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Money News

Crisis pushes sovereign wealth funds to go domestic

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.

Countries from South Korea to Russia to Brazil have seen currency reserves eroded in recent months. Asian reserves excluding China fell by $20.3 billion in September, according to central bank data

“Emerging markets are in a huge bind, and in this environment, investors will not be patient and will punish all emerging market currencies, regardless of fundamentals,” said Jen, who predicted worse outflows to come in 2009.

Local demand for dollars “is a reason wealth funds, while able to invest overseas, may not be as willing as before.”

Also, the conditions that swelled the coffers of oil-exporting countries, have changed, with oil plunging from nearly $150 a barrel in July to less than $70 on Wednesday.

According to Morgan Stanley data, net capital flows to Russia have gone from a $39 billion inflow in the second quarter to a $29 billion outflow in the third quarter.

KINDER, GENTLER SWFs?

The sudden inward-orientation could change the way these funds, which tend to be secretive about their holdings and investment strategies, are viewed in the West.

A year ago, many feared they would use their massive wealth to advance political rather than economic ends while snapping up the crown jewels of Western economies.

Middle Eastern and Asian funds have been active over the last 12 months, spending $25 billion on stakes in global companies such as Citigroup and UBS, though most investments have done poorly as shares in financial firms have declined.

In future, Setser said funds “may decide there’s an advantage to a safe portfolio with liquidity needs higher than expected, or they may decide the problem wasn’t risky assets but overpaying for them, and they no longer have to overpay.”

Indeed, the old concerns haven’t gone away entirely. French President Nicolas Sarkozy this week called for the creation of a European sovereign wealth fund that would buy stakes in firms with low share prices to keep them out of foreign hands.

But for now, analysts say circumstances in emerging markets are such that these funds will remain in a defensive crouch.

“Look at the losses that some of these funds have taken,” said Lex Rieffel, a fellow at the Brookings Institution in Washington and a former U.S. Treasury official. “The political masters are not going to be eager to give them a free license to go out and lose more money.”

And with U.S. growth slowing, Americans will have to save more, Rieffel said. That, too, will reduce emerging market surpluses and the money on hand for investing abroad.

“The sovereign wealth fund phenomenon was the product of a whacked out global economy,” he said. “We can’t expect the economy to remain this way, with large imbalances, forever.”

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