets resulted in huge capital inflows and exposed export oriented economies to risk exposure caused by changes in business cycles. The vast majority of developing countries experienced positive growth and accumulated unprecedented level of foreign exchange reserves in the last decades. However, the opportunity cost of holding liquid foreign assets were too high for  majority of developing countries  making investments in sovereign wealth funds more necessary as part of macroeconomic management. So, time series modelling is useful in understanding the impact of sovereign wealth funds on economic development.

Thus, time series modelling is a dynamic research tool used in modelling and to study past observations of an economic time series which describe the intrinsic structure of the series. Also time series in economics and finance can be used for forecasting future GDP growth trends and to forecast changes in business cycles over time. The Autoregressive Integrated Moving Average (ARIMA) model tends to assume that time series always tends to follow a specific statistical distribution and is in linear form. In addition to that, (ARIMA) model has gained popularity among research because of its flexibility to stand for several varieties of time series with simplicity. Empirical evidence by Matson,M.W, (1986), appear to suggest that most macroeconomic time series exhibit a clear tendency  to grow over time and can be characterized as trending making it a more popular research methodology. However, Beveridge.S and Nelson,C.R, (1981) indicate that cyclical or transitory movements can be observed in an economic time series. Also, time series is an integral part of every empirical investigation aiming at describing and modelling the evolution over time of a variable or a set of variables in a statistically coherent manner Neusser.K, (2013). Moreover, time series may focuses on descriptive statistics which typify empirical properties and regularities of using basic statistical theories such as mean, variance and covariance mechanisms. However, time series in economics enable statistical properties such as mean, variance and covariance to be measured from the data to give a clear summary of observable trend of a given economy. In addition to that, time series methodology is critically important because it enable theories to be tested and also to explore new information regarding the research question or problem.

2.1Reason for using time series

Reasons for using time series data analysis  is that research on  sovereign wealth funds is still on its early stage making it difficult in obtaining data and majority of these sate-owned funds tend to be very secretive. However several empirical studies appear to agree that sovereign wealth funds are financed through trade and budgetary surpluses. The research methodology uses time series data analysis extracted from the World Bank to measures changes in GDP growth rates over time. So time series methodology enables researchers to appreciate the underlying sequence and functions that produce observation and having the knowledge apply time series data analysis permits a mathematical model to be developed. For example, the Autoregressive Integrated Moving Average (ARIMA) can be developed within a time series to make short-term forecasting using past observations, policy evolutions and monitoring among others. As such, the use of time series methodology in the research helps in the prediction and forecasting economic performance of the region in question. Time series is useful in determining the macroeconomic conditions for necessary for sovereign wealth funds (SWFs) and examine their impact on economic development. In addition to that, using time series methodology, help me to develop a mathematical model to explain the role of sovereign wealth funds (SWFs) on macroeconomic management? Furthermore, majority of time series data in economics is believed to follow a linear or quadratic function making it easy to be performed using Autoregressive Integrated Moving Average.  Seasonality is a trend that repeats itself systematically over time.  In addition to that, time series methodology frequently attempts to filter data under examination to reduce errors. Therefore, the use of time series enables me to investigate the role of Sovereign Wealth Funds on economic development with a degree of accuracy.

Methods

The research method focuses on economic performance of Latin American economies between 1960 and 2013 and a sample of data on GDP growth rates is obtained from the World Bank to measure economic conditions of the region from. Also a large sample of data covering a period of 50 years can help provide reliable results in relations to topic under investigation. In addition to that, the use of GDP is relevant because sovereign wealth funds rely on economic performance of the investing economy. The research use SPSS computer software used in time series analysis and this approach will enable me to perform linear regression analysis so I can examine macroeconomic condition for sovereign wealth funds investment in emerging markets.

Reference

Calvo,G.A, Leiderman.L and Reinhart,C.M,(1990),Inflows of capital to Developing Countries: Journal of Economic Perspectives 10(2),pge 123-139, American Economic Association Publishers.

Raymond. H, (2010), Sovereign Wealth Funds as Domestic Investors of Last Resort during Crisis: International Economics 123(2010),pge 121-160, Germany.

Kotter .J and Lel.U, (2010), Friends or foes? Target selection decisions of sovereign wealth funds and their consequences: Journal of Financial Economics 101(2011),pge 360-381, Elsevier Ltd.

