## 1. Stylized Sovereign Balance Sheet

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### I. Introduction — role and challenges of commodity-based SWFs
- Commodity-based SWFs have experienced various strains since the pronounced fall in commodity prices over the past few years.
- Current challenges for resource-based SWFs:
  - Maintaining funding bases amid lower commodity revenues.
  - Improving investment activities in an environment of subdued growth and low interest rates.
  - Organizational and institutional structure issues, investment and risk management mandates, and transparency and accountability as global investors.
- SWF categories and defining features (Santiago Principles, 2008) — paper focus: stabilization and savings funds:
  - Stabilization funds: insulate budget/economy from commodity price volatility; investment horizons and liquidity objectives resemble central banks' reserve managers; role in countercyclical fiscal policies to smooth boom/bust cycles.
  - Savings funds: share wealth across generations by transforming non-renewable assets into diversified financial assets; higher tolerance for volatility and focus on long-term returns.
  - Development funds, Pension reserve funds, Reserve investment corporations (definitions provided).
- Principal aims of the paper:
  - Examine macro-fiscal linkages for SWFs.
  - Present an integrated sovereign assets and liabilities management (SALM) approach with emphasis on liquidity risk.
  - Apply framework to scenarios of asset accumulation in an SWF and to SWF drawdowns to cover financing gaps due to lower commodity prices.
- Key premise: resilience of the sovereign balance sheet is maximized if sovereign assets and liabilities are managed in an integrated manner and liquidity risk across both asset and liability sides is appropriately assessed.

### II. Macroeconomic and fiscal linkages
- Fiscal framework guidance and inflow/outflow rules:
  - Fiscal frameworks should be guided by an assessment of fiscal sustainability and consider external risk factors.
  - Promote sustainability, be flexible to scale up growth-enhancing expenditure, consider absorption capacity constraints and public financial management quality, and provide precautionary buffers against revenue volatility.
  - Inflow/outflow rules for SWFs should be tailored to each country’s fiscal strategy.
- Country examples of rules and integration:
  - Chile:
    - Structural balance rule uses structural revenue forecasts.
    - Copper revenue estimated using a long-term (10-year average), forward-looking reference price from an independent panel of experts.
    - Expenditure is the residual after subtracting the structural balance target from estimated structural revenue.
  - Norway:
    - “Spending rule” (first established in 2001): the non-oil budget deficit should be on average 3 percent of the Norwegian SWF over time, which corresponds to the estimated real return on the fund.
    - Note: Norwegian government recently changed the rule by lowering the non-oil budget deficit from 4 to 3 percent of the fund, reflecting lower expected returns.
    - Comparable practice: U.S. endowment funds often have spending rules based loosely on 4–5 percent of a 5-year moving average of fund value.
  - Russia:
    - Special mechanism for oil and gas revenues to reduce budget dependence and accumulate reserves in downturns; revenues accumulated in the Reserve and the National Wealth Funds.
    - After the 2009 crisis and until January 2015, the mechanism was suspended and funds were used directly to finance the budget deficit.
  - Timor-Leste:
    - Petroleum Fund’s only expenditure is transfers to the budget, payment of operational management fees, and refunds of overpaid taxation.
    - Estimated sustainable income calculated as 3 percent of total petroleum wealth (sum of the value of the Petroleum Fund and remaining oil resources).
    - Transfer to the budget requires an explicit decision of Parliament.
- Policy guidance and coordination:
  - Inflow/outflow rules should be seen in context of improving fiscal framework, including explicit accounting for off-budget spending and government-guaranteed debt.
  - Recommended approach: target the long-term trajectory for spending of commodity revenues through financing the non-resource deficit and let accumulation in the SWF follow.
  - Critical to establish a firm link between asset accumulation/liquidation in SWFs and changes in actual budget surpluses/deficits.
  - Building a portfolio of liquid assets provides benefits in meeting fiscal needs and mitigating liquidity risk.

### III. Sovereign Assets and Liabilities Management (SALM) framing and liquidity considerations
- SALM framing and objectives:
  - SALM is an analytical framework for asset and liability management policies based on the sovereign balance sheet.
  - Sovereign liability management: ensure financing of the budget at the lowest possible cost subject to an acceptable level of risk over the medium to long term.
  - Sovereign asset management: ensure cash balances meet commitments and maximize the purchasing power of long-term capital given an acceptable level of risk.
  - SALM aims at a holistic approach by assessing both sustainability and vulnerability of government finances in the face of potential shocks.
  - Sovereign balance sheet should be based on economic rather than fixed accounting principles.
- Stylized sovereign balance sheet (structure):
  - Assets:
    - Present Value of Incomes: Taxes; Fees; Seigniorage.
    - Present Value of Nondiscretionary Expenses: Social and economic development; Government administration.
    - Balances: Cash; Currency Reserves; Investments (pension funds and SWFs); Government-owned enterprises; Infrastructure; Real Estate; Other assets.
  - Liabilities:
    - Balances: Monetary base; Government debt (In domestic currency; In foreign currency); Pension Liabilities.
    - Contingent claims (explicit and implicit): Guarantees to banks and nonbanks; Guarantees on retirement income; Guarantees on social welfare.
  - Outcomes: Net worth; Net financial worth.
- Measurement and definitional challenges:
  - Choice of accounting practice (mark-to-market vs historical) affects valuation; large movements in interest rates and exchange rates significantly impact bond valuation and external debt if marked-to-market.
  - Determining items to include in SALM: narrow SALM often coordinates international reserves and foreign currency debt; broader definitions include all sovereign financial assets and liabilities; present value of nonfinancial assets often excluded due to measurement difficulty.
  - This paper focuses on financial assets.
- Trade-offs: asset accumulation versus debt reduction:
  - Pros of liquid SWF assets: more flexibility in fiscal policy implementation; easier absorption of short-term fluctuations in resource revenues.
  - Cons: cost of servicing debt usually higher than expected returns on a low-risk stabilization portfolio; holding liquid reserves implies an opportunity cost (carry cost).
  - Recent research suggests net, not gross, debt level is the main determinant of government financing cost (Hadzi-Vaskov and Ricci (2016) and Bianchi et al. (2016)).
  - Implication: drawing on liquid assets to repay debt does not change the net asset position and thus cannot by itself reduce the risk premium; over time reduced opportunity cost of holding liquid assets could translate into lower spreads as benefits feed into fiscal balances and net debt trajectory.
- Liquidity risk as a central unified concern:
  - Major sovereign balance sheet risk: sudden shortages of liquidity in international financial markets.
  - Valuable sovereign assets (e.g., net present value of future tax receipts) are often illiquid.
  - Liability-side exposures include high foreign debt with short maturity, large banking sector dependent on external funding.
  - Insurance framework perspective:
    - Taking more/less risk than the market portfolio equals selling/buying insurance against credit or liquidity events.
    - Sellers of insurance expect higher returns but face potentially large losses in bad years; buyers accept below-average returns for protection in bad years.
  - This perspective helps assess capacity to take liquidity risk across reserves, pension funds, SWFs, and liabilities.

### Conditions increasing exposure of sovereign liabilities to liquidity risk
- Sovereign liabilities more exposed when:
  - The government debt/GDP ratio is high.
  - The share of illiquid assets to total assets is high.
  - The average maturity of government debt is low and/or the investor base is concentrated.
  - The government cannot borrow in its own currency and/or cannot create liquidity in the currency it borrows in.
  - The assets of the banking sector are large relative to GDP.
  - The banks are thinly capitalized and have low reserves of liquidity.
  - The banks rely on funding in foreign markets.
  - The private sector has a high level of external short term debt.
  - The depth and liquidity of the domestic currency and bond market is low.
- Mitigant: ample access to liquidity through high international reserves of liquid assets.

