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Victor Mendez-Barreira
China
Reserves
Since the global financial crisis (GFC) of 2007–09, Switzerland has amassed a huge international reserves portfolio of just under $1.1 trillion – the world’s third-largest, behind China ($3.1 trillion) and Japan ($1.3 trillion). This has regularly triggered debates about whether Swiss authorities should seek to create a sovereign wealth fund (SWF) to manage the country’s excess reserves.
Proponents argue the Swiss National Bank (SNB) is not designed to maximise returns, which makes the country squander the opportunity to reap higher profits or finance initiatives to promote the national long-term interest. Opponents say large Swiss reserves are the result of central bank policy, and their management is best left to the SNB.
Central bank reserve managers prioritise liquidity and short-term maturities to be able to deploy their assets at any given time. Therefore, they focus on sovereign assets such as US Treasuries, which enjoy the depth and liquidity needed to absorb large transactions without negatively affecting asset prices. Nonetheless, this strategy offers limited returns, especially in the low-yield environment that followed the GFC. In this context, an SWF would allow Switzerland to manage part of its large portfolio with a longer-term strategy, which could boost investments in equities or private assets, potentially yielding considerably higher returns.
Higher SNB reserves are the result of the central bank’s monetary policy. Since the Swiss franc is viewed by investors as a safe-haven asset, Switzerland receives hefty capital inflows. This is further reinforced by the country’s openness to international capital and its competitive export sector. However, a strong franc puts downward pressure on inflation, which has been below target for most of the past decade. To offset this effect, the SNB has kept interest rates at a record low of -0.75% and regularly carries out foreign exchange interventions. In a bid to further loosen financial conditions, the SNB expands the monetary base creating francs with which it buys foreign currency assets. These are mostly sovereign bonds denominated in US dollars and euros. This strategy has progressively boosted the portfolio from Sfr84.5 billion ($84.2 billion) in January 2008 to Sfr984 billion in March 2022.
Nonetheless, this massive increase has not been the result of a strategy to boost reserves, but the unintended consequence of managing the franc’s exchange rate, which is the SNB’s key policy goal. This is precisely the reason why opponents think the SNB should resist the creation of an SWF. Facing higher inflation, or an undesired weak franc, the SNB may choose to normalise policy by selling the foreign currency assets on its balance sheet. To do that, it needs to preserve total control over them. The SNB’s chairman, Thomas Jordan, pointed this out in a speech in October 2020. Back then, he argued that if global demand for Swiss franc weakened, the SNB could be forced to unwind its current positions to defend the currency’s value. “We therefore must also firmly reject any ideas aimed at channelling our assets into a sovereign wealth fund.”
Jordan has made this argument over many years. He has also pointed out that the SNB has carried out an asset diversification strategy to protect the reserves’ value since the global financial crisis. “We are decisively against the SNB’s currency reserves being used in a sovereign wealth fund,” the chairman said in a press conference in June 2017. “Our foreign exchange reserves aren’t just banknotes we put under the mattress. We have a sophisticated, well-developed investment policy.”
The SNB’s current asset allocation invests 64% of the portfolio in government bonds; 11% in other bonds including covered bonds, foreign local bonds, supranational bonds and corporate bonds; and 25% in equities, according to SNB data. This has evolved from a 2010 allocation in which government bonds received 83% of investments; other bonds 6%; and equities 11%.
Although this is a bold asset allocation for central bank standards, it is much more conservative than the strategies a typical SWF would implement. People in favour of setting up a new fund in Switzerland usually cite Norway’s example. The Government Pension Fund Global (GPFG) is an independent entity managed by a separate branch within Norges Bank. Following the beginning of oil extraction in the North Sea in 1971, the GPFG was created with the aim of leveraging oil export revenues to provide the government with additional fiscal space. The two main goals were to offset the negative impact falling oil prices would have on the Norwegian economy and offer a source of growing wealth for future generations once oil production ceased.
