ONWARD PROSPERITY

MEDICIFIRMASOVEREIGNFUND

This paper offers a policy and operational “roadmap” topolicymakers considering setting up an SWF. It should also be ofinterest to policymakers in countries where SWFs are already inplace, to review their existing policies and operations. Finally, itoffers an opportunity to identify areas where research inmacroeconomicsandfinanceshouldgivefurtheranswersastotheadequacy of existing practice related to the setting up andmanagementofSWFs,anareawherepracticalconsiderationsoftenlead theoretical research. For instance, policymakers shouldoptimally consider both their sovereign assets and liabilitiestogetherwiththeirmacroeconomicobjectives,whensettingupanSWF.

ThisWorking Paper should not be reported as representing theviewsoftheMediciFirmaInvestments“MFI”.

The views expressed in thisWorking Paper are those of the author(s)and do not necessarily represent those of the MFI or MFI policy.WorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtofurtherdebate.

ContentsPage

I. IntroductionII. WhatisaSovereignWealthFund?III. WhentoSetUpanSWF?IV. WhatAreAnSWF’sV. .WhataretheFunding,Withdrawal,andSpendingRulesofanSWF?VI. SomeConsiderationsinDeterminingtheInstitutionalStructure?VII. WhatDeterminestheInvestmentPolicy?VIII. VIII.Conclusion

GLOSSARY

ALM AssetLiabilityManagement

BoP BalanceofPayments

GDP GrossDomesticProduct

GIC GovernmentofSingaporeInvestmentCorporation

KIC KoreaInvestmentCorporation

SAA StrategicAssetAllocation

SOEs State-ownedenterprises

SWF SovereignWealthFund

I.INTRODUCTION

This paper offers a policy and operational “roadmap” topolicymakersconsideringsettingupasovereignwealthfund(SWF).It should also be of interest to policymakers in countries whereSWFs are already in place, to review their existing policies andoperations.Finally,itoffersanopportunitytoidentifyareaswhereresearch in macroeconomics and finance should give furtheranswers as to the adequacy of existing practice related to thesetting up and management of SWFs, an area where practicalconsiderations often lead theoretical research. For instance,policymakersshouldoptimallyconsiderboththeirsovereignassetsandliabilitiestogetherwiththeirmacroeconomicobjectives,whensettingupanSWF.

ThepaperrelieslargelyontheexperienceofexistingSWFs.RatherthanjustbeingadescriptionofwhatSWFsdo,thepaperdrawsonthe consistency of SWFs experience with macroeconomicframework and investment objectives. It is also based on ourexperience with international reserves management, as suchmacroeconomic and financial theory,when available, support ourrecommendations.

The “roadmap” starts by taking as a given policymakers’ broadobjectives.Typically,SWFsaresetupaftercommoditypricebooms(or more recently in the case of China, large export booms).Following these large accumulation of international assets,policymakerssetupanumberofobjectiveswhichtheydeemtobe“optimal.” For instance, policymakers may aim at enhancingreturns on international reserves, meeting pension liabilities,stabilizing fiscal revenues and investing assets to meetdevelopmentobjectives.

The first set of issues that policymakerswill face is to determinewhether or not they should set up an SWF to meet their broadpolicy objectives. In practice, a key question is to determinewhether the country has an “adequate” or “optimal” level ofinternational reserves. Even if the countryhas indeedan “ample”enough level, policymakers will have to decidewhether theywilluse the SWFs assets tomeet balance of payments needs, shouldtheymaterialize.ArelatedquestionisthatofbetteralternativestosettingupanSWF.

Second, once they have gone ahead and set up an SWF,policymakers will have to decide on a number of operationalquestions which should be consistent with their broad policyobjectives.Operationalobjectivesareneededtoderiveappropriateinvestment policy and include funding, withdrawal, and spendingrules.

Third, often overlooked but key issues pertain to institutionalarrangements. An adequate governance framework will have togiveclearindicationsastowhichinstitutiondeterminestheSWF’spolicy objectives and overall risk tolerance, its operationalobjectives,anditsinvestmentguidelines(andwhowillexecutethelatter).

Finally,giventheabove,policymakerswillhavetodecidewheretoinvesttheSWFsassets,thatisitsstrategicassetallocation,startingwiththeelaborationofaninvestmentpolicy.Theinvestmentpolicyshould be again consistent with broad policy objectives. Theoperational objectives will drive the investment horizon, the risktolerance,andtheinvestmentenvironment(includingassetclassesand their correlation, asset liability management and otherconstraints) which in turn, will determine the strategic assetallocation.

Keyissues,especiallyonepronetopoliticalpressureisthedecisiontoinvestashareoftheSWFsassetsdomestically.Inthiscase,thisdecision should be considered in the light of the broad policyobjectivesandthecountry’smacroeconomicpolicyframework.Forinstance,avoidanceoftheDutchDiseasemayleadtothedecisionofnotinvestingdomestically.Again,institutionalarrangementsareimportant in the context of the SWF’s investment policy. Forinstance, policymakers, although they will bear the responsibilityfor the performance on the SWFs assets, will have to take apositionregardingtheuseofexternalmanagers.

II.WHATISASOVEREIGNWEALTHFUND?

