Economics of Sovereign Wealth Funds

Chapter 2 From Reserves Accumulation to Sovereign Wealth Fund: Policy and Macrofinancial Considerations

Udaibir Das, Adnan Mazarei, and Han Hoorn
Published Date:
December 2010
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Sovereign wealth funds (SWFs) are attracting increasing attention. SWFs are not new, and some of the longer-established funds—for example, those of Kuwait, Abu Dhabi, and Singapore—have existed for decades. The growing prominence of SWFs is one of the results of the profound transformation of the global economy. Following the 1997–98 Asian financial crisis, emerging-market countries built high international reserves cushions; this trend was strengthened by high commodity prices, high demand from the United States, and large global imbalances. Rather than capital importers, emerging-market countries are now capital exporters. Gradually, they have emerged as savers to finance richer economies, a reversal of history.

However, the objectives of SWFs or SWF-type arrangements in meeting domestic policy goals, as outlined in this chapter, is a fundamental issue that must not be lost sight of in any SWF discussion.1 Those objectives can be multiple and overlapping, and are certainly changing over time.

Depletion of nonrenewable resources and volatile commodity prices lead to the first objective: countries need to transform nonrenewable resources into sustainable and more stable future income. Saving commodity revenue can spread the wealth across generations; it can help mitigate the boom and bust cycles commodity exporters experienced following the oil surge of the 1970s; and it can help prevent Dutch disease2 effects on the noncommodity side of the economy. Indeed, most SWFs, as measured by assets, reflect such motives.

Second, significant accumulation of reserves puts pressure on some surplus countries’ balance sheets as a result of carry costs and currency mismatches, prompting those countries to seek prudent and effective management of this type of foreign currency accumulation via SWFs. This situation affects a number of Asian countries in particular.

Third, aging populations in many countries create a need to secure future welfare or meet future superannuation obligations. An aging population leads to future economic vulnerability and expenditures, often related to entitlements that were funded by pay-as-you-go systems resulting in high economic and social costs. A prudent response to such challenges is to accumulate assets in the present to offset the projected higher liability related to sustaining pensions and social welfare in the future.

Along with such specific goals, an SWF’s policy objective and activities also should be consistent with the country’s overall macroeconomic framework. The SWF’s assets, and the returns they generate, affect a country’s public finances, monetary condition, balance of payments, and overall balance sheet. They may also affect public sector wealth and influence private sector behavior. Therefore, appropriate coordination between the SWF and the fiscal and monetary authorities is critical to achieving a country’s overall policy objectives in the context of which an SWF is established.

The global financial crisis of the late 2000s has provided an important reflection point to examine the domestic policy angle of SWFs. The first issue is the level of reserves and foreign assets a country could consider sufficient to contemplate setting up an SWF (examined in the first section of this chapter). The second issue, assuming a country’s foreign reserves are adequate, is what options, other than creating an SWF, should be explored (second section). Given the roles played by some SWFs in cushioning domestic banking systems and insulating budgets from the global financial crisis, the third section examines issues and concerns about domestic support from SWFs. A close examination of the link between management of the SWF and the resulting macrofinancial impacts is presented in the fourth section.


Typically, ample official reserves are a signal to authorities to assess whether the excess reserves should be managed and invested differently and to what alternate uses the reserves could be put. The possibility of calling for liquidity support in a crisis could potentially prevent excess reserves from being used to pursue a long-term investment horizon with less liquid assets in a quest to earn higher returns than reserve assets earn.

Reserves play an important role in reducing the risk of crises and lessening their impact when they occur. Though not a substitute for sound macroeconomic policies, adequacy in reserves can buy time. When trouble appears on the horizon, an adequate reserve position can give countries enough breathing space to implement reforms and so reduce the risk of a full-blown crisis. An adequate level of reserves can increase market confidence that a country can meet its external obligations.

Because reserves provide significant benefits, especially in reducing external vulnerability and providing country insurance, reserve levels need to be carefully assessed. Thus, the “adequate” level of reserves should be established and agreed on between the central bank and the government before establishing an SWF.

