Chapter 4 Sovereign Wealth Funds and Economic Policy at Home
- Udaibir Das, Adnan Mazarei, and Han Hoorn
- Published Date:
- December 2010
This chapter explores the macroeconomic objectives and consequences of sovereign wealth funds (SWFs). It looks at what governments should ask SWFs to achieve, and at what might result if they are not properly tasked and coordinated. The discussion highlights in particular how the macroeconomic implications of an SWF’s actions affect the ways in which it should be structured, operated, and reported upon.
For any government, few decisions can be more significant—politically or economically—than to choose to accumulate financial assets when its citizens still have large unmet needs. Every dollar that a government saves is money that some may believe would have been better spent on social welfare or infrastructure, or taxes that need not have been levied. The government must be able to show both that the money it sets aside will be well managed, and that the economy will benefit directly from increasing public savings. Economic benefits may range from the immediate avoidance of undesirable pressures on the exchange rate or the inflation rate to providing insurance against bad times. The objectives of an SWF may also need to change over time, particularly if the conditions that gave rise to the SWF in the first place change, as witnessed during the recent global financial crisis. In all cases, however, the government needs to be clear to the public not only about the intertemporal objectives of any SWF that is created, but also about its direct consequences in the present.1
This chapter places SWFs within the broad context of their home economies. It analyzes the impact of SWFs in both the short and the long term and discusses how countries that choose to establish SWFs to help manage government savings can ensure that the SWFs also help them achieve their broader macroeconomic objectives. The chapter reviews relevant aspects of SWFs’ governance, transparency, relationship to other parts of the public and private sectors, and actual conduct. A key message is that the rules and provisions governing SWFs can be critical in determining their ability to make a positive impact on their home economies.
THE ROLE OF AN SWF WITHIN THE OVERALL MACROECONOMIC POLICY FRAMEWORK
In practice, SWFs have been established for a variety of reasons and in a variety of circumstances. Many were initially created for fiscal stabilization, that is, to help smooth the impact on government spending of revenues that were large and volatile, particularly revenue from the export of natural resources. Safety buffers were built up when revenues were high so that spending could be protected when times turned bad. Other SWFs were focused more specifically on protecting high revenues from being raided through populist pressures for sharp increases in spending that might prove unsustainable. But behind these motivations were often broader concerns about management of the economy as a whole. The intention was then more specifically one of macroeconomic stabilization, and in particular, of avoiding excessive pressures on the productive capacity of the economy and hence on inflation.
Another objective for the creation of SWFs was longer term: to set aside funds for the future needs of the economy, or of specific groups such as pensioners, or for future generations—a consideration particularly relevant in the case of revenues derived from exhaustible natural resources.
In addition, in many instances, a prime reason for establishing an SWF was to improve the potential return on a government’s financial investments, specifically by investing in riskier assets.2 If the foreign reserves were accrued by sterilized foreign exchange interventions, this objective amounted to reducing the carry costs of those reserves.
Many SWFs were set up with several of these objectives in mind, which tended to complicate their design and operation. For instance, for an SWF with both macroeconomic stabilization and long-term saving objectives, questions arise about the portion of its assets that can in practice be used for short-term purposes. With regard to an SWF’s asset management, short-term macroeconomic factors might require a highly liquid portfolio, while savings objectives might point to a longer-term investment strategy focusing on financial returns. Furthermore, some SWFs have been given the authority to spend directly, bypassing the budgetary process and leading to fragmentation of policy decisions regarding public expenditures.
Impact on the Domestic Economy
Regardless of the initial objectives specified for an SWF, governments need to recognize that the actions of SWFs can influence other dimensions of their economies—and sometimes even in troublesome directions. Depending on the size of assets that the SWF has under management, the economic characteristics of its owner country, and the country’s overall institutional framework, changes in an SWF’s assets, investment strategies, and operations may have substantial implications not only on public finances, but also on monetary conditions, the balance of payments, the exchange rate, domestic financial markets, and private sector balance sheets and behavior.
