Sovereign Wealth Funds:

New challenges for the Caspian countries

Summary

ThisbookconsidersfinancialmanagementandtransparencyaspectsofSovereignWealthFunds(SWF).Italsodiscussestheimpactoftheglobalfinancialmeltdown(2008-2009),commoditypricefluctuationsandtheriseoftherisksintheemergingworldonSWFsfinancialperformanceandtheirinvestmentactivities.ThebookparticularlyconcentratesonCaspianBasincountries(Azerbaijan,Russia,andKazakhstan)plusNorwayasexplanatorycasestudies.

Baku–2011

KhazaruniversityAddress:11Mehsetistr.,BakuAZ1096,Azerbaijan

www.khazar.org

PublicFinanceMonitoringCenterAddress:CaspianPlaza3;44,J.Jabbarlystr.,

9thfloorBakuAZ1065,Azerbaijan

Tel/Fax:(+99412)4978967,4970467E-mail:office@pfmc.az

www.pfmc.az

Acronyms

EITI ExtractiveIndustriesTransparencyInitiative

GAPP GenerallyAcceptedPrinciplesandPractices

GDP GrossDomesticProduct

IFI InternationalFinancialInstitutions

IMF InternationalMonetaryFund

NASDAQ NationalAssociationofSecuritiesDealersAutomatedQuotations

NGOs Non-governmentalOrganizations

NGPF NorwegianGovernmentPensionFund

OECD TheOrganizationforEconomicCooperationandDevelopment

SOFAZ StateOilFundofAzerbaijanRepublic

SWF SovereignWealthFunds

USD UnitedStatesDollar

US/G7 UnitedStatesGroupSeven

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Content

Foreword...........................................................................................................4

SovereignWealthFundsastheemergingplayersintheglobalfinancialarena:characteristics,risksandgovernance................................................................6

Governance,transparencyandaccountabilityinSovereignWealthFunds:remarksontheassessment,rankingsandbenchmarkstodate......................47

StateOilFundofAzerbaijanRepublic:Past,presentandfuture...................................................................................73

TheNationalFundoftheRepublicofKazakhstan(NFRK):Fromstress-testtoglobalfuture.....................................................................100

RussianSovereignWealthFunds.................................................................130 Aboutauthors................................................................................................159

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Foreword

Over the past decade, the boom in commodity prices, global imbalancesbetweensavingsandinvestmentinmajorcountriesandthemassiveaccumulationof foreign exchange reserves have resulted in the rise of Sovereign WealthFunds(SWF)asmajorforcesoninternationalfinancialmarketsandtheglobaleconomy.In2011,accordingtotheSWFInstitute,thelargestSovereignWealthFundsmanagewell over$4 trillion inassets.Thegrowing influenceofSWFshasfar-reachingconsequencesforbothhostandsponsoringcountries.Ontheonehand,SWFscanplayapositiverolebyfinancingdevelopmentprojectsandserving as an instrument to shield economies against shocks. On the otherhand,theeconomicweightofSWFsmayhampertheimplementationofeffectivemacroeconomicpoliciesandcreateadditionalopportunitiesforcorruptioninthesponsoring countries. Furthermore, the economic reach of SWFs engendersconcernsaboutthepotentialdestabilizationoffinancialmarketsinhostcountries.SomeWesterngovernmentsarealsoconcernedabouttransparencyandpoliticallymotivated investments of SWFs. To address these issues, the InternationalMonetaryFund,jointlywiththeInternationalWorkingGroupofSWFs,developedvoluntaryguidelinesfortheoperationsofSWFsin2008.Theseprinciples,knownastheSantiagoPrinciples,wereadoptedbymanySWFs,enhancingtheiroverallcredibilityandstrengtheningtransparencyofSWFactivities.

The recent global financial crisis of 2008-09 elevated the importance ofSWFs and temporarily shifted the focus of SWFs from long term investmentissues to short-term economic stabilization. SWFs have helped to stabilizeeconomies inavariouscountriessuchasChile,KazakhstanandRussia;andin some instances provided liquidity to troubledWestern financial institutions.SWFsalsoexperiencedsignificantfinanciallossesduringthecrisiswhichforcedthemtore-evaluatetheirinvestmentstrategies.Thelessonsfromthecrisisstresstheneedforstrengtheningriskmanagement,financialregulationandachievinggreater transparency. Specifically, SWFs tend to be more successful if theiroperationsareintegratedintothenationaldevelopmentgoalsoftheirsponsoringgovernments.Inaddition,itisimportantforSWFstoprovideadequateinformationtoallstakeholders(particularlycitizens,civilsocietygroupsandthemedia)andbe accountable to public oversight bodies (national parliaments and supremeauditinstitutions).

ThisvolumeadvancesourunderstandingofSWFsbypresentingacriticalanalysisofresource-basedSWFsinAzerbaijan,KazakhstanandRussia.Baseduponcompellingevidence,thisvolumemakesastrongcaseforthesignificanceof transparencyandaccountability instrengthening theperformanceofSWFs.Mostimportantly,thisvolumediscussesactivitiesofSWFsfromtheperspectiveofnationsthatestablishedthesefunds.ThepresentvolumepushestheboundariesofpublicoversightoverresourcerevenuemanagementbydemonstratingthattheSantiagoPrinciplesareinsufficienttoensurefulltransparencyandaccountability

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ofSWFs.WhileSWFsintheCaspianregionenabledthecountriestoweathertheglobalfinancialcrisis,theirinvestmentchoiceshavefailedtopromotelong-termdevelopmentincountriesthatcreatedthesefunds.Moreover,thevolumecriticallyreviewstheexistingmethodologiesofassessingperformanceofSWFsandproposesnewcriteriaforevaluatingperformanceofSWFs.

ThisvolumeprovidesavaluableresourceforanyoneinterestedinassessingtherecentperformanceofSWFsintheCaspianregion.

Antoine Heuty Deputy Director

Revenue Watch Institute

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Sovereign Wealth Funds as the emerging players in the global financial arena: characteristics, risks and governance

Ingilab Ahmadov PublicFinanceMonitoringCenter,Azerbaijan.

Stela TsaniTheCentreforEuroAsianStudies,UniversityofReading,UK.

Kenan AslanliPublicFinanceMonitoringCenter,Azerbaijan.

1. Introduction

Since1997theworld’smarketshavebeenexperiencingthetoughestfinancialcrisissincethe1930s.Thefinancialarchitecturethatwasconsideredtobethebasisoftheeconomicwelfareoftheworldiscollapsing.Underthiscrisissavingcommoditywindfallsinseveralresource-richcountrieshasmitigatedtheimpactofcommoditypricevolatilitywhileithashelpedseveralcountriestosmooththeimpactof theongoingfinancialcrisis.Thedebatearoundthe“invasive”natureoftheSovereignWealthFundshasbeengrowingpriortotheemergenceofthefinancialcrisisbeingverymuchaUS/G7concernfocusingontheriskofhavingopaquestatecontrolledforeigninvestmentvehiclespossiblytakingoverstrategiceconomicinterestsindevelopedeconomies.Nevertheless,thishasnotprovedtobethecaseintheG7countrieswherethedryingupofinvestmentshasaddedanewshifttotheongoingdebate.DevelopedcountriesarereconsideringtheroleandtheinvestmentoperationsoftheSovereignWealthFunds,lookingatpossibleinvestments from the latter intodevelopedeconomies. In this reality theneedbecomesapparent fora thoroughandprofoundunderstandinganddiscussiononthegovernanceoftheSovereignWealthFundsatthedomesticlevel,ontheaccountabilityof thesavingand thespendingdecisions to thecitizensandontheroleofthelegislativebodiesinoverseeingthemanagementoftheSovereignWealth Funds. Furthermore, the economic implications of investing windfallgainsabroadalsohavetobeclarified.Whilethisdoesshelterresource-abundantcountriesfromcommoditypricevolatility,itdoeslittletochangethestructureoftheeconomyandtosustainapublicinvestmentstrategyaimedatincreasinghumandevelopmentandlong-termsustainablesourcesofgrowthinsidetherespectivedomestic economies. In the presence of the ongoing financial crisis, financialliquidityconstraintsmayforceeventhosecountriesthathavebeensuccessfulso far to resort to this typeof investment.Besides, the fact that theseassetsarepossessedbyeconomicallyunstableandpoliticallyunpredictablecountriescausesseriousconcernsbytheworldcommunity.

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ThenatureoftheinvestmentpolicyoftheSovereignWealthFundssubstantiallychangesduring (andpossibly after) financial turmoil. If previously the primarygoal of the SovereignWealth Funds was considered to be the transparencyofwindfall fundsand theirpreferablemanagementabroad,at thepresentandin the case of the exigency to stimulate the economy in natural-resource-richcountries,themanagementoftheseassetsdomesticallybecomesanimperative.This in its turn can darken the actual evaluation of the government on thewithdrawalofthecountryoutofthecrisisandworsentheproblemofensuringtheaccountabilityofpublicfinancemanagement,thusincreasingunlimitedtransfersandbailoutplans.Thus, theongoingcrisisconsiderablychanges the roleandthephilosophyoftheSovereignWealthFundsanditintroducestheneedforathoroughunderstandingoftheseinstitutions.The most important impediment to the understanding of the Sovereign Wealth Fund remains the absence of the precise institutional as well as procedural limitations capable of decreasing the government’s appetite to waste financial funds within the respective economy. The absence of such limitations creates a self-willedatmosphereonfundspending,consequentlymisbalancingthefinancialstructureandestablishingdeepinflationaryconditionsinthedomesticeconomies.Inotherwords,theabsenceoflimitationsontransfersfromtheSovereignWealthFundsto the state budget leads to adverse impacts for macroeconomic equilibriumand has comprehensive socio-economic consequences such as rent-seekingeffects,socialinequality,ineffectivedecisionmakingandemergenceofeconomicauthoritariangovernance.

Taking the above into consideration, the immediate need becomes clearforacareful investigationandclarificationof the roleof theSovereignWealthFunds, of their nature and operational aspects, of the determinants of theirinvestmentstrategiesandtheinteractionofthelatterwiththerecipientcountries.AllofthelattercannotbeassessedwithoutlookingatgovernanceaspectsoftheSovereignWealth Funds andwithout setting somegenerally accepted qualitynorms and interaction levelswith the general public and other economic andpoliticalsettings.Forthispurposethepresentpaperdevelopsasfollows:Section1developstheargumentofhowthechangingglobalfinancialbalancesandtheemergenceoftheSovereignWealthFundsaskeyplayersinthefinancialarenaurgeforadeepunderstandingofthenatureandtheroleoftheSovereignWealthFunds.Inanattempttoaddressthischallengethissectiondetailssomedefinitiveoperationalandgovernanceaspectsofthefunds,offeringsomecomprehensivecategorization of the latter. Section 2 looks into the risk types that SovereignWealth Funds may be faced with while it further investigates the absorptivecapacityofthedomesticeconomiesandthetransparencylevelsexperiencedinSovereignWealthFunds.Section3looksintogovernancedevelopmentsoftheSovereignWealthFunds,identifyingthedeterminantsofgoodgovernanceandthedifferentpartiesinvolvedintheevolutionandtheestablishmentofthelatter.Thelastsectiondrawsconclusions.

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2. Sovereign Wealth Funds: A crucial element of the world economy

Global imbalances deriving from large current account deficits in majoreconomies like thatof theUSAandcounterbalancing largesurpluses inAsianand oil-producing countries have attracted significant attention. These haveboosted the foreign reserves ofmany surplus countries clearly beyond levelsseenasnecessary forsecuring their international liquidity.Decision-makers inthesurpluscountriesareseekingtoincreasethereturnontheir“excess”reservesbymanaging their foreign reservesmoreactively.For thispurpose, theyhaveestablishedspecialSovereignWealthFunds(hereafterSWFs),withmanyoftheminjectingsignificantamountsofcapitalintomajorWesternfinancialorganizations.Despitethefactthatthisflowoffinanceiswelcomedbytheorganizationshitbythefinancialcrisisanditisgoodformarketstability,concernshavebeenraisedintheUnitedStatesandEuropeaboutthenatureandtheintentionsoftheSWFs.

SWFs’ design, establishment, operation and investmentmanagement andallocation are receiving an increasing amount of interest on national as wellas international levels.TherelativelynewandunclearoperationsoftheSWFsurge greater investigation and clarification of the nature of the SWFs aswellas of their importance to and interaction with international financial markets.TheexplorationofSWFsemergesasofprimary importancewhenconsideringthe ongoing financial crisis, where the SWFs emerge as key players in theinternationalfinancialarena.Understanding the nature of the SWFs remains particularly important especially after considering the high degree of misconception, confusion and consequent skepticism around the SWFs. Muchof the interest in theSWFs is related topoliticalconsiderationssuchasthereintroductionofthefailuresofpublicownershipintomarketeconomiesbythebackdoorwhereSWFsserveasthemovinginstrument,whetherSWFsusetheirownershiprightstopursuepoliticalgoalsorwhetherresistancetoforeignownershipemergesasanewformofprotectionism.FurtherconcernsrelatedtotheSWFsregardeconomicoutcomessuchastherelationshipoftheSWFstotheimbalancesintheworldeconomy,howtheyareaffectingfinancialmarketsandthepolicyimplicationsoftheirgrowth1.

InthecurrentglobalfinancialdevelopmentsSWFsareperceivedtorepresentapermanentre-directionininvestmentflowsandashiftinthedominantsourcesoffinancialcapital.Todate,globalfinancialoperationsweredominatedbyAnglo-American financial institutions but recent developments suggest increasingcapitalflowsfromemergingtomatureeconomies.IntheseflowsSWFsimplyaredistributionoffinancialandpoliticalcapitalthroughouttheworld.InthisrealitythepresenceofablurringlinebetweenfinanceandpoliticsraisesconcernsthatSWFswillbeusedillegitimatelytoadvancepolitical,asopposedtocommercial,agendas.InmanycasesSWFsmayevenbeseenasthesourceofanew“state

1Rautava(2008),Gieve(2008),RaphaeliandGersten(2008)

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financial capitalism” raising questions on whether the introduction of publicinvestorsintoprivatemarketswilldoforefficiency.FurthermoreSWFsinvestmentsmayberegardedaspotentiallydisguisingattemptsby foreigngovernments toobtaintechnologyandexpertisebenefitingnationalstrategicinterests.

Figure 1. Regional distributions of official reserves in 1996 and 2006 (official reserves in % of world total)2

1996

2006

2Source:Kern(2007),SovereignWealthSWFsInstitute

47%

17%

36%

Industrialcountries Asia Others

33%

7%2%

54%

4%

Industrialcountries LatinAmerica MiddleEast Asia CEE

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In all cases, SWFs are a new source of political intrigue and concernemergingformanyasoneofthehottesttopicsinglobalfinancialmarkets.Inanyrespect, SWFs are reshaping the economic and political landscape.Althoughconcernsaboutemergingmarket investorsarenotnovel,SWFsdoappear tohave attracted special attention from policymakers. Explorations of the latterhave resulted innewpolicyproposals fordealingwithSWFsbeingatvariousstagesofconsiderationandimplementation(forexample,theU.S.hascreatedaSWFtaskforcetoconsideritsoptions,AustraliaandGermanyhaveimplementednew rules targetingSWFs, and the InternationalWorkingGroupofSovereignWealthFundshasdevelopedaseriesofvoluntary‘generallyacceptedprinciplesandpractices’-knownasGAPPorthe‘SantiagoPrinciples’)3.

Whentakingtheselaterdevelopmentsintoconsideration, itbecomesclearthatinordertounderstandtheurgencyofSWFs’explorationacleardefinitionofsuchfundsshouldbederived.TheconsiderationoftheaspectsthatleadtothecompositionofthedefinitionofSWFscanprovideafirstindicationofthecrucialurgencyoftheSWFtopicindicatingwhySWFshavebecome,andwillcontinuetoemergeas,keyplayersintheworldeconomy.

2.1. Understanding SWFs: Definitions, nature, financial and regional features

A general definition of SWFs would state that SWFs are government owned investment funds operating in private financial markets. RecentinterestinSWFshasfailedtocometoaconsensusastohowSWFsdifferfromotherpublic investment fundsandhowtheyshouldbedefined. Indeed,SWFsdiffer in ownership, underlying assets, degree of dependence, operationalaspects,etc.From theexistingSWFs,someare funded fromfiscal surplusesorforeignexchangereserves,whileothersarefundedfromborrowingsfromthemarket.Of the existing SWFs, almost half operate as separate legal entities,while the rest consist of a dependent entity within theMinistry of Finance ortheCentralBankoftherelevantcountry.Finally,theSWFsthemselvesdeclarevariousobjectivesrangingfromfiscalstabilizationtogeneralsavingsforfuturegenerationstocoveringexpectedfuturepensionexpenditures.Thusitbecomesclear that SWFs vary in nature, operations and ownership, not permitting thecrystallizationofaclearimageoftheseestablishments.

InthisrealityitremainsrelevanttoidentifyanycommonalitiesamongSWFsthatcouldserveasthebasisofanSWFdefinition.Inthisdirectionthefollowingquestionscanbenamedascrucial4:

• Who owns the SWF?

An overview of the existing SWFs reveals that governments, at centralor at sub-national levels,may own theSWFs and exercise control directly or

3InternationalWorkingGroupofSWFs(2008),Pihlman(2009)4 ForadetaileddiscussionseeMonk(2009),Dasetal(2009),Bartsch(2006),Coper(2007),Eiferet

al(2002),Fasano(2000),FriendsofEarth(2002),Tsalik(2003),BaconandTordo(2006),Goldsmith(2001)

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indirectlythroughtheappointmentoftheSWFboard.InthisrespectSWFsareameetingpointofhighpoliticswithhighfinance;thereforetheunderstanding,theexplorationandtheobservationofthelatterremainscrucial.

• What are the liabilities of the SWF?

When considering this question the interesting finding is that SWFs havenodirect liabilities.SeveralSWFshave liabilities, suchassterilizationdebtorsomedeferredcontractualliabilitytotransfermoneyoutofthefundandintothegeneralbudgetorasocialsecuritysystem.Nevertheless,itappearsthatSWFshavenonon-governmental or outside liabilities.For those funds that dohavea liability, it is typically intra-governmental,withonebranchof thegovernmentowingmoneytoanotherbranchofthegovernment(i.e.thefundmayowetotheMinistryofFinance,theCentralBankorthesocialsecurityreservefunds).SWFshavenoexternalcreditor,henceaccumulatedassetsarenotsubjecttooutsidenon-governmentalownerspropertyrights.Thereforeanyexistingfundliabilitiesarepartofthebroadernationalbalancesheet.

• Who benefits from the SWF?

Despite certain explicit goals (e.g. financing future pension paymentrequirements), SWFs are managed according to the interests and objectivesof thegovernmentand/or thesovereign.ThefinalbeneficiaryofaSWF isnota specific individual, but rather it remains the government, the host country’scitizensorthetaxpayeringeneral.

Figure 2. World map of SWFs and respective SWFs volume

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Consideringtheanswerstotheabovequestions,SWFscanalsobedefinedinmoredetailasdirectlyorindirectlygovernment-ownedandcontrolledinvestmentSWFswithnooutsidebeneficiariesorliabilitiesinvolvedinassetinvestmentsintheshortorlongterm,accordingtotheinterestsandtheobjectivesofthesovereignsponsor. Inotherwords,SWFscanbeconsideredgovernment-ownedspecialpurpose investment SWFs or arrangements. Serving further macroeconomicpurposesofthegovernment,SWFshold,manageand/oradministerassetswithfinancialobjectives,developingasetofinvestmentstrategies.Thelattermayalsoincludeinvestmentsinforeignassets.Investmentstrategiesinanycaseexclude,amongother elements, foreign currency reserveassetsheldby themonetaryauthoritiesforthetraditionalbalanceofpaymentsormonetarypolicypurposes,state-ownedenterprisesinthetraditionalsense,government-employeepensionfunds,orassetsmanagedfor thebenefitof individuals.SWFs are commonly established out of a balance of payment surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports.WhileSWFisanall-encompassingterm,itdescribesagroupofheterogeneousfundsexistingandoperatingforyears.Whatremainscommon to thegroupof these funds is thepublicownershipand thefactthatthesefundsareoftenestablishedtomeetamacroeconomicpurpose,though these purposesmay at times bemultiple in nature (e.g. savings andfiscalstabilization).IngeneralSWFshavethecapacitytooperateoveralong-terminvestmenthorizon,hencetheyareusuallylessriskaversethanagenciesmanagingtraditionalforeignexchangereserves.

Typically, SWFestablishment follows commodity price booms,whilemorerecentlySWFestablishmenthasfollowedlargeexportboomslikeinthecaseofChina.Followingimmenseaccumulationofinternationalassets,policymakersinmostoftheempiricalcaseshavesetupanumberofobjectivesconsideredas“optimal.”When taking this into consideration thepresenceand theoperationof an SWF is primarily linked to whether the country has an “adequate” or“optimal” level of international reserves. Even if the level is “ample” enough,policymakers should decide whether they will use SWF assets to meet thebalanceofpaymentneeds.Inthisrespectafund’spresenceandoperationarealsorelatedtowhetherthereexistbetteralternativestosettingupaSWF.OnceanSWFisestablished,policymakershavetodecideonanumberofoperationalquestionsensuringthatthefundisconsistentwithitsbroadpolicyobjectives.Inthisreality, the identificationof theoperationalobjectives isneededinordertoderiveanappropriate investmentpolicy thatwillenvisage funding,withdrawal,andspending rulesof the fund5. In linewith thesourcesof their funds,SWFscan be distinguished along their objectives.Broad categorization based on the objectives of the fund would consider the following different objective categories: (i) reserve investment corporations that aim to enhance returns on reserves, (ii) pension-reserve funds, (iii) fiscal stabilization funds, (iv) fiscal savings funds, and (v) development funds that use returns to invest for development purposes.

Pensionreservefundsseektobuildassetstocoveranidentifiedliabilityoften

5 IMFFiscalAffairsDepartment(2007),LeBorgneandMidas(2007),ManzanoandRigobon(2001),Mohohlo(2007)

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relatedtoanagingpopulationwiththelatterbeingacauseoffutureeconomicvulnerability and expenditure, often related to entitlements that were fundedbyapay-as-yougosystemresulting inhigheconomicandsocialcosts.FundoperationunderthisobjectivecanbeidentifiedinthecaseofAustralia,Ireland,NewZealand,andChile.Dependingonthemacroeconomicframeworkineachcountrytheseassetsareofteninvestedabroad,sothattheycanbedisinvestedand used for imports when the domestic population comes of age. Fiscalstabilizationandfiscalsavingsfundsarerelatedtonaturalresourcewealth(asinthecaseofVenezuelaorChile).Naturalresourceendowmentsarerelatedtovolatileandfluctuatingpricesaswellastooftenhighlydiscontinuousquantities,especiallyinsmallercountrieswithlimitedresourcecapacity.Savingsfundsareconcernedwith intergenerationalequityand transfers. Intergenerationalequityfocusesonbenefitingthecurrentandfuturegenerationsasequallyaspossible.Thismaybedonebysettingupanendowmenttypefundthatconvertsafinite(extractive) asset with an infinite string of financial cash flows to benefit thepresentandall futuregenerations. In someeconomies, savingassetsabroadin an SWF can assist in mitigating “Dutch Disease” symptoms and relatedmacroeconomicconsequences.Attimes,stabilizationfundsgrowbeyondwhatisneededforstabilizationpurposes,especiallywhenpricesareelevatedoveraprolongedperiod,andareconsequentlyredesignedasstabilizationandsavingsfunds(e.g.Russia).

WhenconsideringtheobjectivesofSWFestablishment,theurgencyofthetopicandtheexplorationofSWFbecomesclearerespeciallyafterrealizingthatascircumstanceschange,theobjectivesoftheSWFsdoaswell.ConsideringthisrealityitisimportanttorecognizewhattheSWFs’policyobjectiveandactivitiesare and whether they are consistent with a country’s overall macroeconomicframework.Thisisbecausethefunds’assets,andthereturnsitgenerates,impactacountry’spublicfinances,monetaryconditions,thebalanceofpayments,andtheoverallbalance-sheet.Theymayalsoaffectpublicsectorwealthandimpactprivate sector behavior while having a significant impact upon internationalfinancialmarketsthroughtheirinvestmentdecisionsandchoices6.

Operationalandpolicyobjectivesaswellasthenatureofthefinancialtoolsoffundsdifferaccordingtotheunderlyingestablishmentpurpose.Stabilizationfundshavingasmoothinggovernmentrevenuepolicyobjectivetypicallyformulatecallsforsavingcommodityrevenuesiftheactualcommoditypriceexceedsacertainreferenceprice,basedonalong-termtrend,andwithdrawingfromthefundiftheactualpricedropsbelowthereferenceprice(e.g.AlgeriaandRussia).Savingsfundsformulatetheiroperationalobjectivetospreadwealthacrossgenerationsbyaimingtomaximizetherealannualpayoutpercapitaorthepayoutasashareofgrossdomesticproduct(GDP).DependingonthesizeofpopulationgrowthandrealGDPgrowth,thevariationsinformulatingtheunderlyingobjectivecanhaveprofoundimplications.ForinstanceinacountrywithadecliningpopulationwhileGDPisgrowingrapidly,transfersin linewithGDPimplyfar largerdistributionstodistantgenerations.Assumptionsaboutthediscoveryoffuturewealthcanbeevenmoreimportant.Inpractice,severallargeeconomieshave,overtime,found

6 JensenandWatchekon(2004),RobinsonandTorvik(2005),Sala-I-MartinandSubramanian(2003),SteigumandThogersen(1995)

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newnaturalresourcedeposits thatreplacethoseexploited. Ignoringthisbasicfactcouldleadtotheaccumulationoftoohighasumoffinancialassets,asthecommoditywealthismassivelyunderestimated.

Fundsthataimtoimprovethereturnonfundedassetstendtomaximizereturnssubject to a given risk tolerance.The expected additional return is a functionof theriskthat thegovernmentor theowner iswillingtotake.Theoperationalobjectivecanbe formulatedasa returnobjectivebasedonanassessmentofhistoricdataonthetradeoffbetweenenhancedreturnandrisk.Asthelongevityofthesefundsisnotalwaysclear,therisktoleranceandinvestmenthorizonoftenremain implicit. The operationalization of the objectives of pension and otherliability-focusedwealth funds follows the asset liabilitymanagement approachappliedbythepensionfunds.Incontrasttothereserveinvestmentcorporations,thehorizonoverwhichtheliabilitiesmaterializeisoftenwellidentified.Thisallowsfor theexplicitmaximizationof thenet valueof the funds (inessence thenetpresentvalueoftheinvestmentsminusexpectedpaymentsfortheliabilities)overthe identifiedtimehorizonsubject torisk tolerance. Inpractice, thisprocess isalsosummarizedintheformulationofaconcretereturntargetastheoperationalobjective(e.g.AustraliaandNewZealand).

SWFshaveemergedascrucialoperatorsintheinternationalfinancialmarketsanddevelopments intheworldeconomyafterconsideringtheirkey interactionwith further institutional arrangements. The experience to date suggests thatgovernanceframeworkintherespectivecountriesprovidelittleindicationsastowhatinstitutionsdeterminetheSWF’spolicyobjectivesandoverallrisktolerance,its operational objectives, its investment guidelines andwhowill ultimately bethe executor of the latter. This remains of particular interest especially whenconsidering that the latterdeterminewhereSWFs’assetsare invested. Inanycase,theinvestmentpolicyshouldbeconsistentwiththebroadpolicyobjectives.Whiletheoperationalobjectivesdrivetheinvestmenthorizon,therisktoleranceand the investmentenvironment (includingassetclassesand theircorrelation,asset liability management and other constraints) will determine the strategicassetallocation.Allofthelatterarekeyissuesandparticularlypronetopoliticalpressure(especiallywhenconsideringthedecisiontoinvestashareofthefunds’assetsdomesticallyorabroad).Inthiscontextinstitutionalarrangementsemergeasdetrimentaltothefund’sinvestmentpolicy.

2.2. The magnitude of the SWFs: An assessment

SWFs,likeotherfinancialinstitutions,havenotbeenimmunetotheeffectsof the global financial crisis and to the sharp downturn in asset prices sinceearly2008.ManySWFshavesufferedsignificantlossesinthepresenceofthefinancialcrisis.Amajorpartofthefinanciallosseshasnotyetbeenrealized,asmanySWFsarelong-terminvestorsandhavenotneededtoliquidatepositions.Nevertheless,theselosseshavetobecommunicatedtothestakeholderslikethegovernmentandthepublicsoonerorlater.OverallSWFs,spurredonbyyawningglobaltradeimbalancesandacommoditypriceboom,haveroughly$3-4trillionundermanagement,whicharemoreassetsthantheglobalhedgefundsindustry.Attheendof2008SWFs based on oil and gas revenues accounted for 2/3

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of total SWFs; nevertheless, the proportion of non-raw material SWFs is on the rise.Forecastssuggestthatthisnumbercouldapproach$10trillionby2015whilefurtherestimationssuggestthat,despitetheeconomicandfinancialcrisis,SWFassetsundermanagementincreasedby18%in2008.Inlargepart,thisincreasecanbeattributedtothecreationofnewSWFs.Indeed,whilesomeSWFshavebeenaroundfordecades,28ofthe48SWFsidentifiedbytheU.S.GovernmentAccountabilityOfficewerecreatedsince2000,with12alonebeingestablished since 2005. These SWFs appear to be investing their capital inprivate,riskyassetswithconsiderablefocusonthefinancialsector.