The government completed the first transfers to the fund in 1996. During this period the fund’s market value has gradually grown to reach Nkr11.9 trillion ($1.2 trillion), the highest value of any SWF worldwide. Since 1998, the fund has recorded an annual return of 6.7%. Over these years, returns on financial investments, mainly equities, have replaced oil export revenues as the main source of the fund’s income. In 2021, the GPFG invested 72% of its assets in equities, 25.4% in fixed income, 2.5% in unlisted real estate, and 0.1% in unlisted renewable energy infrastructure.
Institutionally, the Norwegian Ministry of Finance oversees the fund and establishes investment and governance guidelines, which are also sanctioned by Parliament. Additionally, the GPFG transfers to the government are set by a fiscal rule, establishing these must follow the fund’s expected return. This was initially set at 4% and, in 2017, it was reduced to 3%.
Although this share remains stable, because the fund has grown ever bigger its transfers to the government have grown as well. Over time, the government has also increasingly relied on the fund to finance public spending, and the Covid-19 pandemic accelerated this process. In 2020, the government’s budget deficit rose to almost 2.6% of GDP, up from a surplus of 6.6% in 2019. To bridge this gap, the government requested the GPFG to transfer Nkr300 billion ($30 billion) to finance its budget, or 25% of total state spending.
In a speech in February 2021, Norges Bank’s then governor Øystein Olsen warned this greater fiscal dependence on the fund was becoming problematic. “Even in more normal years, transfers have been considerable,” he said. “In 2019, nearly 18% of [state] spending – one krone in six – was transferred from the GPFG,” said Olsen. “In the course of a decade, public budgets have come to rely heavily on the return on the GPFG, which was originally established to shield the Norwegian economy from oil price volatility.”
Olsen warned the evolving nature of the relationship between public finances and the fund’s return is making Norwegian fiscal policies dependent on global equity markets. “Equity prices have risen sharply in recent years,” he said in February 2021. “Taking risk in the equity market has paid handsomely. But we cannot assume that the gains will be as high in the future,” warned Olsen.
Although opponents of a Swiss SWF recognise the overall success Norway has achieved with the GPFG, they stress essential differences with Norway. Firstly, they point out the Scandinavian country has followed the most traditional model to set up a fund. Generally, these have been employed by countries rich in natural resources to avoid ‘Dutch disease’ – an increase in the value of the domestic currency, which tends to depress exports in other sectors, and, in general, to prevent inflationary pressures due to the influx of foreign capital.
“That is why SWFs are generally found in Middle Eastern oil and natural gas exporters, or countries like Norway, which likewise has substantial oil reserves,” says Veljko Fotak, professor at the University of Buffalo School of Management. “In this sense, Switzerland is an atypical case for an SWF.”
Some observers stress it is key to consider that Swiss reserves are mainly the result of foreign exchange interventions. As such they claim these assets on the central bank’s balance sheet cannot be deemed part of the nation’s wealth, because a change in the macroeconomic environment may force the SNB to abandon the ultra-loose practices it has been implementing to depreciate the franc.
However, other analysts seem unconvinced by these arguments, pointing out that the sheer size of the SNB’s reserves pose challenges for an institution not designed to manage a portfolio of this magnitude. “Overall, central banks are not really set up to manage large portfolios. It involves some degree of conflict of interest; even though these are all foreign assets they must decide what equities to buy,” says Edwin Truman, senior fellow at the Mossavar-Rahmani Center for Business and Government of Harvard University.
The SNB’s balance sheet “dwarfs those of most other central banks and, crucially, its assets are mostly in foreign currency”, says a recent report from the SNB Observatory, an independent body aiming to promote an informed debate on Switzerland’s central bank. The report’s authors Stefan Gerlach, Yvan Lengwiler and Charles Wyplosz highlight SNB reserve assets are worth over 130% of GDP.
“This is unique,” say Gerlach, Lengwiler and Wyplosz. The authors acknowledge in Norway’s case the state cannot be required to buy back the oil it has sold, making GPFG’s fund an unquestionable part of the nation’s wealth. Nonetheless, they point out Switzerland’s situation is not entirely dissimilar. “The SNB cannot be required to take back the francs because francs are no longer redeemable in gold as they used to be.” Therefore, insofar as international investors continue to seek the franc, the SNB is likely to accumulate ever higher reserves. “Under this scenario, the foreign currency assets of the SNB are indeed wealth.”