Knill,A.M ,Lee,B.S and  Mauck.N, (2007),Sovereign wealth fund investment and the return-to-risk performance of target firms: Journal of Financial Intermediation 21 (2012),pge 315-340, Elsevier Ltd.

Wignall,A.B,Hu,Y.W,Yermo.J (2008), Sovereign Wealth and Pension Fund Issues :Financial Markets Trends, OECD- ISSN 95-2864.

Subramanian.A, (2007), Behavioral Finance: A Review and Synthesis; European Financial Management, Blackwell Publishers .UK

Matson,M.W, (1986),Univariate Detrending Methods with Stochastic Trends, Journal of Monetary Economics 18(1986),pge 49-75. North-Holland.

Beveridge.S and Nelson,C.R, (1981),A New Approach to Decomposition of Economic Time Series and Transitory Components with Particular  Attention to Measurement of the Business Cycle:  Journal of Monetary Economics 7(1981),pge 151-174. North-Holland.

Neusser. K, (2013), Time Series Analysis in Economics, available online:

http://www.neusser.ch/downloads/TimeSeriesBook.pdf accessed on 07/02/2015

Zimbabwe Asset Management Corporation (ZAMC)- A virtual Sovereign Wealth Fund proposed by us

Introduction

Zimbabwe Asset Management Corporation (ZAMC) is a Sovereign Wealth Fund which manages Zimbabwe`s growing foreign reserve assets. Sovereign Wealth Funds are a large pool of assets or investment vehicles owned and managed by the State to achieve long-term economic development policy frameworks. Thus, Sovereign Wealth Funds (SWFs) are state-owned investment funds which are usually derived from the country`s foreign reserves, revenue from exports and fiscal surpluses as well as other official foreign currency operations. In this report we advise Zimbabwe Asset Management Corporation a sovereign wealth fund investor whose investment strategy has been focusing on local markets. The company was created by the act of Parliament in 2010 to manage and invest $ 2 billion foreign reserves on behalf of the government of Zimbabwe. Zimbabwe Asset Management Corporation (ZAMC) is financed through from the country`s vast natural resources and loyalties from foreign owned companies operating in Zimbabwe. Also Zimbabwe has recently enjoyed high level growth largely to increase in foreign capital inflows and trade expansion prompted by the country’s growing export market base in Europe, Asia and the Middle East.

So the government is using some of its fiscal proceeds to capitalize the state-owned Sovereign Wealth Fund, we then perform economic time series to analysis the company`s current investment strategy. We believe that, having a sovereign wealth fund to manage the growth foreign capital reserves is noble, but we feel that the positive role a Fund could be undermined if majority of its portfolio is invested locally. This is largely because sovereign wealth fund now appear to represent a new paradigm in wealth management only if it invest large chunk of its foreign asset holding in overseas markets. Sovereign wealth funds can provide a sound macroeconomic stabilization process if it manage to re-allocate excess capital to foreign markets. In the event of excess capital inflows/outflows a sovereign wealth fund can insulate a looming crisis through strategic asset allocation investment strategies aimed at redirecting foreign reserves outside domestic markets. Hence, investment purpose of Zimbabwe’s Sovereign Wealth Fund is to support the government`s long term economic and social development objectives. Zimbabwe Asset Management Corporation (ZAMC) has four distinct funds and each with specific investment objectives.  These funds are aimed at reducing the country`s sovereign debt, provide macroeconomic stabilization, infrastructural investments and social enterprises finance. That is the overall objectives of Zimbabwe`s Sovereign Wealth Fund is to insulate and stabilize government and export revenues against external economic shocks. (ii) Providing finance for development, (iii) Reserve investment strategies aimed at increasing the return on currency reserves.

Investment strategy

Zimbabwe asset Management Corporation utilizes wide range of investment windows to ensure the government`s long-term social and economic objectives are met. The current investment strategy is aimed at supporting domestic market and to fund the government`s long term economic and social development objectives. Zimbabwe Asset Management Corporation (ZAMC) managing Zimbabwe`s growing reserve portfolio has been investing in low risk-return assets more particularly in local markets. Thus, (ZAMC) `s current investment goal is not for higher return on asset under management. The firm `s investment objectives are to enable macroeconomic stabilization, boasting infrastructural investments, reducing the country`s public debt and supporting social enterprises.  Zimbabwe Asset Management Corporation`s investment strategy focuses on domestic market, investing in real estate and alternative investment markets. The company also invests part of its portfolio on social development initiatives to encourage growth related economic activities, as such 46% of Zimbabwe`s Sovereign Wealth Funds is invested in industrial and manufacturing sector through the infrastructure investment Fund to boast economic growth following decades of economic and political uncertainty in the country. In addition to that, 20% of is allocated to social enterprise investment Fund, 15% of the total capital is aimed at macroeconomic stability and 19percent is not allocated to a particular investment window but remain central to the future investment strategies of the overall Fund. 