Because of these potentially profound implications, the government needs to specify carefully the setup and operations of the SWF and the coordination of the SWF’s policies with those of the country’s fiscal and monetary authorities, and explain these fully to the public. Among the more important aspects of the economy that can be affected by the activities of an SWF are the following:
The path of public spending. Use of an SWF’s financial assets can help insulate public expenditure from year-to-year volatility in commodity-related revenue, particularly in the presence of liquidity or borrowing constraints. However, if an SWF operates under rigid rules that, for example, require revenues to be set aside from the budget irrespective of economic conditions, the government’s ability to sustain its spending plans can be severely limited.
Aggregate demand and economic activity. By using SWF-managed assets to increase spending, or alternatively increasing SWF assets through government savings, the authorities can affect aggregate demand (that is, the overall level of spending in the economy) with a view to smoothing economic cycles. This capability can be especially important when there are large shocks to the economy and the country has few alternative sources of financing, a situation faced by many resource-revenue-dependent countries in the global financial crisis. However, rigid rules governing the rate of accumulation of assets in the SWF, or of withdrawals from it, can themselves induce substantial cyclical volatility. Domestic spending or investment in domestic assets by SWFs can also affect aggregate demand.
Monetary conditions and the exchange rate. SWF operations can have an impact on the conduct of monetary policy and on the levels of interest rates and the exchange rate. For instance, injecting liquidity into the domestic economy by using an SWF’s assets to increase public spending or invest in domestic capital markets can lead to pressures on inflation and the real exchange rate. But if the existence of an SWF means that foreign currency revenues are used to purchase foreign currency assets rather than being spent at home, the real exchange rate will appreciate less than it would otherwise, alleviating upward pressure on the nominal exchange rate, on inflation, or on both. Using an SWF to reduce the carry cost of foreign reserves may prolong the use of sterilized intervention to avoid exchange rate adjustments.
Private sector behavior. The accumulation of financial assets by the government may trigger offsetting reactions by the private sector. For instance, the private sector, observing that the wealth of the public sector is rising (and sensing that the future tax burden may be lower), may feel more confident about increasing its consumption, investment, and even risk-taking. This latter effect is even more likely if the buildup of public sector financial assets results in lower sovereign premiums in international financial markets.
The returns from public resources over time. By increasing the returns on public financial assets, SWFs may create fiscal space—room for higher spending or lower taxes—or improve the sustainability of the public finances. At the same time, however, because higher risk-taking can translate into financial losses, such investments may pose higher fiscal risks.
The vulnerability of the economy. The assets and liabilities of an SWF can have a bearing on the soundness of the balance sheet of the public sector and its solvency and debt sustainability. This is not just a question of the total net worth of the SWF, but also the composition and liquidity of its portfolio. For instance, an SWF may be required to hold assets whose value tends to move in the opposite direction from the country’s major exports to provide a hedge against country-specific risks. Conversely, SWFs based on the issuance of domestic securities to purchase foreign exchange surpluses from the private sector might cause mismatches in the overall public sector portfolio and lead to balance sheet risks.
The extent and variety of the impacts that an SWF may have on its home economy suggest the need for its owners and managers to adopt a holistic perspective on its role and how it should fit into the overall economic policy framework. The following subsection provides a systematic approach to this issue.
Types of SWFs and Overall Policy Objectives
Four principal categories of SWFs can be discerned, based on their underlying objectives. In addition to stabilization funds and long-term savings funds, there are also pension reserve funds, which are designed to explicitly provide for contingent unspecified pension liabilities from sources other than individual pension contributions, and reserve investment corporations, which are established to reduce the carry cost of foreign reserves. Somewhat different conceptually, and in the composition of their assets and behavior, are so-called development funds, which have been created to direct spending and investment toward the home economy. Of course, to complicate the picture, some SWFs have multiple objectives. Box 4.1 provides some examples of SWFs that have been established with clear single or multiple objectives.
