Optimal Scale and Asset Allocation of SWF: China's Case

Abstract

This paper studies the optimal scale and asset allocation of Sovereign Wealth Fund (SWF), taking China's SWF as an example. We use the AR (1) process to simulate the future foreign exchange earnings of China and generate three patterns of the future earnings. With these three scenarios and based on Deaton's precautionary saving model, we find that the optimal scale and asset allocation of China's SWF mainly depend on the expected trend and fluctuation of the future foreign exchange earnings and expected yields that SWF can get. When foreign exchange earnings shows an upward trend, the scale of SWF should not be expanded even the expected investment yield is very high, and ratio of risky assets should be kept stable and high. When foreign exchange earnings is stabilized as its growth rate slows down, the scale of SWF has the positive correlation with the degree of earnings fluctuation and expected yield of investment, and also ratio of risky assets is generally lower. When foreign exchange earnings decrease, the scale of SWF should be expanded even the expected investment yield is not so high, and the ratio of risky assets is dependent on the characteristics of expected investment yields. We also conclude that investment policy of China's SWF should follow Temasek's investment model, under the current trend of China's foreign exchange trend, and strive for high yield investment chances.