SWFs: the euro zone’s white horse?

Amid feverish discussions about expanding the euro area’s bail-out fund, one key source of potential financing has been largely overlooked: foreign sovereign wealth funds (SWFs). Cash-rich SWFs could be the euro zone’s white horse, storming in to buy up European distressed public and private debt.

With more than US$4trn in assets, according to the SWF Institute, the collective might of SWFs would be more than sufficient to cover the existing EU-IMF lending facilities.

Furthermore, SWFs have a recent history of dabbling in distressed assets, pumping around US$70bn into ailing western banks during the credit crunch.

Although admittedly imperfect, the idea of SWFs stepping in to relieve pressure in the euro area debt crisis has precedents. When Dubai struggled to service its debt in 2009, Abu Dhabi’s SWF—the largest in the world—intervened to finance a US$20bn support fund.

SWFs have also previously invested alongside multilateral institutions, as they would likely do if they participated in a bail-out for euro area members. In April 2010, sovereign funds from Azerbaijan, the Netherlands, South Korea and Saudi Arabia committed US$600m to a new equity fund sponsored by the World Bank.

Of course, neither of these precedents involves a SWF investing directly in other sovereign states. However, investing in bonds issued by the European Financial Stability Facility (EFSF) could give SWFs sufficient distance to make their participation in the rescue effort more politically palatable.

SWFs have the might and the risk appetite, but do they have the interest? China has repeatedly pledged support to Europe’s periphery, motivated by the prospect of currying favour with Europe in order for its domestic firms to gain greater access to the European markets.

Norway’s sovereign fund—the world’s second largest—also has an interest in the euro area’s speedy recovery, given its home country’s proximity and links to the euro zone. Although the fund largely tracks public equity and bond indexes, it leaves some room for active management. Recent statements from government and fund officials suggest that the fund may use its discretion to buy more euro area peripheral debt. As of the third quarter last year, Norway’s SWF held US$3.9bn in Spanish sovereign debt, its seventh-largest individual bond position.

SFW involvement in the euro area debt crisis would remedy two of the major flaws in the existing EU/IMF support facility. First, the EFSM and EFSF are not large enough to cover Ireland, Portugal and Spain, let alone Italy, Belgium and France, which also exhibit worrisome fiscal dynamics. Second, the EU/IMF facility provides funds at a punitive interest rate to avoid moral hazard. Foreign SWFs could lend to euro area countries in trouble without concern for moral hazard, and could therefore offer funding at a rate under which euro zone countries might not buckle.

With or without funding from SWFs, the conditionality of the euro area’s bail-out packages must remain the same. Difficulty in imposing and enforcing conditionality to ensure the necessary structural reforms are implemented might limit the ability of SWFs to single-handedly rescue the euro zone. However, while SWFs may not take the lead role, they could at least step in as supporting actor in drawing a line under the euro crisis.