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Sovereign Wealth Funds: Their Role and Significance -- A Speech By John Lipsky, First Deputy Managing Director, International Monetary Fund
September 3, 2008
As Prepared for Delivery
Before anything else, I would like to congratulate the Government of Chile, in particular Minister Velasco and his colleagues, for organizing this timely and important event. Moreover, I thank them for giving me the opportunity to participate today and to share with you some observations on the economic role and policy significance of Sovereign Wealth Funds (SWFs).
I will begin by placing the expanding significance of these Funds in a global economic and financial context. I will then discuss their role in attaining the goals of their sponsoring governments. I will conclude by examining the Funds' international importance, and the rationale underpinning the deliberations of the International Working Group of Sovereign Wealth Funds, whose successful and productive meeting has just concluded here in Santiago.
A. Global Economic Context
Many profound transformations are taking place in the global economy. Ten years ago, a large number of emerging economies were engulfed by financial and economic turmoil, and afflicted by balance of payments crises. In response, most of the affected countries acted decisively. Many of them significantly strengthened their budgetary and monetary policy discipline—often through difficult and stressful efforts. In many cases, national balance sheets were bolstered by debt reduction.
One result of the efforts was the restoration of economic stability and investor confidence. In fact, emerging economies in the aggregate quickly resumed their relatively rapid growth trajectory. At the same time, they began to run current account surpluses, thereby accumulating international reserve assets. In other words, these economies became net capital exporters to the rest of the world, in particular to the advanced economies.
More recently, this trend became high-powered: strong global growth in the past few years sharply boosted energy and commodity prices. The well-known result has been a striking increase in the foreign currency receipts of many energy and commodity exporting economies. These countries include some of the richest and most developed economies, but also many emerging ones, as well as some developing economies.
With many governments assuming—either by design or by circumstance—the role of guardians of substantial amounts of their countries' financial assets, effective wealth management has become an important public sector responsibility. Many countries have responded by creating sovereign wealth funds.
Of course, the formation of SWFs is not a new phenomenon. However, almost two thirds of the existing Funds were established in the past decade. As a result, the importance of Sovereign Wealth Funds has grown not only within their own countries, but their relevance also has increased for the international financial system. For example, market participants' estimates suggest that assets under management of Sovereign Wealth Funds currently total between US$2-3 trillion, thereby exceeding assets managed by hedge funds (US$ 1.9 trillion). In fact, such Funds today account for between ¼-⅓ of all foreign assets held by sovereigns. SWF assets are projected to surpass the stock of global foreign exchange reserves in the not so distant future and to top US$7-11 trillion by 2013.
B. Home Country Policy Goals
While SWFs share the goal of efficiently and effectively managing their country's official financial wealth, they have specific economic policy roles.
• For example, for countries exporting nonrenewable resources, the principal challenge is to transform such resources into sustainable and stable future income, compensating for the reality of volatile commodity prices and finite supplies. Placing commodity revenue in a Sovereign Wealth Fund is a means to avoid boom/ bust cycles, such as those experienced during the 1970s, by accumulating adequate international assets. Moreover, a well- managed and effective SWF can help protect the economy's non-commodity sectors from destabilizing currency fluctuations while helping to spread the country's wealth more equitably across generations.
• Indeed, 30 of the 38 existing SWFs have been established by commodity-exporting countries for stabilization and/or saving purposes. The Fund for Social and Economic Stabilization (FESS) that the government of Chile established long ago is now being managed as just such a Sovereign Wealth Fund. The purpose of this Fund is to smooth government spending by putting aside fiscal surpluses that are in excess of a structural target, so as to be used in periods of weak terms of trade.
• Some Sovereign Wealth Funds also aim explicitly at developing a broader base for economic growth. Developing an efficient and diversified economy reduces the impact of commodity price volatility and helps to prepare the economy for a post-commodity era. This has been one of the stated purposes of 5 recently established SWFs.
• Ageing populations create a need to fund future social obligations. At least 5 SWFs are driven explicitly by this motive. Among such SWFs is the Pension Reserve Fund created this year in Chile. Chile's Fund aims to cover long-term fiscal liabilities incurred under the new pension reform.
• Finally, reserve accumulation is putting pressure on some central bank balance sheets in terms of carry cost and currency mismatches, driving the need for higher risk-adjusted asset returns. Some countries are seeking prudent and effective management of such type of foreign currency accumulation via Sovereign Wealth Funds.
C. Necessary Conditions for Success
While Sovereign Wealth Funds can help generate long-term economic benefits, several important conditions must be fulfilled in order to produce the intended results.
• First, appropriate budget and monetary policies represent the most important of these preconditions. Thus, the operations of the SWF must be well integrated in the overall policy framework. Failing this, an SWF could produce potential policy pitfalls, such as creating parallel budgets, or—through ill-timed withdrawals—undermining the operations of the central bank.
• Second, for the Fund's operations to be properly integrated into the home country economic policy framework, it is critical that adequate information is reported to the relevant agencies, and that accurate data are included in national accounts, as well as monetary, government finance, and external sector statistics.
