The Changing Investor Base in Emerging Markets

In a Bloomberg Businessweek article on how BNP Paribas is “favoring developing-nation local-currency bonds, betting they will be more resilient than dollar notes to any reduction in the Federal Reserve’s $85 million of monthly debt purchases,” comes this snippet:

Developing economies will expand 5.3 percent in 2013, compared with 1.2 percent growth in advanced nations, according to forecasts by the International Monetary Fund released on April 16.

“The long-term case for emerging markets is very strong,” Victoros said. “What has changed is the client base, where before we used to have hedge funds and mutual-fund clients, now we’re seeing much more sovereign-wealth funds and pension funds.”

There are a couple of reasons for this shift, I think.  The less interesting reason is simply that pension funds and SWFs are chasing alpha wherever they can get it, and they have a lot of capital to spend.

The more interesting reason is that investment horizons seem to be aligning, as indicated by the reference to a “long-term case” for emerging market bonds.  SWFs and, to a lesser extent, pension funds, are all about (or should be all about) the long term.  It is only regulatory restraints and a misalignment of incentives that makes them deviate from this sensible course.

Pakistan Muslim League-Nawaz Government Cleans House

I have no insights into the economic case for Pakistan’s state-owned enterprises–whether there are the kind of market failures in particular Pakistani industries that justify state enterprise–but I certainly applaud attempts to reduce corruption at Pakistani state-owned enterprises.  From the Express Tribune:

The incoming Pakistan Muslim League-Nawaz government has decided to replace heads of all those loss-making state-owned enterprises that need a cushion of billions of rupees every year to keep their wheels moving.

This was announced by PML-N central leader Ahsan Iqbal, who said heads and chief executives of loss-making giants like Pakistan Steel Mills, PIA, Pakistan Railways and Pakistan National Shipping Corporation would be removed in an effort to end financial haemorrhaging worth hundreds of billions of rupees.

“Applications for these high posts will be invited through advertisements in the media on the very first day the new government takes over,” Iqbal told members of the Lahore Economic Journalists Association here on Wednesday.

 

[Image:Pakistan Muslim League-Nawaz (PML-N) Deputy Secretary General, Ahsan Iqbal. Express Tribune photo]

Why Does No One Want to Run The CIC?

Following a Financial Times article, aiCIO has a great piece on why several candidates seem to have had second thoughts about running China’s main SWF, the CIC:

The reference to the $500 billion pot being a hot potato in the Chinese press is two-fold; firstly many believe the CIC may end up being something of a poisoned chalice after it scattered its investment seeds far and wide since its establishment in 2007.

Two of CIC’s earliest investments – stakes in Morgan Stanley and private equity firm Blackstone – have already resulted in big paper losses following the eruption of the global financial crisis in 2008.

Whoever takes on the chairman role will come under pressure to maximize returns for the CIC, especially given China can no longer count on its foreign exchange reserves to grow. Export growth appears to have stalled, and imports are expected to catch up, narrowing the country’s trade surplus.

The secondary issue, which is less covered in the Western press, is that the CIC also plays an important role as the parent company to Central Huijin Investment, the branch of the fund responsible for investing in domestic companies.

It would seem advisable for China to separate these functions: sovereign wealth funds are typically foreign investment vehicles, and sovereign development funds like Central Huijin are domestic investment vehicles.  They do very different things, have different goals, and have different governance issues.  Why keep them within the same legal structure?

The article notes that the subsidiary, Central Huijin, is nearly as important (and perhaps may be as important to the central government) as the CIC:

As China Economic Review points out, Huijin, which predates CIC but is now a subsidiary, is of nearly equal importance as the fund’s international investment branch, having received $90 billion of the initial $200 billion given to CIC on its founding in 2007.

Huijin has pushed to list the banks and other institutions that it holds a stake in, but it has failed to do the same for its securities firms.

The investment branch has already successfully brought many of the 19 firms in which it holds major stakes to IPO, a move seen as maximizing its returns on those investments. Those include big names now listed in both the mainland and Hong Kong, including banks like China Construction Bank, Bank of China, Agricultural Bank of China and insurer New China Life Insurance.

Huijin’s securities firms remain largely unlisted. That includes the five securities firms – Shenyin & Wanguo Securities, China International Capital Corporation (CICC), China Securities, China Investment Securities, UBS Securities – with US$27 billion under management. It was hoped Tu could use his expertise in securities to list these companies, therefore encouraging greater returns from them through additional shareholder pressure.

Managing China’s foreign investments is, no doubt, a tricky business.  Aside from the ordinary pressures that managing a $500 billion fund would bring, the CIC also faces uniquely challenging foreign and domestic political pressures.  And managing Central Huijin …. well, who would want both of these very difficult jobs at once?

