By now it should be apparent that the hottest issue in generally hot Latin America is the furious pace of international reserves accumulation. The current level of reserves in Brazil, about US $ 145 billion, is more than double the US$ 62.7 billion level of the end of June 2006. Likewise, both Colombia and Peru have increased their reserves by more than one third in less than one year; it is not hard to find other cases. While the absolute amounts are small relative to those of Asian economies, they are large relative to the size of Latin countries: the ratio of reserves to GDP is now approaching fifteen percent in Brazil and twenty percent in Peru.
Surely, a fraction of the accumulated reserves should be thought of as a “war chest” intended to prevent and fight against financial crises, as discussed by Andrés Velasco and myself (and then others) more than a decade ago now. But several countries, including those mentioned, now hold reserves substantially in excess of what most of us agree is needed for war chest reasons.
So the question has emerged: what should emerging countries do with their considerable excess reserves? Of course, the time honored tradition has been to invest international reserves in very safe and liquid assets, by and large meaning U.S. Treasury bills. But the low yields on those holdings compared with the large recent returns on risky securities have motivated a reconsideration of that strategy. What would be wrong, one could ask, if a portion of the reserves were invested in, say, the U.S. stock market?
Wall Street bankers, eyeing a profit opportunity, have started to peddle “sovereign wealth funds,” “future generation funds,” and the like, to our ministers and central bankers. A typical sales pitch emphasizes how much more money our reserves can be expected to make if only we were willing to take a little more risk. And the fact that China is already going for it (remember Blackstone) puts more pressure on our policymakers to jump into the bandwagon.
Is there something wrong with this? In principle, the answer is no. But in practice (and having seen some of the bankers’ presentations) I worry that there is too much emphasis in the risk-return tradeoff in contrast to other aspects of reserves management such as liquidity, enforceability, transparency, and political and social purpose. Unlike private investors, whose main focus is risk versus return, our governments and central bankers are agents acting on behalf of the ultimate owners of the excess reserves, our countries’ citizens. And that means, at least to me, that investing our reserves in sovereign wealth funds is a much thornier proposition than it appears. What if, for example, the Peruvian central bank loses one billion dollars (about five percent of its current reserves) in a U.S. stock market crash, after having committed its excess reserves in such a fund? I can imagine several scenarios (Congress investigations, corruption accusations, jail for the central bankers…), none of which is pretty. (Note, by the way, that this illustrates one reason why China is not a leading example for Latin America: we have democracy, China does not.)
I believe that the implication for our countries is not to refrain from investing in sovereign wealth funds, but to make sure that all the relevant stakeholders, not only government technocrats, are on that same page. And to make sure that our countries have competent and powerful representatives actively involved in the management decisions, monitoring, and reporting of the funds’ activities and performance.
Also, once we recall that international reserves belong to the people, the more fundamental question emerges: What exactly is the justification for the government or the central bank to invest excess reserves in sovereign wealth funds, as opposed to investing them on education, health, infrastructure, or just returning them to our citizens (via e.g. lower taxes)? Why should our policymakers assume they have such a mandate? While I am not arguing that a rationale does not exist, it is clear that we would all benefit if it were explicitly spelled out. A compelling argument should identify the applicable market failures (or political failures) and explain how investing in sovereign wealth funds would further our countries’ objectives and welfare more than by just returning excess reserves to the population.
5 Responses to “Sovereign Wealth Funds for Latin America?”
Roberto, Very good piece. I couldn’t agree more with you: what if these Central Banks lose money in a downturn? The advantage of China is that in the absence of democracy they don’t need to ask their people anything. They do whatever they want. You are right: if Central Banks can allocate in SWF then they would be better off using the $ on health, education and so forth. Question: Don’t you think that for governments to allocate reserves in education, for example, they would need to have a flow such that the ‘investment’ is not something populist (one time lump sum) and then discontinued afterwards ?(due to the absence of a regular procedure to allocate part of the reserves in a few programs).
Very interesting points and ideas. Whether execess reserves should be invested in foreign assets or invested at home in real capital accumulation is an important issue? Do we know that the returns to such public investment are higher than the expected returns on foreign assets? i guess it depends on the type of investments. Also, as the Singapore GIC’s experience suggests the returns for SWFs investing in equities and other risky assets can be quite high if the portfolio are highly diversified across currencies and asset classes. Also, if reserves are kept in dollars capital losses will occur if the national currency appreciates relative to the US dollar. So are such currency related capital losses more or less problematic – from a political economy point of view – than market losses from investing in, say, falling equities? Not clear to me.
Anonymous: Sometimes the social cost of an investment may be low in a point in time and high on an intertemporal basis. In turn, it is possible that real investment provide lower net present value than if reserves are invested in SWF. Point is that some of the countries with excess reserves lack basic infrastructure, for example. However, even if real investment has lower present value than equities, these countries need investment to have high growth rates. Question: Do you recommend the Chilean stabilization fund? Or not?
Great post – It touches on a lot of the key motivations and accountability issues of sovereign wealth funds. As you (and Vitoria) pointed out, the fact that these Latin American economies who might be considering investing ‘excess reserves’ are democracies makes them very different from many of the other sovereign investors (except Norway which is much more transparent and some smaller resource funds). Clearly having different domestic actors on board and strong national regulation and associated risk control is key. Beyond national concerns about how money is spent/invested, several commentators have worried about the systemic risks of a sovereign fund imploding. The funds involved in direct investment pose an even thornier set of questions regarding corporate governance and how they might react to losses. Even China, is facing some public questioning on the subject of the on-paper loss sustained after the post-IPO value fell. Though this stake is small compared to the flow of reserves. But one of the biggest challenges is probably determining not only what to buy but when to spend the proceeds, especially for those worried about inflationary pressures of further spending, even if it would be beneficially in the long-term. Venezuela provides a counter example to many of other oil exporters. In 2006 central bank reserves fell by over $10 billion part (and much of PdVsa’s earnings) being transferred to the social development fund (fonden) to be spent on social and infrastructure projects.
Thank you all for the kind comments. Vitoria, as you suggest I would rather set up a savings program to ensure a flow of excess reserves to socially desirable objectives, such as education. But, why doesn’t such a program exist already? There must be some significant political or institutional obstacles impeding such an “obvious” improvement, which we need to understand. As for my view on Chile’s stabilization fund, I think it is a good example and one in which the rationale was explicitly laid out to the public. The same procedure, however, helped establishing objectives and limits for the fund, which is what we do not have in general for excess reserves.