Just like the buffer we know

The drop of the oil price to below $60/barrel in the first quarter of 2015 is a robust stress test of the resilience of oil exporting economies, particularly in the Gulf region. The International Monetary Fund (IMF) expects oil export losses of the Gulf Arab countries to reach roughly $300 billion or 21 percentage points of GDP. Current account surpluses are projected to decline to 1.6% of GDP this year. This is troubling news for most oil exporters in the Gulf, who need oil prices to remain higher than the baseline scenario of $57/barrel projected this year to cover government spending.

But though international energy markets today do not play into their hands, most Gulf Arab economies are much better prepared to deal with oil market volatility than in the past. Only a decade ago, a fairly straight line could be drawn between oil revenues and the fiscal and overall health of the economies in the Gulf region. Their choice to save some of their oil and natural gas based revenues and store them in dedicated savings accounts in times of plenty has provided them with a substantial war chest to sustain a period of depressed prices. That war chest leaves them with room for manoeuvre — as they design fiscal policies, pursue their interests in global markets or as they follow other geopolitical objectives.

In a way, diminishing oil revenues also foreshadow a state of play that countries in the region had anticipated a while ago: a time when economic growth had to be sustained with the diminishing contribution of petrol. The current situation might come somewhat early, as the region’s economic transformation to prepare it for the time “beyond petrol” has yet to be fully rolled out. Also, it might not last very long, as demand might pick up again and alternative supply is exhausted. But, in a way, the current price situation is the first test for Gulf Arab governments to examine how robust the economic policy choices they made some decades ago really are.

Sovereign wealth funds (SWFs) and other investment vehicles have been a part of these calculations. Designed to save financial assets and invest them at home and abroad, they have been an essential policy tool for Gulf Arab economies to facilitate the transition from hydrocarbons-based economies to more diversified ones. They provided the mechanism through which finite commodity assets in the ground were transformed into financial assets, promising a constant stream of income.

As they were given the mandate to manage ever-growing amounts of monies, they also began to leave a substantial footprint in international financial markets. While back in the 1970s, the economies of the Gulf regions were perceived as big spenders, they have now positioned themselves as important global investors. And despite the situation in oil and broader energy markets, Gulf Arab SWFs are here to stay. It therefore becomes mandatory for the international financial community and those economies who seek to attract investments from demanding Arab investors to develop a sophisticated understanding about where these investors come from and where they might be going, given the circumstances the economies of the Gulf region find themselves in.

An overview

A look across the SWF universe from the Arab Gulf region reveals a lot of predictable commonalities but also considerable diversity. The Kuwait Investment Authority (KIA) could be considered to be the most conservative Gulf-based sovereign investor. KIA was established in 1974 and as such is amongst the world’s oldest SWFs. And, over the past decades, it has very much been subject to the dramatic shifts of the country’s political fortunes. During the Iraqi occupation in the early 1990s, the exiled government had to draw down its assets to continue functioning and rebuilding the country once it was liberated. And though KIA’s assets were rebuilt over the following decades, KIA’s investment policies have been much more cautious and liquidity-oriented than those of its Arab peers.

Like its peers, KIA does not disclose the size of its assets under management, which itself is split between the general reserve fund, which serves as the government’s current account, and the future generations fund, the government’s long-term savings fund. Most observers suggest that KIA controls assets worth more than half a trillion dollars, representing more than 300% of Kuwait’s GDP. KIA’s size is considerable by international standards and probably one of the largest worldwide.

If the Kuwaiti sovereign wealth management geography is dominated by KIA, it is much more diverse in the UAE, and in particular Abu Dhabi, which controls the bulk of the UAE’s hydrocarbons reserves. That is also an indication of the firm commitment of the Abu Dhabi government to realise its economic development plan, Abu Dhabi 2030. Abu Dhabi 2030 has been the reference point for the government’s sovereign investment vehicles and provides a sense of common purpose and coordination. 

