## _061014 ## Source details **Canonical URL:** [_061014](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_061014.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_061014.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_061014.pdf.json) --- ### EXECUTIVE SUMMARY — Rationale, framework, and value-added - Rationale for SALM: - Ample natural resource revenues create opportunities and challenges to transform natural resources into well‑managed financial assets. - Inter-temporal smoothing of revenue and consumption/investment is central in resource-rich countries. - Commodity price volatility and intergenerational equity raise urgency of wealth accumulation choices. - A flexible SALM framework is required to integrate macroeconomic and financial trade-offs and contain sovereign balance sheet financial risk. - SALM framework and contribution of the paper: - SALM coordinates management of assets and liabilities across the whole sovereign balance sheet (government, central bank, other public sector entities). - Distinguishing element: coordinate assets and liabilities rather than optimize isolated balance sheets. - Paper operationalizes an integrated SALM approach, showcases country experience, and uses Norway as a model case. - Provides practical framework and advice for managing natural resource wealth and sovereign assets/liabilities with well-defined objectives. - Institutional and editorial details: - June 10, 2014. - Approved By: José Viñals. - Prepared by: Samar Maziad and Martin Skancke with support from the Topical Trust Fund on Managing Natural Resource Wealth (Australia, the European Union, Kuwait, The Netherlands, Norway, Oman, and Switzerland). ### SALM principles, partial adoption, and practicalities - Partial SALM adoption: - Many countries implement partial SALM without an explicit sovereign balance sheet or SALM objectives. - Authorities may match currency mix and duration across some portfolios to reduce currency and interest rate risks (examples: Canada, New Zealand, Mexico). - SALM objectives and scope: - Minimize vulnerability of government finances to shocks; monitor and quantify impacts of exchange rates, interest rates, inflation, and commodity prices. - Main objectives: - Sovereign liability management: finance the budget at the lowest possible cost subject to acceptable risk. - Sovereign asset management: ensure cash meets commitments and maximize purchasing power of long-term capital given moderate risk. - Benefits and implementation: - Portfolio perspective helps detect sovereign risk exposures and identify natural hedges by integrating assets and liabilities. - Many countries already apply partial SALM (matching reserves and external debt, pension fund holding guidelines, coordinated cash management). - Implementation requires coordination among multiple independent institutions while preserving institutional integrity (information sharing, coordination committees, clear mandates). ### Asset management: types of pools, objectives, and time horizons - Investment objectives: - Objectives for asset pools must be clearly articulated and reflect explicit or implicit liabilities. - Volatile commodity revenues → smoothing objective: safer, more liquid assets. - Building assets for future/contingent liabilities → longer-term strategy with higher returns. - Distinction: reserves versus longer-term investments: - Foreign reserves: preserve nominal value, keep liquid, available for central bank monetary policy and BoP transactions. - Excess reserves beyond monetary/external obligations can be invested for higher returns via an investment tranche or dedicated fund. - Types of SWFs (five main types): - (i) Stabilization funds. - (ii) Savings funds. - (iii) Development funds. - (iv) Pension reserve funds. - (v) Reserve investment corporations. - Note: Some funds have dual/multiple objectives. - Time horizon and growth: - Time horizon is a key determinant of investment objectives. - As assets grow, strategy may shift from stabilization to savings objectives and accept higher risk/liquidity premia. - Warning: accumulation must link to fiscal surplus; accumulation financed by new debt can undermine stabilization objectives. ### Strategic Asset Allocation (SAA), risk profiling, and modeling - SAA fundamentals: - SAA maximizes expected return subject to risk parameters and flow uncertainty. - Asset allocation captures the largest component of portfolio risk. - Risk targeting versus return targeting: - If risk-return relationship stable, they are equivalent; generally the relationship is not stable. - Return targeting can force increased risk when risk/return deteriorates; pure volatility targeting may be pro-cyclical. - Recommended: consider measures of risk premia rather than volatility to guide strategy. - Modeling tools: - Stochastic simulation: simulate return paths conditional on distributional assumptions; useful when assumptions are realistic and can allow regime switching and fat tails. - Historical simulation: back-test strategies on historical data; emphasize long-term rolling returns (e.g., 10- or 20-year horizons) and caution against naive extrapolation. ### Case study — Norway (Government Pension Fund—Global, GPFG) - History and strategy changes: - First deposits in 1996; initial emphasis on high-rated liquid sovereign bonds. - 1997 baseline foresaw net assets past 100 percent of non-oil GDP circa 2010 and around 150 percent of GDP in 2020; actual assets exceeded 1997 baseline. - Investment horizon perceived as several decades led to equity allocation increase from 0 to 40 percent in 1998, and equity portion increased to 60 percent from 2007. - Since 2007, the Ministry publishes an annual report using forward-looking model-based approaches and historical simulations. - Simulation evidence: - Historical simulations for a hypothetical GPFG established in 1900 using annual real returns 1900 to 2012 with strategic benchmark 60 percent equities / 40 percent bonds produced: - Rolling 15-year average real return: around 4 percent (close to assumed long-term average). - For the entire period, equity markets outperformed bonds. - Real return to fixed-income instruments: around 1½ percent per annum for the entire period. - Accumulated real return over the first 85 years: close to zero. - Return over the last 30 years: around 6½ percent per annum. - Caution: historical results depend on chosen observation period. ### Investment strategy evolution and examples - Reasons to change strategy over time: - Increase in fund size relative to the economy enables higher-volatility, higher-expected-return strategies. - Longer time horizon increases protection against inflation and favors real assets. - Political tolerance and management capacity suggest gradual increases in risk and complexity. - Examples of strategy shifts: - Norway: 1996 high-grade government bonds → 1998 40 percent equities → 2007 60 percent equities → 2010 first real estate investments. - Timor-Leste: pure bond portfolio in 2005 → 2012 amendment allowing up to 50 percent equities; operational target 40 percent. - Chile’s PRF: established 2006 with government bonds/money market → 2012 included 15 percent equities and 20 percent corporate bonds. ### Reserves, excess reserves, and institutional arrangements - Assessing reserve adequacy: - For emerging markets: ratio of international reserves to short-term external debt is most relevant. - Simple benchmark: reserves coverage of short-term external debt of all residents and instruments measured by remaining maturity. - Additional buffers may be required for current account deficits, high short-term public domestic debt, public sector derivative positions, or weak banking systems. - Institutional approaches to excess reserves: - Carve out an SWF (example cited: China). - Divide reserves into liquidity and investment tranches and co-manage (Botswana, Norway). - Keep excess reserves within central bank and invest in higher-yielding assets (Hong Kong). - Examples of institutional arrangements: - Botswana: Pula Fund launched 1993; maintains liquidity tranche equivalent to six months of imports; drawdowns triggered when liquidity tranche falls below target after macro adjustment. - Hong Kong Monetary Authority: Backing Portfolio (highly liquid U.S. dollar short-term fixed-income) and Investment Portfolio (dynamic, including equities). - Norway: Norges Bank manages investment tranche under guidelines equivalent to ministry-set GPFG guidelines. ### Liability management, domestic debt, and balance sheet optimization - Liability management trade-offs: - Primary objective: finance the budget at lowest possible cost given acceptable risk (refinancing risk, concentration). - Rolling short-term debt cheaper when yield curves upward sloping but increases refinancing risk. - Concentrating borrowing in benchmark loans increases liquidity but raises large simultaneous refinancing risk. - Debt repayment versus asset accumulation: - Net financial assets may not change with debt repayment, but size of sovereign balance sheet does. - Building financial assets can act as self-insurance; cost-of-reserves is an "insurance premium" versus repaying debt. - Dynamic assessment: early-stage reserve accumulation may be favored; example: Moody’s August 2012 noted possible sovereign rating upgrade for Angola due to a fiscal stabilization fund. - Domestic debt considerations: - Governments may issue domestic debt to develop local markets even when financing needs are limited. - Trade-off depends on domestic debt cost, return on additional assets, and institutional capacity. - Coordination with central bank is essential because central bank instruments and government debt substitute. - Market segmentation option: central bank issues short maturity instruments; government finances at longer maturity to build yield curve. - Alternative: centralize issuance with government and use treasury instruments for liquidity (example: Brazil post-2000 fiscal responsibility law). ### Integration of liabilities (pension funds, future imports, contingent liabilities) - Pension liabilities: - Explicit/implicit pension liabilities should guide asset allocation and be integrated into government financial management; actuarial assessment may be required. - Pension liabilities long horizon; matching interest rate sensitivity is prudent. - Chile’s PRF: established 2006; from 2012 SAA includes 15 percent equities and 20 percent corporate bonds. - Future imports as implicit liability: - SWF assets reflect national savings; future imports constitute an implicit liability. - SWF performance can be measured by real return in currency baskets matching import