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1 Commodity Savings Funds: Commodity Savings Funds: Asset allocation and spending rules Asset allocation and spending rules Libreville, Gabon March 28-30, 2008 Stéphane Piot, CFA Lead Financial Officer Sovereign Investments Partnerships World Bank Treasury

Les fonds des ressources naturelles et les politiques d'investissement, Stephan Piot, BM

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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

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Road MapRoad Map

Commodity funds– Challenges of managing commodity revenues– Advantages of stabilization & savings funds

Important design questions– Spending mechanism– Asset allocation– Fund management

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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)

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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

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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

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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

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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

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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’

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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

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0

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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

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-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

1952

1954

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An

nu

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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

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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

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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

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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

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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%

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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

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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

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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

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Sovereign Commodity Fund WorkbenchSovereign Commodity Fund Workbench

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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

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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

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