SWFs are defined as a special purpose investment fund orarrangement, owned by the general government.2Created by thegeneral government for macroeconomic purposes, SWFs hold,manage, or administer financial assets to achieve financialobjectives,andemployasetofinvestmentstrategieswhichincludeinvesting in foreign financial assets. SWFs are commonlyestablished out of balance of payments surpluses, official foreigncurrencyoperations,theproceedsofprivatizations,fiscalsurpluses,and/orreceiptsresultingfromcommodityexports.

With a capacity to operate over a long-term investment horizon,SWFs are less risk averse compared to agencies managingtraditional foreign exchange reserves. The definition of an SWFexcludes, inter alia, foreign currency reserve assets held bymonetaryauthoritiesonly for the traditionalbalanceofpayments(BoP) or monetary policy purposes, operations of state-ownedenterprises (SOEs) in the traditional sense, government-employeepension funds, or assets managed for the benefit of individuals.While SWF is an all-encompassing term, it covers a group ofheterogeneousfundsthathaveexistedforyears.Whatthesefundshave in common is the public ownership and the fact that these

funds are often established to meet a macroeconomic purpose,though these purposes may at times be multiple in nature (e.g.,savingsandfiscalstabilization).

III.WHENTOSETUPANSWF?

Some commodity exports based fundshavebeen in existence forseveral decades with the goal of managing a portion of thecountries’foreignexchangerevenues.Morerecently,anumberofcountries have also set up SWFs using fiscal surpluses andaccumulated foreign exchange reserves. Despite this experience,therearenotheoreticalmodelsyetfordecidingwhentosetupanSWF.

From asset-liability and public debt management perspectives,ideally, the government should approach its balance sheet inentirety, identifying all financial assets and liabilities, includingcommodityvaluesinthegroundandfuturetaxrevenue.Itcanthenoptimize its asset allocation choices based on such an approach.However, inpractice,governmentsapproachtheestablishmentofanSWFinamoreadhocbasisandwhenacriticalmassof

balanceofpaymentorfiscalsurplusesisreached.Thisexplains,inalarge part, why SWFs are typically set up after commodity pricebooms,suchasduringtheseventiesandagaininthelastfewyears.

Fromapracticalviewpoint,thisapproachtakenbycountriescanbeexplained, perhaps, by the concept ofmental accounting. Coinedby Richard Thaler (1980), mental accounting is one of theassumptions underpinning behavioral finance. Compared with atraditional investment approach, which assumes that investorsperceive their assets as fungible, behavioral finance assumes thatinvestors tend to group their assets in anumberof non- fungibleaccounts,andmakedecisionsdifferentlydependingonthepurposeforsettinguptheaccount.

Thisconceptcouldbeappliedtounderstandhowacountrydividesitspoolofsovereignassets.Forexample,whenacountrydiscoversan oil reserve, it may trigger a process of considering theimplications of such a new wealth. It may consider what is the“adequate”levelofrevenuessothatthe“excess”revenuescanbeset aside.3Likewise, if a country is in the process of accumulatingforeign currency reserves, it may earmark them for meetingliquidity needs with a high priority for safety, similar to anindividual’s account set up to purchase necessities. Policymakersarereadyandwillingtotakemorerisksonlyaftersovereignassetsreachanadequatelevelandareconsideredtobeample.Itisatthisstage that policymakers tend to, in practice, allocate excessreserves in a different account, with a higher risk tolerance,following different investment policies. So, the question becomesoneofdeterminingwhenthereservesareadequate.

A.WhenareaCountry’sReservesAdequate?

Typically, ample official reserves are a signal to assess if reservesshouldbemanagedandinvesteddifferentlyanditsalternateuses.Howshould thisassessmentofamplereservesbemade?Atwhatpoint can reserves be invested differently? Since there aresignificant benefits to reserves, especially in terms of reducingexternal vulnerability and providing country insurance, this levelneeds to be carefully assessed. Thus, before other institutionalconsiderations are made, the “adequate” or “optimal” level ofreserves should be established and agreed between the centralbankandthegovernment.

From a crisis prevention perspective, themost relevant indicatorfor emerging market economies is the ratio of internationalreservestoshort-termexternaldebt.4Forcountrieswithuncertainaccesstointernationalmarkets,asimplebenchmarkistheonethattargets the coverage of short-term external debt of all residents

and in all instruments and currencies measured by remainingmaturity. This means that a country with a balanced currentaccountandnocapital flightwillhavesufficient reserves tocoveritsobligationsforafullyearevenif it iscutoutofexternalcapitalinflows. Other factors have an impact as well. Higher levels ofreserves would be preferable in countries with large externalcurrentaccountdeficits,overvaluedexchangerates,high levelsofshort-termpublicdomesticdebt,derivativepositionsofthepublicsector,andweakbankingsystems.

Considerations that limit the need for reserves include a flexibleexchange rate regime, management of the actual exchange ratepolicy in a manner that discourages high foreign exchangeexposure by the private sector, a public sector that borrows indomestic currency from non-residents, sound private sector riskmanagement,soundbankingsupervision,andgovernment’sabilitytoborrowquicklyandinlargeamountsfromnon-residents.

Inadditiontotheempiricalworkbasedonestimatesofthedepthof a crisis, there are insurance models that try to answer thequestion of the optimal level of reserves in a cost- benefit(optimizing) framework, such as the Jeanne-Ranciere (2006) andJeanne (2007) models. In these frameworks, reserve assets canhelp reduce theprobabilityandcostofacrisis in termsofoutputloss but the typically low return of these assets implies anopportunitycostofholdingthem.

B.WhataretheOptionsinCaseofAmpleReserves?