### Policy implications by liquidity access and exposure (four-fold typology)
- Four policy responses depending on liquidity access and vulnerability:
  I. Monitor liquidity risk.
    - Low exposure but low access: monitor risk and mitigate if it increases (e.g., strong banking sector growth or deficits financed by short-term borrowing).
  II. Reduce liquidity risk.
    - Low access and high vulnerability: urgent priority to reduce liquidity risk (extend debt maturity, curb banking-sector lending growth, increase bank capital adequacy, increase official reserves and liquidity of existing reserves).
  III. Consider the liquidity risk capacity of reserves.
    - High access and low vulnerability: may enhance expected returns by shifting into less liquid assets (example: Norway moving into real estate in the Government Pension Fund).
  IV. Consider deleveraging the sovereign balance sheet.
    - High access and high vulnerability: using excess reserves to repay external debt can reduce carry costs (example: Mexico arrangement in the 1990s).

### Asset and debt management with a growing SWF — three-stage SALM application
- Three-stage approach for indebted commodity exporters with growing commodity revenues:
  - Stage I: Debt reduction
    - Priorities: debt reduction and building up a fund as a stabilizer.
    - Evaluate appropriate level of stabilization fund in SALM, accounting for interest rate levels and size of public debt.
  - Stage II: Debt reduction and building up a stabilization fund
    - SWF stabilizes economy by (1) absorbing commodity revenue volatility via changes in rate of debt reduction; (2) allowing automatic budget stabilizers to work within long-term fiscal framework with changes absorbed by SWF.
  - Stage III: Targeting long-term saving objectives
    - Starts once target debt level and optimal stabilization size are reached; focus shifts to long-term savings objectives.
- Notes and caveats:
  - Establishment of SWF presupposes adequate international reserves and not excessive debt.
  - Three-fold "tranching" of SWF resources proposed; process asymmetric when fund must liquidate assets.
  - May not be optimal to reduce gross government debt to zero because having a stock of debt helps keep the market alive and facilitate government liquidity management; a country’s Debt Sustainability Analysis determines suitable debt levels.

### Financing fund model and fiscal coordination
- Financing fund model: transfers from the fund cover non-commodity deficits; outflows contingent on trajectory of non-commodity deficits determined by long-term fiscal strategy.
- In first stage (debt reduction), fiscal targets must be coordinated with debt-reduction targets.
- Effects of asset accumulation on debt servicing costs:
  - Growing reserves and sovereign assets increase resilience and may positively affect credit ratings and debt servicing costs, lowering the “insurance premium” for building financial assets (example: August 2012 Moody’s indicated possibility of upgrading Angola’s sovereign rating after establishment of a fiscal stabilization fund).
- Investment strategy considerations:
  - Domestic investment of SWF assets can create procyclical bias and potentially amplify booms and busts.
  - Depositing SWF funds in domestic banks risks amplifying procyclical effects via banks’ balance sheets and lending capacity.
  - Shifts of SWF assets to international markets may have short-term consequences for financial stability and the exchange rate.
  - Close coordination among institutions managing sovereign assets and liabilities is necessary, typically via legislation establishing policy guidelines and information sharing.

### Investment and risk management under the three-stage approach
- Investment and risk management must begin with the SWF’s purpose/objective; different tranches serve distinct purposes: repaying debt, smoothing fiscal revenues, building long-term savings.
- Tranche investment focuses (expanded in Appendix III):
  - Liability-matching tranche:
    - Objective: match domicile, currency, duration and credit of the liability intended to be repaid.
  - Stabilization tranche:
    - Objective: “maximize returns while ensuring sufficient funds are available to smooth fiscal revenues during foreseeable downturns.”
    - Investment focus: liquidity risk management, definition of “foreseeable,” favored assets include foreign fixed interest assets with good liquidity.
  - Long-term savings tranche:
    - Objective: “maximize long-term returns subject to not incurring undue risk.”
    - Investment focus: higher risk and less liquid investments such as equities and private assets when drawdowns are remote.
- Risk appetite, governance, and costs:
  - Essential elements: risk appetite discussions, transparency and communication.
  - Cost discipline is important in a low-yield environment; unwinding costs can be large and avoidable.
  - Separation of tranches and managers is possible but does not change core principles.

### Saving vs. domestic investment — trade-offs
- A nation can save in financial assets or in domestic assets that increase future consumption possibilities.
- Key trade-offs and constraints:
  - Poorer resource-rich countries may be in a poverty trap where reducing consumption to finance domestic investment is infeasible.
  - Natural resource revenues can break the trap but constraints apply:
    - National accounting identity: for one dollar of increased exports from the resource sector, x+y+z=1 where x = reduced exports from other sectors, y = increased imports, z = increased claims on other countries (financial assets).
    - If z=0, result must be increased net imports or private-sector accumulation of financial assets; accumulation in a fund helps reduce Dutch disease risk.
    - Aggregate profitability of many domestic projects may differ from sum of individual returns due to equilibrium effects.
    - Government-sponsored projects may erode public finances if benefits accrue to private sector without mechanisms to share returns.
  - Recommendation: assess optimal domestic investment levels within a unified macroeconomic framework including long-term growth and fiscal sustainability.

### Closing financing gaps and case studies
- Closing financing gaps (post-2014 price plunge):
  - Governments used a mix of asset drawdowns and debt issuance.
  - Short-run behavior: withdrew deposits from domestic banks, liquidated SWF assets and/or international reserves; later borrowed domestically and externally.
  - Trade-offs in borrowing vs drawing on assets depend on borrowing costs, market access, SWF objectives and size, liquidity, and risk management trade-offs.
- Case study: Saudi Arabia
  - Government debt was less than 2 percent of GDP and deposits at SAMA around 50 percent of GDP as of end-June 2014.
  - Fiscal deficit reached 16 and 17 percent of GDP as of end-2015 and 2016, respectively.
  - Policy mix: drawdown of government deposits at SAMA; domestic borrowing; external borrowing (syndicated loans and Eurobonds).
- Norway example:
  - Growing SWF implied a gradual increase in structural cash returns (dividends, interest coupons, rental income) which broadly offset widening structural non-oil deficit.

### Asset and liability management conclusions
- Key conclusions and policy implications:
  - Countries should assess the relationship between bridging financing gaps and asset accumulation/liquidation of SWFs within a broad SALM framework.
  - Align SWF management to fiscal framework through inflow/outflow rules, balance between debt repayment and asset accumulation, and appropriate investment strategies to meet fiscal financing needs timely.
  - Countries without an asset-liability framework should develop one given potential short- to medium-term financing needs.
  - Integrate management of sovereign assets and liabilities to maximize resilience.
  - Appropriate assessments of liquidity risk on both asset and liability sides are central.
  - Clear and consistent objectives, risk appetite and investment beliefs for each pool are key.
  - Where long-term savings assets were used for stabilization, remaining portfolio allocation may need reevaluation for consistency with long-term objectives.

### Appendix I — SWF asset accumulation and revenue projection models (highlights)
- Forecasting role and challenges:
  - Forecasts of future income from natural resources central to budget processes and SWF asset projections.
  - Commodity sector generally treated as exogenous source of government revenue.
- Quantity forecasts:
  - Data sources: main companies’ production plans, ministries, tax authorities, producer associations.
  - Company-provided expected quantities often treated as “best case scenario”; adjustments made for underperformance bias using historical information.
  - Chile example: between 2004–14, future production was overestimated on average by 20 percent.
- Price forecasts:
  - Long run common assumption: real dollar prices of commodities projected to remain constant (real prices follow a random walk without drift).
  - Chile: structural copper price from a 10-year expert forecast average (excluding highest and lowest).
  - Timor-Leste: forward-looking price estimates used to calculate net present value of petroleum resources feeding into spending rule (3 percent).
- Technological, structural, and climate-related risks:
  - Affect extractable resources, cost of extraction, and earnings projections; should be incorporated into price and volume projections and correlations.
- Transparency and replicability:
  - Main methodology and model inputs should be publicly available to ensure replicability and confidence in fiscal execution.

