SOVEREIGN WEALTH FUNDS AND

MACROECONOMIC STABILIZATION IN THE

HOME ECONOMY

Ibrahim Elbadawi (ERF)

Raimundo Soto (Pontificia Universidad Católica, Chile)

Hoda Youssef (World Bank)

WHY HAVING SWF?

SWF are not “foreign reserves”.

Central banks focus more on liquidity and safe-keeping of reserves. SWFs focus on returns, diversification, and risk-taking and to a large extent they are institution-building mechanisms

SWF are not “pension funds”

SWFs are not financed with contributions from pensioners and do not have a stream of liabilities committed to individual citizens.

SWF are not “private wealth funds”

Objectives of SWFs are usually more complex

Impacts of SWF on home economies may go beyond those of foreign reserves, pension funds, or private investment vehicles 2

SOVEREIGN WEALTH FUNDS

Research Areas in SWF

What role for SWF?

Why are there SWF?

How to best set up and manage SWF?

What are SWF’s effects on global capital markets?

What drives SWF investment strategies?

What are SWF’s effects on home economies?

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POTENTIAL IMPACT OF SWF ON HOME COUNTRIES

Facilitate fiscal stabilization and fiscal saving

Also introduce more professional and comprehensive investment and risk management frameworks

Enhance transparency and accountability in the management of government financial assets.

Support monetary policy

Exchange rate management, if appropriate SWF investment policies

Better management of the public-sector balance sheet

Improve asset management strategy when SWF are consistent with an economy’s underlying macro-fiscal objectives.

Improve external stability in the current and capital account.

Relevant for countries with SWFs and/or receiving large SWF inflows.

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POTENTIAL IMPACT OF SWF ON RESOURCE-RICHCOUNTRIES

Help managing excess reserves being accumulated during good times (particularly in countries with fixed exchange regimes).

Help break the link between resources windfalls and government expenditures that exacerbates boom and bust cycles. Procyclicality is a crucial issue for Arab oil-rich countries.

In fact, it is an issue for emerging economies and resource rich countries as well

Even “graduated countries” can have relapses (Frenkel et al, 2013). Global crisis and its aftermath. 5

EFFECTIVENESS OF SWF ON FISCALPROCYCLICALITY

Key issue: when SWFs are associated with better fiscal outcomes, what causality?

Do countries with prudent fiscal policies tend to establish SWFs?

Do SWF help in adopting a counter-cyclical fiscal policy?

If the inception of SWF is endogenous, econometric models would yield inconsistent (biased) estimates of the effects of the potential contribution of SWF to dampening fiscal procyclicality (or, more generally, supporting the fiscal stance).

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EFFECTIVENESS OF SWF ON FISCALPROCYCLICALITY

Previous case studies.

SWF are not per-se successful in making budget expenditures less driven by revenues availability, commitment to fiscal discipline & sound macroeconomics are key (Fasano, 2000).

SWF do not have impact on expenditure volatility due to lack of integration with the budget, institutional weaknesses, and inadequate controls (Le Borgne and Medas, 2007).

Implicitly, all assume SWF are exogenous.

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EFFECTIVENESS OF SWF ON FISCAL

PROCYCLICALITY

Case studies evidence for resource-rich economies.

Bjørnland and Thorsrud (2015): SWF in Norway has induced more (not less) procyclicality with commodity prices since 2001: rule of withdrawing a fixed percentage of a growing fund each year is not sufficiently countercyclical over the commodity price cycle.

Corbo et al. (2016) also conclude that, by design, Chile’s SWF rule is not countercyclical (actually, a-cyclical) and not an adequate stabilization instrument.

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EFFECTIVENESS OF SWF ON FISCALPROCYCLICALITY

Other studies.

SWF contribute to smoothing government expenditures in 68 resource-rich countries (Sugawara, 2014). Government expenditures are but one part of the issue. SWF are exogenous.

The ability to conduct countercyclical fiscal policy depends on the quality of their institutions and/or the availability of financial resources either in domestic or international capital markets (Calderón et al. 2016, Frenkel et al., 2013).

Omitted from previous research

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MAIN OBJECTIVES OF THIS PAPER

We investigate whether the existence of a SWF helps dampening or overcoming fiscal procyclicality. We test the effects of SWF on fiscal balances and, thereby, on fiscal sustainability. We discuss whether oil-rich countries are different.

Why fiscal procyclicality?

