## _wp07297

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### Sovereign Wealth Funds (SWFs) in Pacific Island Countries (PICs)
- SWFs established using:
  - revenue from non-renewable sources: Kiribati, Timor-Leste, Papua New Guinea, Nauru
  - revenue windfalls: Tonga, Tuvalu
  - donor contributions: Tuvalu, Marshall Islands, Micronesia, Palau
- General SWF objectives identified:
  - short-term stabilization
  - long-term savings
  - long-term budgetary self-reliance
- Common SWF characteristics:
  - vehicles to manage public sector financial assets, with or without specific policy objectives
  - predominantly engaged in cross-border investments
  - investment strategies aiming for higher returns than short-term risk-free instruments
  - closely linked to and dependent on foreign exchange inflows (external current account surpluses or capital inflows)
- Policy-objective classification example: oil-producing countries create stabilization funds (macro-fiscal management) and/or savings funds (longer-term objectives)

### Key characteristics and economic constraints of PICs
- Structural features:
  - small population, small land area, small GDP
  - geographic isolation, often thousands of kilometers from major trading centers
  - population spread across many small and far-flung islands
  - narrow productive sectors based almost exclusively on primary commodities and some tourism services
- Economic constraints and shocks:
  - exposure to significant terms-of-trade shocks
  - frequent natural disasters (especially typhoons affecting fishing revenues)
  - limited incentives to accumulate human capital and higher costs of doing business
  - constraints on fishing and tourism development (geographic isolation, lack of tourism infrastructure, limited skilled labor, threat of overfishing)

### Economic performance and volatility
- Comparative performance and volatility:
  - Since 1995, average GDP growth in the slowest growing region outside of the PICs was 50 percent higher than that of the PICs
  - Emerging Asian countries grew 3½ times faster than the PICs
- Low and volatile GDP growth accompanied by:
  - persistent current account deficits covered mainly by foreign aid and worker remittances
  - large swings in fiscal balances
- Figure notes (as provided):
  - For Timor-Leste, figures refer to non-oil GDP instead of GDP.
  - Fiji official grants figures are based on 2002–04 data.
  - Timor-Leste figure excludes oil revenue.

### Revenue size, composition, volatility, and risks
- Revenue and volatility features:
  - Revenue collection is "around 45 percent higher than in European Union (EU) countries", but PICs "exhibit more than six times the degree of volatility faced by the EU."
  - Nontax revenue highly volatile; fishing license fees can fluctuate by "over ten percentage points of GDP from one year to the next" (example: Kiribati and Tuvalu in 2002–03).
  - Foreign grants "account for more than half of total revenue and grants" in Kiribati, the Marshall Islands, Micronesia, Palau, and the Solomon Islands.
  - Several countries experienced "annual changes in grant levels of over 10 percentage points of GDP" (Kiribati, the Marshall Islands, Micronesia, Palau, Samoa, and the Solomon Islands).
  - Tax revenue is relatively more stable but the small taxable private sector limits its offsetting capacity.
  - Revenue volatility has translated into "highly volatile expenditures."
- Risks to revenue sustainability:
  - Trade liberalization may reduce tariff revenue; countries most at risk: Kiribati, Solomon Islands, Tonga.
  - Overfishing is reducing fishing-license revenue in Micronesia, Palau, Tonga, and Kiribati; Kiribati’s fishing-license revenue declined "from 54 percent of GDP in 2001 to 28 percent of GDP in 2006."
  - In Papua New Guinea, "revenue from the mineral and petroleum sector is projected to decline" due to tax concessions and resource depletion.
  - Some key donors have indicated intentions to scale down budgetary support over time.

### Large public sectors and fiscal outcomes
- Government expenditure and employment:
  - Government expenditure "averages around 58 percent of GDP"
  - Public sector employment in some islands "accounts for over half of total employment"
  - Public wages: "more than 40 percent of GDP in Kiribati" and "between 20-25 percent of GDP in the Marshall Islands, Micronesia, and Palau"
  - Spending on health, education, and social services "relatively low and often linked to donor involvement"
  - Capital spending "relatively large and is mainly financed by donors"
- Notable fiscal outcomes:
  - Kiribati recorded a fiscal deficit of 33 percent of GDP in 2003 and has run annual deficits in excess of over 20 percent of GDP since then
  - Micronesia, Palau, the Solomon Islands, and Tuvalu experienced large (though shorter lived) fiscal deficits in recent years

### SWF design, withdrawal rules, and governance
- Objectives and revenue sources:
  - Funds established mainly to accumulate public savings, stabilize government revenues, or a mix
  - Main revenue sources: non-renewable resources, windfalls, donor grants
  - Examples: Kiribati and Nauru (phosphate), Papua New Guinea (mineral until 2001), Timor-Leste (petroleum), Tonga and Tuvalu (passport sales, satellite leasing), Tuvalu (initial donor assistance and under-spending deposits from Australian aid)
  - Investment income is reinvested in funds
- Withdrawal rules and discretionary drawdowns:
  - Some funds (Timor-Leste, Papua New Guinea, Tuvalu) anchor withdrawal rules in the concept of sustainable income while allowing flexibility
  - CTFs rules and caps:
    - The CTFs of the Marshall Islands and Micronesia do not allow disbursements prior to FY2023 and withdrawals are capped afterwards
    - Palau’s CTF allows withdrawals during accumulation but "are capped at U.S.$ 5 million inflation-adjusted per year until 2009." Once U.S. Compact grants cease in 2009, "the Palau CTF is supposed to transfer to the budget a minimum of U.S.$ 15 million inflation-adjusted per year."
  - Discretionary drawdowns: Kiribati (government discretion, guideline to maintain the 1996 real per capita value of assets), Nauru (Board discretion), Tonga (guidelines not public; government has borrowed from the fund)
- Governance features:
  - Most funds have defined governance roles (board, management, advisory committee, monitoring, audit)
  - Donor-financed funds typically majority-controlled by donors (Marshall Islands, Micronesia, Tuvalu); Tuvalu board chaired by minister of finance with two board members appointed by Australia and New Zealand
  - Palau’s donor-financed fund is fully controlled by domestic authorities but with strict withdrawal limits
  - Some funds impose stringent expertise/experience requirements (Marshall Islands, Micronesia, Timor-Leste, Tuvalu)
  - Example trustee requirements for CTFs: trustee net worth "in excess of $100 million", at least "10 years experience as a custodian of financial assets", and experience managing trust funds of at least "$500 million"