The day-to-day functioning of an SWF is determined by its operational rules, which cover specific principles for the accumulation and withdrawal of resources (that is, when and under what conditions to make deposits or use its money); the management of its assets (for example, in which asset classes to invest and in what proportions); and provisions for the SWF’s governance, transparency, and accountability.
BOX 4.1SWFs’ Objectives: Selected Examples
Chile. Chile’s 2006 Fiscal Responsibility Law established two SWFs with clearly distinct objectives to invest the fiscal surpluses resulting from the application of Chile’s structural balance rule. The Fund for Economic and Social Stabilization was set up as a stabilization fund. The Pension Reserve Fund was created to provision for future pension liabilities of the government; the intention was to lock in its resources for 10 years so that they could subsequently help to cover a specific fraction of the increases in pension-related outlays.
Azerbaijan. The State Oil Fund of the Republic of Azerbaijan has multiple objectives: savings, stabilization, and development. A cornerstone of the SWF is to provide for inter-generational equality with regard to benefit from the country’s oil wealth. But the SWF is also charged with improving the economic well-being of the current population, including assisting in economic management. The SWF’s assets may also be used for undertaking domestic projects, including construction or reconstruction of infrastructure or projects considered strategically important.
The Republic of Korea. Korea Investment Corporation has a single objective in managing the nation’s assets, but it is also expected to contribute to the development of the local asset-management industry. It was created as a reserve investment corporation, a specialized investment management company to manage part of the country’s foreign exchange reserves and other public funds.
Norway. Renamed the Government Pension Fund–Global in 2006, Norway’s long-term savings fund was established in 1990 as a fiscal policy tool to support long-term management of petroleum revenues. While its assets are not specifically earmarked for pension expenditures, its current title reflects the need to facilitate government savings to meet the rapid rise in public pension expenditures in the coming years. The clarity of its savings objective was underlined by the decision not to use its assets for stabilization spending when Norway adopted a large fiscal stimulus package in late 2008. However, inflows into the SWF were reduced by changes in the overall fiscal stance.
Devising operational rules for SWFs that help to achieve their objectives—without complicating the country’s economic management—is not straightforward. For a start, although SWFs are set up to make the best use of government savings, they are not the only players. Governments that are able to borrow from other sources while also accumulating funds in an SWF can determine the level of their net savings independently of any rules set for the SWF. This simple fact has undermined the effectiveness of many commodity-based SWFs. One mistake has been to set rigid rules for the accumulation and withdrawal of funds by the SWFs in the expectation that siphoning off some large and volatile government revenues into the SWF, and refusing to allow them to be spent in the short term, would help reduce fiscal policy discretion and moderate government expenditure. The reality has often been either that governments have simply found other ways to finance their spending—particularly because their ability to borrow may have been strengthened by the buildup of assets in the SWF—or have resorted to changing or circumventing the rules of the SWF to give themselves the flexibility to conduct short-term fiscal management. These considerations highlight the problems of conceiving the SWF as an independent instrument of fiscal policy rather than simply as a medium to manage part of the government’s net worth.
An SWF’s operational rules need to allow it to function effectively within an appropriate overall government-wide framework for economic management. Therefore, clear and stable functional guidelines for an SWF should allow it both flexibility in its conduct and assured coordination with the economic authorities. One way of harnessing these principles is for the SWF to link its operational rules explicitly and transparently with the government’s broader fiscal policy framework. In Norway and Timor-Leste, for example, flows in and out of the oil SWFs depend on oil revenue and policy decisions embodied in each country’s non-oil fiscal stance. Thus, changes in the net assets held by the SWFs correspond to changes in the overall net financial asset position of the government. For such “financing funds,” assets are accumulated as long as surpluses in government finances continue.
