In thinking about how the emergence of sovereign wealth funds (SWFs) may affect global financial prices, or the world’s risk-return balance, it may be useful to consider three different types of SWFs, based on the sources of the accumulation of official reserves/SWFs: (1) oil and other commodities; (2) goods or C/A surpluses; and (3) capital inflows. The sources of ‘funding’ of the rise in official foreign assets will likely dictate the risk-return profile of the investment portfolio of the central banks/SWFs in question. Specifically, Type 1 SWFs should have the highest risk-return profile because they essentially have no distinct liabilities. Type 2 SWFs should have a marginally lower risk-taking appetite than Type 1 SWFs because of the domestic bond liabilities. But the underlying savings-investment (S-I) surpluses should still imply future consumption and the ‘right’ of the surplus countries to accumulate claims on foreign assets, including equities. Type 3 SWFs, however, should have the lowest risk-taking appetite and therefore should have rather modest – and even negative – effects on the overall risk profile of the financial markets. Depending on the relative size of these three types of SWFs/reserves, the world’s risk-return balance may be altered in different ways. Three Types of SWFs, Based on Their ‘Liabilities’ In our previous work, we have commented on how the deployment of SWF investments should, by and large, be positive for risky assets, i.e., equities, and negative for ‘safe’ assets such as bonds (see Sovereign Wealth Funds & Bond and Equity Prices, May 31, 2008; A 25:45:30 Long-Term Model Portfolio for SWFs, October 11, 2007; and Portfolio Allocation for SWFs, November 21, 2007). That analysis was intentionally made simplistic to illustrate a broad point. In this note, we reconsider this question of the impact of SWFs on asset prices from a slightly different perspective. Specifically, we argue that the sources of the accumulation of official reserves and SWF assets could be a key factor in determining the allocation of assets by these SWFs and, in turn, dictate how the overall risk profile in the financial markets could be altered. • Type 1. Reserve and SWF assets derived from oil and commodity exports. Since the assets in question are ‘fiscal reserves’, with no associated liabilities, these SWFs/central bank reserve holders should, in theory, have longer investment horizons and less of a liquidity constraint. • Type 2. Net goods exporters. Non-oil exporters who accumulate official reserves from persistent S-I surpluses (C/A surpluses) should also have a decent risk-taking appetite, despite the fact that the official reserves are financed through the issuance of domestic government bonds. Opponents of the idea of SWFs in some countries argue that foreign reserves should not be invested in foreign equities simply because there are associated liabilities in the form of domestic bonds. In our view, this is not a very compelling argument because S-I surpluses are net savings for future consumption that should be saved through claims on foreign assets, including equities. Being ‘creditors’, the SWFs/reserve managers should not have tight liquidity constraints. This idea applies particularly well to a country like Japan, that its reserve holdings should be invested in foreign equities because the source of these reserves consists of persistent C/A surpluses. Furthermore, Japan’s investment earnings on foreign asset holdings are now larger than its trade surplus: Japan’s official reserves easily generate US$30-50 billion a year in investment returns. This feature of Japan’s external account makes it as much a Type 1 economy (with ‘fiscal reserves’ from investment earnings) as it is a Type 2 economy (one that still runs a large trade surplus). • Type 3. Capital inflows. India’s official reserves have reached US$168 billion – doubling from the level as of end-2005. During this time, India ran large C/A deficits, implying that more than all of the reserve increases came from capital inflows, rather than S-I surpluses. Because of the relative instability of these capital flows, this source of the official reserves makes the proposition for India to have a SWF or invest its official reserves in less liquid or risky foreign assets a very different one from other countries whose reserves are derived from C/A surpluses. We categorise some of the largest reserves/SWF holders in the world into these three types. ‘100%’ denotes that the oil trade or goods trade surpluses can more than explain all of the increase in official reserves. Overall, across these countries in the sample, about 46% of the assets (totaling US$6.0 trillion) are of Type 1, 36% of Type 2 and 18% Type 3. While India and Brazil have been Type 3 countries, Russia could also become one in the not too distant future, as its C/A balance deteriorates and Russia becomes increasingly reliant on capital inflows, like India and Brazil. Similarly, contrary to popular perception, not all of the increase in China’s official reserves is due to its trade surplus. On average, over the most recent five years, the trade surplus accounted for 65% of China’s accumulation in official reserves. However, this ratio has been declining rapidly. In 2007, trade accounted for only 41% of the US$462 billion increase in foreign reserves. In 1Q08, only 42% of the US$154 billion increase in official reserves was due to trade; capital flows accounted for the rest. (The actual ratio was even lower than 42%, if we account the transfers of reserves to CIC.) Different Risk-Return Profiles We looked at the efficient frontier and the single-asset returns over the period 1987 to 2007. Type 1 SWFs, in terms of this analysis, should move from the ‘100% oil’ point to somewhere along the ‘market line’ (the line that is tangent to the efficient frontier and intersects with the risk-free interest rate). (For the current discussion, we assume that Type 1 SWFs could use leverage.) Type 2 and Type 3 SWFs, on the other hand, should move to a point on the market line, but from the ‘100% Gov’t Bond’ point. We argue that the three types of SWFs will end up at different points along the market line. Specifically, they should be in the order with Type 1 SWFs having the highest risk-return profile, and Type 3 SWFs the lowest, for the reasons explained above. The size of the dark circles reflects the size of these funds. (For the accompanying chart, please see the note of this name dated May 8, 2008.) Compare These Points with the ‘Counterfactuals’ To answer the question how global financial assets may be affected by SWFs, one needs to ask not only where the ultimate portfolios will end up, but also how the assets in question would have been deployed had oil prices not risen (Type 1), China not run a trade surplus (Type 2), or there were no capital flows into India (Type 3). We make these points: 1. Type 1 SWFs raise the risk-return profile of the world. If oil prices had not risen from US$20 to US$120 a barrel, how would the oil importers have invested the funds? Since spot oil is a low-return, high-volatility investment, we believe that Type 1 SWFs invest at a higher risk-return balance than the rest of the world, i.e., how Asian exporters or US households would have invested if they didn’t have to pay so much more for oil. 2. Type 2 SWFs should also raise the risk-return profile of the world, but not as powerfully as Type 1 SWFs. While it is not clear that Asian SWFs/central banks are investing in riskier assets than the trade-deficit countries, the mere fact that they are switching, on the margin, from sovereign bonds to equities should raise the risk-return profile of the world. (This, in fact, was the focus of our earlier note from May 31, 2007.) 3. Type 3 SWFs may reduce the risk-return profile of the world. Not only are Type 3 SWFs likely to stay with ‘safe’ assets, but the ‘round-tripping’ of capital flows from risk-seeking flows into EM to ‘safe’ flows back into developed sovereign bonds also actually reduces the world’s risk-return profile, relative to the scenario where risk-seeking investments are not soaked up by the central banks of the recipient countries. Bottom Line Whether SWFs raise the world’s risk-return profile depends on the sources of the SWF/reserve assets. Oil-based SWFs should have the biggest impact on the world’s risky assets, followed by goods-trade surplus SWFs. SWFs based on capital inflows should have minimal – and possibly even negative – effects on the world’s aggregate risk-taking preference. The net effect depends on the relative size of these three types of SWFs. Since Type 1 and Type 2 funds are huge, SWFs should raise the world’s risk-return profile.
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Revisiting India’s Fiscal Stress
May 12, 2008
By Chetan Ahya | Singapore
Fiscal Discipline and Flexibility Are the Basic Principles for Budget Management Policy While fiscal discipline is important for macroeconomic policy credibility and sustainability, flexibility is necessary for managing unexpected shocks to the economic environment. A fiscal policy following both these tenets would help the government intervene during times of economic difficulties. Such a policy can give a government the ability to use the budget as a counter-cyclical policy tool to regulate aggregate demand. Unfortunately, India’s fiscal policy appears not to have followed either of these two sound budget management principles over the last few years. Headline Fiscal Deficit Reduction Overstates the Progress on Fiscal Management India’s headline fiscal deficit has improved significantly over the last few years. The combined central and state government deficit is estimated to have declined to 5.3% as of F2008 from 9.6% five years back. The headline fiscal deficit for the central government is expected to improve to 2.5% in F2009 (budget estimates) from a 6.2% deficit in F2002. The improvement in headline deficit has been driven primarily by (a) strong growth in corporate tax to GDP (which could reverse in line with the corporate earnings cycle), (b) a reduction in interest costs because of the decline in interest rates, and (c) a decline in capital expenditure. The government has not been able to reduce revenue expenses (excluding interest payments). Off-Budget Liabilities Are Rising In a bid to soften the adverse impact of rising commodity prices on inflation and the cost of living for the poor, the government is incurring off-budget subsidies on oil, electricity, fertilizers and food. In addition, the government has committed to two major expenditure items, including a farm loan write-off and an increase in its employees’ wages. Both these items have not been provided for in the proposed F2009 budget released on February 29, 2008. Including the off-budget expenditure items, the underlying F2009 deficit for the central government will be about 6.2% of GDP in F2009, instead of the headline estimate of 2.5%. The combined centre plus state deficit including off-budget liabilities will be about 9.4% of GDP in F2009 as per estimates. Slowdown in Growth Cycle Could Exacerbate the Fiscal Deficit Burden Growth acceleration over the last four years had helped to improve the (centre and state) tax to GDP from 14.3% in F1998 to 18.4% in F2008. We believe that the government’s tax to GDP will decline over the next two years, exacerbating the fiscal burden at a time when the government has been increasing non-development expenditures and subsidies. Moreover, with general elections due in the next 12 months, the