Sovereign Wealth Funds: Appropriate Vehicles for Financial Bailouts?

by: Equitymaster

The International Monetary Fund (IMF), once a saviour to economies in distress, but then relegated to being an onlooker, is suddenly being called back into action. As the list of troubled countries grows, the list of places they can seek help has not.

The IMF is nearing agreements to make emergency loans to Iceland and Ukraine, and discussing aid packages with Pakistan and Hungary. Probably we would not like to forget that it was the IMF that came to India’s rescue when we faced the currency crisis back in 1991.

However back then, the conditions attached to the bailout were much stricter than those today. It is thus being debated whether the IMF is still the best recourse for bailout for economies where the government cannot fund the same.

The US and Western Europe are in the middle of their own costly financial bailouts. While huge sovereign wealth funds (SWFs) have sprung up in the Middle East and Asia (read China), economists say borrowing from them could prove more painful than borrowing from the IMF. The beleaguered Iceland, for example, will borrow from the fund but also supplement that with packages from Russia, Norway and Japan.

The SWFs are government-owned funds set up by the world’s leading exporters. Until now China, Japan and other exporting superpowers, along with the big oil exporters in the Persian Gulf, were content to keep most of their trillions of dollars of reserves in safe investments like bank deposits and US Treasury bonds. That is no longer the case.

Increasingly they are channeling investments into the private sectors of other countries to fetch a higher return. With their huge asset base, the government investors can afford to diversify and pursue riskier opportunities.

These SWFs are therefore increasingly being approached to bailout distressed economies. However, given that their fundamental structure is not autonomous, unlike the IMF, there are risks attached to the same.

Paul Volcker, the former Chairman of the US Federal Reserve, is of the view that the US is in an ‘unprecedented’ financial crisis. And his mantra to repair the same - rebuild the banking system. Another noted economist, Joseph Stiglitz has opined that the economic downturn in the US is unlikely to be as bad as the Great Depression of the 1930s. However, he believes that this is likely to be long drawn and ‘probably the worst in a quarter century’.