No operational framework for an SWF can effectively overcome fundamental flaws in a government’s overall economic policy framework. Indeed, weak policy and institutional frameworks or a defective political process can actually impede the proper functioning of an SWF. Although in a few cases it has been argued that the creation of an SWF with separate procedures and controls might yield better results than a weak public financial management system, little tangible evidence indicates that such “islands of excellence” work in practice. (See discussion in Ossowski and others, 2008.) Moreover, scarce resources may simply be diverted from improving the national public financial management system. Similarly, the argument that an SWF can be useful in resisting spending pressures relies more on the notion of “putting sand in the wheels” than on raising the standard of public financial management.
Rigid operational rules can also become outdated if underlying conditions change, particularly for commodity-based SWFs, because the volatility of commodity prices and revenues may change the relative importance of the SWF to the economy over time. Indeed, international experience shows that many oil SWFs with relatively rigid operational rules have had to change, bypass, or eliminate them in response to significant exogenous changes, shifting policy priorities, or increased spending pressures, or because of broader asset and liability management objectives.3
The 2007–09 global financial crisis offers a clear example of sharp changes in economic policy objectives requiring a flexible framework for the management of SWFs. In response to the need for additional finance for public schemes to bolster their economies and support financial institutions, many governments turned to their SWFs. This resulted in a change in the focus of some SWFs (see Box 4.2) and a consequent blurring of institutional roles. By undertaking activities that would previously have been the responsibility of the government or other public sector entities, these SWFs were deflected from pursuing the financial objectives originally set for them. Changing objectives can also affect the governance arrangements for SWFs and complicate their accountability to their owner governments.
BOX 4.2SWFs and the Global Financial Crisis
The involvement of SWFs in government initiatives to tackle the global financial crisis has been quite varied:
In the Russian Federation and Kazakhstan, resources from SWFs were used to support domestic financial systems through third parties (a development bank and a distressed asset fund, respectively) tasked to deal with domestic institutions directly. For that purpose, the investment rules of SWFs were changed to allow them to acquire sizable long-term deposits and bonds of those government entities. Although helping to address critical policy needs, those investments directly exposed the balance sheets of SWFs to the risks of the governments’ intervention and potential quasi-fiscal losses.
In Kuwait and Qatar, the Kuwait Investment Authority and Qatar Investment Authority are allowed to, and have been, directly investing in domestic financial institutions as part of their governments’ strategies to support their financial systems in light of the global financial crisis.
By contrast, in Norway, the Government Pension Fund–Global has not had a role in financing government measures explicitly aimed at assisting the financial system.
These events highlight the challenge of designing frameworks and rules that can withstand time and changes in situations and the importance of ensuring consistency between broader economic policy objectives and SWFs’ operational objectives. They provide a strong argument in favor of “financing SWFs,” for which changes in asset accumulation are explicitly driven by the conduct of fiscal policy.
An SWF’s operational rules can also be critically important for macroeconomic policy if the SWF is permitted to spend its resources directly. This is especially true for SWFs that describe themselves as development funds. Direct spending by such an SWF may, for example, provide welfare services, finance public prestige projects, help local communities, or be used to invest in private development activities. One motivation for involving the SWF in these actions may be to satisfy a political requirement to show how the revenue from natural resources is being spent. However, if such direct spending is not coordinated with regular budgetary institutions, it can seriously affect the integrity of the budget process and lead to fragmentation of policymaking. In these circumstances, governments may lose effective control over public sector expenditure, and the efficient allocation of resources may be impeded because of a decline in prioritization of resources among different needs.
Relationship to the National Budget
In principle, the national budget should be the key institution for setting and implementing public policies and priorities. Therefore, the growing practice among countries with SWFs has been to limit the ability of the SWFs to spend their resources outside the government’s budget framework. In Chile, Norway, and Timor-Leste, the resources of the oil SWFs can only be used through the budget. In other countries, such as Azerbaijan, the budget of the oil SWF is prepared in consultation with the Ministry of Finance and, to encourage the transparent and efficient allocation of public resources, the documentation submitted to parliament at the time of the annual budget records all direct SWF spending.
