Emerging Markets Lose Their Shine Amid Global Uncertainty

In 2022, sovereign wealth funds retrenched from emerging markets amid greater geopolitical uncertainty and the end of COVID-19 support measures.

In the challenging investment environment of 2022, sovereign wealth funds became more cautious and reduced their risk exposure.

In terms of direct investments, this cautious approach to the market was most evident in their retreat from emerging markets. In 2022, new sovereign wealth fund investments in emerging markets fell from 44% of the total dollar value in 2021 to only 14%, a decline by more than two-thirds, from $33 billion to only $10 billion.

Source: IFSWF Database, 2022.

The challenges of investing in China under the zero-COVID policy are particularly stark. Sovereign wealth fund investments in the world’s second-largest economy fell from $4 billion in 2021 to only $1 billion in 2022 as continued lockdowns and travel restrictions stymied the country’s manufacturing industry, the driver of the economy which accounts for about a third of the world's total manufacturing capacity. The knock-on effects of this were also seen along the supply chain in South East Asia, where sovereign wealth fund investment fell from $9 billion in 2021 to $1 billion.

SWF Investment in China fell from $4 billion to $1 billion between 2021 and 2022
SWF Investment in South East Asia fell from $9 billion to $1 billion between 2021 and 2022

Source: IFSWF Database, 2022.

The Impact of Geopolitics

However, China’s zero-COVID policy is not solely responsible for sovereign wealth funds shying away from investing in Chinese companies. Growing tensions between the US and China, ongoing for over half a decade, also impacted the attractiveness of China as an investment destination. In 2022, China’s refusal to condemn Russia’s actions in Ukraine and the two superpowers’ increasingly disparate views of the status of Taiwan exacerbated these tensions.

The impact of geopolitics on sovereign wealth fund investment is nowhere more apparent than in the case of Russia. Before the conflict in Ukraine, Russia attracted around 20 investments a year from sovereign wealth funds, primarily driven by the Russian Direct Investment Fund, which acted as a domestic partner and asset manager for many of its peers. Under Western sanctions, of course, this flow of investment has completely stopped. Removing this major emerging market from sovereign wealth funds’ investment universes may have an ongoing impact on their investments in these countries. However, as sovereign wealth funds learn to navigate an increasingly fragmented foreign direct investment environment, they will likely find opportunities elsewhere, possibly in South East Asia and India.

Slowing domestic investments

Another contribution to the decline of emerging-market investments was the reduction in domestic investments by sovereign wealth funds, as many are from emerging and frontier markets. In 2022, sovereign wealth funds invested $8.5 billion in their home markets or 12% of the total, almost half the $16 billion they put to work in 2021, representing 22% of the total investments.

The COVID-19 pandemic pushed many sovereign wealth funds, especially those with a development mandate, to step-up support to local businesses such as domestic airlines and other companies in consumer sectors facing existential threats posed by strict lockdowns. However, by 2022 many governments had wound these emergency measures down. There was a sharp year-on-year decline in domestic investments by sovereign wealth funds between 2021 and 2022. However, this was still more than double the amount they invested in 2019 – the year that marked the beginning of a trend of increasing sovereign wealth fund investment at home – when they only invested $4 billion into local markets.

Source: IFSWF Database, 2022.

Nevertheless, direct investments in domestic economies are here to stay. Many new sovereign wealth funds in emerging and frontier markets have a domestic development mandate. They will continue to invest in their home economies, particularly as rising geopolitical tensions have contributed to the rise of inward-looking merger control policies that inhibit the cross-border free flow of capital.

Current geoeconomic conditions might also encourage those sovereign wealth funds without an explicit development mandate but can invest at home to do so. “We take a total portfolio approach and consider the best marginal spend of our investment dollars and the most promising opportunities”, a director of portfolio strategy from one of our members told an IFSWF member webinar in April 2023. “Geopolitical risk is one of the pillars of the total portfolio construction framework, and it’s a very important risk factor to consider in this new environment. We currently have a preference for domestic assets because we have a CPI [consumer-price inflation]-linked mandate and local assets are generally linked to local inflation, which will help us improve our portfolio’s inflation resilience.” They also noted that domestic assets have the advantage of not requiring hedging against currency or interest rates outside of an investor’s control.

Looking Forward

Emerging markets will likely continue to offer attractive investment opportunities for sovereign wealth funds, particularly in the consumer and tech-adjacent consumer sectors. Despite challenging economic conditions, many sovereign wealth funds continue to see the growth of the middle class in many developing countries as an attractive investment proposition.

The current environment could also aid sovereign wealth funds in deploying capital into emerging markets. The lifting of COVID restrictions in China in December 2022 and the rebound of its economy to 4.5% growth during the first quarter of 2023 may reveal more investment opportunities in China and unlock prospects in South East Asian markets along the supply chain. Equally, the governments of many sovereign wealth funds might position themselves to take advantage of geoeconomic fragmentation, which may reduce competition in emerging markets from investors from the United States and Europe as firms and policymakers look to make supply chains less vulnerable to geopolitical tensions by moving production processes to trusted countries with aligned political preferences.1