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April 09, 2015

Why Sovereign Wealth Funds Should Not Invest at Home

 Refinery

Posted by Andrew Bauer[1]

Developing, capital-scarce countries need domestic investment. Governments in countries such as Angola, Mongolia, and Timor-Leste must invest in education, health and public infrastructure if they hope to achieve middle- or high-income status. What’s more, mineral-rich countries have access to large (yet finite) sources of income that can be used to boost domestic investment and help overcome the poverty trap. On this nearly everyone can agree.

In response to this need for domestic investment, some commentators have recently suggested that there might be opportunities for these countries’ sovereign wealth funds (SWFs) to directly invest at home. Nearly every country with significant oil, gas or mineral exports operates a SWF. Already, governments in Angola, Azerbaijan, Iran, Nigeria and Russia, for example, use their SWFs to channel money to special domestic projects.

A SWF is a type of extra-budgetary fund that operates outside the annual government budget process. SWFs have traditionally been created for a macroeconomic objective (e.g., fiscal stabilization), or to save for future generations. All invest at least partly in foreign assets.

While the idea of using a SWF to invest in domestic assets may resonate with government officials and politicians, there are strong arguments against using SWFs for this purpose. A fund with multiple objectives can undermine public financial management systems, and lead to poor investment decisions, patronage and even corruption.

Governments can establish safeguards to limit SWF mismanagement and corruption, such as conflict-of-interest standards combined with strong fund transparency and oversight. However the challenges associated with creating a parallel budget or multiple mandates may not be so easy to overcome. A single SWF may not be well-placed to be a checking account, a savings account, an education or health financing vehicle, and a development bank all at once.

In countries where funds have helped to improve macroeconomic management, fiscal rules can help determine how much resource revenue is saved and spent. All spending is then channeled through national or subnational budget processes, or through state-owned companies like development banks that act at arms’ length to the government. In most cases, savings are placed in an SWF and invested abroad with purely financial returns in mind.

I am not suggesting that natural resource revenues should not be used for domestic spending. Just the opposite; there is no other reason to extract these resources from the ground. But SWFs, as mechanisms of macroeconomic management, should not be the vehicles of such direct spending. If there is under-spending in the domestic economy, a far better way to increase it is to enact fiscal rules that allocate resource revenues more appropriately between the budget and a SWF.

 Here are six reasons why it is generally inadvisable to use a SWF to invest at home:

  1. Domestic investment can undermine macroeconomic objectives. The very reason governments usually create SWFs is to address the macroeconomic challenges associated with natural resource revenue inflows. If governments transfer money to a fund, then transfer money back into the economy through domestic investment, the fund’s macroeconomic objective of sterilizing capital inflows could be undermined.

  2. Domestic investment can undermine public financial management systems. In many developing countries the budget process—including project appraisal, public procurement, and project monitoring—does not adequately deliver needed social programs and physical infrastructure. Governments sometimes respond by creating new institutions to bypass budget systems that do not work, such as a SWF that invests at home as well as abroad. This can lead to the establishment of uncoordinated parallel budgets—each with its own appraisal, procurement and monitoring system. A better approach is usually not to create new institutions with unintended consequences, but rather to repair what is broken.

  3. Domestic investment can undermine public accountability. Budget allocations are usually examined and approved by legislatures. This is rarely the case for specific SWF investments. In Azerbaijan and Iran, for instance, governments have used SWFs to finance politically motivated projects without submission to legislative scrutiny.  The risk is even higher in countries where most SWF activities are not publicly disclosed, which is the case is more than 50 percent of the funds NRGI has examined in recent research.

  4. Financial and development mandates require different expertise. Financial managers specializing in maximizing financial returns are usually not trained in identifying or managing infrastructure projects.  A single institution may not be well placed to achieve both financial returns and domestic development, unless there are strict firewalls between the two portfolios.

  5. Multiple mandates can confuse managers, leading to poor investment decisions. What percentage of the fund should be allocated to what objective? Can the ratio change, and if so, with whose approval? If one portfolio grows faster than another, is there a need for rebalancing? Is fund liquidity or investing in local businesses for the long-term more important? In theory, strict guidelines can help address these challenges, but in practice, where funds are allowed to make home investments, such guidelines are rarely drafted or enforced, allowing fund managers excessive discretion to make politically- or privately-motivated investments.