 Zimbabwe Asset Management Corporation total asset $ 2 billion foreign reserves

Asset allocation  techniques
Infrastructural Fund	46 %
Social enterprise Funds	20%
Stabilization Funds	15%
Unallocated Funds	19%

 

Zimbabwe infrastructural investment Fund

The infrastructural investment window is responsible for industrial development and has invested in the energy sector, hospitality industry and real estate markets. So Zimbabwe Asset Management Corporation is the largest investor in Zimbabwe`s domestic markets it has recently acquired stake in Zimbabwe`s energy company commonly known as ZESA for the purpose rehabilitating the country`s energy supplier. The infrastructural fund as an investment strategy for Zimbabwe Asset Management Corporation is also involved in the railway construction network through a partnership with local companies. In addition that, more recently Zimbabwe Asset Management Corporation has taken over the Zimbabwe Water Authority a state owned company responsible for the water purification supply. Through the infrastructural Fund, the company has gone into a joint venture with a Chinese investor (China Water PLC) to manage and supply water throughout the country.  Since 2010, Zimbabwe Asset Management Corporation has been aggressively investing in roads, rail network, and hydro and thermal power energy production.

Social enterprise Funds

Social enterprise Fund is part of Zimbabwe Asset Management Corporation`s investment strategy responsible for citizen empowerment programs. The company support small to medium enterprises through providing financial assistance and marketing consultancy. The Social enterprise Fund investment window is not aimed at making profit for the government but to empower the general population so it can be self-reliance. In the long-run, the investment strategy aim to help government to reduce expenditure on social security once majority of the population succeed.  

Macroeconomic stabilization Fund

Macroeconomic stabilization Fund is intended to insulate the economy against adverse effects of business cycle changes. As Zimbabwe Asset Management Corporation gets its investment capital from commodity exports, then stabilization Fund act as a macroeconomic risk manager safeguarding foreign reserves. So Zimbabwe Asset Management Corporation`s macroeconomic stabilization investment window/Fund finance budget and balance of payment deficits brought about by changes in commodity prices. Moreover, macroeconomic stabilization Fund is also responsible for ensuring that excess reserves are managed in such a way that capital inflows would not lead to financial crisis. Thus, the stabilization Fund is paramount investment strategy for Zimbabwe Asset Management Corporation given as it enables a stead flow of revenue which finances its operation. This is largely due to the fact that, excessive capital inflow or outflows can potentially resulting in financial crisis similar to that of the Latin America debt crisis. 

Time Series    

We conducted two time series data on FDI inflows and a forecasting time series to project Zimbabwe`s economic performance. The two time series performed were intended to give us a clear macroeconomic environment in which our client is operating. The time series methodology we applied was fundamentally important because it can help us assess Zimbabwe Asset Management Corporation`s current investment strategy. According to the time series we carried out, Zimbabwean economy appear to have enjoyed a sharp increase in capital inflow between 2010 and 2012. At the same time, a forecasting time series we performed on GDP growth rates and Current Account Balance appear to show a different economic prospect as both GDP growth rates and Current Account Balance show signs of a stead decline from 2010 to 2016.  Zimbabwe`s Sovereign Wealth Fund aim to promote sustainable economic growth and macroeconomic stability.

