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The Impact of SWFs on financial markets

FX Invest Middle East conferenceAbu Dhabi, October 2 2012

Fabio ScacciavillaniChief Economist, OIF

Agenda

The emergence of SWFs as an epiphenomenon of the tectonic shift driven by globalization

An economic environment favoring newcomers rather than incumbents

How SWFs are influencing the new financial architecture and underpinning the valuation of several asset classes => Risk management

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Millennial View

Western Europe FSU

United States Japan China India

1500 17.9% 3.4% 0.3% 3.1% 25.0% 24.5%

1600 20.0 3.5 0.2 2.9 29.1 22.5

1700 22.5 4.4 0.1 4.1 22.3 24.4

1820 23.6 5.4 1.8 3.0 32.9 16.0

1870 33.6 7.6 8.9 2.3 17.2 12.2

1913 33.5 8.6 19.1 2.6 8.9 7.6

1950 26.3 9.6 27.3 3.0 4.5 4.1

1973 25.7 9.4 22.0 7.7 4.6 3.1

1998 20.6 3.4 21.9 7.6 11.5 5.0

2006e 19.0 3.8 19.7 6.3 15.1 6.3

Source: Angus Maddison, The World Economy: A Millennial Perspective, OECD (2001); IMF; Morgan Stanley Research

Contribution to global GDP in the last 6 centuries at 1990 International (PPP) US$

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Millennial Mean Reversion

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Shift in Barycenter

Source: World Bank Global Development Horizons 2011Note: Shares are expressed in real 2005 US dollars

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Economic Barycenter

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Gompertz curve

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Macrowaves

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The Century of the Dragon

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Asset Allocation

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Globalization

Ironically, before the Great Recession the narrative on globalization hinged on the expectations that Anglo-Saxon finance and free markets paradigm would gradually extend to the rest of the world

Few expected that the globalization would reshuffle the economic landscape and pave the way for a shift of the economic barycenter from mature economies to emerging markets

Contrary to the script the extras have become the protagonists giving raise to a multipolar world

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How The Extras Became

Protagonists• Most Western countries have been living above their means,

thanks to mounting private liabilities in the US, UK, Spain and public liabilities in Continental Europe

• This came as a result of an attempt to counter the loss of technological edge and a demographic decline

• Public opinion and leaders in developed world are still in denial

• Cuts to discretionary spending, marginal entitlement trimmings and cuts in public investments are mere palliatives

• It is required a re-engineering of the fundamental functions of the public sector and its financing starting from the education system

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Secular decline treated as cyclical

problem

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Aftermath

• The world will deal with the aftermath of this crisis for several years.

• The illusion of quickly reverting to the days of easy money and inflated stock indices courtesy of the Fed are giving way to the awareness that the adjustment will be painful

• Some call it the ‘New Normal’

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State Capitalism?

“The crisis of Western liberal capitalism has coincided with the rise of a powerful new form of state capitalism in emerging markets”

“The crisis of liberal capitalism has been rendered more serious by the rise of a potent alternative: state capitalism which tries to meld the powers of the state with the powers of capitalism”.

Source : Special Report on State Capitalism

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SWFs: Public vs Private

• Historically, the demarcation between public and private sphere in the economy swings like an irregular pendulum in response to circumstances and political mood.

• Financial markets were widely viewed as a preserve of individuals, firms and private institutions

• Any interference by a publicly owned entity was deemed an undue interference at odd with well-established laws, norms and practices.

• The massive bail out of key international banks and industries like car manufacturing shattered this sanctimonious attitude.

• KfW, EDF, ENI, Fannie & Freddie, Landesbanken etc.

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Reversal of Capital Flows

• Until the 1970s, the capital flows typically moved from the developed world towards developing economies.

• This situation had prevailed since the industrial revolution and was a dominant feature of the first wave of globalization (1870-1914) when the British Empire and the US were the unmatched powerhouses.

• Until recently a Brazilian or an Asian company looking for financing would obtain it directly or indirectly from London or New York.

• Slowly, but with a remarkable acceleration over the last few years capital flows inverted their course: particularly from emerging economies to the US. China, Japan, some Asian Tigers and MENA are net supplier of capital.

• ‘South-South’ flow are rising, including FDI. Intra emerging market flows could be channeled directly without the intermediation of the developed counties financial centers by strengthening the links among the outer nodes.

• Recent example: Qatar bought 20% of CITIC

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The role of SWFs

• The surge in capital flows that we have witnessed over the last 25 years is the fundamental propeller of this re-balancing because it transformed the sign of the demographic variable in the equation of economic development

• Qatar vs Russia

• The expanding role of SWF reflects this secular inversion in the distribution of global wealth from mature economies, primarily the United States and Europe, to countries such as China, India and Brazil which enjoy favourable demographics, and to those with sizable natural resources such as the UAE, Norway, Australia and Russia.

