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Commodity Savings Funds:Commodity Savings Funds:Asset allocation and spending rulesAsset allocation and spending rules
Libreville, GabonMarch 28-30, 2008
Stéphane Piot, CFALead Financial Officer
Sovereign Investments PartnershipsWorld Bank Treasury
2 2
Road MapRoad Map
Commodity funds– Challenges of managing commodity revenues– Advantages of stabilization & savings funds
Important design questions– Spending mechanism– Asset allocation– Fund management
3 3
Several countries have setup oil Several countries have setup oil funds to avoid oil cursefunds to avoid oil curse A number of countries have adopted the use of oil or
commodity funds– Portion of government revenues from oil (and gas) or other
commodities is saved– Fund rules separate oil revenues from budgetary spending
(stabilizes impact of commodity revenues)– Allows for conversion of non-renewable resources into earning
financial assets
Typically funds have one of 2 (or both) purposes:– Stabilize or dampen effect of oil revenues on fiscal budget– Savings for current & future generations to ensure
intergenerational equity (oil and gas typically depleted in 20 to 50 years)
4
Commodity savings and heritage Commodity savings and heritage fundsfunds
Generate long-term wealth for future generations (by converting non-renewable resources into financial wealth) while meeting current income needs– Set real target rate of return equal to spending rate– Minimize risk subject to achieving target rate of return
Smooth fiscal expenditures (self-insurance) – this objective should be achieved through setting a
sensible spending policy Fund is usually kept outside domestic currency,
government transfers will need to be made in domestic currency
Maintain international purchasing power of the fund
5 5
Examples of savings & stabilization Examples of savings & stabilization fundsfunds
CountryAUM
(US$ bn)Inception
Year Source Purpose
Abu Dhabi 350 to 875 N/A Oil Saving
Norway 350 1990 Oil Saving
Kuwait 250 1960 Oil Saving
Russia 160 2004 Oil Both
Qatar 50 2000 Oil and gas Saving
Alaska 40 1976 Oil Saving
Kazakhstan 18 2000 Oil, gas, metals Both
Alberta 16 1976 Oil Saving
Chile 10 1985 Copper Both
Botswana 7.5 1966 Diamonds Saving
Timor-Leste 2 2005 Oil Saving
Azerbaijan 2 1999 Oil Saving
Trinidad & Tobago
2 2007 Oil & Gas Both
Source: Morgan Stanley, Wikipedia, and others
6
Important considerations in designing Important considerations in designing commodity fundscommodity funds
Design of spending and savings rules– Integrate fund in budget/fiscal policy– Ideally all revenues flow into the fund and government withdraws a
portion annually to support budget– Spending rule can be designed to ensures stable income to the
government
Asset allocation– Convert depleting asset into diversified portfolio to create financial
wealth– Design an asset allocation that generates sufficient returns over the
long-run– Keep bulk of the fund outside the domestic economy
Management of the fund– Central Bank, separate investment unit or separate agency– Internal management or external management
7
Sterilizing foreign currency inflowsSterilizing foreign currency inflows
Budget: Budget: domestic domestic investmentsinvestments
Investment Income
FUNDFUND
Liquidity Liquidity
InvestmentsInvestmentsCommodity revenues Finance
Income
Revenue flow directly into fund would improve transparency and simplify sterilization operations
8
Creating permanent wealth by transferring Creating permanent wealth by transferring commodity wealth into financial wealthcommodity wealth into financial wealth
• The values are expressed in real terms (i.e. 2008 dollars)• Example for country with oil expected to last from 2007 to 2022
Several oil-exporting countries are on a declining production path They may only have one chance to ‘get it right’
9
Risk habitat of FundsRisk habitat of Funds
Central bank Reserves & Stabilization
funds
Funds for the futurePension funds
State owned enterprises & government
holding companies
Money marketsHigh grade fixed income
Small, if any, allocation to corporate
Global fixed incomeGlobal equityHedge fundsReal estate
Commodities
Strategic corporate stakes
Russia Stabilization FundChilean Stabilization FundCentral Bank of NigeriaCentral Bank of AlgeriaCB of MalaysiaCB of Indonesia
Temasek, SingaporeRussia Pension FundChile Pension Reserve FundSingapore GICChina Investment CorpBank of Korea—KICNorway Pension (Oil) Fund
10
0
2
4
6
8
10
12
14
16
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
An
nu
al R
eal
Ret
urn
Cumulative Real Return on 3-mo T-Bills
Cumulative Real Return on 50% Stocks/50% Bonds
Strategic Asset allocation is criticalStrategic Asset allocation is critical
11
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
An
nu
al R
eal
Ret
urn
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Cu
mu
lati
ve R
eal
Ret
urn
Real Return on 3-mo T-BillsReal Return on 50% Stocks/50% BondsCumulative Real Return on 3-mo T-BillsCumulative Real Return on 50% Stocks/50% Bonds
Expect VolatilityExpect Volatility
12
The path from oil to equitiesThe path from oil to equities
12Data from 1983 to 2007Graph is based on a speech by Knut Kjaer (Norges Bank Investment Management) – “from oil to equities”