Table 1. Outlook of several SWFs

Country Fund nameAssets

managed(in bn USD)

Incep-tion year

Com-modity7

Algeria ReserveFund 25 2000 Oil

Angola ReserveFundforOil na 2007 Oil

AustraliaAustralianGovernmentFutureFund(AGFF)

50 2004 N.C

Azerbaijan StateOilFund 1.5 1999 Oil

Botswana PulaFund 4.7 1993Dia-

monds

Brunei BruneiInvestmentAgency(BIA) 35 1983 Oil

Canada AlbertaHeritageFund(AHF) 17 1976 Oil

ChileEconomicandSocialStabilizationFund(ESSF)

6 2007 Copper

ChilePensionReservesFund 0.6 2007 Copper

China ChinaInvestmentCompanyLtd. 200 2007 N.C

CentralHujinInvestmentCorp. 100 2003 N.C

EastTimor Timor-LestePetroleumFund 1.2 2005 Oil,gas

7 N.Cstandsfornon-commodityfunds

16

HongKongHongKongMonetaryAuthorityInvest-mentPortfolio

140 1998 N.C

Iran ForeignExchangeReserveFund 15 1999 Oil

IrelandNationalPensionsReserveFund(NPRF)

29 2001 N.C

Kazakh-stan

KazakhstanNationalFund(KNF) 18 2000Oil,gas,metals

KiribatiRevenueEqualisationReserveFund(RERF)

0.6 1956Phos-phates

Kuwait KuwaitInvestmentAuthority(KIA) 250 1953 Oil

Libya ReserveFund 50 2006 Oil

Malaysia KhazanahNasionalBHD(KNB) 18 1993 N.C

MauritaniaNationalFundforHydrocarbonRe-serves

0 2006 Oil,gas

NewZea-land

NewZealandSuperannuationFund 10 2003 N.C

Nigeria ExcessCrudeAccount 11 2004 Oil

NorwayGovernmentPensionFund-Global(GPFG)

322 1990 Oil

GovernmentPetroleumInsuranceFund(GPIF)

2.6 1986 Oil

OmanStateGeneralStabilisationFund(SGSF)

8.2 1980 Oil,gas

PapuaNewGuinea

MineralResourcesStabilizationFund(MRSF)

0.2 1974 Minerals

Qatar QatarInvestmentAuthority(QIA) 40 2000 Oil

RussiaStabilizationFundoftheRussianFed-eration(SFRF)

127 2003 Oil

Saudi Arabia

VariousFunds 300 various Oil

17

Singapore

GovernmentofSingaporeInvestmentCorporation(GIC)

330 1981 N.C

TemasekHoldings 108 1974 N.C

SouthKorea

KoreaInvestmentCorporation(KIC) 20 2006 N.C

TaiwanTaiwanNationalStabilisationFund(TNSF)

15 2000 N.C

Uganda PovertyActionFund 0.4 1998 Aid

UnitedArabEmir-ates

DubaiIntern.FinancialCentreInvest-ments(DIFC)

na 2002 Oil

AbuDhabiInvestmentAuthority(ADIA) 875 1976 Oil

UnitedStates

AlaskaPermanentReserveFundCor-poration(APRF)

40 1976 Oil

NewMexicoStateInvestmentOfficeTrustFunds

15 1958 N.C

PermanentWyomingMineralTrustFund(PWMTF)

3.2 1974 Minerals

VenezuelaInvestmentFundforMacroeconomicStabilization(FIEM)

0.8 1998 Oil

Total assets under SWFs emerge as an impressive figure, representingamultiple of the assets held a decadeago; nevertheless, theymakeup lessthan1/2of global foreignexchange reserves, less than1/6of global pensionassets,around1/7ofglobalinvestmentSWFsandinsuranceassets,lessthan1/10ofglobalstockmarketcapitalizationandonly3%ofbankassetsworldwide.However, the aggregate comparison cannot diminish the importance ofindividual,oftenhigh-profile-investmenttransactions.CurrentaccountsurplusesofparentcountriesofmajorSWFshavenarrowedastradesurplusesdeclinedanddramaticallydiminishedoilandothercommodityprices reducedrevenuesfromsalesofnaturalresources,leadingtoavisiblydeceleratedaccumulationofforeignexchangereserves.Market-to-marketvaluesofSWFportfoliosarelikelytohavesufferedduringthefinancialcrisis.TypicalequityportfoliosheldbySWFsmayhave lost 45%betweenend-2007andearly 2009.Additional changes inportfoliovaluesmayresultfrompricevariationsinotherassetclasses.Overall,suchchangesinportfoliovalueshave,withveryfewexceptions,notbeenrealizedsofar,asSWFsareholdingontotheirinvestments.

Long-termprospectsforSWFsremainpositivealbeitthelossesinthecurrentfinancial crisis. Scenarios for the development of assets managed by SWFs

18

basedonpastperformanceof foreignexchangereservessuggeststhat in10years,totalassetsunderSWFmanagementarelikelytoamounttoUSD7trwiththe latter figure being two times larger than the current accumulated volume.Nevertheless,theunderlyingSWFgrowthpotentialiscontingentuponthefutureofglobalization.On the assumption that current account balances resume their recent trend of widening deficits in the US and strongly growing surpluses in the emerging markets, the fundamentals for SWF development remain strong.Ifsignificantreductionsincurrentaccountbalancesoccur,thenSWFinflowsaresettoremainclearlybelowthelevelsseenintherecentpast.Fromthelatter itbecomesclearthatSWFsremainparticularlysensitivetotheglobal macroeconomic risks such as exchange rate movements, commodityprice changes, trademovements, capital flows, global political risks, potentialprotectionisminrecipientcountries,andthepoliticalclimatebetweentheoriginandtherecipientgovernments.

SWFs have long investment horizons and generally have no commercialliabilities,henceinperiodsofmarketstresstheyarelikelytofacelesspressurethanmostprivate investors to reduce thesizeor increase the liquidityof theirinvestments.Theyarewellplacedtoplayacontrarianroleandhelptostabilizemarketsbyinvestingintimesofstress.Forexample,whentheglobalequitymarketfellsharplybetween2000and2002,theNorwegianGovernmentPensionSWFwasalargebuyerofglobalequities.AnumberofSWFshaveplayedanimportantstabilizingroleduringthecurrentfinancialcrisisbyprovidingaround$40billionofnewcapitaltosomeoftheworld’sbiggestcommercialandinvestmentbanks.

Takingabroaderview, theswitchofsomereservesfromgovernmentdebtintoSWFswhichinvestinawiderrangeofinstrumentsshouldhelptoimprovetheallocationofresourcesiftheseinvestmentsarebasedoncommercialcriteria.Investing in equities may also help to reinforce and bring to the surface thecommoninterest thatemergingmarketsandtheadvancedeconomieshave inthegoodperformanceofthecompaniesinvolvedandthemarketstheyoperatein.Ontheothersideofthecoin,SWFoperationsraiseconcernsontheirobjectivesandhowfartheirinvestmentswillbedrivenonlybyfinancialreturns.SWFobjectivesmightalsoservenationalpoliticalinterests,suchasaccessingmilitarytechnology,controllingstrategicresourcesormarkets,andinfluencingpublicopinion,withallofthelatterbeingrelatedtotransparencyaspectsoftheSWFs.

2.3. Commodity price fluctuations and the SWFs

SWFs are related to two principal challenges in the accumulation ofnational wealth over time. First, natural resources are exhaustible; once theyareextractedandconsumedtheyaredepleted.Similarly,superiorinternationalcompetitiveness of domestic industries can be a transitory phenomenon thatmaysubstantially change in thecourseof time. In this light,governmentsareconfrontedwithinter-generationalequityaswellasoftransformingthepresent-dayrevenuestreamsfromthesaleoftheresourcesorotherexportsuccessesintosustainableincome.Thesecondchallengeisrelatedtotheinternationalmarketforcommodities’highlevelofpricevolatility.Thisvolatilitymakesnaturalresourcescomparativelyriskyassetsfromwhichsocietiesmaywishtodiversify.Takingthe

19

aboveintoconsideration,thepotentialadvantagesofdelegatingnationalwealthmanagementtoaSWFcanberelatedtointer-temporalstabilizationwherefunds,especially stabilization funds, can help shield an economyagainst volatility inmarketsofcritical value foraneconomy,suchasoilorothercommodities. Inthiscase, theSWFsserveasa liquiditypoolwhich is replenishedat timesoffavorablecommoditypriceconditionsorreserveinflows,andwhichcanbedrawnuponincasesoflowassetpricesorshortageofreserves.

SWFs can be related to diversification outcomes. Oil or other commodityexporting economies often run substantial concentration risk from theirdependenceonthenaturalresourcetheysellininternationalmarkets8.Thisriskisparticularlysalientwithregardtotheexhaustibilityofnaturalresourcesaswellastothedangerofmisallocationofcapitalifthesaleofnaturalresourcesinturnleads toanappreciationof therealexchangerateand therebydiminishes thecompetitivenessofothersectorsintheeconomy(alsoaddressedasthe“Dutchdisease”effect).Thediversificationofnationalwealthbyinvestinginternationallyand in a greater range of assets can help reduce these concentration risks.Empirical assessment to date indicates that for resource-rich countries with resource funds, the establishment of the fund did not have an identifiable moderating impact upon government spending.Intermsofcausality,countrieswithmoreprudentexpenditurepoliciestendedtoestablishresourcefunds,ratherthan the fundpresence itself leading to the increasedexpenditure restraint. Inmany cases the establishment of resource funds may have helped maintaincautiouspoliciesinthecontextofongoingrevenuevariability.Nevertheless,thecoordinationof fundoperationswithoverallnationalfiscalpolicy(to theextentthatthisisdefinedasapolicyobjective)hasbeendifficult.Theseresultsseemtobestrongerforcountrieswheretheextentofrelianceonresourcerevenueshasbeenlarger.Intermsofpublicinvestmentprojects,inmanycasesresourceallocation has been determined by political motives rather than economicoutcomesoroptimalallocationofresources.

3. SWFs:Transparency, risks and macroeconomic considerations

AfterderivingacomprehensivedefinitionoftheSWFsitremainsofprimaryimportancetounderstandtherisksthatsuchfundsarefacedwithaswellasthetransparencythatfundsexperience.Letusfirstlookattransparencyaspects.

3.1. Assessing the transparency of the SWFs

SeveralattemptshavebeenmadeatanofficialrankingoftheSWFsbasedonriskassessmentcriteria.BVSWFRiskIndexranksthetop20prominentSWFsaccordingtothepotentialrisktheypresenttotheWesterninterests9.TheindexscoreseachSWFfrom1to5ineachoneofthefollowingcriteria10:

8 Dunning(2008),BaconandTordo(2006)9 www.breakingviews.com10 DetailedvaluesandrespectiveaspectsmeasuredaredetailedinAppendixA

20

1. Transparency:Thiscriterionassessesaspectssuchas:Whocallstheshotsforthefund?Doesthefundmakeitsinvestmentsusingclearlyidentifiedinvestmentcriteria

oristhefundsubjecttopoliticalcontrol?Doesthefundpublishdetailsofitsinvestmentsanditstrackrecord?

2. Strategic control:Thiscriterionassessesaspectssuchas:Hasthefundsoughtcontrolofcompaniesinstrategic–i.e.defense-related–

orsemi-strategic–suchasbanksandutilities–sectors?Hasthefundtriedtoinfluencedecision-making,eitherbybuyingalargestake

orviaboardrepresentation?

3. Political threat:Thiscriterionassessesaspectssuchas:How sympathetic is the sponsoring government towestern economic and

politicalinterests?Willthefundtrytointerfereanddoesithavetheclouttodoso?Istheorigincountry’sregimestable,preferablyademocraticregime?

Table 2. BN SWFs Risk Index11

SovereignWealthFund

Coun-try

Trans-parency

StrategicControl

Politicalrelationship

Totalscore

1ChinaInvest-mentCorpora-

tionChina 4 3 4 11

2QatarInvest-mentAuthority

Qatar 5 3 2 10

3National

DevelopmentFund

Venezu-ela

5 2 3 10

4AbuDhabiInvestmentAuthority

UAE(AbuDhabi)

4 3 2 9

5StateGeneral

RFOman 5 2 2 9

6 NationalFundKazakh-stan

4 2 3 9

7Stabilization

FundRussia 2 2 4 8

11 http://www.breakingviews.com/2008/01/04/Sovereign%20wealth%20SWFs%20index.aspx?sg=breakingstories

21

8BruneiInvest-mentAgency

Brunei 4 2 2 8

9 Economic and SocialStabili-zationFund

Chile 4 2 2 8

10 KuwaitInvest-mentAuthority

Kuwait 3 2 2 7

11 NationalStabi-lizationFund

Taiwan 4 1 2 7

12 Istithmar UAE(Dubai)

3 2 2 7

13 GovernmentofSingaporeInvestment

Corp

Singa-pore

2 3 1 6

14 Temasek Singa-pore

2 3 1 6

15 DubaiInterna-tionalCapital

UAE(Dubai)

2 2 2 6

16 KoreaInvest-mentCorpora-

tionKorea 2 2 2 6

17 KhazanahNazional

Malaysia 2 1 2 5

18 AlaskaPerma-nentFund

US 1 1 1 3

19 AlbertaHeri-tageSavingsTrustFund

Canada 1 1 1 3

20 GovernmentPensionFund

Norway 1 1 1 3

TheBVindexsuggestssomesurprisingpointstoconsider.ChinaInvestmentCorporation, the giant $200bln SWF that recently acquired stakes inMorganStanleyandBlackstone,isthetopwith11points.ButonlytwootherSWFsareplacedinthiscategory:theQatarInvestmentAuthorityandVenezuela’sNationalDevelopmentCorporation (bothscored10points).All three fundsalsoscoredhighmarksforlackoftransparency.AfurthernineSWFsscoredbetween7and9ontheBVindex,whichmakesthemmediumrisk.ThisgroupincludesRussia’sStabilizationFund,whichturnsouttobelessriskythantheAbuDhabiInvestmentAuthority, the flagship SWF for a country recently hailed by former PresidentBushasabeaconfor theMiddleEast.That isbecausetheRussianfundonly

22

buysbondsaccordingtoclearcriteria,whileADIA,whichrecentlytookastakeinCitigroup,won’tevenconfirmthesizeofitsfunds.Nevertheless,theindexomitsseveralhigh-profilestate-ownedentitiesthathavealsocausedalarm.Russia’sGazpromandChinaDevelopmentBankwouldnodoubtscorehighlyontheindexcriteriabutareoperatingcompanies,notSWFs.Alsoexcludedaresomewesterninvestmentgroupswithclosestatelinks,suchasCalpersandHermes,theUSandUKpensionfundswhichareoccasionallypaintedwiththeSWFbrush–sincethesehaveclearobligationstoschememembers.

Overall,theindexpointstotwoclearconsiderations:ThefirstisforwesternpoliticianssuggestingthattheyshouldacknowledgethefactthatthebulkoftheSWFsposelittlethreattowesterninterests.8outofthetop20SWFsscored6pointsorless.ThatranksthemonaparwithmanyrespectedUSandEuropeanprivate equity firms and hedge funds, which also take controlling interests incompanies and are often far from transparent. The index suggests that evenhigh ranking SWFs should not be automatically penalized. They just requirecloserscrutiny.Dealsshouldbeassessedonacase-by-casebasis.Thesecondconsideration regards theSWFs themselves: if theyarealarmedat their highranking–andtheriskunscrupulouswesternpoliticiansmightuseitasacoverforprotectionism–thesolutionliesintheirhands.MostSWFscouldreducetheirscoresimplybyimprovingtheirtransparency.Ifthisistheirgoaltheyshoulddosoassoonaspossible,actingpriortothepublicationoffuturerankingassessments.

An alternative index of transparency is the Linaburg-Maduell Transparency Index developed by the Sovereign Wealth Fund Institute. Theindexassesses10essentialprinciplesthatdepictSWFtransparencytothepublicusing thePensionFundofNorwayasa leading transparencyexampleandbasis.Eachoftheprinciplesadds1pointoftransparencytotheindexrating.TheindexisanongoingprojectoftheSovereignWealthFundInstitute(SWFI).TheminimumratinganSWFcanreceiveis1;however,theSWFIrecommendsaminimum ratingof8 inorder toclaimadequate transparency.TransparencyratingsmaychangeasSWFsreleaseadditionalinformation.Therearedifferentlevelsofdepthwithregardstoeachprinciple;judgmentoftheseprinciplesislefttothediscretionoftheSWFI.TheprinciplesemployedbytheLinaburg-MaduellTransparencyIndexassessaspectslike:

• Doesthefundprovidehistoryinformationincludingreasonforcreation,originsofwealth,andgovernmentownershipstructure?

• Doesthefundprovideup-to-dateindependentlyauditedannualreports,ownershippercentageofcompanyholdings,andgeographiclocationsofholdings,totalportfoliomarketvalue,returns,andmanagementcompensation?

• Does the fund provide guidelines in reference to ethical standards,investmentpolicies,andenforcementofguidelines?

• Doesthefundprovideclearstrategiesandobjectives?• If applicable, does the fund clearly identify subsidiaries and contact

information?• Doesthefundidentifyexternalmanagers?WithregardstothecountriesoftheCaspianregion,compatiblescoresare

9forAzerbaijan,5forRussia,and2forKazakhstan.Divergencesinthescoresarean indicationof thewillingnessof the respectivegovernments to discloseinformationwhichdependon(i) thescaleof the fund,(ii) the learningandthe

23

harmonizationwiththetransparencytools,and(iii)thecooperationwithsuitableregional and global organizations and initiatives like the Extractive IndustriesTransparencyInitiative(EITI).

Figure 3. Transparency scores for the SWFs of the Caspian basin countries

3.2. SWFs: Risk overview

OthertypesofrisktobeconsideredwhenexploringSWFsarerelatedtotheoperational,economicandpoliticalenvironment,totheinvestmentchoicesandto theexistingfiscaland institutionalstructures.Startingwithpolitical risks theaboveareassessedinthefollowingsections.

Political risk

The experiences strongly suggest that SWFs are likely to face politicalrisks inbothdevelopedanddevelopingeconomiesdue to the inherentsalientcharacteristicofthefunds,i.e.thegovernmentownership.However, the political risk in developing economies appears to be higher due to the uncertainties stemming from harder-to-anticipate regime changes and weaker regulatory frameworks. Nevertheless,sinceakeyobjectiveofthefundistoreapreturnshigherthanthoseofferedbyfixedincomeinvestments(whichgenerallyofferlow-risk,capital-protectionand lowreturns),exposureto thehigher levelofpoliticalrisksfromdevelopinghostcountriescanbejustifiedbythehigherrateofreturns.Calibratedpolitical-risk-reductionapproachandstrategythatcoverthepolitical,economicandsocialdimensionscanhelptheSWFstoreducetheirriskexposurecausedbytheirrespectiveinvestments.GiventhecurrentclimateofskepticismovertheSWFs,theneedforpoliticalriskmanagementbytheSWFscanonlybe

 

Linaburg-Maduell Transparency Index (score)

2 

5

9

0 2 4 6 8 10

Kazakhstan 

Russia

Azerbaijan 

24

expectedtorise,regardlessofwheretheychoosetoinvest12.It is important to remember thatSWFsarepartlyapolicy response to the

growing calls from the general public to use the burgeoning reserves moreproductivelysothattheycanmakeabiggercontributiontothedomesticwelfare.ThereareconcernsthatSWFsmaypursuegeopoliticalorstrategicobjectivesandthatthoseobjectivesmaycomplicatetheirpursuitofprofitmaximization.Whilethereissomeelementoftruthtothis,suchconcernstendtobeoverestimated.TheprimaryimpetusbehindthecreationoftheSWFsisthepopularbeliefthatapotentiallyvaluablenational resource isbeingwasted.Morespecifically, theprimaryconcernamongbothpolicymakersandthegeneralpublicisthattherateofreturnontraditionalreserveassetsis“toolow”andthatitisincurringalargeopportunitycostbyforegoinghigher-returnassets.

General economic activity risks

The risks that SWFs face in their investment operations can be classified into four broad categories: financial, operational, regulatory, and reputation risks.Themainfinancialrisksaremarketrisk(interestrate,foreigncurrency,equityandcommoditypricerisks),creditrisk(issuer,counterparty,andsettlement risks), and liquidity risk.Themain operational risks include peoplerisk(incompetenceandfraud),businesscontinuityrisk,processrisk,technologyrisk, and legal risk.Themain regulatory risk stems from changes in the lawsandregulationsgoverningtheoperationofSWFsincountriesoforiginaswellas recipient countries, or from changes in the application of such laws andregulations. Reputation risk is the potential that negative publicity regardinga SWF’s business practices, whether true or untrue,may cause a decline ininvestmentreturns,costlylitigation,orlossofcounterparties,orimpairthehomecountrygovernment’s international standing.The riskmanagement frameworkshould includereliable informationand timely reportingsystems,whichshouldenable the adequate monitoring and management of relevant risks withinacceptableparametersandlevels,controlandincentivemechanisms,codesofconduct,businesscontinuityplanning,andanindependentauditfunction.

Themeasurement andmanagement of financial risks is typically done byusingquantitativemethodologiesandmodels.Tocomplementthesemodelsandtomitigate“modelrisk,”stresstestsshouldregularlybeconductedtoevaluatethe potential effects of macroeconomic and financial variables or shocks. Toassess,manage,ormitigateoperational risks, thereshouldbeanestablishedand documented framework that has clear lines of responsibility, segregationofduties,and reliablecontrolmechanisms.Codesofconductand recruitmentpolicies are important to ensure the professional and ethical behavior of staffinvolvedinthefund’soperations.ToensurethattheSWFcancontinueoperatinginthecaseofatechnologybreakdownornaturaldisaster,contingencyplanning,including alternative sites of operation, is an important part of the framework.Inmitigating regulatory and reputation risks, it is important to have adequatesystems to track current regulatory and legal requirements in each recipientcountrythattheSWFsinvestin.Tosatisfytheownerandthegoverningbodythat

12Rajaratnam(2008)

25

thoserisksintheSWFsaremanagedproperly,theriskmanagementframeworkshouldbesubjecttoaregularindependentaudit.

Riskobjectivesaretypicallydeterminedbytheownerorthegoverningbodyof the SWF. While broad principles are generally established within the lawor by the owner of the SWFs,more specific riskmanagement objectives aretypicallylaidoutbythefund’smanagers.SWFsindicatethattheseareusuallysetastrackingerrorlimitsorriskbandsrelativetoabenchmarkindexfortacticalmanagement.SWFsareparticularlysensitivetotheglobalmacroeconomicriskssuchasexchangeratemovement,commoditypricechanges,trademovements,capitalflows,globalpoliticalrisks,potentialprotectionisminrecipientcountriesand the political climate between governments. In addition to tactical risklimits, SWFs typically observe general constraints on investment classes andinstruments.MostSWFrespondentsnotethattheyarenotallowedtoborroworuseleverage.Severalfundspointoutthattheyinvestincertainassetclassesthatuseleverage(e.g.,privateequityandmulti-strategyfunds)oremployderivativesforthepurposeofprotectingthevalueorreturnoftheirinvestments.Inaddition,manySWFshaveestablishedlimitsonstakesthattheycanholdincompanies,the typesof investment theycanhold (investmentgradeassetsonly),andonothercharacteristicsoftheirportfolio.

ForseveralSWFs theoperational risk iscontrolled through theseparationofresponsibilities,includingfront,middle,andbackoffices.SWFsalsomitigateoperational risk through the implementation of codes of conduct and policiesonconflictof interest forstaffandthegoverningbody,regularreconciliationofaccounts,andregularandactiveaudits.SeveralSWFsnotethattheyuseback-upfacilities,globalcustodianservicesandbusinesscontinuityplans,aswellasregularlyreviewedoperatingmanuals,tomitigateoperatingfailures.OneSWFalsomonitors operational risk with early warning indicators and by assigningdirectresponsibilityforoperationalriskmonitoringtolinemanagers.SomeSWFsnotetheuseofworkflowautomationandfrequentreportsbythemiddleofficetomanagementtoensuretimelycommunicationandearlywarningofoperationalrisks.

Investment risks and risk tolerance

Risktolerancereferstoaninvestor’swillingnessandabilitytohandledeclinesinthevalueof itsportfolio.Forexample, itcanbeexpressedasthedegreeofuncertainty that an investor can accept with regard to a negative change inthevalueof theportfolio13Abenchmarkportfolio isa referenceportfoliooranindexconstructedonthebasisoftheinvestmentpolicy.Itservesasabasisforcomparisonof theperformanceof theactual portfolio.Asset class refers to agroup of securities that exhibit similar characteristics, and behave similarly inthefinancialmarket.Examplesofassetclassesincludestocks,bonds,andrealestate.The investmentpolicyshouldguide theSWF’sfinancial riskexposuresandthepossibleuseofleverage.Exposurestofinancialrisks(includingmarket,credit,andliquidityrisks),theuseofderivatives,andleveragecommensuratewiththeSWF’sinvestmenthorizonandrisk-bearingcapacityarekeydeterminantsof

13http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf

26

itsabilitytomeetitsinvestmentobjectivesandcontributetothefinancialmarketsstability.Suchexposuresandtheuseofderivativesandleverageshouldbewellunderstood,measuredandmanagedappropriately.

Derivativesareuseful inSWFs’operations - somemayuse themonly forhedgingpurposes,whereasothersalsousethemforactivepositiontaking.While SWFs typically do not use much leverage, this is often an integral part of an SWF’s investment, risk management, and cash management frameworks. Itmayshowup inavarietyof forms, including traditionalborrowingtofinanceinvestments, use of futures and options contracts, interest rate and currencyswaps,repos,andbuy/sell-backoperations.Inaddition,leverageisanintegralpartof investingincertainassetclassessuchas“alternativeinvestments”andreal estate (including froma rateof returnand froma taxperspective,whereappropriate).ItisacoreprinciplethatSWFs’overarchingobjectiveistomaximizerisk-adjustedfinancialreturns,giventherisktoleranceleveloftheowner.

SWFs’investmentdecisionsandactivities,therefore,shouldbeguidedbyandbeconsistentwiththisobjective.TheSWFmayhaveaframeworkthatidentifies,assesses,andmanagestherisksofitsoperations.ItisimportantfortheSWFtohaveastrongriskmanagementculture,whereseniormanagementisengagedincraftingandenforcingriskmanagementprocesses,andawell-functioningriskmanagementframeworktoensurethatitisabletoidentify,assess,andmanageits risks toprotect itsassetsandstaywithin the tolerance levelsasset in theinvestmentpolicy.Adherencetohighstandardsinriskmanagementwithsoundoperational controls and systemswill alsohelp achieve theaimof preservinginternational financial stability as well as maintaining a stable, transparent,and open investment environment. The general approach to the SWF’s riskmanagement frameworkshouldbepubliclydisclosed.Publicdisclosureof theSWF’sgeneralapproachtoitsriskmanagementpoliciesandkeyactionsrelatedto governance and the soundness of its operations reassures that the fund,its governing body, ormanagement adheres to a high standard ofmanagingoperational,regulatoryandreputationrisks.

TheinvestmentpolicyguidestheSWFinimplementingactivitiesconsistentwith theapproved investmentobjectivesandstrategies,andrisk tolerance,aswellas its investmentmonitoringprocedures.Although there isnoset formulathat suits all situations, the investment policy, including the strategic assetallocation,shoulddrawuponappropriateportfoliomanagementprinciples.Thestrategic asset allocation is typically embodied in a benchmark portfolio anddetermined by the SWF’s policy purpose, liability profile, horizon over whichexpected returns and risk are defined, and characteristics of different assetclasses.Theinvestmentpolicynormallydefinespermissibleassetclassesandgivesguidanceonconcentrationofriskwithregardtoindividualholdings,liquidity,andgeographicalandsectoralconcentration.In linewiththepolicypurposeofthefund,thestrategicassetallocationmaysetcertaininvestmentparameters,for example, exclusively investing in foreign assets. In addition, the strategicassetallocationmayconsidertheSWF’sinvestmentsinconjunctionwithotherassetsor liabilitiesof thecountry,resulting in, forexample, investing inassetsnegatively correlated with the country’s natural resources.As the parametersandassumptionsunderlyingtheSWF’sinvestmentpolicy–includingitsstrategicassetallocation–changeovertime,aperiodicreviewisneeded(asitiscurrently

27

donebyfundsinAustralia,NewZealandandSingapore).Therisk tolerance isakeyconstrainton themaximizationof theexpected

returnovertheinvestmenthorizon.Theriskconstraintisbasedontheultimatestakeholders’ willingness and ability to take risk. Ideally, the risk preferencefocusesontheentireinvestmenthorizon,andcantaketheformofamaximumacceptable deviation at the points ofwithdrawals and the risk/return tradeoffsat thesepoints. Inotherwords, there is lessofaneedtobeconcernedaboutdailyvolatilityiftheinvestmenthorizonisayear.Forexample,thevalueoftheinvestmentcanincreaseanddecreasedailybytenpercentbutthekeyaspectis the value in a year’s time when the withdrawal takes place. However, inpractice,investorsmayhavesomeconcernsaboutshort-termvolatility.Atypicalconstraint innewfunds is thereforethesponsor’sdesiretopreservecapital.Acapitalpreservationobjectiveisequivalenttozerotolerancefornegativereturns,ineithernominalorrealterms.Ifformulatedwithregardtothestartofthefund,thisconstrainthasatimedimension:overtimeabufferisbuiltuptoallowmorerisk.Inotherwords,addingthisconstraintofcapitalpreservationallowseasingintoarisktolerancethatismorereflectiveoftherealinvestmenthorizon.Inthisregard, an early startwith investing resources to build up a buffer, having anoversightbodywithexperiencedandrespectedprofessionals,andeducatinglaystakeholderscanhelplimitthecostimposedbythisadditionalconstraint14.