ThenextstepindecidingonwhethertosetupanSWFistoreviewthe origins of the ample reserves, the longevity of these sources,and the other assets and liabilities of the sovereign to make ajudgment as to whether there are no better alternatives thansettingup an SWF. Sovereign foreign asset accumulation typically

comesfromafewmainsources.

The source of ample reserves can be capital inflows,mopped upthrough issuing central bank liabilities, and some times throughissuanceofgovernmentpaper.Inthiscase,thecentralbankandortheministryoffinancehavetoweighthelongevityoftheseinflowsin deciding whether the stream of inflows is sufficient to investassetsoveralongertermandwithgreaterrisk.

Foreign asset accumulation could also reflect the general fiscalbudget surpluses, privatization receipts or surpluses related torevenues from booming commodity exports, in which case theinitial or anticipated reserve build-up will, typically, have acounterpart in government depositswith the central bank.5Basedon these individual sourcesof flows, an assessment canbemadewhethertheseareone-offandsmallorlikelytocontinueovertime.

A first option, and this applies in either case, of reducing ormatching external debt obligations is a straightforward way ofusing ample reserves to reduce currency mismatches and carrycosts. For instance, promptedby negative income results in 2004and 2005 as a result of both the carry cost and currencyrevaluation, Banco de Mexico has used excess reserves to repayloans from the Inter-American Development Bank and theWorldBank,inessenceshrinkingtheoverallbalancesheet.6

Asecondoption istostartmanagingreservesonthecentralbankbalance sheet with a long- term perspective. Often reserves aresplit intotranches,andtheinvestmenttranchecouldbeamplifiedand itsmandate expanded to a longer horizon. For instance, theHongKongMonetaryAuthorityseparatesforeignreservesintotwoportfolios,BackingPortfolioandInvestmentPortfolio.7AssetsintheBackingPortfolioare invested inhighly liquidandshort-termU.S.dollar-denominated fixed income securities. While assets in the

InvestmentPortfolioareinvestedinamoredynamicway,includinginvestmentinequities.Typically,however,thelimitedtoleranceforreporting losses, combined with marked-to-market accountingstandards, may limit the risk and the size of the investmentportfolio.8

AthirdoptionistosetupanSWF,beitonthecentralbankbalancesheet, or as a separate institution. This is usually donewhen thefirst options are exhausted or when there is a clear source andobjective of increasing reserves. For example, net commodityexportingcountries facinga largeandprolongedcommoditypriceboommayhavefewothersoundoptionsbuttosetupanSWFasthey typically have limited external government debt left and animportant macro aim is to reduce the volatility of governmentrevenues and limit Dutch Disease effects of crowding out theprivatesectorthatcomeabout ifcommodityrevenuesarerapidlyspent.

C.WhatifBoPCrisesCallforLiquiditySupportfromtheSWF?

Providing liquidity during a balance of payment (BoP) crisis is theobjectiveofacountry’sofficial foreigncurrency reserves,andnotthat of a typical SWF. Contingent call for liquidity support couldpotentially prevent the SWF from pursuing long-term investmenthorizonandholdinglessliquidassets.IftheSWFneedstoprovideBoP support, a clear policy and supporting rules and proceduresshouldbeestablishedconsistentwiththatpurpose.ThispromotestransparencyandaccountabilityoftheSWF.

SomecountriesdosetupsomearrangementsforassetsinSWFstobeusedforBoPpurposes.Forexample,thePulaFundinBotswanahasagreedtriggerpointsthatallowthefundtobedrawnfrominthe event that macroeconomic policy adjustments have provedinsufficienttostabilizethereservelevelintheLiquidityPortfolio.9In

thecaseofKoreaInvestmentCorporation(KIC),assetsarequalifiedasreserveassetsandcouldbeusedforBoPpurposes.10

Typically, commodity funds also result in disbursements whencommodity prices are weak and thus tend to support balance ofpayments even when they have no explicit balance of paymentssupportfunction.

IV.WHATAREANSWF’SOBJECTIVES?

A.CanSWFsbeDistinguishedbyTheirStatedPolicyObjectives?

In linewith the sourcesof their funds, SWFscanbedistinguishedalong theirobjectives. TheMFIbroadlydistinguishes five typesofSWFs: (i) reserve investment corporations that aim to enhancereturns on reserves (ii) pension-reserve funds; (iii) fiscalstabilization funds;(iv) fiscal savings funds; and (v) developmentfundsthatusereturnstoinvestfordevelopmentpurposes.11

Pension reserve funds seek to build assets to cover an identifiedliabilityoftenrelatedtoanagingpopulation.Anagingpopulationisa cause of future economic vulnerability and expenditure, oftenrelated to entitlements that were funded by a pay-as-you gosystem resulting in high economic and social cost. A prudentresponse to such challenges is toaccumulateassetsnowsoas tooffset the projected higher liability related to sustaining pensionsand socialwelfare in the future. This approach can be found, forexample,inAustralia,Ireland,NewZealand,andChile.12Dependingon the macroeconomic framework, these assets can often beinvested abroad, so that they can be disinvested and used forimportswhenthedomesticpopulationcomesofage.

Fiscal stabilization and fiscal savings funds are often related tocommodity related wealth. There are fundamentally two issueswith commodity wealth. First, prices are often very volatile

compared to other income streams; and, second, quantities areoften highly discontinuous, especially in smaller countries withlimitedresourcecapacity.

