The Gulf's sovereign dilemma

With oil prices still faltering around their lowest level in 11 years, many GCC governments are drawing down assets from their once swelling sovereign wealth funds to plug budget deficits. Yet this is having a knock-on impact on global markets
The Gulf's sovereign dilemma
Saudi Arabian Monetary Agencys (SAMA) net foreign assets — among the largest in the world — totalled $628bn in November.
By Sarah Townsend
Sat 09 Apr 2016 12:15 AM

To withdraw or not to withdraw?” asks American University of Sharjah professor Dr Jorg Bley in a column for Arabian Business (see page 34) about the present state of Gulf sovereign wealth funds (SWFs).

The multibillion-dollar funds have enjoyed strong growth in recent years but analysts now warn that growth is slowing as flat oil prices and low liquidity force governments to break into their investment vehicles.

Across the Gulf, evidence abounds of governments drawing down on SWF assets to plug budget deficits or otherwise stabilise national economies. The biggest oil-producing nations are under particular stress while commodity prices remain low — the International Monetary Fund (IMF) estimated that Gulf countries together lost more than $300bn of hydrocarbon revenues last year.

In particular, Saudi Arabia’s foreign reserves fell to under $642bn in September from a high of around $731bn in August, ratings agency Moody’s noted in a report last November. Around the same time the Saudi Arabian Monetary Agency (Sama) reportedly withdrew between $50-$70bn from its SWF asset managers as it sought to liquefy assets. It also withdrew an estimated $1.3bn from European equities last year, according to analysts at Dubai’s Nasdaq.

On April 1, Saudi Deputy Crown Prince Mohammed bin Salman outlined plans to create a $1 trillion mega-fund to help wean the kingdom off oil. It would include selling up to 5 percent of shares in Saudi’s national oil company Aramco.

“IPOing Aramco and transferring its shares to [a] PIF [public investment fund] will technically make investments the source of Saudi government revenue, not oil,” the prince was quoted as saying by Bloomberg. The share placement could happen as early as next year, he said.

Meanwhile, other SWFs have reportedly cashed in on some of their assets. Last October, Qatar Investment Agency (QIA) sold a 10 percent stake in German construction company Hochtief, valued at $615m. It also announced stake sales in French construction giant Vinci and two London office buildings, and sold its stake in film production house Miramax to Qatari broadcaster BeIN Media Group in March.

QIA is believed to have incurred losses of up to $12bn as a result of investments in Volkswagen, Glencore and Agricultural Bank of China — all of whose balance sheets were hit for a variety of reasons last year.

Kuwait Investment Authority (KIA) reportedly sold $30bn of assets in 2015. Abu Dhabi’s Mubadala also made redemptions, however, it is understood that its decision last year to sell most of the assets of its commercial finance joint venture with General Electric (Mubadala GE Capital) to Wells Fargo was driven principally by GE’s move to wind down its GE Capital business.

UBS predicted last October that central bank and sovereign wealth fund assets would shrink by a total of $1.2 trillion by the end of the year. UBS Asset Management head of global strategy Massimiliano Castelli told Bloomberg at the time:  “This is the beginning of a reversal in the trend we have seen of sovereign wealth funds and central banks accumulating assets.”

Moody’s predicted sovereign outflows would be at least 25 percent higher in 2016 due to the decline in oil price. Its forecast has yet to be proven, however data provider eVestment published data in February showing that state funds pulled at least $46.5bn from asset managers in 2015 —  greater than the sovereign outflows recorded at the height of the financial crisis.

“The fall in oil prices has affected the pace and volume of fresh fund inflows into GCC SWFs,” says M R Raghu, senior vice-president of research at Kuwait Financial Centre (Markaz).

“SWFs are typically long-term investors and are clear with the asset class exposures they require. However, the current environment where liquidity is key has forced them to re-evaluate their exposures to riskier asset classes such as private equity and long gestation vehicles such as infrastructure funds.

“GCC SWFs have either been liquidating their assets or reorienting their portfolio towards liquid assets, [in part] to fund government deficits. This is especially true in the case of Saudi Arabia and Qatar.”

A substantial portion of SWF assets is likely to be diverted into local investments, most likely through funds and external managers, says Fahd Iqbal, head of Middle East research at Credit Suisse. “The primary purpose behind the creation of SWFs in the GCC was to provide a safety cushion for future generations, given the heavy reliance the GCC economies have on oil. For instance, the bulk of ADIA’s assets are in passive investments, with limited exposure to exotic and alternative investments,” he says.

“As a result, most SWFs take a very conservative investment approach focused on international diversification by region and asset class.

“SWFs are tasked with specific geographic mandates that determine where they are allowed to invest. There has historically been a tendency for those SWFs that can invest locally to increase allocations to local equity markets at times of deep distress.