Costly stop-and-go policies can induce macroeconomic volatility, depress investment in real and human capital, hamper growth, and harm the poor.

Expansionary fiscal policies in good times that are not fully offset in bad times may produce a large deficit bias and lead to debt unsustainability and eventual default.

Complements our companion paper on investment strategies

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METHODOLOGICAL ISSUES

Unveiling the impact of SWF on the fiscal stance:

Has the treatment (implementing a SWF) had any discernible effect on fiscal procyclicality or fiscal balances?

Controlling for other potential determinants of the fiscal stance

Recognizing countries are quite heterogeneous (individual effects)

Capturing the characteristic significant inertia of fiscal variables

General model:𝑃𝑖𝑡 = 𝑓 𝛼𝑖 , 𝑥𝑖𝑡 , 𝐷𝑖𝑡 , 𝑃𝑖𝑡−1

Causal effects depends crucially on the validity of the implicit or explicit identification assumptions:

Treatment must be exogenous11

METHODOLOGICAL ISSUES

General econometric model:𝑃𝑖𝑡 = 𝑓 𝛼𝑖 , 𝑥𝑖𝑡 , 𝐷𝑖𝑡 , 𝑃𝑖𝑡−1 + 𝜀𝑖𝑡

Use dynamic panel-data models to account for heterogeneity, fundamentals, and inertia

Instrumental variables in first-differenced model (Arellano-Bond GMM-type estimator)

This would not solve endogeneity issues in the treatment variable

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METHODOLOGICAL ISSUES

Endogeneity of fiscal institutions SWF may be endogenously set up as a response to the fiscal

stance: reverse causality from fiscal outcomes to SWF

Create an instrument to deal with such endogeneity Probit-model for the presence of a SWF in 146 countries 1984-2015

Use predicted probability of having a SWF in place as instrument

“Fundamentals” –which are lagged—include

Export proceeds: foreign trade (% GDP), export concentration, and natural resource rents (% GDP).

Macroeconomic stance and general development level: inflation and real per capita GDP in US$.

Government revenue structures: revenue instability (coefficient of variation of revenues computed using a rolling three-year window) and federalism.

Idiosyncratic factors: including a dummy for GCC economies.

Institutional factors: political participation and accountability13

INSTRUMENTATION OF FISCAL RULES & COUNCILS

We also control for two other key fiscal institutions: Fiscal Rules and Fiscal Councils

These are independent public institutions aimed at strengthening commitments to sustainable public finances through various functions, including public assessments of fiscal plans and performance, and the evaluation or provision of macroeconomic and budgetary forecasts.

May be endogenous, therefore we create instruments for probability

We follow Schmidt-Hebbel and Soto (2017) to select the appropriate set of fundamentals and generate instruments for four national rules placing limits on government debt and government expenditure, as well as targets on revenues and the fiscal balance. 14

MEASURING FISCAL PROCYCLICALITY

We define and measure procyclicality as:

Correlation of the cycle in government expenditures and the cycle of GDP, both at constant prices.

Correlation of the cycle in fiscal balances and the cycle of GDP, both at constant prices.

The data were obtained from World Development Indicators, World Economic Outlook, and IMF Fiscal Database

Cycles: we de-trend variables in logs using the HP filter

Correlations: we use 10-year rolling correlations to avoid transient phenomena (5 years yield similar results).

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DETERMINANTS OF FISCAL PERFORMANCE

In addition to our SWF instrument, we control for the following sets of “fundamentals”

Access to borrowing by governments. Capital account openness and financial development largely determine the ability of governments to borrow money in domestic and external markets to fulfill their financial needs.

Institutional determinants of fiscal performance. Political representation, political accountability, perceived political stability of government, corruption, fiscal federalism.

Exchange-rate and monetary regimes. Exchange regime (de jure and de facto), monetary unions.

Fiscal Institutions. Fiscal rules (instr.), fiscal councils (instr.), fiscal revenue instability and SWF (instr.)

Cyclical phenomena. Business cycles, resource-rent cycles and price instability.

Overall development, as customarily measured by GDP per capita in constant US$ of 2000.

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MAIN RESULTS I: PROCYCLICALITY OF

GOVERNMENT EXPENDITURES

Find significant inertia in fiscal outcomes ⇒ static models are inadequate. 90% of a shock dissipate in 4 years.

Countries tend to have lower levels of procyclicality if

They belong to monetary unions

Inflation is low

Business cycles are smaller

Fiscal revenues are stable

We found no role for political instability, political regimes, or political accountability.

