Experiences with Sovereign Wealth Fund Management - PowerPoint Presentation

Slide1

Experiences with Sovereign Wealth Fund ManagementEric LE BORGNE The World Bank (Beirut office)May 10, 2013Slide2

OUTLINEChallenges and policy instruments available for natural resource rich countriesSWFs objectives and associated designSWFs’ best practices and challengesRecent trends in SWF designSlide3

CREATING A LEBANESE SWF MAY, UNDER CERTAIN CONDITIONS, HELP ADDRESS CHALLENGES RESULTING FROM NATURAL RESOURCES ABUNDANCE (Resource curse/paradox of plenty)

Resource

Revenue

Characteristics

Policymaking Incentives

Volatile:

as a result of natural resource price volatility

Excessive spending today:

of resource revenues, at the expense of future generations, due to excessive discounting of the future, the assumption that future generations will be richer, and/or to gain political support

Rent-seeking, corruption

Uncertain:

due to uncertainty of reserve volume and production potential ex ante

Exhaustible:

due to the nature of the resource

Sizable:

as a share of GDP and government revenues (which translates into the high magnitude of potential impact of volatility on the economy, and the incentives for rent-seeking)

Key Challenges

Spend

commodity revenues

efficiently

within a

sound macroeconomic frameworkEnsure revenue stabilization to avoid boom and bust cyclesGuarantee revenue sustainability for future generations and/or generate alternative sources of income different from non renewable resources

Policy Objectives

Resource Sovereign Wealth Funds

Fiscal Rules Fiscal Responsibility Laws Budgetary oil pricesExtractive Industries Transparency InitiativeEtc.

Examples of Potential Policy InstrumentsSlide4

To ensure counter-cyclical fiscal policy that can mitigate the impact of highly volatile commodity prices on fiscal revenues

Stabilization

Description

Potential Policy Objective

To set aside revenue for future generations or future needs of current generations (e.g. future pension

liabilities)

To ensure intergenerational equity

Inter-generational Saving

To develop long-term fiscal sustainability (generate alternative non-resource revenues)

To support local or national economic development

For

lack sufficient current opportunities for domestic investment or consumption expenditure that provide the same current benefits as financial

investment

Investment

To hedge against extraordinary shifts in the fiscal situation of a country (e.g. natural disasters, blow-outs, war, etc.)

Precautionary

KEY DESIGN ELEMENTS OF A SWF FOR

LEBANON

WILL DEPEND ON THE POLICY OBJECTIVE(S) THE FUND IS MANDATED TO ACHIEVESlide5

Examples of Sovereign Wealth FundsSlide6

Examples of Sovereign Wealth FundsSlide7

Alaska Permanent Fund Corporation

Norwegian Government

Petroleum Fund

Consists of the Alaska Permanent Fund (APF) and the Earnings Reserve Account (ERA)

50% of resource revenues are deposited in the APF and cannot be withdrawn, while the rest remains with Treasury

Income from APF investments is deposited in ERA and used for (1) inflation proofing of APF funds, (2) cash transfers to households, and (3) other uses as per Legislature’s discretion (e.g. budget support)

Consists of one fund which is managed by the Central Bank on behalf of the government

Oil revenues are deposited in the fund and are used for making financial investments overseas with a long term horizon

Oil revenues and income from their investment is used as necessary to finance deficits in the state budget as per Parliament decisions

Deposits and withdrawals adhere to fiscal policy guidelines

Institutional Setup

Safeguarding

against pressures to spend

revenue

Automatic stabilization

Insulation of investment

policy from

political arena

Contribution

to increase

in average

income of the poorest familiesSterilization of oil revenues through overseas investmentAccumulation of liquidity buffer that can stabilize potential future fluctuations in oil revenue and fund investment income

Achievements

Income Redistribution

through direct cash transfers to households to improve the quality of life of all, and of the poorest families particularly

Fiscal Management

through transfers to the state budget to cover non-oil budget deficits, through conservative s

aving

and

investment to (1) generate

revenue when oil runs out,

(2) manage

oil revenue volatility,

(3) reduce

public debt,

(4) reduce

taxes, etc

.

Objectives

SUCCESSFUL

SWFs

SUCH AS THE ALASKAN AND NORWEGIAN FUNDS HAVE ACHIEVED DISPARATE OBJECTIVES USING VARIED INSTITUTIONAL SETUPSSlide8

* This led to the closure of the SWF and the depletion of almost all SWF assets, respectivelySource: Le Borgne and Medas, 2007, “Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages”, Working Paper 07/297, International Monetary Fund, Washington, DC

Fiscal Challenges Facing Many Asia Pacific Economies

Volatile government spending and fiscal deficits

Significant or complete depletion of SWF funds

Accumulation of expensive debts

and/or

payment arrears

Causes of Fiscal Challenges

Weak spending controls

Poor cash management

Rigid SWF operational rules

Use of SWF funds as collateral to finance fiscal deficits (e.g. Papua New Guinea, Nauru*)