weights (practice in Ghana, Norway, Singapore, UAE). - Geographical asset distribution matters less for long-term investors under purchasing power parity, but deviations can matter short/medium term. - Contingent liabilities and development funds: - Contingent liabilities (guarantees, joint ventures) must be managed via rules, permitted instruments, and reporting. - Development funds should be explicitly integrated with fiscal policy; match asset currency to import content of projects when appropriate. ### Governance, delegation, transparency, and the Santiago Principles - Governance architecture and bodies: - Distinguish owner (central government/parliament), full government/minister of finance, executive board, CEO, CIO, and internal/external managers. - Supervisory bodies include Auditor General, external auditor, internal auditor, compliance unit. - Clear division of roles and responsibilities avoids accountability gaps. - Delegation and mandates: - Owner sets aggregate risk; mandates can range from fully delegated SAA determination to owner-set benchmarks and limits. - Decide whether manager focuses on absolute or relative returns; mandate design affects incentives and risk-taking. - Managers should have authority to dissent and provide market-informed input. - Reporting and transparency: - Internal and external reporting must support risk management and legitimacy; transparency increases accountability. - Santiago Principles summary: - Objectives: build transparent governance, invest on economic/return basis, conform to host country regulations, ensure free capital flows, preserve global financial stability. - Cover legal framework/objectives, institutional framework/governance, and investment/risk management framework. - Voluntary guidelines that assist in enhancing governance and accountability. ### Risk management, culture, and operational controls - Risk management culture: - Senior management must engage in developing/enforcing risk management; adherence to high standards preserves domestic legitimacy and international stability. - Risk process components: - Risk policies and procedures; risk identification; risk measurement; risk monitoring; risk reporting; risk verification and audit. - Rewarded vs non‑rewarded risks: - Market risks expected to be rewarded; operational, legal, reputational risks are consequential and not rewarded. - Setting risk tolerance: - Owner/governing body sets risk objectives; translate into quantifiable measures (shortfall probability, probability thresholds). - Examples of risk parameters: probability of achieving a return in excess of domestic inflation; probability of negative return at the end of 3 years; probability of negative accumulated real return after 15 years. - Operational management and delegation: - Operational investment management by professionals; internal vs external management choice depends on costs and skills. - Principal-agent issues require oversight capacity; smaller or developing-country funds should start with simple transparent SAA benchmarks. - Operational risk management: - Segregation of duties between front-, middle-, back-office; reliable IT systems; public disclosure of risk management enhances stakeholder confidence. - Operational risk mitigation involves trade-offs between mitigation cost and residual risk. ### Key policy recommendations and guiding principles (concise) - Determine whether the fund policy targets risk or return and align governance, mandate, and delegation accordingly. - Ensure owner oversight when risk is owner-set; if returns are delegated, verify managers’ required risk is within owner tolerance. - Provide managers with right and obligation to dissent; governance should permit sufficiently long-term mandates. - Use stochastic simulation (with realistic assumptions, regime switching, fat tails) and historical simulation (long rolling horizons) appropriately. - For stabilization funds: prioritize liquidity and align strategies with central bank reserve principles. - For savings funds: prioritize long-term purchasing‑power protection, integrate funds into fiscal frameworks with flexible procedural anchors. - For development funds: coordinate mandates with fiscal policy, analyze future cash needs, and manage contingent liabilities with rules and reporting. - For pension reserve funds: explicitly link mandates to identified liabilities and consider foreign investment to facilitate future import financing. - When reserve adequacy indicates ample reserves, consider carving out portions for long-term investment in dedicated savings funds, subject to institutional safeguards and coordination. - Optimize sovereign balance sheet considering stage of asset accumulation: early accumulation may favor reserve build-up; debt reduction may be preferred when reserve carrying costs exceed self-insurance benefits or when institutional capacity for reserve investment is limited. *Source: _061014 (Sovereign Asset-Liability Management — selected excerpts).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Rationale for Sovereign Asset-Liability Management (SALM) - Ample natural resource revenues create both opportunities and challenges for a sovereign to transform its natural resources into well-managed financial assets. - Inter-temporal smoothing of revenue and consumption/investment is central to macroeconomic policy in resource-rich countries. - Commodity price volatility and the need for intergenerational equity make questions about wealth accumulation increasingly pressing. - Addressing these questions requires a flexible SALM framework that integrates macroeconomic and financial trade-offs to contain financial risk to the sovereign balance sheet. ### SALM framework and value-added of the paper - SALM coordinates management of assets and liabilities based on the whole sovereign balance sheet (government, central bank, and other public sector entities). - The distinguishing element of an integrated SALM is coordinating assets and liabilities rather than optimizing isolated balance sheets. - The paper operationalizes key principles of an integrated SALM approach and showcases country experience, with Norway used as a model case. - The paper provides a practical framework for managing natural resource wealth and advice for managing sovereign assets and liabilities with well-defined objectives. ### Institutional coordination and governance - Although separate asset and liability management strategies may be optimal for individual institutions, it is suboptimal to manage isolated balance sheets; mismatches can expose the sovereign to interest rate and exchange rate risks. - Close coordination among institutions managing sovereign assets and liabilities is desirable, with appropriate legislation and policy guidelines. - Sovereign funds aimed at smoothing consumption or building wealth for future generations should have: - A clear investment mandate. - A transparent governance structure. - Appropriate delineation of responsibility between the owner of the fund and its management. ### Investment objectives and strategies - Investment objectives for different pools of assets should be clearly articulated to reflect explicit or implicit liabilities. - In resource-rich contexts: - Smoothing volatile commodity-price-driven government revenues requires investing financial wealth in safer and more liquid assets. - Building assets to meet future or contingent liabilities requires a longer-term investment strategy with higher returns. - Where sovereign assets/reserves exceed levels needed for short-term liquidity, the excess could be invested in less-liquid/higher-yield instruments to preserve wealth for future generations, preferably in a dedicated savings fund subject to appropriate institutional safeguards. ### Liability management and domestic debt - Even where natural-resource wealth meets fiscal financing needs, issuing domestic debt may be meritorious to: - Promote a liquid local-currency debt market. - Assist in responding to volatile capital flows and commodity prices. - Decisions on issuing domestic debt should consider: - The cost of domestic debt relative to the return on financial assets. - The institutional capacity to manage a domestic debt program. ### Contingent liabilities and asset strategy linkage - The structure and nature of contingent and implicit liabilities should inform the investment objectives and strategies of sovereign assets. - This linkage will be reflected in the type of savings fund, associated investment horizon, mandate, and risk profile. ### Background, scope, and supporting arrangements - The IMF’s Monetary and Capital Markets Department provides technical assistance (TA) on natural resource wealth management, focusing on trade-offs between return and risk, hedging natural resource revenues, and managing long-term liabilities. - Module four of the Topical Trust Fund on Managing Natural Resource Wealth funds TA on investment strategies, SAA, risk management frameworks, and governance aspects. - The paper’s framework is applicable beyond resource-rich countries to those with large current account surpluses and ample fiscal reserves. - Norway is showcased as a model case throughout the analysis. - The work was completed with financial assistance from donors to the TTF-MNRW, including Australia, the European Union, Kuwait, The Netherlands, Norway, Oman, and Switzerland. ### Organizational and editorial details - June 10, 2014 - Approved By: José Viñals - Prepared by: Samar Maziad and Martin Skancke with support from the Topical Trust Fund on Managing Natural Resource Wealth (Australia, the European Union, Kuwait, The Netherlands, Norway, Oman, and Switzerland) *Source: _061014 - EXECUTIVE SUMMARY* ### 11. In practice, a partial SALM framework can be adopted to identify and manage financial ### 11. In practice, a partial SALM framework can be adopted to identify and manage financial ### Partial SALM adoption - Many countries implement partial SALM without identifying an explicit form of the sovereign balance sheet or establishing SALM objectives. - Authorities may implement debt management or reserve management strategies by matching the currency mix and duration for at least some part of these portfolios to reduce currency and interest rate risks across the sovereign balance sheet (examples given: Canada, New Zealand, and Mexico). ### Aspects of asset management (overview) - Resource-rich countries build up various forms of funds to address macroeconomic challenges connected with inflows of resource revenues. - Coordination issues arise between monetary policies, reserve management, and debt management when funds accumulate. - Natural