SWF and FX reserves

Source: Castelli & Scacciavillani, The New Economics of SWFs

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SWF Direct Investments

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Global Role

• The end of the saving glut and the coming era of capital scarcity

• Long term investments: SWFs as the ultimate risk bearers

• SWF emerging investments trends • SWFs investing in the less developed

economies: Africa as the last investment frontier: savings – investment bottleneck

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Financial Barycenter

• The “hubs and spikes” model of global financial markets is inadequate for a multipolar world and implies a dangerous concentration of systemic risks

• Pinnacles: London and New York• Cobweb model is the most natural alternative• South-South relationships need to strengthen and

find alternatives linkages• Towards a multi-currency regime

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Capitalism is Risk

• Growth, progress, new ventures, technological advances and implementation of new discoveries are subject to uncertainty

• Risk will materialize no matter how many precautions one adopts, so a capitalist system is inherently subject to instability, cycles, crises and disruptions.

• This does not imply that capitalism is ‘wrong’. It implies that risk management is at the core of capitalism and the cornerstone of free markets.

• Widespread ineptitude in risk management is more dangerous for free markets than any collectivist ideology.

• Incompetent bankers can obliterate free markets. Communists can’t.

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Financial fragility

•Clash between macro and micro level–Diversification => risk underestimation=> leverage => contagion–Fund Benchmarking => herd behavior–Capital adequacy ratios => stampede to the exit–Ratings => irresponsible lending

• Regulation induced pro-cyclical risk building

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The strategies of most SWFs or FWFs display a higher risk tolerance on longer term investments, with far reaching implications for their risk management.

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SWFs as an Asset Class

• SWFs rarely face sudden redemptions, hence they do not need to be over-concerned about liquidity risk or crippling margin calls.

• Stable endowment and long-term focus do not imply complacency on risk management or careless risk assessment.

• It means that they need to assign a different set of weights to various sources of risks than mainstream asset managers.

• But the risk management for long term investing is completely different from the mainstream concept.

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Risk Management• If you cannot estimate risk, you cannot

estimate a meaningful measure of true return and profit

• Without this estimate capitalism cannot function

• Risk determination is built upon US Treasury Bill yields.

• Add equity risk premiums, market betas, political risk etc. ...and you get the target rate for capital remuneration.

• FX is the key driver of performance for global asset managers

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We must look at

risk under a new light

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Hedging

Everybody thinks he will be smarter

than the rest and be able to reach for

an exit before the

others

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KEY POINT

Financial returns diversification

vs Growth drivers diversifications

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Six Killer Applications

• Political and economic competition • Rule of law • Scientific revolution • Modern medicine • Education• The work ethic

Institutional Capital

Human Capital

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Turn off the Autopilot

• Risk management is human judgment guided by a set of imperfect quantitative tools and constantly updated qualitative assessment. Quantitative tools must not be considered an auto-pilot system

• Asset valuations are probability distributions, not exact calculations

• These probability distributions will always be influenced by the business cycle, which remains the fundamental driver of market and systemic risk.

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Macroeconomics

• Forming expectations on the macroeconomic outlook is critical but not enough, because the link between macroeconomic fluctuations and asset prices is inherently unstable

• Models that aim to estimate the parameters of such a relationship are not reliable, nor are models that rely on past data to estimate a probability distribution of returns and correlations

• Sloppy currency risk management is financial suicide in a multi-polar world. FX is a fundamental driver of performance

Long Run Growth Drivers and

Implications for Risk Management

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What drives long term growth? => Investment Themes rather than asset classes in order to diversify risk.

• Demographics & Education• Infrastructure & Urbanization• Natural Resources Super-cycle• Technological Advances• Logistics and integration of value chains• “Fluidification” of Business Environment• The Six Killer Applications (Niall Ferguson)

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International Role of the Dollar

Post WWII was an unusual

period from a historical perspective

The Triffin dilemma and the

relative size of major

economies

Exorbitant privilege

turns into unbearable

burden

Currency Debasing => Commodity inflation =>

Oil shock => Recession => Financial Crisis

New source of international liquidity for a multipolar world =>

Hard SDR

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Concluding Remarks

• The classification of developed economies and emerging economies starts to be out of touch with reality, because some of the emerging economies have in fact emerged and overtaken some of those classified as developed which in turn are sinking (Greece is just a point in case) like South America in the 1960s. So it would be more apt to talk about mature and high growth economies.

• The expanding role of SWF reflects this secular inversion in the distribution of global wealth from mature economies, primarily the United States and Europe, to countries such as China, India and Brazil which enjoy favourable demographics, and to those with sizable natural resources such as the UAE, Norway, Australia and Russia.

• The surge in capital flows that we have witnessed over the last 25 years is the fundamental propeller of this re-balancing because it transformed the sign of the demographic variable in the equation of economic development.

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Thank YouFabio ScacciavillaniOman Investment Fund (OIF)P. O. Box 329, P.C. 115Sultanate of Oman T: +968-2464 3035M: +968-9321 4978F: +968-2469 1344E: fabio@oif.omW: http://www.oif.om