government has been liberal in initiating additional fiscal measures, resulting in loss of tax revenue and an increase in subsidies. Missed Opportunity India’s recent strong economic growth has provided a great opportunity to correct the underlying deficit levels, building a buffer for down cycles. Indeed, during the up cycle of the early/mid-1990s (coinciding with the previous emerging market cycle), budget management was significantly better, resulting in reductions in the deficit and public debt. In the current cycle, India is probably the only emerging market that has witnessed a relatively smaller correction in its deficit over the last five years. India’s deficit is the highest among those in major emerging markets and about 2-3 times those of major developed economies on a percentage of GDP basis. Although there has been some improvement in the fiscal deficit trend at the margin, there is little evidence that the government is implementing any major structural reforms to reduce revenue expenditure, which we believe is critical to achieve a sustainable reduction in the deficit. Unprecedented Global Capital Inflows Mask Fiscal Risks Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India has witnessed an unusually low real interest rate environment right at the time when its fiscal policy has been expansionary, as reflected in rising public debt to GDP. The key to lower-than-warranted real interest rates is the supply of global liquidity in the form of portfolio, private equity and debt inflows. About 85% of the total US$183 billion capital flows that India has received over the past four years have been in the form of non-FDI flows. No Major Risk to Macro Stability Likely… Although we believe that India’s public debt to GDP is way too high, it is unlikely to cause any instability in the near term. We believe that two key factors have allowed such a large deficit to be sustained without a major shock to the economy. First, until recently the government has maintained control over the capital account. Second, India’s deficit has been largely funded through domestic debt as opposed to external debt. In fact, the ratio of external public debt to India’s total public debt was only 6.8% as of March 2007. …but Cost Will Come in the Form of Lower Future Growth Clearly, expansionary fiscal policy is currently supporting India’s growth – seemingly without any concomitant costs. The costs of this policy will be evident in the form of higher real interest rates and slower growth, and these costs will get magnified if global capital inflows were to slow down. One could argue that considering India’s long-term fundamentals, global capital inflows should continue unabated and a further rise in real interest rates would be prevented for longer. However, the past trend indicates that these global capital inflows have invariably witnessed significant moves up and down, influenced by US monetary policy and the macroeconomic environment. Moreover, the current high level of unproductive government expenditure and public debt is weighing on the long-term growth potential. The government’s spending on productive areas such as infrastructure, education, health and welfare has been constrained by high levels of non-development expenditure and a high starting point for debt. The government’s development expenditure has averaged 15% over the last five years, declining from 17% at the commencement of the liberalization process in F1991. Conclusion: Road to Sustained Fiscal Correction Is Hard, but Necessary We believe that a heavy fiscal deficit burden is one of the major hurdles to the government achieving its GDP growth target of 8-10% on a sustainable basis. As discussed earlier, the government has benefited from a cyclical rise in the tax-to-GDP ratio, and there has also been an increase in the off-budget liabilities. However, the government is understating the headline expenditure number, thus resulting in reduced headline revenue and the fiscal deficit over the past five years. A sustainable reduction in the government’s deficit would have to entail difficult and politically sensitive measures, in our view. First, the government could initiate major expenditure reforms and move effectively to outcome-based expenditure management from the current outlay-based system to cut non-interest revenue expenditure. Second, interest costs currently form about one-quarter of total receipts and one-fifth of total expenditure. Indeed, interest costs have been consistently higher than capital expenditure since the mid-1990s. To control the interest cost component, India needs not only to stop accruing fresh debt for funding less efficient current consumption expenditure, but also to reduce its stock of debt to GDP. Third, the government could reduce the debt burden in a short period by stripping out its assets in the form of large public sector entities (PSEs). The government could sell stakes in PSEs worth, say, US$15-20 billion a year in the next five years to invest in infrastructure. This could help to reduce the negative impact of the current high level of deficit on productive expenditure and growth. Silver Lining While public debt to GDP has been high, the good news is the government’s assets have also increased significantly over the last few years. The government can reduce its debt burden by divesting these assets. Our broad estimate indicates that the total market value of government-owned listed companies is about US$280 billion (24.1% of GDP) currently, compared with US$20 billion (4.1% of GDP) in F2002. At the same time, the retained earnings of the government-owned listed companies have also increased to US$12 billion (1.3% of GDP) in F2007 from US$3.8 billion (0.8% of GDP) in F2002.
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