However, fiscal policy management can be complicated if transfers from SWFs to the budget are earmarked for specific purposes, such as spending in priority areas.4 Such provisions generally reduce the flexibility of public finances to adjust to changing conditions or priorities, complicate liquidity management, and affect the efficiency of government spending. They can also result in offsetting actions being taken by the government, such as borrowing to finance other spending.
Monetary and Exchange Rate Policies
The monitoring of SWFs’ operations by monetary authorities can be critical because SWFs can have an impact on the conduct of monetary policy and on the levels of interest rates and the effective exchange rate through the injection or withdrawal of liquidity in the domestic economy. Operations by reserve investment corporations (or any SWF that has some counterpart sovereign debt) deserve special emphasis because they bring to the surface more strategic policy considerations. By improving the likely financial returns on foreign exchange reserves, reserve investment corporations reduce the expected carry costs of sterilized foreign exchange interventions. This may tempt the authorities to prolong the use of such interventions to delay adjustment in the real exchange rate. A further twist may be added to this spiral by the growing currency mismatch it produces (short domestic and long foreign currency), which will make future currency appreciation increasingly costly.
Economic Policy Coordination
Depending on the type of institutional arrangement chosen for the SWF, mechanisms may need to be established to ensure appropriate coordination with the fiscal and monetary authorities. For SWFs established simply as central government accounts managed by the central bank (as in Norway and Kazakhstan), or as agencies managing international reserves under the government’s direction (Government of Singapore Investment Corporation, Korea Investment Corporation), the SWFs themselves may have little independent impact on fiscal and economic management. However, SWFs set up as separate public entities (Temasek in Singapore, Kuwait Investment Authority), with or without authority to undertake off-budget expenditure and maintain their own sources of revenue, are likely to need specific coordination mechanisms. At a broad level, the SWF’s legal framework and corporate governance arrangements can help to frame the institutional relationships between the SWF, the government, and the central bank. But clear guidelines should also direct any large operations of the SWF involving intervention in foreign exchange markets or domestic market operations, including coordination with the monetary authorities.
Economic policy coordination can also be complicated by blurred institutional roles for an SWF. If, for example, an SWF provides subsidies, or undertakes other quasi-fiscal activities, it can obscure the impact and extent of government operations.
Use of SWF resources to invest in domestic markets raises a range of additional economic and governance issues. With regard to potential macroeconomic impact, particularly if SWFs are funded from foreign exchange sources, such operations may have an impact on interest rates, the real exchange rate, and the relative prices of securities. From a market perspective, a critical question is whether the SWF is able to invest purely on commercial grounds, or whether it will be much more susceptible to political or ethical pressures than when investing overseas. Considerations of portfolio diversification, or helping to develop deeper domestic capital markets, may also motivate investment in home markets. From a fiscal perspective, a more complex issue is whether some domestic transactions by SWFs should be considered government spending rather than financial investment. Some transactions clearly fall in this category, including transfers, subsidies, and investment in physical capital. But others may be more difficult to identify. For example, some investments may turn out to be profitable, but may have been undertaken initially because of a strong policy motive. Ideally, the quasi-fiscal activities inherent in such investments should be quantified and reflected separately in budget documentation and fiscal accounts.
Fiscal Risks and the Public Sector’s Balance Sheet
In assessing the sustainability of a government’s fiscal plans, not only must realistic central projections of spending, revenues, and deficits be considered, but also the probability and size of potential deviations from these projections. Given the inherent uncertainties about the likely returns from an SWF, and any potential liabilities held on the SWF’s balance sheet, it is crucial that risks associated with an SWF be taken into account when assessing the net worth of the public sector’s balance sheet.
Of course, SWFs are generally created to reduce the potential impact on the economy of fiscal risks. For example, commodity-related SWFs are designed to help manage revenue volatility and protect the value of financial savings for future needs (e.g., depletion of oil reserves or pension liabilities). But SWFs can be sources of risks, too. Judging by the experiences of some small Pacific Island countries, SWFs can easily create fiscal risks if they accumulate riskier and more volatile investments in a drive for increased financial returns (see Le Borgne and Medas, 2007).