 Analysis

We think the projected decline in both Current Account Balance and GDP growth rates by 2016 rest is purely caused by our client’s investment strategy.  Empirical studies by Cardarelli.R, Elekdag.S and Kose, M.A (2010), indicate that a large inflow of foreign capital can cause domestic currency to appreciate, as such making domestically produced goods expensive. For a Sovereign wealth fund to be effective, it must invest in foreign markets majority of its portfolio otherwise investing in local economy is not helpful in the event of excess capital flows. This is because capital inflows can be a source of economic instability as they may put pressure on exchange rates, so the current investment strategy of Zimbabwe Asset Management Corporation appear to be vulnerable on the basis it only invest domestically. However, it appears though that Zimbabwe experienced high volume of capital inflows in the form of Foreign Direct Investment, and these capital inflow caused Zimbabwe`s local currency to appreciate  leading to decline in demand for export goods. For this reason we think, the current investment strategy applied by Zimbabwe Asset Management Corporation is very risk and could hamper its overall investment objectives. So we remanded that 60% of the total Funds be invested in the Reserve Fund which an sovereign investment window aim at higher return on the country`s foreign reserves. This is similar to China`s Reserve Fund which now the main foreign direct investment of China Investment Corporation (CIC). We believe if Zimbabwe Asset Management Corporation follows our advice on investing part of its portfolio in high risk-high return markets such as the Hedge Funds Industry where return is likely to be impressive. This will enable the company function and to operate within its mandate of help the country evade a looming balance of payment crisis by 2016.

Conclusion

The report follows traditional economic analysis to enable us to examine if our client`s current investment strategy is working to safeguard economic fortunes of a country. However, after performing two time series on foreign capital inflows as represented by FDI inflows into the country. We then carried out a forecasting time series on GDP growth rates and Balance of Payments  from 2010 to 2016  to assess the likely impact of Zimbabwe Asset Management Corporation`s investment strategy. It was expected that, both GDP growth rates and Balance of Payments were to fall as Sovereign wealth Funds to tend to be effective when they invest in foreign Markets compared to the home economy.  

Reference

Cardarelli.R,  Elekdag.S and Kose ,M.A (2010), Capital inflows: Macroeconomic implications and policy responses: Economic System  34 (4),pge 333-356.Elsevier .

Furcer.D,Guichardc.S and Rusticelli.E, (2012),The effect of episodes of large capital inflows on domestic credit: North American Journal of Economics and Finance 23 (2012) 325–344. Elsevier.

Calvo,G.A, Leiderman.L and Reinhart,C.M,(1990),Inflows of capital to Developing Countries: Journal of Economic Perspectives 10(2),pge 123-139, American Economic Association Publishers.

Raymond. H, (2010), Sovereign Wealth Funds as Domestic Investors of Last Resort during Crisis: International Economics 123(2010),pge 121-160, Germany.

Kotter .J and Lel.U, (2010), Friends or foes? Target selection decisions of sovereign wealth funds and their consequences: Journal of Financial Economics 101(2011),pge 360-381, Elsevier Ltd.

Development Finance: The role of Sovereign Wealth funds on economic development.

Abstract

Sovereign Wealth Funds are a large pool of assets or investment vehicles owned and managed by the State to achieve long-term economic development policy frameworks. In other words, Sovereign Wealth Funds (SWFs) are state-owned investment funds which are usually derived from the country`s foreign reserves, revenue from exports and fiscal surpluses as well as other official foreign currency operations. However, the source of funds for Sovereign Wealth funds may differ from country to country depending on its comparative or absolute advantage. In addition to that sovereign wealth funds have recently gained recognition as institutional investors largely due to the nature of their investment styles. Since the early 2000s, there has been a significant wave of new sovereign wealth funds entering the capital markets utilizing a range of investment strategies. Sovereign wealth funds investment strategies aim to achieve positive return on assets under management making the sector more attractive to both policymakers and institutional investors such as pension, mutual and hedge funds. Hence it can be argued that, these state-owned managed funds are increasingly becoming part of the financial system as they actively invest in mainstream markets.

Chapter 1: Background

Sovereign Wealth Funds (SWFs) are state-owned investment funds which are usually derived from the country’s foreign reserves, revenue from exports and fiscal surpluses as well as other official foreign currency operations. In other words, sovereign wealth fund can be defined as a large pool of assets or investment vehicles owned and managed by the State to achieve long-term economic development policy goals. These state-owned investment vehicles are increasing becoming popular in emerging markets largely due to their role of enabling a new paradigm in sovereign wealth management.Since the early 2000s, there has been a significant wave of new sovereign wealth funds entering the capital markets utilizing a range of investment strategies. Sovereign wealth funds investment aim to achieve positive return on assets under management making the sector more attractive to both policymakers and other institutional investors such as pension, mutual and hedge funds. Hence it can be argued that, these state-owned managed funds are increasingly becoming part of the financial system as they are active mainstream markets.Thus, Sovereign wealth funds (SWFs) are active in real estate, financial and alternative investment markets making them more attractive to both policymakers and investors. The source of funding for sovereign wealth funds largely emanate from through trade and budgetary surpluses and majority of countries are keen to set up or investing in the sector to achieve specific investment goals. However, majority of these State-owned funds are located in emerging markets holding excess foreign exchange reserves and the main participating countries are of oil exporting countries such as Russia, Qatar, Kuwait, Norway and United Arab Emirates (UAE).However, countries like China, India, South Korea and Malaysia which enjoy favorable economic growth have invested part of their foreign reserves into the sovereign wealth funds sector. For example, China Investment Corporation (CIC) a sovereign wealth fund which manages China’s $3.44 trillion in reserves has aggressively invested worldwide with a sole mandate of seeking higher returns and to increase diversification of the country’s foreign reserve.