Saving funds generally focus on intergenerational equity andtransfers. Especially for countries that have limited naturalresources or face great uncertainty as to the future size ofcommodity streams, spreading this wealth over generations andsustaining future income from extraction of non-renewableresources is a key objective of many governments.Intergenerational equity focuses on benefiting the current andfuture generations as equally as possible. This may be done bysettingupanendowmenttypefundthatconvertsafinite12 See http://www.futurefund.gov.au/faqs, http://www.nprf.ie/home.html,http://www.nzsuperfund.co.nz/, andhttp://www.hacienda.cl/publicaciones.php?opc=redirect&id=10260&actual=95 forthesefunds’policyobjectives.

(extractive) assetwith an infinite string of financial cash flows tobenefitthepresentandallfuturegenerations.

Commodityextractingeconomiesmaybeabletostabilizethefiscalimpactoffluctuatingcommoditypricesviafiscalstabilizationfundsdesignedtosmoothboom/bustcycles(e.g.,TrinidadandTobago13).In some economies, saving assets abroad in an SWF can assist inmitigating Dutch Disease and related macroeconomicconsequences. At times, stabilization funds grow beyond what isneeded for stabilization purposes, especially when prices areelevatedoveraprolongedperiod,andareconsequentlyredesignedasstabilizationandsavingsfunds(e.g.,Russia14).

Indeed,asseenintherecentperiod,objectivesforsettingupSWFsmay be multiple, or changing over time. For example, somecountriessetupfundsforbothstabilization,andsavingsobjectives.

Ascircumstanceschange,theobjectivesofthefundsmaydosoaswell.Thisisespeciallytruefornaturalresourceexportingcountries.Initially,astabilizationfundisestablishedtosmoothfiscalrevenueor sterilize foreign currency inflows. As the assets in the fundcontinue to grow beyond the level needed for the purpose ofstabilization, country authorities may revisit the objectives andredesignthestructureofthefundtobroadentheobjective.

It isimportantthoughtorecognizethattheSWF’spolicyobjectiveand activities should be consistent with a country’s overallmacroeconomic framework.This isbecause theSWFs’assets,andthe returns it generates, impact on a country’s public finances,monetary conditions, the balance of payments, and the overallbalance-sheet. They may also affect public sector wealth andimpact private sector behavior. Therefore, appropriatecoordination between the SWF and the fiscal and monetaryauthoritiesiscriticaltoachieveacountry’soverallpolicyobjectivesinthecontextofwhichanSWFisestablished.

B. How to Formulate Operational Objectives to Achieve PolicyObjectives?

WhilethebroadpolicyobjectivesofSWFsaresufficienttomotivatetheir set-up, they need to supplemented with an operationalobjectivetohelpderiveanappropriateinvestmentpolicyandassetallocationstrategy.

For stabilization funds with the policy objective of smoothinggovernment revenue, a typical formulation calls for savingcommodity revenue if the actual commodity price exceeds acertain reference price, based on a long-term trend, andwithdrawing from the fund if the actual price drops below thereferenceprice(e.g.,AlgeriaandRussia).15

For savings fund, the operational formulation of the objective tospreadwealthacrossgenerationsisoftenthemostconcrete.Suchfundsgenerallyaimtomaximizetherealannualpayoutpercapitaor the payout as a share of gross domestic product (GDP).DependingonthesizeofpopulationgrowthandrealGDPgrowth,the variations in formulating the underlying objective, can haveprofoundimplications.16AcountrywithadecliningpopulationwhileGDPisgrowingrapidly,sotransfersinlinewithGDPimplyfarlargerdistributions to distant generations. Evenmore important can betheassumptionsaboutthediscoveryoffuturewealth. Inpractice,several large economies have, over time, found new naturalresourcedeposits that replace thoseexploited. Ignoring thisbasicfactcould lead to theaccumulationof toohighasumof financialassets,asthecommoditywealthismassivelyunderestimated.

Funds (or reserve investment corporations) that aim to enhancethereturnonfundedassetstendtomaximizereturnssubjecttoagivenrisktolerance.Theexpectedadditionalreturnisafunctionofthe risk that the government or the owner iswilling to take. Theoperationalobjectivecanbeformulatedasareturnobjectivebasedon an assessment of historic data on the trade off betweenenhanced return and risk. As the longevity of these funds is notalways clear, the risk tolerance and investment horizon oftenremainimplicit.

The operationalization of the objectives of pension and otherliability focused wealth funds follows the asset liabilitymanagement(ALM)approachappliedbypensionfunds.Incontrastto reserve investment corporations, the horizon over which theliabilities materialize is often well identified. This allows for theexplicitmaximizationof thenet valueof the fund (inessence thenetpresentvalueoftheinvestmentsminusexpectedpaymentsforthe liabilities) over the identified time horizon subject to risk

tolerance. In practice, this process is also summarized in theformulationofaconcretereturntargetastheoperationalobjective(e.g.,Australia,andNewZealand).17

V.WHATARETHEFUNDING,WITHDRAWAL,ANDSPENDINGRULESOFANSWF?A.RulesforTransferringFundsbetweenanSWFanditsOwner

Policiesandrules foranSWF’s funding,withdrawal,andspendingoperationsshouldbeclearandconsistentwiththepurposesofthefund.AnSWFwithastabilizationobjectiveusuallyhasclearly laidout rules for the deposit and withdrawal of resources. Savingstypes of SWFs receive contributions from excess revenues, buttheirpurposeistospendearningsorprofitssoastosharewealthwithfuturegenerations.Whilefiscalprocessesoftencall forsomeflexibility in the withdrawals from these funds—so as to avoidborrowing—this approach can resultonposing constraintson theinvestmentprocess.Itmaybebestto16ThemaximizationofthepayoutasashareofGDPisakintothecommonpracticeoftargetingasustainablenonoil(orothercommodity)budgetdeficit,whichisthensupplemented with a steady withdrawal from the SWF based on its long-termexpectedincome.

