Sovereign funds: a welcome source of market stabilization and globalisation

Sovereign wealth funds (SWF’s) are investment arms created to channel the huge surpluses built up by oil exporters, commodity-rich nations and tightly run economies into established western markets. Their activity has caused some concern recently as many countries, and in particular European states, have raised questions on the transparency and activities of the funds.

While they have existed since 1950’s their current size of greater than 3 trillion USD has made their impact significant. The scale increase is quite spectacular. The 29 sovereign wealth funds monitored by Morgan Stanley are worth more than 3 trillion USD, with the Abu Dhabi Investment Authority, the largest, worth an estimated 875 bUSD. They are growing at an extraordinary pace, as soaring oil and commodity prices and compound interest bring in a bonanza. The IMF reckons that they will be worth 12 trillion USD by 2015. Some economists predict that within five years these funds will be able to buy a third of all the equities listed on global stock markets. Already they have substantial holdings in key Western institutions: 6 bUSD and 14.5 bUSD in Merrill Lynch and Citigroup banks respectively, with a total stake, before the Barclays investment, of 87 bUSD in Western banks. Two funds alone, from Qatar and Dubai, own a third of the London Stock Exchange plc.

Transparency and investment strategy:

While many may argue that these funds operate in similar fashion as hedge funds or operate through them the overall tendency of the sovereign funds is to go long on securities, that is to say, they buy and hold or stay invested for longer periods. This way, they may be a more stabilising influence on stock markets than hedge funds in general.

The recent meltdown in capital markets hassled to increased and visible investments by these funds into buying up stakes in troubled US and European money-centre banks, brokers, and other financial institutions, at such a rapid pace that they are being perceived as saviors in many cases. In the past two years, sovereign wealth funds and Chinese financial institutions invested at least 77.2 bUSD in Western banks and money managers. These investments are vital to the global economy. It is a classic and welcome instance of surplus cash being put at the service of credit-starved organisations, to the benefit of both sides.

The other side:

The big question is whether the money comes with strings. Most funds buy into blue-chip companies, hoping to win more than simply a good dividend: they want access to influence, brainpower and essential skills. Few countries worry that Qatar or the Gulf states have disturbing political agendas. But what of Russia and China? While Russia argues that its fund is set up as a stabilisation source to counter the volatility of energy prices, China and South Korea, for example, are clearly interested in western markets, technology and ideas. Might they not use sovereign wealth, and especially giant state industries, to acquire political leverage? Is the west not mortgaging vital assets to powers that may not always be benign or motivated by business interests alone?

Despite calls for new restrictions, it won’t be prudent to set up protectionist barriers and wholly wrong to discriminate, in advance, on the basis of nationality. What matters is the management record. To date, there have been no abuses. The funds are not just Government proxies, they are sophistically managed investment instruments and the Governments linked to them understand and respect the governance issues prevalent in the Western markets and it is that respect that makes them buy into them. More transparency would indeed be welcome and good disclosure and regulatory environments like those in Britain are a better way to handle the issue rather than building protectionist barriers.

Alistair Darling, in the first speech he made after taking over as the UK’s Chancellor of the Exchequer when Gordon Brown became Prime Minister last June, referred to sovereign wealth funds specifically and said the UK was open to inward investment from all quarters. Darling said: ‘Future prosperity and hundreds of thousands of jobs depend on it. Of course, all investors, including government-backed companies, need to operate according to the rules of the market in which they participate, including high standards of governance and appropriate transparency.’

One should also note the recent development where the members of the International Working Group of Sovereign Wealth Funds (IWG), which met on September 1-2, 2008 in Santiago, Chile, reached a preliminary agreement on a draft set of principles and practices for recommendation to their respective governments.

The Generally Accepted Principles and Practices for Sovereign Wealth Funds (GAPP) is a voluntary framework that would guide the appropriate governance and accountability arrangements, as well as the conduct of appropriate investment practices by SWFs. In response to the call from the International Monetary Fund’s policy-guiding International Monetary and Financial Committee (IMFC), the IWG expects to present the GAPP to the IMFC at its October 11 meeting in Washington DC. The IWG intends to publish the GAPP thereafter.

The IWG members also decided to explore the establishment of a standing group of sovereign wealth funds (SWFs). This is in recognition of the need to carry forward the work relating to the GAPP, as necessary, and to facilitate dialogue with official institutions and recipient countries on developments that impact SWF operations.

(The above mentioned opinion is based on research conducted by SG Analytics (www.sganalytics.com) and several sources of information such as Morgan Stanley, Deutsche Bank, Peterson IIE, PIMCO and SWF websites)

Non Banking Financial Companies or NBFC in India are registered companies conducting business activities similar to regular banks. Their banking operations include making loans and advances available to consumers and businesses, acquisition of marketable securities, leasing of hard assets like automobiles, hire-purchase and insurance business.