“Such action serves two purposes: firstly, it allows long-term-focused SWFs to take advantage of short-term price dislocations, thus generating added growth for the fund itself. Second, it supports local markets by providing needed liquidity and acting as a signal of value to the broader market.”

SWFs redeemed a significant amount of money from passive products in particular, the eVestment data shows. More than $7bn was withdrawn from passive funds offering global equity exposure in the fourth quarter of 2015, while SWFs increased their exposure to less liquid asset classes such as private equity and infrastructure.

This is reportedly having a knock-on impact on profitability at large investment houses, which include BlackRock, Aberdeen Asset Management and State Street, among others. The CEO of one large European asset manager told the Financial Times in February: “[State funds] have had a steep and very fast escape from the market. I am afraid it will continue.”

Nasdaq’s Advisory Services analyst Alexander Free tells Arabian Business: “SAMA was again among the top sellers across all European equities over the last quarter of 2015 [according to Nasdaq estimates], as QIA, KIA and Abu Dhabi Investment Authority [ADIA] were also seen divesting their equity holdings across Europe.

“This selling impacts markets at a wider level as oil-dependent sovereign wealth funds play a major part in financial markets, providing both solid long-term positions in large corporations and supporting share prices via their demand.

“Therefore, selling could well contribute to higher volatility on equity markets, and may also affect the long-term shareholder stability of many European corporations as these investors typically have a very long-term investment horizon.”

As long as the oil price remains at low levels, selling from oil-dependent SWFs should continue, he adds. Credit Suisse’s Iqbal agrees: “When oil prices are high, GCC governments generate strong fiscal surpluses which are then channelled into SWFs.

“But when oil prices fall below the fiscal budget break-even oil price, governments will dip into their reserves to fund the deficit.

“The oil price drop over the past year has been significant enough to warrant potentially substantial redemptions by SWFs that have exacerbated market volatility and negatively affected currencies.”

US bank Morgan Stanley predicted last year that if sovereign redemptions continue at the same pace in 2016, listed asset managers could suffer a 4.1 percent fall in earnings per share.

However, Nigel Sillitoe, CEO of Dubai-based market intelligence firm Insight Discovery, says the very size, scale and breadth of SWF portfolios mean they will continue to be perceived as an important investor group.

“Given the deficit situation of [many GCC states] over the next few years, SWFs will be drawing down their reserves,” he says. “Also, SWFs have been aggressive investors in the form of direct investments in emerging markets such as China, India, Africa and Latin America. These factors might lead to a significant slowdown, which in turn might hurt emerging markets.

“However, while it’s been widely reported that last year was something of a blood bath for many global asset management companies, who lost some sizeable mandates, it mustn’t be forgotten that SWFs in the GCC manage well in excess of $2 trillion.

“With assets of this magnitude, GCC SWFs will continue to be courted by asset management companies, perhaps even more so now that certain countries have announced plans to launch new SWFs.”

Reuters reported in January that Saudi Arabia intends to create a new sovereign fund to manage part of its oil wealth and diversify investments, and has invited proposals from investment banks and consultancies.

James Dervin, managing director of Deloitte Corporate Finance, says: “In terms of trends, it can be misleading to lump together ‘Middle Eastern SWFs’. The response of the respective SWFs to the current environment is influenced by many different factors, including their respective national fiscal positions and the particular SWF’s maturity and degree of autonomy, which varies significantly even within the GCC.

“I’m not aware of any exit from certain markets by any one fund — on the contrary, there is evidence of new investment [such as entries into Brazil, China, France and Spain by Mubadala in the past four months].

“There was, however, some monetisation of highly liquid assets towards the end of 2015 and early 2016 by some, but my understanding is that these are fairly negligible in the context of the overall value of assets under management.”

Most GCC funds provide little information on their investments or performance, but the latest data from the US-based Sovereign Wealth Fund Institute (SWFI) shows that the five largest SWFs — in Norway, Saudi Arabia, China, UAE and Kuwait — each hold between $500bn and $900bn and collectively manage at least three-quarters of total SWF assets.

GCC SWFs are estimated to manage about 37 percent of total assets. ADIA holds about $773bn, while Saudi Arabia’s SAMA has about $632bn (down from an estimated $671bn mid-2015), KIA has about $592bn and QIA holds about $256bn.

Dervin says any rebalancing by Gulf SWFs in the coming year will vary depending on the composition of the existing portfolio, maturity of the institution and each funds’ mandates — “the trade-off between pure maximisation of returns versus a more traditional long-term investment approach”.

GCC governments may be raiding their state funds at a faster rate than in the past, but, for now, there is plenty more where that came from.

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