Risky and/or undiversified

investment,

mismanagement and poor governance (e.g. Nauru

)

Poor / fragmented cash management combined with rigid

SWF withdrawal

rules (e.g. Marshall Islands and Tuvalu)

Depletion of cash reserves due to required contribution to SWF’s (e.g. Marshall Islands

)

Without consistent overall fiscal framework (incl. strong spending controls and cash management), a SWF is unlikely to achieve its objectives of limiting size and volatility of spending. Rigid operational rules limit ability to use funds for stabilization, ability to adjust to changing circumstances, and may result in need for costly borrowing

Asset mgt

strategy (incl. chosen level of risk-return tradeoff) must be consistent with SWF policy objectives (e.g. stabilization vs. income generation)

Lessons Learned

OTHER SWFs, SUCH AS THOSE IN THE ASIA PACIFIC ISLANDS, HAVE NOT BEEN AS SUCCESSFUL IN ACHIEVING FISCAL GOALSSlide9

Source: Le Borgne and Medas, 2007, “Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages”, Working Paper 07/297, International Monetary Fund, Washington, DCGLOBAL TRENDS IN SWF DESIGN ARE SHIFTING TOWARDS FUNDS THAT ARE FELXIBLE, TRANSPARENT, AND INTEGRATED WITH FISCAL SYSTEMS AND COUNTRY INVESTMENT STRATEGIES

Description

Design

F

eature

Flexible rules (for deposit and withdrawal) facilitate use of funds for stabilization, avoid need for costly borrowing or arrears

in asset accumulation

period, and permit adjustment to changing circumstances (e.g. Norway)

Flexible

Operational Rules

Limited earmarking and/or extra-budgetary spending using SWF funds ensures

Flexibility to adjust to changing conditions and priorities,

Efficiency of spending through competition for resources between priority areas

Simpler liquidity

management

Limited Earmarking and/or Extra-budgetary Spending

Integration of SWF investment policy in country’s broader fiscal and asset management strategy avoids simultaneous accumulation of public debt and SWF financial assets

Choice

of portfolio

geared towards maximizing (

risk-adjusted) financial return, conditional on

underlying fiscal objectives

(e.g., stabilization, long-term fiscal sustainability

)

Investment Coherence with Country Investment Strategy

Integration of resource revenue expenditure with the budget system ensures spending

decisions are aligned with

fiscal policy and addresses

fungibility

challenges (e.g.

Financing Funds in Norway

, Timor

Leste

)

This, however, eliminates SWF role in enforcing fiscal discipline in resource revenue expenditure

Integration with Budget Systems

Fund oversight (including performance reports, external audits, standards for disclosure of information) can promote better performance, limit corruption, and build public confidence in the management of resource revenues and in turn foster public support for the fund

Transparency & AccountabilitySlide10

Thank Youhttp://worldbank.org/LebanonSlide11

Extra SlidesSlide12

Prior information campaignEstablishment Accumulation and Withdrawal Management and InvestmentGovernance

Constitutional amendment, parliamentary act, presidential decree

Rigid rules, budget support, mixed

Special fund strategy body, investment advisers, external managers, target returns and benchmarks, permitted investments

Autonomous body, multilevel oversight, published audits and performance reports,

Special dissemination programs, limited public debate

COMMON FEATURES OF OIL FUNDSSlide13

OVERVIEW OF ACCUMULATION AND WITHDRAWAL RULES AMONG SWF’S AROUND THE WORLDEach method has pros and cons. Whatever the methodology, operational rules need to be consistent with actual fiscal policy. Oil fund gross assets should not detract attention from the government’s overall net financial position.

Description

Withdrawal Rules

Fully specified mechanisms:

Price or revenue contingent withdrawal rules

Earmarking

for specific uses (Alaska, Azerbaijan, Chad, Ecuador, ..)

Financing funds:

Budget needs (e.g. Norway, Timor

Leste

)

Accumulation Rules

Direct Transfers:

Price

or revenue contingent deposit rules (Algeria, Iran, Mexico, Russia, Trinidad and Tobago, Venezuela,

etc.)

Pre-determined share of oil revenue is deposited into the fund (Equatorial Guinea, Gabon, Kazakhstan, Kuwait,

etc.)

All

government oil revenue (Chad, Sao Tome et Principe, Timor

Leste

, etc.)