Though they are similar to banks, they differ in a couple of ways. NBFC’s cannot accept demand deposits (deposits that can be withdrawn at immediate notice), they cannot issue checks to customers and the deposits with them are not insured by the DICGC (the India equivalent of FDIC in the US system). Either the RBI (Reserve Bank of India) or the SEBI (Securities and Exchange Board of India) or both regulate NBFC’s.

Though the NBFC’s have been around for a long time, they have recently gained popularity amongst institutional investors, since they facilitate access to credit for semi-rural and rural India where the reach of traditional banks has traditionally been poor.

NBFC’s have also had a major impact in developing small business in rural India through local presence and strong customer relationships. Usually the loan officers in such NBFC’s know the end customer or have a strong ‘informal’ understanding of the credibility of the borrower and are able to structure their loans appropriately.

With the next wave of growth in India expected to come from the semi-rural and rural sector, the unique access of NBFC’s to these sector puts them in a great position to benefit from this growth. As evidence of their attractiveness, Goldman Sachs bought a 20% stake in Sriram Credit for 75 mUSD in Q1 2008. Credit Suisse is planning to take a majority stake in Bokdia Marketing and Finance (as reported in May 2008). Foreign Institutional Investors (’FII’) are also setting up their own NBFC’s in India to offer corporate banking and private banking operations. As an example, Societe Generale got approval for its NBFC launch in the country in October 2007. The French financial services group plans to strengthen its brand in India though NBFC’s.

There are three categories of NBFC’s,

a. Asset Financing Companies (’AFC’)

b. Loan Companies (’LC’)

c. Investment Companies (’IC’)

In our current post, we will focus on two NBFC sectors of Microfinance and Infrastructure finance which fall under the category of AFC and LC. In a future post, we would focus on consumer finance with specific focus on the automobile sector.

Microfinance Sector (very attractive)

There is a huge need for credit in the rural sector in India. Roughly 245 million people need 52 bUSD of microfinance credit. This includes small and marginal farmers, landless labourers, micro entrepreneurs in the rural and semi-urban areas. NBFC’s constitute almost 66% of the microfinance (MF) sector. The customer base covered by microfinance is expected to reach 49 million people by 2012 growing at a CAGR of 43% with an expected loan portfolio of 6 bUSD. (Source: Recent report on microfinance by Intellecap, a research firm specializing in microfinance).

The key growth drivers in the microfinance sector are:

a. Need for broader suite of products: Products such as investment products, insurance products, retirement planning can be offered to the customer base

b. Regional diversification: The NBFC’s in this space are mostly concentrated in South India. I expect this to grow in other regions.

c. Market consolidation and entry of FII: The smaller NBFC’s will get acquired and large FII’s (such as Fullerton) will come in and build franchising models to accelerate the quality and penetration of MF in rural areas.

On the flip side, there are some constraints in the microfinance sector such as lack of regulatory rules which are still evolving, lack of standardization, ability to attract quality human resources and an industry attitude that it is still a social enterprise versus for profit professional enterprises.

Lastly, in terms of recent investment activity, SKS microfinance (37.3 mUSD), Share Microfin (27.5 mUSD) and Spandana (12 mUSD) were financed in the last year. Additional NBFC’s such as Bandhan, Cashpor and Grameen Koota are looking actively for investments.

Infrastructure Finance Sector (very attractive)

During the economic boom of the 1990’s, the Govt. implemented many policies for infrastructure development with focus on roads, telecommunications, ports, and power. Special purpose vehicles (’SPV’) were formed to facilitate the credit demands of various projects. A majority of these were setup as NBFC’s. The Govt. also implemented public private partnerships (’PPP’).

As a perspective, during the period 1990-2006, 233 PPP projects were completed with total investment of 69 bUSD. The PPP investments grew from 0.6 bUSD in 1991 to 17.1 bUSD by 2006 representing a CAGR of 25%.

During the period 2007-2017 the levels of investment is expected to further accelerate fueled by the economic growth and the need to catchup on infrastructure to facilitate this growth. During this period investment of roughly 1500 bUSD (Source: Govt. website, World Bank and E&Y report) would be needed on power, roads and telecommunications.

The Govt. is setting up favorable policies to attract at least 50% of this investment from the private sector. The private NBFC’s are expected to become a major investment vehicle to funnel the private investment into the growing infrastructure sector in India.

SG Analytics an investment research firm based in India which i work for does sector research work on emerging markets such as India and China.