Sovereign Wealth Funds: Their Role and Significance -- A Speech By John Lipsky, First Deputy Managing Director, International Monetary Fund
IMF News, September 3, 2008
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- Authors: John Lipsky
- Published: September 3, 2008
A. Global Economic Context
- Emerging economies recovered from financial turmoil over the prior decade by strengthening budgetary and monetary policy discipline and, in many cases, reducing debt, which restored economic stability and investor confidence.
- These economies resumed relatively rapid growth and began running current account surpluses, thereby accumulating international reserve assets and becoming net capital exporters to advanced economies.
- Strong global growth in the past few years sharply boosted energy and commodity prices, producing a striking increase in foreign currency receipts for many energy and commodity exporting economies (including rich, emerging, and some developing economies).
- Many governments have become guardians of substantial national financial assets, prompting the creation of Sovereign Wealth Funds (SWFs).
- Historical and recent growth of SWFs:
- Almost two thirds of the existing Funds were established in the past decade.
- Market participants' estimates suggest that assets under management of Sovereign Wealth Funds currently total between US$2-3 trillion, thereby exceeding assets managed by hedge funds (US$ 1.9 trillion).
- Such Funds today account for between ¼-⅓ of all foreign assets held by sovereigns.
- SWF assets are projected to surpass the stock of global foreign exchange reserves in the not so distant future and to top US$7-11 trillion by 2013.
B. Home Country Policy Goals
- Core objective: efficiently and effectively manage a country's official financial wealth with specific economic policy roles, including:
- Stabilization and saving for commodity exporters:
- Transform nonrenewable resource receipts into sustainable and stable future income.
- Avoid boom/bust cycles (such as those experienced during the 1970s) by accumulating adequate international assets.
- Protect non-commodity sectors from destabilizing currency fluctuations and spread wealth across generations.
- Empirical note: 30 of the 38 existing SWFs have been established by commodity-exporting countries for stabilization and/or saving purposes.
- Example: The Fund for Social and Economic Stabilization (FESS) in Chile smooths government spending by putting aside fiscal surpluses in excess of a structural target to be used in periods of weak terms of trade.
- Economic development and diversification:
- Some SWFs aim explicitly at developing a broader base for economic growth to reduce commodity-price vulnerability.
- Empirical note: This has been one of the stated purposes of 5 recently established SWFs.
- Funding future social obligations:
- Ageing populations motivate at least 5 SWFs oriented to cover long-term liabilities.
- Example: The Pension Reserve Fund created this year in Chile aims to cover long-term fiscal liabilities incurred under the new pension reform.
- Managing reserve accumulation pressures:
- Reserve accumulation places carry cost and currency mismatch pressures on central bank balance sheets, prompting some countries to seek higher risk-adjusted returns via SWFs.
C. Necessary Conditions for Success
- Preconditions and best practices for SWF effectiveness:
- Appropriate budget and monetary policies:
- SWF operations must be well integrated into the overall policy framework to avoid pitfalls such as parallel budgets or ill-timed withdrawals that could undermine central bank operations.
- Adequate information and statistical integration:
- Critical that relevant agencies receive adequate information and that accurate data are included in national accounts, monetary, government finance, and external sector statistics.
- Well-designed funding and withdrawal rules:
- Cross-country evidence indicates success when rules align with stated goals.
- Example: Chile's 2006 fiscal framework apportioned fiscal surpluses between the SWFs within a fiscal rule designed to smooth government expenditures across the business cycle; Chile's two existing SWFs have been established as part of this macroeconomic framework.
- Well-framed corporate governance arrangements:
- Government as owner should set objectives, governance structure, and an effective accountability framework.
- Governance should articulate clear roles, responsibilities, and interrelationships to facilitate operational independence for investment decisions.
- Clear accountability and transparency procedures:
- Prevent misuse of public resources and build public support for saving rather than spending.
- Transparency entails regular public disclosure of investment objectives, funding, withdrawals and spending on behalf of the government, the governance framework, and the Fund's asset size, allocation, and return.
- Practice example: Chile publishes monthly reports on SWF size and portfolio composition and quarterly performance reports; several other SWFs follow similar governance, accountability, and transparency principles.
- Responsible investment policies and risk management:
- Investment policies must be consistent with policy purpose and based on care, skill, prudence, and a robust risk framework.
- Investment horizons and asset allocations differ by fund type:
- Stabilization funds: shorter horizons, conservative investments, relatively large liquid asset holdings.
- Savings funds: longer horizons, pursuit of higher returns across major asset classes including alternative investments.
- Pension reserve funds: may adopt asset-and-liability approaches to match entitlement payments, with portfolios similar to funds with direct pension liabilities.
D. The International Environment
- SWFs have become central to international financial and economic deliberations given their size and rapid growth.
- Role during recent financial market turmoil:
- SWFs have played a notably positive role, dampening short-term market volatility due to long-term investment horizons, limited immediate redemption needs, and mainly unleveraged positions.
- Many SWF managers are highly skilled, with incentives to preserve open, liquid global markets.
- Recipient-country concerns and risks:
- Concerns have been raised about national security implications and potential noncommercial motives for SWF investments.
- Although these concerns have little or no basis in past SWF operations, negative perceptions could trigger protectionist backlash, curtail SWF investment, increase investment risk, provoke retaliatory measures, and undermine global capital flows and financial stability.
- International responses and cooperation:
- Recipient countries, acting through the OECD, have developed and are implementing an investment code.
- SWFs formed the International Working Group (IWG) facilitated by the IMF to develop the Generally Accepted Principles and Practices for Sovereign Wealth Funds (GAPP).
- The IWG reached a preliminary agreement on a set of voluntary practices and principles in Santiago, referred to as the "Santiago Principles."
- The IWG is scheduled to present its report on the GAPP to the October meeting of the International Monetary and Financial Committee of the IMF.
- The GAPP specifies practices and principles across three key areas:
- The Fund's legal and macroeconomic framework;
- Governance and institutional structures; and
- Investment and risk management practices.
- Implementation of the GAPP by SWFs is intended to help meet the necessary conditions for success, maintain free cross-border investment, sustain open and stable financial systems, improve understanding of SWFs, allow newer SWFs to benefit from experience, reduce concerns, and mitigate protectionist pressures and restrictions on international capital flows.
Source: Speech by John Lipsky, First Deputy Managing Director of the International Monetary Fund — Santiago, September 3, 2008.