SWF significantly lower procyclicality

Reinforced by a fiscal rule on expenditures

Not reinforced by fiscal councils.17

MAIN RESULTS II: PROCYCLICALITY OF FISCAL

BALANCES

Find significant inertia in fiscal outcomes ⇒ static models are inadequate. 90% of shocks dissipate in 9 years.

Countries tend to have lower levels of procyclicality if

They belong to monetary unions

Inflation is low

Business cycles are smaller

Fiscal revenues are stable

Political accountability (checks and balances) is high

We found no role for political instability, political regimes.

SWF significantly lower procyclicality

Reinforced by a fiscal rule on debt ceilings but (surprisingly) hampered by balance rules

Not reinforced by fiscal councils.18

MAIN RESULTS III: FISCAL BALANCES

Find significant inertia in fiscal outcomes ⇒ static models are inadequate. 90% of shocks dissipate in 9 years.

Countries tend to have “better fiscal stance” if

They are more stable in political terms

If they conduct monetary policy using fixed exchange regimes

Hit by (transitory) upswings in business cycles or resource prices

SWF significantly improve “fiscal stance and sustainability”

Direct effect and indirectly by lowering revenue instability

Direct effects larger in more developed economies

Expenditure fiscal rules enhance the positive effect of SWF, but revenue rules works in the opposite 19

IMPLICATIONS FOR GCC ECONOMIES

GCC countries pioneers of SWF (Kuwait, Saudi Arabia)

GCC hold around 40% of SWF wealth (2017)

Fiscal sustainability not an issue in most GCC

Fiscal procyclicality is an issue:

most SWF are not stabilizing instruments

SWF however

Are not enough to instill fiscal discipline

Have not supported building modern fiscal institutions

Are not supported by other fiscal institutions (rules, councils)

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CONCLUSIONS

In this paper we:

Study the likely effects of SWF on the fiscal stance of the home economy Fiscal stabilization and fiscal saving (sustainability)

Fiscal procyclicality is a key issue for most Arab oil/gas exporters

Fiscal procyclicality/stability are key issues for most emerging economies

Provide a rigorous methodology to deal with Unobservable country heterogeneity

Isolating the role of SWF from other determinants of fiscal stance

Inertia and dynamic adjustments

Potential endogeneity of fiscal institutions: SWF, fiscal rules, fiscal councils

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CONCLUSIONS

In this paper we:

Create measures of fiscal procyclicality and instruments for fiscal institutions

Test our models using data for 140 countries in the period 1984-2015 (data availability)

Find that SWF do have a stabilizing effect in the home economy as they reduce fiscal procyclicality

Find that SWF do increase fiscal sustainability in the home economy as they improve fiscal balances

Other fiscal institutions complement and amplify the benefits of SWF, such as fiscal rules and (less clearly) fiscal councils

Are aware that SWF can have other unmeasurable benefits (fiscal transparency, accountability, etc.)

Suggests a road for GCC as well as non-GCC MENA countries22

APPENDIX

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MAIN TYPES OF SWF

Stabilization funds

Savings funds

Reserve investment corporations

Development funds

Contingent/pension reserve funds

We do not separate SWF by type since

SWF may be hybrids

Money is fungible (with varying costs)

Circumstances dictate 24

HIGH OIL-PRICE PROCYCLICALITY IN GCC COUNTRIES

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MILD/NO OIL-PRICE PROCYCLICALITY IN GCC COUNTRIES

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OIL-PRICE PROCYCLICALITY IN OTHER ARAB COUNTRIES

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LINABURG-MADUELL SWF TRANSPARENCY INDEX

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Source: SWFI

FIGURE 1PROCYCLICALITY IN GOVERNMENT EXPENDITURES AND DEVELOPMENT LEVEL, 1980-2015

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On average, negative relationship …

… but there’s a lot of heterogeneity

Per capita GDP US$ 13,500

FIGURE 2PROCYCLICALITY IN GOVERNMENT EXPENDITURES AND RESOURCE RENTS, 1980-2015

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On average, positive relationship …

… but there’s a lot of heterogeneity

Rents per capita US$ 500

ON GRADUATION FROM FISCAL PROCYCLICALITYFRANKEL, VEGH, VULETIN, 2013

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Fiscal Procyclicality

Fiscal Countercyclicality

ON GRADUATION FROM FISCAL PROCYCLICALITYFRANKEL, VEGH, VULETIN, 2013

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