Specific financial risks such as currency, interest rate, and maturity risks become relevant if SWFs undertake leveraged operations, invest in derivatives, or finance foreign currency assets through domestic sterilization operations. Currency mismatches (short domestic and long foreign currency positions) can have sizable costs if the underlying exchange rate policy proves unsustainable.
One particular element that became more critical in the recent global financial crisis was the degree of liquidity of SWFs’ financial assets. Given the extent and speed of the crisis, governments were faced with the prospect of requiring SWFs to realize short-term capital losses to compensate for large government revenue shortfalls or to support the domestic financial system. This focused attention on the underlying tensions between an SWF’s liquidity and its potential returns, and between protecting its assets and supporting the domestic economy. As a result, more countries are accepting the need to approach SWFs from a holistic perspective, which may lead to a reconsideration of the objectives of some SWFs. In such circumstances, their degrees of liquidity and risk-taking are likely to change, with direct consequences for their original investment strategies and policies.
Implications for Asset-Liability Management
Both the underlying objectives of an SWF and the various risks mentioned above need to be considered when designing the SWF’s asset-liability management framework and its strategic asset allocation (SAA). Some basic principles are stressed here (and discussed extensively in Chapters 10–12 of this book):
Different objectives generally require different SAAs. Stabilization SWFs should generally have conservative SAAs, using shorter investment horizons and low risk-return profiles, or other instruments that vary inversely with the risk the SWF is meant to cover. The same rationale could apply in a country that is highly dependent on the returns on SWF assets.5 By contrast, SWFs with long-term objectives, such as savings funds, may seek to maximize returns while also aiming to preserve a certain amount of capital, in real terms, so that the purchasing power of the SWFs is guaranteed. Therefore, they may have longer investment horizons and riskier investment strategies.
Risks from reversal of the original conditions leading to the accumulation of assets in an SWF need to be considered in defining appropriate investment horizons and risk tolerance. For instance, many SWFs are funded by volatile, and in some cases exhaustible, commodity revenue, making the SWFs only temporary vehicles.
SWFs with explicit (or even implicit) liabilities should develop SAAs and investment guidelines aimed at preserving the soundness of their balance sheets in the face of portfolio mismatches. Inappropriate asset-liability management in this context could result in losses with macroeconomic implications, particularly for reserve investment corporations with large currency mismatches associated with sterilized foreign exchange interventions.
Accounting for an SWF
Regardless of its legal form, an SWF is first and foremost a guardian of public financial assets. SWFs can also provide the scope and means through which fiscal action can be taken. So no representation of a sovereign’s balance sheet, income, or expenses is complete without full recognition of the size and performance of the assets (and liabilities) being managed or controlled by the SWF and the sources and uses of its funds. Such disclosure does not in any way compromise the institutional independence of an SWF.
In many cases, consolidating the activities of an SWF within the sovereign’s balance sheet and income and expenditure statements is fairly straightforward. No complications are likely if the SWF is an account managed by the central bank, or is permitted only to receive funding or make transfers through the national budget. However, consolidation can be more complex if an SWF receives inflows directly from revenue sources (e.g., a company’s payments of oil royalties) or makes payments for goods and services outside the national budget. Such transactions need to be fully and separately identified so that they can be assigned to the appropriate components of the government’s accounts. The same considerations apply to interest and dividends earned by an SWF, regardless of whether they are in practice retained and reinvested by the SWF. Even for an SWF that functions legally as a public corporation, a strong case can be made for it to produce accounts that consolidate its activities within the government because of its custodial role.
At the same time, it is also important to report separately an SWF’s individual contributions to aggregate demand, national savings, and investment to highlight its importance to economic management and to improve the quality of fiscal analysis and coordination of economic policy. An SWF’s own financial statements and accounts, which should be independently audited and published, needs to clearly disclose all sources and beneficiaries of income and spending, including other parts of the public sector.