The debate about the adequate level of reserves has developed in conjunction with the evolution of balance of payments needs. After the demise of the gold standard in the early 1970s, the focus of reserve adequacy assessment shifted to the current account. Thus, reserves should first be compared with a country’s trade figures, especially import coverage.

The emerging-market crises of the 1990s made clear that for many countries that had been able to tap the capital markets, exposure was in the capital account. With this realization, the emphasis on risk in the balance of payments switched from the current account to the capital account. As a result, and supported by empirical analysis, the Greenspan-Guidotti rule of 100 percent coverage of short-term external debt emerged as the most useful rule of thumb for reserve adequacy for emerging-market countries with access to private capital markets.3 This indicator has become widely used as a measure of reserve adequacy. Other factors have an impact on the level as well. Higher levels of reserves would be preferable in countries with large external current account deficits, overvalued exchange rates, high levels of short-term public domestic debt, derivatives exposures of the public sector, and weak banking systems.

The lessons from the global financial crisis have led to proposed adjustments to or augmentation of these indicators. First, although still a relevant indicator for reserve adequacy, the Greenspan-Guidotti rule focuses entirely on an “external drain” on a country’s reserves. But an “internal drain” on reserves is also possible, reflecting capital flight by residents. Residents may not be willing to roll over government debt, or a run on banks could occur, with residents withdrawing their deposits. If residents seek foreign currency as a safe haven, foreign exchange reserves will be drawn down. Such drains are likely if the central bank stands ready to provide the foreign exchange under a fixed exchange rate regime. Internal drains involving runs on foreign currency deposits are even harder to thwart under a floating regime with a more open capital account; therefore, foreign currency maturity mismatches in banks typically require an additional reserve cushion.

Second, in addition to short-term debt drains, other forms of external drains could materialize in a crisis. For example, other types of capital inflows that are usually considered to be immune from crises could also put pressure on reserves if inflows stop or are reversed. Nonresident holders of the country’s local bonds, who may not be willing to liquidate their positions, can build up derivative positions to hedge against a domestic currency depreciation, putting pressure on reserves. Equity flows have become an important source of finance in emerging-market countries, but during the global financial crisis of the late 2000s the trend has been for investors to pull back some of the equity investments. Experience in previous crises suggests that such outflows are halted quickly by declining stock prices, making such withdrawals no longer attractive.

Third, in a crisis, a large drop in private demand can be offset by fiscal stimulus measures. However, the global financial crisis has actually made the borrowing environment for emerging-market countries more challenging and is, in a number of cases, forcing fiscal contraction. An ample reserve cushion provides some leeway to pursue fiscal stimulus and avoid contraction.

Fourth, a worrisome aspect of the global financial crisis is that its core is a banking crisis, and banking crises tend to be prolonged. Moreover, given low demand, current accounts may not adjust as quickly as during previous crises to offset the drought in capital flows. Thus, the question becomes whether reserve coverage of just one year of short-term debt is sufficient.


The next step in deciding to set up an SWF is to review the origins of the ample reserves, the longevity of the sources of the reserves, and the other assets and liabilities of the sovereign to judge whether there are better alternatives to setting up an SWF.

Sovereign foreign asset accumulation typically comes from a few main sources. The first source is capital inflows, mopped up through the issuance of central bank liabilities, and sometimes through issuance of government paper. In such a case, the central bank or the ministry of finance (or both) has to assess the longevity of these inflows in deciding whether the stream of inflows is sufficient to permit assets to be invested over a longer term and with greater risk to reduce the cost of carry.

A second source of the accumulation could reflect the government balance sheet—general fiscal budget surpluses, privatization receipts, or surpluses related to revenues from booming commodity exports—in which case the initial or anticipated reserve buildup will, typically, have a counterpart in government deposits with the central bank.4 Whether these are one-off and small or likely to continue over time can be determined based on these individual sources of flows.