### Tuvalu case: two-account structure and fiscal flexibility
- Fund structure and rules:
  - Evolved from single TTF to two-account structure with a stabilization account (CIF)
  - Recommended annual transfers from TTF to CIF based on the difference between TTF’s market and maintained values, with maintained value deflated by the Australian CPI
  - CIF is effectively a government account; "the entire value of the CIF funds can be used by the ministry of finance at any point in time"
  - Guideline target minimum CIF balance: "16 percent of the TTF’s maintained value" to ensure a "sustainable TTF contribution"
  - Design assumptions: annual real rate of return on TTF’s assets averages "around 4 percent" and a buffer of "4 years in the CIF (16 percent of TTF assets) will be enough to weather yearly volatility"
- Fiscal shock management capacity:
  - If CIF met the minimum balance target, it "would allow the budget to manage considerable shocks—amounting to a cumulative 48 percent of GDP over a four year period (a cumulative 16 percent of the TTF’s assets of 300 percent of GDP) based on 2006 data."
  - Such flexibility contingent on: (i) "the government having a balanced overall fiscal position on average"; and (ii) "having the full 16 percent buffer in the CIF."

### Assessment of funds’ effectiveness and selected country outcomes
- General assessment:
  - Funds have accumulated significant fiscal savings where fiscal policies were sound
  - Funds’ success in accumulating assets clearer than success in smoothing budgets, substituting for donor grants, or ensuring long-term fiscal self-reliance
- Country-specific outcomes:
  - Timor-Leste’s Petroleum Fund: "has accumulated substantial assets" with framework oriented to long-term sustainability; spending kept below estimated sustainable levels
  - Kiribati’s RERF: accumulated substantial savings early but "has run down its assets" as withdrawals financed expansionary fiscal policy and increased spending volatility; trend could be unsustainable if declining non-tax revenue (mainly fishing rights) is permanent
  - Tuvalu’s SWF: "has had limited impact in shielding the budget from the volatility in revenue" because CIF assets were not large enough and TTF rules were rigid

### International experience with non-renewable resource funds (Box 2 & Box 4 findings)
- Key findings:
  - Resource funds often have limited impact on fiscal outcomes and can hamper fiscal management if poorly designed
  - Success cases are those integrated in sound fiscal frameworks and good institutions
  - Lessons for fund design: operational rules, budget integration, asset management, transparency/accountability
- Operational rules and flexibility:
  - Flexible operational rules usually preferable; rigid deposit/withdrawal rules often changed, bypassed, or abolished as circumstances evolve
  - Examples of fund abolishment or rule changes include Chad, Ecuador, Papua New Guinea
- Integration with budget systems and cash management:
  - Earmarking or extrabudgetary spending reduces flexibility, complicates liquidity management, and can increase borrowing
  - Financing funds (e.g., Norway, Timor-Leste) are preferable as they integrate with the budget and finance the budget as needed
- Asset management:
  - Few funds have comprehensive, transparent investment strategies; lack of strategy sometimes coincided with large accumulation of debt
  - Funds tended to keep assets invested abroad to allay currency appreciation concerns
- Transparency and accountability:
  - Oversight and disclosure vary substantially; Norway cited as highly transparent
  - Only Timor-Leste and Tuvalu consistently publish annual reports among PIC funds; Marshall Islands and Micronesia have stringent quarterly reporting requirements but reports have contained incomplete/unreliable information
- Examples of poor outcomes and causes:
  - PNG: MRSF assets accumulated while public debt rose by more than 30 percentage points of GDP; MRSF assets used as collateral and the fund was closed in 2001
  - Nauru: NPRT assets decreased by more than 90 percent between 1991 and 2006; sale of real estate to repay public debt; fund in receivership with expected residual value around A$60 million
  - Tonga: risky concentrated investments led to legal action against an investment manager; marginal compensation received after settlement
- Compact Trust Funds and self-sufficiency concerns:
  - Marshall Islands and Micronesia Compact Trust Funds expected to replace declining U.S. grants after 2023; recent estimates indicate funds may not provide needed returns and transfers, implying further fiscal tightening
  - Palau’s CTF expected to disburse U.S.$ 15 million annually from 2010 while maintaining real asset value; at current asset levels unlikely to sustain $15 million per year permanently and could be depleted in less than 15 years if withdrawals exceed returns
- Governance, reporting, and capacity:
  - Governance structures vary; oversight and reporting typically limited
  - Capacity constraints and limited resources contribute to governance and transparency problems
  - Donors can play a more active role in providing assistance and advice (example: Tuvalu TTF advisory committee)
- Box 1 numerical volatility highlights (Volatility of Government Revenue and Expenditure, 1990-2005, staff estimates):
  - Pacific Islands: Revenue 4.06, Expenditure 6.00, Revenue (as share of GDP) 0.07, Expenditure (as share of GDP) 0.10
  - Cook Islands: Revenue 4.07, Expenditure 7.40, Revenue (as share of GDP) 0.11, Expenditure (as share of GDP) 0.16
  - Fiji Islands: Revenue 2.72, Expenditure 2.30, Revenue (as share of GDP) 0.10, Expenditure (as share of GDP) 0.08
  - Kiribati: Revenue 24.03, Expenditure 31.80, Revenue (as share of GDP) 0.21, Expenditure (as share of GDP) 0.25
  - Marshall Islands: Revenue 15.61, Expenditure 18.50, Revenue (as share of GDP) 0.22, Expenditure (as share of GDP) 0.28
  - Micronesia: Revenue 14.31, Expenditure 12.50, Revenue (as share of GDP) 0.19, Expenditure (as share of GDP) 0.16
  - Nauru 1/: Revenue 33.95, Expenditure 51.70, Revenue (as share of GDP) 0.44, Expenditure (as share of GDP) 0.45
  - Palau 2/: Revenue 33.15, Expenditure 5.30, Revenue (as share of GDP) 0.54, Expenditure (as share of GDP) 0.08
  - Papua New Guinea: Revenue 2.42, Expenditure 2.20, Revenue (as share of GDP) 0.08, Expenditure (as share of GDP) 0.07
  - Samoa: Revenue 10.01, Expenditure 15.50, Revenue (as share of GDP) 0.24, Expenditure (as share of GDP) 0.33
  - Solomon Islands: Revenue 11.51, Expenditure 10.70, Revenue (as share of GDP) 0.36, Expenditure (as share of GDP) 0.27
  - Timor Leste 3/: Revenue 53.64, Expenditure 4.30, Revenue (as share of non-oil GDP) 0.88, Expenditure (as share of non-oil GDP) 0.21
  - Tonga: Revenue 2.43, Expenditure 3.50, Revenue (as share of GDP) 0.08, Expenditure (as share of GDP) 0.11
  - Tuvalu: Revenue 51.24, Expenditure 1.40, Revenue (as share of GDP) 0.48, Expenditure (as share of GDP) 0.40
  - Vanuatu: Revenue 2.04, Expenditure 4.50, Revenue (as share of GDP) 0.09, Expenditure (as share of GDP) 0.17
  - Notes: 1/ Refers to 1996-2001. 2/ Large Palau revenue volatility reflects a one-time advance on grants from the US in 1995. 3/ Timor-Leste figures are in percent of non-oil GDP and refer to 2002-05.
- Selected fund assets and public debt (Table 1, selected entries as presented):
  - Kiribati — Revenue Equalization Reserve Fund: A$ 659 702 A$ 1617
  - Marshall Islands — Compact Trust Fund: US$ 63  1/55 US$ 82 72
  - Micronesia — Compact Trust Fund: US$ 87  1/38 US$ 5625
  - Nauru — Phosphate Royalties Trust Fund: In receivership 2/ ...A$630...
  - Palau — Compact Trust Fund: US$ 152  3/105 US$ 32  3/24
  - Papua New Guinea — Mineral Resources Stabilization Fund: Fund closed in 2001 ...US$ 2,23339
  - Timor Leste — Petroleum Fund: US$ 957  1/22500
  - Tonga — Tonga Trust Fund: US$ 1  4/0 US$ 106 4/47
  - Tuvalu — Tuvalu Trust Fund: A$ 103  4/300......
  - Notes: 1/ As of September 30, 2006. 2/ The Fund is in receivership. The authorities expect the fund to retain assets worth A$60 million or approximately 200 percent of GDP. 3/ As of end-2005. 4/ As of June-2006.