resources can be viewed as part of the sovereign balance sheet in a larger sense; the SALM framework can be usefully employed to address these issues. - Key policy question after deciding to save and invest: how to optimize return on assets. ### Investment objectives - Investment objectives for funds and other pools of assets, including those based on natural resource revenues, should be clearly articulated as a necessary first step toward formulating an investment strategy. - Objectives should reflect the policy objective of the assets and take into account any explicit or implicit liabilities associated with them. - Examples: - Volatile commodity prices require smoothing the impact of revenue volatility on the government budget and investing in safer and more liquid assets. - Building assets to meet future or contingent liabilities requires a longer-term investment strategy with higher returns. ### Distinction between reserves and longer-term investments - Foreign reserves: - Have to be available to the central bank for monetary policy purposes. - Typically managed with an objective of preserving nominal value and keeping reserves liquid. - When reserves exceed needs for external obligations and monetary policy, an investment strategy to boost returns on excess reserves is often employed (e.g., defining an investment tranche of reserves or establishing a dedicated fund with a mandate to increase returns given a moderate risk profile). ### Box 2 — Reserve Management (key points) - Central bank reserves primary purposes: facilitating balance of payment (BoP) transactions, supporting monetary policy implementation, and providing liquidity during a crisis. - Primary objective of reserves management: keep reserves liquid while minimizing the opportunity costs of holding them. - Reserves for immediate availability are held in short-maturity instruments issued by high-rated governments in major international reserve currencies. - Composition of international reserves should be derived from the type of shocks they are meant to offset. - A portion of highly liquid reserves is determined through assessment of potential liquidity needs based on BoP stress tests and past interventions. - Countries with limited international market access may structure reserves to match the currency composition of future imports. - Where reserves cover short-term debt, currency composition should match the currency composition of short-term debt. - Excess reserves can be invested with less emphasis on liquidity to improve returns subject to reasonable risk; relevant assets could include: - longer-maturity fixed-income instruments, - fixed-income instruments issued by lower-rated issuers (usually still investment grade), - less liquid fixed-income instruments, - nonfixed income, particularly equities. - The risk factor approach outlined in Appendix I is a useful tool to track overall exposure to different risk factors across all assets in the portfolio. ### Types of SWFs (five main types) - (i) Stabilization funds: set up to insulate the budget and the economy from volatile commodity prices (usually oil). - (ii) Savings funds: intended to transfer wealth (e.g., nonrenewable assets transformed into diversified financial assets) across generations. - (iii) Development funds: allocate resources to priority socioeconomic projects, such as infrastructure. - (iv) Pension reserve funds: target pension and/or contingent-type liabilities on the government’s balance sheet. - (v) Reserve investment corporations: intended to reduce the negative carrying costs of holding reserves or to earn higher return on ample reserves while assets in the funds are still counted as reserves (example: China). - Note: Some funds have dual or multiple objectives (e.g., saving and stabilization). ### Box 3 — Strategic Asset Allocation for Sovereign Wealth Funds (key points) - SAA refers to a portfolio of financial assets that meets a pre-specified investment objective and maximizes expected investment return subject to a set of risk parameters, taking into account uncertainty of flows in and out of the fund. - The SAA captures the largest component of portfolio risk; cited evidence: - Brinson and others (1986) and Ibbotson and Kaplan (2005) findings summarized: - Ibbotson and Kaplan (2005) show that asset allocation explains about 90 percent of the variability of a fund’s return over time, but it explains only 40 percent of the variation of returns among funds. - SWFs broadly categorized as stabilization and savings funds: - Stabilization funds: investment horizon broadly reflective of underlying commodity price cycle; invest in less risky instruments (e.g., high-grade fixed-income) to preserve capital over short- to medium-term and ensure high liquidity. - Savings funds: much longer horizon and greater risk-bearing capacity; can invest in riskier and less liquid assets (e.g., public and private equity, and alternative investments). - When stabilization and savings objectives coexist, differences in SAA can be achieved by allocating the fund between liquid and longer-term tranches. - Prudential sequencing: if fund initially small and primarily for stabilization, start with capital preservation objective and diversify into higher-risk assets as the fund grows. ### Time horizon, growth of funds, and linkage to fiscal position - Time horizon of investments is an important determinant of investment objectives. - As SWF assets grow, objectives may change to hedge risks originating in different components of the sovereign balance sheet. - Example pathway: - A SWF set up as a stabilization fund to smooth fiscal revenue or sterilize foreign currency inflows may, as assets grow beyond stabilization needs, carve out portions, revisit objectives, and redesign structure to broaden objectives and mandates. - Warning: accumulation of financial resources in a SWF should be strongly linked to the government’s overall fiscal surplus; otherwise accumulation financed by new debt expands the sovereign balance sheet and undermines the stabilization objective due to procyclicality of market access by resource-rich countries. ### Liabilities and solvency considerations - Explicit or implicit liabilities of an SWF will guide optimal asset allocation. - For explicit-liability pools (e.g., pension funds), the growth of liabilities over time provides the relevant benchmark for return on assets. - Properties of liabilities matter: e.g., net present value of future pensions depends on interest rates; lower interest rates increase today’s value of future pensions and thus liabilities. - Prudent asset allocation would imply matching interest rate sensitivity of assets with that of liabilities. - Most SWFs do not have explicit liabilities but usually have implicit liabilities in the form of expected future transfers to the fiscal budget; projected time profile of these transfers provides guidance for investments. - Establish solvency for funds with fixed, explicit liabilities: - Example practice in some institutions (noted especially in the United Kingdom): systematically increasing asset duration as yields increase and funding ratios improve to avoid locking in underfunding. - Caution: do not blindly close a duration gap at the expense of future solvency. ### Case studies (illustrative) - Norway (Government Pension Fund—Global): - First deposits in 1996; initial investment guidelines similar to central bank currency reserves (emphasis on high-rated liquid sovereign bonds). - Updated long-term forecasts in 1997 baseline foresaw government net assets growing past 100 percent of non-oil GDP circa 2010 and reaching around 150 percent of GDP in 2020. - Actual growth of government assets exceeded the 1997 baseline scenario. - With new projections, investment horizon seen as several decades; prompted major review and increase in equity allocation from 0 to 40 percent in 1998. - Since 2007, the Norwegian Ministry of Finance has published an annual report to parliament discussing investment returns and strategy options using forward-looking model-based approaches and historical simulations. ### Governance and risk management - Investment strategies must be supported by appropriate governance structures to set risk tolerance and for proper monitoring and reporting of risk and returns. - Governance must be robust to allow consistent implementation of investment strategies over time. - Further aspects of governance and risk management of SWFs are covered in Section 6 (not reproduced here). ### Investment strategies for sovereign asset pools - After clarifying investment objectives, the next step is to set appropriate risk tolerance. - Challenges: - “Risk” is complex and cannot be fully captured by a single number or indicator. - Multiple indicators are necessary to assess riskiness of a strategy. - There is no single right level of risk; risk tolerance of political stewards must be ascertained. - Volatility of returns: - Most common indicator of risk; useful but limited because it implicitly assumes normal distribution of returns. - Asset returns are generally not normally distributed; large losses occur more frequently than normal-distribution assumptions imply. - Volatility-based measures should be interpreted with care. - For sovereigns: alternative risk definition - Define risk as the probability of failing to meet some predetermined policy objective. - For a SWF intended to transfer wealth to future generations, “safe” low-volatility fixed-income may be risky if expected real returns are very low or negative, undermining the intergenerational transfer objective. - Similarly, locking in low returns for liabilities (e.g., defined benefit pensions) increases the risk that liabilities will not be met. ### Risk targeting versus return targeting - Choice between risk targeting and return targeting is important in strategy formulation. - Generally assumed positive relationship between risk and expected return. - If relationship constant, risk targeting and return targeting are equivalent: for any level of risk there is one optimal expected return and vice versa. - Example: targeting a real return of 4 percent or a risk level corresponding to an equity portion of 60 percent would result in the same portfolio if a 60 percent equity portion yields an expected return of 4 percent. *Italic: Source — _061014 - 11. In practice, a partial SALM framework can be adopted to identify and manage financial* ### 27. However, the relationship between risk ### _061014 - 27. However, the relationship between risk ### Risk versus return targeting - The relationship between risk and expected return is not generally stable. - In a