### Appendix II — inflow and outflow rules of selected SWFs (selected entries)
- Australia (Future Fund):
  - Inflows: government budget surpluses; proceeds from Telstra sale; discretionary transfers.
  - Outflows: only once superannuation liability fully offset or from July 1, 2020, subject to oversight.
- Canada (Alberta Heritage Fund):
  - Inflows history: transfers initially of 30 percent of non-renewable resources; retention rules changed over time; current legislated inflation-proofing retention forecast $304 million.
  - Investment income less inflation-proofing transferred to General Revenue Fund since 1982.
- Chile (ESSF):
  - Inflows: effective fiscal surpluses above 0.5 percent of GDP.
  - Outflows: support counter-cyclical fiscal policies, finance authorized public expenditures in case of fiscal deficit, amortize public debt, finance annual contribution to Pension Fund PRF.
- New Zealand (Pension Reserve Fund):
  - Inflows: establishing legislation funding formula; contributions suspended in July 2009.
  - Outflows: after 2020 potential withdrawals; around 2035 government to begin withdrawals to smooth superannuation costs.
- Norway:
  - Inflows: net cash flow to government from petroleum sector plus returns on fund investments.
  - Outflows: transfer to cover non-oil deficit; “spending rule” non-oil deficit on average 3 percent of the fund.
- Kuwait:
  - GRF receives all revenues; FGF established 1976 with 50 percent of GRF balance and annual transfer of 10 percent of all State revenues.
  - FGF: no assets withdrawn unless authorized by specific legislation.
- U.S. (Alaska Permanent Fund):
  - Inflows: at least 25 percent of mineral lease rentals, royalties, royalty sales proceeds, federal mineral revenue-sharing payments, and bonuses.
  - Managed as single investment pool with principal (non-spendable) and earnings reserve (spendable).
- UAE (ADIA):
  - Inflows: government surplus funds.
  - Mandate: make resources available to government as needed; withdrawals infrequent.
- Timor-Leste (Petroleum Fund):
  - Inflows: tax revenues, first tranche petroleum and oil profit, investment returns, other revenues.
  - Outflows: transfers based on Estimated Sustainable Income = 3 percent of total petroleum wealth; transfers require explicit Parliamentary decision and certification.

### Appendix III — considerations in investment and risk management (highlights)
- Investment decision hierarchy and responsibilities:
  - Investment objective, risk and return expectations, investment beliefs: Owner/Executive Board.
  - Strategic asset allocation (SAA), numeraire currency, investment constraints, benchmarks, active risk budget: Executive Board or owner.
  - Investment/divestment decisions: Investment managers (may be external).
- Investment objectives by fund type:
  - Stabilization funds: maximize risk-adjusted returns subject to low risk and high liquidity.
  - Savings funds: maintain exposures through downturns; greater allocation to volatile assets such as equities.
- Reference portfolio and numeraire currency:
  - Reference portfolio composed of liquid listed asset classes as implementable owner benchmark (used by Canada Pension Plan Investment Board, NZ Super Fund, GIC).
  - Numeraire currency choices vary: single currency (often USD) or weighted basket (Norway, Singapore).
- Risk appetite and constraints:
  - Risk appetite statements may express tolerance as a stress loss or drawdown limit: example phrasing in text: “the prospective losses from the fund shall not exceed x percent over a period of y years.”
  - Investment constraints include prohibitions on domestic assets for stabilization funds; limits on single manager, asset, or opportunity.
- Benchmarks, active risk, transition strategies:
  - SAA accounts for majority of total risk; active risk contributes less.
  - Transition strategies should be clearly stated and staged (Norway, New Zealand examples).
- Statement of Investment Policies should include:
  - Asset classes, benchmarks, balance between risk and return, concentration limits, governance, voting policy, derivatives and leverage policy, and risk management coverage.
- Risk management practices:
  - Rebalancing: calendar-based or risk-based approaches.
  - Definition of risk: potential to not achieve fund objectives; includes financial, operational, strategic, regulatory risks.
  - Risk analytics: volatility, correlations, sensitivity to macro variables, currency exposures, liquidity-event susceptibility, downside risk under stress.
  - Review frequencies:
    - Stable funds with dynamic allocation: review SAA every three years.
    - Less mature funds: review period one year.
  - Use of derivatives: integral for hedging and exposure management but requires higher controls due to leverage and credit/currency/liquidity risks.

*Italicized source: wp1826 - 1. Stylized Sovereign Balance Sheet (IMF working paper excerpt).*

### 1. Stylized Sovereign Balance Sheet

### 1. Stylized Sovereign Balance Sheet

### I. Introduction — role and challenges of commodity-based SWFs
- Commodity-based SWFs have experienced various strains since the pronounced fall in commodity prices over the past few years.
- Current challenges for resource-based SWFs:
  - Maintaining funding bases amid lower commodity revenues.
  - Improving investment activities in an environment of subdued growth and low interest rates.
  - Organizational and institutional structure issues, investment and risk management mandates, and transparency and accountability as global investors.
- SWF categories (Santiago Principles, 2008) and defining features relevant to the paper:
  - Stabilization funds: insulate budget/economy from commodity price volatility; investment horizons and liquidity objectives resemble central banks' reserve managers; role in countercyclical fiscal policies to smooth boom/bust cycles.
  - Savings funds: share wealth across generations by transforming non-renewable assets into diversified financial assets; higher tolerance for volatility and focus on long-term returns.
  - Development funds: allocate resources to priority socioeconomic projects, usually infrastructure.
  - Pension reserve funds: meet identified outflows in the future related to pension-type liabilities; usually hold high shares in equities.
  - Reserve investment corporations: reduce negative carry costs of holding reserves or earn higher return on ample reserves while assets are still counted as reserves; often maintain high allocations in equities and alternative investments.
- Paper focus: stabilization and savings funds.
- Principal aims of the paper:
  - Examine macro-fiscal linkages for SWFs.
  - Present an integrated sovereign assets and liabilities management (SALM) approach with emphasis on liquidity risk.
  - Apply framework to scenarios of asset accumulation in an SWF and to SWF drawdowns to cover financing gaps due to lower commodity prices.
- Key premise: resilience of the sovereign balance sheet is maximized if sovereign assets and liabilities are managed in an integrated manner and liquidity risk across both asset and liability sides is appropriately assessed.

### II. Macroeconomic and financial linkages
- Fiscal frameworks should:
  - Be guided by an assessment of fiscal sustainability and consider external risk factors.
  - Promote sustainability of fiscal policy, be sufficiently flexible to scale up growth-enhancing expenditure, consider absorption capacity constraints and public financial management quality, and provide precautionary buffers against revenue volatility (see Baunsgaard et al., 2012).
- Inflow/outflow rules for SWFs should be tailored to each country’s fiscal strategy (Appendix II referenced).
- Examples of country approaches to rules and integration with fiscal frameworks:
  - Chile:
    - Structural balance rule uses structural revenue forecasts.
    - Copper revenue estimated using a long-term (10-year average), forward-looking reference price from an independent panel of experts.
    - Other revenue based on potential output estimated by a panel of experts.
    - Expenditure is the residual after subtracting the structural balance target from estimated structural revenue.
  - Norway:
    - “Spending rule” (first established in 2001): the non-oil budget deficit should be on average 3 percent of the Norwegian SWF over time, which corresponds to the estimated real return on the fund.
    - Note: Norwegian government recently changed the rule by lowering the non-oil budget deficit from 4 to 3 percent of the fund, reflecting lower expected returns.
    - Comparable practice: U.S. endowment funds often have spending rules based loosely on 4–5 percent of a 5-year moving average of fund value.
  - Russia:
    - Special mechanism for oil and gas revenues to reduce budget dependence and accumulate reserves in downturns; revenues accumulated in the Reserve and the National Wealth Funds.
    - After the 2009 crisis and until January 2015, the mechanism was suspended and funds were used directly to finance the budget deficit.
  - Timor-Leste:
    - Petroleum Fund’s only expenditure is transfers to the budget, payment of operational management fees, and refunds of overpaid taxation.
    - Mechanism for integrating the Petroleum Fund and budget is the estimated sustainable income, calculated as 3 percent of total petroleum wealth (estimated as the sum of the value of the Petroleum Fund and remaining oil resources).
    - Transfer to the budget requires an explicit decision of Parliament.
- Policy guidance on inflow/outflow rules and broader fiscal framework:
  - Inflow/outflow rules should be seen in the context of necessary improvements to the fiscal framework, including explicit accounting for off-budget spending and government-guaranteed debt.
  - Ideally, the fiscal framework targets a sustainable longer-term trajectory for the non-commodity budget deficit.
  - The inflow and outflow rules for an SWF would reflect the accumulation of assets associated with the chosen long-term trajectory of non-resource deficits and act as a buffer for changing commodity revenues.
  - Rather than targeting a specific size of the SWF or a specific share of commodity revenues to the fund, the recommended approach is to target the long-term trajectory for spending of commodity revenues through financing the non-resource deficit and let accumulation in the SWF follow.
  - The inflow and outflow rules for an SWF should be aligned closely with the actual net fiscal position of the government (IMF, 2015).
    - Critical to establish a firm link between asset accumulation/liquidation in SWFs and changes in actual budget surpluses/deficits.
    - This is especially urgent for countries with an increasing stock of debt and a high cost of servicing it.
  - Building a portfolio of liquid assets provides benefits in terms of meeting fiscal needs and mitigating liquidity risk.