### Fund performance metrics and investment outcomes
- Investment strategy and returns:
  - Conservative FX-reserve-like strategies used by nascent funds (Timor-Leste, Marshall Islands, Micronesia) investing in fixed-income instruments such as U.S. Treasury bonds
  - Ambitious return benchmarks may be unrealistic: Marshall Islands’ CTF earned an annual nominal return of "over 3½ percent" in its first few years versus a stated objective of "6 percent"
  - Undiversified/aggressive strategies led to large losses (Nauru’s real estate; Tonga’s concentrated U.S. company exposures)
  - Diversified portfolios produced average nominal returns "around 10 percent a year" but with high volatility (Tuvalu and Palau)
- Tuvalu performance specifics:
  - Tuvalu real annual returns (Australian CPI deflator), 1988–2005: ranged from -8.5 (in 2001) to 21.7 (in 1997); averaged 6.3 percent with a standard deviation of 8.6 percent
  - Comparisons:
    - 5-year performance benchmark: 4.5 percent
    - Returns on 10-year Australian government bonds: 4.6 percent
    - 70/30 S&P ASX 200/10-year Australian government bonds portfolio: 5.9 percent
    - 100 percent S&P ASX 200 index mean return: 7.8 percent
  - Management fees can significantly impact long-term cumulative returns

### Governance, transparency, and PFM weaknesses
- PFM systemic weaknesses in PICs:
  - Comprehensiveness and transparency, and budget cycles weak
  - Oversight of aggregate fiscal risk from other public sector entities weak (example: Kiribati)
  - Extent of unreported government operations (PNG, Tuvalu, Vanuatu)
  - Public access to key fiscal information generally weak
  - Policy-based budgeting often lacks multi-year perspective (PNG, Samoa, Tuvalu, Vanuatu)
  - Predictability and control in budget execution poor; reliance on borrowing or arrears despite fund assets (Marshall Islands, Tuvalu)
  - Recording/managing cash balances, debt and guarantees often poor (Kiribati, Tuvalu)
  - Accounting, reporting, and external audit weak across sampled PICs
- Fiscal consequences of weak PFM:
  - Funds operating outside the budget reduced usable cash reserves and increased borrowing (Marshall Islands and Micronesia during accumulation)
  - Use of fund assets as collateral or onlending occurred (Tonga, Marshall Islands, PNG, Nauru)
  - Quasi-fiscal and extrabudgetary activities often carried out with limited controls or reporting

### Conclusions and reform agenda (policy recommendations)
- Overall conclusion:
  - Most PICs need structural reforms and large fiscal adjustments to improve prospects and reduce macro-fiscal vulnerabilities
  - SWFs can support a sound fiscal framework if well-designed but should not divert attention from key fiscal reforms
- Main problems hampering SWF benefits:
  - Lack of integration with the budget
  - Institutional weaknesses and inadequate controls
  - Weak spending controls and cash management
  - Rigid operational rules hindering response to revenue volatility
  - Governance weaknesses that led to risky investments and asset losses
- Reform priorities:
  - Better integrate funds into the budget process
  - Strengthen basic PFM systems, including:
    - Spending controls
    - Cash management
    - Reporting
  - Develop institutional capacity and timely, reliable economic data
  - Fund design principles:
    - Prefer flexible operational rules (examples: Timor-Leste, Kiribati)
    - Prevent funds from engaging in extrabudgetary spending or quasi-fiscal activities
    - Strengthen governance and transparency to enhance accountability
  - Medium-term fiscal frameworks (MTF) and fiscal risk management:
    - Incorporate long-term perspective in budget via MTF to link annual budgets to medium/long-term challenges
    - Gradually prepare and implement more comprehensive MTFs conditional on institutional capacity (MTFF, medium-term budget frameworks, medium-term expenditure frameworks)
    - Integrate SWF asset management with broader asset-liability and fiscal strategy:
      - Portfolio choices to maximize risk-adjusted returns consistent with fiscal objectives
      - Stabilization assets invested in relatively liquid instruments
      - Cautious investment strategies where budgets highly dependent on fund resources
      - Consider assets to hedge key vulnerabilities, but favor conservative portfolios until capacity/safeguards adequate

*Source: Excerpt from IMF working paper content unit _wp07297.*

### References..............................................................................................................