Cross-border investments and the risk of protectionism

ThebiggestexternalriskfacedbynewSWFsisthatoffinancialprotectionism,especially from industrialized countries. The cross-border investments of SWFs not only affect the legitimate interests of home countries but also those of host countries.As such, foreign investors,whether state-ownedornot,havetoconformtohost-countrylawsandregulations.However,host-countrygovernmentsandcitizensaresometimesmorewaryofstate-ownedinvestorsthanprivatesectorinvestors,andareparticularlyconcernedthattheirinvestmentsmaybepartlydrivenbynon-commercialobjectives.Ataminimum,thoseconcernswillsubjectSWFstogreaterscrutinybyhost-countrygovernmentsthantheirprivatesectorcounterparts.Moreseriously,thoseconcernsmaygivewaytovariousformsof financial protectionism in host countries. Financial protectionism constrainshowandwherethenewSWFscaninvestandthusimposesasignificantcost.

Thefirstmajor rejectionofanArabSWF investment involvedDubaiPortsWorld'sacquisitionofP&O,aBritishcompany thatoperatedsixmajorportsintheeasternUnitedStates.ConcernsaboutnationalsecurityledmanyintheU.S.CongresstotrytoblocktheDubaicompany'soperationofU.S.ports,anissue settled only when, in March 2006, Dubai Ports World agreed to handoveroperationofthoseportstotheU.S.entities.SimilarconcernswereraisedbothinNewZealandandSwedenfollowingDubai'sofferstobuytheAucklandInternational Airport, and the Swedish stock exchange OMX. Though DubaiwithdrewitsofferfortheAucklandairportinthefaceofopposition,itcontinuestoseekthepurchaseofOMX,aspartofadealinwhichitwillexchangeOMXforNASDAQ's28%shareintheLondonStockExchangeandanas-yetunspecified

14 Dasetal(2009)

28

amountofequityinNASDAQitself.OnSeptember20,2007,PresidentGeorgeW. Bush stated in a news conference about the then-pending acquisition ofNASDAQ that an investment by a government-owned company in NASDAQwouldbesubjecttoreviewbynationalsecurityagencies,althoughheprovidedaprovisionalwelcomeofthedeal15.

Fiscal and institutional risks

The prospect of government support forSWFsmay encourage excessiverisk-taking. The flip side of this argument is that using SWFs to support thegovernmentwillalsocreateserious risks forSWFs. Inparticular, therehas tobeaclear-cutseparationbetweentheforeignexchangeassetscontrolledbytheCentralBankandthosecontrolledbythefund.TheremustbecleargroundrulesforensuringthatSWFresourceswillnotbeusedtosupplementthecentralbank’straditionalreservesintheeventofafinancialcrisis.Otherwise,havingtoliquidatelong-termassets,whichare likely tobeamajorpartofanSWF’sportfolio,onshortnoticewillbringaboutmajorlossesfortheSWF.More generally, serious financial risks for SWFs will ensue if the government views their assets as free fiscal resources to be used ad hoc so as to meet various fiscal needs. ThevastmajorityofreservesarenotfiscalreservesbutCentralBankreserveswith counterpart liabilities.The balance sheet of even the best-runSWFswillsufferifthegovernmentviewsSWFassetsasfiscalassetstobeusedfreelyatitsowndiscretion.

Overall, new SWFs simply do not yet have the institutional capacity toeffectivelymanagea portfolio of high-risk, high-return investments.SWFsarefinancially sophisticated investors with large investments in alternative assetclassessuchasprivateequity,venturecapital,andrealestate.Furthermore,theyareoftenactiveinvestorsseekingtocontroloratleastinfluencethemanagementofcompanies. It isnotonlyunrealisticbutalsodownrightdangerous forsomecountriestobelievethatitispossibletobuildcapacityovernight.Intheabsenceof adequate investment management capacity, including risk managementcapacity, pursuing investment strategies creates dangerously high levels ofrisk.Nevertheless,popularpressuresforprofitsmayencourageSWFstotrytorunbefore theycanwalk, topursuehigh-risk,high-return investmentswithoutadequatecapacitytohandlerisk.Succumbingtosuchpressuresentailsaclearriskoflarge,evencatastrophic,investmentlosses.Inaddition,theparticipationofa foreignSWF inafinancial institution (credit institution)mayendanger theeffective supervision of this institution. Financial supervisors could experiencedifficultieswhentheyattempt, for instance, in theexerciseof theirsupervisoryfunction,todeterminewhethertheparticipationoftheSWFinabankjeopardizesthe‘soundandprudentmanagement’ofthecreditinstitution16.

15http://www.meforum.org/1863/sovereign-wealth-funds-investment-vehicles-for16BartDeMeest.Needforamultilateralapproachtosovereignwealthfunds.PolicyBriefNo.

4–May2008

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3.3. SWFs and the macroeconomic implications WheretheSWF’sactivitieshavesignificantdirectdomesticmacroeconomic

implications, those activities should be closely coordinated with the domesticfiscal andmonetary authorities, so as to ensure consistency with the overallmacroeconomic policies. Since SWFs are often created for macroeconomicpurposes, their operations should support and be consistent with a soundoverallmacroeconomicpolicy framework.The SWF’s operations can have a significant impact on public finances, monetary conditions, the balance of payments, and the overall sovereign balance sheet.Thus,operationsoftheSWFthathavesignificantmacroeconomicimplicationsshouldbeexecutedin coordination and consultationwith the competent domestic authorities. Forinstance,transactionsthat involveanexchangebetweendomesticandforeigncurrenciesbyaSWFmayaffectmonetaryconditions, theexchange rate,andthedomesticdemandconditions.Broadlyspeaking,therearethreemainkindsofsovereignwealthfunds.Thefirstgroupcontainsthenaturalresourcesfunds,withanestimated70%oftotalsovereignwealthfundassetholdingsinthehandsofresource-richcountries,suchastheUnitedArabEmiratesandNorway.Thefocusof thesefunds is tomaintaineconomicstabilityagainstcommoditypricefluctuationsandtoensurethatfuturegenerationswillnotbedisadvantagedbytheexploitationofnaturalresourcesbythecurrentgeneration.Thesecondgrouprelates to the foreign reserve funds, and notably includes a number ofAsiancountriessuchasChina,KoreaandSingapore.Thefocusofthesefundsshouldbetohedgeawaytheimpactofriskfactorsbehindthesecommercialsurpluses,andalsotogeneratehigherreturnsthanlocalsterilizationbondcostsrelatedtotheissuanceofsovereigndebtaimedatreducingthemonetarybaseexpansionrelated to capital inflows.The last groupof funds,whichaccounts for amoremarginalfractionoftotalsovereignwealth,containsthepensionreservefundsforcountriessuchasNewZealand,FranceorIreland,whichhavesetasideaportionof their pension funds and manage them separately to prepare for an agingsociety.Recentadvancesindynamicassetpricingtheoryhaveinfactpavedthewayforabetterunderstandingofoptimaldynamicassetallocationdecisionsforsuchlong-terminvestors,bypreciselytakingintoaccountthestochasticfeaturesofthesovereignfundsendowmentprocess(wherethemoneyiscomingfrom),thestochasticfeaturesofthesovereignfund'sexpectedliabilityvalue(whatthemoneyisgoingtobeusedfor),andthestochasticfeaturesoftheassetsheldinitsportfolio.

Forexample,inthecaseoftheNorwegiansovereignfund,whichisanaturalresourcefundthathasbeensetuptohelpmeetfuturepensionpayments,theoptimalallocationstrategyshouldinvolveashortpositioninoil/gascommodityfutures,ora longposition instocksofcompaniessuchasairlines,companiesthat benefit fromdecreases in oil prices, soas todiversify away someof theriskexposureinthecountries'revenues.Itshouldalsoincludealongpositionininflation-linkedsecuritiesthatwillhelpthesovereignstatetohedgeawaysomeoftheinflationuncertaintyinfuturepensionpayments.Suchportfoliostrategiesare theequivalent for sovereignwealth fundsof the liability-driven investment

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strategiesrecentlydevelopedinthepensionfundsindustry17.TwomajorconsiderationsusuallyguidetheallocationanddistributionofSWF

assets.Thefirst is theaccumulationandwithdrawalrulesregardingthefund’sfuturecashflowswhereapplicable.Thesecondisthefund’sobjectives.Together,theseconsiderationsdrivethestrategicassetallocation,whichreflectsthereturnobjective,risktolerance,andidentifiedconstraints(suchasliquidityandfinancingneeds,investmenthorizon,legalandregulatoryrequirements).SWFsmayholdassetswithnegativecorrelationtothecountry’smajorexports(oil)oroffsetthepriceriskoffutureimports(dependingonthecountry’sriskprofile)viaitsstrategicasset allocation decisions. SWFswithout identified liabilities allow for amoreexclusivefocusonareturnobjectiveandacceptablelevelofrisk.However,forsomeSWFs,sterilizationinstrumentsusedtomopupexcessliquiditymayneedtobeconsideredas liabilities,especially froman integratedassetand liabilitymanagementperspective.TheobjectivesofSWFscouldbeunderminedbytheaccumulationof liabilitieselsewhere in thepublicsector.Somefunds,suchasthepensionreservefunds,mayhaveidentifiedliabilitiestobematchedwithinthestrategicassetallocationframeworktoallowforaclearoperational frameworkandtransparentobjectives.

Funds’allocationsofsovereignreserveassetstodomesticinvestmentshavemacroeconomic implications, especially for developing and emerging marketeconomies.To invest domestically, SWFs would typically need to convert part of their accumulated assets back into domestic currency, possibly reversing the economic policies that led to reserve accumulation.Investingdomesticallycouldstimulatedomesticdemandwith inflationaryconsequences.Issuesof fiscal accounting, transparency, and risk couldalsoemerge if thoseinvestments are actually government spending operations that should takeplacewithinthebudget.Therefore,domesticinvestmentsaregenerallyseentobe ruledout inSWFs.Different typesofSWFscould havemarkedly differentstrategicassetallocationsreflectiveoftheirdifferentobjectivesandconstraints.Stabilization funds, for instance, are generally conservative in their strategicassetallocation,usingshorterinvestmenthorizonsandlowriskreturnprofiles,orotherinstruments(perhapslonger-term)thatvaryinverselywiththeriskthefundismeanttocover.Typically,suchfundsaredesignedtoinsulatethebudgetfromterms-of-trade shocks and to meet contingent financing requirements. In thisregard,theyareakintoreserves,whicharemanagedforsafetyandliquidity,anditisonlyaftersuchconsiderationsaresatisfiedthathigherrisk/returnobjectivesareset.Fundswithlong-termobjectives,suchassavingsfunds,maybebetterabletoaccommodateshort-termvolatilityinassetreturns.Nonetheless,savingsfunds and pension reserve funds also aim to preserve aminimumamount ofcapital, in real terms,so that thepurchasingpowerof the fund isguaranteed.Pension reserve funds with explicit liabilities typically design strategic assetallocationbenchmarksthatpreservetheirsolvency.

17http://www.edhec-risk.com/edito/RISKArticleEdito.2009-02-24.4440

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Despitethesebenefits,manygovernmentsintheWestareconcernedaboutinvestments by SWFs. The concerns are based on three domains: nationalsecurity, corporate governance, and financial stability. The worries that areexpressed themost involveconcernsofnationalsecurity.Governments in theWestfearthatSWFsarebeingusedbygovernmentstopursuetheirgeo-strategicgoals,ratherthanpureprofit-maximization.Thegovernmentasashareholder,bymeansofinvestmentsthroughSWFs,distinguishesitselffromothershareholdersbecause thegovernmentmaydrawbenefits from itsparticipation inways thatother shareholders cannot. As has been indicated, SWFs were at one timeconsideredthe‘saviors'offinancialinstitutionsthatranintotroubleasthecreditcrisiswidened.However,someeconomistswonderedwhetheritisreallydesirablethatcreditinstitutionsthathavemadeseriouserrorsofjudgmentwhengrantingmortgage loansshouldnotsuffer theconsequencesof theirmistakes. Indeed,thefunctioningofthefreemarketisbasedonweakcompaniesdisappearingandonthesurvivalofonlythebestcorporations.StatesarealsoconcernedwiththepossibleconsequencesofinvestmentsbySWFsuponfinancialstability.Thisisarguably themost real and pressing concern. The enormous amounts SWFshaveattheirdisposalmaketheiractivitiesof‘systemicimportance.’Thismeansthatnegativeconsequencesoftheiractivitiesmayendangertheentirefinancialsystem.WhenaSWFwould,forinstance,suddenlysellitsstakeinacorporation,thiscouldgiverisetounrestofthefinancialmarkets.OthershareholdersofthiscorporationmayfearthattheSWFhasobtainedmoreinformationthantheyhaveandconsequentlytheymaywanttoselltheirstakestoo.Thismayspillovertoothermarketparticipantsandresultingeneralfinancialunrest.

Turning tosupportivearguments in favorof theSWFs, recent investmentsin developed financial institutions are not financial resources buried inthe Persian Gulf and discovered by the leaders of those institutions. Theassets of the SWFs already are invested abroad - by definition.A significantproportion already is in US dollars probably in the United States. Thus,when SWFs invest in a US financial institution, only the form of its USinvestment is changed. The SWFs sells one US asset and buys another 18.Contrarytowhatthecomfortingnarrativemightsuggest,acountryseekingtouseitsholdingsofdollarssoastoinfluencesuitablepolicyhasoptionsthatfallshortofthe“nuclearoption”ofdumpinglargequantitiesofdollarreserves.Acreditorgovernmentcouldsellholdingsof“risk”assetsandpurchase“safe”assets,creatinginstabilityincertainsegmentsofthemarket.Thiscouldbedonewithouttriggeringtheappreciationofitsowncurrencyagainstthedollarordirectlyjeopardizingitsexports.Acreditorgovernmentcouldchangehowit intervenes inthecurrencymarket.A country, for example, could halt its accumulation of dollars withoutendingallinterventioninthecurrencymarketifitsellsallthedollarsitbuysinthemarketforothercurrencies.Also,acreditorgovernmentcouldstopinterveninginthecurrencymarket,haltingitsaccumulationofforeignassets,whetherindollars

18 http://www.iie.com/publications/papers/paper.cfm?ResearchID=892

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orothercurrencies.Acreditorgovernmentcouldhaltitsinterventionandsellitsexistingstocksofdollarsanddollar-denominatedfinancialassets, the“nuclearoption.” If it held a large equity portfolio, this could include large stock sales 19.

4. SWFs: Assessing governance

AssessmentofthenatureoftheSWFsandoftherisksassociatedwiththelatterindicatestheprimaryimportanceofthegovernancequalityexperiencedbythefunds.Inthiscontextitremainsinterestingtoidentifythesegmentsandthefactorsthataffectthedevelopmentofthelatter.

4.1. SWFs, public control and public disclosure policy

Often,theofficialsofthecountriesofsimilarSWFsindicatethateveniftheSWFsdoneedregularpromulgationofinformationontheiractivity,thisinformationshouldbemeasuredoutindosesunderthestrictcontrolofthegovernment.Theargumentsbehindthatarewellknown–theSWFisaspecificstructure,operatingsometimeswithcolossalresources.SWFsaimatthesolutionofstrategicissuesofthestateandthustheyremainveryvulnerableintheeyesofoutsiders.Leaksof important information could harm the state interests. Therefore, it is betterto be reassured and preclude all possibilities of promulgation of informationregarding questions of how and where the SWF’s resources are managed.Actually, amid the existent 56 similar SWFs, as we can see from practice, the best performing ones are those which truly have real public control and access to most of the information. Adherencetostateinterests,i.e.profitableworkoftheSWFandbetterintegritywiththemacroeconomicgoalsofthestate,isparticularlywelltracedhere.Onthecontrary,closedSWFsareverydubiousintheirstategoalsandinformationontheirefficientoperationismissingor,toputitmildly,isopentoquestion.

SWFs as financial structures working in extremely sensitive financial andinvestmentsitesshouldofcoursehaveaspecialpromulgationpolicy,say,differentfromthatofthestate’sbudget.However,thatdoesnotdisaffirmtheavailabilityofamoreclear-cutandfirmpolicyofpubliccontrolofinformationandaccesstoit,butstronglyimpliesit.Followingcircumstances,needforratherfocusedpubliccontrolcouldpossiblybeexplainedinthiscase:

1. The state establishes and manages the SWF on behalf of the society and it is accountable to the society.Therefore,mentioningsomeseparateandout-of-public-controlpolicyoftheSWFscontradictsthegenerallyknowncanonsofstatebuilding.Thatisparticularlythecaseifthematterregardsthedemocraticstate. It is important toensure that thecontrol ispublicandnot imitated. It isalsoimportanttoconsidertheactualsituation,theconditionsandthedevelopedpracticeofdecisionmakinginthestate.WithregardstothecaseofAzerbaijan:intheSupervisoryBoardoftheStateOilFundofAzerbaijan(SOFAZ),officiallyonlythePresidentoftheAcademyofSciencesofAzerbaijanrepresentsthesociety.

19 Setser(2008)

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Indifferenceandinactivityoftheaforesaidpersontothisissuebringsthepubliccontroloverthefundtonothing.AtthesametimetheEITIissuccessfullybeingrealizedinthecountryandthereisastrongcivilsector,capableenoughtonotonlycriticizethegovernmentbuttoalsointroduceamotiononimprovementofthe funds’ policy. Thus, the conventionality ofAzerbaijan implies that the civilsector successfully engaged in the EITI can effectively exert control over thefund.

2. An SWF administers colossal resources, which occasionally exceed the capacity of the state budget, thus mistakes could cost too much.Intheoverwhelmingmajorityofcases,totalassetsoftheSWFsexceedthebudgetsofthecountries theyrepresent.Stepwiseexamination,discussionandeventuallyadoption of the state budget by the respective Parliaments have become apracticewithanestablishedfoothold.HoweverinthecaseoftheSWFs,thiskindoftrackingsystemdiffersfromcountrytocountryandinthemajorityofcases,itisjustbeingformed.Adoptionofthenextyear’sstatebudgetasalawimpliesthesamenecessarypublicresponsibilitywhichisstillmissinginmanySWFs.It isgenerallyknownthatdiscussionandadoptionofthelawonthenextyear’sbudgetintheParliament,inadditiontoeverythingelse,hasthepurposeofsecuringthegovernmentagainstpossiblemistakesandalop-sidedapproach.Theessentialconsensusonmoreoptimalregistrationoffinancingofstateprioritiesbetweenthe government and the legislators is reached in Parliament. The practice ofSWFs’futurebudgetdiscussionsintheParliamentinthecontextofconsolidatedbudgets certainly smoothesaway thesedefects.However, this practice is notthecaseinallcountries,andmostimportantly,itcoversonlythefundresourcespending in theframeworkof theassets’budget for thenextyear.Meanwhile,SWFassetsandtheirmanagementinthevastmajorityofcasesremainoutofdiscussionsandeffectivecontrolofthelegislators.

3. Assets of the SWFs are generated not by atomized taxpayers, but rather from a single source of raw materials. The difference of the SWFsfromthestatebudgetconsists,amongotherthings,intheSWFs’accumulationofassetsfromasinglesource–salesofhydrocarbons(herebywemeanonlycommodityfunds).Atthesametime,itiswellknownthatbudgetisbasicallyformedattheexpenseofatomizedtaxpayers.Likeamirror,thestatebudgetdisplaystheefficiencyofthegovernment’seconomicpolicy.Asequentofthispolicycouldbeastoutorconverselyweakbudget.However,agoodbudgetcouldalsobethesequentofsuccessfuleconomicperformanceconducive to thegreaterbudgetgrowthinthefuture.ThegoalinthiscaseistocomparetheeconomicnatureofthesetwofinancialinstrumentsinordertoelicittowhatextentthepubliccontroloverSWFsisimportant.AccumulationofSWFs’assetsoutofhydrocarbonsmaynotdisplaytherealeconomicsituationanditmaycausetheillusiveimpressionofsuccessfulworkoftheSWFs.Inthecase,withabudget,economicrealitiesveryquickly “bring round” thegovernment,whichbrokenly looks formeansofbudgetimprovementandgenerallyeconomicpolicy,whereaswithSWFssuchadirectlinkmaynotappear.Forexample,ifacountryisatitspeakofproductionofhydrocarbonsandthereisanadvantageousmarketsituation,thentherateofinvestmentsmaygroweveniftheeconomyisheadingintheoppositedirectionbutnotdemonstratinganadequate trend.Professionalpublic control and full-fledgedinformationaccesscouldminimizesuchdeformationsandserveasthe

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missingcritical indicator,which in thecaseofastatebudgetwoulddisplay itsdeficitperformance.

4. The vast majority of the SWFs pertain to the countries of risk, which institutionally still remain weak.Internalcontrolinthiscaseisinsufficient,whilstexternalisoftenineffective.Only9outof56SWFsbelongtotheOECDcountries(Australia,Canada,France,Ireland,Japan,SouthKorea,NewZealand,NorwayandUSA)andtheremainingpertaintothecountriesofhighrisk.Asarule,nosolidgoodgovernance is recorded,but it is ratherobserveda lackofprecisesystemofeffectiveself-control–systemofan“irontriangle”(oneofthegroupsgrantsapower,whilsttheothermanagesandathirdrunsabusinessandearnsaprofit).InternationalFinancialInstitutions(IFI)whoseethisgaparetryingtofillitbystrengtheningtheinternationalcontrol.However,inthemajorityofcasesthathappenstonoeffect,becauseonecannotreplacethelackofimmanentinternalcontrol,whichattheprimarylevelcouldensureabalanceofpowerandnaturalresponsibility of the subject instances before others, with merely an externalimpact. As a result, we can observe periodically recurring recommendationsof international agencies, although implementation of these recommendationsleavesmuchtobedesired.Oneshouldacceptthefactthatfortheindependentstates, these recommendations will always remain as recommendations andtheirimplementationislefttothediscretionofthestates.Onceimplemented,apracticeofeffectivepubliccontrolcouldmovealltheseissuesawayfromthedeadpoint.Thepublicitself(civilsectorwouldbemoresuccessfulinthisrole)wouldbeaninitiatorofsuchlegislativeandpracticalimprovementofmoreaccountablemanagementoftheSWFs.

5. Traditions of strong non-governmental movements in the vast majority of those states which have similar SWFs are not developed and are even alien to the public mentality. 30 out of 56SWFsbelong to countries with poorly developed traditions of civil movements

20.Insomecountriessuchmovementsdonotexistatall.Insuchconditions,itisextremelydifficulttosetuppubliccontrolembodiedbycivilorganizations.However,these very countries above all others need control. Norway, demonstratingbrilliantexperienceofopenmanagementoftheSWF,isnotinacuteneedofsuchcontrol.However,itisbrillianthere.YetinIranwherethereisnoexperience,notraditions,andnocapacityforsuchundertaking,thevulnerabilityoftheReserveFundisveryapparentfromtheviewofitspredictablemanagement.Societyisonthelookoutforthepurposesonwhichtheassetsofthefundwillbespentduetothestateofaffairsandthenatureofthepowerinthecountry.

The importanceof,andsimultaneouslyacuteneed for, the increaseof theroleofthecivilsectorincountriesofriskandintensificationofformationworksofthefirstshootsofcivilcapacitycouldbeanewchallengefortheworldcommunityinthelightoftheimpactoftheSWFsupontheinternationalscene.Civilsectorcapacity-buildingeffortsinthesecountriesmayhavefar-reachingobjectives.Thecivilsector,initiallyengagedforthislocalgoal(althoughfromthescopeofSWFs’capacitygrowth this is far from the localobjective) can later focusentirelyonotherimportantstateobjectives.Atypicalexampleofthatcouldbethecivilsectorfocusedon theoilandgasfieldofAzerbaijan.Established in 2004, the EITI

20http://www.swfinstitute.org/research/transparencyindex.php

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coalition has evolved from year to year and is capable enough today to set some greater global tasks.Thecapacitybuildingthatwasrealizedsignificantlyadvanced the coalition in the fields of study, watchdog and other activities.ReinforcementofSWFs’ internationalroleshouldbecomeanewchallengeforthestrengtheningofthecivilsectorcapacityinresource-richcountriesthesamewaythattheEITIhasbecomeanimportantinternationalinitiativeduetowhichknowledgecapacityinresource-richcountrieswasbuiltup.

Inthislight,thequestionofhoweffectivecontrolovertheactivityoftheSWFsbythecivilsocietycanbearrangedremainsofprimaryimportance:inanattempttoanswerthis,fourdifferentangleshavetobetakenintoconsideration,namelynon-governmental organizations (NGOs), themedia, independent parties andpoliticalparties.Inordertoensureeffectivepubliccontrol,itisimportanttohaveeveryelementofthisfour-angledschemefunctioningasaseparatecomponentofasinglewhole.

Figure 4. Public control and the SWFs

NGOs

NGOs at this point are entrusted with a special mission. NGOs alongside the media are the structure most interested in securing the transparency of the SWFs.Apart fromthiskeen interest,non-governmentalorganizationsalsohavethegreatestcapacityinthisactivity.Thiscapacitywasaccumulatedwithinthe last decadeowing todifferent programs, initiativesandother internationalinstruments.Thecampaign“PublishWhatYouPay,”whichisaninitiativeofmorethan400unitedNGOs(in70countriesaroundtheworld)andEITI,where theNGOstandsasakeychainof trilateralpartnership(thestate,companiesandcivilsector)hasgainedgreatrecognition21.However,theproblemliesinthefactthat none of the previouslymentioned instruments are applicable to our end.Aswas alreadymentioned, SWFs have specificmissions and peculiarities of

21 www.eiti.org

 

Media NGOs

SWF

Ind. research

Political party

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work.Obviously,inthecourseofthedevelopmentofthisworkNGOswillhavetoimprovetheskillspertainingtotheaboveinitiativestosecurethetransparencyoftheworkoftheSWFs.NGOswillhavetocomeupwithanewhybridandperhapsa brand new instrument to ensure the transparency of the SWFs. The goodnewsisthataftertheadoptionofthe“Santiagoprinciples”thereisafavorableopportunityfortheNGOs.Thus,basedonthis,anInternationalWorkingGroup(IWG)shoulddeliberate themechanismofpracticalworkofNGOswith theseprinciples.

Media

MediaisanextremelyimportantcomponentinensuringthetransparencyoftheSWFs.Itisgenerallyknownthatfortransparencythereshouldbeaccesstoinformationandall-rounddisclosureofittothewiderpublic.Thisisaparticularlyimportantmissionofthemedia.Thankstothemedia,thewideraudiencelearnsaboutSWFs’activityand theirgrowingcapacities.Unfortunately, in the vast majority of cases, it is mostly a question of international level and world-renowned print agencies and electronic means that rarely get to have materials about SWFs in countries of risk.Meanwhile,hereinonemayfeeltheacute lackof impartialcoverageof theactivityof theseSWFs.ThemediahasanirreplaceableroleintheorganizationofthejournalisticinvestigationsontheexpendituresandthemanagementoftheSWFs’assets.Certainly,essentialqualificationistherequirementforthisgenreaswellasanyprofessionalactivity.Acute lack of this qualification is felt almost in all countries. If the SWFs aretruly interestedinaqualifiedarmyofreporterscoveringtheiractivitythentheyshouldactasinitiatorsoftheorganizationofperiodicextensivecoursesforthejournalists,creatingopportunitiesforthemtoobtainnewskillsandknowledge.Inthisview,theexperienceoftheStateOilFundoftheRepublicofAzerbaijan(SOFAZ)ispositive,astheSOFAZhassponsoredsuchcoursesforjournalistsinBaku.

