As economic data show increasing fragmentation, investment strategies face unprecedented challenges. The OMFIF Global Public Pensions 2023 report examines how global public pensions and sovereign funds are coping with the weakest global growth prospects in decades. While the report reveals the challenges sovereigns face in managing public assets and their changing priorities away from ‘target returns’, it also exposes their contradictory approaches to emerging markets and their continued indifference towards investing in developing markets.
This paradox could seriously affect cross-border capital flows, economic growth and traditional asset markets. Sovereigns are between two conflicting goals: setting up domestic safeguards against uncertain macroeconomic and financial stability risks and supporting international efforts to invest in climate change and facilitate broad-based sustainable development.
For the past two decades since the Asian crisis, sovereigns have faced persistent balance sheet pressures from various sources, such as financial and market failures, income inequality and supply chain shocks. These pressures have led to higher sovereign debt issuance and non-debt liabilities, driven by public interventions and social insurance demand. Moreover, flawed growth models, ageing populations, demographic changes and climate-related costs exacerbate longer-term balance sheet weaknesses.
The GPP 2023 report implies that asset management choices are limited by rising liabilities, which have increased as expected returns have not been materialising. As the global economy undergoes an unprecedented stress test, the need to rebalance sovereign balance sheets is even more apparent. This also calls for financial guardrails against the consequences of unforeseen events, including a possible, new and protracted economic Cold War.
This is an opportunity for sovereigns to address the long-standing neglect of balance sheet management. For instance, sovereigns should know all their assets (financial and non-financial), liabilities (current and contingent) and net financial position, especially in emerging and developing markets. Using the rapidly emerging technology choices and combining this with information stewardship, sovereigns can better understand their financial situation and invest or raise monies guided by the dynamic interplay between all liabilities.
However, only some sovereigns produce formally integrated balance sheets. This hampers their ability to recognise financial risks promptly, improve capital efficiency and enhance their financial resilience to adverse economic shocks.
A changing paradigm
Once built, sovereign assets become both a source of economic security and a potential source of liability. The social welfare outcomes from building this wealth are no longer a matter of matching or beating investment benchmarks. As the global economy is overhauled, sovereign liabilities become more critical for the effectiveness and accountability of asset management activities. However, a common gap in managing a sovereign’s finances is the need for integration between a returns-only driven asset management approach, its liabilities and the resulting potential financial exposures. This explains in part, why many sovereigns have insolvent balance sheets of central banks and state-owned enterprises and have gradually lost credibility with investors.
By aligning their liabilities and asset management, sovereigns can enhance their resilience, optimise resource allocation and achieve long-term goals. This not only requires a holistic and strategic view of the sovereign balance sheet but a clear and transparent governance framework that ensures accountability and alignment of interests.
One example of a visionary and prudent sovereign is Singapore. To build Singapore’s financial assets and invest them for the long term, a dedicated sovereign wealth fund initiative was launched 40 years ago with an objective more powerful than financial returns – ‘to steady the nerves of Singaporeans.’ To this end, Singapore has focused on its portfolios of assets and long-term liabilities and prepared itself for a new technological ecosystem and a climate-friendly world.
A key to sovereign resilience in the 21st century
Effective management of sovereign balance sheets is crucial for economic governance. Sovereign asset and liability management helps governments optimise the composition of what they owe and own, reduce their financial risk exposure and enhance their financial resilience. With the cooperation of the International Monetary Fund (and others), a few countries are trying to move in that direction.
This integrated approach allows for more flexibility for different types of sovereign assets as well as their interplay with implicit and explicit financial liabilities. Those who have successfully managed sovereign assets and liabilities have followed some common principles. They are adopting a more systematic approach to integrating data from different sources; collecting, extracting, transforming, cleansing, validating and loading/distributing data to other target systems and actively using it for sovereign-level policy formulations.
Balance sheet risks have become more challenging and critical for resource-rich, low-income countries, especially in Africa. These countries face a possible long-term decline in actual commodity prices, the long cycles that characterise accurate commodity prices, the excessive volatility of actual commodity prices, and the fact that this volatility varies over time. SALM can help these countries manage their natural resource wealth, diversify their economies and cope with external shocks.
Every sovereign – advanced, developing or fragile – has financial and non-financial assets and liabilities. According to pre-pandemic data, public assets were about $101tn, or 200% of the sovereign’s gross domestic product, comprising 65% of the global economy. Liabilities were similar. By analysing its portfolio continuously within the SALM framework, the sovereign will be able to recognise risks and test its financial resilience promptly. It will also allow for more accurate and effective sovereign actions in economic crises or financial system problems.
Some may argue that reliable information makes a consolidated view realistic. The solution is to begin and gradually enhance the accounting and statistical methods, data and estimates of the balance sheet items. We should also simulate various stress and economic disaster scenarios to prepare for the future. Together, the sovereign will lay the path to modelling macrofinancial dynamics, leading to more robust and resilient macroeconomic performance, economic development and financial stability.
Udaibir Das is a Non-Resident Fellow at the National Council of Applied Economic Research, a Senior Non-Resident Adviser at the Bank of England, a Senior Adviser of the International Forum for Sovereign Wealth Funds and Distinguished Fellow at the Observer Research Foundation America.