### _wp07297 - References

### Sovereign Wealth Funds in Pacific Island Countries (PICs)
- Several PICs have established SWFs using:
  - revenue from non-renewable sources (Kiribati, Timor-Leste, Papua New Guinea, Nauru)
  - revenue windfalls (Tonga, Tuvalu)
  - donor contributions (Tuvalu, Marshall Islands, Micronesia, Palau)
- General objectives identified:
  - short-term stabilization
  - long-term savings
  - long-term budgetary self-reliance
- SWF characteristics (as described in the text):
  - vehicles to manage public sector financial assets, with or without specific policy objectives
  - predominantly engaged in cross-border investments
  - investment strategies aiming for higher returns than short-term risk-free instruments
  - closely linked to and dependent on foreign exchange inflows, either through external current account surpluses or capital inflows
- Policy-objective classification example: oil-producing countries create stabilization funds (macro-fiscal management) and/or savings funds (longer-term objectives)

### Key characteristics and challenges of PIC economies
- Structural features:
  - small population, small land area, small GDP (Appendix Table A.1 referenced)
  - geographic isolation, often thousands of kilometers from major trading centers
  - population spread across many small and far-flung islands
  - narrow productive sectors based almost exclusively on primary commodities and some tourism services
- Economic constraints and shocks:
  - exposure to significant terms-of-trade shocks
  - frequent natural disasters (especially typhoons affecting fishing revenues)
  - limited incentives to accumulate human capital and higher costs of doing business
  - constraints on fishing and tourism development (geographic isolation, lack of tourism infrastructure, limited skilled labor, threat of overfishing)

### Economic performance and volatility
- Comparative performance:
  - Since 1995, average GDP growth in the slowest growing region outside of the PICs was 50 percent higher than that of the PICs
  - Emerging Asian countries grew 3½ times faster than the PICs
- Real GDP growth and volatility (Figure 1 references):
  - Real GDP Growth and Volatility, 1995-2006 (In percent) — figure shows growth rates and volatility (coefficient of variation) for regions including Pacific Islands and Emerging Asia
  - Figure 1. Recent Economic Developments in the Pacific Islands Countries (2002–2005 average) — panels show Real GDP Growth (In percent), Official Grants (In percent of GDP), Overall Fiscal Balance (in percent of GDP), External Current Account (Excluding grants, in percent of GDP)
  - Notes in figures:
    - For Timor-Leste, figures refer to non-oil GDP instead of GDP.
    - Figure for Fiji official grants are based on 2002–04 data.
    - The Timor-Leste figure also excludes oil revenue.
- Low and volatile GDP growth accompanied by:
  - persistent current account deficits covered mainly by foreign aid and worker remittances
  - large swings in fiscal balances (Appendix, Table A.2 referenced)

### Fiscal outcomes and notable country examples
- Protracted deficits and fiscal sustainability concerns for some PICs:
  - Kiribati recorded a fiscal deficit of 33 percent of GDP in 2003 and has been running annual deficits in excess of over 20 percent of GDP since then
  - Micronesia, Palau, the Solomon Islands, and Tuvalu experienced large (though shorter lived) fiscal deficits in recent years
- Revenue characteristics:
  - Fiscal revenue in the PICs is highly volatile by international standards, particularly with respect to non-tax revenue (for some countries) and grants (for most countries) (Figure 2 and Appendix references)

### Organization of the paper (as provided)
- Section II describes key characteristics of PIC economies that motivated fund creation
- Section III provides an overview of the structure of the funds
- Section IV assesses whether the funds have met their objectives
- Section V presents main conclusions and proposes a reform agenda
- Supporting materials listed:
  - Tables: Table 1; Table A.1; Table A.2; Table A.3
  - Figures: Figure 1; Figure 2; Figure A.1; Figure A.2
  - Boxes: Box 1; Box 2; Box 3; Box 4

*Source: _wp07297 - References.*

### Appendix Figure A.1). For example, in relation to GDP, revenue collection is around 45

### _wp07297 - Appendix Figure A.1). For example, in relation to GDP, revenue collection is around 45

### Revenue size, composition, and volatility
- Revenue collection is "around 45 percent higher than in European Union (EU) countries", which have the second-highest revenue level, "but exhibit more than six times the degree of volatility faced by the EU."
- Nontax revenue is highly volatile; a key shock source is fishing license fees, with "annual changes in nontax revenue from these fees in Kiribati and Tuvalu, for example, fluctuating by over ten percentage points of GDP from one year to the next (e.g., in 2002–03)."
- Foreign grants "account for more than half of total revenue and grants in a number of PICs (including in Kiribati, the Marshall Islands, Micronesia, Palau, and the Solomon Islands)."
- Over the past five years, several countries experienced "annual changes in grant levels of over 10 percentage points of GDP" (Kiribati, the Marshall Islands, Micronesia, Palau, Samoa, and the Solomon Islands).
- Tax revenue is "relatively more stable", but the small size of the taxable private sector limits its ability to offset volatility from other sources.
- Revenue volatility has translated into "highly volatile expenditures."

### Risks to revenue sustainability
- Trade liberalization initiatives may reduce tariff revenue; "countries such as Kiribati, Solomon Islands, and Tonga are most at risk because of their reliance on this revenue source" and "will likely require tax reforms (Tonga recently started this process)."
- Non-tax revenue pressures: "overfishing is reducing the revenue from fishing license fees in Micronesia, Palau, Tonga and Kiribati," with Kiribati’s fishing-license revenue declining "from 54 percent of GDP in 2001 to 28 percent of GDP in 2006."
- In Papua New Guinea, "revenue from the mineral and petroleum sector is projected to decline as a result of tax concessions and resource depletion."
- Some key donors have indicated intentions to scale down budgetary support over time.