17 See http://www.futurefund.gov.au/faqs andhttp://www.nzsuperfund.co.nz/index.asp?pageID=2145831973 for their returnobjective.

provide the SWF with a clear investment mandate without theneed to keep liquidity for unpredictable calls by the government,but allow it to invest in government bonds if it sees fit and isconsistentwiththemacroframework.18

Savings SWFs are often integrated in the general budgetframework, given their centrality for determining sustainableexpenditure, throughanexplicit linkbetweenfiscalpolicyandtheaccumulation and return on the financial assets. One example is

Norway’s Government Pension Fund-Global.19 The fund is anintegrated part of government finances. The accumulation ofcapitalinthefundconsistsofthenetcashflowfromallpetroleumrevenuesplus the returnon the fund’sassets.Theoutflowof thefund is a transfer to the budget to finance the non-oil budgetdeficit. Furthermore, the fund also plays a role in the fiscalguidelineforthestatebudget,whichstatesthatthestructuraloil-adjustedbudgetdeficitshallovertimecorrespondtotheexpectedrealreturnonthecapitalofthefund.20

Some SWFs directly pay dividend to the citizens or to thegovernment. Alaska’s Permanent Reserve Fund pays an annualdividend to the population based on a fraction of the fund’srealized earnings.21 Half of the average realized income for fiveyears isdistributed for thispurposeaccording to state law.Otherfunds allow a great deal of discretion for the government. In thecase of Government of Singapore Investment Corporation (GIC),the Constitution provides that part of the investment income onSingapore’sreservescanbetakenintothegovernment’sbudgettosupport spending on the government budget; specifically, theConstitutionallows thegovernment to spendup to50percentofthe“NetInvestmentIncome”derivedfrompastreserves.2218Indeed,reflectingsuchconsiderations,someSWFshaverelativelyhardrulesforthedeposit andwithdrawal of resources. In the caseof Russia, for example, theamountofoilandgasproceedsinexcessoftheamounttransferredtothebudgetis channeled to the Reserve Fund until it reaches 10 percent of GDP (see MFI(2008a)).Ifafteralltheseoperations,thereisanexcess,thenitischanneledtotheNationalWealthFund.ReserveFundassetsmaybeusedtocoverfinancingneedsincasenosufficientoilandgasrevenuesaretransferredtothebudgetinthefirstplace (i.e., to cover federalbudgetdeficit inunfavorable conditions). Inaddition,the Reserve Fund capital can be transferred to make early debt repayments.WithdrawalsfromtheReserveFundshouldbeapprovedbythefederalbudgetlawforthecorrespondingfiscalyearandplanningperiod.

20NewZealand’sSuperannuationFundisagoodexampleofpension-reservefunds.

Itaimsatpayingyearlysuperannuationentitlements.Dependingontheexpectedshortfall,whichfluctuatesannuallybasedonactualreturnsandevolvingliabilities,thegovernmentneedstomakeannualcapitalcontributiontothefundaccordingtoover time close the funding gap. (SeeNewZealand (2006).)Australia’s FutureFund states that no withdrawal is allowed until 2020 (seehttp://www.futurefund.gov.au/faqs).

21SeeCowper(2007).22Seehttp://www.ifaq.gov.sg/mof/apps/fcd_faqmain.aspx.

VI.SOMECONSIDERATIONSINDETERMININGTHEINSTITUTIONALSTRUCTURE?

A.SWFsasaUnitwithinaCentralBankortheMinistryofFinance,or,asaSeparateLegalEntity?

SWFscouldbesetupasseparatelegalentities,asaunitwithinthecentral bank, orwithin theMinistry of Finance. Regardless of thegovernance framework, the operational management of an SWFshould be conducted on an independent basis to minimizepotential political influence or interference that could hinder theSWFinachievingitsobjectives.

SWFs established as separate legal entities usually have agovernance structure that differentiates an owner, a governingbody(ies), and operational management of the SWF. Theoperational independence could be embedded in the rules andprocedures for appointment and removal of the members ofgoverningbody.WheretheSWFisaunitwithinacentralbank,,theoperational independence could be embedded in a clear legalfoundationand internalgovernance structure,where thedecisionmaking framework and oversight functions are clear and therelationship between the principal (owner) and its agent is well-established. Funds established within a ministry of finance oftencouldhavelessoperationalindependenceandsuchasetupwouldonly be appropriate for very specific investment mandates withnarrowlydefinedmandates—suchassomestabilizationfundsthat

investinmoderatedurationbondportfolios.Still,thereshouldbeaclearseparationbetweentheunitthatexecutesandthoseinvolvedinoversight.