Moreover, sovereign wealth funds employ various investment strategies which are specialist in nature to ensure positive return on assets under management, as such drawing large pool of foreign investment into the investing market. As a result, there has been a significant wave of new sovereign wealth funds entering the markets since the early 2000s and their investment strategies appear to target foreign markets. In addition to that, sovereign wealth funds are actively taking positions in other institutional investors such as pension funds, hedge funds as well as the banking sector. It is reasonable t suggest that, sovereign wealth funds play a major significant role in emerging market economies in all areas of economic development processes. Since its inception in the early 1950s, its size and asset under management has increased dramatically from about $500 billion in 1990 to nearly $4 trillion in 2009, Kotter and Lel, (2010). As of now the size of the sovereign wealth funds sector is believed to have surpassed the hedge funds industry by far making them vital player in global investment. Furthermore, sovereign wealth funds investment styles have been characterized by their tendencies to invest in foreign markets. The repaid expansion in terms of both asset under management and the size does appear to suggest that sovereign wealth funds now represent a new paradigm in finance for economic development.

Sovereign wealth funds (SWFs) into categories, that is, the macroeconomic stabilization funds whose principal role is to stabilize government and export revenues against external economic shocks. (ii) Development funds specialize in the promotion of industrial development or socioeconomic schemes to raise potential output of the domestic economy, (iii) Reserve investment strategies  of sovereign wealth funds are aimed at increasing the return on currency reserves and more commonly is (iv)  the intergenerational savings funds which aim to accumulate wealth for future generations.  Due to the nature of their investment styles, (SWFs) can provide stable source of capital for both investors and markets, making them vital part of the economic and financial system. For example, the Russian Reserve Fund (RRF) and the Russian Social Welfare Fund (RSWF), more recently opted to invest locally in order to address liquidity issues in domestic market. There is increasingly evidence that, these state-owned investment vehicles play a vital role in addressing liquidity issues and promoting economic development of emerging markets. In addition to that, majority of sovereign wealth funds invest in both traditional and alternative markets highlighting their growing importance in economic development.

Despite their perceived benefits, the operations of sovereign wealth funds continue to raise serious questions on corporate governance since they generate incidence of inadequacy level of transparency and accountability because of their secretive nature. Thus, majority of these sovereign managed funds do not disclose their actual size, their investment objectives and the source of funds making prone to counterpart risk exposures. Although investing in sovereign wealth funds seems to raise concerns among investors and policymakers, there is no doubt that these state-owned funds play a major significant role in macroeconomic stabilization. For example, empirical studies by Patton, J.R (2012), highlight the importance of sovereign wealth funds in terms of liquidity provisions in financial institutions. In addition to that,   Raymond.H, (2010) noted that majority of sovereign wealth funds were actively involved in bailing the banking sector during the recent financial crisis.  Therefore, it can be argued that sovereign wealth funds present emerging markets with greater opportunities to mitigate external economic pressure. The investment nature of sovereign wealth funds can help countries to counter the adverse effects of changes in business cycles. The research conclude that, developing countries such as those in Latin America, Asian economies and in the Sub-Saharan African region might have  benefited by investing part of their surplus into the sovereign wealth funds sector.

1.1Research objectives

Sovereign wealth funds (SWFs) are increasingly becoming popular among investors and policymakers particularly in emerging markets where majority of funds are located. There is a growing empirical evidence to suggest that sovereign wealth funds play an important role in macroeconomic stabilization and development. Hence, throughout the study, the research aims are:

v  To scrutinize the main macroeconomic economic conditions leading to the setting up and investments in sovereign wealth funds sector.

v  To analyze the role of sovereign wealth funds in macroeconomic management.

v  To examine the impact of sovereign wealth funds on economic development.