### Large public sectors and fiscal outcomes
- Government expenditure "averages around 58 percent of GDP," higher than most other regions.
- Public sector employment is large: in some islands it "accounts for over half of total employment."
- Public wages are especially large: "public wages represent more than 40 percent of GDP in Kiribati and between 20-25 percent of GDP in the Marshall Islands, Micronesia, and Palau."
- Spending on health, education, and social services is "relatively low and often linked to donor involvement."
- Capital spending is "relatively large and is mainly financed by donors."
- Some countries have implemented difficult structural reforms to improve sustainability; Samoa’s 1994 expenditure-led fiscal consolidation led to higher investment, higher and more stable growth, and a reduced government debt-to-GDP ratio "from 62 percent of GDP in 2002 to 39 percent of GDP in 2006."

### Sovereign wealth funds — overview of objectives and design
- Objectives:
  - Funds were established mainly to "accumulate public savings, or to stabilize government revenues, or a mix of both."
  - Savings funds promote long-term fiscal sustainability and inter-generational equity (Timor-Leste’s Petroleum Fund is a typical example).
  - Papua New Guinea’s former Mineral Resources Stabilization Fund (MRSF) was "the only pure stabilization fund of the region."
  - Most funds combine savings and stabilization objectives, including Kiribati’s Revenue Equalization Reserve Fund (RERF), the Compact Trust Funds (CTFs) of the Marshall Islands and Micronesia after FY2023, Palau’s CTF, Nauru’s Phosphate Royalties Trust Fund (PRTF), and the Trust Funds of Tonga and Tuvalu.
- Revenue sources:
  - Main sources are "non-renewable resources, windfalls, and donor grants."
  - Examples: Kiribati and Nauru (phosphate revenue), Papua New Guinea (mineral revenue until 2001), Timor-Leste (petroleum), Tonga and Tuvalu (windfalls such as passport sales and satellite leasing), Tuvalu (initial donor assistance and under-spending deposits from Australian aid).
  - Investment income from assets is reinvested in the funds.
- Withdrawal rules:
  - Some funds (Timor-Leste, Papua New Guinea, Tuvalu) "anchored ... withdrawal rules in the concept of sustainable income" while allowing some flexibility.
  - CTFs adopted more rigid rules with the expectation the funds would replace U.S. budgetary grants (presently accounting for "over 50 percent of total revenue") and fulfill a stabilization objective:
    - "The CTFs of the Marshall Islands and Micronesia do not allow disbursements prior to FY2023 and withdrawals are capped afterwards."
    - Palau’s CTF allows withdrawals during accumulation but "are capped at U.S.$ 5 million inflation-adjusted per year until 2009." Once U.S. Compact grants cease in 2009, "the Palau CTF is supposed to transfer to the budget a minimum of U.S.$ 15 million inflation-adjusted per year."
  - Discretionary drawdowns: Kiribati (government discretion, guideline to maintain the 1996 real per capita value of assets), Nauru (Board discretion), Tonga (guidelines not public; government has borrowed from the fund when needed).
- Governance:
  - Most funds have clearly defined governance (roles of board, management, advisory committee, monitoring, audit).
  - Donor-financed funds are typically majority-controlled by donors (Marshall Islands, Micronesia, Tuvalu); boards include donor and domestic representatives (Tuvalu board chaired by minister of finance with two other board members appointed by Australia and New Zealand).
  - Palau’s donor-financed fund is fully controlled by domestic authorities but has strict withdrawal limits.
  - Governance requirements vary: some funds (Marshall Islands, Micronesia, Timor-Leste, Tuvalu) impose stringent expertise and experience requirements.
  - Example trustee requirements for CTFs: trustee must have net worth "in excess of $100 million", at least "10 years experience as a custodian of financial assets", and experience managing trust funds of at least "$500 million."

### Tuvalu case — fund structure and fiscal flexibility
- Tuvalu evolved from a single savings fund (TTF) to a two-account structure with a stabilization account (CIF):
  - Recommended annual transfers from TTF to CIF are "based on the difference between the TTF’s market and the maintained values of its assets," with the maintained value deflated by the Australian CPI.
  - The CIF is effectively an account of the government; "the entire value of the CIF funds can be used by the ministry of finance at any point in time," but a guideline recommends a target minimum balance of "16 percent of the TTF’s maintained value" to ensure a "sustainable TTF contribution."
  - The design assumes "the annual real rate of return on TTF’s assets averages around 4 percent" and that a buffer of "4 years in the CIF (16 percent of TTF assets) will be enough to weather yearly volatility in financial returns."
- Fiscal shock management capacity:
  - If CIF met the minimum balance target, it "would allow the budget to manage considerable shocks—amounting to a cumulative 48 percent of GDP over a four year period (a cumulative 16 percent of the TTF’s assets of 300 percent of GDP) based on 2006 data."
  - Such flexibility is contingent on: (i) "the government having a balanced overall fiscal position on average"; and (ii) "having the full 16 percent buffer in the CIF."

### Assessment of funds’ effectiveness and outcomes
- Some funds have accumulated significant fiscal savings where fiscal policies were sound:
  - Timor-Leste’s Petroleum Fund "has accumulated substantial assets" as oil revenue surged, reflecting a framework oriented toward long-term sustainability and capacity constraints that kept spending below estimated sustainable levels.
  - Kiribati’s RERF "accumulated substantial savings in its early decades" but more recently "has run down its assets as withdrawals from the fund have financed an expansionary fiscal policy and contributed to higher spending volatility."
  - Kiribati’s trend could be unsustainable "particularly if the steadily declining non-tax revenue (mainly fishing rights) proves to be permanent."
- Donor-financed funds aimed at reducing aid dependence have had mixed results:
  - Tuvalu’s SWF "has had limited impact in shielding the budget from the volatility in revenue" despite creating a stabilization account, partly because "the assets in the CIF were not large enough to have a significant impact" and because of rigid rules of the TTF.
- Overall, the funds’ success in accumulating assets has been clearer than their success in achieving broader policy goals such as smoothing budgets, substituting for donor grants, or ensuring long-term fiscal self-reliance.