Independent investigation

Activities of the SWFs, just like the activities of any other financial structure, are multidimensional and in their content, they require not only regular press coverage but also thorough elaboration. This isbeyond thepower of a regular observer. It requires special qualifications. For instance,the fact of how well information access is arranged and how regularly andcomprehensivelyitisdisclosedisabasistojudgethetransparencyoftheSWFs;however, this information is insufficient to judge its efficiency. Even regularlyupdatedinformationonprofitabilitylevelisnotyetsufficient,asanyrateoftheprofitabilityof theSWFrelates tohundredsof factorswhich requirestudyandconsideration.Onlyprofessionalexpertsandfinancierscanhandlethisspecificjob.Thereisaneedforaparallelindependentinvestigationconsideringthefactthatthespecialistsevenofthehighestqualificationinvolvedinpublicinstitutionsare subject for engagement. Therefore, independent and simultaneouslyprofessionalstudy focusedon theappraisalof theSWFsand theirsuccessful

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connectionswiththemacroeconomicarchitecturecanbevaluablematerialnotonlyfortheinternationalcommunity,butalsoforthemanagementoftheSWFs.

Political Parties SWFsarealwaysasensitiveobjectforpoliticians,populistsandotherlayers

ofsociety,whichisunderstandable.TheultimatemissionofthevastmajorityofSWFs is theaccumulationof assets received from thesaleof non-renewableresources for the next generations aswell.Thatmakes this structure sociallysensitive and politically vulnerable. Therefore, it is not surprising that in themajority of the resource rich countries, such SWFs are the subject of sharpcriticismfromthepoliticalopponents.Political parties, as a rule, criticize the authorities for ineffective management of the SWFs’ assets and urge the government to have better consideration of the interests of all the layers of society.Thepopulistsproposetodistributepartoftheassetsamongcitizens,allegedly for the fair consideration of the interests of the entire population.However, as practice shows, for themajority of resource-rich countries, apartfromsingleinstances(theAlaskafundcanbeconsideredapositiveexceptionalcase),suchanexperiencecanhardlybeedifying.Thus,politicianstrytouseanymistakeinthemanagementoftheSWFsasa“trumpcard”tostresstheirownpoliticalactivityandtowinmoresupporterswiththistide.However,themajorityofclosedcountries’authoritiesleavefewerchancestopoliticalopponentsduetotheamountsofsuchfunds.Thus,ontheonehand,existenceoftheSWFfromthestandpointofdevelopmentofcriticsmaylooklikeablessing;nevertheless,beingagoodadvantageinthehandofagovernment, it turnsagainst them.Itis not a wonder that political activity in the respective countries leavesmuchtobedesired,whileoppositionisextremelyweaktogaininthemajorityoftheexaminedcountries.

4.2. Assessing good governance in the SWFs SofarthedifferentpartiesinvolvedinSWFcontrolandoverviewhavebeen

identified.Nevertheless,thenatureandtheaimofthiscontroldependonwhatisperceivedtobegoodgovernance.Inthisrespect,itremainsimportanttoidentifythecharacteristicsofthelatter.Thesecanbesummarizedasfollows:

a) Clarity of goals, roles and responsibilities

Thisgenerally-knownprincipleinthecaseoftheSWFshasaspecialsemanticassignment. SWFs are relatively new agencies in the public administrationsystem.Unliketraditionalstatestructures(forexample,theMinistryofFinance),itissometimesnotsoeasytoclearlydefinetherolesandthedestinationofthefunds,andoptimallyconnectthisagencytothemanagementsystemdevelopedinthecountry.The risk of the SWF remaining an alien element in the state organism is high. In this case, as practice shows, this gap is not that much a matter of concern of preservation of assets for future generations. Meanwhile, a policy of stabilization and promotion of macroeconomic

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development may not gain the necessary support from the SWFs. ThatisparticularlytraceableinMiddleEasternfunds.Onthecontrary,intheOECDcountries,wecanobservethepolicyofagoodcombinationofSWFswithbothcurrentandstrategicpolicyofthestate.Unlikethecountriesofrisk,indevelopedcountries,asarule,weseeamorecleardefinitionoftheroleandthesignificanceoftheSWFs,andthatisnotaminorfactor.Functionsandgoalsarewelldefined.Thereby, sound legislative basis and strong institutional frameworks havesignificantimportanceinthesuccessfulfunctioningoftheSWFs.Intheabsenceofsuchabasisandframework,therespectivegovernmentsshouldcreateallthenecessaryattributesontheleveloftheSWFitselftorealizethestatusandtheplaceof theSWFandhencedetermine theadequatemechanismof decisionmakinginthemanagementoftheSWF.

b) Sustainable development for the benefit of future generations

Resource-rich countries suffer most of all from the volatility of themarket, hence they have continuous problems stemming from the lack ofstableeconomicgrowth.Provisionofthelong-termstabilityhereinistheprioritytask of the government. Exhaustibility of resources aggravates the executionof this task.For this very reason, the countries extracting for more than one decade show preference to the establishment of SWFs for future generations. Thus, themissionof theSWFsdirectlyaimsat theprovisionoflong-termstability,whichisfurtherensuredbytheeffectivemanagementoftheSWFassets. It isworthnotingthat inanumberofcountries,whilstseparatingthe two functions of theSWF (stabilizing and accumulative), authorities showpreferencetotheestablishmentoftwoseparateSWFs(e.g.Russia,Alaska,etc).Inotherexamples,likethecaseofAzerbaijan,thegovernmentpreferstocombinethese two functions in oneSWF.With a purposeof theprovisionof essentiallong-termstability,governmentsarepayingmoreattentiontothefindingoftheoptimalproportionbetweenthevolumesofthecurrentexpensesandtheassetspreservedforthefuturegenerations.Discoveryofanoptimalpointhereinisquiteahardtaskanditdependsonmanycircumstances.Factorspredeterminingthelevelof thecorrelationare thevolumeofpredictedreserves,productionrates,macroeconomicstrategy,socialdemographicsandotherfeatures.

c) Transparency and accuracy of information

Transparencyisthekeyprincipleofgoodgovernance.HowistransparencyensuredinthecaseofSWFsandwhatshouldbetheoptimalpolicyofinformationaccess?Asarule,thetransparencyoftheSWFsimpliesdisclosureofregular,comprehensive and understandable information. It is important to have an opportunity to compare the potential and efficiency of SWF activity with analogical SWFs in other countries based on available information and within its boundaries and its own dynamics. Once the determinantsof good governance are clarified it remains interesting to examine how theseprinciplesofgoodgovernancecanbeensured.All thingsequal, thebetter theSWFisadministeredthemoresuccessfullyitwilldevelop.Poormanagementisassociatedwithpooroutcome.AnSWF,evenifitisanindependentlegalentity,

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doesnotoperateinavacuumandbearsthemarksofthepublicadministrationsystem formed in the country. However, does that mean that there is a ruleaccordingtowhichthesuccessoftheSWFfollowsthelevelofprovisionofgoodgovernance?Woulditbeappropriatetomentionheretheproverb“onecandonomorethanonecan”?Theshortansweris“no.”Morecomprehensively,wecanoperatewithhistoricalexamplesandeconomicregularities.

AtypicalexampleofsuchinconsistencyistheStateOilFundofAzerbaijan(SOFAZ),whichtakesitswell-deservedplaceamongthetop5inallthelistings,whileAzerbaijanasacountryinasimilarappraisalenjoysaconsiderablypoorerranking.The level of SOFAZ’s success leaves behind the national indicators.Besides,theprincipaldistinctionoftheSWFsfromotherpublicfinancialstructuresconsists inthefact that thetitle“independent” inthiscontentplaysakeypart.UnliketheMinistryofFinance,thesestructuresarenotentirelyincorporatedintothesinglepublicadministrationschemeandtheyenjoyacertainautonomy.Evenifthereisnotapracticeoflegalentityandserviceoftheaccountsisperformedonatrustbasis(as,forexample,inKazakhstan),theSWFwouldstillhaveanautonomousregimeofmanagementduetoitsspecialnatureandmission.Thisparticular factormakesSWFsspecialand inacaseofgoodgovernance, theycanindeedenduponahigherlevelofgovernancethanthecountryasawhole.

However,thisisnottheonlyfactor.Byvirtueofthepeculiarityoftheassetsmanagement,SWFs,asarule,haveahigherlevelofresponsibilityandfinancialaccountability (audit) on foreignmarkets; hence, these structures are treatedwith special requirements.Eventually, the savings function of theSWFsaddsserious requirements, and demands to have a proper approach towards themanagementoftheSWFasthefactorofpreservationofpartoftheassetsforthenextgenerationseriouslyurgespoliticianson,and theyaredemonstratinghereinacertaindiscipline.Thus,thesuccessoftheSWFswithgoodgovernancecanindeedexceedthesuccessofthecountryandthisappearstobethecaseinseveralcountries.

ThesuccessandtheefficiencyofSWFmanagementbecomemoreapparentinaconcentratedform(Fig5)reflectingtheprocessofdecision-makingvis-à-vistheSWFmanagementwhenconsideringallthedifferentpartiesinvolved.Thesepartiesarethegovernment,theparliament,theinternationalfinancialinstitutions(IFI)andtherespectiveChambersofAccounts(CA).

Figure 5. Decision making process and the SWF governance

 

Government Parliament

SWF

CA  IFI

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1. Government

GovernmenthastheprincipalresponsibilityforthesuccessfulmanagementoftheSWF.The government, usually represented by the Ministry of Finance, is the owner of the SWF.Inthemajorityofcountries,theadministrationoftheSWFisperformedbythehighestpoliticalranksofthestatebytheappointmentof the specific head of this structure. The government is interested in theoptimal incorporation of the SWF to the overall macroeconomic architectureofthecountry.It isfurtherinterestedintheresolutionofmanycurrentfinancialproblemsrelatedtotheSWF.Thus,inaperiodofdifficultiessuchasthoseofthebudgetand itsdeficit planning, thegovernmentwouldpossiblyprefer tohaveunimpededaccesstotheSWFreserves.Hence,thegovernmentmightnotbeconcernedaboutthelegislativelimitationsoverthespendingofSWFassetsatthegovernment’sdiscretion.This“unrestrained”desiretocommandtheassetsof theSWF in practicemight not bring anything positive.Higher inflation andmacroeconomicimbalancebecomestheoutcomeofsuchapolicy,whichintheendresults inalossofthecompetitiveadvantageforthecountry.Consideringthat the termsof thegovernment’spowerarediscreteand limited in time, thegovernment tends to spend the assets of the SWF for smoothing purposesand economic development over time, handing a legacy of debts and pooreconomytothenewauthority.Inthecountrieswithpoorinstitutions,thisriskofuncontrolleduseofassets(aslongasthegovernmentmayeasilytrampledownall other supervising agencies responsible to oversee theexecutive power) isimminent.Thus,thegoalofcarryingoutbalancedpolicyoftheSWFmaymakethegovernmentexceeditsownpowersand,intheconditionofweaknessofotherauthorityagencies,torolldowntothefieldsofvoluntarism.ThelattermayendwithineffectivemanagementandevenstealingoftheSWF’sassets.

2. Parliament

ForthesuccessfulfunctioningoftheSWFs,itisakeyrequirementtohaveastrongparliament.Parliament as the legislative body is able not only to ensure the necessary long-term supervision over the spending of SWF assets but also to restrain the appetite of the government by putting up a legislative screen against the unrestrained spending of the assets. TheexperienceshowsthatsuccessfulSWFsaregenerallyaccountable to theparliament.Norway can be considered a good example in this regard. In theplaceswheresuchaccountabilityandresponsibilityisweakormissing,theresultiscontroversialandrathernegative.Inthissense,theimportantmissionofthelegislativebodyisalegislativerestrictionofthelevelofspendingoftheassetsof theSWF inside thecountryand themandatorycompliancewith this rule inpractice.InthecaseofAzerbaijan,thesubordinationofSOFAZtotheheadofthestateofAzerbaijanandthepoorroleofParliament isactuallyaweakspotforSOFAZ.ThelackofaclearrestrictionlineofthespendingoftheSWFmay(and it already has) lead to serious violation of macroeconomic proportionswhichresultsinfinancialimbalancesandunusuallyhighratesofinflationfortherespectivecountries.

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3. Chamber of Accounts

TheChamber ofAccounts has a key role in securing the external controlovertheactivityoftheSWF.Forexample,inthecaseofAzerbaijan,inlinewiththearticle92oftheConstitution,CAisestablishedbytheParliamenttowhichitissubordinated.Inlinewiththearticle2oftheLawon“ChamberofAccounts,”theChamberalongwithastatebudgetrepresentsthebudget-financingcontrolorganizationandexercisescontrolonout-of-budgetfundsofAzerbaijanaswell.Thus,SOFAZ falls under the full control of theChamber.As is stipulated in the aforesaid law, the Chamber exercises control over the volume of the receipts and the expenditure assets of the state budget and out-of-budget SWFs, control over their structure and timely execution in line with their assignment.

4. International financial institutions

Amidall international financial institutions (IFI), themost activelyengagedintheprocessofpromotionofthesuccessfulmanagementoftheSWFsistheInternationalMonetaryFund(IMF).IMF in the context of the country reviews and regularly develops recommendations on the improvement of the SWF management and expresses special interest in the identification of an optimal model of the SWF development in different countries.That isunderstandablebecauseinextractingcountries,theprocessofthemanagementofthehydrocarbons’revenueshascolossalimportanceforthecurrentpolicyanddeterminationofthestrategyoftheperspectivedevelopment.Forinstance,theIMFwasveryactiveinAzerbaijanfromtheverybeginningofthegenerationofoilandgasrevenuesandithasofferedmanyrecommendationsonthissubjecttotheAzerigovernment22.TheroleoftheIMFisgrowinginthisrespect.TheIMFinitiatedtheadoptionof theSantiagoPrinciples inSeptemberof2008andthecreationoftheInternationalWorkingGroup(IWG)includingtheseniorleadershipof the 23 significant SWFs around the world. Inauguration of the Forum oftheSWFs inOctober inBakucanalsobeconsideredan importantmilestoneon the way to the cooperation of these structures. The IMF coordinates thisactivityviatheSecretariatestablishedespeciallyforthetimelymanagementofthisactivity.TheIMFandtoalesserdegreeotherinternationalinstitutions(suchastheWorldBank,theEuropeanBankforReconstructionandDevelopmentandtheAsianDevelopmentBank)payspecialattentiontotheworkonSWFs.Giventhisreality,andtakingintoconsiderationtheimplicationsoftheongoingglobaleconomiccrisis,theneedforcoordinationofeffortsbyaninternationalinstitutionsuchastheIMFremainsextremelyhigh.

22 Thestudyon“Managingoilwealth:thecaseofAzerbaijan”preparedbyJohnWakeman-Linnin2004couldbeconsideredamoresuccessfulspecializedworkofIMFonthismatter.

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Conclusion

The present brief has reviewed SWFs and their emergence as key players in the global financial arena. The latter has stimulated a fresh look at the nature, the operations, the risks and the governance patterns that SWFs experience. Initial assessment of the current developments indicates that under the ongoing global financial developments, SWFs are seen to represent a permanent redirection in investment flows and a shift in the dominant sources of financial capital. To date, global financial operations were dominated by Anglo-American financial institutions, but recent developments suggest increasing capital flows from emerging to mature economies. In these flows SWFs imply a redistribution of financial and political capital. Considering this reality, the presence of a blurring line between finance and politics raises concerns that SWFs will be used illegitimately to advance political, as opposed to commercial, agendas.

The conceptualization and the understanding of the latter lie with the thorough clarification of the nature and the operation of the respective SWFs as they seem to differ widely in purpose, maturity, risk attitude and investment preferences. In the present analysis these differences have been identified and analyzed indicating where the peculiarities and the dangers may lie. In particular the experiences to date suggest that SWFs are likely to face political risks in both developed and developing economies due to the inherent salient characteristic of the SWFs of government ownership. These political risks appear to be higher in developing economies due to the uncertainties stemming from harder-to-anticipated regime changes and weaker regulatory frameworks. When considering the financial risks, these are related to the fact that the respective governments might view SWF assets as free fiscal resources to be used ad hoc. Overall assessment of the SWFs and their changing role in the global financial arena indicates that the quality of the governance patterns of the SWFs and the relationship of the latter with the domestic and international economic and institutional structure remain of primary importance. In this context the present attempt has offered some crystallized characteristics of good governance looking at transparency, accountability and public awareness. In this direction of governance strengthening and overall improvements the respective governments, parliaments, civil society groups and international financial organizations emerge as players of key importance.

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Recommendations

1. Stakeholders should take into account that the political risk related to SWF activities in developing economies appears to be higher due to the uncertainties stemming from harder-to-anticipate regime changes and weaker regulatory frameworks.

2. In order to assess, manage, or mitigate overall risks, there should be a prescribed and documented framework that has clear lines of responsibility, segregation of duties, and reliable control mechanisms in SWFs.

3. SWFs’ financial supervisors could experience difficulties when they attempt the exercise of their supervisory function, to determine whether the participation of the SWF in a financial institution jeopardizes the ‘sound and prudent management’ of the credit organization.

4. Funds’ top managements have to evade serious fiscal risks for SWFs which will ensue if the government views their assets as free resources to be used ad hoc to cover various fiscal needs.

5. In order to ensure predictability of the SWF, its necessary for government, as owner of the fund, to focus on public disclosure and public control issues. This work should be more comprehensive and for this, governments have to provide to IWG the relevant program for further improvements.

6. Local CSO have to work out the program of cooperation with SWF in the resource rich countries and for this they can cooperate with international NGO’s. The main line of this program should be “how to achieve good results of the public disclosure policy of the SWF in the country.”

7. International financial institutions, particularly the IMF, should develop the indicative assessment mechanism of the SWFs in order to improve good governance practice, and after that they must popularize this practice in the world.

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References

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Coper,S.(2007).Awordtothewise:ManagingAlaska'soilwealth.Sovereign Wealth Management, Central Bank Publications.

Das, U. S., Lu, Y., Mulder, C., & Sy, A. (2009). Setting up a sovereignwealth fund:Somepolicyandoperationalconsiderations. IMF Working Paper, WP/09/179.

Dunning,T.(2008).Crude Democracy: Natural Resource Wealth and Political Regimes:CambridgeUniversityPress.

Eifert,B.,Gelb,A.,&Tallroth,N.B.(2002).Thepoliticaleconomyoffiscalpolicy and economicmanagement in oil exporting countries.The World Bank Policy Research Working Paper 2899, The World Bank.

Fasano,U.(2000).Reviewoftheexperiencewithoilstabilizationandsavingsfundsinselectedcountries.IMF Working Paper WP/00/112.

FriendsofEarth.(2002).Oilfunds:Answertotheparadoxofplenty?Apolicybriefonoilrevenuemonitoringplans:Comparisonacrosscountries.

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Goldsmith, S. (2001). The Alaska Permanent Fund Dividend Program.Presented at the Conference on Alberta: Government Policies in a Surplus Economy September 7, 2001 University of Alberta, Edmonton, Alberta.

International Monetary Fund (IMF) FiscalAffairs Department. (2007).The Role of Fiscal Institutions in Managing Oil Revenue Boom:IMF.

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Jensen,N.,&Watchekon,L.(2004).ResourcewealthandpoliticalregimesinAfrica.Comparative Political Studies, 37,816-841.

Kern, S. (2007). Sovereign wealth funds- state investments on the rise.International topics-Current issues, Deutsche Bank Research (10.09.2007).

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LeBorgne,E.,&Medas,P. (2007).Sovereignwealth funds in thePacificIslandcountries:Macro-fiscallinkages.IMF Working Paper, WP/07/297.

Manzano, O., & Rigobon, R. (2001). Resource curse or debt overhang?NBER Working Paper NO W8390 Cambridge MA.

Mohohlo,L.(2007).Traditionalreservesandcommodityrevenues:thecaseofBotswana.Sovereign Wealth Management, Central Bank Publications.

Monk,A.H.B.(2008).Recastingthesovereignwealthfundsdebate:Trust,legitimacy and governance. Oxford University Working Paper, http://ssrn.com/abstract=1134862

Pihlman,J.(2009).Sovereignfundssetuppermanentrepresentativeforum.IMF Monetary and Capital Markets Department, 06.05.09.

Raphaeli, N., & Gersten, B. (2008). Sovereign wealth funds: InvestmentvehiclesforthePersianGulfcountries.Middle East Quarterly, Spring 2008,45-53.

Rautava, J. (2008). Sovereign wealth funds arouse political passions.Finland’s Bank Focus, Expert view 2/2008.

Robinson, J. A., & Torvik, R. (2005). White Elephants. Journal of Public Economics, 89,197-210.

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Appendix A

Foreachriskindexthepointsgivenrepresentdifferentqualitylevels.Theseare:

Transparency

5 - Noclearlyidentifiedinvestmentcriteria;nodisclosure4 - Noclearlyidentifiedinvestmentcriteria;limiteddisclosure3 - Vaguelyidentifiableinvestmentcriteria;limiteddisclosure2 - Clearlyidentifiedinvestmentcriteria;limiteddisclosure1 - Clearlyidentifiedinvestmentcriteria;fulldisclosure

Strategic control

5 - Seekscontrollingstakes(30%-plus)instrategicindustry(defense-related)4 - Substantialminority stakes (10%-plus) or/plus board representation in

strategicsectors3 - Substantialstakes(10%-plus)plusboardrepresentationinsemi-strategic

sectorssuchasbanksandutilities2 - Substantialminority stakes (10%-plus)without board representation in

non-strategicsectors,noevidence1 - Explicitlylimitedtosmallscaleinvestments(lessthan10%)

Political relationship

5 - Majornon-democraticcountries,activelyhostiletowestern-stylemarketeconomies

4 - Majornon-democraticcountries,potentiallyhostiletowestern-stylemarketeconomies

3 - Unstablecountries,potentiallyhostiletowestern-stylemarketeconomies2 - Non-democraticwestern-stylemarketeconomy1 - Western-styledemocraticmarketeconomy

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Governance, transparency and accountability in Sovereign Wealth Funds: remarks on the assessment, rankings and benchmarks to date

Stela TsaniTheCentreforEuroAsianStudies,UniversityofReading,UK.

Ingilab Ahmadov PublicFinanceMonitoringCenter,Azerbaijan.

Kenan AslanliPublicFinanceMonitoringCenter,Azerbaijan.

1. Introduction

SovereignWealthFunds(hereafterSWFs)aregovernment-ownedinvestmentfundsoperating in private financialmarkets.SWFsare commonly establishedout of receipts resulting from commodity exports, out of balance of paymentssurpluses, official foreign currency operations, the proceeds of privatizationsand/or fiscal surpluses. Recent interest in the SWFs has failed to come to aconsensusastohowSWFsdifferfromotherpublicinvestmentfundsandhowthey should be defined. Indeed SWFs differ in ownership, underlying assets,degreeofdependence,operationalaspects,etc.OftheexistingSWFs,almosthalf operate as separate legal entities, while the rest consist of a dependententitywithintheMinistryofFinanceortheCentralBankoftherelevantcountry1.SWFs themselves declare various objectives ranging from fiscal stabilizationor general savings for futuregenerations to coveringexpected futurepensionexpenditures.Despitecertainexplicitgoals(e.g.financingfuturepensionpaymentrequirements),SWFsaremanagedaccordingtotheinterestsandtheobjectivesofthegovernmentand/orthesovereign.InthisrespecttheultimatebeneficiaryofaSWFisnotaspecificindividualbutratheritremainsthegovernment,thehostcountry’scitizensorthetaxpayeringeneral.

Differentials in the nature, the operations and the ownership render theassessmentandthecomparisonoftheSWFsdifficult. Inthisreality itremainsrelevanttoidentifythecommunalitiesamongSWFsthatcouldserveasthebasisofSWFsdefinitionandassessment.EvidencefromtheexistingSWFssuggeststhatgovernments,at centralorat sub-national level,mayown theSWFsandexercisecontroldirectlyorindirectlyuponthem.Inthiscase,SWFscanbeseenasameetingpointofhighpoliticswithhighfinance. In termsof theavailableliabilities,anumberofSWFshaveliabilities,suchassterilizationdebtorsomedeferredcontractualliabilitytotransfermoneyoutofthefundandintothegeneralbudgetorasocialsecuritysystem.However,inthemajorityofthecasesSWFshavenonon-governmentaloroutsideliabilities.

OftheSWFsthatdohaveliabilities,theseareusuallyintra-governmental,with

1SeeAhmadovetal(2009).

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onebranchofthegovernmentowingmoneytoanotherbranchofthegovernment(i.e.thefundmayowetotheMinistryofFinance,theCentralBankorthesocialsecurity reserve funds). SWFs have no external creditor, hence accumulatedassetsarenotsubjecttooutsidenon-governmentalowners’propertyrights.Hencetheexistingfundliabilitiesarepartofthebroadernationalbalancesheet.InthisrespectSWFscanbedefinedinmoredetailasdirectlyorindirectlygovernment-ownedandcontrolledinvestmentfunds,withnooutsidebeneficiariesorliabilitiesinvolvedinasset investmentsintheshortor longterm.Thesovereignandthecitizensofthecountryremaintheultimatebeneficiariesofthefund’soperations.

Following immense accumulation of international assets, policymakers incountrieswithSWFshavesetupanumberofconsideredas“optimal”operationaland policy objectives. These “optimal” objectives vary between the existingfunds.ThedifferentialsamongtheSWFs,whichreflectthesedifferentpolicyandoperationalobjectives,theincreasingnumberoftheSWFsandtheaccumulatingassetsheldandmanagedby theSWFs,have triggered interest inSWFsandin theestablishmentofasetofcommonassessmentcriteriaandbenchmarksforSWFs. Indicativeare theTruman(2008)scoreboard, theLinaburg-MaduellTransparency Index developed by the Sovereign Wealth Fund Institute, orthe guidelines forSWFsdeveloped by the IMFand theOECD.The attemptstoestablishbenchmarksand to rankSWFshavebeen further intensifiedasaresponsetotheincreasingimportanceoftheSWFstotheinternationalfinancialmarkets,especiallyduringthelatestfinancialcrisis.

SeveralSWFshaveobtainedsignificantsharesinprominentWesternfinancialinstitutions.Theacquired4.9%stakeofCitigroupfromtheAbuDhabiInvestmentAuthority in November 2007, the 9.9% stake of Morgan Stanley acquired bytheChinaInvestmentCorporationinDecember2007orthe9.8%stakeofUBSobtainedinDecember2007byGICSingaporearejustafewexamplestoname2.OverthelastyearsSWFshaveworkedaspivotalactorsinprovidingliquiditytoWesterncompanies,whichhasbeenverymuchneededinthetimesofthelatestfinancialcrisis.InthisrespectSWFshaveconstitutedanopportunitysignificantlyrelatedtothefutureofcapitalmarkets(EpsteinandRose,2009).Inthisrealitythe developed assessment and ranking attempts of the SWFs have primarilyreflected theconcerns that the internationalfinancial institutionsand individualrecipientcountriesofSWFs’investmentshavebeenfacedwith.

Theseconcernshaveprimarily regarded thegovernancestructuresof theSWFs and the lack of transparency and accountability on funds’ operations.ConcernshavebeenexacerbatedbythefactthatthewidemajorityoftheSWFsarebasedinundemocraticcountries.Thishasraisedfurtherquestionsonwhetherpolitical, as opposed to economic, considerations guide fund operations andtheiractivitiesintheinternationalfinancialsystem.Todate,theassessmentandrankingattemptsoftheSWFshavebeenbasedonthefinancialperformanceoftheSWFs,ontheirinvestmentmanagementandontheirgovernance,transparencyand accountability standards. The present paper focuses on governance,transparencyandaccountabilityperspectives.Theaimof thepresentpaper istocriticallyreviewthegovernance,transparencyandaccountabilityrankingsandbenchmarksdevelopedfortheSWFs.

2Source:SovereignWealthFundInstitute.

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The recorded efforts come in large part from Western countries andindependent organizations and mainly reflect the needs and the standardsrequiredfromtheinternationalfinancialmarketsandcountriesthatarerecipientoftheSWFinvestments.Inlightofthisreality,theassessmentandtherankingsarebasedonwhatis“necessary”and“adequate”fromtheinternationalfinancialmarkets’perspectiveratherthanfromwhatis“beneficent”and“adequate”forthecitizensofthecountriesthatremaintheultimatebeneficiariesoftheoperationsoftheSWFs.Moreover,theseattemptsdevelopontheassumptionthatwhatis“good”and“working”foronefundorcountryitshouldbe“good”or“working”forotherfundsorcountriesaswell.Overviewoftheseattemptsfurtherindicatesthatthemethodologicalconsiderationsshouldbekept inmindwhenemployingthelatterrankingsandbenchmarks.

Theremainderof thepaper isstructuredasfollows.Section2reviewstheconceptualframeworkrelevanttogovernance,transparencyandaccountabilityaspectsoftheSWFs.ThissectionhighlightsthecriticalroleofstronggovernanceandtransparentandaccountableoperationsoftheSWFsformicroandmacrodevelopmentsonanongoingbasisaswellasfortheperformanceoftheSWFs.Section3comparesanddiscussestheexistinggovernance, transparencyandaccountability benchmarks and ranking attempts. The analysis summarizeddiscussesthemainlimitationsintheseattemptsindicatingtheirimpactupontheobtained results.Arguments that such ranking attempts might reflect specificpurposes,orthattherankingsmaybeconstructedmakingspecificconsiderationsarefurtherdeveloped.Thelastsectionmakesconclusions.