Investing in a financial portfolio of stocks and bonds can reduce the risk of oil significantly while improve total income
1313
Real Returns on Financial Assets when Natural Resource Prices Fall by more than 5%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
TIPS Govt. Bonds Corp. Bonds Stocks Real Estate
Oil
Natural Gas
Bonds and stocks do well when oil Bonds and stocks do well when oil and gas prices are fallingand gas prices are falling
1414
Commodity fund designCommodity fund design
OBJECTIVE DESIGNCapital preservation for future spending
Saving rule, spending rule or guideline based on total wealth that assures minimum annual income to government and meets future spending needsMeet current income needs
Generating independent source of foreign currency income
Investment in diversified portfolio of risk assets for return
Smoothing of total foreign currency revenues
Investment in financial assets with low or negative correlation to commodities
Sterilizing foreign currency inflows
Investment only in overseas assets
Domestic investments flow through budget process
1515
Spending rules used by commodity Spending rules used by commodity savings & stabilization fundssavings & stabilization funds
Common spending rules Bird-in-hand rule: spending is equal to the expected
real rate of return* times the market value of the fund Implemented in e.g. Norway and Alaska
Total wealth rule: spending is equal to the expected real rate of return times the total wealth (= market value of the fund + oil in the ground) Implemented in East-Timor, Mauritania, Sao Tome
Hybrid rule: in between bird-in-hand and total wealth rule
Mixed rule: in between bird-in-hand (or total wealth) and constant real spending Used by university endowment funds
* Expected real rate of return assumptions vary between 3% to 5%
1616
Other rules used by commodity Other rules used by commodity savings & stabilization fundssavings & stabilization funds
Price-based savings rules save revenues in excess of budgeted revenues based
on reference price for oil & gas Implemented in e.g. Russia and Oman
Save revenues in excess of budgeted revenues (based on reference price) and can withdraw when falling short of budgeted revenues Implemented in Trinidad & Tobago and Chile
Macro-economic rules Target non-oil primary deficit to GDP (with or without
debt reduction) Implemented in Norway
17
Generic module for commodity savings funds
– Analytical framework that models revenues from both hydrocarbons (or other commodities) and fund investments
– Allow policy-makers and analysts to test the impact on revenues, fund size and spending amount over time of:
• Alternative spending/saving assumptions and/or
• Alternative asset allocations
– Simulate uncertainty around oil and gas prices and capital market returns to assess risks to the fund
Commodity saving fund modelCommodity saving fund model
Designed by Treasury’s asset allocation team to support policy makers in designing spending/saving rules and making asset allocation decisions
18
Model objective: test robustness of fund Model objective: test robustness of fund design under uncertaintydesign under uncertainty
OBJECTIVESOBJECTIVES
Fiscal budget Fiscal budget requirementsrequirements
Capital Capital preservationpreservation
Future Future spending needsspending needs
Fiscal Fiscal smoothingsmoothing
TEST KEY DESIGN TEST KEY DESIGN FEATURESFEATURES
SPENDING SPENDING GUIDELINESGUIDELINES
STRATEGIC STRATEGIC ASSET ASSET ALLOCATIONALLOCATION
RISK SCENARIOSRISK SCENARIOS
OIL PRICE OIL PRICE • stochasticstochastic• mean mean revertingreverting
INVESTMENT INVESTMENT RETURNSRETURNS
CORRELATION CORRELATION AssumptionsAssumptions
OUTCOMESOUTCOMES
Assess Assess distribution of distribution of outcomes outcomes versus versus objectivesobjectives
Adjust rules if Adjust rules if necessary necessary
RetestRetest
Model is also a fiscal planning tool for medium term planning
20
Institutional solutions for fund Institutional solutions for fund managementmanagement
Managed by Central Bank alongside reserves– Not an ideal solution as many CBs typically manage assets conservatively
Managed by Ministry of Finance (e.g. previous setup of Alberta Investment Management)– Risk of politicization of fund management
Separate investment unit in central bank (e.g. Norges Bank) Separate investment agency with professional board (e.g. New
Zealand Superannuation Fund, GIC, CPP, Australia FF) Outsource management of a portion of the fund
– Investment management of unfamiliar assets / strategies– Risk management technology– DO NOT outsource ownership of risk
21
Institutional characteristics for successful Institutional characteristics for successful long term public wealth managementlong term public wealth management
Achieve political commitment to long-term objectives, articulated in a clearly defined legal mandate
Depoliticize the management of the funds Ensure ownership of risk and return profile of the
portfolio consistent with fund’s macro objectives at highest level
Create specialized institutional arrangements for the implementation of investment policy decisions within civil service budgetary, procurement and salary restrictions
Establish independent oversight and controls Allow a high degree of transparency