*Italic: Source — Excerpt from IMF working paper content unit provided.*

### Box 2. International Experience with Non-Renewable Resource Funds 1/

### Box 2. International Experience with Non-Renewable Resource Funds

### Key findings
- Resource funds have had limited impact in influencing fiscal outcomes and, if poorly designed, can actually hamper fiscal management.
- Cases where funds have been more successful are those integrated in sound fiscal frameworks and good institutions.
- International experience provides lessons on key aspects when designing a fund, including operational rules, budget integration, asset management, and transparency/accountability.

### Operational rules and flexibility
- Flexible operational rules are usually preferable.
- Many countries have rigid deposit/withdrawal rules (e.g. share of oil revenue accrues to the fund, or a commodity price-based rule), but it is difficult to design a rule that can withstand time and wide variations in the commodity price or revenue.
- As economic or political circumstances change, countries have searched for flexibility by changing, bypassing or eliminating the rules.
- Examples of rule changes or abolishment:
  - Operational rules of the funds were changed (e.g., the reference price or the revenue base) to adjust for budget needs.
  - In some cases, the funds themselves were abolished (Chad, Ecuador, Papua New Guinea).

### Integration with the budget systems
- Earmarking and extrabudgetary spending:
  - Problems arise when revenues in the fund are earmarked or funds spend outside the budget process.
  - Pre-assignment or allocation outside the budget process:
    - reduces flexibility to adjust to changing conditions or priorities;
    - complicates liquidity management;
    - affects the efficiency of government spending by reducing competition for resources between different priorities and needs.
  - Rules can create further fiscal pressures as the government may have to increase borrowing to finance other budgeted (priority) spending.
- Cash management:
  - Rigid rules and fragmentation of cash management can complicate asset and liability management.
  - In some countries, rigid rules resulted in the need for costly borrowing to make deposits in the funds.
- Financing funds (examples: Norway, Timor-Leste) tend to be preferable:
  - They allow for greater flexibility and are fully integrated with the budget, as the fund is designed to finance the budget as needed.

### Asset management
- Few countries have a comprehensive and transparent investment strategy.
- Lack of strategy has in some cases resulted in accumulation of assets being matched by large accumulation of debt.
- Resource funds tended to keep most assets invested abroad, mainly to allay fears about appreciation of the currency.

### Transparency and accountability
- Oversight of oil funds varies substantially across countries, including provisions for compliance by government, audit of the accounts of the fund, and standards for disclosure of information.
- Degree of transparency varies:
  - Some countries provide detailed information on operations and assets of the fund (Norway is usually seen as the most transparent).
  - Others provide very limited information.

### Pacific Island Countries: Expenditure volatility and fund performance
- The Pacific region has some of the highest revenue volatility; a key priority for fiscal policy is to protect the budget from such volatility and smooth spending to avoid disruptions in public services and investment.
- In practice, Pacific Island Countries (PICs) have, on average, not limited expenditure volatility; in some cases expenditure volatility has exceeded revenue volatility.
- Sovereign wealth funds have not shown a clear impact on expenditure volatility; countries that contained expenditure volatility did so based on sound fiscal policies.

- Country-specific observations:
  - Kiribati:
    - Expenditure volatility exceeded revenue volatility, reflecting a sharp rise in expenditure in 2001–2004 partly financed by large drawdowns from the fund.
    - Raised concerns regarding sustainability given steady decline in fishing receipts.
  - Tuvalu:
    - Concerns with TTF’s ability to provide stabilization; expenditure remains almost as volatile as revenue.
    - TTF Advisory council (TTFAC, 2006) suggests the TTF may have contributed to higher expenditure volatility (expenditure reacts to the size of TTF disbursements).
    - Weak spending controls likely prevent a cautious fiscal stance in periods of windfalls.
  - Samoa:
    - After 1994, once fiscal adjustment started, volatility declined and expenditures became less volatile than revenue.
  - Timor-Leste:
    - The SWF is part of a broad strategy ensuring a sound and sustainable fiscal policy; authorities have limited the impact of volatile revenue on the budget.
  - Papua New Guinea (PNG):
    - During the 1990s assets were accumulated in the MRSF (from 3 percent of GDP in 1990 to almost 9 percent of GDP in 1998) while public debt rose by more than 30 percentage points of GDP over the same period.
    - Fund assets were used as collateral for new borrowing; by 1999 authorities used MRSF assets to repay expensive debt and subsequently closed the fund.
    - Cash management problems and overall PFM weaknesses remained after the fund closed in 2001; the country continued to have deposits earmarked for projects while borrowing expensively to finance the deficit. In recent years fiscal position improved and authorities started to reduce public debt.
  - Nauru and Tonga:
    - Funds have been almost depleted due to risky investment decisions, mismanagement, and financing needs of the budget.
    - Nauru’s NPRT assets reportedly decreased by more than 90 percent between 1991 and 2006; sale of real estate to repay public debt contributed. Authorities expect residual value of around A$60 million following receivership; Government of Nauru is developing a new trust arrangement and considering a separate national trust fund.
    - Tonga sued an investment manager of its fund and, after a settlement, managed to receive a marginal compensation.

- Compact Trust Funds and long-term self-sufficiency:
  - Marshall Islands and Micronesia Compact Trust Funds will need significant fiscal efforts to achieve long-term budgetary self-sufficiency.
  - Under Compact agreements with the U.S., grants to the budget will decline over time and after 2023 are to be replaced by annual contributions from the funds (projected at the level of 2023 grants in real terms).
  - Recent estimates indicate the funds may not be able to provide these levels of returns and transfers to the budget, implying further fiscal tightening and raising concerns about the funds’ ability to provide a stabilization mechanism (Baig, 2004; Faulkner-MacDonagh, 2007; GAO, 2007).
  - Palau:
    - The CTF was expected to disburse U.S.$ 15 million every year (adjusted for inflation) starting in 2010 while maintaining the real value of assets, but at current levels of CTF assets it is unlikely the fund could generate $15 million per year permanently.
    - Given heavy dependence on foreign aid, a substantial fiscal effort would be required to ensure a sustainable fiscal position after 2009; otherwise the CTF could be depleted in less than 15 years as withdrawals are likely to be significantly higher than financial returns on assets (Abdelati 2006).
- In a few cases funds have been almost depleted or closed; disappointing performance of PNG and Nauru funds was related to inconsistency between fund objectives and fiscal policies being followed (accumulation of assets accompanied by unsustainable large fiscal deficits and rising public debt).