Anotherconsiderationisthecost.Settingupafundwithaseparatelegal entity has sunk costs. SWF as a unit in the central bank (orministry of finance) could use existing resources, including aportfolio or debt management capacity. Therefore, it could bemore cost-efficient if a small size fund is managed within anexisting institution and make use of existing infrastructure andhuman resources. However, if investment mandates are moreadvanceditismaybebettertohaveaclearseparation,particularlyas the culture and pay structure within existing institutions mayhamperanefficientfunctioning.Inaddition,activitiesoftheunitinthe central bank should not impact the central bank’s incomestatementandbalancesheetasitsowneristhegovernment,whotakesareturnaswellasitsrelatedvolatility.

B.HowaretheDecision-MakingHierarchyandLinesofReportingOrganized?

A well-defined organizational structure could establish a clearseparationofresponsibilitiesandauthority.Indoingso,thiscreatesa decision-making hierarchy that limits risks by ensuring theintegrityof,andeffectivecontroloverSWFmanagementactivities.Usually four types of decision making can be distinguished: (i)determinationofthepolicyobjectivesandoverallrisktolerance;(ii)determinationof theoperational objectives; (iii) determinationofthe strategicassetallocation (SAA), includingallowabledeviationsformbenchmarksandtheirreflectionininvestmentguidelines;and(iv) the operational execution of investment decisions incompliance with investment guidelines. How these levels areseparatedinspecificSWFsdependsonthenatureandobjectiveofthe SWF. In some cases, the second level of decision making is

mergedwiththethirdlevelofdecisionmaking.However,generallythe decision on the SAA is the responsibility of the organs of theSWF.

The line of reporting usually is consistent with the institutionalstructure. In thecasewhereanSWF isaunit in thecentralbank,theMinistryofFinanceoftenreportstoParliamentontheactivitiesof the fundbasedonaudited financial statementsof the fund. IncaseswheretheSWF isaseparate legalentity, it typically reportsto the government representedby theMinister of Finance for itsperformance. Separate legal entities often have themost explicitreporting requirements. Timely and accurate reporting of SWFactivities to theowneror theappropriatenational agencieshelpsensure that SWF operation is integrated into themacroeconomicpolicymakingprocess.

VII.WHATDETERMINESTHEINVESTMENTPOLICY?A.WhataretheGeneralConsiderationsinDesigninganSWF’sSAA?

DevisingaSAA isadynamicprocessaswell asa result. SAA isanintegrativeelementoftheplanningstepinportfoliomanagement.In a SAA, an investor’s operational objectives are integratedwithexpectationsabouttherisk/returncharacteristicsofdifferentassetclasses, including the correlation between asset classes and thefund’s liabilities. The expectations of the asset classes should beconsistent with macroeconomic projections and constraints (e.g.,profit growth is in the long-term bounded by GDP growth). Bycombining asset classes with low or negative correlation, theinvestor may achieve diversification benefits. Also, from asovereignperspective, itwould alsomake sense to look for assetallocation with offsetting characteristics to the economic riskprofileofthecountry.Theresultisasetofportfolioweightsforthedifferenteligibleassetclassesreflectiveoftheinvestor’sobjectivesand risk tolerance.23The SAA is expressed in strategicbenchmarks

allowing for the measurement, attribution and assessment ofreturn. The SAA is typically reviewed periodically or when aninvestor’s objectives change significantly. In the early days of anSWF, there isaneed tobecautiousasexperience isaccumulatedandpositionsarebeingbuiltup.

Theoperationalobjectivesdrive the investmenthorizon,which incombinationwith the risk tolerance and investment environmentare the key determinants of the strategic asset allocation. Thesekey ingredients, investment horizon, risk tolerance, asset classesand their correlation, ALM, and other constraints are detailedbelow.

Investmenthorizon

Theinvestmenthorizonreflectsthetimethatthefundisexpectedto be used and the period over which the return is to bemaximized. Each of the operational objectives specified aboveimplies an investment horizon. For intergenerational funds andpension funds the horizon is typically very long, for stabilizationfunds the horizon is relatively short depending on the averagecommoditypricecycle.Forreturnfocusedfunds,thetimehorizonismorefluidand23InsomecaseswheretheSWFoperateslikeaprivateequityfund,thefocusisnotontheassetclasses,butonspecificholdings,theirdistributionacrosssectorsandcountries,andthechoicebetweenholdingcashequivalentsandbeinginvested.

depends on whether the focus is on keeping the funds forever(endowments), or on depleting the funds throughinterventions/withdrawals.

Inpractice,therearealsootheruncertaintiesthatneedtobetakenintoaccount inderiving the investmenthorizon. Inparticular, thesizeofreservesofnaturalresourcesmaybeuncertainortheremay

be unusual (politically motivated) claims on the funds. Typicallythese forces work in opposite directions. Resources that aredepleted are often replaced by discoveries of new deposits,especially in largercountries,andthis lengthensthetimehorizon.Overtheexistenceofthefundtheremaybepoliticalchangeswithparties taking a dimmer view on the need to save for futuregenerations,whichuncertaintiesreducetheinvestmenthorizon.

These arguments can be reflected by assigning a larger discountrate to future inflows (effectively assigning a lower probability tothem), or by taking a more agnostic approach and reducing theinvestment horizon, thus reducing the horizon over which one ismaximizingthereturn.

Riskconstraint:capitalpreservation

The risk tolerance is a key constraint on themaximization of theexpectedreturnovertheinvestmenthorizon.Theriskconstraintisbasedontheultimatestakeholders’willingnessandabilitytotakerisk. Ideally, the risk preference focuses on the entire investmenthorizon,andcantaketheformofamaximumacceptabledeviationatthepointsofwithdrawalsandtherisk/returntradeoffsatthesepoints. In other words, there is less of a need to be concernedabout daily volatility if the investment horizon is a year. Forexample, the value of the investment can increase and decreasedailyby10percentbutthekeyaspectisthevalueinayear’stimewhenthewithdrawaltakesplace.