To be an effective instrument for economic management, an SWF needs to be perceived by the public as responsible and relevant. Transparency often provides the key to developing this perception. For example, being open and clear about its operations shows that an SWF is fully answerable for the government savings that it handles. Published reports on its performance demonstrate accountability for the objectives set by its owner government. And disclosure of its governance structure and integrity standards provides assurance that political or personal motivations are not undermining its effectiveness.
It is occasionally argued that disclosure of an SWF’s assets and operations could generate excessive public pressure to spend some of the resources, or focus attention too much on the SWF’s short-term performance. But these are minor risks compared with the problems that can be created by hiding such information. Ignorance about a country’s financial wealth or the governance of its assets can undermine public confidence in its economic policies by generating unrealistic expectations about the country’s capacity to support its citizens or suspicions about the honesty and effectiveness of its wealth management.
In many respects, the transparency requirements for an SWF are similar to those for other entities responsible for government functions, which are summarized in guidelines published by the IMF and the Organisation for Economic Co-operation and Development.6 Particularly relevant to SWFs are provisions dealing with holdings of government assets and the reporting of revenues and expenditures. The need for comprehensive disclosure of information about the size and types of financial assets and the gross flows of revenue and spending is especially stressed.
The IMF “Code of Good Practices on Fiscal Transparency” also emphasizes the need to clearly specify roles and responsibilities for the holding of financial assets, implying the need for legal frameworks and regulatory documents that include an unambiguous statement of an SWF’s objectives and mechanisms for ensuring accountability (IMF, 2007b). Equally important is to have clear and publicly accessible corporate governance arrangements that frame the SWF’s relationships with other institutions, including coordination of fiscal, monetary, and exchange rate policy, and asset-liability management. Operational rules and the asset management strategy should be made public.
Accessibility and timeliness of information are important aspects of fiscal accountability. For an SWF, this entails regular publication of audited balance sheets and operations and performance statements. Details of the SWF’s revenue, borrowing, spending, and performance should also be provided in the government’s budget documentation.
This chapter concludes with some lessons for the proper design of an SWF. As discussed, the operations of SWFs can be wide-reaching, influencing many dimensions of an SWF’s own economy. Public finances, monetary conditions, the balance of payments, the exchange rate, domestic financial markets, and private sector balance sheets and behavior can all be affected by an SWF. So, while a well-designed SWF operating under clear and flexible rules in good coordination with the macroeconomic authorities can be a valuable instrument in helping to maintain economic stability, a poorly designed one can be a source of disruption and instability.
Operational rules for SWFs need to be consistent with the overall macrofiscal policy framework and permit flexibility in the face of changes in underlying conditions. International experience shows that many oil SWFs with relatively rigid operational rules have had to change, bypass, or eliminate those rules in response to significant exogenous changes, shifting policy priorities, or increased spending pressures, or because of broader asset and liability management objectives. This argues for a better balance in operational rules between sufficient firmness to prevent the SWF being raided for short-term political considerations and sufficient flexibility to accommodate the requirements of macroeconomic management. Financing funds largely avoid these problems because the government’s fiscal position (the overall fiscal balance) itself determines net flows into the fund.
SWFs should have no or minimal ability to spend their resources directly. Ensuring that all spending of an SWF’s resources is conducted transparently through the budget prevents fragmented fiscal policymaking and allows for a more efficient allocation of resources. This also applies to any intervention by an SWF in the domestic economy: to the extent that such intervention entails a subsidy or other form of quasi-fiscal activity by the SWF, it would be better for it to make an explicit transfer to the relevant government entity. By the same token, earmarking withdrawals from SWFs should be discouraged because such earmarking generally reduces the flexibility of the public finances to adjust to changing conditions or priorities and complicates liquidity management.
Using SWF resources to invest in domestic markets raises complex economic and governance issues. From a macroeconomic perspective, particularly if an SWF obtains funds from foreign exchange sources, buying domestic financial assets could have an impact on interest rates, the real exchange rate, and the prices of securities. The investments might also be more susceptible to political or ethical pressures.