The currency’s strengths also reflect the solid underpinnings of the economy’s fundamentals. Switzerland has a competitive export sector. “The persistent surplus on the Swiss balance of payments means the country is facing a lot of the same issues of major commodity exporters – an inflated currency and the need to insulate the economy from a rapid influx of foreign capital,” adds Fotak.
Since 1990, the country’s current account surplus has averaged 7.6% of GDP, in 2021 it reached 9.3% of GDP. According to World Bank data, Swiss exports of goods and services hover around 66% of GDP. This economic feature is highly resilient. Exports are highly diversified, including industrial component products such as metals and plastics, machinery and electronics, chemicals, and expertise in financial services. Additionally, the country’s main trading partners are Western democracies such as Germany, which absorbed 15.3% of exports in 2019, the US 14%, the UK 9% and France 6.2%. Meanwhile, China purchased 6.9% of Swiss exports that year, Turkey 1.1%, and Russia 1%.
Additionally, over the decades, the Swiss authorities have built up a solid fiscal position running a low budget deficit and public debt. In the period 2000–21, the budget deficit has averaged 0.1% of GDP, and even in 2020 – when most economies multiplied debt issuance to tackle the pandemic – the Swiss deficit only rose to 2.8% of GDP, in 2021 it declined to 1.9%. Partly as a result of this, gross government debt is at just 42% of GDP, while according to the International Monetary Fund the average for advanced economies is 120% of GDP.
Truman adds that Switzerland would not be the first current account surplus country exclusively financing an SWF through monetary and financial operations rather than commodity exports. “China, Singapore or South Korea have created their funds financing them out of their reserves,” he says.
In 2007, the Chinese government funded China Investment Corporation “as a vehicle to diversify China’s foreign exchange holdings and seek maximum returns for its shareholder within acceptable risk tolerance”, says the fund’s website. CIC is funded with the issuance of special treasury bonds. The Standing Committee of the 10th National People’s Congress allowed the Ministry of Finance to issue 1.55 trillion yuan and use the proceeds to purchase foreign reserves of $200 billion and inject it as the fund’s equity capital.
CIC distributes dividends to the State Council to cover the cost of these special treasury bonds. The appointment and dismissal of its board of directors is also approved by the State Council.
According to the fund’s latest annual report, in 2020 CIC’s net assets reached $1.1 trillion, posting a net return of 14.1%. The fund’s investment horizon is 10 years. At the end of 2020, its asset allocation recorded 43% of its portfolio in alternative assets, including hedge funds, risk parity investments, industry-wide direct investments, private equity, private credit, commodities, real estate and infrastructures; 38% was allocated to publicly listed companies; 17% to sovereign and corporate bonds; and 2% to cash and overnight US Treasury bills.
Nonetheless, some experts question whether funds such as CIC are SWFs. “The term SWF has never been properly defined in a universally acceptable manner. So nowadays different commentators will group everything from development funds to superannuation funds under the same moniker,” Fotak says.
Fotak stresses these funds usually aim to address three main challenges. Firstly, they want to insulate the local economy from the volatility of commodity prices – a ‘rainy day’ fund for commodity exporters. The second is to ensure some degree of intergenerational wealth transfer, which might make sense for countries rich in natural resources that are facing a future shock to country GDP due to dwindling reserves. And the third is to work as a currency stabiliser and contribute to macroeconomic stability.
“SWFs originating from countries like China, which are accumulating foreign currency reserves due to imbalances in their balance of payments unrelated to commodities, are facing the first of these issues, fear of Dutch disease and the related wage inflation, but not usually the second and third,” says Fotak.
Singapore’s two funds also take different models. Temasek is a development fund that plays a role similar to traditional state-owned asset management companies. “In some way, it is more akin to Italy’s old Istituto per la Ricostruzione Industriale, than a typical SWF,” points out Fotak.
The second Singaporean fund, the Government Investment Corporation is more akin to an intergenerational wealth preservation fund and, in general, it has a stronger connection with the traditional SWF model.