However, inpractice, investorsmay (the typicalendstakeholder)have some concerns about short-term volatility. A typicalconstraint in new SWFs is therefore the sponsor’s desire topreserve capital. A capital preservation objective is equivalent tozerotolerancefornegativereturns,ineithernominalorrealterms.If formulatedwith regard to the start of the Fund this constraint

hasatimedimension:overtimeabufferisbuiltuptoallowmorerisk. Inotherwords, adding this constraintof capitalpreservationallowsaneasingintoarisktolerancethatismorereflectiveoftherealinvestmenthorizon.Inthisregard,anearlystartwithinvestingresources to build up a buffer, having an oversight body withexperienced and respected professionals, and educating laystakeholders can help limit the cost imposed by this additionalconstraint.

Assetclassesandtheircorrelation

The return over the investment horizon ismaximized subject notonly to the risk tolerance, but is also to expected asset classreturns. The number of choices of investment instruments andasset classes is very large allowing near infinite portfoliocombinations. To be operational, investors in practice limitthemselves to investing in specific asset classes because theybroadlydisplaythesameproperties.

16

Typically,ashortinvestmenthorizonresultsinahighallocationtofixed income assets with predictable returns. Funds with theobjective to insulate the budget from commodity price volatilityusuallyhavea shorter timehorizonbecause the cycleoverwhichthe stabilization objective is shorter, and it may be difficult toestimate the size of the optimal required buffer and withdrawalandtransferrulesmaynotbeadheredto—aspracticeshows.Asaresult,theyaregenerallyrequiredtohaveaconservativeSAAwithalowrisk-returnprofile.

However, ALM considerations (see below) may imply the use ofsome long-term asset classes with low or negative correlation tothe exposure (e.g., amodest proportion of long- termbonds andequitythatisinverselycorrelatedwithoilprices).Fundswithlonger

investment horizons allow for a broader asset allocation tomostasset classes. However, proper understanding of all eligible assetclasses is important.Someclassescanbeverycomplex,andwhilemanagementoftheseassetscanbedelegated,thewealthfundasthe principal owner of the assets will remain exposed to, andresponsible for, the investment risk. This stresses the need forsoundriskmanagementsystemandequippedwithrelatedsystemsandhumanresources.Asageneralrule,assetclassesthatarenotadequatelyunderstoodshouldbeexcluded.

Especially for funds whose owner is exposed to large-scalecommoditypricerisks,aproperconsiderationofassetclassesandtheir correlation is important. For example, oil funds should takeintoaccount the future revenue streamassociatedwith theoil intheground,whichisequivalenttohavingalargeoilpricesensitivefinancial asset. A balanced portfoliowill therefore usually requirehavingassetsthatareinverselyrelatedwithoilprices.Thismaybespecificstocks(e.g.,car industryorairlines)orassetclasses (long-termbondswhichmayincreaseinpriceiftheoilpricesfall,totheextentthishasadampeningeffectoninflation).

Assetliabilitymanagement

The return over the investment horizon, net of any withdrawals,and includingnon investment income ismaximized subject to therisk toleranceandasset class returns.Recognizingnotonly futurerevenues (e.g., commodity taxes) but also future liabilities allowsfor a better determination of the SAA. As noted above, pensionfunds focus onmaximizing the net value of a fund. This allows aconsiderationofthecorrelationbetweenassetpricesandliabilitiesasoneinputintheportfoliooptimizations.Similarly, it isusefultorecognizeanycurrentliabilities,notablyforreservesbuildthroughsterilized intervention, if theyarenotyetcoveredbythereservesthatremainonthecentralbank’sbooks.

Currencycomposition

ThechoiceofcurrencycompositiondependsontheobjectiveandtheliabilitystructureoftheSWF.Inthecaseofmanagingsovereignwealth with a stabilization objective, a sharp drop in commodityexportpricesandrevenuesmayrequireawithdrawaloffundwhichentailsshortinvestmenthorizonandhighliquidityconstraints.Asaresult, sovereign wealth with stabilization objective implieschoosingacurrencycompositionthatisnegativelycorrelatedwiththe commodity price. This is most likely to weigh the basket infavor of the countries that import the most (relatively) of thecommodity. Countries should, in general, not invest the assets inthe currency to which its own currency is pegged. The reason isthat the risk is thenpassedon to anotherpart of the sovereign’sownbalancesheet(thecentralbank)andthusnotlaid-off.

Managing sovereign wealth with liabilities need to consider thecorrelation of the liabilities with the foreign currencies. Thus,pension and fiscal savings funds are designed to support futureimports,theycanbeinvestedincurrenciesofcountriesfromwhichthe SWF countries’ citizensobtain their imports.However, over along time horizon, when import patterns shift, generaldiversificationargumentsmaybecomemoreimportant.

Otherconsiderations

Liquidityrequirements

If outflows are certain in terms of time and amount, then therequired amount could be set aside and invested in liquid assetswith matching cash flows or risk characteristics as the liabilities.This generally follows from ALM considerations in which theoutflowsareseenasliabilities.