  1.2 Research questions

ü  Do macroeconomic conditions matter in sovereign wealth fund investments?

ü  What is the impact of sovereign wealth fund on economic development?

ü  What are the roles of sovereign wealth funds (SWFs) on macroeconomic management?

1.3 Research merit

Over the last four decades the global economy has expanded more rapidly driven by openness and new economic fortunes were created among developing countries. There were upsurge in foreign capital flows to developing countries and according to Calvo,G.A, Leiderman.L and Reinhart,C.M,(1996), foreign capital inflows to emerging markets rose to  about $670 billion between 1990 and 1994. So, in the event of excess capital inflow or outflow sterilization was a common monetary policy tool used to stabilize the money supply in the economy of all major markets. However, acquiring excess foreign capital could be detrimental as it may cause domestic currency to appreciate thereby making local produced goods to expense in export markets. This could lead to slowdown in global demand for exports in the event of a strong currency, and may also affect growth rates of export-oriented economies. The fact that economic liberalism increased the macroeconomic volatility, sovereign wealth funds can be a major source for long-term capital in emerging markets. Therefore, there is no doubt that these funds represent a new paradigm in sovereign wealth management. As such, the merit of the research topic is that it shed light on the role of sovereign wealth funds on macroeconomic stabilization processes. 

Furthermore, sovereign wealth funds have been in operational since the early 1950s, but they were little known investment vehicles until more recently when increased their role in capital markets. In addition to that, sovereign wealth funds are increasingly becoming attractive to both investors and policymakers in recent years making researching into this topic an important area. Given the growing popularity of the sector, there are still little empirical studies regarding these state-managed wealth funds` on economic development. This largely due to the fact that, a lot of empirical studies have been focusing on macroeconomic stabilisation purpose, reserve investments and intergeneration saving funds. Also there has been a traditional assumption within the research community that only oil rich countries could invest part of their foreign exchange earning into the sovereign wealth funds sector. However, I think sovereign wealth funds can be central in managing sovereign debt burdens in developing countries. Furthermore, sovereign wealth funds can be a stable source of development finance for the majority of developing countries since they utilise various investment strategies linked to macroeconomic objectives of an investing country. As such, the research acknowledge the contributions made so far, but accept with caution the general perception among academics that only oil rich  countries have the upper hand to invest in sovereign wealth funds. How can one explain the rapid growth of these state–owned investment vehicles in last decade in non-oil exporting countries? For this reason, it appears as though there is a research gap in relation to the role of sovereign wealth funds in macroeconomic policies. So the merit of the research topic is that it contributes to knowledge and understanding of the impact of sovereign wealth funds on economic development. The research also argues that, sovereign wealth funds are part of macroeconomic stabilization forces safeguarding countries against adverse effects of changes in business cycles.

2. Methodology

Research on sovereign wealth funds is still on its early stage and majority of these sate-owned funds tend to be very secretive making it difficult to obtain data concerning their investment styles and objectives. However several empirical studies appear to agree that sovereign wealth funds are financed through trade and budgetary surpluses. So the research methodology focuses on economic performance in emerging markets of Latin American economies from 1960 to 2013. The research methodology uses time series data analysis extracted from the World Bank to measures changes in GDP growth rates over time. Time series modelling and forecasting is fundamental importance to various practical statistical analysis in the areas of finance and economics. In this regards, the use of time series methodology in the study enables me to investigate the impact of sovereign wealth fund investment on economic development in emerging markets. Given that, the gradual opening up of domestic economies particularly in emerging markets resulted in huge capital inflows and exposed export oriented economies to risk exposure caused by changes in business cycles. The vast majority of developing countries experienced positive growth and accumulated unprecedented level of foreign exchange reserves in the last decades. However, the opportunity cost of holding liquid foreign assets were too high for  majority of developing countries  making investments in sovereign wealth funds more necessary as part of macroeconomic management. So, time series modelling is useful in understanding the impact of sovereign wealth funds on economic development.