Where some observers find strong arguments in favour of an alternative model for a Swiss SWF, including the franc’s strength, the current account surplus, the massive reserves portfolios, the possibility of reaping higher returns; others retort that the transfer of SNB’s foreign currency assets to another body would seriously hamper the central bank’s monetary policy, and even its standing as an independent institution.
Analysts believe the key to understanding this opposition lies in the incentives national financial and political actors have in perpetuating the status quo. In contrast to an overwhelming majority of central banks, the SNB is a ‘private’, or special status joint-stock, institution. While approximately half of its capital is held by the Swiss cantons, the cantonal banks and other public institutions, the rest is owned by private individuals. The central bank’s profit distribution derives from this ownership structure.
Against this backdrop, “the outsourcing of part of the Swiss National Bank’s reserves for a national SWF would lead to reduced assets, which in turn would reduce the profit potential of the Swiss National Bank”, argues Juergen Braunstein, fellow at the Belfer Center for Science and International Affairs at Harvard Kennedy School, in his book, Capital choices, sectoral politics and the variation of sovereign wealth.
For the financial years through to 2025, the annual allocation to the provisions is at least 10% of the preceding year’s provisions. The maximum annual distribution to public shareholders is now Sfr6 billion (and Sfr15 per share to private shareholders), but for the SNB to be able to reach this level, its net profit must be Sfr40 billion or higher. In 2021, the net profit stood at Sfr108.5 billion. As a result, the central bank was able to distribute Sfr6 billion, with one-third going to the Swiss Confederation and two-thirds to the cantons. Lower reserves would almost certainly reduce these profits, potentially curbing transfers to these public institutions. In 2021, the profit on foreign currency positions stood at Sfr25.7 billion, up from Sfr13.3 billion in 2020.
The SNB Observatory makes a similar point in its report. “Various interest groups feel that more should be distributed, and in their direction. More generally, large wealth whets appetites. The large balance sheet of the SNB is a potential threat to its independence,” it says.
Gerlach, Lengwiler and Wyplosz stress the central bank’s mandate is to preserve price stability and to support financial stability, rather than making profits to secure high transfers to its stakeholders. “It should also not have to worry about the possibility of making substantial losses. Yet, a large loss could wipe out the bank’s equity. While it cannot go bankrupt, the SNB may fear the impact on its reputation and its independence,” they add.
The authors warn though, that fear of losses could also influence the SNB’s exchange rate policy. In fact, chairman Jordan raised the same topic in a speech in April 2015. “An expansion of the balance sheet would have severely impaired the SNB’s ability to conduct monetary policy in future,” said Jordan, just after the SNB ended the franc’s cap to the euro. “Such a long balance sheet would have made further monetary policy measures substantially harder.”
In addition to public authorities, the national banking sector has traditionally opposed the creation of an SWF in the country. The Belfer Center’s Braunstein says Swiss bankers are of the view that “the state is not able to make better investment decisions than the private sector”.
The Swiss Bankers Association also supports a free market approach toward investments by international SWFs. In a 2008 position paper, the group warns the government against stricter regulations making it difficult for foreign funds to invest in Swiss assets, urging that “a hasty or unjustified political response would threaten capital inflows into Switzerland and raise the prospect of retaliatory action by other countries”.
Nonetheless, the association opposes the development of a Swiss SWF. In its 2008 position paper, it argues “Switzerland already has a private-sector equivalent to safeguard future generations in the form of the well-established system of second-pillar pension funds. These funds have been successfully managing globally diversified assets on a private-sector basis for decades.”
The SNB Observatory concludes Switzerland’s current institutional framework makes the reserves portfolio fiscally relevant, which is not ideal for an institution focused on monetary and financial stability. Additionally, it argues the country is incurring a major opportunity cost relinquishing the option to increase investments into equities, real estate, private equity, hedge funds, infrastructure or commodities.
As a result, they propose the creation of an SWF as a separate entity from the SNB, enjoying a similar degree of independence. Nonetheless, because the bulk of SNB reserves are denominated in foreign currency, the central bank cannot just transfer these assets to a new entity without covering its liabilities. It would also need to reduce the liabilities on its balance sheet by the same exact amount. The report proposed to swap part of the SNB foreign currency assets against an SWF liability. “A straightforward way to do this is to have the SWF issue bonds denominated in CHF, which are given to the SNB in exchange for some of its foreign assets,” says the SNB Observatory.