### III. Sovereign Assets and Liabilities Management (SALM) framing and liquidity considerations
- Optimal SWF management is closely linked to broader SALM.
- In periods of low commodity prices, SWFs face critical decisions on asset accumulation versus liquidation in the presence of sovereign debt and fiscal deficits.
- The paper emphasizes management of liquidity risk at the sovereign balance sheet level and its relevance to SWF strategy.
- Key implication:
  - Asset accumulation/liquidation in SWFs should reflect changes in the actual financial position of the sovereign balance sheet to avoid undermining fiscal sustainability.

_Italicized source: wp1826 - 1. Stylized Sovereign Balance Sheet (IMF working paper excerpt)._

### Appendix I provides an overview of SWF asset accumulation and revenue projection models.

### Appendix I provides an overview of SWF asset accumulation and revenue projection models.

### Investment location, procyclicality, and fiscal links
- When a fund is set up to manage revenue from exports of natural resources, it is essential that its assets be largely invested abroad for the fund to meet its stated objectives.
- Investing the fund’s assets domestically will have a procyclical bias and not be compatible with the stabilization objective of the fund.
- Upward swings in commodity prices tend to result in a boom in aggregate domestic demand, inflationary pressures, and thus an appreciation of the real exchange rate vis-à-vis trading partners in resource-based economies; investing the fund outside the domestic economy would help mitigate that risk.
- Investing assets domestically implies:
  - More money flowing into domestic assets when resource revenues are high, pushing up asset prices.
  - Potential withdrawals from the fund to support the budget if resource revenues fall, with sales depressing domestic asset prices when they are already likely to be depressed.
  - If the fund purchases domestic government debt instruments, the fund would essentially be functioning as an extension of the fiscal budget and create an unwanted loophole in the fiscal framework.
- Even when a fund is invested abroad, procyclicality can stem from fiscal rule design:
  - If the fiscal rule is linked to the size of a fund, cyclical swings in asset prices can translate into cyclicality in spending.
  - For countries with spending rules based fully or partly on estimates of future prices of resources, projections of future prices may be influenced by the current price environment, introducing procyclicality in spending.
- Other links between commodity-based SWF investment strategies and the macroeconomic framework relate to monetary policy and exchange rate movements.

### SALM (Sovereign Asset and Liability Management) framework and objectives
- The SALM approach (as analyzed by Das et al. (2012)) is an analytical framework for asset and liability management policies based on the sovereign balance sheet.
- Main objectives:
  - Sovereign liability management: ensure financing of the budget at the lowest possible cost subject to an acceptable level of risk over the medium to long term.
  - Sovereign asset management: ensure cash balances meet commitments and maximize the purchasing power of long-term capital given an acceptable level of risk.
- SALM aims at a holistic approach by assessing both sustainability and vulnerability of government finances in the face of potential shocks.
- A sovereign balance sheet should be based on economic rather than fixed accounting principles (Merton, 2007), considering the underlying intertemporal objective of the sovereign and including future income and expenditures.
- The IMF’s Government Finance Statistics Manuals is an accounting approach for the valuation of government’s assets and liabilities (footnote context).

### Stylized sovereign balance sheet (structure)
- Assets:
  - Present Value of Incomes:
    - Taxes
    - Fees
    - Seigniorage
  - Present Value of Nondiscretionary Expenses:
    - Social and economic development
    - Government administration
  - Balances:
    - Cash
    - Currency Reserves
    - Investments (pension funds and SWFs)
    - Government-owned enterprises
    - Infrastructure
    - Real Estate
    - Other assets
- Liabilities:
  - Balances:
    - Monetary base
    - Government debt
      - In domestic currency
      - In foreign currency
    - Pension Liabilities
  - Contingent claims (explicit and implicit):
    - Guarantees to banks and nonbanks
    - Guarantees on retirement income
    - Guarantees on social welfare
- Outcomes:
  - Net worth
  - Net financial worth
- Source indicated as Merton (2007).

### Measurement and definitional challenges
- Two main challenges in defining the sovereign balance sheet:
  1. Choice of relevant accounting practices: asset and liability values depend on valuation measure (mark-to-market vs historical price); large movements in interest rates and exchange rates significantly impact bond valuation and external debt if marked-to-market.
  2. Determining items to include in SALM: narrow SALM often coordinates international reserves and foreign currency debt; broader definitions include all sovereign financial assets and liabilities (present value of nonfinancial assets often excluded due to measurement difficulty).
- This paper focuses on financial assets.

### Trade-offs: asset accumulation versus debt reduction
- For indebted resource-rich countries, SALM suggests striking the right balance between debt repayments and building up SWF assets.
- Pros of liquid SWF assets:
  - More flexibility in fiscal policy implementation.
  - Easier absorption of short-term fluctuations in resource revenues within a long-term framework.
- Cons:
  - Cost of servicing debt would usually be higher than expected returns on a low-risk portfolio aimed at stabilization; holding liquid reserves in a fund implies an opportunity cost (carry cost) for the government.
  - Government liabilities costs are near certain (issuance-weighted coupon on current debt outstanding), while returns on prospective investments vary widely across time horizons.
- Recent research suggests net, not gross, debt level is the main determinant of government financing cost (Hadzi-Vaskov and Ricci (2016) and Bianchi et al. (2016)).
  - Implication: drawing on liquid assets to repay debt does not change the net asset position and thus cannot by itself reduce the risk premium; however, over time reduced opportunity cost of holding liquid assets could translate into lower spreads as benefits feed into fiscal balances and net debt trajectory.

### Liquidity risk as a central unified concern
- Sovereign balance sheet major risk: sudden shortages of liquidity in international financial markets.
- Valuable sovereign assets (e.g., net present value of future tax receipts) are often illiquid.
- Liability-side exposures to adverse international liquidity events include:
  - High foreign debt burden with short maturity increases rollover risk under constrained liquidity.
  - Large banking sector dependent on external funding can be a significant contingent liability.
- From an asset allocation perspective, risk factors (liquidity, credit, equity premium) are building blocks of expected returns; some factors (liquidity) may have skewed return distributions—modest positive returns most years, few periods of significant losses that often coincide with when investors can least tolerate them.
- Investment problem reframed in an insurance framework:
  - Taking more/less risk than the market portfolio is equivalent to selling/buying insurance against credit or liquidity events.
  - Sellers of insurance expect higher returns but face potentially large losses in bad years; buyers accept below-average returns for protection in bad years.
- Insurance perspective helps assess capacity to take liquidity risk across reserves, pension funds, SWFs, and liabilities (e.g., borrowing long duration implies higher expected financing cost due to term premium but lower rollover risk under tight liquidity).

