Crisis pushes sovereign wealth funds to go domestic

By Steven C. Johnson - Analysis

NEW YORK (Reuters) - Sovereign wealth funds, once feared as the lions of global finance, are looking more like lambs now that the credit crisis has them shoring up domestic banks rather than gobbling up choice Western assets.

Investing at home rather than abroad is a big shift for these state-run agencies that control trillions of dollars and could signal a long-term shift in their strategy.

One thing is clear: the sudden domestic focus indicates how perilous the financial landscape has become for emerging market countries, which boast some of the top sovereign wealth funds.

As access to credit worldwide has dried up, investors have fled from emerging market equities and debt. That's put pressure on local currencies, increasing the vulnerability of domestic banks with large foreign exchange liabilities.

Banks in the euro zone, Britain and Switzerland have been able to draw on Federal Reserve currency swap lines for access to desperately needed dollars, but those in Russia, South Korea, Kuwait and elsewhere have had to fend for themselves.

That means using foreign exchange reserves to backstop currencies and support local banks and, in many cases, calling on sovereign wealth funds to invest at home.

"There's been a consistent pattern of this, and I would expect it to continue in a world where countries have much higher liquidity needs than before because there's no access to cross-border bank financing," said Brad Setser, a fellow in geoeconomics at the Council on Foreign Relations in New York.

This month, Russia cleared its sovereign wealth fund to invest $6.7 billion in the domestic stock market, which has fallen more than 70 percent since its May peak.

Funds in Qatar and Kuwait have also started buying shares of listed banks to boost confidence, while the China Investment Corporation has pumped cash into state commercial banks.

IN A BIND

The strategy "makes good sense," said Stephen Jen, global head of currency research at Morgan Stanley in London.

"By investing at home, they do three things: they support their own asset prices, they keep trophy assets in domestic hands and when they convert dollar holdings to buy domestic assets, they're intervening and supporting their currencies."

According to EPFR Global, a net $6.4 billion has been pulled out of U.S. dollar-denominated and local currency emerging market debt funds so far this year.

State Street Global Markets noted last week that flows into emerging Asia had hit an all-time low, worse even than those seen in the midst of the 1997-98 Asian crisis.

That type of shift is obliging some countries to run down reserves at a fast clip, Jen said, to boost falling currencies and shore up banks with foreign liabilities.