Abstract
This Selected Issues paper examines the acceleration of inflation over the past year in Chile, identifying domestic shocks to food and energy prices as main drivers. The paper uses the Jeanne-Rancière model to calculate Chile’s optimal ratio of international reserves to GDP. It analyzes the stabilization properties of Chile’s macroeconomic framework and compares it with alternative policy rules. The paper concludes that Chile’s framework based on an explicit inflation target, a floating exchange rate, and a structural fiscal surplus rule is superior to other arrangements.
V. Chile’s Sovereign Wealth Funds: An International Perspective1
Following the accumulation of large fiscal surpluses, Chile has established two sovereign wealth funds (SWFs) to partly finance future pension expenditure and maintain general government spending in case of an economic downturn. While maintaining a conservative investment policy, the government is developing a strategic asset allocation framework to increase the returns available to the annual budget, which in turn provides room for higher spending on priority needs.
A. Domestic Background
1. Chile’s macroeconomic policy framework is anchored by the structural fiscal surplus rule. The rule sets a spending ceiling for each year consistent with a long-run surplus target of ½ percent of GDP. Expenditure is based on structural, rather than actual revenues, taking into account estimates of potential GDP to calculate nonmining tax revenue, and long-term average prices for copper and molybdenum to estimate structural mining revenues.
2. The substantial accumulation of assets by the public sector is a natural outgrowth of that policy when mining revenues are high. In order to smooth government spending, the government saves surpluses in excess of the structural target in the Fund for Economic and Social Stabilization (FESS) to be used when revenues slow. It is thus to be expected that the government accumulates assets during periods of high copper prices, with income earned from those assets adding to structural revenue. These assets are available to finance government spending during a downturn, but given the significant increase in the size of the FESS, it is now being managed as a Sovereign Wealth Fund.
3. Indeed, tying FESS contributions to budget surpluses rather than mineral revenues sets the FESS apart from practices in other countries. In Norway, for example, all oil revenue is deposited into the country’s Pension Fund, and withdrawals are set under an institutionalized framework. In Chile, the surplus rule imposes that not only copper revenue, but all revenues beyond the structural surplus target are saved in the FESS.
4. The government has also created an SWF to finance part of the pension reform that was passed by Congress this year. The new system guarantees a pension to all retirees, although the public pension benefit is reduced for those with larger self-financed pensions. While the inherently private character of the old system is retained, the new system does introduce a moderate long-term fiscal liability, which the government plans to address in part through the Pension Reserve Fund (PRF) and new mechanisms for measuring pension risks.
5. Chile’s SWFs are thus an integral part of the macroeconomic framework. In 2006, the government strengthened the fiscal framework by establishing the PRF and FESS, and apportioning future fiscal surpluses between the two.2 The fiscal rule is designed to smooth government expenditure across the business cycle, providing for a counter-cyclical fiscal stance, and the government’s decision to invest SWFs abroad supports this objective by reducing exchange rate volatility and avoiding Dutch disease.
B. International Practices
6. Recent shifts in the world economy have increased the number and size of SWFs. Some of the longer-established SWFs, e.g., those of Kuwait, Abu Dhabi, and Singapore, have existed for decades (Table 1). However, following the Asian financial crisis, many emerging market countries have increased stocks of international reserves, a trend strengthened by high commodity prices and global imbalances.
Market Estimates of Assets Under Management for SWFs
Based on Latest Available Information (As of February 2008)
(In billions of U.S. dollars)
Part of the investment tranches of these countries’ central banks.