A first option for the use of these reserves, applicable in the first case, where the objective is to reduce the cost of carry when mopping up excess liquidity, is to increase the reserve requirement ratio on banks’ foreign deposits. If a need arises to inject foreign liquidity, the central bank can reduce this ratio. In Peru’s experience, reducing this ratio was more effective than the direct sale of foreign currency in the exchange market because the reduction in the reserve requirement ratio allowed banks to increase liquidity in foreign currency without reducing their liquidity in domestic currency (Bardález and Rondán, 2009).

A second option, again applicable in the first case, is to relax foreign exchange regulations on residents’ investments abroad and accommodate the outflows through central bank intervention in the foreign exchange market. This approach could slow the net inflows of capital and reduce the cost of carry of mopping up excess liquidity, although relaxing foreign regulation and opening capital markets cannot be done overnight.

A third option, applicable in either case, is to reduce external debt obligations, which is a straightforward way of using ample reserves and reducing currency mismatches and carry costs. For instance, Banco Central de Chile and Banco de Mexico have used excess reserves to reduce external foreign currency debt, in essence shrinking the overall balance sheet (Ortiz, 2007).

A fourth option is to start managing reserves on the central bank balance sheet with a long-term perspective. Often reserves are split into tranches, such as a liquidity tranche and an investment tranche, and the latter could be amplified and its mandate expanded to a longer horizon. For instance, the Hong Kong Monetary Authority separates foreign reserves into two portfolios, the Backing Portfolio and the Investment Portfolio (IMF, 2005). Assets in the Backing Portfolio are invested in highly liquid and short-term U.S. dollar-denominated fixed-income securities, while assets in the Investment Portfolio are invested more dynamically, including investments in equities. Typically, however, a limited tolerance for reporting losses, combined with marked-to-market accounting standards, may limit the risk and size of the investment portfolio, unless the risks (and rewards) are explicitly borne by the ministry of finance.5

A fifth option is to set up an SWF, be it in the central bank or as a separate institution. The SWF option is usually chosen when there is a clear objective for the increased reserves. For example, a net commodity-exporting country facing a large and prolonged commodity price boom may have few sound options other than to set up an SWF; net commodity-exporting countries typically have limited remaining external government debt. An important macro aim is to reduce the volatility of government revenue and limit the Dutch disease effects that arise from crowding out the private sector if commodity revenue is rapidly spent.


The global financial crisis has compelled SWFs to take more prominent and direct roles in their home countries.6 These roles include providing liquidity support to domestic banks or to companies, recapitalizing domestic banks, investing in domestic stocks, and financing the budget deficit or fiscal stimulus packages.

Several of these roles are supported by the objectives of some SWFs. For example, financing the budget is the objective of SWFs mandated to stabilize the budget, and assets are intended to be drawn down in periods of recession. Several SWFs have investment policies to invest a part of their assets domestically (for example, Australia’s Future Fund and the Alaska Permanent Fund Corporation). As long as their domestic asset allocation is within the strategic asset allocation (SAA), investing domestically in the current environment is likely to boost SWFs’ long-term returns when asset prices rebound.

If an SWF does not have a mandate to invest domestically but is compelled to do so in the wake of the crisis, there could be implications for domestic macroeconomic policy. One result could be that foreign exchange management becomes difficult as the swap of foreign currency into domestic currency brings foreign currency into the domestic monetary system. If spending is allowed to take place outside the budget, issues of fiscal accounting and transparency could emerge, which could undermine budgetary control, imply unequal treatment of different types of spending, and possibly lead to mismanagement of funds and to waste.

Moreover, the role of providing liquidity, especially foreign currency liquidity, is the objective of a country’s official foreign currency reserves, and not that of a typical SWF. Contingent calls for liquidity support could prevent the SWF from pursuing a long-term investment horizon and holding less liquid assets. Therefore, if the SWF needs to provide liquidity support, a clear investment policy and supporting rules and procedures should be established consistent with that purpose, thus promoting transparency and accountability of the SWF and safeguarding the value of the SWF’s assets.