The oldest and largest SWF operating out of Abu Dhabi is the Abu Dhabi Investment Authority (ADIA), which, by estimates, manages just below $600 billion, representing roughly 150% of the emirate’s GDP. Over the years, ADIA developed a diversified portfolio spread across all asset classes, managed mostly by external asset managers and invested in index-replicating strategies. But ADIA is complemented by a set of other, more dedicated investment vehicles. The Abu Dhabi Investment Council, which has long remained in the shadow of the more prominent ADIA, is a major domestic investor and most recently made headlines with substantial agribusiness investments. The Mubadala Development Company pursues many of the government’s direct investment projects, focusing on aerospace, metals and mining, ICT and other sectors, designed to advance diversification of Abu Dhabi’s economy. The International Petroleum Investment Company (IPIC) is an older, more dedicated investment house, developing the emirate’s widespread energy interests and infrastructure projects worldwide.

The Qatar Investment Authority (QIA) is a more recent addition to the SWF industry, set up only in 2005. The fastest growing global SWF of the past decade, QIA today manages assets worth roughly $300 billion, representing 150% of Qatar’s GDP. QIA has assumed a much more activist investment approach than its peers and is one of the most dynamic equity investors within the global SWF industry. It is a major shareholder in international corporations in the automobile, construction, retail and financial services sectors, amongst others, and is an active investor in real estate. Its network-based investment policy has enabled the government of Qatar to build strong political alliances with key international actors. At the same time, QIA is very much under the control of the royal family and as such its leadership is very much subject to its political preferences.

Finally, there is the Saudi Arabian Monetary Authority (SAMA), which officially manages the foreign exchange reserve of the kingdom of Saudi Arabia and as such might not qualify as a SWF. However, SAMA might be considered as one of the key players in current oil politics. Its investment approach is more conservative than those of other SWFs, preferring liquidity over return. But its balance sheet includes roughly $400 billion in government reserves, the government’s current account and deposits allocated to government projects, representing the financial buffer. That buffer could help the Saudi government sustain lower oil prices over a four- to five-year period. In other words, the Saudi decision not to work against the oil price decline some months ago is backed up by considerable financial reserves.

Where will SWFs go from here?

Definitively, there are a number of tangible and not-so-tangible assets that the SWFs of the Gulf Arab countries have built for themselves. They have acquired tremendous asset management capabilities based on a long (KIA) or at least considerable (QIA) history of institutional development. Governments are beginning to be more conscious of the positive contribution that robust corporate governance arrangements can make to the commercial success of their sovereign asset managers. They have also acquired the status of reliable and professional long-term investors amongst the international community. Greeted with suspicion and mistrust in many recipient countries few years ago, they are today welcomed as investors. They have also solidified their status as an integral part of the global investor community, developing mutually beneficial networks with like-minded entities, facilitating an increasing number of co-investments. They have continued to diversify their portfolios across asset classes — including alternative investments — but also geographically, seeking stronger exposure towards developing economies. And they have developed strategic partnerships across industries that help national economies to further diversify. All these aspects indicate a bright future.

Clearly, energy prices will constitute the largest risk for sovereign asset managers in the future. With energy prices remaining relatively soft, Gulf-based SWFs will no longer receive the exorbitant funding that they used to some months ago. The decline in surpluses will reduce the pace of foreign asset accumulation across the oil exporters of the Gulf. Though that might be deplorable, this would still be a more favourable scenario than the liquidation of foreign assets to meet domestic liquidity needs, that is, the reversal of the sovereign asset build-up. But for this to happen, oil prices would need to remain depressed over a longer period and governments would have to consider the financing of government deficits less favourable than liquidating assets.

But perhaps the biggest challenge for SWFs in periods of low energy prices and low hydrocarbons-based revenues will be their performance. Over the past years, when governments’ oil revenues were healthy, one got the impression that asset accumulation and the hunt for trophy assets were the core purposes of several SWFs. To be sure, few Gulf Arab SWFs, if any, publish their returns on a regular basis. And there is little transparency regarding the benchmarks that they use to evaluate their fiscal performance. Though that does not mean they do not reach satisfactory results, one cannot be certain either. Today, satisfactory financial returns may constitute the essential argument for asset managers to convince sovereign asset owners not to liquidate assets for stabilisation purposes. Of course, what makes things complicated for sovereign asset managers is the current low interest environment, which pushes them to diversify further into higher yielding asset classes. This, of course, provides an opportunity for those who can offer creative investment solutions.