The report argues this would control exchange rate risk on the SNB’s balance sheet. The SWF bonds would not be tradeable and would simply sit on the central bank’s books. And once the SWF receives these foreign currency securities, it can start investing them according to the new investment criteria and objectives included in its mandate.
The authors acknowledge the SWF’s liabilities would be denominated in francs, and its assets in foreign currency. To contain this risk, the SNB Observatory proposes that the SWF could be required to build up equity over time, avoiding the distribution of all its income for a while.
Veljko Fotak, University of Buffalo
Another option could entail the Confederation extending equity to the fund in francs or in other currencies. “The state, as the equity owner, ultimately bears the risk and earns all the profit the SWF makes,” says the report. “Alternatively, the Swiss Confederation could guarantee the SWF, but without its stock of foreign currency reserves it would need to borrow these assets to cover potential losses.” This factor should not be a major hurdle given low public debt levels.
And although protracted adverse market conditions could produce several years of negative returns, the SNB experience demonstrates that a big factor behind major losses is a strong franc depreciating returns denominated in other currencies. Nonetheless, the SNB would still likely prevent the franc from rising unchecked. Considering the SNB would lose a hefty part of its profits, authorities could make interest payments on the SWF bonds variable and pegged to market interest rates. This protection would be important once interest rates rise and the central bank resumes paying interest on banks’ reserves.
An SWF would not contribute to change the reasons why the SNB intervenes in foreign exchange markets. As a result, it is likely to continue accumulating reserves. Gerlach, Lengwiler and Wyplosz say further purchases should be transferred to the SWF. If in the future, the franc depreciated and the SNB needed to support it by selling foreign currency securities, “an agreement can specify that the SWF must return any amount requested by the SNB”.
One important limitation the SNB faces as an asset manager is that it cannot hedge against currency risks, because that runs counter to its monetary policy goal of preventing the franc’s appreciation. The report deems “it is vital that it can continue to do so, even if the foreign currency investments are under management by the SWF. For this reason, the SWF should be prohibited from selling any part of its holdings against francs”.
Despite all the financial guarantees and institutional precautions to secure independence, some experts warn an SWF is no panacea. “In many ways, the idea of a Swiss SWF feels to me like a solution in search of a problem,” says Fotak from the University of Buffalo. “Politicians like SWFs, because having an SWF gives them control over significant capital, which, in turn, means power.” Fotak is wary of supporting the formation of SWFs, as a default position.
Fotak believes any new fund would need to address a well-defined objective and, even then, he calls on institutions to err on the side of caution. “The world abounds with tales of corrupt officials abusing SWFs, and even Norway, seen as the prototype for a well-managed, well-governed fund, has recently faced ethical scandals,” adds Fotak. “I think SWFs should never be a permanent solution.”
The academic highlights three structural difficulties associated with SWFs. First, domestic pressures often make it difficult to offer SWF staff the wages that private-sector financial institutions can afford. As a result, SWFs are often understaffed, and managers tend to be underqualified compared with individuals managing similar pools of money in the private sector. Second, domestically, investment returns suffer because of cronyism and corruption, and policies that prioritise political objectives such as employment maximisation over financial returns. Third, when investing abroad, SWFs tend to suffer from adverse selection. Government-owned entities are seen with suspicion and are often discouraged, or barred, from taking significant stakes, or from exercising significant governance oversight.
“The exception is during times of distress – during crises, when liquidity suffers and firms need injections of capital,” says Fotak. “The result is they end up investing in the worst firms, at the worst times. Unsurprisingly, their performance tends to lag well behind broad market indexes.”
In his view, no country has managed to produce a well-governed, well-managed SWF. “Norway was the closest to it – but, even then, Norway did not lag markets simply because it became the most well-diversified global equity investor. The Norwegian SWF is the ultimate passive index fund, despite recent noise about ethical investing and climate change,” adds Fotak. “Yet, I will admit that, if anyone can do it, it is probably Switzerland.”
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