Thus, time series modelling is a dynamic research tool used in modelling and to study past observations of an economic time series which describe the intrinsic structure of the series. Also time series in economics and finance can be used for forecasting future GDP growth trends and to forecast changes in business cycles over time. The Autoregressive Integrated Moving Average (ARIMA) model tends to assume that time series always tends to follow a specific statistical distribution and is in linear form. In addition to that, (ARIMA) model has gained popularity among research because of its flexibility to stand for several varieties of time series with simplicity. Empirical evidence by Matson,M.W, (1986), appear to suggest that most macroeconomic time series exhibit a clear tendency  to grow over time and can be characterized as trending making it a more popular research methodology. However, Beveridge.S and Nelson,C.R, (1981) indicate that cyclical or transitory movements can be observed in an economic time series. Also, time series is an integral part of every empirical investigation aiming at describing and modelling the evolution over time of a variable or a set of variables in a statistically coherent manner Neusser.K, (2013). Moreover, time series may focuses on descriptive statistics which typify empirical properties and regularities of using basic statistical theories such as mean, variance and covariance mechanisms. However, time series in economics enable statistical properties such as mean, variance and covariance to be measured from the data to give a clear summary of observable trend of a given economy. In addition to that, time series methodology is critically important because it enable theories to be tested and also to explore new information regarding the research question or problem.

2.1Reason for using time series

Reasons for using time series data analysis  is that research on  sovereign wealth funds is still on its early stage making it difficult in obtaining data and majority of these sate-owned funds tend to be very secretive. However several empirical studies appear to agree that sovereign wealth funds are financed through trade and budgetary surpluses. The research methodology uses time series data analysis extracted from the World Bank to measures changes in GDP growth rates over time. So time series methodology enables researchers to appreciate the underlying sequence and functions that produce observation and having the knowledge apply time series data analysis permits a mathematical model to be developed. For example, the Autoregressive Integrated Moving Average (ARIMA) can be developed within a time series to make short-term forecasting using past observations, policy evolutions and monitoring among others. As such, the use of time series methodology in the research helps in the prediction and forecasting economic performance of the region in question. Time series is useful in determining the macroeconomic conditions for necessary for sovereign wealth funds (SWFs) and examine their impact on economic development. In addition to that, using time series methodology, help me to develop a mathematical model to explain the role of sovereign wealth funds (SWFs) on macroeconomic management? Furthermore, majority of time series data in economics is believed to follow a linear or quadratic function making it easy to be performed using Autoregressive Integrated Moving Average.  Seasonality is a trend that repeats itself systematically over time.  In addition to that, time series methodology frequently attempts to filter data under examination to reduce errors. Therefore, the use of time series enables me to investigate the role of Sovereign Wealth Funds on economic development with a degree of accuracy.

Methods

The research method focuses on economic performance of Latin American economies between 1960 and 2013 and a sample of data on GDP growth rates is obtained from the World Bank to measure economic conditions of the region from. Also a large sample of data covering a period of 50 years can help provide reliable results in relations to topic under investigation. In addition to that, the use of GDP is relevant because sovereign wealth funds rely on economic performance of the investing economy. The research use SPSS computer software used in time series analysis and this approach will enable me to perform linear regression analysis so I can examine macroeconomic condition for sovereign wealth funds investment in emerging markets.

Reference

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Raymond. H, (2010), Sovereign Wealth Funds as Domestic Investors of Last Resort during Crisis: International Economics 123(2010),pge 121-160, Germany.

Kotter .J and Lel.U, (2010), Friends or foes? Target selection decisions of sovereign wealth funds and their consequences: Journal of Financial Economics 101(2011),pge 360-381, Elsevier Ltd.

Knill,A.M ,Lee,B.S and  Mauck.N, (2007),Sovereign wealth fund investment and the return-to-risk performance of target firms: Journal of Financial Intermediation 21 (2012),pge 315-340, Elsevier Ltd.

Wignall,A.B,Hu,Y.W,Yermo.J (2008), Sovereign Wealth and Pension Fund Issues :Financial Markets Trends, OECD- ISSN 95-2864.

Subramanian.A, (2007), Behavioral Finance: A Review and Synthesis; European Financial Management, Blackwell Publishers .UK

Matson,M.W, (1986),Univariate Detrending Methods with Stochastic Trends, Journal of Monetary Economics 18(1986),pge 49-75. North-Holland.

Beveridge.S and Nelson,C.R, (1981),A New Approach to Decomposition of Economic Time Series and Transitory Components with Particular  Attention to Measurement of the Business Cycle:  Journal of Monetary Economics 7(1981),pge 151-174. North-Holland.

Neusser. K, (2013), Time Series Analysis in Economics, available online:

http://www.neusser.ch/downloads/TimeSeriesBook.pdf accessed on 27/07/2014