Mechanisms may need to be established to ensure appropriate economic policy coordination. An SWF should work closely with—under clear operational guidelines—government entities charged with implementing fiscal, monetary, and exchange rate policies. The precise arrangements for that working relationship will depend on the type of institutional arrangement chosen for the SWF.
The underlying objectives of an SWF, as well as potential fiscal risks, need to be taken into account in determining its asset-liability management framework and its SAA; and these objectives and risks should be clearly disclosed. Basic principles in this regard include the need to adapt the SAAs to different objectives, robustly define investment horizons and risk tolerance, and ensure that SAAs and investment guidelines for SWFs protect balance sheet soundness in the face of explicit (or even implicit) liabilities. This is particularly applicable to reserve investment corporations with large currency mismatches associated with sterilized foreign exchange interventions.
Transparency is a key factor in ensuring that an SWF supports the objectives of its owner government. Transparency underpins accountability and public trust. A nation’s balance sheets, and its income and expenses, need to fully recognize the size and performance of the assets (and liabilities) being managed or controlled by the SWF, and the sources and uses of its funds. The identification of an SWF’s contributions to aggregate demand, national savings, and investment will help to highlight its importance to economic management and to improving the quality of fiscal analysis and coordination of economic policy.
DavisJ. and others2001“Stabilization and Savings Funds for Nonrenewable Resources: Experiences and Fiscal Policy Implications” IMF Occasional Paper 205 (Washington: International Monetary Fund).
International Monetary Fund2007aGuide on Resource Revenue Transparency (Washington). Available via the Internet: http://www.imf.org/external/np/fad/trans/guide.htm.
International Monetary Fund2007bManual on Fiscal Transparency (Washington). Available via the Internet: http://www.imf.org/external/np/fad/trans/manual.htm.
LeBorgneEric and PauloMedas2007“Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages,”IMF Working Paper 07/297 (Washington: International Monetary Fund).
Organisation for Economic Co-operation and Development2002“OECD Best Practices for Budget Transparency” (Paris: OECD). Available via the Internet: http://www.oecd.org/dataoecd/33/13/1905258.pdf.
Many of these issues are covered in depth in the IMF “Guide on Resource Revenue Transparency” (IMF, 2007a).
The contention that setting aside financial savings in an SWF will necessarily enhance or maximize returns to the government (and the economy at large) is, nevertheless, often disputed. In countries where governments are liquidity constrained, and social and infrastructure needs are sizable, net returns to the economy from social spending and public investment may exceed those of (foreign currency) financial assets.
Many oil stabilization funds have or have had price- or revenue-contingent deposit or withdrawal rules (e.g., Algeria, the Islamic Republic of Iran, Libya, Mexico, the Russian Federation, Trinidad and Tobago, and República Bolivariana de Venezuela). Most savings funds are revenue-share funds, in which a predetermined share of oil or total revenues is deposited in the SWF (e.g., Equatorial Guinea, Gabon, and Kuwait). Ossowski and others (2008) provide examples of SWFs for which rules were changed. The SWFs in the U.S. state of Alaska, the Canadian province of Alberta, and Papua New Guinea in the 1980s and 1990s, and more recently, the SWFs in Kazakhstan, the Russian Federation, and Trinidad and Tobago, are cited as examples of frequent changes in operational rules in response to changes in oil prices. In addition, Chad, Ecuador, and Papua New Guinea are highlighted as cases in which SWFs were abolished because they were found to be operationally or politically unworkable.
In some cases, such earmarking provisions have derived from political economy considerations, such as creating a constituency supportive of the oil SWF (e.g., Alaska). This can make it easier to resist political pressures to use oil revenues inappropriately, or (as in Azerbaijan, Chad, and Ecuador) to prioritize resources for special purposes, such as poverty reduction or debt service.
This is a critical lesson from the study by Le Borgne and Medas (2007) on the operation of SWFs in Pacific Island countries, where weak asset management led to substantial financial losses and severely jeopardized fiscal sustainability.