By Dillon Yeh
Correspondent, Economics Undergraduate Student 

There is your money, which usually sits in a checking or savings account in a bank. But if you have enough money, then you can put some of it into stocks. Enter stage left, your retail investors. But if you have even more money, then you can pay other people to invest it for you. Enter stage right, your private individual investment firms, mutual funds and similar things of sorts. But if you have even more money than that, or are a corporation, university endowment, union pension, insurance company or of the magnitude, then enter stage left, your large institutional investors and their traditional money managers and alternative asset investment groups. And yet, you can be the richest person in the world and still not be anywhere near the main character of the show.

Enter from above, a whale collapsing onto the stage: the sovereign wealth funds.

Sovereign wealth funds are state-owned reserves of money typically from their respective governments’ budgetary surplus. In this manner, sovereign wealth funds act as a means of generating additional national revenue off of excess money, a lucrative alternative to simply parking it in the vaults of their central banks. The origins of these funds fall into two categories, commodities and non-commodities, with the former really referring to oil-export dependent nations. And thus, these funds also act as a rainy-day fund, allowing those oil-dependent countries to diversify their holdings in case of down times. In fact, four of the top five largest sovereign wealth funds are held by the oil producing governments of Norway, the UAE, Saudi Arabia and Kuwait.

Traditionally, these funds have been passive investors, committing their capital to conventional equities, bonds and foreign direct investments. However, sovereign wealth funds now invest in alternative investments: the hedge funds, the private equity firms, the venture capitalists, real estate investment development and trust vehicles. And these entities commit to riskier investments than the normal retail investors. Instead of the safe big name stocks, sovereign wealth funds now hold exposure to positions in volatile emerging market or dicey leveraged corporate holdings. More risk, more reward. More money for the nation. And so far, most sovereign wealth and public funds have been on the right side of the trade, with few notable losses.

The real problem arises when the underlying source of these funds take a beating, as they have been for the past eighteen months with the collapse of oil prices. For the countries with the largest sovereign wealth funds also give exceedingly high social benefits to their citizens. Incentive to keep them at bay in a way, thus making it all the more paramount to preserve the status quo. Yet suddenly those same countries that relied on previous elevated oil prices now have to compensate for the price difference.

While these governments have survived so far by raising production levels to the stars, recent conferences have focused on an output freeze. And to make matters even worst, the soaring strength in the US Dollar has driven a capital flight of investments from emerging markets, China and even Europe to the US markets. For the first time since 1988, capital inflows to emerging markets are being lapsed by outflow. Petrodollars are running back home, and as they do emerging markets are being strangled by a phenomenon Deutsche Bank dubs Quantitative Tightening, the very opposite of Quantitative Easing.

There’s not only an iceberg straight ahead, but the ship is also made out of Styrofoam. With a production output freeze and ever rapidly drying liquidity markets, prospects have never looked bleaker. It is fair to say that a rise in oil price levels can alleviate the pain and be the Superman that lifts the Styrofoam boat out of water from inevitable doom, but the realistic and logical conclusion is that these countries will have to tap even further into their sovereign wealth funds. There will be no choice but to sell.

Focusing on Norway, one of the most developed nations and also owner of the $830bn Government Pension Fund, the largest sovereign piggy bank in the world thanks to decades of saving those weekly parental allowances from exporting oil. Established in 1990 and intended for the future generations of Norwegians to come, a recent Bloomberg commentary asserts that the time of reckoning may have already arrived. With petroleum-tax generated revenue down a whopping 42% or $12.5bn from a year earlier, the Norwegian budget spending of 2016 will outpace income. Consider this: the average capital inflow to the fund for over the past ten years has been 60bn kroner. Per quarter. So. 240Bn kroner per year. Give or take. The inflow for the first half of this year has been 17bn kroner. An entire half of a year reduced to what was normal for an average 3 weeks.

Norway is not an isolated case. This is behavior observable across the globe. From the similarly oil-crash affected Middle Eastern funds to even China, who has depleted their forex reserves at an average rate of $100bn per month in attempt of shoring up a plummeting equity market, going so far as to dramatically devalue and reduce price pegs of the renminbi.

Indeed, the question becomes: what is going to happen when all of these countries begin to indiscriminately sell their sovereign wealth fund assets in order to balance their budgets? Some estimate that a total of some $404bn is to be drained from funds alone this year. And though that is but a fraction of total world investments, it would have a cascading effect upon every other financial actor on the stage.

While the simultaneous liquidation of assets by sovereign wealth funds might be quiet in the beginning, chaos would ensue. Conventional asset management, hedgefunds, private equity and venture capital firms would have to return committed capital by selling. The price drop would catalyze even further selling. The mountain of derivatives that depend on those underlying securities would tumble. The negative feedback cycle of liquidation would trigger an even larger systematic sell-off across the world markets by institutional and retail investors. The curtains close.

Of course all is unknown, but food for thought.

Feature image by Richard Masoner