2. SWFs: The role of governance, transparency and accountability

ThedebateandtheempiricalevidenceonSWFs,particularlyonthosebeingestablishedoutofresourcerevenues,remaincontroversialandinconclusive.Thescholarlyliteratureonresource-basedfundsremainspatchyandconsistsmainlyoftheworkbytheIMFandtheWorldBank3.Ingeneral,itispossibletoidentifytwostreamsofarguments.Thefirstdebatesthatfundsarenotnecessary.Accordingtothispoint,iftheconditionsthatarerequiredforthesuccessfulfunctioningofthesefundsexist,thenresourcerevenuesorfiscalsurplusescanbemanagedwithoutthemwithinthebudgetaryprocess(Davisetal,2001).Thesecondstreamsuggeststhatevenifitisimpossibletocreate‘ideal’conditions,theexistenceoffundscouldpreventexcessivespending.TheexperienceofthesuccessfulfundsofAlaskaorNorway isusuallyemployed insupportof thisargument(Fasano,2000; Birdsall and Subramania, 2004). To date, indeed, there are not manyexamplesofsuccess.TheAlaskanandNorwegianfundsarestrikingexceptions.

Nevertheless,inthesecases,giventhebroadernationalpolicyframeworksand the wide support for deferring somewealth gains for future generations,further questions have regarded whether separate funds were needed inthese countries in the first instance.History provides uswithmany examplesof“problematic”funds,likethoseofNigeriaorVenezuela,thenumberofwhich

3AmongothersseePetersenandBudina(2003),CrainandDevlin(2003),ShabsighandIlahi(2007)andBrownetal(2009).

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exceedsthesuccessfulcases(Davisetal,2003;Davisetal,2003;DelvinandLewin,2002).WiththeexceptionofNorway,withitsstronggovernmentinstitutionsand healthy democracy, the experienceswith resource-based funds have notbeenencouraging(BirdsallandSubramania,2004).Moreover,theexamplesofthecountriesintheMiddleEastdemonstratelimitedsuccessinthefunctioningofthefunds.Thereasonfortheinefficiencyofthefundshasbeenattributedtothelackofclearrulesandoperations,whichshouldbetransparent,withstringentmechanismstoensureaccountabilityandpreventresourcemisuses(Davisetal,2003).Theoperationalsideof thismanagementcouldcausefurtherobstacles(BarnettandOssowski,2003).

OveralltheexperienceofunsuccessfulfundsliketheVenezuelanInvestmentFund or the Nigerian Petroleum Trust Fund has indicated an even morecomplicatedproblem:thequestforrigorousgovernance,adequatetransparencyand accountability. Governance regards the role of the government, of thegoverning bodies and of the managers of the SWFs in the decision-makingprocess regarding the flows into and out of the funds, the investmentsmadeand thediversionof theaccumulatedassets toeconomicends.Transparencyisrelatedtotheadequate, fullandtimelyprovisionof informationtothepublicregardingtheoperationsofthefundsaswellaswiththeclearcommunicationoftheroleofthefundstothebroaderpublic.AccountabilityregardsthemultileveloversightoftheSWFsandthedegreetowhichthegovernment,thegoverningbodiesandthefundmanagersareheldresponsiblefortheirdecisions.

CaspianRevenueWatchprovidesapublicdebateontheseissuessuggestingthat weak governance along poor transparency and accountability make thefundsandtherespectivecountrieslesslikelytoconvertsocialexpendituresintoimproved income(Tsalik,2003). InmanycountriesSWFsaresetup followingincreasingsurplusesfromexportsofnaturalresources.Theliteratureonresource-rich economies supports the view that natural wealth can pose problems foreconomicmanagement4. Ina rangeofcases,economicperformanceappearsto suffer rather than benefit from the impact of natural resource endowments(Paldam,1997;GylfasonandZoega,2003).The international communityandmajor international financial organizations have become growingly concernedabout the effectiveness with which natural resource revenues are used. Inparticular they are concerned with the question of how funds can contributetowardslong-termeconomicandsocialdevelopment.

The latter is a subject of the political economyof resource-driven growth.Nevertheless, in the investigation of this relationship, it is also acknowledgedthecrucialdependencyofthefundestablishmentandoperationaloutcomestoimplemented policies, in particular with regards to governance, transparencyand accountability. SWFs out of natural resource revenues can contribute toeconomicgrowthbysmoothingsomeoftheinstabilitythatmayarisefromenergy

4Theliteraturetodateoffersagrowingamountofworksinsupportoftheconceptthatnaturalresourceendowmentisaneconomiccurseratherthanablessing(AutyandMikesell,1998;SachsandWarner,2001;Gylfason,2001;AutyanddeSoysa,2006).

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pricefluctuations.Inthisattempttheadverseincentivesthathaveplaguedsomeresource-richcountriescanbeavoidedwiththeemploymentofstronggovernancestructuresofresourcewealthmanagementandwith theprovisionofadequatetransparencyandaccountabilitytothelatter.

Inthisrespectakeyquestiontobeaddressediswhetherfundsarepanaceaforthesocalled“paradoxofplenty”orwhethertheyareeffectiveonlyincircumstancesthatareinanycaseparticularlybenign.Inthiscasefundsmayserveasaformof“commitmentmechanism,”thussubstitutingforothercommitmentmechanismspossibly resulting from the involvement of international financial organizationssuchas the IMF(Kalyuzhnova,2006).Nevertheless, thekey requirements forsuccesswithsuchfundsappeartoultimatelyliewithgovernance,transparencyand accountability standards. Governance, transparency and accountabilityaspects and their differentials depend in large part on the role that SWFsserve(i.e.accumulatingfundssoastostabilizetheeconomy,savingfundsforfuture generations, addressing future payment obligations, etc)5.Governance, transparency and accountability aspects that reflect political economy factorsrelated to SWFs, such as institutions and the organizational design, remainimportantforseveralreasons.

A first area where governance, transparency and accountability remainimportant is the microeconomic domain. This regards in particular the risingconcernsaboutrent-seekingandcorruption.Theseproblemscanbeworsenedby the lack of strong governance and sound provision of transparency andaccountability.Theprincipleswhere clarity remains of primary importance aretherulesthatultimatelygovernwhowillbenefitfromredistributionofthenation’swealth and how far governmental policies act as disguised transfers in thisregard(Tullock,1997).Forresource-basedSWFs, theroleof thecommitmentmechanisms is further important in order to limit the possibility of dynamicinconsistency (Dixit, 1996) or of conflicting interests. Overcoming distortedincentives in government intervention could be perceived as a challenge inachievinganoptimal pathof thepublicwelfare from resources (Kalyuzhnova,2006).Aspecialreferenceshouldbemadeatthispointtorent-seekingbehaviorofcorruptgovernments,namely to theaggregateresourcesabsorbedbyrent-seeking. In thecaseof resource-richcountries theserentscanbequite large,becauseasaruletheyrepresent themainsectorof theeconomicactivities inthesecountries.Therefore,theeffectofrent-seekingontheorganizationaldesignofthegovernmentalprogramsissignificantoverall6.

A second area where governance, transparency and accountabilityremain important regards macroeconomic developments and the design and

5 The literature to date offers a rich discussion andexplanation of the differentials that theexistingfundsexperienceintheirgovernance,transparencyandaccountabilitystandards.Moreover,a significant amountofwork looks into the role that variousparties suchas thegovernment, themanagingboardand thecivil societyplay in thegovernanceof the funds.Thediscussionon thedifferentialsingovernance,transparencyandaccountabilityandontherolethateachpartyplaysinthegovernanceofthefundsextendsbeyondtheaimofthepresentpaper.ForadetaileddiscussionseeamongothersTsalik(2003)andBaconandTordo(2006).

6 Stigler (1975) and Posner (1975) demonstrated that the latter can be particularly observed in the area of regulation.

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implementation of fiscal policy in particular. Links to fiscal policy emerge asparticularly important in a saving context (Kalyuzhnova, 2006). In successfulcasesfundsshouldensuresignificantpublicsavings.For instance in thecaseof SWFs being funded out of oil revenues, the creation of the fund, and theagreementonitsrules,canbeseenasacommitmentdevice.Thiscouldfurtherhelptobuildapublicconstituencyforsavingpartofrevenues.Incaseswherethegovernmentfinancesdeficitsbyborrowingfromsavingsfunds,thensavingfundassetsaremerelyoffsetbygovernmentdebt(Davisetal,2001).Thisfurtherhighlights the critical link between the fund operations, in this case serving asavings role,and thedesignof fiscalpolicy.Thekey issue in thiscase is thestrictdisciplineandabilityofthegovernmenttokeepafinancialbalanceintheaccumulationandspendingofthesavingfundincome.Inthisrespect,thelargeaccumulationofthefundassetscouldcreatepoliticalunrest.Thiscouldderivefromincreasingpublicdemandsforthegovernmenttoincreasepublicspendinganddecreasetaxes,etc.

These considerations help address the legitimate question of whether aconcretestrategyofpublicsavingforfuturegenerationscouldnotbeimplementedwithoutcreatingaformalandseparatefund.Infinancialtermsthismightbethecase.Nevertheless,inthecaseoffundsbeingfundedoutofresourcerevenues,theirpresencecanpotentiallyplayakeyrolebyhelpingthepromotionofpublicunderstandingoftheneedtosaveforfuturegenerations.However, inordertomeetthisgoal,theanalysisneedstobeclearlyformulated,followedbyasetofclearandtransparentrules.Thisistheonlycasewhentheanalysiscanprovepersuasivetopoliticalcirclesandtothewiderpublic.Inthisrespectgovernanceisthecorechallenge.

In the context of preventing corruption, conflicting interests between thepublic and the private sector andmisuse ofSWFs’ assets atmacroeconomiclevels,theroleofstronggovernance,transparencyandaccountabilityinSWFsremain important. The presence of SWFs poses great policy, political andeconomicchallenges.Amongothers,thesearerelatedtotheprudentmobilizationoftherevenues,tothefairallocationoftheresourcesbetweengenerations,tothe identificationof thebest investmentalternatives, to the temptations tousethefundsforpoliticalasopposedtoeconomicpurposesandtothefavoringofspecificsocialoreconomicgroupsagainstothergroups.WhereSWFassetsareusedsoastofavortherulingelite,tokeeptheinefficientpublicsectorrunningor so as to promote political goals, successful performancemight not be thecase.Inthepresenceofstronggovernanceandadequatemechanismsthatcanguarantee the transparentandaccountablemanagementandoperationof thefunds,thelattertemptationsordistortionsofSWFoperationsmaybeprevented,safeguardingtheperformanceofthefunds.

Moreover,thetensionscreatedbetweenthepublicandtheprivatesectorasaresultof theSWFinvestmentsandassetallocationsmaybemitigatedwhengovernance structures are robust. Governance structures that can guaranteeavoice forallandadequate representationofdifferentgroups in thedecisionmakingprocessmaypreventanytensionsoranypoliticallymotivatedinvestmentsoftheSWFs.Moreover,theclearunderstandingofthegovernancestructureofthe fundsregarding theadequateprovisionof transparencyandaccountabilityin theiroperationsmayhelp in the identificationofanypoliticalobjectives that

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thefundsmayservealongtheireconomicobjectives.ThismayfurtherhelptheunderstandingoftheSWFs’performanceandtheacceptanceofSWFinvestmentsinthedomesticeconomyandinforeigncountries.

Governance, transparencyandaccountabilityaspectsremain important forthewelcomingoftheSWFsintheinternationalfinancialmarketsandtherecipientcountries of SWF investments.Global imbalances deriving from large currentaccountdeficitsinmajoreconomies,likethatoftheUSA,andcounterbalancinglargesurpluses inAsianandoil-producingcountries,haveattractedsignificantattention.Thishasbeen triggeredby thevastflowoffinance fromdevelopingcountries todevelopedcountriesandmaturefinancialmarkets.Thishasbeenwelcomedbytheorganizationshitbythefinancialcrisisandhasprovedbeneficialformarketstability.Nevertheless,concernshavebeenraisedinmajoreconomiesandrecipientsofSWFinvestments,suchastheUnitedStatesandEurope,aboutthenatureandthepossiblepoliticalintentionsoftheSWFs.

In the current global financial developments SWFs are perceived asrepresenting a permanent redirection in investment flows and a shift in thedominantsourcesoffinancialcapital (Ahmadovetal,2009).With theseflows,SWFs suggest a redistribution of financial and political capital throughout theworld.Inthisrealitythepresenceofablurringlinebetweenfinanceandpoliticsraises concerns that SWFswill be used illegitimately to advance political, asopposedtocommercial,agendas.InmanycasesSWFsmayevenbeperceivedas a source of state financial capitalism.This can trigger further concerns onwhether the introduction of public investors into private markets will do forefficiency.Inthisrespectcleargovernancestricturesandprovisionofadequatetransparency andaccountability regardingSWFs’ governance, operations andinvestmentswould ease the concerns of the recipient countrieswhile it couldfurtherfacilitatetheiroperationsintheinternationalfinancialarena.

AnyassessmentattemptoftheSWFshastoaddressasetofquestionsandto further choose the perspective of the assessment employed. For instance,anyassessmentattemptswouldhavetoconsiderthekeyobjectivesassignedtothefunds(suchasstabilizationand/orsaving).Inadditiontheframeworkshouldbe clarified in which their effectiveness can be analyzed.Moreover, the corecriteriaofsuccessofthefundsshouldbeidentified(Kalyuzhnova,2006).Inthisrespectthecrucialpointisthecleargoalsofthefund.Forinstance,thefundsofNorwayorAlaskapursuestabilizationandperformsavingfunctions.Manyotherfundshavethesamefunctionsbuthavenotbeensuccessful.Analternativesetofcriteriathathavebeenexaminedarefundmanagementrulesthatguaranteeaccountability.

It is important forevery fund toclearly indicatewho ismanaging the fund.For instance theNorwegian fund ismanagedby theNorwegianCentralBankaccordingtotheMinistryofFinanceguidelines.TheAlaskaPermanentReserveFund is managed by theAlaska Permanent Fund Corporation while externalmanagershandleequity,fixedincomeandrealestateportfolios.Thelastbutnotleastsetofcriteriaofsuccessshouldbeconnectedwithahighleveloftransparencyof fund operations. Every fund necessitates professional management. If thefundhas independent spendingauthority, that couldundermine thebudgetaryprocess.Moreover,regularreportingandauditarequiteimportant.Inadditionthemanagementofthefundneedstomaintainpublicawarenessabouttheexistence

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ofthefund.Todate, several assessmentattemptsof theSWFshavebeendeveloped

from scholars, Western Financial Institutions and independent organizations(Truman,2008;SWFInstitute,IMF,etc).Alloftheseassessmentattemptshaveidentifiedgovernance,transparencyandaccountabilityasofprimaryimportanceto the successful performance of the SWFs. The majority of them offer aqualitativeapproach to theassessmentof theSWF,while latereffortsattempta quantitative approach to SWF rankings. Indicative of these efforts are theTruman(2008)scoreboardand theSovereignWealthFund InstituteLinaburg-Maduell Transparency Index. Both of the latter attempts have developed aclassificationsystemoftheexistingfundsassessinggovernance,transparencyandaccountabilityaspectsalongfinancialaspectsoftheSWFs.

Following the growing international demand for SWFs’ governance,transparency and accountability fostering, the InternationalWorkingGroupontheSWFshasdevelopedthe“SantiagoPrinciples”7.Theprincipleshavebeenareflectionoftheincreasingdemandforcleargovernance,adequatetransparencyandaccountability,and integrationof theSWFswith the internationalfinancialmarkets.Thepurposeoftheprinciplesistoidentifyasetofgenerallyacceptedpracticesthatcanreflectappropriategovernance,transparencyandaccountabilityarrangementsaswell as topromoteSWF investmentsbaseduponaprudentandsoundeconomicbasis.Acceptanceoftheprincipleswillallowtherespectivecountries and funds to gain greater understanding at home and in recipientcountriesaswellasintheinternationalfinancialmarkets.

Overallcleargovernancestructuresandadequateprovisionoftransparencyand accountability of SWFs can play a determinant role in micro andmacroeconomicdevelopmentsinthehostcountries.Moreoveritcandeterminetheperformanceofthefundswhileitcanfacilitatetheirinternationalwelcoming.Overthelastfewyearsseveralattemptshavebeenmadetoassess,evaluateand rank governance, transparency and accountability aspects of the SWFs.ThesehavebeendevelopedalongwithattemptstoidentifyfundcasesthatcouldserveasbenchmarksandtoestablishacodeofgenerallyacceptedpracticesforSWFs.Nevertheless,therankingresultsandtheproposedbenchmarksshouldbetreatedcarefully.Therankingresultsandthebenchmarkanalysismaysufferfromseveralmethodologicallimitations.Moreover,theseattemptshavereflectedinlargepartthegovernance,transparencyandaccountabilitystandardsrequiredasminimumbytherecipientcountriesofSWFinvestments.Inthisrespectthedeveloped rankingsandsuggestedbenchmarksandbestpracticesshouldbetreatedcarefullyandtheirlimitationsshouldbeacknowledgedandaddressed.

3. SWFs, governance, transparency and accountability:Assessing rankings, benchmarks and best practices

SWFs vary in objectives and size, and further, they operate in countriesthatdiffer intermsofgovernmentalstructures.Inthisrespectanycomparativeassessment has to overcome significant difficulties. However the extractionof a set of core elements that remain important for all the SWFs’ short term

7InternationalWorkingGrouponSovereignWealthFunds(2008).

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stabilizationpurposesandlongtermintergenerationalwealthdistributioncanleadtoasignificantfirststepassessmentandranking.Todate,severalattemptshavebeenmadetoassesstheperformanceoftheSWFsemployingavarietyofsetsoffundsandsetsofinstitutionalandfinancialaspects.Fasano(2000)providesacomparativeanalysisoftheoperationalmodalitiesandoftheexperiencewiththeresource-basedfundssuggestingthatthefundsofNorway,Kuwait,ChileandtheStateofAlaskahavebeensuccessfulinstitutionscontributingtoeffectivefiscalpolicy.Eifertetal(2002)tackletheissueofresourcewealthandsuccessfulfundsemploying theprismofpoliticaleconomy for thecasesofNorway,Venezuela,Mexico,SaudiArabia,Nigeria, Indonesia andChad, concluding that technicalsolutionssuchas thesettingupof resource-based fundswill notworkunlesssupportiveconstituenciesaredevelopedinsupportofsuchmeasures.

Similarattemptstoofferapolicybriefonoilrevenuemanagementbyoilfundsismade by the Friends of Earth (2002).With a reference and a comparativeanalysis of the cases of Chad, Azerbaijan, Kazakhstan and Uganda theassessmentconcludes that in theabsenceof realpoliticalwill, soas toallowpublic scrutiny and participation in resource management and the decision-makingprocess,fundswillfailtoaddresscoreissuesofcivicempowermentanddemocratic development. Kalyuzhnova (2006), comparing and contrasting theoilfundsofAzerbaijanandKazakhstan,suggeststhatthekeyrequirementsforsuccessfulperformanceof funds lieupongovernance issues. Inanattempt toaddresstheproblemofoilwealthmanagementandmineralfundsintheCaspianregionTsalik(2003)incorporatestheevidencefromthefundsofAzerbaijanandKazakhstan into a wider set of oil funds. In a comparative review the authorconcludes that the oil funds of Norway,Alaska andAlberta can be proposedas successful fund models. Bacon and Tordo (2006) attempt a comparativeanalysis and classification of a set of resource-based funds building a moresystematicmethodofcomparison.Theassessmentisbasedonasetoffundingand operational aspects. The authors suggest governance, transparency andaccountabilitytobekeysuccessfactorsthatallowedcertainfundstobebetterperformersthanothers.

Truman (2008) offers a first systematic approach of fund ranking andquantitativeanalysisoffundperformance.Thestartingpointofthisassessmentisthepresentfundpractices,providingabasisfortheevaluationoftheresultsoftheIMF-sponsoreddialogueonSWFs’bestpractices.Themainargumentisthatnofundshouldbeaskedtoimplementguidanceorpracticesthatatleastoneotherfunddoesnotimplementorpracticealready.Thescoreboardisconstructedusingthesumofpointsthateachfundcollectsinaseriesofquestions,wheretherespectiveanswerscanbeeither“yes” or “no”givingtherelevantpoint(being0or1,aspredeterminedforeachquestion) to thefundassessed.Theresultsof thisassessmentofferascoreboard thatquantifies thedegreeofsuccessfulperformanceforawidersetoffundsconsideringarangeofdifferentassessmentelements(Table1).

The Truman (2008) scoreboard indicates that in a comparative analysis,pensionfundsarerelatedtobetterscoresofgovernance,structure,transparency,accountabilityandbehavior.Whenconsideringnon-pensionfunds,theSWFsofUSAandNorwayscorehigher in therankingsystemwhile theGulfCountries’SWFs perform relatively lower. The scoreboard provides and indication of

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standards and requirements that SWFs can fulfill without providing moreinformation or beingmore exposed than other funds. In troubled times, suchas the latestfinancial turmoil, the indicationofsuchscoreboardscanhighlightdifferentials and possible particularities that are related to each specific fund.Moreover, it can provide information and fair predictability of the nature anddecision-makingprocessoftherespectivefunds,loweringthespeculativerisk,discontentandgeneratedambiguityovertheroleandtheinvestmentpurposesof the relevant funds.Similarly toearlierattempts,Truman (2008) indicates inparticulartheimportanceoftransparencyandaccountabilityofSWFs,suggestingthatthelatterremainsakeypointinwelcominginvestmentsfromSWFsandafurtherimportantstabilizingfactorintheinternationalfinancialmarkets.

Table 1. Truman (2008) scoreboard of SWFs

Country Fund Struc-ture

Gover-ance

Account-abil-

ity and Transpar-

ency

Behav-iour Total

CanadaCanadaPensionPlan

100 100 96 83 95

NewZealandSuperannuationFund

100 100 100 75 95

USAAlaskaAlaskaPermanentFund

100 80 100 83 94

CanadaQuebec

CaissededepotetplacementduQuebec

100 100 89 83 92

FranceFondsdereservepourlesretraites

100 100 89 83 92

NorwayGovernmentPen-sionFundGlobal

94 100 100 67 92

USACalifor-nia

CaliforniaPublicEmployeesRetire-mentSystem

100 100 96 67 92

USAWyo-ming

PermanentMin-eralTrustFund

100 90 82 100 91

JapanGovernmentPen-sionInvestmentFund

100 90 80 83 87

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IrelandNationalPensionsReserveFund

100 100 86 58 86

USANewMexico

SeveranceTaxPermanentFund

100 50 86 100 86

NetherlandsStichtingPensio-enfondsABP

100 100 86 50 85

Australia FutureFund 100 80 68 83 80

TimorLestePetroleumFundforTimor-Leste

100 40 96 50 80

AzerbaijanStateOilFundoftheRepublicofAzerbaijan

88 60 89 50 77

ChinaNationalSocialSecurityFund

100 40 82 67 77

CanadaAlberta

AlbertaHeritageSavingsTrustFund

94 60 79 50 74

ChileEconomic and SocialStabiliza-tionFund

94 60 82 17 70

HongKong ExchangeFund 88 40 79 33 67

KazakhstanNationalFundfortheRepublicofKazakhstan

88 60 64 33 64

Botswana PulaFund 69 60 54 33 55Trinidad and Tobago

HeritageandSta-bilizationFund

100 60 46 0 53

KoreaKoreaInvestmentCorporation

75 60 45 25 51

RussiaReserveFundandNationalWelfareFund

72 40 50 33 51

KuwaitKuwaitInvestmentAuthority

75 80 41 0 48

São Tomé andPríncipe

NationalOilAc-count

100 60 29 17 48

MexicoOilIncomeStabili-zationFund

69 20 43 50 47

Singapore TemasekHoldings 50 50 61 0 45

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SingaporeGovernmentofSingaporeInvest-mentCorporation

63 40 39 17 41

MalaysiaKhazanahNasi-onal

44 50 46 0 38

ChinaChinaInvestmentCorporation

50 50 14 17 29

KiribatiRevenueEqual-izationReserveFund

69 60 7 0 29

AlgeriaRevenueRegula-tionFund

56 40 11 17 27

NigeriaExcessCrudeAc-count

50 30 14 17 26

IranOilStabilizationFund

50 20 18 0 23

VenezuelaMacroeconomicStabilizationFund

50 0 18 17 23

OmanStateGeneralReserveFund

50 0 18 0 20

SudanOilRevenueSta-bilizationAccount

56 0 14 0 20

VenezuelaNationalDevelop-mentFund

38 0 27 0 20

BruneiDa-raussalam

BruneiInvestmentAuthority

31 0 25 0 18

UAEAbuDabi

MudabalaDevel-opmentCompany

44 10 7 0 15

UAEDubai IsthmarWorld 38 10 7 0 14

QatarQatarInvestmentAuthority

34 0 2 0 9

UAEAbuDabi

AbuDhabiInvest-mentAuthorityandCouncil

25 0 4 8 9

InanattempttoassessSWFs’transparencyandaccountabilityprovision,the“Linaburg-MaduellTransparency Index”hasbeendevelopedby theSovereignWealth Fund Institute researchers8. This is based on Norway’s SWF, widelyseen as the benchmark of transparency. The index implements 10 “essential

8http://www.swfinstitute.org/research/transparencyindex.php

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principles”9.Foreachprincipleassessedtherearedifferentlevelsofdepth,thejudgmentofwhichislefttothediscretionoftheSovereignWealthFundInstitute.The index results in a transparency index rating from 1 to 10 (Table 2), with8 recommended from the Sovereign Wealth Fund Institute in order to claimadequate transparency. The Linaburg-Maduell Transparency Index identifiesthefundsofAlaska,NorwayandNewZealandashighscorersbytransparencystandards.

SimilarlytothefindingsofTruman(2008),Gulfcountries’SWFsarefoundtoscorelowintermsoftransparency.Theindexrevealsaveryinterestingpicturewhen considering the funds established in theCaspian region. The StateOilFundofAzerbaijan (SOFAZ), althougha relatively recent establishmentwhencomparedtootherSWFs,hasmanagedtosucceedintermsoffulltransparencyandaccountability,scoringatsimilarlevelstomodelestablishmentssuchasthatofNorway.IndeedtheSWFofAzerbaijanhasbeenapioneeringestablishmentintheregioninpromotingtransparencystandardsandfurtherpushingforwardregionalstandards.InthisrespecttheexperienceofAzerbaijananditsrespectivepolicestowardsfundtransparencymightbeusefultothecountriesoftheregion.

Table 2. Linaburg - Maduell Transparency Index10

Country Fund Name Index

Azerbaijan StateOilFund 10

Chile SocialandEconomicStabilizationFund 10

Ireland NationalPensionsReserveFund 10

NewZealand NewZealandSuperannuationFund 10

Norway GovernmentPensionFund–Global 10

Singapore TemasekHoldings 10

UAE-AbuDhabi MubadalaDevelopmentCompany 10

US-Alaska AlaskaPermanentFund 10

Australia AustralianFutureFund 9

Canada Alberta’sHeritageFund 9

SouthKorea KoreaInvestmentCorporation 9

US-NewMexico NewMexicoStateInvestmentOfficeTrust 9

US-Wyoming PermanentWyomingMineralTrustFund 9

Bahrain MumtalakatHoldingCompany 8

China-HongKongHongKongMonetaryAuthorityInvestmentPortfolio

8

9TheprinciplesassessedandtherespectivepointsgivenaresummarizedinAppendixA.10AssessmentasofOctober2009.