### Box Table 1. Volatility of Government Revenue and Expenditure, 1990-2005 (staff estimates)
- Pacific Islands: Revenue 4.06, Expenditure 6.00, Revenue (as share of GDP) 0.07, Expenditure (as share of GDP) 0.10
- Cook Islands: Revenue 4.07, Expenditure 7.40, Revenue (as share of GDP) 0.11, Expenditure (as share of GDP) 0.16
- Fiji Islands: Revenue 2.72, Expenditure 2.30, Revenue (as share of GDP) 0.10, Expenditure (as share of GDP) 0.08
- Kiribati: Revenue 24.03, Expenditure 31.80, Revenue (as share of GDP) 0.21, Expenditure (as share of GDP) 0.25
- Marshall Islands: Revenue 15.61, Expenditure 18.50, Revenue (as share of GDP) 0.22, Expenditure (as share of GDP) 0.28
- Micronesia: Revenue 14.31, Expenditure 12.50, Revenue (as share of GDP) 0.19, Expenditure (as share of GDP) 0.16
- Nauru 1/: Revenue 33.95, Expenditure 51.70, Revenue (as share of GDP) 0.44, Expenditure (as share of GDP) 0.45
- Palau 2/: Revenue 33.15, Expenditure 5.30, Revenue (as share of GDP) 0.54, Expenditure (as share of GDP) 0.08
- Papua New Guinea: Revenue 2.42, Expenditure 2.20, Revenue (as share of GDP) 0.08, Expenditure (as share of GDP) 0.07
- Samoa: Revenue 10.01, Expenditure 15.50, Revenue (as share of GDP) 0.24, Expenditure (as share of GDP) 0.33
- Solomon Islands: Revenue 11.51, Expenditure 10.70, Revenue (as share of GDP) 0.36, Expenditure (as share of GDP) 0.27
- Timor Leste 3/: Revenue 53.64, Expenditure 4.30, Revenue (as share of non-oil GDP) 0.88, Expenditure (as share of non-oil GDP) 0.21
- Tonga: Revenue 2.43, Expenditure 3.50, Revenue (as share of GDP) 0.08, Expenditure (as share of GDP) 0.11
- Tuvalu: Revenue 51.24, Expenditure 1.40, Revenue (as share of GDP) 0.48, Expenditure (as share of GDP) 0.40
- Vanuatu: Revenue 2.04, Expenditure 4.50, Revenue (as share of GDP) 0.09, Expenditure (as share of GDP) 0.17

Notes:
- 1/ Refers to 1996-2001.
- 2/ The large revenue volatility reflects a one-time advance on grants from the US in 1995.
- 3/ Timor-Leste figures are in percent of non-oil GDP and refer to 2002-05.

*This analysis is primarily based on Davis et. al. (2003) and IMF (2007).*

### Box 4. State of Public Financial Management in Selected PICs

### Box 4. State of Public Financial Management in Selected PICs

### Public Financial Management (PFM): overview and systemic weaknesses
- PFM systems are generally weak among PICs.2/
- Weaknesses particularly acute in:
  - Comprehensiveness and transparency, and budget cycles.
  - Oversight of aggregate fiscal risk from other public sector entities (example: Kiribati).
  - Extent of unreported government operations (examples: PNG, Tuvalu, and Vanuatu).
  - Public access to key fiscal information is generally weak.
- Detailed PFM problems:
  - Policy-based budgeting: especially poor with regard to maintaining a multi-year perspective in fiscal planning, expenditure policy, and budgeting (examples: PNG, Samoa, Tuvalu, and Vanuatu). SWFs’ management is complicated when fiscal policy planning often does not extend beyond the current fiscal year (example: Tuvalu, TTFAC (2006)).
  - Predictability and control in budget execution: poor for all sampled PICs; consequences for SWFs include reliance on expensive short-term borrowing or running arrears despite large assets in TFs (examples: Marshall Islands and Tuvalu).
  - Recording and managing cash balances, debt and guarantees: often poor (examples: Kiribati and Tuvalu: no public debt data are available).
  - Accounting, recording and reporting: very weak overall, notably the quality and timeliness of in-year budget reports and annual financial statements.
  - External scrutiny and audit: very weak overall; poor central government audit often translates into poor records in other public entities, including SWFs.

### Fiscal consequences and examples
- Funds operating outside the budget reduced usable cash reserves and increased borrowing at times of weak fiscal positions (Marshall Islands and Micronesia Compact funds during initial asset accumulation).
- Marshall Islands example: in 2006 authorities used assets provided by Taiwan to address a cash crisis (to pay for fuel supplies), although assets were meant to be accumulated for future needs and only used once accumulated Taiwan grants reached a minimum level.
- Use of fund assets as collateral or onlending occurred in some cases (Tonga, Marshall Islands, PNG, and Nauru).
- Quasi-fiscal and extrabudgetary activities often carried out by other funds or public enterprises subject to limited controls or reporting.

### Asset management: accumulation, composition, and outcomes
- Some PIC SWFs have accumulated larger assets, as a share of GDP, than most other countries, though not always integrated in an asset-liability strategy.28/
- Accumulation sometimes occurred while countries were highly indebted, facing systematic deficits, or running arrears (Nauru, PNG, Marshall Islands, Micronesia).
- In some cases assets were used as collateral to finance fiscal deficits, resulting in one fund being closed (PNG) and another losing almost all assets (Nauru).
- Marshall Islands and Micronesia: significant accumulated assets, but Compact Agreements prevent use prior to 2024 while countries face dwindling usable cash reserves and debt servicing difficulties.