### Conditions increasing exposure of sovereign liabilities to liquidity risk (as listed)
- The liabilities of the sovereign balance sheet will be more exposed to liquidity risk in circumstances such as:
  - The government debt/GDP ratio is high
  - The share of illiquid assets to total assets is high
  - The average maturity of government debt is low and/or the investor base is concentrated
  - The government cannot borrow in its own currency and/or cannot create liquidity in the currency it borrows in
  - The assets of the banking sector are large relative to GDP
  - The banks are thinly capitalized and have low reserves of liquidity
  - The banks rely on funding in foreign markets
  - The private sector has a high level of external short term debt
  - The depth and liquidity of the domestic currency and bond market is low
- Risks are mitigated if the government has ample access to liquidity through high international reserves of liquid assets.

### Policy implications by liquidity access and exposure (four-fold typology)
- Four combinations of liquidity access and liquidity exposure (illustrated in Figure 1) yield general policy implications:
  I. Monitor liquidity risk.
    - Low exposure but low access: monitor risk and mitigate if it increases (e.g., strong banking sector growth or deficits financed by short-term borrowing).
  II. Reduce liquidity risk.
    - Low access and high vulnerability: make liquidity risk reduction an urgent priority (extend debt maturity, curb banking-sector lending growth, increase bank capital adequacy, increase official reserves and liquidity of existing reserves).
  III. Consider the liquidity risk capacity of reserves.
    - High access and low vulnerability: resource-rich economies with relatively large SWFs and low gross debt/robust banking sector may enhance expected returns by shifting into less liquid assets (example: Norway moving into real estate in the Government Pension Fund).
  IV. Consider deleveraging the sovereign balance sheet.
    - High access and high vulnerability: although liquid assets reduce short-term liquidity shock risk, carry costs may be high; using excess reserves to repay external debt can reduce cost (example: Mexico used excess currency reserves to repay government debt through an arrangement between the Central Bank and the Ministry of Finance in the 1990s).

### Asset and debt management with a growing SWF — three-stage SALM application
- Practical SALM application for indebted commodity exporters with growing commodity revenues suggests a three-stage approach (Figure 2):
  - Stage I: Debt reduction
    - Key priorities during stage one and two are to allow for debt reduction as set out in the fiscal framework and building up a fund to act as a stabilizer to cushion the budget and the economy against volatile commodity prices.
    - Critical to strike the right balance between debt repayments and asset accumulation for stabilization purposes.
    - The appropriate level of the stabilization fund should be evaluated in a SALM framework, taking account of interest rate levels and the size of public debt.
  - Stage II: Debt reduction and building up a stabilization fund
    - The SWF contributes to stabilizing the economy in two ways:
      1. Use of annual commodity revenues for debt reduction implies commodity revenue volatility will be absorbed by changes in the rate of debt reduction rather than changes in government spending.
      2. Allow automatic budget stabilizers to work within a long-term fiscal policy framework, with resulting changes in budget stance absorbed by the SWF.
  - Stage III: Targeting long-term saving objectives
    - Starts once target debt level and optimal size of stabilization objective are reached; focus shifts to long-term savings objectives.
- Notes and caveats:
  - The establishment of a SWF presupposes that the SWF owner country has (i) adequate international reserves and (ii) not excessive debt.
  - The three-fold "tranching" of the SWF's resources is proposed; the process is not symmetric when the fund must liquidate assets to finance budget deficits and will depend on magnitude of commodity price fall, fiscal shortfalls, and availability of buffers.
  - It may not be optimal to reduce gross government debt to zero because having a stock of debt helps keep the market alive and facilitate government liquidity management; a country’s Debt Sustainability Analysis determines suitable debt levels under plausible assumptions.

### Financing fund model and fiscal coordination
- As part of the fiscal strategy and SALM framework, a “financing fund” model can be considered where transfers from the fund cover non-commodity deficits.
- Actual outflows would be contingent on the trajectory of non-commodity deficits, which should be determined by an appropriate long-term fiscal policy strategy.
- The appropriate fiscal rule depends on factors including the size of the non-commodity deficit at the time of transition to a financing fund model.
- In the first stage, where the focus is on debt reduction, fiscal targets must be coordinated with debt-reduction targets.
- Effects of asset accumulation on debt servicing costs:
  - Growing reserves and sovereign assets increase resilience to adverse shocks and may positively affect credit ratings and debt servicing costs, lowering the “insurance premium” for building financial assets (example: August 2012 Moody’s indicated possibility of upgrading Angola’s sovereign rating after establishment of a fiscal stabilization fund).
- Investment strategy considerations:
  - If some SWF assets are invested in the domestic financial system, it may contribute to procyclical macro-policies (acquiring domestic currency-denominated assets in booms and disposing in busts).
  - Depositing SWF funds in domestic commercial banks risks amplifying procyclical effects via banks’ balance sheets and lending capacity.
  - Shifts of SWF assets to international financial markets may have shorter-term consequences for financial stability and the exchange rate.
  - Close coordination among institutions managing sovereign assets and liabilities is necessary, typically via legislation establishing policy guidelines and information sharing.

### Investment and risk management under the three-stage approach
- Investment and risk management must begin with the SWF’s purpose/objective; the three-stage approach delineates funds serving different purposes: repaying debt, smoothing fiscal revenues, building long-term savings.
- A single SWF may house two or three purposes via financing model, but clarity and calibration of tranches is key to establishing an appropriate overall investment strategy.
- For the debt repayment tranche, funds are generally applied directly to retiring debt; where delays occur, the objective of any pool...

*Source: Appendix I, wp1826 — overview of SWF asset accumulation and revenue projection models.*

### Appendix III provides further considerations on investment and risk management.

### Appendix III provides further considerations on investment and risk management

### Investment tranches and objectives
- Three implied tranches and their investment-management focus:
  - Liability-matching tranche
    - Objective: match the domicile, currency, duration and credit of the liability (i.e., the debt that it is intended to repay).
    - Investment management focus: appropriate level of mismatch given available investments.
  - Stabilization tranche
    - Stated objective: “maximize returns while ensuring sufficient funds are available to smooth fiscal revenues during foreseeable downturns.”
    - Investment management focus:
      - Liquidity risk management and the definition of “foreseeable.”
      - If the pool is well funded relative to fiscal revenues, a greater degree of risk can be borne and higher returns anticipated.
      - If stakeholders require “foreseeable” to mean “any” downturn, less risk can be taken and less return anticipated.
      - Favored assets: foreign investments with good liquidity and a tendency to go up in price, or at least not do go down, during the sorts of crises that would lead to fiscal deficits — characteristics that favor foreign fixed interest assets, though other foreign assets lowly correlated with crises may be considered.
      - Framework elements: approved asset lists, credit and currency management, modeling of price movements during stress tests to assess likelihood of sufficient liquidity to meet foreseeable fiscal shortfalls.
  - Long-term savings tranche
    - Reasonable objective: “maximize long-term returns subject to not incurring undue risk.”
    - Investment management focus:
      - When stabilization tranche is effective and drawdowns are remote, include higher risk and less liquid investments such as equities and private assets to seek higher returns.
      - Key discussion: stakeholders must agree what level of risk constitutes “undue.”
      - Framework elements: sizing allocations across investment types (asset allocation) to maximize return for a given level of risk; clear investment beliefs; appointing aligned managers; currency management; liquidity management.

### Risk appetite, governance, and costs
- Essential elements:
  - Risk appetite discussions among stakeholders around definitions of “foreseeable” and “undue.”
  - Transparency and communication.
- Cost considerations in a low-yield environment:
  - Focusing on costs has never been more important.
  - The costs of unwinding one investment to establish another after a change of heart or knee-jerk reaction are likely to be among the most expensive avoidable costs.
  - To avoid such costs, trust and transparency must be established.
- Appointment and separation:
  - A more formal separation of investment tranches into separate funds, and different managers for different funds (for instance the Central Bank for the most liquid fund and a separate manager for longer term savings), is possible but does not affect the general principles outlined.