strict risk-targeting system, shifts in the risk/return relationship are translated into higher/lower expected returns. - If returns are targeted, more risk must be taken to keep expected returns constant when the risk/return relationship deteriorates; this implies more risk is added as the return per unit of risk falls. - In the factor framework outlined in Appendix I, increasing exposure to systematic risk factors when the expected returns to these factors are lowest can occur under return-targeting. - A pure volatility-targeting approach may be pro-cyclical. - Instead of volatility, measures of risk premia rather than volatility could be used to guide the investment strategy. - Footnote: “There may be important systemic implications related to widespread use of return targeting and the resulting pro-cyclical behavior, but these fall outside the scope of this paper.” ### Governance implications and delegation - Choice between risk and return targeting has important implications for fund governance. - Where the owner sets the risk level directly through setting the SAA, the allocation process should ensure consistency with government risk preferences. - Where asset allocation is delegated to a manager with a mandate to achieve a specific (or minimum) level of expected returns, risk becomes an endogenous variable; owners must ascertain that the risk required to meet the return objective is within the owner’s risk tolerance. - A clear and well-designed investment process is necessary, along with clear channels of oversight and communication between owners and managers. - Managers are closer to markets and have valuable information; delegation is justified, but managers should have a right and obligation to dissent if they identify inconsistencies in the owner’s estimates of risk and expected return. - Governance should allow for a sufficiently long-term mandate for fund management. - Clear communication to the public about objectives, strategy, and risks is important given that realized risk and return outcomes may fluctuate significantly over time. ### Modeling tools for risk analysis - Stochastic simulation: - Used to simulate return paths of alternative investment strategies and assess probabilities of accumulated returns being over or below a certain level over a specified investment period. - Relies on assumptions on the probability distribution of asset returns; results are meaningful only if assumptions are realistic. - Historical simulation: - Based on back-testing a specific investment strategy using historical return data. - Can answer questions such as, “How would this strategy have performed during the recent financial crisis?” or “How many years of the last 100 would this strategy have yielded negative real returns?” - Advantage: does not impose restrictions on the probability distribution of returns and may be easier to explain to policymakers and the public. - Caution: should not predict future returns only by extrapolating history; emphasize long-term rolling returns (for example over a 10- or 20-year horizon). ### Case Study: Norway — use of stochastic and historical simulation - The Norwegian Ministry of Finance developed a stochastic simulation model used to illustrate risk and return properties of different asset allocation strategies. - The model gives probability distributions for returns based on expected returns, risks, and correlations for various asset classes. - The model allows for regime switching and “fat tails” (i.e., probability distributions with a higher occurrence of extreme outcomes than in the standard normal distribution). - Results were used as part of material given to parliament when evaluating proposed changes to the strategy of the GPFG, for instance when deciding to increase the equity portion of the GPFG from 40 to 60 percent in 2007. - Historical simulations published by the Ministry for a hypothetical GPFG established in 1900 (rather than in 1996) use annual real rates of return for the period from 1900 to 2012. - Strategic benchmark: 60 percent equities and 40 percent bonds, distributed across many countries and currencies. - Rolling 15-year averages of real returns: the actual historical real return for this portfolio was around 4 percent, close to the assumed long-term average return for the GPFG, but with long periods of significant deviations. - Equity vs bond decomposition: - For the entire period, equity markets outperformed bonds. - Real return to fixed-income instruments was around 1½ percent per annum for the entire period. - Accumulated real return over the first 85 years was close to zero. - Return over the last 30 years was around 6½ percent per annum. - Caution: observed historical returns depend on the choice of observation period; even long samples may not be representative. ### Fund types and recommended investment emphases - Stabilization funds (natural-resource rich countries; usually oil): - Set up to insulate the budget and economy from volatile commodity prices. - Governed by rules stipulating circumstances for allocations and withdrawals (e.g., oil price thresholds). - Expected time horizon of investments is comparatively short and unpredictable. - Caution when setting price-contingent rules due to commodity price volatility. - Primary emphasis: liquidity for easy access on short notice. - Nature similar to central bank reserves; optimal investment strategies are similar to central bank currency reserves in practice. - Savings funds: - Intended to transfer wealth across generations (e.g., nonrenewable assets transformed into diversified financial assets). - Often created when stabilization fund assets or central bank reserves grow beyond what is needed for short- and medium-term buffering. - Long-term focus requires investment in assets capable of generating returns to protect and enhance purchasing power over the longer term. - Liquidity and short-term volatility have lower priority. - Savings funds should be fully integrated with the government budget and may fulfill stabilization and savings roles simultaneously. - As financial assets grow, the savings aspect becomes more pronounced and should be reflected in gradual changes to investment strategy. - Box 5: Changes in Investment Strategies Over Time (findings) - Reasons for strategy changes: - Increase in fund size relative to the economy can increase willingness to adopt higher-volatility, higher-expected-return strategies. - A longer time horizon increases the importance of protecting against inflation effects on purchasing power. - Political tolerance for investment risk may be uncertain; prudent approach is to increase risk only with demonstrated tolerance for fluctuations. - Management capacity constraints suggest strategies should develop gradually in line with experience and capacity. - Examples: - Norway: first investments in high-grade government bonds in 1996; 40 percent allocation to equities in 1998; equity portion gradually increased to 60 percent from 2007; first real estate investments in 2010. - Timor-Leste: pure bond portfolio in 2005; 2012 amendment allowing up to 50 percent allocation to equities; operational target 40 percent. - Chile’s PRF: established in 2006 with government bonds and money market instruments; strategy changed in 2012 to include 15 percent allocation to equities and 20 percent allocation to corporate bonds. - General pattern: gradual move from nominal, liquid assets (high-grade government bonds) to less liquid, real assets to capture liquidity risk premia and accept higher short-term volatility; also reflects increased investment horizon and inflation concerns. - Integration of savings funds into fiscal framework: - Requires transparent rule-based systems for transfers from the fund to the budget. - Common fiscal rules: nonresource balance rules or resource price-based rules. - To enhance credibility amid commodity price volatility, fiscal anchors and associated targets should be flexible and focus on procedural rules rather than fixed numerical targets. - Examples: Chile targets a fiscal variable (structural balance); Timor-Leste’s Petroleum Fund Law sets out a rules-based approach for withdrawals, allowing increases under certain circumstances within a transparent process. - Development funds: - Allocate resources to priority socioeconomic projects (e.g., infrastructure); funding sources include government transfers, privatization revenues, bond issuance, or combinations. - Mandates and activities vary widely; portfolios are less commercially driven and often focus on infrastructure, energy supply, industry development, or small enterprise funding. - Investment activities may finance primary development activities or be the main operational focus (e.g., managing ownership stakes). - Important to integrate development funds into the government budget. - General principles: appropriate governance, clear mandate coordinated with fiscal strategies, investment activities reflecting explicit and implicit liabilities (future disbursements). - Investment strategy must analyze future withdrawals to ensure sufficient cash when needed; match foreign currency investments to anticipated import content of projects when appropriate. - Contingent liabilities: - May arise from guarantees for private funding or joint ventures where partners fail to meet obligations. - Must be managed through appropriate rules, permitted instruments, and reporting. - Pension reserve funds: - Some resource-rich countries link savings fund mandates to contingent liabilities, such as pensions, to offset projected higher liabilities from aging populations. - Purpose: accumulate assets now to offset future pension and social welfare liabilities; assets can often be invested abroad to be disinvested for imports when domestic population ages. - Examples: Australia, Chile, and New Zealand. ### Key governance and policy recommendations (implicit and explicit) - Determine whether the fund’s policy will target risk or return and align governance and mandate accordingly. - Ensure owner oversight when risk is set by the owner (SAA) and verify risk tolerance if returns are delegated to managers. - Provide managers with authority to dissent and supply market-informed input to allocation decisions. - Design governance to support long-term mandates and transparent public communication about objectives, strategies, and risks. - Use stochastic simulation and historical simulation tools appropriately: - Stochastic models: incorporate realistic assumptions, allow regime switching and fat tails where relevant. - Historical simulations: present rolling long-term horizons (e.g., 10- or 20-year) and caution against naive