- Investment strategy variation:
  - Conservative/FX-reserve-like strategies used initially by some new funds (Timor-Leste, Marshall Islands, Micronesia), investing in fixed-income instruments such as U.S. Treasury bonds.30/ This is often preferable early on given limited capacity and low asset levels.
  - Ambitious return benchmarks may be unrealistic: Marshall Islands’ CTF earned an annual nominal return of over 3½ percent in its first few years, lower than the 6 percent stated objective.
  - Undiversified and aggressive strategies led to large losses (examples: Nauru’s lumpy real estate investments; Tonga’s investments concentrated in three U.S. companies).
  - Diversified portfolios produced average nominal returns of around 10 percent a year but with relatively high volatility (Tuvalu31/ and Palau). Tuvalu and Palau portfolios: broadly 66–70 percent in stocks and the remainder mostly in bonds.
  - Marshall Islands and Micronesia CTF portfolios: diversified across asset classes and geography (U.S. equities, international equities for Marshall Islands, U.S. bonds, U.S. real estate, and cash). Performance evaluated against pre-determined benchmarks.32/

- Selected numerical examples and performance metrics:
  - Marshall Islands CTF: early annual nominal return of over 3½ percent vs stated objective of 6 percent.
  - Tuvalu sovereign wealth fund real annual returns (using the Australian CPI as deflator) from 1988 to 2005: ranged from -8.5 (in 2001) to 21.7 (in 1997); averaged 6.3 percent with a standard deviation of 8.6 percent.31/
  - Tuvalu comparisons (real average return of 6.3 percent):
    - 5-year performance benchmark: 4.5 percent;
    - Returns on 10-year Australian government bonds: 4.6 percent;
    - Investment in a 70/30 weighted portfolio of the Standard & Poor’s Australian Stock Exchange 200 index and 10-year Australian government bonds: 5.9 percent;
    - 100 percent S&P ASX 200 index mean return: 7.8 percent.
  - Management fees can significantly impact long-term cumulative returns (noted for Tuvalu).

- Table 1 (selected fund assets and public debt, as of end-2006 unless otherwise noted) — selected entries preserved exactly as presented:
  - Kiribati — Revenue Equalization Reserve Fund: A$ 659 702 A$ 1617
  - Marshall Islands — Compact Trust Fund: US$ 63  1/55 US$ 82 72
  - Micronesia — Compact Trust Fund: US$ 87  1/38 US$ 5625
  - Nauru — Phosphate Royalties Trust Fund: In receivership 2/ ...A$630...
  - Palau — Compact Trust Fund: US$ 152  3/105 US$ 32  3/24
  - Papua New Guinea — Mineral Resources Stabilization Fund: Fund closed in 2001 ...US$ 2,23339
  - Timor Leste — Petroleum Fund: US$ 957  1/22500
  - Tonga — Tonga Trust Fund: US$ 1  4/0 US$ 106 4/47
  - Tuvalu — Tuvalu Trust Fund: A$ 103  4/300......
  - (Source: IMF staff reports, Tuvalu Trust Fund reports, and country authorities.)
  - Notes attached in source: 1/ As of September 30, 2006. 2/ The Fund is in receivership. The authorities expect the fund to retain assets worth A$60 million or approximately 200 percent of GDP. 3/ As of end-2005. 4/ As of June-2006.

### Governance and transparency
- Governance structures vary widely; oversight and reporting of SWF activities typically limited.
- Only Timor-Leste and Tuvalu consistently publish annual reports.
- Marshall Islands and Micronesia Compact Trust Funds: stringent quarterly reporting requirements exist, but reports have contained incomplete and unreliable information (GAO, 2007).33/
- Other funds (Kiribati, PNG, Tonga) do not provide regular public information or provide information insufficient to assess fund performance.34/
- Nauru’s PRTF: no mandated public disclosure of its investment strategy.
- Capacity constraints and limited resources are key contributors to governance and transparency problems.
- Donor role: donors could play a more active role in providing assistance and advice. Example: Tuvalu’s TTF advisory committee provides evaluation of fund operations and broader economic advice, particularly on fiscal policy.

### Conclusions and policy recommendations (Reform Agenda)
- Overall conclusion: most PICs need structural reforms and large fiscal adjustments to improve economic prospects and reduce macro-fiscal vulnerabilities.35/
- SWFs can support a sound fiscal framework if well designed but should not divert attention from key fiscal reforms.
- Main problems hampering SWF benefits: lack of integration with the budget, institutional weaknesses, inadequate controls, weak spending controls and cash management, rigid operational rules that hinder response to revenue volatility, and governance weaknesses that led to risky investments and asset losses.

- Reform priorities (funds effective only within a sound fiscal policy framework and effective PFM):
  - Better integrate the funds into the budget process.
  - Strengthen basic PFM systems, including:
    - Spending controls,
    - Cash management,
    - Reporting.
  - Develop institutional capacity, including timely and reliable economic data essential for policy making and fiscal planning.
  - Fund design principles:
    - Flexible operational rules (examples: Timor-Leste, Kiribati) are preferable to facilitate stabilization and avoid costly borrowing or arrears; operational rules must be consistent with sound policy objectives.
    - Funds should not have authorization to spend on or be involved in extrabudgetary activities to ensure budget integrity and transparency.
    - Strengthen governance and transparency to enhance accountability and ensure public assets are well managed.36/

- Medium-term fiscal frameworks (MTF) and fiscal risk management:
  - Incorporate a long-term perspective into the budget process via a sound MTF to link annual budgets to medium- and long-term challenges, identify long-term consequences of policies, and build consensus for reforms.
  - Conditional on institutional capacity, countries could gradually prepare and implement more comprehensive MTFs (including MTFF, medium-term budget frameworks, medium-term expenditure frameworks).37/
  - Developing an MTF helps identify key fiscal risks and improves design of stabilization policies and tools, including SWFs.
  - Asset management of SWFs should be integrated with broader fiscal and asset management strategy:
    - Portfolio choices should maximize risk-adjusted returns consistent with fiscal objectives (stabilization, long-term sustainability) and asset-liability management.
    - Stabilization assets should be invested in relatively liquid instruments.
    - Where budgets are highly dependent on fund resources, a more cautious investment strategy is advisable.
    - Assets could be invested to hedge against key vulnerabilities (commodity prices, exchange rate), but conservative portfolios are preferable until capacity and safeguards are adequate.

*Source: IMF staff reports and the referenced Box 4 in the provided IMF working paper.*

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