### Saving vs. domestic investment (Box 1)
- Framing: A nation can save in financial assets (accumulating claims on other countries) or in domestic assets that increase future consumption possibilities (physical infrastructure, human capital).
- Key trade-offs and constraints:
  - Many poorer resource-rich countries face constrained access to credit and low income, which can lead to a poverty trap where reducing consumption to finance domestic investment is not feasible.
  - Natural resource revenues can break the trap by channeling revenues into domestic investments that may yield higher returns than foreign financial assets, but several constraints apply:
    - National accounting identity for one dollar of increased exports from the resource sector: it must be matched by a combination of
      - Reduced exports from other sectors of the economy (x); and/or
      - Increased imports (y); and/or
      - Increased claims on other countries in the form of an accumulation of financial assets (z),
      - where x+y+z=1.
    - If the government chooses z=0 (no fund accumulation), the result must be either increased net imports or increased private-sector accumulation of financial assets; increased net imports occur via real exchange rate appreciation, which must be reversed when resource income falls, creating Dutch disease risk. Accumulation of financial assets in a fund helps reduce this risk.
    - Sum of many individually profitable domestic projects may be less profitable in aggregate because investments affect equilibrium prices, wages, and exchange and interest rates.
    - Projects profitable for society may erode government finances over time because investment costs are borne by government while benefits accrue to the private sector; weak mechanisms for sharing returns with government (taxes, user tariffs) lower the optimal level of such investments.
  - Recommendation: assess optimal domestic investment levels within a unified macroeconomic framework that includes longer-term growth and fiscal sustainability.

### Financing funds: models and linkages (Box 2 and Section V)
- Fund typologies and primary features:
  - Stabilization funds
    - Set up to reduce impact of volatile revenues (example: Chile, Russia).
    - Inflows and outflows contingent on whether revenues are “high/low.”
  - Savings funds
    - Objective: build wealth for future generations (examples: Abu Dhabi Investment Authority, Libya, Norway, Russia National Welfare Fund).
    - Typically fixed inflows and discretionary outflows; set up when government can set aside funds and be confident short/medium-run liquidation is not necessary.
  - Financing fund model
    - Combines characteristics of savings and stabilization funds (examples: Norway, Timor-Leste).
    - Fully integrated with the government budget process.
    - Inflows: government resource revenues plus returns on investments.
    - Outflows: transfers to cover the non-resource budget deficit.
    - Accumulation in the fund corresponds to an improvement in the government’s net asset position; stabilization and savings funds are not necessarily linked to government budget deficits/surpluses (example: New Zealand).
    - Central feature: a fiscal policy guideline (rule) that sets the desired trajectory of the non-resource budget deficit to be covered by transfers from the fund.
- Closing financing gaps (Section V)
  - The plunge in commodity prices since mid-2014 created fiscal shortfalls; countries closed financing gaps (fiscal deficits plus servicing of debt) via a mix of asset drawdowns and debt issuance.
  - Short-run behavior:
    - Many governments initially withdrew deposits from domestic banking systems and liquidated SWF assets and/or international reserves.
    - Subsequently they borrowed domestically and tapped international debt markets, and in some cases used syndicated loans.
  - Trade-offs in choosing between borrowing and drawing on assets depend on:
    - Borrowing costs, market access and sentiment.
    - Objectives and size of SWFs.
    - Liquidity of financial assets.
    - Risk management trade-offs for the sovereign balance sheet.
  - Example strategies (Phase I / Phase II linkage in closing financing gap):
    - Withdrawing deposits from the banking system.
    - Domestic borrowing.
    - Liquidating sovereign assets.
    - External borrowing (bonds, syndicated loans).
  - Consideration: even if stabilization funds did not fully protect against the 2014 shock, that does not necessarily mean they were too small — high insurance costs against very large shocks matter for calibration of stabilization vs savings portions.

### Case study: Saudi Arabia (Box 3) and related observations
- Saudi Arabia context and response:
  - Government debt was less than 2 percent of GDP and its deposits at SAMA (considered as a SWF) stood at around 50 percent of GDP as of end-June 2014.
  - Due to the collapse of international oil prices, the country incurred fiscal deficits after years of surpluses; the fiscal deficit reached 16 and 17 percent of GDP as of end-2015 and 2016, respectively.
  - To limit pressures on drawing down financial assets, the government optimized asset-liability management using a mixture of:
    - Drawdown of government deposits at SAMA.
    - Domestic borrowing from the banking system and institutional investors.
    - External borrowing (syndicated loans and Eurobonds).
  - Managing an increasing issuance of debt posed challenges for minimizing interest rate and exchange rate risks.
- Norway example:
  - A growing SWF implied a gradual increase in structural cash returns from financial assets (dividends, interest coupons, and rental income from properties—excluding any revaluations), which broadly offset the effect of a widening structural non-oil deficit.

### Asset and liability management conclusions (Section VI)
- Key conclusions and policy implications:
  - As commodity prices may stay low for longer, countries should assess the relationship between bridging financing gaps and asset accumulation/liquidation of SWFs within a broad SALM framework.
  - Align SWF management to the fiscal framework through inflow and outflow rules, the balance between debt repayment and asset accumulation, and appropriate investment strategies that can meet fiscal financing needs timely.
  - Countries without an asset-liability framework should develop one, especially given potential short- to medium-term financing needs.
  - Integrate management of sovereign assets and liabilities to maximize the resilience of the sovereign balance sheet.
  - Appropriate assessments of liquidity risk on both asset and liability sides are central.
  - Clear and consistent objectives, risk appetite and investment beliefs for each pool of sovereign wealth are key to consistent and transparent investment decisions and SWF functioning.
  - Where long-term savings assets have been used for stabilization, the allocation of the remaining portfolio may need reevaluation to ensure consistency with long-term objectives.

*Source: wp1826 - Appendix III provides further considerations on investment and risk management.*

### Appendix I. SWF Asset Accumulation and Revenue Projection Models

### Appendix I. SWF Asset Accumulation and Revenue Projection Models

### Forecasting challenges and role in policy
- Forecasts of future income from natural resources are central to budget processes and macroeconomic modeling in most resource-rich countries.
- Commodity sector is generally treated as an exogenous source of income for the economy and for government revenue (royalties, taxes, dividends).
- Forecasts feed into projections of asset growth for SWFs where flows are linked to commodity exports and inform investment strategy decisions.

### Data sources and institutional practices for quantity forecasts
- Sources used:
  - Main companies in the sector (production plans for operating and under-construction projects).
  - Specialized institutions: relevant ministries, tax revenue service, producers associations.
  - Country examples: Chile (central bank and MoF collect from companies, Ministry of Mining, tax revenue service); Norway (forecast of expected future petroleum production on the Norwegian continental shelf provided by Norwegian Petroleum).
- Treatment of company-provided expected quantities:
  - Often treated as a “best case scenario.”
  - Adjustments are made for underperformance bias using historical information.
  - Chile example: between 2004–14, future production was overestimated on average by 20 percent.
- Main causes of overestimation for mines in operation (Chile):
  1. Overestimation of average mineral proportion per ton of cinder (small source of bias).
  2. Unpredictable natural events (landslides, earthquakes, rock explosions).
  3. Accidents with life casualties forcing temporary cessation of operations.
  4. Equipment failure.
- Additional issue: regular delays in construction of new mines.