An SWF is often designed as an integral part of the owner country’s policy framework, with purposes such as minimizing the distortions that large and volatile commodity flows might cause to the fiscal accounts, inflation, and the exchange rate. While the objective of an SWF could be to further reduce fiscal cyclicality, provide for future government contingent liabilities, or reduce the cost of carry, the ways in which SWFs manage their assets have other significant effects on policy, specifically fiscal, monetary, and exchange rate policies (Brown, Papaioannou, and Petrova, 2010).

Fiscal Policy

This discussion of the linkages between SWF management and fiscal policy focuses on stabilization SWFs and pension reserve SWFs, given that they are set up with the mandate to ensure a country’s fiscal viability.

The objective of a stabilization SWF is to finance future potential deficits through resources of the SWF and, thus, to smooth fiscal spending, or to finance regular or extraordinary public debt amortization. If a commodity-rich country has a fiscal rule such that government expenditures must be equivalent to long-term revenues minus a structural surplus, as a certain percentage of GDP, every year, then the actual government balance depends upon the cyclicality of government revenues. As shown in the formula below, this cyclicality is reflected in the revenue shortfall relative to the long-term revenues.

The stabilization features of the SWF are then determined by the parameters of the fiscal rule and the amplitude of the revenue gap. A greater structural surplus requirement would mean that the SWF would have to be tapped only in very extreme cases, that is, to offset very large revenue shortfalls. In such cases, the SWF would serve as an additional source of stabilization to the surplus savings rule. A small surplus savings requirement or an allowance for a structural deficit would place great pressure on the SWF as a stabilization fund because it would have to be used more often. Therefore, while the stabilization function of the SWF is to counteract the revenue gap, the surplus savings requirement determines the threshold that triggers use of the SWF’s resources.

The revenue gap has two main components: a cyclical effect resulting from the commodity price and a cyclical effect resulting from tax revenues. Because the commodity price effect often dominates and the two effects are highly correlated, the SWF will, as a stabilization fund, be used primarily to neutralize the effects from movements in the commodity’s price.7 The SAA of the SWF should, therefore, contain assets that are negatively correlated with the commodity price.

If an SWF is intended to cover the government’s future pension liabilities, the structure of the pension payments should be well defined to appropriately specify the SWF’s withdrawal rules. Alternatively, a law may lay out how the SWF’s resources can be spent to support pensions. For example, spending may not exceed the return generated by the fund in the previous year. Hence, spending rules set for an SWF are intended to relieve pension-related budgetary spending pressures. From a sovereign balance sheet perspective, the macrofinancial linkages from the pension-system liability to the SWF have implications for the SWF’s asset allocation. In particular, the SWF’s SAA will have to be concentrated in assets of countries whose currencies exhibit high positive correlations with the domestic currency so as to reduce exchange rate risk.

Monetary Policy

The country’s monetary policy could be affected by the way in which the SWF is managed. The volatility of fiscal revenues—specifically commodity revenues—presents a challenge for monetary authorities because that volatility affects the volatility of aggregate demand, either through the channel of government spending or through the additional private-sector lending enabled by government deposits, leading to excessive inflation and real exchange rate fluctuation.

The funding and withdrawal rules of a stabilization SWF, in combination with a fiscal rule, should seek to minimize such effects on domestic demand. Use of the stabilization SWF to cover fiscal liabilities during cyclical downturns ensures that these resources will enter the economy during periods when private demand is relatively weak, and the absorption capacity for additional public resources is correspondingly strong. Because the stabilization SWF may reduce the amplitude of budget balances, the transmission mechanism of monetary policy is likely to be enhanced.

Exchange Rate Issues

Investing SWF resources abroad reduces the exchange rate impacts of the exported commodity. If the SWF’s resources are saved abroad and commodity-extraction companies and exporters are allowed to pay tax liabilities in foreign currencies, the export-related revenue can be prevented from affecting the value of the exchange rate. In particular, this policy may reduce the real appreciation associated with increases in GDP growth and commodity prices, as well as reduce the impact of later exchange rate reversals.