Apparently, no one.  All the more reason to separate Huijin from the CIC.  

 

The Perils of Ethical Investment for SWFs

If a small investor wants to invest ‘ethically”–and I do not define that term with any precision, as I believe investors will differ somewhat in what they believe ethical investing to be–the challenge is difficult but not insurmountable.  If you are investing in equities on your own, simply screen your portfolio companies by reviewing the public filings and other sources of information, and keep up with what the companies are doing.  Or, you may just choose to have someone do the work for you by investing in one or more of the many funds set up to pursue only ethical investments. 

Perhaps not as easy (or, frankly, as profitable) as selecting broad-based, no-load mutual funds, throwing darts at the stock pages, or even letting a monkey throw the darts for you, but not very difficult. 

But have a care for fund managers who have to select “ethical” stocks according to guidelines set up by fund owners.  Their job is significantly more difficult for two reasons:

1. The composition of the portfolio is likely to be public knowledge (I suspect a high correlation between fund transparency and funds that would have an ethical investment mandate), so the activities of portfolio companies will be scrutinized and any taint from those activities will reflect on the fund.  Because of this, funds will need to have an ongoing compliance program in place to make sure that portfolio companies are acting in accordance with the guiding ethical principals of the fund, and if not, the fund must either divest or attempt to influence the offending company management.  However. . .

2. Compliance programs are expensive, and the expenses rise with the size of the fund (although some overhead costs do not rise steeply as more portfolio companies are added), and . . .

3.  Huge funds like Norway’s Government Pension Fund-Global have huge amounts of money to invest and limited places to put their funds.  Ethical investing significantly reduces the universe of investment targets.  This becomes a bigger problem as the fund grows larger.

Some of these difficulties are apparent in a recent Reuters report on the GPF-G’s ethical investments:

Norway’s oil fund, the world’s largest sovereign wealth fund, has no strategy for dealing with possible violations of human rights by the companies in which it invests, an independent committee set up to safeguard OECD ethical guidelines said.

The Norwegian committee pointed to the fund’s investment in South Korean steel maker POSCO, which plans to build a $12 billion steel plant in India, saying the fund was not doing enough to protect against human rights breaches.

Several non-governmental organisations say the plant in Odisha state would displace more than 20,000 people, among them indigenous people who receive special legal protection.

While the committee of experts, set up by the Norwegian government, has no legal power, its criticism could potentially damage the fund’s reputation as a socially responsible investor.

The oil fund, whose investments totalled $740 billion on Monday, is one of the world’s most transparent wealth funds and has excluded companies for what it has deemed to be unethical behaviour, such as the production of nuclear weapons and tobacco or the use of child labour.

The committee said on Monday that the fund had “failed to take appropriate steps to prevent or mitigate negative human rights and environmental impacts in connection with its investment in POSCO”.

The fund lacked “a strategy for identifying and handling possible violations of human rights in the companies they invest”, it said.

Hans Petter Graver, head of the committee, said a company or investment group that had this type of complaint directed at it might face questions from future business partners.

 

Does This Mean There Will Be No Ohio SWF?

The Utica shale, which some hoped would yield $500 billion in oil, has turned out to hold more gas (which is less valuable) than thought, and the oil that is there is harder to extract than expected.  I have hoped that Ohio would be able to use some of its oil funds to create a large SWF; I may have to settle for a small SWF, but hey, I’ll take it.

Why should Ohio create a SWF with its oil and gas tax revenues?  The Central Appalachia Regional Network offers the following reasons:

Severance taxes are typically collected on the removal of natural resources.
They are often used for immediate local and state needs. However,
designating a small percentage of severance tax revenues for permanent
trust funds could create an economic legacy for resource-rich communities.
This will remain long after mineral wealth is exhausted. Wyoming, Alaska,
Montana, and Colorado have established permanent endowments from a
portion of severance tax revenue decades ago. They have yielded millions,
and sometimes billions of dollars for community development.

Recommendation #1

The Central Appalachia Regional Network, (CARN) advocates that a minimum of 1 percent of severance taxes collected on non-renewable resources, (e.g.coal, natural gas, uranium, etc.) be placed in permanent trust funds. These will be used by and for the communities from which the resources were extracted.

Long after non-renewable resources are depleted, income from permanent trust funds can continue to support economic diversification. It can provide funds for investments in infrastructure and human capital. Trust funds can lower future tax burdens, and deal with costs associated with past and future resource extraction. If, in 1990 Kentucky, Maryland, Ohio, Tennessee, Virginia and West Virginia had and implemented a permanent fund it would have generated approximately $1.4 billion in earnings. The combined balance of would have reached $2.8 billion. (This is based on a 1 percent severance tax, an annual investment return rate of 7.5 percent, and a yearly 5 percent withdrawn.)