### Price forecasts: short run vs long run and structural prices
- Short run:
  - Combination of external and internal forecasts used to project prices.
- Long run:
  - Common assumption: prices in U.S. dollars increase at a rate similar to global inflation, i.e., real dollar prices of commodities are projected to remain constant.
  - This implies the real price follows a random walk without drift (practice at the World Bank and the IMF).
- Forward-looking structural price calculations (country examples):
  - Chile:
    - SWFs accumulate assets according to a rule based on a “structural surplus.”
    - Government uses a structural price for copper among other variables.
    - Once a year a committee of experts provides their forecast for the average price of copper for the next 10 years.
    - The structural price is the simple average of each expert’s forecast (excluding the highest and the lowest estimate).
  - Timor-Leste:
    - Forward-looking price estimates used to calculate a net present value of petroleum resources, which feeds into the fiscal framework through a spending rule linked to sustainable income.

### Technological, structural, and climate-related risks
- Technological and structural risks affect:
  1. Total amount of extractable natural resources (evolving extraction technology, e.g., oil sands extraction and renewables).
  2. Cost of extraction may fall over time due to technological progress.
  3. Earnings projections may be affected by technology available to rival producers and regulatory changes that affect demand.
- These shifts should be incorporated into:
  - Price projections.
  - Volume projections.
  - Modelling of correlations between commodity price movements and other variables (e.g., global interest rates).
- Technology risk implicitly includes risks related to climate change.

### Transparency and replicability
- Transparency should guide the use of forecasting models.
- Main methodology and model inputs should be publicly available to ensure:
  - Forecasting results are replicable.
  - Prevention of data and modeling manipulation.
  - Enhanced confidence in fiscal policy execution.

*Source: Appendix I and Appendix II excerpts from wp1826 - Appendix I. SWF Asset Accumulation and Revenue Projection Models*

---

### Appendix II. Inflow and Outflow Rules of Selected Sovereign Wealth Funds

### Australia: Pension Reserve Fund (Future Fund and Nation-building Funds)
- Inflows:
  - Contributions come from the Australian government's budget surpluses.
  - Received proceeds from sale of government’s stake in Telstra in late 2006 and approximately 2 billion shares in Telstra remaining after this sale process.
  - May receive discretionary transfers from the Finance Minister.
- Outflows:
  - Withdrawals occur only once the superannuation liability is fully offset or from July 1, 2020, whichever is earlier, except for operating costs or if the Future Fund’s balance exceeds the target asset level.
  - Withdrawals determined by the government, subject to Advisory Board advice and Parliamentary oversight.
  - Board must ensure during a financial year that the Fund Account is sufficient to cover its purpose.
  - The Fund Account is a Special Account for the purposes of the Financial Management and Accountability Act 1997.

### Canada (Alberta): Savings Fund / Heritage Fund
- Inflows history:
  - Initially: annual transfers of 30 percent of non-renewable resources.
  - Until 1982: retained all investment income.
  - In 1984, retention reduced to 15 percent and to 0 percent in 1987.
  - Since 1987: automatic annual payments apart from inflation-proofing stopped; ad hoc capital transfers from budget surpluses occur.
- Current practices:
  - Legislated provision for retaining portion of income as inflation-proofing; annual amount forecast to be retained is $304 million.
  - ALM approach: assets and income fully consolidated with provincial assets and revenue.
  - Since 1982, investment income less inflation-proofing is transferred to the General Revenue Fund to pay for priority programs.
  - Minister of Finance may charge costs or expenses to the Heritage Fund if incurred in respect of the Heritage Fund.

### Chile: ESSF (Stabilization Fund)
- Inflows:
  - Effective fiscal surpluses above 0.5 percent of GDP.
- Outflows:
  - Support counter-cyclical fiscal policies, finance authorized public expenditures in case of fiscal deficit, regular or extraordinary amortization of public debt, and financing the annual contribution to the Pension Fund PRF.

### New Zealand: Pension Reserve Fund
- Inflows:
  - Establishing legislation includes a funding formula deriving an annual government contribution, made during early period while superannuation cost is low; contributions come from tax revenue.
  - Contributions suspended in July 2009; funding formula disclosed (legislation link provided in source).
- Outflows:
  - After 2020, if required annual capital contribution is less than 0, Minister may require a capital withdrawal up to that amount.
  - Around 2035 government will begin making withdrawals from the Fund in line with the funding formula to smooth superannuation costs.
  - Money may be paid out to pay investment manager fees, meet obligations directly related to operation of the Fund, and pay taxation liabilities arising in respect of the Fund.

### Norway: Stabilization and Savings Fund
- Inflows:
  - Defined in legislation: net cash flow to the government from the petroleum sector plus returns on the fund’s investments.
  - Net cash flow includes taxes and duties on petroleum companies, net cash flows from government direct participation in the petroleum sector, and dividends from Statoil.
- Outflows:
  - Transfer to cover the non-oil deficit of the central government budget (difference between total expenditures and non-oil revenues).
  - “Spending rule”: non-oil budget deficit should be on average 3 percent of the fund over time, corresponding to the estimated real return on the Fund.

### Kuwait: GRF (General Reserve Fund) and FGF (Future Generations Fund)
- Inflows:
  - GRF receives all revenues (including all oil revenues); FGF established in 1976 with 50 percent of GRF balance and annual transfer of 10 percent of all State revenues; all investment income reinvested, including 10 percent of GRF net income.
- Outflows:
  - GRF: transfers to pay State budgetary expenditures sanctioned by law.
  - FGF: no assets can be withdrawn unless authorized by specific legislation.

### U.S. (Alaska): Permanent Fund (Savings Fund)
- Inflows:
  - At least 25 percent of all mineral lease rentals, royalties, royalty sales proceeds, federal mineral revenue-sharing payments, and bonuses.
- Management and accounting:
  - Managed as a single investment pool but divided for accounting into principal (non-spendable) and earnings reserve (assigned).
  - Principal may not be spent per Alaska Constitution; earnings reserve may be spent by the Legislature for any public purpose, including Permanent Fund Dividend distribution.
- Outflows:
  - Legislature decides Fund income use; past uses include inflation-proofing principal, paying dividends to qualified applicants, special appropriations to principal, and paying some Fund-related state expenses.
  - Majority of spending has been for dividends to qualified Alaska residents.

### UAE: Abu Dhabi Investment Authority (ADIA)
- Inflows:
  - Government provides funds that are surplus to budgetary requirements and other funding commitments.
- Outflows/mandate:
  - ADIA required to make available financial resources to government as needed to secure and maintain future welfare of the Emirate; withdrawals have occurred infrequently and usually during extreme or prolonged commodity price weakness.
  - ADIA manages fund to ensure sufficient short-term liquidity for anticipated funding requests.
  - ADIA not involved with nor has visibility on government spending requirements.

### Timor-Leste: Petroleum Fund
- Inflows:
  - Income from upstream (and downstream) petroleum activities enters the Petroleum Fund mainly from: (1) tax revenues, (2) first tranche petroleum and oil profit, (3) investment returns, and (4) other revenues such as pipeline rental.
- Outflows:
  - Only expenditure is transfer to the central government budget based on the Estimated Sustainable Income, calculated as 3 percent of total petroleum wealth, payment of operational management fees, and refunds of overpaid taxation.
  - Transfer to State budget requires explicit decision of Parliament.
  - No transfer in a Fiscal Year unless government has provided Parliament with reports specifying the Estimated Sustainable Income for the Fiscal Year and preceding Fiscal Year and an Independent Auditor certifying the amount.
  - Transfers by the Central Bank take place after publication of the budget law.
  - Central Bank may deduct reasonable management expenses by direct debit of the Petroleum Fund account as provided in the operational management agreement.