Market Estimates of Assets Under Management for SWFs
Based on Latest Available Information (As of February 2008)
(In billions of U.S. dollars)
| Name of Fund | Assets (range) | |||
|---|---|---|---|---|
| Lower | Upper | |||
| I. Oil and Gas Exporting Countries | ||||
| UAE | Abu Dhabi Investment Authority | 250 | 875 | |
| Norway | Government Pension Fund-Global | 380 | 380 | |
| Saudi Arabia 1/ | No designated name | 289 | 289 | |
| Kuwait | Reserve Fund for the Future Generations/Government Reserve Fund | 213 | 213 | |
| Russia | Reserve Fund | 125 | 125 | |
| National Welfare Fund | 32 | 32 | ||
| Libya | Libyan Investment Authority | 50 | 50 | |
| Qatar | State Reserve Fund/Stabilization fund | 30 | 50 | |
| Algeria | Reserve Fund/Revenue Regulation Fund | 43 | 43 | |
| USA (Alaska) | Alaska Permanent Reserve Fund | 40 | 40 | |
| Brunei | Brunei Investment Authority | 30 | 30 | |
| Kazakhstan | National Fund | 21 | 21 | |
| Malaysia | Khazanah Nasional BHD | 19 | 19 | |
| Canada | Alberta Heritage Savings Trust Fund | 16 | 16 | |
| Nigeria | Excess Crude Account | 11 | 11 | |
| Iran | Foreign Exchange Reserve Fund | 9 | 9 | |
| Azerbaijan | State Oil Fund | 2.5 | 2.5 | |
| Oman | State General Reserve Fund | 2 | 2 | |
| Timor-Leste | Petroleum Fund of Timor-Leste | 1.4 | 1.4 | |
| Venezuela | FIEM | 0.8 | 0.8 | |
| Trinidad & Tobago | Revenue Stabilization Fund | 0.5 | 0.5 | |
| II. Asian Exporters | ||||
| Singapore | Government Investment Corp. | 100 | 330 | |
| China | State Foreign Exchange Investment Co. | 200 | 200 | |
| Singapore | Temasek | 108 | 108 | |
| Hong Kong | Investment Portfolio (HKMA) | 100 | 100 | |
| Korea | Korea Investment Corp. | 30 | 30 | |
| Taiwan, Province of China | National Stabilisation Fund | 15 | 15 | |
| III. Other Countries | ||||
| Australia | Australian Future Fund | 54 | 54 | |
| Chile | FEES and Pension Reserve Fund | 19 | 19 | |
| Botswana 1/ | Pula Fund | 4.7 | 4.7 | |
| Kiribati | Revenue Equalization Fund | 0.4 | 0.4 | |
| Total | 2,191 | 3,066 | ||
Part of the investment tranches of these countries’ central banks.
Market Estimates of Assets Under Management for SWFs
Based on Latest Available Information (As of February 2008)
(In billions of U.S. dollars)
| Name of Fund | Assets (range) | |||
|---|---|---|---|---|
| Lower | Upper | |||
| I. Oil and Gas Exporting Countries | ||||
| UAE | Abu Dhabi Investment Authority | 250 | 875 | |
| Norway | Government Pension Fund-Global | 380 | 380 | |
| Saudi Arabia 1/ | No designated name | 289 | 289 | |
| Kuwait | Reserve Fund for the Future Generations/Government Reserve Fund | 213 | 213 | |
| Russia | Reserve Fund | 125 | 125 | |
| National Welfare Fund | 32 | 32 | ||
| Libya | Libyan Investment Authority | 50 | 50 | |
| Qatar | State Reserve Fund/Stabilization fund | 30 | 50 | |
| Algeria | Reserve Fund/Revenue Regulation Fund | 43 | 43 | |
| USA (Alaska) | Alaska Permanent Reserve Fund | 40 | 40 | |
| Brunei | Brunei Investment Authority | 30 | 30 | |
| Kazakhstan | National Fund | 21 | 21 | |
| Malaysia | Khazanah Nasional BHD | 19 | 19 | |
| Canada | Alberta Heritage Savings Trust Fund | 16 | 16 | |
| Nigeria | Excess Crude Account | 11 | 11 | |
| Iran | Foreign Exchange Reserve Fund | 9 | 9 | |
| Azerbaijan | State Oil Fund | 2.5 | 2.5 | |
| Oman | State General Reserve Fund | 2 | 2 | |
| Timor-Leste | Petroleum Fund of Timor-Leste | 1.4 | 1.4 | |
| Venezuela | FIEM | 0.8 | 0.8 | |
| Trinidad & Tobago | Revenue Stabilization Fund | 0.5 | 0.5 | |
| II. Asian Exporters | ||||
| Singapore | Government Investment Corp. | 100 | 330 | |
| China | State Foreign Exchange Investment Co. | 200 | 200 | |
| Singapore | Temasek | 108 | 108 | |
| Hong Kong | Investment Portfolio (HKMA) | 100 | 100 | |
| Korea | Korea Investment Corp. | 30 | 30 | |
| Taiwan, Province of China | National Stabilisation Fund | 15 | 15 | |
| III. Other Countries | ||||
| Australia | Australian Future Fund | 54 | 54 | |
| Chile | FEES and Pension Reserve Fund | 19 | 19 | |
| Botswana 1/ | Pula Fund | 4.7 | 4.7 | |
| Kiribati | Revenue Equalization Fund | 0.4 | 0.4 | |
| Total | 2,191 | 3,066 | ||
Part of the investment tranches of these countries’ central banks.