China's SASAC Disciplines Underperforming Firms

The Chinese government supervises holdings in its state-owned enterprises through the State Assets Supervision and Administration Commission (SASAC).  The approach SASAC takes with SOEs is demanding, but certainly not controlling from a day-to-day managerial standpoint, as described in an article in The Economic Observer:

Earlier this year, the State-owned Assets Supervision and Administration Commission (SASAC) instructed the more than one hundred state-owned enterprises (SOE) under its supervision that it expects them to achieve profit growth of over 10 percent in 2013. This is the first time that the central government body has set such a profit growth target for the SOEs under its supervision. At the same time, the supervisory agency also announced that it was establishing a special “maintain growth” working group to help some of the centrally-administered SOEs deal with some of the challenges that they are facing.

A person connected to SASAC told the EO that the new team will not offer assistance to all the SOEs operating under SASAC’s remit, noting that they would instead “put the focus on companies with huge losses and also on those big companies making big profits.”

. . . The message coming from inside SASAC is that the main tasks of these “maintain growth” teams are to “take the pulse” and “prescribe medicine,” noting that SASAC is there to help the company not come in and take it over.

A participant in the process revealed to the EO that some of the support that Angang hoped to receive on a policy level, for example addressing some of the “historical issues” and the company’s role in providing social services, were not easily addressed as they would require coordination between various departments and levels of government, especially local government.

In addition, the steel group also called for support in terms of raising capital, because even the big steel companies are now finding it difficult to borrow money from the banks.

China Ocean Shipping Group (COSCO) has also made similar requests for assistance to SASAC calling on the agency to help the group get access to cheaper financing and to help deal with overcapacity in China’s shipbuilding industry. COSCO also wants SASAC’s help to strengthen policies that put pressure on other big state-owned companies to sign strategic long-term freight deals with the shipping company.

A person connected to SASAC told the EO that the agency would be willing to provide appropriate policy support but they won’t be helping these large state-owned companies get access to loans from financial institutions.

“To ask us to use SASAC’s influence to get loans from financial institutions, this is not the kind of thing that an investor should be doing,” the above-mentioned source at SASAC told the EO.

China's PR Campaign: Australia Edition

China doesn’t hesitate to speak out when it perceives it is being treated unfairly by regulators in the countries in which its SOEs or funds invest (see, for example, this prior post about Chinese investment being stigmatized in the U.S.).  The latest example: Australia.  From the Herald Sun:

 

Chairman of the China Chamber of Commerce in Australia, Hu Shanjun, said Australia was still a popular place for Chinese groups to invest, but that could change.

 

Mr Hu, who also heads the Bank of China in Australia, said the Australian government remained suspicious of Chinese companies, especially state-owned enterprises, and it showed in their policies.

 

“Some new policies we think they are not very fair for Chinese investors,” Mr Hu said.

 

“They have certain limitations, especially for government-owned companies.”

 

“I think it is a bit unfair and also hurts Chinese investors’ feelings,” said Mr Hu, who spoke to AAP outside the Australia China Minerals Investment Summit in Darwin on Tuesday.

One example was that Chinese government-owned businesses had to seek approval even to rent an apartment, whereas other groups didn’t need to, Mr Hu said.

 

“If the Australian government has limitations and has restrictions, we will go to other countries to look for opportunities,” he said.

 

 Hurts Chinese investors’ feelings?

State Investment Funds: the Vietnamese SCIC and JobsOhio

I have a friend who believes that Ohio’s publicly-funded but quasi-private business development fund, JobsOhio, is a sovereign wealth fund.  I am not fully convinced, but there is certainly some overlap between what some SWFs do and what JobsOhio does.  To me, JobsOhio is simply a state-financed business development fund that has taken the clever step of taking public funds and funneling them to a private enterprise, thereby eliminating much of the bureaucratic red tape that slows investment decision-making (and, according to its critics, the structure also impedes normal accountability mechanisms that should govern the use of public funds). 

Typically, SWFs do not have a direct business development purpose–other state vehicles are used for such purposes.  However, JobsOhio, like most SWFs, is a separate legal entity that operates largely independent of the state bureaucracy.

I thought of the comparison of JobsOhio and SWFs as I read an article today about Vietnam’s State Capital Investment Corporation (SCIC), which is supposedly modeled on Singapore’s Temasek (which is generally acknowledged to be a SWF).  Like Temasek, the SCIC was designed to help manage the extensive holdings in Singaporean state-owned enterprises.  Temasek now invests quite broadly, in addition to its holding company activity. 