*Source: Appendix I and Appendix II excerpts from wp1826 - Appendix I. SWF Asset Accumulation and Revenue Projection Models*

### Appendix III. Considerations in Investment and Risk Management

### Appendix III. Considerations in Investment and Risk Management

### Investment Framework: hierarchy and responsibilities
- The formulation of a strategy for investment management is a hierarchy of decisions from the investment objective to the rationale for individual investment and divestment decisions. The table of decisions and responsible entity includes:
  - Investment objective: Establishing a basis for the management of the fund. Entity: Owner.
  - Risk and return expectations and risk tolerances: Aiding transparency and consistency in investment decisions. Entity: Owner.
  - Investment beliefs: Ensuring transparency and consistency when making both asset allocation and investment/divestment decisions. Entity: Executive Board, or owner.
  - Strategic asset allocation (SAA): Combines the purpose and beliefs into a portfolio expected to meet the objective of the fund. Entity: Executive Board, or owner.
  - Numeraire currency: Sets out the base by which to measure currency risk; should approximate procurements financed by the fund in the long run. Entity: Executive Board, or owner.
  - Investment constraints: Sets out maximum exposures appropriate to purpose, objective, and risk tolerance. Entity: Executive Board.
  - Asset class performance benchmarks: When assigned with appropriate numeraire currency, the SAA represents a theoretical portfolio benchmark. Entity: Executive Board.
  - Active risk budget and constraints: Sets where active risk is expected to be used in aggregate and at the opportunity level. Entity: Executive Board.
  - Statement of investment policies: Keeps all investment policy statements in one place for regular review and high-level attention. Entity: Executive Board.
  - Investment and divestment decisions: In accordance with active risk budget and constraints; may involve external managers. Entity: Investment managers.

### Investment objectives and fund types
- Core objective: maximize risk-adjusted returns subject to an appropriate level of risk for the investment horizon of the SWF.
- Stabilization funds:
  - Purpose: partially cover cyclical reductions in fiscal revenues.
  - Characteristic: relatively low risk-bearing capacity.
  - Objective: maximize risk-adjusted returns subject to maintaining overall low levels of risk and high levels of liquidity.25
- Savings funds:
  - Characteristic: ability to maintain exposures through market downturns.
  - Typical allocation: greater portion in more volatile assets, such as equities, to add return for higher risk-bearing capacity.

### Investment beliefs, SAA, and reference portfolio approaches
- A statement of investment beliefs and principles:
  - Ensures investment decisions are consistent across organization and external managers.
  - Facilitates comparison of investment opportunities by specifying beliefs required to invest.
- Strategic asset allocation (SAA):
  - Established early; takes into account SWF liabilities.
  - Based on belief that asset allocation is the key investment decision (aggregate risk and return driven by targeted mix of asset classes).26
  - SAA chosen before selecting individual investments within asset classes.
  - Authority: can be set by fund owner or delegated to operational manager; examples:
    - Norway: MoF determines and reviews SAA and mandates central bank to implement it.
    - Australia, Canada, New Zealand, Singapore: minister’s mandate more generic; Board decides SAA.
- Reference portfolio approach:
  - Owner sets a benchmark comprised only of liquid and listed asset classes and an appropriate numeraire currency.
  - Serves as implementable guide to owner’s risk preference while granting manager discretion for unlisted, less liquid assets.
  - Used by Canada Pension Plan Investment Board, NZ Super Fund, and GIC of Singapore.
- Numeraire currency choices:
  - Returns usually measured in foreign currency terms; relevant yardstick is international purchasing power.
  - Some use one currency (often the United States dollar) — examples: Chile, Timor-Leste.
  - Others use a weighted basket of foreign currencies — examples: Norway, Singapore (GIC).29

### Risk tolerance, appetite statements, and constraints
- Explicit risk tolerance statements aid consistency, transparency, and accountability.27
- Risk appetite statement:
  - Sets tolerance embodied in SAA or reference portfolio choice.
  - Includes average expectations through time and tolerance through shorter-term cycles.
  - May express tolerance as a stress loss or drawdown limit, example phrasing: “the prospective losses from the fund shall not exceed x percent over a period of y years.”
  - Can cover non-investment risks (e.g., reputational risk).
  - Aids in making procyclical changes in risk appetite visible during crises and bubbles.28
- Investment constraints derive from fund objective and owner risk tolerance:
  - Examples: prohibitions on domestic assets for stabilization funds; limits on single manager, asset, or opportunity to avoid concentration.

### Benchmarks, active risk, and transition strategies
- Benchmarks for each asset class should:
  - Represent full universe of assets investable on a passive basis.
  - Be constructed with objective selection criteria; be complete, replicable, investable, and accepted by investors.
- Active risk budgets:
  - Establish ex ante expectations of active risk on average.
  - Aim to optimize expected extra return by allocating active risk discretion to managers while controlling total deviation from SAA.
  - In most actively managed SWFs, SAA risk remains majority of total risk, with active risk contributing much less.30
  - A clearly stated transition strategy should be used when adjusting SAA or active risk budget.31
  - Examples of staged transitions:
    - Norway: moved from a bond portfolio into 40 percent equities after two years, then took a further 20 years to move into real estate.
    - New Zealand SWF: moved immediately into desired portfolio of effectively 80 percent equities, but took a number of years to increase exposure to active risk strategies including illiquidity.

### Statement of Investment Policies: content elements
- A Statement of Investment Policies should include:
  - The classes of investment assets and selection criteria within those classes.
  - Determination of benchmarks or standards for fund, asset class, and individual asset performance assessment, including numeraire currency.
  - The balance between risk and return in the fund.
  - Constraints on investment, including concentration risk limits.
  - Organizational structure for investment and management, including appointment and oversight policies for external managers.
  - Policies on voting rights on behalf of the owner.
  - Use of derivative financial instruments and leverage, including principles covering implicit leverage via derivatives and reinvestment of cash collateral from securities lending or repurchase agreements.
  - Management of credit, liquidity, operational, currency, market, and other risks.

### Risk Management: principles and practices
- Integration with investment management:
  - Risk and return are intrinsically linked; hard to separate risk management from investment management.
  - Investment policies articulate strategy and management of investment risk; strategy specifies asset choices.
  - Policy statements can be prescriptive or principles-based.
- Rebalancing policy:
  - Should minimize rebalancing costs while controlling deviation from SAA.
  - Methods:
    - Calendar-based rebalancing (e.g., end of every month) suitable for simple portfolios.
    - Risk-based rebalancing (e.g., when portfolio risk exceeds a specified limit) suitable for complex portfolios to allow offsetting movements in asset classes.
- Definition of risk:
  - Broadly: potential to not achieve the fund’s objectives.
  - Types include financial risks (market, currency, credit, liquidity), operational risk (error, fraud), strategic risk (governance risk, agency risk, poor organizational design), and regulatory risk.
- Management of uncompensated risks:
  - Some risks are not compensated with return; manage these by balancing mitigation cost against implications of the risk.
  - Elimination may be impossible or undesirable if mitigation cost is too high relative to risk impact.
- Risk analytics and monitoring:
  - Risk analytics teams or external providers support full understanding of market risks.
  - Typical analyses: asset volatility, correlation across asset classes and sub-asset classes, sensitivity to macroeconomic variables, contribution from non-numeraire currency exposures, susceptibility to liquidity events, downside risk across diverse market distress scenarios.
- Risk policy review:
  - Policies should set approach, risk parameters, and timetable for review.
  - Suggested review frequencies:
    - Funds with stable investment horizon and dynamic asset allocation: review SAA every three years.
    - Less mature funds or those not engaging in dynamic asset allocation: review period of one year.
  - Triggers for review: change in investment objective or investment horizon.
- Use of derivatives:
  - Integral to investment management for hedging, cost-efficient exposure, and implementing active risk.
  - Purposes:
    - Reduce risk by hedging components that do not suit portfolio mix, fund purpose, or owner risk appetite.
    - Obtain exposure to global equities or bonds cost-efficiently.
    - Implement active risk taking.
  - Risks and controls:
    - Complex use can create unintended credit, currency, liquidity, and leverage exposures, plus reputational risk and risk of significant financial losses.
    - Derivatives require much higher controls and monitoring of associated leverage, credit, liquidity, currency, and market risk implications.

*Source: IMF Working Paper — Appendix III. Considerations in Investment and Risk Management*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1826.pdf_