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China ChinaInvestmentCorporation 6

EastTimor Timor-LestePetroleumFund 6

Kazakhstan KazakhstanNationalFund 6

Kuwait KuwaitInvestmentAuthority 6

SingaporeGovernmentofSingaporeInvestmentCor-poration

6

China NationalSocialSecurityFund 5

Malaysia MalaysiaDevelopmentBerhad 5

Qatar QatarInvestmentAuthority 5

Russia NationalWelfareFund 5

Trinidad&Tobago HeritageandStabilizationFund 5

China China-AfricaDevelopmentFund 4

Malaysia KhazanahNasional 4

UAE-Dubai InvestmentCorporationofDubai 4

Vietnam StateCapitalInvestmentCorporation 4

SaudiArabia PublicInvestmentFund 3

UAE-AbuDhabi AbuDhabiInvestmentAuthority 3

UAE-RasAlKhaimah

RAKInvestmentAuthority 3

China SAFEInvestmentCompany 2

Libya LibyanInvestmentAuthority 2

SaudiArabia SAMAForeignHoldings 2

UAE-Federal EmiratesInvestmentAuthority 2

Algeria RevenueRegulationFund 1

Botswana PulaFund 1

Brunei BruneiInvestmentAgency 1

Iran OilStabilizationFund 1

Kiribati RevenueEqualizationReserveFund 1

Mauritania NationalFundforHydrocarbonReserves 1

Nigeria ExcessCrudeAccount 1

Oman StateGeneralReserveFund 1

Venezuela FIEM 1

The overview of the different ranking attempts reveals some interestinginformationwithregardstofundlevelperformance.First,thefundofNorwayis

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repeatedlyclassifiedasa “goodperformer”andemployedasabenchmarkofgovernance,transparencyandaccountability.TheNorwegianmodelissuggestedbymanyasaprimeexampletofollowandindeedseveralcountrieshaveemployedtheNorwegianmodelwhenestablishingtheirfunds(likethefundofKazakhstan).The Norwegian fund remains by far themost examined and best performingfund,especiallywhengovernance,transparencyandaccountabilityaspectsareconsidered.Nevertheless,when considering the practices that theNorwegianfundhasimplementedandthesuggestionstothelargergroupofSWFstofollowitsexample,thespecificcountrycharacteristicsofNorwayshouldbetakenintoconsideration(Box1).InthisrespecttheemploymentoftheNorwegianSWFasaprototypeanda successful performer shouldnotbeexaggerated,while thetypespecificsofthecountries/fundsthatarecalledtoimplementsimilarpracticesshould be further taken into account. Hence the scoreboards and blueprintattemptsshouldfurtherconsiderthepossiblelimitationsoftheNorwegianmodelasabenchmarkforotherSWFs.

Furthermore,severalmethodologicallimitationsshouldbeconsideredwhenemployingthesescoreboards.Theemploymentofthequantitativerankingandscoreboardattempts,suchas theTruman (2008)scoreboardor theLinaburg-Maduell Transparency Index, should consider the subjective nature of theindexesandthebiasthatthelattercancreate.Forinstance,intheSWFInstituteLinaburg-Maduell Transparency Index, for each principle assessed there aredifferent levelsofdepth, the judgmentofwhichreflectsthe judgmentsandthediscretionof theSovereignWealthFundInstitute.This is indicativeof the lackofobjectivequalitativeassessmentthatmaybepresentintheexistingrankingsand scoreboards.This can be further exacerbated by the fact thatSWFsareoften required to assess their own constituents. The available rankings andbenchmarks are largely developed based on the available public informationon theSWFs.Nevertheless, in some cases these facts have been confirmedwiththefundsthemselves. In thisrespect thefundsarecalledtocommentontheirownconstituents.Hencetheconflictof interests thatmayemergefor theassessedSWFsmightbiastheprovidedinformationandthederivedestimationresults,rankingsandscoreboards.

Box 1. The “Norwegian Model”11

11Source:Tsani(2009)

OilproductioninNorwaystartedintheearly1970s.Duringthefirstoilshock,productionwasonly32.000barrelsaday.Theexperiencewiththespikingoilpricesstimulatedtheproductionthatescalatedtoabout1millionbarrelsadayby1987and3millionbarrelsadayby1996(BaconandTordo,2006).Norwayhasasmallpopulationanddomesticdemandforoilislimited,makingitoneoftheleadingoilexporters.OilrichesinNorwayfledatatimewhentheeconomywas well-developed (Cappelen and Mjoset, 2009). Nevertheless, the scaleof thediscoverywas large in relation to the total sizeof theeconomyand ithas continued to grow considerably.Over the last decade, oil andgashaveaccountedforabout17%ofGDPand40%ofexports.Sincetheverybeginningofoildevelopment,questionswereraisedinfearof“Dutchdisease”abouthow

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tousetherevenueswithoutdistortingthenatureof theeconomyandsociety(Hannesson,2001).Furtherconcernswereraisedwithregardstothelong-termfundingneedsoftheincreasedpensionrequirementsthattheagingpopulationwouldrequire(Skancke,2002).Inresponsetothoseconcerns,inJune1990thegovernmentestablishedbyAct36oftheStorting,theNorwegianparliament,theNorwegianGovernmentPensionFund(NGPF)1.

Accordingtotheact,alloil-relatedrevenuesarepaidintotheNGPF,asareanyinterestsordividendsearnedonassetsalreadyheld.Themanagementof the fund has been entrusted to theMinistry of Finance. Since 1996 theMinistry has delegated responsibility for management to the Central Bank(Norges Bank). Norges Bank has further contracted externalmanagers forpartoftheportfoliobutithasalsomanagedalargepartoftheportfolioitself.From the very beginning, all the investments of the fund have beenmadeoutside Norway. This was due to the fear of distorting the relatively smalleconomybytheinjectionoflargesumsoffinancing.TheMinistryofFinancealongwiththegovernmenthasfurtherissuedinstructionstotheNorgesBankregardinginvestmentsinsociallyresponsibleactivities2.Accordingtothefundestablishing act the deficit on the government non-oil budget, determinedbytheParliament,ispaidoutofthefundwhilesurplusesremaininthefund(BaconandTordo,2006).Inthisrespectneithertheincomenorthecapitalofthe fund issafeguarded,as theParliamentcouldauthorizeabudgetdeficitlargeenoughtouseallcurrentoilrevenuesandsomeoftheaccumulatedpastrevenues.Thisisrelatedtothefungibilityofresources,astransfersintooroutofthefundtakeplaceaccordingtothenon-oildeficitofthecentralgovernment,whichitselfisdeterminedthroughnormalparliamentarybudgetaryprocesses.

DebtinNorwayissmallandastablefractionofGDP,whilethefundalreadyaccountsforavalueof60%ofGDP3.Henceitsassetscorrespondapproximatelytothenetfinancialpositionofthecentralgovernment.Thisenablesaprofoundprovisionoftransparency.Theassetsofthefundandtheirtrajectorycorrespondtogovernmentsavings,andpeoplearethuswellinformedofthenetpositionof thegovernmentthroughthefund’shighlypublicizedannualreports(eveniftheyarelesswell informedonthemagnitudeofoverallgovernmentdebt).WhenconsideringtheNorwegianfundthedistinctivefeatureisthatthefundis,dejure,partofthegeneralbudgetprocess.Theonlyexplicituseofthefundistosupportnon-oilbudgetdeficits.Similarly,thestatusofthefundissuchthatatanytimetheParliamentcanwithdrawasmuchasitwishesfromthefundtosupportthenon-oilbudgetdeficit.Inthisrespect,absenceofnoaccumulationorwithdrawalrulesmakesthefundveryflexible.Inpractice,thefundhasbeendefactousedlargelyasasavingsfund,althoughtherehavebeensubstantialyear-to-yearvariationsintheproportionofoilrevenuessaved.

1ThefundisalsoknownastheNorwegianGovernmentPetroleumFund.2In2001,theenvironmentalfundhasbeenestablishedassub-portfolioheldintheNGPF.

Itspurposeistoholdequitiesbasedonsoundenvironmentalcriteria.In2004,followingthedebateonthebudgetandthereportoftheCommitteeonEthicalIssuesforthePetroleumFund(GraverCommittee), theMinistryofFinance issuednewguidelineswith regards toethical investmentsundertakenbythefund.

3Asof2006.

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AttemptssuchasthoseofTruman(2008)ortheSWFInstituteTransparencyIndexemploya set of questionsaccording towhich fundsare ranked. In thiscasea“yes”or“no”answerisenoughsoastograntornotgrantfurtherpointstoeachfund.Nevertheless,thisapproachdoesnotallowforthecontrolofqualitydiscrepanciesbetweenthefunds.Forinstance,fundswillbegivenextrapointsintermsoftransparencyandaccountabilityiftheyoperateawebsite.Nevertheless,thequalityandthequantityof theinformationprovidedintherespectivefundsarenotreallyassessed.Hencefundsthatprovideverybasicinformationontheirwebsitemaybegrantedthesamepointsasfundsthatoperateamoredetailedand more frequently updated website. In addition the assessment questionsemployedmightaddressoverlappingaspects.

Forinstance,fundsthatregularlypublishannualreportsmightalsopublishinformationonthegeographicalspreadoftheirinvestmentsorontheperformanceagainsttheestablishedportfoliobenchmarks.Incontrast,fundsthatwouldchoosetobesecretiveintheiroperationswouldchoosetodosoinasetofinformationgiventothepublic.Inthiscasenon-identificationofthecommonalitiesbetweenthequestionsemployedandthecommonvariancemightleadtoduplicationofthe transparencyandaccountability aspectsassessed.This canduplicate thepointsawardedineachcaseandartificiallyinflatethequantitativeresults.

Theemploymentofscoreboardsandbenchmarksshouldconsiderinadditionthemotivation,theobjectivesandtheperspectivefortheconstructionoftheseindexes.ThequantitativerankingsandscoreboardsoftheSWFstodatereflectthe need for the international financial markets, the International FinancialinstitutionsandindependentcountriestounderstandtheroleofSWFs.Thishascome as an outcome of the realization that SWFs are becoming increasinglyimportantparticipantsintheinternationalfinancialsystem.Inaddition,recipientcountrieshave realized thepotentialbenefitsofopenness towards theSWFs.Nevertheless,thedebateontheroleoftheSWFsisongoing.Supportersconsiderthemlong-terminvestorsthathaveprovidedvery-much-neededcapitalinjectionsintimesoffinancialdistresslikethelatestfinancialcrisis.Skepticshighlightthepolitical controversy related toSWFsnotonly in the recipient countriesbut inmanycasesinthehostcountriesaswell.

The contrasting nature of whatmight be donewith the fund, andwhathasactuallybeendone,illustratesthestrongdisciplineoftheStorting.Suchstructure could be particularly vulnerable to a political election cycle, andoverlongerperiods,thismayprovetobeanimportantfactorintheuseofthefund.ThedisciplineofStorting is furtheraccompaniedby the limitedroleoftheParliamentandbodiesoutsidetheMinistryofFinance.Thewidepublicitygiventotheperformanceandmanagementofthefundthroughthewidespreadpublicationofthereportscaninfluencetheactivitiesofthefundthroughthedemocratic process. In short, the operation andmanagement of theNGPFhasbeensuccessfulinaccumulatingfundsfortheNorwegianstate.Itremainsto be seen whether the aggressive saving of oil funds and sophisticatedinvestment policies followed by the government will be able to accumulatesufficientfundstofinancefuturespendingneedsatatimewhenoilproductionwillbeindecline.

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Inanattempttoaddressthelaterdebate,theIMF,theOECD,theUSAandtheEUhavebeenworkingontheestablishmentofbestpracticesontheSWFs12.ThishasbeenshapedandinitsturnithasbeenshapingtheassessmentattemptsoftheSWFs.Theassessmentattemptshavebeenmuchmoreconcernedwithgovernance, transparencyandaccountabilitystandards thatareneeded in theinternationalfinancialmarketsratherthanwithwhatwouldbeadequateforthecitizensof thehostcountries.For instance, incases like thatofAzerbaijanorKazakhstan,theattemptsoftherespectivefundstoimprovetheirgovernance,transparency and accountability standards employing the benchmarks andrecommendationsestablishedbytheinternationalinitiativeshaveledtoimprovedrankingsfortherespectivecountries.TheStateOilFundofAzerbaijanhasbeenactivelyworkingtowardstheprovisionofhigherstandardsoftransparencyandaccountability leading to significant improvements in the respective rankingattemptssuchastheLinaburg-Maduelltransparencyindex.

Nevertheless, when assessing the later developments, it should be keptinmindthat fullpresidentialdiscretiononthereleaseandtheutilizationof theaccumulatedfundsstillremainsinplace.DevelopmentsaresimilarinthecaseofKazakhstan.Inbothcasesthepresidentsenjoysignificantpower.Inthiscontexttherespectivefundshavebeenworkingtowardsgreaterprovisionoftransparencyandaccountability;nevertheless,littlehaschangedintheirgovernanceasbothfunds remain governed by presidential decrees. Thus the funds emerge asthe “king (under the pressure of the IMF) binding his own hands by his ownrules” (Heuty andAristi, 2009). In this case the increased transparency andaccountabilityrecordedoverthelastyearsmightmerelyworkasanapparatusforpublicdemonstrationsofopennesswithoutessentiallyaffectingtheunderlyingpowerrelationships.

InasimilarwayinternationalinitiativessuchastheSantiagoPrincipleshavebeen aiming at addressing primarily concerns raised byWestern countries13.TheSantiagoPrincipleshavedevelopedinanattempttoputWesternconcernsat easeover the lackof accountability and transparencyof theSWFs. In thisrespecttheyhavebeendevelopedwithapreemptivepurposesoastocontrolthepossibleadoptionofprotectionistornationalistpolicies.This,however,hasbeenattemptedcarefullysoastonotaffectthefreeinvestmentflowsandtonotdiscomforttheSWFsthatclaimtheirinvestmentsarebasedpurelyoneconomicgrounds.Similarly,theprinciplesmakeuseofthesamevaluesthatthescoringandrankingattemptsmake.

In the same way, the Santiago Principles develop from an internationalperspective, hence transparency and accountability towards the citizens ofthe host countries is not addressed to the same extent. The effectiveness ofsuchinitiativesandthedegreetowhichtheycanbenefitthecitizensofthehostcountriescanbefurtherchallengedoncethevoluntarynatureofthecommitmentto the Principles is considered. Further concerns would emerge once the

12SeeTheTimes(2007),TheSundayTimes(2007),TheGuardian(2007),IMF(2008a;2008b),EuropeanCommissionCommunication(2008),EuropeanCommissionpressrelease(2008)andUSTreasuryDepartmentpressrelease(2008a;2008b).

13 Severalscholarsconsider theSantiagoPrinciplesas theoutcomeof the influenceofagroupofWesternCountries.ForadetaileddiscussionseeRose(2008).

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implementationsandenforcement limitationspresent in theverynatureof theSantiago Principles are taken into consideration. In this respect, views rangefromconsidering theSantiagoPrinciplesdeficient (Rose,2008) toa“band-aidoveragapingwound”(Wong,2009).

Overall governance, transparency and accountability improvements of theSWFs remain a core aspect of their effectiveness and their success. This isrelatednotonly to the internationalwelcomingof theSWFsbut to thebenefitof the domestic economies and the citizens of the respective host countries.Thedevelopedscoreboards, rankingattemptsand thesuggestedsetsofbestpracticesshouldbeconsidered,acknowledgingtheirmethodologicallimitationsandtheirinternationalperspective.Theinvolvedpartiesandpolicymakersshouldactivelyworkinimprovingthesescoringattemptsandindentifiedbestpractices.TheseeffortsneedtoaddressnotonlyinternationalskepticismtowardsSWFs’operationsandinvestments;theyshouldfurtheraddresstheconcernsabouttoSWFsinthehostcountries.Thelattercanbeaddressedwiththeclearformulationofthegoalsandtheoperationsofthefundstothepublic.Thiscanenforcethelegitimacyofthefunds,allowingpublicscrutinyandreducingrent-seekingorofpoliticalbenefitactions.DevelopmentsintheassessmentoftheSWFsaswellasintheidentifiedbestpracticeshavetobeconductedenforcingtheprovisionof greater transparency and accountability towards the citizens of the hostcountries.Thelattercansignificantlyreducethemarginformisinterpretationinsuchinitiativesandintheidentifiedbestpractices.

4. Conclusion and policy recommendations

The experience to date suggests that strong governance structures,transparency and accountability remain key factors of success for theSWFs.Success is related to thewelcomingof theSWFs in the internationalfinancialarenaaskeyplayersandtothewelcomingoftheirinvestmentsintherecipientcountries.Inaddition,successisrelatedtotheeaseofcontroversysurroundingSWFs in the host countries. Strong governance and adequate provision oftransparencyandaccountabilitycanfostersuccessincombatingpoliticalmisuse,rent-seekingandcorruptioninSWFoperations.

ForcountriesendowedwithnaturalresourcesandSWFsestablishedoutofnaturalresourcerevenues,thiswouldfosterthecontrolofrevenuemanagementand theprudent intergenerationaland intra-generationalallocationof thefinitenationalwealth. Inmacroeconomic terms,stronggovernanceandprovisionofadequatetransparencyandaccountabilitywouldfosterfiscalsustainabilityoftherespectivecountries,furtherenforcingtheirinternationalpositioning.StrongandtransparentgovernancecanstrengthenpublicconstituencyonthemobilizationandtheuseoftheSWFassets.Inaddition,itwouldfacilitatethemonitoringofthefinancialcommitmentofthepoliticiansandtheirconsistencyinmaintainingafinancialbalance in theaccumulationandspendingof theSWF,overcomingproblemsofpoliticalmisuseoftheassetsandsubsequentpoliticalunrest.

Reflectinginlargeparttheneedsoftheinternationalfinancialmarkets,theperceptionsoftheInternationalFinancialInstitutionsandtheconcernsofmajorWesterneconomies,severalattemptshavebeenmadeatprovidingscoreboardsandquantitativerankingsoftheSWFs.Theseattemptshaveprogressedalong

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thelinesofthedevelopmentandtheestablishmentofasetofgenerallyacceptedbest practices as suggested by organizations like theOECD, by InternationalFinancial Institutions such as the IMF, or by individual countries or group ofcountriesliketheUSAortheEU.

Themost characteristicof suchattempts remains theSantiagoPrinciples.Similar to the earlier attempts, the Santiago Principles reflect in large partWesternworriesandtheneedofinternationalfinancialmarketsfortransparencyandaccountabilityprovision from theparticipatingfinancialactorssuchas theSWFs.Nevertheless,theneedforstronggovernancestructuresandtheprovisionof adequate transparency and accountability towards the citizens of the hostcountries shouldnot bedisregarded. In this respect, theexisting scoreboardsaddresstheseneedstoa limiteddegree.Furthermore, thevoluntarynatureofthecommitmenttointernationalinitiativesandthelimitedreferencetoprovisionoftransparencyonnationallevelsleavessignificantroomforimprovementsonnationallevels.

The overview of the assessment attempts, the scoreboards ofSWFs andthe proposed fund benchmarks and best practices developed to date furtherindicate the necessity of a better understanding of their particularities andtheirmethodological limitations.Thesubjectivenatureof thecriteriaemployedand theassessmentprovided, the internationalperspectiveemployedand theconflictinginterestsinvolvedmighthindertheestimationresultsandconsequentrecommendations.Moreover,theadoptionofspecificfundcasesasbenchmarksmight not be applicable to every single fund and country. Macroeconomicdifferentials, the pace of institutional development and integration, and fiscalneedsmightrenderthe“one-size-fits-all”approachunrealistic.Ontheotherhand,thevastdiscrepanciesbetweendifferent fundsand theirperformance indicatethattheycannotbestudiedinagrouporassessedagainsteachotherunlessasetofgenerallyacceptedprinciplesandpracticesisputinplace.

In the absence of the latter, the welcoming of SWFs in the internationalfinancialarenaandoftheirinvestmentsintherecipientcountriescanbesubjecttoskepticism.ThisbecomesmoreapparentwhenconsideringtheinjectionofvastamountsfromtheSWFsofcountries likeChinaorQatar towardstheWesternmarketsintimessuchasthelatestfinancialturmoil.Thelattershiftintheworldeconomic balanceshasmademany international organizations and individualcountrieshighlight theneed for theestablishmentofagenerallyacceptedsetof practices and standards of transparency and accountability to be adoptedby theSWFs. InadditionmanyWesterncountrieshaveclarified theirpositiontowardstheinvestmentsmadebytheSWFandtheirfinallegitimacytoprotecttheirnationalinterests.

In this respect policymakers and international financial institutions shouldkeepworkingonfosteringtheexistingsetsofbestpracticesandonpromotingtheactiveengagementof theSWFsand therespectivecountries to the latter.Nevertheless, theseattemptsshouldnotdisregard that littleprovision ismadein the existing practices for the fostering of governance, transparency andaccountability towards the citizens of the countries that remain the legitimatebeneficiaries of the fund operations and the ultimate domestic monitoringapparatus.SystematicmonitoringoftheSWFsagainstthesetofgoodpracticesand international benchmarks should continue. Nevertheless, this should

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developsoastofurtherensurethatthecitizensbenefitfromSWFsoperationsand investments and they receive full transparency and accountability. If thisparameter is not taken into serious consideration the assessed and recordedlevels of governance strengthening might merely monitor superficial publicdemonstrationsof transparencyandaccountabilitywithoutessentiallyaffectingtheunderlyingpowerrelationships.

In order to strengthengovernance, transparencyandaccountability of theSWFs:

1. International initiatives should keep working on the fostering of good governance, transparency and accountability practices and on their being embraced by a larger group of SWFs.ExperiencewithsuccessfulSWFsshouldbeusedasastartingpointsoas toderiveasetofgovernance, transparencyandaccountabilitypractices thatcan foster theefficiencyand the internationalwelcoming of the SWFs. Systematic monitoring of SWFs against the set ofgood practices and international benchmarks should continue. Nevertheless,suchattemptsshouldconsider thecountry-fundspecifics thatmightmake thereplicationofthesamemodelineachcaseunrealistic.Inaddition,thefactthatthecitizensremaintheultimatebeneficiariesoftheSWFoperationsandthemostappropriatedomesticmonitoringapparatusofpoliticalmisuseshouldbekeptinmindinthelatterefforts.

2. Employment of the existing SWF rankings and scoreboards should acknowledge their international perspective and the methodological limitations present. Thesemightsignificantlyaffecttheobtainedrankingsandthesubsequent recommendations. In thisarea the internationalorganizations,the International Financial Institutions, individual countries andSWFs have tofurtherworkonimprovingtheexistingmethodologyemployed.Atthesametimeany assessmentmaking use of the scoreboards and rankings to date shouldcarefullyconsiderwhethertherecordedimprovementsofchangesrepresentrealchangesintheexistingpowerrelationships.

3. The ranking attempts and the international initiatives on best practices should not disregard the fact that the citizens of the countries remain the ultimate beneficiaries of the SWF investments and operations.Citizenscanfurtherprovidevaluablesupport inmonitoring thepoliticallymotivatedusesoftheSWFsorthepoliticalmisuseoftheaccumulatedassets.Inthisrespect,anyassessment attempts should further consider governance, transparency andaccountabilitydevelopmentsvis-à-visthecitizensofthecountries.Internationalinitiativescanbeusedas leverage in fosteringgovernance, transparencyandaccountabilitychangesnotonly towards the internationalmarketsbut towardsthecitizensofthecountriesaswell.

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Appendix A

Table 3. Principles of the Linaburg-Maduell Transparency Index

Point given Principle

1Fundprovideshistoryincludingreasonforcreation,originsofwealth,andgovernmentownershipstructure

1 Fundprovidesup-to-dateindependentlyauditedannualreports

1Fundprovidesownershippercentageofcompanyholdings,andgeo-graphiclocationsofholdings

1Fundprovidestotalportfoliomarketvalue,returns,andmanagementcompensation

1Fundprovidesguidelinesinreferencetoethicalstandards,investmentpolicies,andenforcerofguidelines

1 Fundprovidesclearstrategiesandobjectives

1Ifapplicable,thefundclearlyidentifiessubsidiariesandcontactinforma-tion

1 Ifapplicable,thefundidentifiesexternalmanagers1 Fundmanagesitsownwebsite

1Fundprovidesmainofficelocationaddressandcontactinformationsuchastelephoneandfax

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State Oil Fund of Azerbaijan Republic: Past, present and future

Ingilab Ahmadov PublicFinanceMonitoringCenter,Azerbaijan.

Kenan AslanliPublicFinanceMonitoringCenter,Azerbaijan.

Introduction Throughout the formersocialistcamp,Azerbaijanwas thefirst toestablish

astabilization fund for theaccumulationof income fromhydrocarbonexports,and in late 1999, by a special decreeof thePresident, theStateOil FundofAzerbaijanRepublic(SOFAZ)wasfounded.EstablishmentoftheFundcoincidedwith the period when in public opinion, in the run-up to the expectations ofincrediblyhighoilrevenues,therewasasenseoftransformationofAzerbaijantoasecondKuwaitinthenearfuture.SOFAZwasestablishedforcollectionandeffectivemanagementoffundsfromthesaleofprofitoilextractedbybothlocalandforeigncompaniesaswellasfordirectionofthesefundstodevelopmentofleadingspheresandimplementationofsignificantprojects.Forthisperiod,asitwassupposedbyexperts,Azerbaijandidn’tturnintoKuwait.However,thewideexperienceinmanagementofoilandgasrevenueswhichwascollectedduringthisperiodappearstobearemarkablelessonformanyresource-richcountries.

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SOFAZ’s history and governance principles

TheStateOilFundoftheRepublicofAzerbaijan(SOFAZ)wasestablishedinaccordancewiththedecreeofthePresidentoftheRepublicofAzerbaijandatedDecember 29, 1999 “OnEstablishment of theStateOil Fund of theRepublicofAzerbaijan.”StatutoryRegulations of theStateOil Fundof theRepublic ofAzerbaijanwereapprovedbythePresidentoftheRepublicofAzerbaijandatedDecember29,2000.ThecornerstoneofthephilosophybehindtheOilFundwasto ensure intergenerational equality of benefit with regard to the country’s oilwealth,whilst improving the economicwell-being of the population today andsafeguardingeconomicsecurityforfuturegenerations1.

A number of agreements on joint development of oil and gas resourcesweresignedwithforeigninvestorswhichhavebeenbeingrealizedsince1994.Theissueoneffectivemanagementofrevenuesfromimplementationof theseagreementswasbroughttotheagenda.SOFAZhasthepurposeofformationofsuchamechanism.TheFund’sactivityisdirectedtowardtheachievementofthefollowingobjectives:(i)preservationofmacroeconomicstability,ensuringfiscal-taxdiscipline,decreasingdependenceonoilrevenuesandstimulatingdevelopmentof the non-oil sector; (ii) taking into account that oil and gas are deployableresources ensuring intergenerational equality with regard to the country’s oilwealthandtoaccumulateandpreserveoilrevenuesforfuturegenerations;(iii)financingmajornationalscaleprojectstosupportsocio-economicprogress.

SOFAZ's activities in the field of assets accumulation and spending areoverseenbyaSupervisoryBoard.TheBoardistoreviewtheFund'sdraftannualbudget,annualreportandfinancialstatementsalongwithauditor'sopinionandprovideitscomments.MembersoftheSupervisoryBoardareappointedbythePresidentandrepresentmainlystatebodies.InaccordancewiththepresidentialdecreedatedNovember27,2008,sevennewmembersoftheSupervisoryBoardwereappointed.PrimeMinisterArthurRasizadewasre-electedChairmanoftheSOFAZSupervisory Board. Civil society’s participation in themanagement ofSOFAZhasn’tbeenimplementedyet.

SOFAZ’sdailymanagementisvestedwiththeExecutiveDirector,appointedby and accountable to the President. SOFAZ’s Executive Director as a chiefexecutiveofficer is vestedwith thepowers tobea legal representativeof theFund, organize and conduct business of the Fund including appointment anddismissal of employees,management and disbursement of the assets of theFund in conformity with the rules and regulations approved by the PresidentofAzerbaijan.TheExecutiveDirector is responsible for thepreparationof theannualbudgetofSOFAZ,incorporatinganannualprogramoftheFund’sassetsutilization,anditssubmissionfortheapprovalofthePresidentofAzerbaijan.

Regarding “Decree of the President of the Republic of Azerbaijan onestablishmentoftheStateOilFundoftheRepublicofAzerbaijan”(29.12.1999)SOFAZ fulfilled itsoperations throughaspecialaccountof theNationalBank.SOFAZ is accountable and responsible to the President of the Republic ofAzerbaijan.TheFundisanextra-budgetaryinstitution.TheFundisalegalentity

1http://www.oilfund.az

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andmusthaveasettlementaccountandotheraccountsatbankinginstitutions2.ASupervisoryBoardexercisesgeneralcontroloverestablishmentandspendingoftheFund’sassets.The main responsibility of the Fund is to ensure collection and effective management of foreign currency and other assets that are generated from the implementation of agreements signed in the field of oil and gas exploration, and development, as well as from the Fund’s own activities, in the interest of citizens of the Republic of Azerbaijan and their future generations. The Fund’s assets form on the account of the followingsources:

- Revenues generated from implementing agreements on exploration,development and production sharing for oil and gas fields in the territory ofAzerbaijan;

-NetrevenuesfromthesaleofhydrocarbonsfallingtotheshareofAzerbaijan;-Oilandgasagreements’signatureorperformancebonusespaidbyinvestors

totheStateOilCompanyoftheAzerbaijanRepublic;-Acreagepayments;-DividendsandprofitparticipationrevenuesfallingtotheshareofAzerbaijan;-RevenuesgeneratedfromoilandgaspassingovertheterritoryofAzerbaijan;-RevenuesgeneratedfromthetransferofassetsfrominvestorstotheState

OilCompanyorwithintheframeworkofoilandgasagreements;- Revenues generated from the placement, management, sale or other

utilizationof theFund’sassetsandrevenuesfromassetrevaluationandotherrelatedrevenues;

-Grantandotherfreeaid,andotherrevenuesandreceipts inaccordancewiththelegislation.