SCIC reminds me of JobsOhio in that it was also designed to make investments within Vietnam–essentially, a business development function.  This part of its mission has not gone well, however, as reported in VIG and VYM:

The state once put a high hope on SCIC when it made its debut in 2005. However, the business performance of the “super corporation” has been disappointing. What SCIC has been focusing on since its establishment is selling the state’s capital contribution in the enterprises and business fields where the state’s investment is not necessary.

Meanwhile, no effective investment deals have been reported, and SCIC has not poured money into the big projects Vietnam called for both domestic and foreign capital.

To date, SCIC has not made any important investment deal in the role of the state’s investor.

The powerful corporation has recently reported a “bountiful crop” 2012 with sky high profits from the investment deals. However, economists have pointed out that most of the profits came from one investment deal in Vinamilk, the dairy producer which now holds the biggest dairy market share in Vietnam.

Vinamilk and some other state invested enterprises, including FPT Telecom or Hau Giang Pharmacy, affirmed that SCIC has not played any important role in their successes, even though SCIC is a big shareholder.

The SCIC’s finance report showed that the corporation got VND1,568 billion from deposit interests in 2012. If noting that the average interest rate was 8 percent per annum, one could make a guess that SCIC is now holding VND19 trillion in cash, or 25-30 percent of the VND62 trillion worth of total assets.

As such, the SCIC’s profits came from some enterprises operating in the business fields with big advantages, and from bank deposits, rather than from their successful investment activities.

I am not surprised that the results are not strong; business development funds and business subsidies are often a loser’s game, or, as my colleague pointed out, a siren’s trap.  I find it disappointing and ironic, however, that the SCIC may be more transparent than JobsOhio, as JobsOhio seems to be digging in its heels on whether it has to provide any financial information regarding its activities.

Should Every Resource-Rich Country Have a SWF?

When I put the question like that, you can guess that I think the answer should be “not necessarily”.  SWFs are very useful financial vehicles that can solve a wide range of economic and social issues . . . provided that the right governance conditions are in place. 

More specifically, what about a country like Myanmar?  Foreign policy analyst Oliver Gilbert offers 7 reasons why Myanmar should not create a sovereign wealth fund:

  • Myanmar lacks a balance of payments surplus necessary to responsibly fund a SWF
  • Myanmar lacks technocratic expertise necessary to provide domestic oversight of a SWF
  • Myanmar does not need a SWF to manage adverse macroeconomic effects of the resource curse
  • Myanmar can achieve economic diversification without creating a SWF
  • Creating a Myanmar SWF would carry an excessive opportunity cost
  • Myanmar lacks the necessary political consensus to manage a SWF
  • Myanmar’s extreme corruption would lead a SWF to fail

It is that last point that I think is especially interesting.  Gilbert cites a Harvard Business School study that (unsurprisingly) links measures of corruption to direct investment in domestic enterprises:

The HBS team compared SWF management to the International Country Risk Guide, a widely accepted metric of country corruption that ranks countries from zero (most corrupt) to ten (least corrupt), and discovered that each point of additional corruption creates a 10.8% greater likelihood that countries with direct investments domestically. Alarmingly, the researchers also observed that politically influenced funds that made direct domestic investments significantly underperformed by 16% in the following six months compared to funds managed by experts without domestic political interference who would otherwise be predisposed to invest globally.

According to the 2011 Corruption Perception Index, an annual index released by Transparency International that gauges perceptions of domestic corruption, Myanmar ranked among the most corrupt states in the world at 180 out of 183 countries. Myanmar’s extreme corruption and the opaque nature of many global petroleum-fueled SWFs casts serious doubt on the ability of a SWF to overcome significant political pressure that has previously ruined funds or resist corrupt abuses by government officials.

So how does one keep a SWF from becoming simply a mechanism of the ruling elite to enrich and entrench themselves at the expense of the general citizenry?  As a law professor, my answer is simple: make sure a strong legal framework is already in place.  Finance must be built on law, a point supported by research by R. LaPorta,  F. López-de-Silanes, A. Shleifer, and R. Vishny (finance professors!) in their seminal article The Legal Determinants of External Finance. We cannot build a financial structure and expect the supporting legal foundation to fill itself in over time.

SWFs Continue Move into Real Estate

Business Week reports:

Real estate topped the list of sovereign wealth funds’ investments last year, overtaking commodities and financial services, according to Institutional Investor’s Sovereign Wealth Center.

Properties made up 26 percent of investments by these funds last year, up from 14 percent in 2011, according to the center’s report on investment trends by the funds released today. That’s followed by financial services and commodities, each accounting for 23 percent, down from about 30 percent a year earlier, it said.

State funds have increased investments in alternative assets including real estate and private equity after monetary policy easing lowered the prospects for bond returns and added to the volatility of stocks.

Check out Institutional Investor’s new Sovereign Wealth Center,  directed by Victoria Barbary, here.  Read their 4th quarter report here.