Q: What direct impact has the financial crisis had on sovereign wealth funds?

A: The dramatic drop in commodity prices, the collapse of world trade and the reversal of foreign capital flows are undermining funding sources for most SWFs around the world, just as sharp declines across various asset classes are decimating their portfolios. This is happening at the worst possible moment: many SWFs are being asked by their sponsors to help support domestic spending and investment and to help stabilise local banks and financial markets.

Their first response has been to refocus on liquidity; many SWFs that were moving into riskier asset classes in search of higher yields and diversification benefits have effectively put these plans on hold and started building up large liquidity buffers. This abrupt de-risking of investment programs has led to an increased appetite for traditional reserve assets, such as the US dollar and US government paper. Second, the pressing need to provide emergency support to local economies and institutions has shifted the funds' focus to domestic markets.

Such policy adjustments help address immediate problems that the crisis presents. At the same time, they point to a bigger set of issues that SWFs and their sponsor governments may need to consider in the longer term once the crisis subsides. For example, many emerging market economies may want to revisit their criteria for determining reserve adequacy. Monetary authorities in some countries may have underestimated the amount of dollar liquidity they need in times of distress, especially in the context of a once-in-a- lifetime global financial crisis. Calculating sufficient levels of foreign exchange reserves is more art than science and will vary for individual countries. However, countries hit badly by the current crisis will most likely err on the side of caution in the future and set aside higher reserves for prudential policy purposes.

Q: What problems have been posed by the increased presence of sovereign wealth funds in domestic markets?

A: It is one thing for a government to be a portfolio investor and a minority shareholder in a foreign company, which is located and regulated outside its jurisdiction. But when the government is a significant owner as well as regulator and referee, the situation can be more challenging.

While the current financial crisis certainly favours pragmatism over ideological dogma, it is important to keep in mind that government interference can and often does result in corruption, waste and inefficiency - a lesson many societies have learned the hard way.