Experiences with Sovereign Wealth Fund Management

Eric LE BORGNE The World Bank (Beirut office)

May 10, 2013

OUTLINE

Challenges and policy instruments available for natural resource rich countries

SWFs objectives and associated design

SWFs’ best practices and challenges

Recent trends in SWF design

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 framework

Ensure revenue stabilization to avoid boom and bust cycles

Guarantee 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 prices

Extractive Industries Transparency Initiative

Etc.

Examples of Potential Policy Instruments

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

Stabilization

DescriptionPotential 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 ACHIEVE

Examples of Sovereign Wealth Funds

Fund Ess. Objectives Accumulation rule Withdrawal rule Management and Investment

Kiwait -General Reserve Fund 1960 Stabilization and savings.

Residual budgetary surpluses Discretionary transfers to the Budget.

Minister of Finance, central bank, governor, and other officials.

Kuwait - Reserve Fund for Future Generations

1976 Savings 10 % of all government revenue Discretionary transfers to the Budget (approved by National Assembly)

Minister of Finance, central bank, governor, and other officials.

Norway - Government Petroleum Fund

1990 (1995)

Stabilization and savings.

Net government oil revenue Discretionary transfers to the Budget to finance the non-oil deficit (approved by Parliament)

Ministry of Finance, Central Bank.

Oman - State General Reserve Fund 1980 Savings Since 1998, oil revenue in excess of budgeted amount.

Discretionary transfers to the Budget.

Autonomous government agency

Oman - Contingency Fund 1990 (abolish

ed 1993)

Stabilization Residual oil revenue after budget support and allocation to SGRF

Oman - Oil Fund 1993 Investment in the oil sector

Since 1998, market value of 15,000 Bopd

Not disclosed. Ministry of Finance

RB Venezuela - Investment Fund for Macroeconomic Stabilization

1998 Stabilization Since 1999, 50 % of oil revenu above reference value, with exceptions.

Transfers to the budget or other state entity based on reference values, also discretionary transfers.

Parliament and the executive.

Timor Leste -Petroleum Revenue Fund

2005 Stabilization and savings.

All petroleum revenue and income

Discretionary transfers to the Budget to finance the non-oil deficit but withdrawals not to decrease the permanent income derivable from the Fund. Parliament to decide.

Minister of Planning and Finance, Central Bank

Examples of Sovereign Wealth Funds

Fund Ess. Objectives Accumulation rule Withdrawal rule Management and Investment

Alaska Permanent Reserve Fund 1976 Savings 50 % of eligible mineral revenue Principal (inflation proofed) invested permanently. Use of earnings decided by Governor/Legislature.

Independent Trustees, ultimately governor and legislature.

Alberta Heritage Saving Fund 1976 Savings (pre-1997 also economic and social development)

30 % of resource revenue until 1983. 15 % between 1984-87. Transfers discontinued.

Discretionary transfers to the Budget.

Oversight Committee (members of parliament) and provincial treasurer

Azerbaijan - State Oil Fund 1999 Savings, economic and social development, investment in the oil sector

Government petroleum revenue by nature (defined by law)

Discretionary transfers to the Budget to finance the non-oil deficit (approved by Parliament), plus special expenditure determined by presidential decree, subject to withdrawal limit.

Autonomous government agency

Chad - Revenue Management Program

1999 Stabilization and savings. Future generation Fund discontinued in 2005.

Net Government Direct Oil Revenue until 2006, Net Government Oil Revenue thereafter.

Earmarking to priority expenditure set by law until 2006. From 2007, discretionary transfers to the Budget to finance non-oil deficit (approved by Parliament).

Minister of Finance, central bank., regional committee, and ultimately legislature.

Chile - Copper Stabilization Fund 1985 (1987)

Stabilization Based on discretionary reference price determined by the government.

Transfers to the budget (and extrabudgetary lending) symmetric to accumulation rule.

Ministry of Finance, Central Bank, and state copper company (CODELCO)

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 families

Sterilization of oil revenues through overseas investment

Accumulation 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 saving 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 SETUPS

* 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 GOALS

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, DC

GLOBAL TRENDS IN SWF DESIGN ARE SHIFTING TOWARDS FUNDS THAT ARE FELXIBLE, TRANSPARENT, AND INTEGRATED WITH FISCAL SYSTEMS AND COUNTRY INVESTMENT

STRATEGIES

DescriptionDesign Feature

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 & Accountability

Thank You

http://worldbank.org/Lebanon

Extra Slides

Prior information campaign

Establishment

Accumulation and Withdrawal

Management and Investment

Governance

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 FUNDS

OVERVIEW OF ACCUMULATION AND WITHDRAWAL RULES AMONG SWF’S AROUND THE WORLD

Each 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.)

CB Core Reserves & Stabilization Funds

Future & Endowment Funds

Pension Liabilities

Objective Cover unexpected Balance of Payments outflows or budget shortfalls

Preserve capital in real terms for future generations or to generate alternative source of revenue

Cover contractual and measurable long term obligations

Investment Horizon

Short Term Long term Maturity of contractual obligations: 20 to 40 years

Return Target Prevailing nominal returns Long term real return target

Discount rate on future benefit payouts

Risk 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 POLICIES

SANTIAGO PRINCIPLES FOR MANAGING INSTITUTIONAL RISKS FACED BY SWF’S

The 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 paid

Indirect raiding: unsustainable fiscal behavior e.g. excessive debt accumulation on the back of fund’s resources

Inefficient management of funds: constraints on investments that are inconsistent with the fund’s long-term objectives because of reputational risk concerns

Key Institutional Risks facing SWF’s…

Sound legal framework to enable SWF to accomplish its stated objectives

Clearly 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 Principles

The Case of Alaska

Alaska 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].

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 principal

Flows in and out of the APF

Eligible Revenues

Treasury

General Fund Alaska Permanent Fund

APF Corporation

Earnings Reserve Account

Dividend Fund50% 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.

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 stabilizer

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.

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.

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.

Flows in and out of the GPFG

Source: 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”

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.

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.