extrapolation. - For stabilization funds prioritize liquidity and align strategies with central bank reserve principles; for savings funds prioritize long-term purchasing-power protection and integrate funds into fiscal frameworks with flexible procedural anchors. - For development funds, coordinate mandates with fiscal policy, analyze future cash needs, manage contingent liability risks through rules and reporting. - For pension reserve funds explicitly link mandates to identified liabilities and consider foreign investment to facilitate future import financing. *Source: IMF PDF content unit _061014 - 27. However, the relationship between risk* ### 44. The optimal investment strategy for this class of funds depends on the nature of the ### _061014 - 44. The optimal investment strategy for this class of funds depends on the nature of the ### Liability management: objectives and trade-offs - Primary objective of issuing government debt: ensure financing of the budget at the lowest possible cost subject to an acceptable level of risk. - Core optimization trade-off: low cost versus various forms of risk (refinancing risk, concentration/refinancing timing). - When yield curves are upward sloping: - Rolling over short-term debt can be cheaper than long-term financing. - Refinancing risks will be higher. - Concentrating borrowing in a few liquid benchmark loans: - Increases liquidity and lowers issuing costs. - Implies risk of large simultaneous refinancing needs. - Trade-offs can be viewed as self-insurance: higher expected borrowing costs as an insurance premium against adverse liquidity events. ### Currency composition and market depth considerations - Foreign-currency debt exposes governments to exchange-rate risk when revenues are primarily domestic. - Exception: resource-rich countries with significant foreign-currency revenues—foreign borrowing can offset asset-side FX risk. - Emerging and low-income countries often face higher borrowing costs in local currency due to shallow domestic financial markets, limited credibility, and insufficient liquidity to attract international investors. - Benefits of a domestic debt market: - Local-currency debt as the “risk-free” domestic investment alternative. - Serves as store of value and reference price for other financial assets. - Can be used as collateral in money market transactions. - Contributes to financial deepening and stability and can reduce sovereign balance sheet risk. - Even resource-rich countries may issue sovereign debt for reasons other than deficit financing. ### SALM (Sovereign Asset-Liability Management) framework: objectives and scope - Integrated SALM: holistic approach aiming to minimize vulnerability of government finances to potential shocks. - Main objectives: - Sovereign liability management: finance the budget at the lowest possible cost subject to acceptable risk. - Sovereign asset management: ensure cash balances meet commitments and maximize purchasing power of long-term capital given a moderate level of risk. - SALM basic idea: choose size and characteristics of sovereign assets and liabilities to meet macroeconomic and developmental objectives while preserving positive sovereign financial net worth, subject to acceptable costs and risks. - SALM entails monitoring and quantifying impacts of movements in exchange rates, interest rates, inflation, and commodity prices. - SALM tools listed: financial risk models, contingent claims approach, intuitive risk management approaches. ### Benefits and practicalities of SALM - Portfolio perspective: SALM helps detect sovereign risk exposures and provides natural hedges by integrating assets and liabilities. - Typical sovereign balance sheet major components: - Asset side: foreign reserves. - Liability side: public debt (and for some countries, monetary base or pension liabilities). - Integrated risk management can lead to higher risk-adjusted returns on assets and/or lower financing costs. - Many countries already apply partial SALM concepts (matching currency of reserves with external debt, guidelines for public pension fund holdings, managing government cash balances for debt repayment). - SALM implementation usually involves multiple institutions with operational independence (ministry of finance, central bank, pension funds, SWFs). Coordination mechanisms are required while preserving institutional integrity (information sharing, coordination committees, mandates/regulations). ### Resource-rich countries and SWF coordination - Resource-rich economies: need prudent management of revenues from nonrenewable sources; building up public financial assets poses investment strategy, governance, and risk management challenges. - SWFs affect public finances, monetary conditions, external accounts, and sovereign balance sheet linkages; should be integrated into monetary and fiscal policy frameworks. ### SALM application and liquidity/insurance trade-offs - Many governments apply partial SALM even without a formal framework, considering government funds, central bank reserves, and public debt simultaneously. - Liquidity risk is a key government balance sheet factor; illiquid sovereign assets (e.g., taxation rights) contrast with liquid needs. - Willingness to pay (lower expected returns) to hold liquid assets versus higher expected returns for less liquid assets that bear losses during liquidity events — viewed as buying or selling insurance against liquidity events. - Key trade-off questions highlighted: - Should SWFs hold higher exposure to illiquid assets for higher returns, accepting losses in liquidity events? - Should countries build high reserves to reduce output loss risk during crises despite opportunity costs? - Should countries hold liquid reserves rather than repay debt even if debt servicing costs exceed expected returns on reserves? - Should countries borrow short (to contain costs) or pay a maturity premium to avoid rollover risk during tight liquidity? - SALM analysis in the rest of the section focuses on resource-rich countries while noting broad applicability. ### Central bank reserves, excess reserves, and investment strategy - Link between central bank reserves and other sovereign asset pools is fundamental. - Structural current account surpluses (e.g., due to natural resource revenues) lead to reserve growth and raise questions about investing “excess” reserves and institutional arrangements to separate/manage asset pools. - Country approaches to excess reserves: - Carve out parts as a basis for an SWF (example cited: China). - Divide reserves into separate tranches and co-manage investment tranche with SWF (Botswana, Norway). - Keep excess reserves within central bank and invest in higher-yielding assets (Hong Kong). - Key questions in designing investment framework: - (i) assessment of excess reserves; - (ii) investment strategy; - (iii) appropriate institutional arrangement to implement strategy. ### Assessing ample reserves and reserve adequacy - Reserve adequacy assessment should precede institutional changes or investment strategy shifts. - For emerging market economies, the most relevant indicator: ratio of international reserves to short-term external debt. - Simple benchmark for countries with uncertain market access: target coverage of short-term external debt of all residents and in all instruments and currencies measured by remaining maturity. - Implication: a country with a balanced current account and no capital flight will have sufficient reserves to cover obligations for a full year even if cut off from external capital inflows. - Countries may build additional buffers beyond standard metrics in cases of: - running current account deficits, - high levels of short-term public domestic debt, - derivative positions of the public sector, - weak banking systems. - At some point the cost of carrying excessive reserves outweighs benefits and alternative investment strategies should be considered. ### Cost-of-reserves as insurance framework - Holding reserves reduces probability and cost of a crisis in terms of output loss but carries an opportunity cost due to typically low returns. - The insurance framework parallels the factor-based investment framework discussed in Appendix I and links to optimal debt level discussions when reserves are increasing. ### Investment strategies for excess reserves and institutional responses - Large central bank reserves may warrant investment strategies similar to long-term savings funds, but limited tolerance for reporting losses and marked-to-market accounting may limit risk on central bank balance sheets. - Carving out reserves to manage under other institutional arrangements (e.g., SWF) may be appropriate when reserves are sizable. - Examples of institutional arrangements and practices: - Central Bank of Botswana: created the Pula Fund (formally launched in 1993) as a separate investment tranche; maintains a liquidity tranche equivalent to six months of imports; withdrawals from Pula Fund occur if liquidity tranche falls below target after macroeconomic policy adjustment; rebalancing back to the fund if liquidity tranche exceeds target. - Hong Kong Monetary Authority (HKMA): separates foreign reserves into Backing Portfolio (highly liquid, short-term U.S. dollar-denominated fixed-income securities) and Investment Portfolio (more dynamic, including equities). - Norway: Norges Bank established a separate investment tranche managed by NBIM; investment guidelines for this tranche are broadly equivalent to guidelines set by the ministry of finance for the GPFG. ### Institutional issues in establishing SWFs for excess reserves - Considerations before setting up an SWF: - Building a new institution requires substantial time and human capital; reasonable only if excess reserves are judged to persist. - Review origins and longevity of reserve sources and other sovereign assets/liabilities to judge appropriateness of creating a separate SWF. - Coordination with central bank reserves: - Official foreign currency reserves exist to provide liquidity during a BoP crisis, not typically the objective of a SWF. - Contingent calls for liquidity could prevent a SWF from pursuing long-term, less liquid investments and undermine SWF objectives. - If SWF may provide BoP support, clear policy and supporting rules/procedures should be established to preserve transparency and accountability. - Examples of rules/guidelines: - Pula Fund (Botswana): agreed trigger points allowing drawdowns when macroeconomic policy adjustments are insufficient to stabilize Liquidity Portfolio reserves. - Korea Investment Corporation: assets qualified as reserve assets and could be used for BoP purposes. - Commodity funds: often disburse when commodity prices are weak and may support BoP even without explicit mandate. *Source: _061014 - 44. The optimal investment strategy for this class of funds depends on the nature of the liabilities it is meant to cover.