Legalandregulatoryconstraints

Legal and regulatory constraints vary. Usually legislation specifiespermissibleassetclassesthatafundcaninvest in.Typically,fundsare not allowed to invest domestically given the potential impactontheinflationandexchangerate,andsomefundsarenotallowedto invest in private equity, real estate, or hedge funds. Also,legislation may disallow the use of derivatives and swaps. Thepotential for risk taking is further constrained if a capitalpreservationobjectiveisputintolegislation.

Ideally legislation is generic and focuses on overall objectives,allowingforthederivationoftheappropriateSAAbyqualifiedandauthorizedbodies,ratherthenspecifyingspecificassetclasses.Thisis especially important as legislation is often set up during earlystagesoffunds,whentherearelimitedbuffersandthereislimitedexperienceamongthestakeholders.

B.Whatare theConsiderations for an SWF to FinanceDomesticProjects?

Thedecisionofinvestingapartoftheassetsdomesticallydependson the purpose of the SWF. If the SWF has developmentalobjective,itcouldinvestdomestically.However,itsoperationmustsupport and be consistent with the country’s macroeconomicpolicy framework. Using assets in SWFs to purchase domesticinputscouldstimulatedomesticdemand,andputupwardpressureon prices. Thismay result in an appreciation in the real effectiveexchangerate,withadverseconsequencesforexportsandgrowth.On theotherhand, sterilizationofdomestic input financing couldlead to higher interest rates and crowd out private sectorinvestments. Thus, while the new domestic project could add tooutput, it may also through the real exchange rate undermineprivateexportsanddomesticinvestment,oftentherealsourcesof

growth.

EvenifSWFfinancingisutilizedfordomesticprojectswhichwouldclearly augment growth prospectswith positive externalities, it isarguable that theseprojects shouldbe formed in thegovernmentfiscalpolicyandbudget.Ifspendingisallowedtotakeplaceoutsidethe budget, issues of fiscal accounting and transparency couldemerge,whichcouldunderminebudgetarycontrol, implyunequaltreatment of different types of spending, and could lead tomismanagementoffundsandwaste.

C.WhataretheConsiderationswhenanSWFHiresExternalAssetManagers?

External managers could bring expertise and access to newmarkets. Externalmanagersmayhave skills that an SWF lacks, ortheymayprovideameansofloweringoperationalriskduetolackofadequatehumanorinformationtechnologyresources.Theymayhave skills and established systems for undertaking investmentactivitiesinspecializedinstrumentsandmarketsforwhichtheSWFdoesnotwishtodevelopacapacityorhasoperationalconstrains.Most importantly, delegation of the execution of investments toexternalmanagers allows the SWF to focuson the SAA—which isthe predominant source of return—and manager selection. Foradvancedassetclassestheacquisitionofinhouseexpertisecanbeespecially costly and not efficient especially in low-incomecountries. External managers can also be subject to greatercompetition and harsher regimes for ending mandates theninternal managers. If a similar portfolio is already managedinternally, the external managers may also provide an additionalbenchmark for evaluating SWF’s own investment activity. Finally,externalmanagers canalsoplay a role in the trainingof the SWFstaff.

The ultimate responsibility for the performance on the assetsmanaged externally is entirely that of the SWF. The SWF or thegovernment still bears all the risk—market, credit, and liquidityrisks—no matter whether assets are managed internally orexternally. Accordingly, the SWF should make sure that the riskstakenbyexternalmanagersarewithintheSWF’soveralltolerancefortheserisks.Inparticular,thestrategicassetallocation,reflectedinclearbenchmarks for thecurrencycompositionand investmentrisk profile (duration, credit, etc.) remains the SWFs owner’sresponsibility.

Furthermore, the SWF needs to specify the allowed degree ofdeviation by the external managers from these benchmarks intaking positions to try to outperform the benchmark. In thatregard, the risk parameters that are to be used to measure andreport on risks should be clearly specified, as well as theinstruments that the external managers are allowed to use. It iscrucialthattherisks involvedintheportfoliosmanagedexternallyare evaluated in conjunctionwith the risks on portfolios that areinternallymanaged,sothataglobalviewoftherisksoftheSWFisobtained.

Another issue is thenumberof externalmanagers touses.Whenactivemanagementispursued,itisingeneralpreferabletoemployseveral managers to diversify risk against a bad performingmanager.However, a too largenumberofmanagers increase theadministrative burden and the total cost of fees owing to thegenerallydigressivefeeframeworkwiththesizeoftheportfolio.

VIII.CONCLUSION

In conclusion, this paper discusses a number of policy andoperational considerations that are relevant when assessing themeritsofsettingupanSWF.Itoffersa“roadmap”topolicymakers

considering setting up an SWF and would be of interest topolicymakers in countries where SWFs are already in place toreviewtheirexistingpoliciesandoperations.Itstartsbydiscussingwhetherornotpolicymakers should setupan SWFandwhat arethe other options. Once they decide to set up an SWF, they willfaceanumberofoperationalquestions ranging from institutionalarrangement, fiscal rules, to appropriate investment policy. Thispaper offers an opportunity to identify areas where research inmacroeconomics and finance should give further answers, forexample, the level of adequate reservesor revenues, theoptimallevel of foreign debts that a country should hold and not useforeignassetstorepay,andingeneralthetheoryonthesovereignassetliabilitymanagement.

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Policy and Operational Considerations Udaibir S. Das, Yinqiu Lu,ChristianMulder,andAmadouSy

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