• Third, recent cross-country evidence suggests that SWFs are successful in achieving efficient resource management when they have well-designed funding and withdrawal rules that are consistent with their stated goals. Most recently, following such rules, the government of Chile has established its two existing SWFs as an integral part of Chile's macroeconomic framework. The fiscal framework adopted in 2006 apportioned fiscal surpluses between the SWFs within a fiscal rule designed to smooth government expenditures across the business cycle.
• Fourth, an SWF should be underpinned by well-framed corporate governance arrangements. These include the government as its owner setting the Fund's objectives, its governance structure, and an effective accountability framework. Governance structures typically articulate clear roles, responsibilities, and interrelationships between the different bodies involved in the SWF's administration and management with the goal of facilitating operational independence in making investment decisions.
• Fifth, clear accountability procedures among the different levels of SWF governance, and to the public, are important in order to prevent misuse of public resources and to gain public support for the Fund and its objectives. These arrangements can generate public support for saving resources rather than spending them, inform the public about the accumulated revenue, and provide the economic rationale for the buildup of SWF resources. Transparency arrangements, in this regard, entail regular public disclosure of the investment objectives of the SWF, its funding, the withdrawals and spending on behalf of the government, the governance framework, and the Fund's asset size and its allocation, and return.
In the case of Chile, the two existing Funds are being operated by the government based on well-accepted international practices relevant for the structures of such types of Funds. The authorities publish monthly reports on the size and portfolio composition of the SWFs, as well as quarterly reports discussing performance. Several other SWFs around the world also follow similar carefully constructed governance, accountability and transparency principles.
• Finally, the success of a Sovereign Wealth Fund is contingent upon responsible investment policies that are consistent with its policy purpose. These include care, skill, and prudence in investment practices, and a robust framework to identify, assess, and manage the risks of its operation. For instance, stabilization funds—that are the most common form of SWF and have shorter investment horizons—are more likely to invest conservatively and may hold relatively large stocks of liquid assets. In contrast, savings funds seek to earn higher returns over a longer horizon, and may invest across all major asset classes, including alternative investments. Pension reserve funds may even determine their investment policies in an asset and liability context to match entitlement payments, thereby choosing portfolios similar to those of funds with direct pension liabilities.
D. The International Environment
As is clear from recent data, the size and rapid growth of Sovereign Wealth Funds is placing them front and center with regard to public attention, as well as for international financial and economic policy deliberations. Thus far, the role of SWFs in the context of the past year's turmoil in advanced economy financial markets has been notably positive. If anything, the Funds' actions have shown that they can play a shock-absorbing role in global financial markets, at least in terms of dampening short-term market volatility. This is a reflection of their typically long-term investment horizons, limited immediate redemption needs, and mainly unleveraged positions. In addition, many of these Funds' managers are highly skilled and experienced investors. As such, they understand clearly their long-term interest in preserving well-functioning, open, liquid global markets.
Nevertheless, some concerns about SWF investments have been raised in recipient countries. Worries have been expressed that SWF investments could affect national security, or that SWF investments could be based on noncommercial motives. Although it is clear that these concerns have little or no basis in the way SWFs have operated up to now, it is important to avoid negative perceptions or run the risk of a protectionist backlash. Such outcomes would be damaging for all parties concerned. It could curtail the scope for SWF investment, increase the investment risk SWFs face, and lead to retaliatory measures. Also, such negative dynamics could undermine the efficient flow of global capital and even diminish the stability of the international financial and monetary system.
It is not surprising, therefore, that public and private leaders in both SWF sponsor countries and recipient countries recognized that the international system would benefit from enhanced clarity regarding the principles and practices followed by both sides. Recipient countries, acting through the OECD, have developed and are implementing the investment code that has been described by Pierre Poret.
The Sovereign Wealth Funds, for their part, earlier this year formed the International Working Group facilitated by the IMF. The IWG is finalizing an important document—the Generally Accepted Principles and Practices for Sovereign Wealth Funds (GAPP) and has reached a preliminary agreement on a set of voluntary practices and principles, here in Santiago, referred to as the "Santiago Principles". The IWG is scheduled to present its report on the GAPP to the October meeting of the International Monetary and Financial Committee of the International Monetary Fund. This ministerial-level Committee meets twice yearly, and plays the key role in setting the priorities for developing and managing the international monetary and financial system.
The IWG meeting of the past two days in Santiago focused on achieving new advances on the GAPP. This document specifies practices and principles in three key areas, including the Fund´s legal and macroeconomic framework; governance and institutional structures; and investment and risk management practices. Implementation of the GAPP by the SWFs will help them significantly in meeting the necessary conditions for success that I listed earlier.
The GAPP also seeks to help maintain the free flow of cross-border investment and sustain open and stable financial systems. Both the SWFs and the recipient countries recognized that the GAPP will work to their mutual advantage, as it improves the understanding of SWFs, and allows newly-established SWFs to benefit from the experience of others. Furthermore, by embracing the GAPP´s principles and practices, SWFs could reduce concerns and thereby help to mitigate the risk of protectionist pressures on their investments and restrictions on international capital flows. Thus, the GAPP represents a valuable solution that, alongside the ongoing work of the OECD and its members, should help secure the global environment for effective and beneficial cross-border investing, while ensuring that the SWFs will continue to play their meaningful and constructive economic and financial role for the foreseeable future.
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