* ### 67. A common issue in the context of ample government revenues is how to optimize ### A common issue in the context of ample government revenues is how to optimize government debt levels. ### Balance sheet optimization: debt repayment versus asset accumulation - Core problem framed as a balance sheet optimization: net financial assets may not be affected by debt repayment strategies, but the size of the balance sheet will. - Faster repayment of debt shrinks the sovereign balance sheet relative to accumulating financial assets in an SWF; magnitude and pace of asset accumulation depend on generation of fiscal surpluses. - Issue most relevant for choice between accumulating foreign assets and repaying external debt; domestic debt introduces additional considerations. ### Insurance framework for reserves versus debt repayment - Building financial assets provides fiscal flexibility and resources during crises when other funding may be scarce. - Risk-adjusted return on financial assets will, in most cases, be lower than the cost of servicing the debt—this net loss from building reserves rather than repaying debt is characterized as an "insurance premium". - Sufficient build-up of financial assets to fend against external shocks would be warranted before reducing external debt. ### Effects of asset accumulation on debt servicing costs - Growing reserves and sovereign assets can increase economic resilience and may improve credit ratings and reduce costs of servicing debt, lowering the effective "insurance premium". - A dynamic assessment may favor reserve accumulation at early stages of natural-resource extraction. - Example: In August 2012 Moody’s indicated the possibility of upgrading the sovereign rating of Angola due to reduced vulnerability after establishing a fiscal stabilization fund. ### Debt profile, asset management capacity, and optimal pace - Long-dated loans imply less refinancing risk and may argue for slower debt repayment. - Low-income countries with concessional debt may find asset accumulation preferable when expected returns exceed low cost of debt service, making the insurance premium negative. - Lack of institutional capacity to prudently manage larger reserves favors debt repayment until capacity improves. ### Coordination of asset allocation with debt characteristics - Matching asset composition to liability characteristics (currency composition, duration) reduces currency and interest rate risks. - Case examples: - Central Bank of Mexico used excess reserves to repay IADB and World Bank loans after negative income results in 2004 and 2005, shrinking the balance sheet. - Denmark coordinated external debt and reserves between 1992 and 2001 at quarterly meetings of the Ministry of Finance and Danmarks Nationalbank to reduce net valuation adjustments; in 2001 authorities moved to exposure only to the euro. ### Domestic debt in an SALM framework - Resource-rich countries typically lack financing needs that warrant issuing domestic debt, but may issue domestic debt to develop domestic debt markets while accumulating foreign assets. - Trade-off depends on cost of domestic debt, return on additional financial assets, and institutional capacity for managing financial wealth. - Coordination between government and central bank is required because central bank instruments and government debt are close substitutes. - Market segmentation approach: central bank issues short maturity instruments; government finances at longer maturity to build a domestic risk-free yield curve—requires close coordination. - Alternative: centralize debt issuance with the government and use treasury instruments for liquidity management. Example: Brazil adopted a fiscal responsibility law (2000) after 1999–2000 sterilization costs and negative central bank capital, incorporating central bank debt into public debt and prohibiting central bank issuance of its own debt instruments. ### Domestic pension funds in an SALM framework - Implicit or explicit pension liabilities should be integrated into government financial management with appropriate investment strategies; actuarial assessment of accrued liabilities may be required. - Pension liabilities typically have very long horizons; in defined benefit systems, net present value is highly sensitive to the discount rate. - Historically, long-duration fixed-income instruments have been important for matching pension liabilities. - Pension funds often hold significant domestic government bonds, raising diversification concerns, especially when bond yields are very low. - Chile Pension Reserve Fund (PRF) case: - Established in 2006 to help finance fiscal pension liabilities. - PRF has a medium to long-term investment horizon, with an SAA that has included equity (15 percent) and corporate bonds (20 percent) since 2012. - Before 2012 the PRF emphasized high liquidity and low credit risk and volatility. - Diversifying pension fund portfolios may divert demand away from the government bond market, increasing gross debt to finance increased exposure to risky assets and affecting consolidated government balance sheet robustness. - International diversification implications for small economies: shifts from domestic to foreign assets affect capital flows, exchange rates, and monetary operations; central bank may sterilize by drawing down reserves or accept exchange rate movement. - Coordination recommendation: provide an appropriate investment mandate and operational independence for pension funds while setting investment guidelines that reflect effects on other parts of the government balance sheet. ### Future imports as an implicit liability of SWFs - Resource-rich countries often have twin surpluses: government budget surpluses and current account surpluses; SWF asset accumulation reflects savings for the country as a whole. - Future imports can be considered an implicit liability for an SWF since current account surpluses finance future imports. - Measuring SWF performance may use real return in a basket of currencies corresponding to import weights (practice in Ghana, Norway, Singapore, and the United Arab Emirates). - If purchasing power parity holds, geographical distribution of assets should not materially affect purchasing power; deviations can be significant in short and medium term but matter less for long-term investors. - For equity investments, a market-weighted portfolio provides exposure to global productive capacity and may better hedge implicit liabilities of future imports. ### Natural resources on the sovereign balance sheet - SALM can be extended to nonfinancial assets: the net present value of government cash flows from natural resources is an asset. - Transforming natural resources into financial assets would smooth sovereign balance sheet volatility, since commodity-price-derived present value of in-ground resources typically exhibits higher volatility than income-producing financial assets. *Source: IMF — Sovereign Asset-Liability Management (excerpts).* ### 90. Income volatility is a major challenge for most resource-rich countries. Countries have ### _061014 - 90. Income volatility is a major challenge for most resource-rich countries. Countries have ### Income volatility, TGT, and SALM insights - Income volatility is a major challenge for most resource-rich countries; buffer or stabilization funds have become central to volatility management, and some countries (e.g., Mexico) have used financial instruments (options or forward contracts) to put a “floor” under resource revenues or reduce their overall volatility. - The design of the system for “total government take” (TGT) will have a large influence on the level of income volatility. - TGT is defined as the sum of all income to the government from a natural resource, including taxes, royalties, dividends, and income from direct participation. - Income volatility can be viewed as a policy variable: countries choose optimal volatility levels based on risk preferences, capacity, and assessments of expected returns. - A SALM framework can evaluate optimal TGT design because: - The TGT system determines the division of revenues between government and private sector companies and also the division of risks. - When government shifts risk to private sector companies through reliance on TGT elements like royalties that have low correlation with profitability, the government must compensate companies with higher expected returns (thus a higher share of the overall resource rent) to keep the risk/return trade-off attractive. - Conversely, a government prepared to take more risk through the TGT system should expect a higher share of the resource rent. - In SALM, the value of holding liquid reserves in a buffer fund increases if it allows the government to rely more on TGT elements, like profit taxes that provide more volatile revenues but a higher share of the resource rent over time. - Countries differ in whether they exclude petroleum-related assets from SWF portfolios: - Rationale for exclusion: avoid increasing the government’s total petroleum price risk by having SWF financial investments correlated with government oil and gas revenues and overall economic activity. - Rationale against exclusion (Norwegian Ministry of Finance analysis, 2009): given the investment strategy of the GPFG and characteristics of Norwegian petroleum wealth, excluding oil- and gas-related assets would have negligible effects on oil price risk; excluding large portions of the equity market would increase weight of other sectors (financial sector remains largest), possibly increasing exposure to other correlated risk factors (e.g., liquidity); many petroleum companies are transforming into broader energy companies with investments in new and renewable sources of energy—excluding petroleum companies reduces exposure to these energy-sector areas. - Both approaches (excluding or not excluding petroleum-related investments) may be warranted depending on country circumstances: variation in petroleum’s role in the national economy, SWF investment strategies, and SWF size relative to the domestic economy matters. - Recommended practice: resource-rich economies should integrate analysis of natural resource assets in an SALM framework, particularly when countries have both substantial resource assets and large financial reserves and when the resource sector is a significant part of the national