TheFund’sassetsundermanagementareplacedininvestment-graderatedbanksandinstruments.TheSupervisoryBoardoftheFunddeterminesrulesforaccountingandreportingtheuseoftheFund’sassets.UtilizationoftheFund’sassetsiscarriedoutinaccordancewithmaindirectionstobeapprovedeachyearthroughPresidentialResolutions.TheFund’sassetsmaybeusedforsolvingthemostimportantnationwideproblems,andforconstructionandreconstructionofstrategically significant infrastructure facilities for the purpose of the country’ssocio-economicprogress.

FordecreasingtherisksinthemanagementoftheOilFund’sforeigncurrencyassets, their limits shall be defined on the basis of the following principles3:definingcredit risk, i.e.maximum limitof theamount invested inonefinancialinstitutionandassetand theminimumsufficientcredit rating;defining liquidityrisk,i.e.maximummaturityoftheinvestmentportfolioandminimumliquiditylimitforstandardsperiods;anddefiningmarketrisk(currencyriskand interestraterisk)aswellaseachcurrencyincludedintheinvestmentportfolioandmaximumweightoftheinvestmentassetsdominatedinthesecurrencies,andmaturityoftheinvestmentportfolio.

2“Regulations(Statute)ontheStateOilFundoftheRepublicofAzerbaijan”approvedbytheDecreeofthePresidentoftheRepublicofAzerbaijan№434datedDecember29,2000.

3“Rulesonholding,placementandmanagementof foreigncurrencyassetsof theStateOilFund of theRepublic ofAzerbaijan” approved by theDecree of thePresident of theRepublic ofAzerbaijan№511datedJune19,2001

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TheOilFund'sbudgetisanannualfinancialprogrampreparedincompliancewiththelegislationofAzerbaijantoensuretheimplementationoftheOilFund'sobjectivesandfunctionsandreflectstheOilFund'srevenuesandexpenditures.ThepreparationandexecutionoftheOilFund'sbudgetshallbebasedontheprincipleoftheimplementationofacoherentmacroeconomicpolicyinAzerbaijanandtheconsolidation of revenues and expenditures of the consolidated government.EffectingofanyexpenditureonOilFund’sassetsextraneousfromtheOilFund’sbudget by theOil Fund is inadmissible. Expenditures that can arise from theOilFund’sassets’ revaluation in theOilFund’s reportedcurrency (Azerbaijanimanat)aswellasexpendituresinconnectionwithpaymentoflawfullydeterminedtaxesandanyotherobligatorypaymentsarenotintendedinthebudgetoftheOilFundandareinfactreflectedasextra-budgetaryexpendituresinthebalanceoftheOilFund.BudgetexpendituresoftheOilFundaswellasfinancinglawfullydeterminedtaxesandanyotherextra-budgetaryobligatorypaymentsareeffectedontheOilFund’sassetsinthenationalcurrencyoftheRepublicofAzerbaijanandforeigncurrency.FinancingtheOilFund’sexpendituresandpaymentsinthenationalcurrencyoftheRepublicofAzerbaijanisprovidedincompliancewiththelegislationofAzerbaijanbyconversionoftheOilFund’sforeigncurrencyassetstothenationalcurrencyofAzerbaijan4.

Along-termstrategyonmanagementofoilandgasrevenues,whichcoversthe period 2005-2025, establishes the principles for the use of oil and gasrevenues andmedium-term expenditures policy for this period5. This strategyensuresthemanagementoftherevenuesacquiredfromsaleofnaturalgasandoilinconformitywiththesourcesdescribedbelow,accruedintheStateOilFundoftheAzerbaijanRepublic,andinthestatebudget.Theprinciplesforlong-termuseofoilandgasrevenuesareasfollows:whenforecastingtheamountoflong-termexpenditures fromoil andgas revenues, the ‘constant realexpenditures’principle shall be used as a basis and annual limits shall be set for theseexpendituresthataretobemadewithintheperiodcoveredbythestrategy;whenincomesfromoilandgasrevenuespeak,atleast25percentofthemissaved;theregulationsadoptedforspendingoilandgasrevenuesshallremainunchangedduringtheeffectiveperiodofthelong-termstrategyonmanagementofoilandgasrevenuesandtheexpenditurelimitsprojectedonthebasisoftheconstantrealexpendituresprincipleisobserved;thevolumeofmedium-termexpendituresshallbedeterminedbasedonthenon-oildeficit(thedifferencebetweenrevenuesand expenditures of the consolidated budget of the country, excluding the oilsector)andtakingaccountofthelong-termexpenditurelimit.Sharpyear-to-yearfluctuations inexpendituresareundesirableand thenon-oildeficitmaynotbeabruptlychanged; investmentexpendituresshallbemade in the frameworkofthemedium-termStateInvestmentProgramthatisdraftedannually;meetingthecurrenthighdemandofAzerbaijanforinvestmentwillresultinlargerexpendituresduringtheinitialperiodandcreateconditionsforthedevelopmentofthenon-oil

4“Rulesonthepreparationandexecutionoftheannualprogramofrevenuesandexpenditures(budget)oftheStateOilFundoftheRepublicofAzerbaijan”approvedbytheDecreeofthePresidentoftheRepublicofAzerbaijan№579datedSeptember12,2001

5“Long-termstrategyonthemanagementofoilandgasrevenues”approvedbytheDecreeofthe PresidentoftheRepublicofAzerbaijan№128datedSeptember27,2004

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sectorand thegradual reduction in thedependenceonoilandgas revenues.Thedevelopmentofthenon-oilsectorbasedontheuseoflong-termoilandgasrevenueswill help in reducing the country’s need for external borrowing.Thestrategyonuseofoilandgasrevenuesincludesthefollowingobjectives,whileaimingatretainingmacroeconomicstability:

-developingthenon-oilsector,regions,SMEs;- large-scale development of infrastructure; fulfillment of poverty reduction

measuresandthesolutionofothersocialproblems;-stimulatingtheimprovementoftheintellectual,material,andtechnicalbase

oftheeconomy;developmentof“humancapital;”-consolidatingthedefensecapabilitiesofthecountry;-executingprojectsrelatingtoreconstructionactivitiesinliberatedterritories

andthereturnofinternallydisplacedpersonstotheirnativelands.SOFAZ’sactivitiesareregulatedbyregulations.ButtherearecriticsbyEITI

NGOCoalition that themain regulatorydocument shouldbe law.Azerbaijani civil society groups have already prepared a draft law on SOFAZ.Regardingthatdraftlaw:

“administrationexpensesoftheFundshallnotbemorethan5%ofitsannualrevenue.It isimpossibletosubstantiatethe5%,astheinternationalstandardscontainthelimitof5%asanexceptionalcase.Inmyopinion,wemaypreserve10%andnotwriteanyotherfigureshere.TheFundshallbeaccountableandresponsibletotheMilliMejlisoftheRepublicofAzerbaijan.TheliquidfundsoftheFundwillbepreservedinthehighlyratedandinternationallyrecognizedbanksdeterminedby theSupervisionBoardwith theassetsexpressedmainly inUSdollars,Euro,BritishpoundsterlingandJapaneseyenandinothercurrenciesnotexceeding10%.Theassetspreservedwithanybanksmaynotexceed20%oftheFund’sliquidfunds.30%oftheFund’sannualrevenuesshallbeallottedforcollectionpurposeswithineachfiscalyear.TheFundscollectionassignmentassetsarepreservedforneedsofthenextgenerations,andexcludingprovisionscontainedinthislaw,itcannotbeusedforothergoals.ByreleaseoftheoccupiedAzerbaijanilands,approximately50%oftheFund’sstockingassignmentassetsmaybeusedforthepurposeoffinancingofactionsrelatedtothereorganizationof these territories and returning of refugees to their homeland. The Fund’sstocking assignment assetsmay be sued if the net revenues generated fromsaleofhydrocarbonsfallingtotheshareoftheAzerbaijanRepublicarelessthanthosegeneratedfromplacementandmanagementoftheFund’sassets.

TheFund’sInvestmentportfolioisplacedbasedonthefollowingprinciples:theweightofonedirectionintheinvestmentportfoliomaynotexceed50%;theshareofonecontinentintheinvestmentportfoliomaynotbemorethan50%;theshareofinvestmentsintheinvestmentportfoliomaynotbemorethan50%.TheFund’sinvestmentsareimplementedbasedonthefollowingcriterion:theethicalprinciples prepared by theSupervision Board are applied to the investments;thestateauthoritieswithoutastrategicplanmaynotbeallottedanyfunds;theshare in the inter-country investments by small and average enterprisesmaynot exceed30%.Fundassetsmaybeassigned to financeprojects aimingat

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developmentofthenon-oilsectoroftheeconomy,aswellassmallandmedium-sizedentrepreneurship basedonpreservingthemacroeconomicstability.ThelistoffinancedprojectsisdeterminedbytheFund’sSupervisoryBoardaccordingtotheproposalsoftherelatedexecutiveauthority.Approximately1%oftherevenuesgeneratedbytheFundwithinayear is tobedirectedtowardsfinancingof thesocial investment programs. The financingwithin the framework of the socialinvestmentprogramsisassignedtothecivilcommunityinstitutionsbasedonthecompetitionscarriedoutaccording to the rulesdeterminedby theSupervisoryBoard. The expenditure of assets allotted for projects’ implementation will beunder control of the Supervisory Board. The amount transferred from the Fund’s assets to the budget each year shall not exceed 20% of the Fund’s annual revenue.

TheSupervisoryBoardoftheFundcaninclude9members.3membersoftheSupervisoryBoardfromthecorrespondingexecutiveauthoritiesareappointedbythePresidentoftheAzerbaijanRepublic.6membersoftheSupervisoryBoardfromthecandidatesofthefieldtradeunionorganizationsactingintheoilandgasindustry,NGOsspecializinginthecorrespondingfieldsandscientificinstitutionsareselectedbytheMilliMejlisoftheAzerbaijanRepublic.TheExecutiveDirectorshallbeappointedfor3years.ThesamepersonshallnothavetherighttobetheExecutiveDirectortwice.TheactivityoftheFundisauditedbytheAuditChamberof the Azerbaijan Republic and the independent foreign auditor. InformationregardingtheFund’sactivityincludingtheFund’sprofits,assets,otherinformationconcerningtheplacinganduseofthesefundsmaynotpertaintotherangeofinformationwithrestrictedaccess”.

SOFAZ’s asset and revenue management

SOFAZ’sassetsaremanagedinaccordancewiththe“Rulesforaccumulation,investmentandmanagementofassetsoftheStateOilFundoftheRepublicofAzerbaijan”(InvestmentGuidelines)approvedbyapresidentialdecreeofJune19,2001.AccordingtotheseRulesthepurposeofmanagementoftheOilFund’sforeigncurrencyassetsistoholdforeigncurrencyassetsoftheOilFundsecurelyand to generate revenues by effectivemanagement. Outside theRepublic ofAzerbaijan,thecurrentaccountsoftheOilFundshouldbeopenedwithbanksrated by reputable international rating agencies such as Standard & Poor’s,Moody’sandFitchwithalong-termcreditratingnotlowerthan:“AA-”asdefinedby Standard & Poor’s or Fitch, or “Aa3” as defined by Moody’s. The Fund’scounterpartsininternationalfinancialmarketsmightbeinstitutionswithlongtermcreditratingsnotlessthanBBB(byStandardandPoor’s),BBB(byFitch)orBaa(byMoody’s).ThemaximumweightofonefinancialinstitutionoroneinvestmentintheinvestmentportfoliooftheFundissetat15%ofthetotalamountoftheinvestmentportfolio(exceptionsarecentralbanks,custodianbanksandexternalmanagers).50%ofthetotalamountoftheinvestmentportfoliooftheFundistobeinvestedinassetsdenominatedinUSDollars,and40%inassetsdenominatedinEuro,5%inassetsdenominatedinGBP,whereas5%ofthetotalamountoftheinvestmentportfoliooftheFundistobeinvestedinassetsdenominatedeitherincurrenciesofcountrieswithlong-termcountryratings(sovereigndebt)notless

78

thanthecreditratingsA(Standard&Poor’s,Fitch)orA2(Moody’s);inUSDollarsorinUSDollars,EuroandGBPbasedontheirrespectiveweight6.

Source: State Oil Fund, author calculations

Accordingtoinvestmentpolicy,upto60%oftheFund'sinvestmentportfoliocanbemanagedbyexternalmanagers.Theassetsgiventoanexternalmanagercannot exceed 15% of the total amount of the investment portfolio. SOFAZ'sinvestmentportfolioshouldnotbeinvestedincurrencyarbitrage,swaps,forwardsand futures (except for the purpose of hedging or optimizing the currencycomposition of the investment portfolio and structure of theSOFAZ’s assets),preciousmetalsandstones,orrealestate.

Themain projects are financed by SOFAZ include: a) “State Program oneducationofAzerbaijaniyouthabroadintheyears2007-2015”;b)“Baku-Tbilisi-KarsNewRailway”Project;c)constructingawaterpipelinefromOguz-GabalaregiontoBakucity;d)reconstructionoftheSamur-Absheronirrigationsystem;e)FormationofthestatutorycapitalofAzerbaijanInvestmentCompany;f)SettlementoftheproblemsofrefugeesandinternallydisplacedpersonswhowereforcedtofleetheirnativelandsasaresultofArmenianinvasionontheNagornoKarabakhregionofAzerbaijan;g)Baku-Tbilisi-CeyhanMainExportPipeline.

As a result of three quarters of 2010, theSOFAZ continued the policy ofplacingtheinvestmentportfoliointheshort-terminstruments,andtheshareoffundsinvestedforuptofiveyearsmakesup94.85percentoftheassets.Intotal,

6http://www.oilfund.az

 

0.369

Increasing up to 44 times

16.2

0

2

4

6

8

10

12

14

16

18SOFAZ's assets (bln.$)

79

the investmentportfolioofSOFAZaccountsfor99.82percent($21.681billion)ofthetotalassets.AsofOctober12010,38.02percentoftheportfoliohasbeenplacedinsecuritiesforaperiodexceedingoneyear,25.93percent-fromonetothreeyears,30.99percent-fromthreetofiveyearsand4.97percent,including0.1percentofincomeinassets-morethanfiveyears.Currently,43.59percentoftheFund'sinvestmentportfoliohasbeenplacedinsecuritiesratedAAA,21.74percent -AA, 27.55 percent -A, 7.09 percent - BBB, 0.04 percent accountsforother.SOFAZ'sassetshavebeenplacedpartly insecuritiesandmonetarymarket instruments (deposits, bankaccounts).Only0.1percentof theFund'sportfoliohasbeenplacedinshares.Currently,34.08percenthasbeenplacedinthebondsofagenciesandinternationalorganizations,13.35percent-sovereigndebtsecurities,3.54percent -depositsandmonetarymarket instrumentsand4.08percent-bankaccounts.GeographicplacementoftheassetsoftheOilFundisasfollows:73.66percentplacedinEuropeancountries,10.82percent-NorthAmerica,8.04percent-ininternationalfinancialinstitutions,4.31percent-Asiaandothers.AsofOct.1,2010,SOFAZ'sassetsincreased45.8percentcomparedwiththebeginningofthisyear($14,900.4billion),amountingto$21,720.8million.

SOFAZ’s relations with the state budget

TherevenuesoftheStateOilFundofAzerbaijanRepublic(SOFAZ)madeup8,176.7millionAZNanditsexpenses5,294.5millionAZNin2009.TheincomesoftheFundwerefulfilledby97.8%andexpensesby99.5%.Thegreatestpartof theFund’s income (93.4%)wasprovidedby theprofit tablesaleofoil andgas. It’sprobably impossibletoevaluatetheeconomic-budgetmodelofrecentyearswithout theSOFAZ / state budget relationship.The transfers of theOilFund to thebudgetasof2003gaveastart to this relationship.Thegrowthofthesetransfersyearbyyearanditsbudgetshareofalmost50%atthepresentconsiderably improve this relationship. Such a situation itself causes certainanxiety.Hence,thegrowthstrengthensthedependenceofthebudgetupontheoilfundandweakensitsmotivationfortaxcollections.Theshareoftransfersinbudget incomesexceeded40%(AZN4915million)during thecrisisyear.Thetransfersaregoingtocomprisehalfofbudgetincomesthatwillbereducednextyear.The increase of the amount of transfers directs the attention to SOFAZand necessitates the acceptance of fiscal policy guidelines based on seriousprinciples for the fund-budget relations.Thecurrentestimationsshow that themostsuitablefigureforAzerbaijaninthisregardis30%ofSOFAZassets7.

TheapprovedbudgetincomesofSOFAZhavebeenapprovedas5,963,126.7thousandAZNandexpensesas5,428,431.2thousandAZN.AsisseentheFundisgoingtospendalmostallofitsrevenues(91%)duringthecurrentyearwhichishappeningforthefirsttimeinthehistoryofitsactivity.Itshouldbementionedthatthegreatestpartofthisamount(90.5%)belongstostatebudgettransfers.The concern related to the expansion of the dependence upon oil factor isalreadyquiteobviousin2010.Thus it’s clear that the tendency of the Oil Fund to become the main donor of the state budget is growing and reaching a level

7Dr.İngilabAhmadov,KananAslanli,ShahriyarAhmadov.“Globaleconomiccrisisandstatebudget:ThecaseofAzerbaijan”,NationalBudgetGroup,Baku2010

80

that can become dangerous for the continuous development perspectives of the economy. WhenreviewingthedynamicsofthelinkbetweenthestatebudgetandSOFAZ,thingsbecomefairlyclear.

Share of SOFAZ transfers in budget incomes

Source: National Budget Group

IftheamountofOilFundtransferstothestatebudgetwas100millionAZNin2003, thefigurewentup to130million in2004, to150million in2005,585millionin2006,another585millionin2007,1.1millionin2008and4.9billionin2009andfinally4.915billionin2010.However,thepointofconcernisnotonlythe increased amount of transfers, but also the Fund’s decision to spend thegreatestportionofitsbudgetin2010.ItshouldbementionedthatthePresidentialdecreeofSeptember27,2004on“Long-termStrategyfortheUtilizationofOilandGasrevenues”specificallynotesthatatleast25%ofoilandgasrevenuesshall be accumulated for the coming generations during the peak periods.Withoutadoubt,thelackofprecisestandardizationmechanismsintheabove-mentioned strategymakes itmore complicated to legally evaluate howmuchthemanagementofOilFundresources in2010complieswith thePresidentialdecree.And namely this fact makes it necessary to accept a perfect law onSOFAZ.Sucha lawwouldalsoeliminate theproblemof themissing limitationmechanism. It’sworthwhile tomention that theEITINGOcoalition functioninginAzerbaijan has carried out continuous activities in this field and developedtheprojectof theLawon“OilFund.”Despiteall this, thedecisionof theFundtospendthegreatestportionof itsresourcesobtainedduring thecrisisperiodindicatesto its tendencytosolvetheproblemof theshortageofmeansof thestatetreasurythroughaneasierwayunderanunfavorableeconomiccondition.WhentakingalookatthedynamicsofSOFAZprofitabilityandbudgettransferswe comeupwith somecuriousoutcomes.Thoughnot observed in 2007, theincreaseofbudgettransfersagainstthedecreaseoftensionin2008and2009

 

81

istheproblemofalarmingfiscaltension.Thoughprofitabilitywentdownin2008and2009comparedto2007,the549%increaseintransfersisproofofourpoint.TheincreaseofSOFAZpaymentsinbudgetincomesespeciallyduringthecrisisyeardenotedthattheglobalcrisisdidnotbypassAzerbaijanandthegovernmentwasobligedtorelyontheresourcesaccumulatedintheoilfundandtreatthemas an income source.The year of 2010,which is still impacted by the crisis,witnessesthecontinuationofthealarmingtendencybothinthestatebudgetandoil fundbudget.Nowthefundwillbeproviding50%ofbudget incomes.Alongwiththis,nogrowthisexpectedintheprofitabilityoftheoilfunditself.

BudgetrevenuesoftheStateOilFundoftheRepublicofAzerbaijan(SOFAZ)fortheperiodofJanuarytoDecember2009reached8,176.7billionmanat,whilebudget expenditures constituted 5,294.5 billionmanat. 2009 budget revenuesandexpendituresoftheFundwereexecutedaccordingly:97.8percentand99.5percent.Revenueof7,870.8billionmanatwasreceivedfromimplementationofoilandgasagreements,including7,702.6billionmanatfromthesaleofprofitoilandgas,156.8millionmanatfromAzerbaijan'sStateparticipationshareintheHeydarAliyevBaku-Tbilisi-Ceyhan(BTC)MainExportPipeline,8.9millionmanatastransitpayments,1.1millionmanatasacreagepayments,0.8millionmanatasbonuspaymentsand0.6millionmanatfromsaleofassetsreceivedfromforeigncompanies.Therevenues frommanagingassetsof theFund for thereportingperiodamountedto305.9millionmanat.TheFund'sextra-budgetaryrevenuesrelatedtotherevaluationofforeignexchangetotaled97.6millionmanat.Asperthe2009budgetoftheFund,4,915.0billionmanatweretransferredtothestatebudget.Theexpendituresintheamountof89.9millionmanatweredirectedtofinancingofimprovementofsocialconditionofrefugeesandinternallydisplacedpersons, 130.0millionmanat and 120.0millionmanatwere accordingly usedfor financing the reconstruction of the Samur-Absheron irrigation system andfinancing construction of the Oghuz-Gabala-Baku water supply system. 22.1millionmanatweredirectedtofinancingBaku-Tbilisi-Karsrailwayand7.9millionmanat to financing «The state programon the education ofAzerbaijani youthabroad in the years 2007-2015.» The Fund's administrative and operationalexpenses in this period were 9.6millionmanat. The transfer from SOFAZ tothe2011StateBudgetwasincreasedto9,203,200.0thousandmanatfromtheprevious6,480,000.0thousandmanatinJuly201118.

18http://www.oilfund.az

82

Table 1. Dynamics of transfers from SOFAZ to state budget

YearsSOFAZ’s transfers to state budget (million

AZN)

Growth dynamics

Share in state bud-

get

Share in SO-FAZ’s expendi-

tures2003 100 -- 8.2% 41%2004 130 30.0% 8.6% 77%2005 150 15.4% 7.2% 70%2006 585 290.0% 15.6% 59.6%2007 585 0.0% 9.7% 55.1%2008 1100 88.0% 35.3% 88.5%2009 4915 346.8% 40.4% 92.8%2010 5915 20.3% 51.4% 90.5%2011 9203 9.6% 58% 93%

Source: National Budget Group, author calculations

SincetheestablishmentofSOFAZ,itsrevenuesamountedto$40billion,$20billionofwhichhasbeenspent.HalfofSOFAZ’srevenuesweremaintainedforfuturegenerationsinaccordancewithSOFAZ’stotalstrategy.SOFAZ’sincomefrombonuseshit0.8millionmanat,fromdividendsontheBaku-Tbilisi-Ceyhanoilpipeline-156.8million,fromtransitpayments--8.9millionmanatin2009.About25percentofrevenuesintheoilfundmustbekeptinaccordancewiththestrategyofalong-termoilrevenuemanagement,approvedbythepresidentin2004.Butsofarthefundhasmorethan50percentofrevenue.Theincreaseintransferstothestatebudgetfromtheoilfund,determinedattheamountof6.48billionmanatin2011,isassociatedwithareductionofimpactofrisingoilpricesonthestatebudget.Regardlessofchangesinoilpricesandforeignexchangerate,wemustprovidethestatebudgetwithtransferstotheamountof6.48billionmanat.Itwillensurethestabilityofthecountry’sfiscalpolicyandreaffirmSOFAZ’sroleasabuffer.Theoilpricewassetat$60perbarrel,andtherateofdollarforthenextyearat0.8manattoformthebudgetforecastsfor2011.

83

Source: National Budget Group, author calculations

IftheoilpricesandexpensesoftheFundremainatcurrentlevels,theStateOilFundcanaccumulateupto$50billion.Overthepastthreeyears,theresourcesofSOFAZhave increased10 times.So far,Azerbaijanhasgainedabout $40billionfromoil revenues,andhalfof thesefunds-about$20billion- isstoredintheSOFAZ.Giventhefactthatinthenext15years,oilrevenuesamounttoabout$200billion,thenifSOFAZwillsavehalfoftheserevenues,thecountrywillhaverevenuesof$100billion.DuetoincreasedrevenuesfrommanagementofFund’sassets, in the future, the level of transfers to thepublic budget canremainatcurrentlevelsduetorevenuesfromassetmanagement.SOFAZhasreceived $1 billion from the asset management up to now. With a minimumprofitabilityonassetsplacedat5percent,after15yearswecanreachthelevelof$6billionincomefromassetmanagementperyear.Ifwecontinuetoadhereto theseprinciplesandcriteria,after some time thegovernmentofAzerbaijanwillbeabletokeepaconstantleveloftransfersattheexpenseofrevenuesonlyfromthemanagementatcurrentlevels.SOFAZexpectsitsrevenuestoexceedforecasts.TheStateOilFundrevenuesforthisyearwereapprovedat5.96billionmanat,andexpenditureat5.43billionmanat;thatis,90percentofrevenuesisactuallyplannedtocoverexpenditure.Averyconservativeapproachwastakeninpreparingbudgetforecasts.ThebudgetoftheFundwasmadebycalculatingthepriceofoilat$45perbarrel.However,sincethebeginningof theyear,oilpricesrangebetween$70-80perbarrel,andthisconfirmsthefactthat90percentofadditionalrevenueswillbekept.TheaveragepriceforAzerbaijanioilin2009was$56dollarsperbarrel,whilein2008ittotaled$70perbarrel.Asaresultof

 

2862

1329 141612101100

4915

5915

6480

0

1000

2000

3000

4000

5000

6000

7000

2008 2009 2010 2011

"Budget's revenue paradox": oil generated revenues (million AZN, 1 USD = 0.8 AZN)

Corporate profit tax SOFAZ's transfers Profit tax without ACG

84

2009,StateOilFundexpendituresamountedto5.29billionmanatcomparedto4.29billionmanat in2008. In2007thisfigureamountedto1.06billionmanat,andin2006-981.4millionmanat.During2001-2009,thetransfersfromSOFAZtothepublicbudgetamountedto10.26billionmanat.Thegovernmenthasplansto diversify funds in subsequent years in riskier assets, but one of the mostimportant investments is education.The fund is financing a special educationprogramallowingAzerbaijanicitizenstoreceiveaneducationintheworld’sbestuniversities.

SOFAZ’s durability in global turmoil

The global financial crisis affected the activity of SOFAZ only in viewof its income cut. The StateOil Fund does not face any difficulty due to theglobal financial crisis. SOFAZ held a conservative and protective position byforeknowingthecrisis.Therefore,thecrisisonlyaffectedthefund's income.Atpresentmanycountries'fundshavelostbillions.Therearefundswhichdevaluedby 30 percent, but SOFAZ completed 2008 with income worth $300 million.Therefore, therewillnotbeanyproblemswithfinancingprojectsand itwillbeimplementedaspartof thebudget.TheSOFAZ fundsweredeposited inhighqualitativesecurities.These includesecuritiesof thegovernment, internationalorganizations,WorldBank,AsianDevelopmentBank,andEuropeanBank forReconstructionandDevelopment,andthesesecuritiescanbesoldatahighpriceatanytime.DuetoSOFAZ’sposition, if thenecessityarisestoday,Azerbaijancanexchange$10billiondepositedinsecuritiesintomoney.

InternationalratingagencyStandard&Poor'ssaysinitsoutlook«HowdoesAzerbaijanreacttotheworldeconomiccrisis?»thatifpricesforoilincreaseandexpendituresdonotexceedtheoilpricelevelstipulatedinthestatebudget,thenbytheendof2009thevolumeoffinancesinStateOilFundofAzerbaijanwillgrowupto$11.5-12blnversus$11.2blninDecember2008.AsforApril1,2009,thisfiguredecreasedto$10.9blncomparedto$11.2blninDecember2008.«InthiscasethepositivebalanceoftheAzerbaijanstatesectorin2009canincreaseupto32.3percentofGDP,»theoutlooksays.Theagencyclaimsthat“theFundisakindofbufferallowingsolutionofproblemsappearinginthecountry'sbudgetandgivingthegovernmentapossibilitytofollowacounter-cyclingpolicy.”Thereportalsosays,«theFund'sfinancesareinvestedinthenon-oilsectorandcanpromoteeconomydiversificationandreduceitsdependenceontheoilandgasindustry.»AnalystsofStandard&Poor’sbelieveSOFAZcanpromotereductionofinflationcausedby a large flowof hard currency as awayof investing «superfluous»moneyoutsideofAzerbaijan.

85

Source: National Budget Group, author calculations

EvenifthefinancialcrisishasaffectedtheprofitabilityofSOFAZ,3.79percentisnotabadfigureinsuchcircumstances.SOFAZhasproventhatithascomeoutof theglobalfinancialcrisiswithout losses.Thefinancialcrisis isoverandaneconomiccrisisisstarting.SOFAZwillnotprovideamandatetonewforeignmanagerstohandleitsfunds.Onthecontrary,consultationsarealreadyunderwaywiththecurrentmanagement,whowillbetoldtobemoreresponsibleabouttheirobligations.Theywill be offered to diversify their portfoliowithmore lucrativefinancialinstruments.Duetotheglobalfinancialprocess,theyieldfromSOFAZfundsmanagedbyforeignersasidefromtheWBTreasurywasclosetozerolastyear.The foreignmanagersdepartment runsabout $20million, excluding theWBTreasury's funds. The few foreignassetmanagementcompaniesSOFAZengaged includedClaridenLeuandDeutscheAssetManagement.Earlier, theFundhadmadeplans toexpand the list ofexternalmanagers toan increasein the fund's stock portfolio. The head of SOFAZ said the fund's investmentpolicieswillbe reviewed,andSOFAZfundswillbediversifiedwithmore long-terminstruments,includingshares.