7. There are varying rationales for the establishment of SWFs. An often found rationale is to transform nonrenewable resources into sustainable and more stable future income. Saving commodity revenue can help avoid boom-bust cycles and spread the benefits of commodity wealth across generations. Indeed, most SWFs today reflect these motives. Oil-exporting countries own 23 of the 38 SWFs identified by the IMF, holding around 72 percent of all SWF assets. Two other motives for establishing SWFs are to balance the significant costs associated with excessive reserves accumulation (such funds are estimated to hold around 20 percent of SWF assets) and the need to secure future welfare obligations.
8. SWFs invest in a broad variety of assets, depending on individual objectives. For countries with reserves pools in excess of immediate central bank liquidity needs, creating a separate SWF can allow some monies to be managed with higher returns to compensate part of the cost of maintaining large liquidity stocks. Other SWFs are managed for income purposes, and may invest across all major asset classes, including alternative investments. The evidence suggests that, in general, SWFs act like long-term investors that have no desire to impact company decisions by actively using their voting rights.
9. Most SWFs employ external expertise. While public sector investment managers (such as reserve managers) have significant experience in fixed-income markets, they often have limited capacity for investment in other asset classes. SWFs thus often rely on external fund managers to implement investment decisions in areas where their own capacity is limited. This is true for funds that pursue aggressive investment strategies (such as private equity) as well as for those that pursue more passive equity-index strategies. Some large SWFs (e.g., Norway, Abu Dhabi, and Singapore) have highly professional in-house investment managers, and are thus able to rely less on external managers.3
C. Rules and Institutionality: How does Chile compare?
Asset Allocation
10. Chile’s SWFs have been invested relatively conservatively. The PRF and the FESS at present are both invested in cash and sovereign securities (Table 2). Most other SWFs invest heavily in equities and riskier fixed-income securities, and quite a few invest in private equity, or take large shares in companies, both of which have been excluded as investment categories by the Chilean authorities.
Asset Allocation of Chile’s Sovereign Wealth Funds
(in percent of total assets)
Asset Allocation of Chile’s Sovereign Wealth Funds
(in percent of total assets)
| Current | End-2008 Target | |
|---|---|---|
| Sovereign Bonds (Nominal) | 66.5 | 45 |
| Sovereign Bonds (Inflation-Indexed) | 3.5 | 15 |
| Money Market Assets | 30 | 5 |
| Corporate Bonds | 20 | |
| Equities | 15 | |
| Total | 100 | 100 |
Asset Allocation of Chile’s Sovereign Wealth Funds
(in percent of total assets)
| Current | End-2008 Target | |
|---|---|---|
| Sovereign Bonds (Nominal) | 66.5 | 45 |
| Sovereign Bonds (Inflation-Indexed) | 3.5 | 15 |
| Money Market Assets | 30 | 5 |
| Corporate Bonds | 20 | |
| Equities | 15 | |
| Total | 100 | 100 |
11. Both the PRF and the FESS are moving toward a strategic asset allocation (SAA) framework. Higher returns are the primary objective of moving from a very conservative and liquid portfolio of sovereign bonds and cash to a slightly more return-oriented portfolio. The authorities have proposed a new allocation for end-2008 which would invest both funds in a wider variety of securities, and are developing a framework for the optimization of the long-term SAA for both funds taking into account Chile’s overall macroeconomic position.
12. Nevertheless, the FESS will remain more conservative than other stabilization funds. Similar to oil-rich nations such as Saudi Arabia and the U.A.E., Chile’s stabilization fund is small relative to its unextracted natural resources. This argues for an SAA focused mostly on maximizing asset returns within an acceptable level of risk. However, Chile’s policy of investing only in publicly traded securities will continue to separate it from larger funds such as those of Abu Dhabi and Singapore, which also engage in private-equity transactions.