economy. An explicit SALM analysis of implications of resource wealth for optimal management of other assets and liabilities can mitigate risks and improve resilience of the economy and sovereign balance sheet. ### SWF governance structure: principles and institutional design - The legal framework of an SWF should include a clear ownership structure, management responsibility, and an investment mandate. - Typical legal/ownership relationships: - In most cases, the SWF manager acts on behalf of the beneficiary and legal owner (often the central government) and operates under conditions prescribed by the owner. - In other cases, the SWF is the legal owner of the assets under its management. - Distinguish governing bodies and supervisory bodies: - Authority to invest is delegated from the top governing bodies down to individual (internal or external) asset managers; delegation implies more granular regulations down the chain. - Each governing body should establish a supervisory body to verify that the supervised unit acts in accordance with regulations set by the governing body immediately above it. - Distinguish internal and external bodies: - Internal bodies are part of the legal structure of the SWF; external bodies are other legal persons with defined roles (e.g., owner or external auditor). - Five governing bodies in a generic SWF setup: - The owner of the SWF is the central government. Parliament adopts the laws establishing the legal structure of the fund and the legal basis for operations; the parliament may also have a role in determining the appropriate aggregate risk level of the fund. - The full government (cabinet or council of ministers) or the minister of finance typically carries out owner functions, including setting a mandate for the investment organization within the parliament-provided framework. - The executive board is the highest governing body inside the management organization; it sets internal rules and regulations (e.g., investment guidelines) and appoints the chief executive officer (CEO). - The CEO is the administrative head responsible for day-to-day operations within board guidelines. - Individual managers (internal and external) operate within risk limits set by the CEO and his/her staff; the CEO normally delegates running of the investment department to a chief investment officer (CIO). - Supervisory bodies typically include: - Auditor General: established by parliament to audit and control executive activities; verifies that the ministry of finance (or other formal owner) operates within laws and that reports to parliament are correct and relevant. - External auditor: usually appointed by the governing body representing the owner; audits SWF accounts and verifies compliance with owner-set rules and regulations; can perform ad hoc control activities (e.g., assessing internal control quality). - Internal auditor: appointed by and reporting to the executive board to support board supervision and verify adherence to internal regulations. - Compliance unit: a tool for the CEO to verify compliance with rules and regulations governing SWF operations. - Governance design risks and practical considerations: - Supervisory bodies supervising several governance levels simultaneously can blur roles and responsibilities and risk preventing sufficient delegation. - Differences in political institutions (parliamentary vs. separate elections) affect interactions between parliament and ministry of finance and can influence SWF setup. - Auditing complexities for SWFs with extensive foreign investments may warrant joint audit arrangements between auditor general and private sector external auditors to draw on private sector experience. - Role clarity and accountability: - Clear and transparent division of roles and responsibilities is required to achieve accountability and legal certainty; avoid regulatory gaps and overlaps. - Distinguish between owner and manager of SWF assets: central government is owner on behalf of the people; owner duties are normally vested in a governing body below parliament (usually the ministry of finance) and these governing bodies are outside the legal structure of the asset management organization (principals), with management being the agent. - Distinguish government’s role as owner of the asset management institution and as owner of the managed assets; this is useful when SWFs are managed as pools of assets by institutions like central banks. - Distinguish between a corporation with paid-in capital managing its own assets and an asset management company where managed assets constitute a liability to the central government; both approaches have advantages and disadvantages. - A fund management entity can manage different portfolios under separate mandates (e.g., a stabilization portfolio and a savings portfolio). ### Risk management for SWFs: delegation, mandates, reporting, and principles - Appropriate delegation: - There must be appropriate delegation of investment decisions from the owner to the asset manager and within the management organization because asset management is highly skill-intensive. - Delegation focuses attention of each governing body on critical issues at its governance level and provides flexibility to deal with changing market conditions, often requiring faster decision-making than highly centralized systems. - Owner determination of aggregate risk: - Governance must allow the owner to determine the appropriate aggregate level of risk because the appropriate level of risk depends on the risk aversion of the ultimate beneficiaries (the people). - Political bodies like parliament and/or the ministry of finance should be able to establish at least broad guidelines for the appropriate level of risk for SWF investments. - Investment mandate formulation: - The investment mandate is a key decision and forms the basis for the investment process; mandates vary with the level of delegation: - Most delegated form: mandate empowers manager to determine the SAA (Strategic Asset Allocation) himself, often restricted by minimizing risk for an explicit return objective. - Less delegated: owner sets explicit benchmarks for each eligible asset class and an overall benchmark portfolio with explicit limits on deviations (active management). - Intermediate: set broad intervals for allocations to various asset classes with quantitative and/or qualitative risk regulations. - The mandate determines whether the manager should focus on absolute or relative returns: - Absolute return objective aligns manager incentives with owner interests if return objective is consistent with owner-acceptable risk, but realized returns may deviate substantially from targets over short and medium term. - With benchmarks and owner-set risk limits, owner has more direct control over SAA; manager’s focus shifts to returns relative to the benchmark. - Reporting and transparency: - Guidelines for internal and external reporting must be integrated into governance to support good risk management and accountability. - Transparency through good external reporting increases SWF legitimacy and provides disciplinary pressure on managers. - Basic principles for risk management: - Risk management should be characterized by clearly delegated mandates, defined roles and responsibilities, accountability, transparency, and professionalism. - Scope of risk management should cover all material risks affecting investment operations, including financial (credit, market, liquidity), operational, and reputational risks. - Case study references: - For the GPFG, the ministry of finance (owner) has set a relatively detailed mandate for central bank management of the fund specifying allocation to asset classes, benchmarks, risk limits, and risk management requirements. - Norway: governance structure of the GPFG follows the generic structure with the exception that, since the manager is the central bank, the Supervisory Council of the bank appoints the external manager, not the ministry of finance. *Source: _061014 - 90. Income volatility is a major challenge for most resource-rich countries.* ### 114. A SWF needs to have a strong risk management culture, in which senior management ### _061014 - 114. A SWF needs to have a strong risk management culture, in which senior management ### Risk management culture and purpose - A SWF needs a strong risk management culture, in which senior management is engaged in developing and enforcing the risk management process. - Adherence to high standards in risk management with sound operational controls and systems is necessary to meet the objectives of the SWF and to preserve legitimacy domestically. - Internationally, such standards are necessary for: preserving international financial stability, and maintaining a stable, transparent, and open investment environment. ### Components of the risk management process - Risk policies and procedures: a set of written principles endorsed by the board of directors (BoD), implemented by the CEO, and disseminated within the institution. - Risk identification: the process by which a SWF defines the nature of the risk it faces. - Risk measurement: a measurement methodology that allows comparison across different dimensions of risk and enables risk considerations to be factored into performance measurement and investment management decisions. - Risk monitoring: the operational process by which the SWF ensures that it operates within its defined risk policies and procedures. - Risk reporting: typically refers to an internal reporting process. - Risk verification and audit: the component that ensures risk management systems and techniques are effective. ### Distinguishing rewarded and non-rewarded risks - Market risks: various forms are rewarded through positive expected returns. - Consequential risks: operational and legal risks that inevitably arise from being in the financial/investment management industry and are not rewarded. ### Setting risk objectives and tolerance - The owner or governing body typically determines risk objectives. - Broad risk principles are generally established within the law governing the SWF or by the owner. - Risk tolerance should reflect the fund’s investment horizon and overall risk tolerance and be translated into a quantifiable risk measure. - A quantifiable risk measure could be expressed as a shortfall probability, the probability of not achieving a certain return target or worst case outcome at a certain confidence level. - Examples of specific risk parameters (footnote 11) include: - probability of achieving a return in excess of the domestic inflation rate, - expected annual shortfall relative to long-term domestic