Indirect Transfers:

Oil revenues are first paid to the treasury, then a part is transferred to the fund (Norway, etc.) Slide14

CB Core Reserves & Stabilization FundsFuture & Endowment FundsPension LiabilitiesObjectiveCover unexpected Balance of Payments outflows or budget shortfallsPreserve capital in real terms for future generations or to generate alternative source of revenueCover contractual and measurable long term obligationsInvestment HorizonShort TermLong termMaturity of contractual obligations: 20 to 40 yearsReturn TargetPrevailing nominal returnsLong term real return targetDiscount rate on future benefit payoutsRisk Tolerance

No

negative nominal returns over the investment horizon

Not meeting the real return target over time

Not meeting expected benefit payouts

Increasing tolerance for short term risk and decreasing need for liquidity

OVERVIEW OF SWF

INVESTMENT

POLICIESSlide15

SANTIAGO PRINCIPLES FOR MANAGING INSTITUTIONAL RISKS FACED BY SWF’SThe main problem that SWF’s face over time is the potential conflict between their strategic objectives and short term political objectives. This conflict may result in Direct raiding: funds are used for purposes other than originally intended, or ex-ante contributions are not paidIndirect raiding: unsustainable fiscal behavior e.g. excessive debt accumulation on the back of fund’s resourcesInefficient management of funds: constraints on investments that are inconsistent with the fund’s long-term objectives because of reputational risk concernsKey Institutional Risks facing SWF’s…Sound legal framework to enable SWF to accomplish its stated objectivesClearly defined and publicly disclosed SWF strategic objectives (in particular for the procedure that governs accumulation and withdrawals)Institutional arrangements for fund management shielded from political interference and supportive of efficient management of funds to achieve SWF objectives…can be managed using Santiago PrinciplesSlide16

The Case of AlaskaAlaska Constitution Article IX, Section 15Alaska Permanent Fund.At least twenty-five percent of all mineral lease rentals, royalties, royalty sale proceeds, federal mineral revenue sharing payments and bonuses received by the State shall be placed in a permanent fund, the principal of which shall be used only for those income-producing investments specifically designated by law as eligible for permanent fund investments. All income from the permanent fund shall be deposited in the general fund unless otherwise provided by law [Effective February 21, 1977].Slide17

What are the key features of this fund? Established by constitutional amendment Managed by autonomous body with clear mandate and objectives The capital (inflation proofed) cannot be withdrawn. Rule to determine the cash transfers to households.

Most Alaskans thought the Fund should be considered a public trust and that the paramount concern should be protection of the principalSlide18

Flows in and out of the APFEligible Revenues

Treasury

General Fund

Alaska Permanent Fund

APF Corporation

Earnings Reserve Account

Dividend Fund

50% of Income available for distribution

Inflation proofing

1

1

2

4

5

50% of Eligible Revenues

3

Income

Note:

The

Legislature decides the use of the balance remaining in the Earnings Reserve Accounts (budget support, back to the Fund, keep it on ERA to stabilize future low income.Slide19

What has the Alaska Permanent Fund achieved?

Description

Achievements

Safeguard against pressures to spend the oil revenue;

Insulate the investment policy from the political arena;

Equal sharing of the revenue from publicly owned resources

Build a strong constituency in support of the fund

Macroeconomic effects

No evidence of impact on current labor force supply

Contributed to increase the average income of the poorest families

Served as automatic stabilizerSlide20

What is the future of the Alaska Permanent Fund? The earnings of the fund could help to address the fiscal problem of Alaska but so far no consensus has been reached on the issue…..

In practice, the dividends have come to be seen as entitlements, making changes in rules a challenging proposition.Slide21

The Case of Norway The Petroleum Fund was established in 1990 after a decision by the legislature to counter the effects of the expected decline in income and to smooth out the disrupting effects of highly fluctuating oil prices. The broad objectives of the fund were to: safeguard the long-term use of oil revenues, manage the government’s net cash flow from oil, and transfer money to the fiscal budget to cover the non-oil deficit.

In 2006 the government established the Government Pension Fund consisting of two parts: "The Government Pension Fund - Global", which is a continuation of the Petroleum Fund, and "The Government Pension Fund - Norway", which invests in domestic companies quoted on the stock market. Slide22

What are the key features of this fund? The fund can be used only for transfers to the central government budget following an annual resolution by the Storting.The minister of finance controls the management policies of the fund: limitation of the investment universe. The fund cannot be used to provide credit to the central government or private sector entities, or to raise loans Norges Bank invests the capital in its own name (directly/external managers) in financial instruments and cash deposits denominated in foreign currency. Annual audit reports, and performance reports are published.Slide23

Flows in and out of the GPFGSource: Vidar Ovesen (2013), Presentation at the International Conference on Effective Sovereign Wealth Fund Management, titled “How to agree on why, when and how much to save – Norway’s experience”Slide24

Was the fund successful in shielding the economy from fluctuations in prices and extraction rates in the petroleum sector? By investing abroad the fund has effectively sterilized oil revenues … but the effects of the new investment strategy are untested Given the size of the fund, future governments should be able to cope with fluctuations in revenue (and returns). The true long term benchmark is the pension liabilities Given diversified portfolio, all limits on expected volatility of the returns impose costs.

The Fund allows petroleum revenues to be gradually phased into the economy, and provides resources to face future pension liabilities of an aging population. Given its large size, it becomes more and more difficult to reduce volatility of the returns through investing in uncorrelated assets. Slide25

Conclusion

Oil funds with best management practice are subject to certain common principles:

Strong governance

Clearly defined goals and transparency

Integration with the state budget

Sound asset management strategy

Broad political support for the pursued objective is an important ingredient for the efficient use of oil revenue.