13. The PRF’s objective relates to future pension liabilities. PRF resources are intended to be used on specific pension liabilities, which argues for managing the assets such that the government has access to the required liquidity when the liabilities come due. Most other national pension funds are invested in long-term domestic securities. Given Chile’s decision to invest PRF funds abroad, one option would be for the fund to invest in fixed-income securities denominated in currencies that co-move with the peso, such as those of other natural resource exporters.
Management of Chile’s SWFs
14. While both SWFs are public assets, they are operationally managed by the Central Bank. The Banco Central de Chile (BCC) has signed an agreement with the Ministry of Finance to manage both funds as a fiscal agent. The Ministry of Finance has sent investment instructions to the BCC, which implements the investments. Decisions about disbursements from the funds are made by the Ministry of Finance, but decisions about investment choices within the government’s investment instructions are being made by the BCC.
15. Chile’s SWFs are being managed transparently, and the government is committed to best practices in this area. The authorities publish monthly reports on the size and portfolio composition of both funds, and more extensive quarterly reports discussing performance relative to financial market developments and established benchmarks. Moreover, both the authorities and its Financial Advisory Committee (FAC) are committed to public discussion of the funds’ strategies, and all asset income and use of PRF and FESS assets are included in the annual budget.4 As stated above, Chile is also committed to the development and implementation of GAPP.
D. Outlook
Pension Reserve Fund
16. The PRF can be used to directly finance pension expenditure beginning in 2016. To protect the PRF’s principal, however, disbursements from the PRF will be capped at one third of the increase in pension spending after 2015. Assuming future pension costs evolve according to the authorities’ baseline forecast, staff estimates that the PRF will eventually be able to cover one quarter of the additional expenditure incurred by the new pension system.
17. According to staff calculations, the PRF will remain well-capitalized in the medium term. Staff estimates that the ceiling on PRF outflows will remain below 0.15 percent of GDP for the next twenty years. These amounts would be greatly exceeded by the annual surplus transfers, leading to continued accumulation during this period, from about 1¼ percent of GDP at end-2008 to around 5½ percent of GDP in 2020.
Fund for Economic and Social Stabilization
18. With macroeconomic stabilization its primary objective, the FESS should be in a position to finance government expenditure even under a sharp decline in revenues. An optimal asset allocation for the FESS will have to take into account the uncertainty regarding future economic and financial developments. However, with the FESS approaching 13 percent of GDP by end-2008, the fund provides a comfortable insurance level for Chile’s medium-term liquidity needs.
19. Staff analysis confirms that the authorities have room to invest the FESS into assets with longer duration. Simulations on the basis of a VAR model allowing for global shocks confirms that a significant portion of the FESS is unlikely to be drawn down over the next 15-20 years, and can therefore be invested in assets with longer duration. This finding is also consistent with the government’s decision to set aside US$6 billion (3¾ percent of GDP) in a Bicentennial Fund, and to change the investment policy towards new asset classes and a much longer duration. All revenues related to the Bicentennial Fund would count as structural revenue, and are to be used to provide for scholarships of Chilean students abroad.
20. In the long run, however, the FESS would be expected to stabilize relative to GDP. The structural fiscal surplus target of ½ percent of GDP corresponds to a steady-state level of both SWFs (that is, the sum of FESS and PRF) of around 6 percent of GDP.5 Therefore, while Chile’s SWFs are likely to continue to grow in the medium-term as long as copper prices remain high, the structural surplus rule sets an implicit limit on their long-term size.
Prepared by James P. Walsh, Michael Papaioannou, Manmohan Singh (both MCM), and Eugen Tereanu.
Under the 2006 Fiscal Responsibility Law, the first ½ percent of GDP in budget surpluses accrues to the PRF. Remaining surpluses are banked in the FESS, although the government may choose to recapitalize the Central Bank with up to ½ percent of GDP until 2011.
The IMF and Chile are part of a broad effort to draft a set of voluntary generally accepted principles and practices (GAPP) for SWFs. Issues to be addressed include legal practices, coordination with macroeconomic policies, institutional framework, governance structure, transparency and accountability, and risk management.
An additional example of transparency has been the recent release of the FAC’s Annual Report that discusses the rationale for changing the investment policy of the funds (see http://www.hacienda.cl/fondos).
The long-term asset stock of the FESS (f) is f = b/ã, where b is the fiscal surplus target (½ percent of GDP) and ã the assumed trend nominal GDP growth rate (8 percent).