inflation, - probability of negative return at the end of 3 years, - probability of achieving return target over 20 years, - probability of negative accumulated real return after 15 years. ### Operational investment management and delegation - Operational investment management must be carried out by investment professionals. - Management should be delegated from the owner to the fund, implemented via internal and/or external portfolio managers with clearly defined operational mandates. - The choice between internal and external managers will usually reflect costs and access to relevant skills. - Large funds: economies of scale may make internal management cost efficient. - Smaller funds or resource-rich developing countries: may face human-resource constraints and find external managers necessary. - Principal-agent problems arise when outsourcing, requiring minimum oversight and capacity by the owner to supervise managers. - For developing countries with limited oversight capacity: advisable to start with a simple and transparent benchmark for SAA and avoid unnecessary risk-taking or sophisticated risk-management strategies. ### Operational risk: nature and management - Operational risks are not rewarded; objective is to mitigate residual risks to an acceptable level. - Financial risks: exposure leads to greater volatility but expected higher returns over time. - Operational risks could lead to significant losses of principal or failure of the firm (footnote 12). - Operational risk is largely endogenous to the SWF and linked to business environment, investment complexity, processes and systems, management quality, and information flows. - Operational risks cannot be completely avoided; reducing them entails costs — trade-off between cost of accepting risk and cost of mitigating it should be explicit in risk policy and often based on impact and likelihood analysis. - Recent example (footnote 12): failure at Societe Generale in January 2008 led to estimated losses of €4.9 billion when appropriate separation of controls between front- and middle-office functions was absent. ### Case Study: Norway (GPFG / NBIM) - For the GPFG, focus is on returns relative to the benchmark set by the owner. - The board of the central bank has set quantitative regulations on the acceptable level of operational risk within the bank, including for management of the GPFG. - NBIM manages both the GPFG (under a mandate from the ministry of finance) and the investment tranche of the central bank’s own reserves (under a separate mandate given by the board). ### Organizational structure and controls - The most important operational risk management tool is an appropriate internal organizational structure with clear segregation of duties. - Segregation should separate execution of portfolio transactions from operations such as compliance monitoring, performance measurement and reporting, settlement, and accounting. - Achieve segregation by setting up separate departments with heads reporting directly to the CEO and clearly defined roles and accountabilities. - Reliable information technology systems with access limited to authorized personnel (e.g., back office) support reporting and enforce segregation. - Public disclosure of the SWF’s approach to risk management policies and key governance and operational actions reassures domestic and international stakeholders. ### Conclusion: SALM framework and guiding principles - The paper presented a conceptual framework for an integrated SALM framework aiming to minimize vulnerabilities on the sovereign balance sheet and analyzed relevant country examples. - Broad guiding principles distilled include: - When reserve adequacy assessment points to ample reserves, consider carving out a portion for long-term investment strategies in dedicated savings funds, accounting for institutional framework and coordination mechanisms. - Optimizing the sovereign balance sheet should consider the stage of asset accumulation: expand sovereign balance sheet by allowing reserve accumulation and building financial wealth during early stages of extraction; reduce sovereign debt when external debt costs are high and/or carrying cost of reserves exceeds self-insurance benefit and alternative arrangements for investing reserves are not feasible. - Resource-rich countries may issue domestic debt for objectives such as developing a domestic debt market while accumulating foreign assets; feasibility depends on cost of domestic debt, return on additional financial assets, institutional capacity, and sound debt management principles. - The structure and nature of contingent and implicit liabilities should inform investment objectives and strategies of sovereign assets, reflected in type of savings fund, investment horizon, mandate, and risk profile. - Sovereign funds should favor a clear mandate and legal structure, transparent governance, and clear delineation of responsibility between owner and management; clarity about the fund's investment mandate and managers’ accountability should be ensured. ### Appendix I — Risk and the pricing of financial assets - The value of a financial asset reflects expectations of future cash flows, which must be discounted to present value. - Discount rate components: a risk-free rate (compensating deferred cash flow) and a risk premium (compensating associated risk). - Movements in asset prices stem from changes in expected future cash flows or changes in the discount rate. - Modern theory emphasizes how changes in risk premiums affect pricing. - Changes in risk premiums reflect investors’ ability and willingness to take risk; higher perceived risk and/or lower appetite for risk implies higher expected return in equilibrium, causing asset prices to fall until expected returns clear the market. - Risk factors are building blocks of expected returns: various forms of systematic risk that cannot be diversified away and for which investors expect to be rewarded. - Assets are bundles of underlying risk factors; risk premiums reflect exposure to these factors. - Some factors (credit and liquidity) may have skewed return distributions: modest positive returns most years, few periods of significant losses — analogous to selling insurance. - Investment decisions can be reframed in an insurance framework: selling insurance (taking more systematic risk) yields higher expected returns but larger drawdowns in bad periods; buying insurance yields below-average returns but protection against large losses. - Increased correlations in market stress reflect common exposure to underlying risk factors (e.g., liquidity), not new relationships; monitoring exposure to underlying risk factors helps avoid being caught by unexpected changes in asset-level correlations. ### Appendix II — The Santiago Principles - The International Forum of Sovereign Wealth Funds (IFSWF) was established by the International Working Group of Sovereign Wealth Funds in April 2009; IFSWF members meet annually to exchange views and facilitate understanding of SWFs’ generally accepted principles and practices as outlined in the Santiago Principles. - The guiding objectives of the Santiago Principles are to: - (i) build a transparent and efficient governance structure that ensures adequate operational controls, risk management, and accountability; - (ii) invest on an economic and return-related basis; - (iii) conform to all regulatory and disclosure requirements in recipient countries; - (iv) ensure free flow of capital and investment; and - (v) preserve global financial stability. - The Santiago Principles, albeit voluntary, assist in identifying, developing, and enhancing governance and accountability frameworks and investment conduct; implementation is subject to home country laws and may require transitional periods, especially for newer SWFs. - The Santiago Principles broadly cover three key areas: - (i) the legal framework, objectives, and coordination with macroeconomic policies; - (ii) the institutional framework and governance structure; - (iii) the investment and risk management framework. - These areas are interlinked: a clear legal framework and objectives underpin a robust institutional framework and governance structure that assist in developing investment strategies consistent with the SWF’s stated policy objectives. *Source: _061014 - 114. A SWF needs to have a strong risk management culture, in which senior management (PDF chapter/section).* ### 136. Several SWFs have conducted and published self-assessments to confirm their degree ### _061014 - 136. Several SWFs have conducted and published self-assessments to confirm their degree ### Self-assessments and intended effects - Several SWFs have conducted and published self-assessments to confirm their degree of adherence to the Santiago Principles. - Purposes of these self-assessments: - To help assure home and recipient countries that SWFs’ activities are solely based on economic and financial considerations. - To contribute to the stability of the global financial system. - To reduce protectionist pressures. - To help maintain an open and stable investment climate. - To enable SWFs to develop, review, and strengthen their organization, policies, and investment practices. ### Main Elements in the Santiago Principles (Box 6) - Governance and accountability - A clear objective. - A sound legal framework. - Adequate reporting systems. - Integration in domestic policy formulation - Appropriate coordination. - Clear rules on funding and withdrawal. - Incorporating SWF data into macroeconomic datasets. - Management of the nation’s wealth - A clear investment policy. - Diligence, prudence, and skill in investment practices. - A robust risk management framework. - Investment motivation - Public disclosure of policy purpose, governance framework, and relevant financial information. - Refraining from pursuit of any objectives other than maximization of risk-adjusted financial returns. - Public disclosures of general approach to voting and board representation. - Fair competition in markets - Respecting and complying with all applicable host country rules, laws, and regulations. - Not seeking advances of privileged information. - Impact on global imbalances and capital movements - Disclosure of relevant financial information. - Description of the use of leverage or disclosure of other measures of financial risk exposure. - Execution of ownership rights consistent with the SWF’s investment policy. - A transparent and sound operational control and risk management system. *Source: IMF — sovereign asset-liability management chapter excerpt (Box 6).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_061014.pdf_