Under a flexible exchange rate regime, the (nominal) exchange rate of the local currency vis-à-vis the foreign currency mitigates negative terms-of-trade shocks related to the (nominal) price of the endowed commodity, which could have direct implications for the objective, use, and SAA of an economic stabilization SWF. In most commodity-exporting countries, the local currency tends to depreciate when the commodity price falls. The SWF’s interest returns measured in domestic currency are then boosted by the domestic currency depreciation, providing an additional cushion to the budget.

However, if the authorities decide to prevent a substantial depreciation of the exchange rate stemming from a sharp drop in commodity prices, the resulting fiscal deficit may have to be financed with SWF resources. Although this advances the argument for investing the SWF in assets that are negatively correlated with domestic economic growth, such correlation—and the asset choice—will be affected by the authorities’ tolerance for exchange rate adjustment.


Although SWFs have provided greater portfolio diversification and their economic and financial benefits in the global financial crisis of the late 2000s have been proven, they clearly have an important role in meeting domestic policy objectives. This positive role of SWFs, however, also poses challenges that SWF-owner countries face, especially in the context of an increasingly globalized financial and monetary system. From the macroeconomic perspective, it is important to assess whether SWFs help or hinder broader economic policy objectives, and whether they pose potential sovereign balance sheet risks. Equally important is ensuring that the management processes for these funds have a relatively high degree of accountability to ensure that SWFs are well governed and prudently managed.


    BardálezPaul Castillo and DanielBarco Rondán2009“Peru: A Successful Story of Reserves Management” in Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin Americaed. by E.Cavallo and A.Izquierdo (Washington: Inter-American Development Bank).

    BrownAaronMichael G.Papaioannou and IvaPetrova2010“Macrofinancial Linkages of the Strategic Asset Allocation of Commodity-Based Sovereign Wealth Funds,”IMF Working Paper 10/9 (Washington: International Monetary Fund).

    BussièreMatthieu and ChristianMulder1999“External Vulnerability in Emerging Market Economies: How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion,”IMF Working Paper 99/88 (Washington: International Monetary Fund).

    BussièreMatthieu and ChristianMulder2001“Which Short-Term Debt over Reserves Ratio Works Best? Operationalising the Greenspan Guidotti Rule” in Capital Flows Without Crisis? Reconciling Capital Mobility and Economic Stabilityed. by D.DasguptaM.Uzan and D.Wilson (New York: Routledge).

    International Monetary Fund2000“Debt- and Reserve-Related Indicators of External Vulnerability” IMF Board paper (Washington).

    International Monetary Fund2001“Issues in Reserves Adequacy and Management” IMF Board paper (Washington).

    International Monetary Fund2005Guidelines for Foreign Exchange Reserve Management: Accompanying Document and Case Studies (Washington).

    International Monetary Fund2007Global Financial Stability Report (Washington,October).

    OrtizGuillermo2007“A Coordinated Strategy for Assets and Liabilities: The Mexican Experience” in Sovereign Wealth Managemented. by J.Johnson-Calari and M.Rietveld (London: Central Banking Publications).

See IMF taxonomy of SWFs in IMF, 2007.

“Dutch disease” arises when foreign currency inflows caused by commodity exports cause an increase in the affected country’s real exchange rate. The effect of Dutch disease is to reduce external competitiveness, which weakens net noncommodity exports, contributing to the loss of jobs in the relevant industries. The end result is that nonresource industries are hurt by the increase in wealth generated by the resource-based industries.

See IMF (2000, 2001) and Bussière and Mulder (1999, 2001).

SWFs funded from public savings and privatization are more akin to nonrenewable resource funds because they represent an increase in net financial wealth.

We abstract from the option to reduce excess reserves through an appreciating currency and assume that the exchange rate is already optimally managed.

See Chapter 11 for further discussion.

The cyclical deterioration of factors that are not correlated with the commodity price must be dramatic to have any negative effect on the revenue gap.

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