  6. There is no opportunity cost to prohibiting domestic investments in most developing countries. If we construe SWFs as government stabilization and savings mechanisms (rather than extra-budgetary spending funds), they should be managed in much the same way a family or institutional trust fund is managed—meaning maximizing returns for future use given a particular risk appetite. SWF managers generally set an investment target (e.g., 4-6 percent annually), which is an implicit declaration of risk appetite. In order to achieve this objective, fund managers will choose financial instruments that are likely to generate the target financial return while minimizing the risk of loss. In most developing countries, the chance is quite low that any single domestic asset can satisfy the fund managers’ criteria for maximizing return and minimizing risk. Therefore, in developing countries, the opportunity cost of prohibiting domestic investment in order to maximize financial returns is near zero.

Evidence on SWF treatment of domestic investments already exists. On the one hand are countries and subnational jurisdictions whose funds cannot invest domestically. These include Abu Dhabi (ADIA), Botswana, Chile, Ghana, Kazakhstan, Norway and Timor-Leste.

On the other hand there are countries where funds can invest at home: for example, Angola, Azerbaijan, Equatorial Guinea, Iran, Kuwait, Libya, Nigeria and Russia. Many of these funds have become conduits for corruption, patronage and financial mismanagement. The Libya Investment Authority invested with close personal friends of fund managers. Russia’s National Welfare Fund, an oil-financed pension fund, has been depleted to the tune of $20 billion since 2011. These horror stories illustrate the dangers of establishing an unaccountable extra-budgetary fund. The Natural Resource Governance Institute (NRGI) and the Columbia Center on Sustainable Investment’s (CCSI) recent research on SWFs in resource-rich regions found that half of these funds were too opaque to study. Of those that we were able to examine, we found that very few achieved their stated objectives.

In short, different vehicles may be required to achieve domestic investment goals and manage the macroeconomic challenges associated with large and volatile fiscal revenue inflows. One tool cannot fix every problem.

An expanded version of this blog will be available at http://www.resourcegovernance.org/news/blog.

[1] Senior Economic Analyst, Natural Resource Governance Institute (NRGI).

 Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

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Comments

I think you cover the "SWF investments as a tool for development investment"-type arguments well here. I'm a bit worried, however, that there might be a bit more to this story, specifically when analyzing SWF investment with a finance theory, portfolio analysis lens. Although I think on net the development-based arguments given here are the stronger force for developing countries, there are second-order arguments that we should consider, such as asset-liability matching and fiscal/macroeconomic hedging. In fact, as economies do develop these second-order effects can often take precedence. Now I accept that asset-liability matching and fiscal/macroeconomic hedging can shift optimal SWF investment strategies towards international investment or away from it. But one thing is certain: they shouldn't be ignored.


Asset-liability matching - What is the purpose of the SWF and how do we best match its investments to this purpose?

If a SWF has a defined purpose, for example financing future retirement income, matching the SWF investment risk profile to the future liability's risk profile is an integral component of risk management and could reasonably shift optimal strategy away from international investment towards domestic investment. If your SWF is going to finance future retirement income at home, its liability is going to be in the domestic currency and is also likely indexed to domestic incomes (for example retirement income may be defined at some percent - say 50% - of the median wage). So the SWF's liability faces domestic inflation risk and domestic growth risk (growth risk because the Govt will need to be able to fund the higher retirement incomes as the economy and wages grow). By investing domestically the government can more-or-less hedge the domestic growth risk (because the govt's investment should increase in value with domestic growth) and the inflation risk (domestically held assets are nominal). So the assets available to fund retirement incomes should be well matched to their risks. If the SWF invests internationally, however, the assets will now face both FX risk and the risk that the home country has higher growth rates than the SWF's internal assets, driving a wedge between the SWF's assets and its liabilities that will need to be funded. This is an especially big risk when a low income country with high expected growth rates and a long-term horizon invests in developed country assets with low expected growth rates.


Macroeconomic/fiscal hedging - we should consider the broader economic risks to the country and hedge SWF assets with these in the back out our mind. International assets, domestic assets, or a mix could be optimal. It depends.

I'll keep this short as this comment is getting waaay too long. Basically a government's balance sheet (or it's Net Present Value in a forward-looking sense) is subject to a bunch of large risk factors that can push it around or put it on an unsustainable path. A SWF can account for a fair chunk of the Govt's balance sheet. So when we think about optimal asset investment and setting investment parameters we must consider how these SWF assets - and importantly for this article, where they are domiciled - interact with the rest of the govt assets (or its Net Present Value, including drivers like future expected taxation).


There are various finance/portfolio-based arguments in favour of international investment, and there are equally as many against it. But the key point is that international investment is not by assumption a good thing given the varied composition of countries' balance sheets and risk drivers. Further, to ignore such arguments altogether may in fact lead to poor, unforeseen, and largely avoidable fiscal outcomes.

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