Sovereign Wealth Funds’ Impact on Debt and Equity Markets during the 2007–09 Financial Crisis

The authors found that news related to the financial crisis and sovereign wealth fund investments in U.S. and European firms not only affected returns on U.S. money market instruments and U.S. firms’ common stock but also created negative “spillover” effects on Canadian money markets and Canadian firms’ equity returns.We examined the largely unexplored effect of sovereign wealth fund (SWF) investments in two major developed markets that have strong economic linkages: the United States and Canada. The economic relationship between the United States and Canada is one of the most successful relationships in global economic history. Between the Automotive Products Trade Agreement (also known as the Auto Pact), the United States–Canada Free Trade Agreement, the North American Free Trade Agreement, and scores of other bilateral and multilateral agreements, the United States and Canada have embraced a fully interconnected and market-based economy. Although both countries encourage a free market approach, the Canadian financial system has a different organizational structure (five large commercial banks are dominant), tighter regulation (including lower leverage ratios than their U.S. counterparts), and a generally lower risk appetite. Thus, despite their strong economic linkages, the two countries might not have the same reaction to the recent financial crisis and the devastating effects that the crisis has had on the global economy.By engaging in this analysis, we can identify how news related to the financial crisis and SWFs’ capital injections into large U.S. and European financial institutions has not only affected returns on U.S. money market instruments and the common stock of U.S. financial institutions but also created negative “spillover” effects on Canadian money markets and the equity returns of Canadian financial institutions. These spillover effects may be the result of the aforementioned economic linkages between these two countries. Therefore, investors might fear the threat of large institutional failures in Canada when U.S. and European financial institutions require capital infusions from sovereign wealth funds or other large investors. Overall, we found that news of an SWF capital injection into a large U.S. or European financial institution caused across-the-board declines of 13–61 bps in U.S. short-term rates, such as one- and three-month commercial paper rates (a “stabilizing” effect of SWF investments). These news announcements also created a negative spillover, or “destabilizing, ” effect for short-term Canadian corporate rates, such as the overnight money market rate and the Canadian Deposit Offered Rate (Canada’s equivalent to LIBOR), with heightened global systemic risk causing rates to increase 15–29 bps.This increase in Canadian rates suggests that SWF investments in the United States can have unintended “crowding-out” effects on the demand for capital in other parts of the world because other countries might feel the need to increase rates in order to attract capital and remain competitive in the global capital markets. In contrast to Canadian debt market rates, U.S. money market rates reacted more consistently and significantly to news specifically related to the financial crisis (with declines of 24–72 bps). A “flight-to-quality” effect is also clearly evident for both U.S. and Canadian short-term treasury rates (with rate declines of 43–97 bps when major news related to the crisis was publicly released). These debt-specific reactions to news related to SWF investments and the financial crisis highlight how the credit crunch, initiated by problems in the subprime credit sector, quickly rippled through both the U.S. and Canadian markets.

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