Becauseof theuncertainsituation inglobalfinancialmarkets,SOFAZhasrefusedtoinvestitsresourcesinhighlyprofitableandriskyfinancialinstruments,particularlyinshares,in2010.Todayanuncertaineconomicsituationstillcoverstheworld, soweexpect the improvement of the situation inworldmarkets todiversifyour investmentportfolio.Earlier theWorldBankofferedAzerbaijan toreconsideritsinvestmentpolicyandinvestintomoreriskyfinancialinstruments.Such long-term investments for a period of 10-20 years havealways justifiedthemselves,asthereturnonthemishigherthanonbonds.Inashortperiodoftimethesituationisusuallyresolvedandthestockmanagementrevenuesriseanumberof times.Before transition tosuchan investmentpolicy, thecountrymustbereadyforanychangesinstockprices.SofarSOFAZhasbeenpursuingaconservativeinvestmentpolicy,becauseaplatformformanagementoffunds

 

05

101520253035404550

01.01.2004 01.01.2006 01.01.2007 01.01.2008 01.01.2009 01.01.2010 01,10,2010

SOFAZ's assets Oil export

86

wasbeingformedduringthatperiod.However,itishightimetoinvestinmoresophisticatedfinancialinstruments.Theywillgivemorerevenuestothecountry.SOFAZannounceditsplanstoexpandthestockportfolio,but theyhavebeenpostponedduetotheglobalprocesses.Thisdecisionwascorrect,asevidencedby the fact that the crisis has had no impact on SOFAZ revenues, thoughstockpricesfellbynearly50percent.Whenthecrisisslowsdown,SOFAZwillreconsideritsinvestmentpolicybeforetheendof2009orbeginningof2010andwillinvestfundsinsecuritiesofthecompanieswhichdecreasedtheirstockpricesbutarenotclosetobankruptcy.

The volatility of the dollar and the euro sinceearly 2010hasaffected theamountofassetsofSOFAZ.Theincomeandassetscontinuetoincrease.Thefund'sassetsamountedto$14.9billioninearly2010.Nowtheirvolumeexceeds$16billion.Despitetheincreaseinassets,SOFAZhasnoplanstoexpandthelistof foreignmanagers.PetroleumFundcooperateswith theprogramRAMP(ReserveAssets Management Program). Currently, theWorld Bank TreasuryManagementhas$114million.RAMPhasbeen inoperation formore than40years.SOFAZassetsasofJanuary1,2010increased32.8percentcomparedtoearly2009.Theyhit11966.5millionmanat(14900.4million).SOFAZ'sassetsatthemomentofitscreationin1999amountedto$271million.

SOFAZ,togetherwiththeInternationalFinanceCorporation(IFC),theDutchPGGM,theKoreaInvestmentCorporationandtheSaudiArabianFoundation,willinvest inthenewly-createdAfrican,LatinAmericanandCaribbeanFundundertheauspicesoftheIFC.Thenewfundisexpectedtoaccumulate$1billionandthese fundswillbemanagedbyan IFCassetmanagementcompany.This, inturn,will create conditions to improve the capacityof developing countriesbyinvestingininvestorequitiessuchassovereignandpensionfundswiththeIFC.Underthefirsttranche,thefundwillmanage$600million,ofwhich$100millionwillbeprovidedbySOFAZ.Theseinvestmentsareanimportantstepinbuildingthefund'slong-termstrategytoimproveandprotectthewealthofthestate.In2009,thecrisisyear,duetoasharpreductioninoilpricesintheworldmarket,the Fund accumulated 14 billion 900million dollars of income, instead of theexpectedapproximately$18billioninassets.

SOFAZ’s transparency and accountability

SOFAZ represents Azerbaijan in the Extractive Industries TransparencyInitiative(EITI).Thus,thecountryhastheopportunitytobecomethefirstfullEITImember.Additionally,oneoftheprioritiesforSOFAZistoassistothercountriesin the EITI. Kazakhstan, Yemen, Mongolia, Nigeria and other countries haveappliedtoAzerbaijaninthisconnection.EITIunites26members.Azerbaijanhasanopportunity to further improvetheextractive industryaccountabilitysystem.The multi-stakeholders group (consisting of SOFAZ and foreign companies)and theNGOCoalition have heldmeetings to discuss possible changes andimprovementsinEITI.EITIincludesallextractiveindustries.Accountabilitycoversnotonlytheoil-and-gasindustry,butalsoalltypesofextractiveindustries.Inlinewithqueueprinciples,companiesinvolvedinextractiveindustrieswillpayfortheaudit.Deloittedevelopedthe10thEITIreporton2008outcomes.Deloitteheld

87

auditsfor2003,2004,2005andthefirsthalfof2006;AGNMakAzerbaijanLTD(partofAccountantsGlobalNetwork)developedareportonthefirsthalfof2005.MooreStephensdesignedreportsfor2006and2007andthefirsthalfof2008.Ernst&YoungHoldings(CIS)B.V.wasappointedastheauditoroftheFund'sfinancialstatementsfor2010,2011,and2012bythepresidentofAzerbaijan.

As an independent auditing and financial control body, The Chamber ofAccountsmustinformthesocietyabouttheresultsofthebudgetaryexpenditurecheckups in accordance with Clause 6.0.3 of the national law on the MainPrinciplesofInformation.IthastotakeintoaccountthatSOFAZisAzerbaijan’slargestfinancialinstitutionmanagingpublicfunds9.

Internationaltoolshavealsobeendevelopedtomeasureaccountabilityandtransparencyofsovereignwealth funds, includingSOFAZ.Oneof them is theLinaburg-Maduell Transparency Indexwhichwas developed at the SovereignWealth Fund Institute by Carl Linaburg and Michael Maduell. The Linaburg-Maduell transparency index is a method of rating transparency in respect tosovereignwealth funds.Pertaining togovernment-owned investment vehicles,wheretherehavebeenconcernsofunethicalagendas,callshavebeenmadetothelarger“opaque”ornon-transparentfundstoshowtheirintentions.AsofMarch2008, theGovernment Pension Fund-Global of Norway ranks second amongthelargestsovereignwealthfundswithapproximatelyUS$380billion;thisfundalsoranksamongthehighestintransparency.Norwaycurrentlyleadsthewayinreducingtheneedforacodeofconduct,possiblytothebenefitofallsovereigninvestors.Thisindexofratingtransparencywasdevelopedaroundthisfund,asitisknowntobethepinnacleofclearinvestmentintentions.

Source: http://www.swfinstitute.org

9 http://www.turan.az/Default_en.asp

 

Linaburg-Maduell Transparency Index (score)

2

5

9

0 2 4 6 8 10

Kazakhstan

Russia

Azerbaijan

88

Thisindexisbasedontenessentialprinciplesthatdepictsovereignwealthfundtransparencytothepublic.Thefollowingprincipleseachaddonepointoftransparencytotheindexrating.TheindexisanongoingprojectoftheSovereignWealthFundInstitute.Theminimumratingafundcanreceiveisa1;however,theSovereignWealthFundInstituterecommendsaminimumratingof8inordertoclaimadequatetransparency.Transparencyratingsmaychangeasfundsreleaseadditional information. There are different levels of depth in regards to eachprinciple; judgmentof theseprinciples is left to thediscretionof theSovereignWealthFundInstitute.PrinciplesoftheLinaburg-MaduellTransparencyIndexarethefollowing:thefundprovideshistoryincludingthereasonforcreation,originsof wealth, and government ownership structure; the fund provides up-to-dateindependentlyauditedannualreports;thefundprovidesownershippercentageofcompanyholdings,andgeographiclocationsofholdings;thefundprovidestotalportfoliomarketvalue, returns,andmanagementcompensation; fundprovidesguidelines in reference to ethical standards, investment policies, andenforcerof guidelines; fund provides clear strategies and objectives; if applicable, thefundclearlyidentifiessubsidiariesandcontactinformation;ifapplicable,thefundidentifiesexternalmanagers;thefundmanagesitsownwebsite;thefundprovidesamainofficelocationaddressandcontactinformationsuchastelephoneandfax.Asyouseebelow,Azerbaijan,KazakhstanandRussiaobtaineddifferentscorespertaining to the Linaburg-Maduell transparency index.The respective scoresare9forAzerbaijan,5forRussia,and2forKazakhstan.Ofcourse,thisisaresultof thewillingness of countries (governments) to disclose information about (i)scaleofthefund,(ii)learningandharmonizationwithtransparencytools,and(iii)cooperationwithsuitable regionalandglobalorganizationsand initiatives (likeEITI).ThesecondpointmeansthatitismorecomplicatedforRussiatodisclosefinancial reportsof theNationalWelfareFund,whichaccumulated$162.5bln,thanAzerbaijan’sStateOilFundwith$21bln.

SOFAZ and civil society sector

TheexperienceofinteractionbetweentheFundandcivilsectorhasauniquesense.Awell-knownEITI initiative is amain factor here. Because of EITI, inthelast7yearsSOFAZgainedvaluableexperienceofcooperationwiththecivilsector ofAzerbaijan, which ultimately improved the image of the Fund in theeyesofboththelocalcommunityandtheworldcommunity.Itshouldbenotedthatofmorethan30countriesinvolvedinEITI,perhapsonlyinAzerbaijantheFoundationactsasastakeholder.Asarule, inothercountries, thisfunction isperformedbytherelevantministryintheminingsector.Inthissense,Foundationattachmenttopublicoperationcanbeestimatedasaverywiseandfar-sighteddecision.TheFund,asanewlyestablishedagency,withouthaving theballastof theSovietpastandnumbedbureaucracy,canquitecomfortablyfit into theEITIrulesandprocedures.Initsturn,EITIhasbroughtandcontinuestobringamuch-neededpositivereputationscoretotheFund.

InAzerbaijan,asaformerSovietcountrywhichgainednationalindependenceonly19yearsago,thereisstillasenseofdiscomfortaboutestablishinganactivedialoguebetweentheauthoritiesandcivilsector.Insomespherescivilsociety

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activity isevaluatedasharmful.Lackofeffective interactionofauthoritieswiththenon-governmentsector,manypublicofficials’misunderstandingofNGOsinthecurrentconditions,andfinallytheweakcapacityoftheknowledgeandskillsofthecivilsector--inasense,thepoliticizationofNGOs--arethemainobstaclesinthecreationofaregimeoffullandeffectivedialogue.Againstthisbackground,thepositivefactisunusuallyactiveworkofthegovernmentinEITI,theessenceofwhichinvolvestheworkof itsthreesupporters inasinglemultilateralgroup(government,businessandcivilsector).In2004,astategovernmentpanelonEITIwasestablishedbyaspecialdecisionoftheCabinetofMinistersandtheFundwasdeterminedbyaresponsiblegovernmentagency.Wecan’tsaythatduringthisperiodtheprocessoftheFund’spartnershipswithNGOs(inAzerbaijanthisNGOcoalitionplaysroleof«increasingtransparencyintheextractivesector»)has developed smoothly. Thereweremany discussions about EITI prospectsand thenatureof interactiononensuring transparency in theextractivesectorbetween government and NGOs. Even today parties still have a number ofdisagreementsregardinginformationdetailingEIcompanies’payments,aswellas the role ofNGOs in this issue.НалатиницеNGOs still have a number ofcomplaintsanddissatisfactionsrelatedtothegovernmentandparticularlywithEIcompanies’work.But thefactremainsthatEITI isoneof thefewplatformswhereactiveinteractionbetweengovernmentandNGOshasconcretepositiveresults.TheFund,thankstoEITI,hasalreadymanagedtorecruitandgraduallyincreasethepotentialforsuccessfulinteractionwiththeciviliansector,whichhasapositiveeffectingeneralforallitsactivitiesintermsofworkingwiththepublic.

Butalongwiththis,thereisanexigencyformutualcooperationoftheFundwiththecivilsectorinorganizationofmonitoringofinvestmentprojectsinthedomesticeconomyfinancedbytheFund.Therearemanygapsandevenlegislativecasesinthisarea.Forexample,thecivilsectorstilldoesn’thaveaclearanswertothequestionofwhichauthorityisresponsibleforefficientandtransparentspendingoffundsforOguz-Gabala-Bakuwatersupplysystemandothersimilarprojects.According to theOrder dated February 24, 2006,№ 42 “Azersu” Joint StockCompany was entrusted with construction, management and implementationofcustomer’sfunctionsfor“Oguz-Gabala-Baku”WSSprojectbytheCabinetofMinistersofAzerbaijanRepublic.InJanuary01,2010SOFAZappropriatedfundstotaling547.4millionmanatandanadditional200millionthisyearforfinancingthe project. Repeated requests to the Fund about enablingmonitoring of thisexpensiveprojectyieldnopositiveresults.ThestandardanswerofmanagementisthattheFundisnotresponsibleforthetargetandthetransparentuseoffundsintheseprojects,soitisbettertoappealtopublicoperators,inthiscasethestatewatercompanyAzersu.Obviously,thisanswercan’tsuitanNGO.Itisalsoclearthat thepromotionofNGOs inmonitoring is in the interestsof theFundalso,whichishighintheratingsofgoodandtransparentgovernanceandtriestoholdthisposition.

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Conclusion

The management approach envisions the full or partial reserve of therevenueswhenexploitationlevelsofnaturalresourcesareontheupswingandwhentherawmaterialscommandhighprices.Theapproachalsostipulatestheuseofthereservedmoniesinperiodsofreducedproductionorafallinprices,that is, pre-distribution of budget resources over time. This kind of revenuemanagementisusefulformoderatingstateexpendituresandensuringlong-rangemacro-economic stability. In the most concise form, the functions of SOFAZ,without exception,may be ranked as follows: accumulating income for futuregenerations;ensuringmacro-economicandfinancialstability;ensuring liquidityofthestate;raisingtransparencyofstateexpenditures;moreaccuratelyreflectingthebaselevelofthebudgetdeficit;fightingcorruption;andprotectingthemoniesfrompoliticians.Thus,with respect to the importanceof themissionof theoilfunds,itmustbementionedthatmanyofthemcontinuetosufferfromineffectivemanagement andespecially from theobsoletemacroeconomic instruments inthehandsofthegovernment.

The efficiency gap in the management of oil money in Azerbaijan isenormous.Improvementsneedtobemadeintheoilmoneyaccumulation,savingand spending processes so that this short-term national resource can betterservethelong-termdevelopmentneedsofthenation.Thenecessarychangesincluderedefiningandstreamlining theOilFund inparallelwith improvementsin budgetary and public investment work. Sustainable long-term developmentneedstobeamajorfocusandtheonlycriterionfortheuseofoilmoney,aswithanypublicresource.Theshort-termavailabilityofthisresource,however,makestheissuemoresubtleandbringsadditionalconcerns.Theneedforsustainablelong-termdevelopmentmakesthemacroeconomicconcernsapriority.Thisistosaythatthenation’sstrategyfortheuseofoilmoneyneedstofocusonthelong-termgrowthofGDP,fiscalstabilityandindependence,andmonetaryconcernsinordertoavoidinflation,accountforthecapacityofthepublicsectorandpreventthecreationofanenvironmentconducivetocorruption.Thestrategymustclearlydelineatetheshareanddynamicsofnationalconsumption,publicinvestments,governmentexpendituresand tradewithothercountrieswith thehydrocarbonresourcesdeductedandoilmoneyaddedtothenationalassets.Agoodstrategywillmeasureandusetheoilmoneynotforseparateconsumptionexpendituresorinvestmentprojects,butinlinewithallpublicspending,whileaccumulatingandsavingthatoilmoneyseparately.

MacroeconomicdevelopmentstrategiesflowintothefinancialstrategyoftheOilFundasaninstitutionthataccumulatesandsavesmoney.Oncetheextentoftheapplicationofoilmoneyisdeterminedtoreflectthenation’sthemostpressinglong-term interests, then strategies for portfolio investments, transfers to thestatebudgetandpublicinvestmentprojectsmustbeadoptedandimplemented.TheFund isnotdirectly responsible forensuringeconomicgrowth,supportingmacroeconomicequilibrium,ordeficitofpublicfinances.Inthissense,thescopeandrangeofaction,mutualliabilitiesbetweengovernmentagencies,andfinally,fearof the fund’s failureof theplan ismuchsmaller than, forexample, in theFinanceMinistry.

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The improvements regarding the development of the institutional andlegal framework will address and make the implementation of the proposedfinancial strategy for theOil Fund possible.Thiswill include the developmentofinstructions,guidelinesandstandardsforportfolioinvestmentsaswellastherulesandstandards for transfers from theFund to thestatebudgetandotherdomestic public and private uses. The recommended institutional and legalimprovementsare,ontheotherhand,basedontheexistingsituationandcurrentpractices,andhavepolitical feasibility implications for thesuggestedchanges,which aremore extensively discussed in the analysis section of this paper.Astrategyis importantforcreatingtherulesfortheeffectivemanagementoftheFund.Additionally,itisimportanttotakeintoconsiderationallimpactedmonetaryandfiscalfactorsduringallocations,aswellastransfersfromfunds.Thereisasimple reasonwhynatural resource revenue fundsdon’t usually contribute tobetter fiscal policy in those countries which are heavily dependent on oil-gasexports.Thereason is that theeconomicconsiderations thatareusuallyusedtomotivatefundssupportonlyacertainoptimalfiscalpolicy,andaresilentonwhatistherightinstitutionalframeworkforimplementingthatpolicy.However,thepoliticaleconomyofpowerrivalrycancreateincentivesforrapidoverspendingofnatural resource revenues relative to the ideal levelsofexpenditureofanygivengovernment.Theseadverseeffectsarestrongestwhenpoliticaldivisionsare deep, when institutions and policies are otherwise weak, where politicalandeconomicalpowerareconcentrated,where transparency iscomparativelylimited,andwheretherearerisksofrapidchangesofgovernment.Thefirstitemtoconsiderishowmuchoftheoilmoneytosave,i.e.accrueintheFund,andhowmuch to consume, i.e. allocate for state budget expansion.This is not aconsume or invest question,however,becausetheelementsofthestatebudgetmayalsosuggestinvestmentsinthefuture.Instead,itisaquestionofhowmuchmoneyfromthecurrenteconomyneedstobetakenandsavedintheFund.Thisrequiresananalysisofwherethatmoneywillprovidethebestlong-termbenefitforsociety.Regardingsuitablecalculations(takingintoconsiderationbudgetincomeandSOFAZ active’s forecasting), empirical evidence and expert opinions, wepresumethattransfersfromSOFAZtothestatebudgetinAzerbaijanshouldn’texceed30%ofthetotalSOFAZassetsregardingitsownbudgetreceipts.

The status of Oil Fund of Azerbaijan is off-budget organization, such astheStateSocialProtectionFund.Inthissense,thereflectionofthebudgetofSOFAZ, itsdiscussionandapprovalbyparliament, alongwith theFoundationforSocialProtection’sannualbudget inoverviewof thecountry, iscompletelylogical.Butatthesametime,SOFAZisaspecialgovernmentorganizationthatdoesnotfit intothetraditionalstructureofpublicadministrationof thecountry.ПрослушатьPeculiaritiesoftheoperationandmanagementofthisstructureareexplainedbythefollowingcircumstances.НалатиницеRegulationsoftheFundclearlypredeterminedsourcesofincome,whichareallpaymentsfromtheoilandgassectorofthecountry,exceptthetaxesthataccumulatedinthestatebudget.Thus, theFunddoesnotworkwith taxpayers in their traditional form,butonlyaccumulatesthenon-taxpartofpayments,themainoneofwhichistheprofitofoil,partofthetaxpaymentswhichfalltotheshareofthePSAcontracts.Indirectly,thisfactmeansthattheFundisnotresponsiblefortheimproperaccumulationof taxes.Asnotedby thegovernment, reductionof incomeof theFundwasa

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resultofeconomicdowntownintheworldmarket,expressedbyasharpdropinoilprices.

Inthecountry,theFundhasonlyanarrowlydelineatedrangeofpartnersonthestatemanagementsystemwhichitcontactsbyfinancialflows.Intheannualbudget of theFund approved by theParliament, as a rule the lion's share ofexpensesisintendedtobetransferredtothestatebudget,whichconsequentlymakes theMinistryofFinance itsmainfinancialpartner.TheFundworksonlywithselectedgovernmentagenciesandinthissenseitisnotfullyincorporatedintothedomesticstatecontrolsystemlikeotherstateagencies.However,thereremainsahugeresponsibilityfortheFundtoensuretheeffectivemanagementoftheFund'sassets,which,incidentally,isrelatedtoitsactivitiesabroad.Thisfactorunderlines the importance of focusing primarily on the global financialmarketsituation. Simultaneously, this same factor underlines some of the concernsregardingtheFund'smanagementoftheincreasingfundsspentinthedomesticeconomy.Afterall,itisobviousthatforeffectivemanagementofFundassets,i.e.,greaterprofitability,SOFAZisinterestedinminimizingtheexpenditureoffundswithinthecountry,inordertooperatewithalargeamountinforeigninvestmentmarkets.

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Recommendations

1. SOFAZ’sactivitiesshouldberegulatedwithlawstatusregulatoryacts;2. Governmentshouldcreateopportunity forcivilsocietyorganizations to

takepartinSOFAZ’sBoard;3. FiscalrulesregulatingtransfersfromSOFAZtothestatebudgetshould

stipulateconditionsandlimitationsforsuchtransfers;4. TheChamberofAccountsshouldbeentrustedwithobligationstoaudit

SOFAZ’saccounts;5. SOFAZ has to frame new strategy encompassing long-term asset

managementandindicesissues;6. The Government should link SOFAZ’s asset management policy with

generalfiscalandmacroeconomicpolicy.

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Addendum 1. SOFAZ (Azerbaijan) compliance with Santiago principles

Principles In Azerbaijan GAPP1.Principle ThelegalframeworkfortheSWFshouldbesoundandsupportitseffectiveopera-tionandtheachievementofitsstatedobjective(s).GAPP1.1SubprincipleThelegalframe-workfortheSWFshouldensurethelegalsoundnessoftheSWFanditstransac-tions.GAPP1.2SubprincipleThekeyfeaturesoftheSWF'slegalbasisandstructure,aswellasthelegalrelationshipbetweentheSWFandtheotherstatebodies,shouldbepubliclydisclosed.

Applicable

Therequirementsofbothsub-principleshavebeenfulfilled.PublicawarenessonboththelegalbaseandthestructurehasbeenprovidedthroughSOFAZwebsite.Also“InformationPolicy”includingthedetailedresponsetosurveysontheseissueswasacceptedinApril2007.

GAPP2.Principle ThepolicypurposeoftheSWFshouldbeclearlydefinedandpubliclydisclosed.

Applicable

IndeedthereareargumentsaboutthedegreetowhichtheOilFundisreach-ingthegoalsset(especially,thegoalofequaldistributionofoilrevenuesamonggenerations).However,thegoalshavebeenclearlydeclaredandarenothiddenfromthepublic.

GAPP3.Principle WheretheSWF'sactivitieshavesig-nificantdirectdomesticmacroeconomicimplications,thoseactivitiesshouldbecloselycoordinatedwiththedomesticfiscalandmonetaryauthorities,soastoensureconsistencywiththeoverallmac-roeconomicpolicies.

Notapplicable

Giventheincreaseofthebudgettrans-fersdespitethedeclineofprofitabilityrateofSOFAZassetsmanagementthereisneedtoreviewthecoordinationoffiscalandmacroeconomicpolicies.

GAPP4.PrincipleThereshouldbeclearandpubliclydisclosedpolicies,rules,procedures,orarrangementsinrelationtotheSWF'sgeneralapproachtofunding,withdrawal,andspendingoperations.

Applicable

Therearecertainconcernsinthisfield.TheconditionoftheassetsinthebanksthatSOFAZisinpartnershipwithandthenon-accountabilityoftheinvestmentprojectsoftheFundgivemoregroundtostatethis.

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GAPP5.Principle TherelevantstatisticaldatapertainingtotheSWFshouldbereportedonatimelybasistotheowner,orasotherwisere-quired,forinclusionwhereappropriateinmacroeconomicdatasets.

Applicable

SOFAZprovidesthisthroughitsquarterlyreportsandwebsite.

GAPP6.Principle ThegovernanceframeworkfortheSWFshouldbesoundandestablishaclearandeffectivedivisionofrolesandresponsibili-tiesinordertofacilitateaccountabilityandoperationalindependenceinthemanage-mentoftheSWFtopursueitsobjectives.

Notapplicable

ThoughthemanagementsystemofSOFAZissufficientlyeffectiveforthisprinciple,thefactthattheSupervisoryBoardincludesnocivilsocietyrepresen-tativecausesconcern.

GAPP7.Principle TheownershouldsettheobjectivesoftheSWF,appointthemembersofitsgoverningbody(ies)inaccordancewithclearlydefinedprocedures,andexerciseoversightovertheSWF'soperations.

SOFAZ’smanagementisvestedwiththeExecutiveDirector,appointedbyandaccountabletothePresidentoftheRepublicofAzerbaijan.SOFAZ’sExecu-tiveDirectorasachiefexecutiveofficerisvestedwiththepowerstobealegalrepresentativeoftheFund,organizeandconductbusinessoftheFundincludingappointmentanddismissalofemploy-ees,managementanddisbursementoftheassetsoftheFundinconformitywiththerulesandregulationsapprovedbythePresidentofAzerbaijan.http://www.oilfund.az/en/content/4

GAPP8.Principle Thegoverningbody(ies)shouldactinthebestinterestsoftheSWF,andhaveaclearmandateandadequateauthorityandcompetencytocarryoutitsfunctions.

Notapplicable

ThereisaneedtoacceptalawonOilFundsinordertofulfillthisprinciple.

GAPP9.Principle TheoperationalmanagementoftheSWFshouldimplementtheSWF’sstrategiesinanindependentmannerandinaccor-dancewithclearlydefinedresponsibilities.

Notapplicable

ParticularlythefactthatlimitationofSO-FAZtransferstothebudgethasnotbeendeterminedmakesitimpossibleforitsactivitiestofullycomplywithitsstrategy.

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GAPP10.Principle TheaccountabilityframeworkfortheSWF'soperationsshouldbeclearlydefinedintherelevantlegislation,charter,otherconstitutivedocuments,ormanage-mentagreement

Notapplicable

ThereisaneedforanimprovedlawonOilFunds.

GAPP11.Principle Anannualreportandaccompany-ingfinancialstatementsontheSWF'soperationsandperformanceshouldbepreparedinatimelyfashionandinac-cordancewithrecognizedinternationalornationalaccountingstandardsinaconsistentmanner.

Applicable

SOFAZreportsarebeingpreparedontime.SOFAZalsopreparesitsfinancialreportsinaccordancewithInternationalFinancialReportingStandards(IFRS).

GAPP12.Principle TheSWF'soperationsandfinancialstate-mentsshouldbeauditedannuallyinac-cordancewithrecognizedinternationalornationalauditingstandardsinaconsistentmanner.

Applicable

SOFAZreportsareauditedbybigfourinternationalauditcompanies.ThemostrecentannualreportwasauditedbyDeloitte.

GAPP13.Principle ProfessionalandethicalstandardsshouldbeclearlydefinedandmadeknowntothemembersoftheSWF'sgoverningbody(ies),management,andstaff.

Notapplicable

SOFAZhasnoprofessionalandethicalcodedetermined.

GAPP14.Principle DealingwiththirdpartiesforthepurposeoftheSWF'soperationalmanagementshouldbebasedoneconomicandfinan-cialgrounds,andfollowclearrulesandprocedures.

Notapplicable

GAPP15.Principle SWFoperationsandactivitiesinhostcountriesshouldbeconductedincompli-ancewithallapplicableregulatoryanddisclosurerequirementsofthecountriesinwhichtheyoperate.

Applicable

CertainlySOFAZmeetsalltheagreedre-quirementsinareaswhereitimplementsitsinvestmentprojects.

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GAPP16.Principle Thegovernanceframeworkandobjec-tives,aswellasthemannerinwhichtheSWF'smanagementisoperationallyindependentfromtheowner,shouldbepubliclydisclosed.

Applicable

GAPP17.Principle RelevantfinancialinformationregardingtheSWFshouldbepubliclydisclosedtodemonstrateitseconomicandfinancialorientation,soastocontributetostabil-ityininternationalfinancialmarketsandenhancetrustinrecipientcountries.

Applicable

SOFAZdisclosesrelevantstatisticaldatainthisregard.It’sduetothisfactthatAzerbaijanwasamongthetop5onLina-burg-Maduellindexdeclaredinthefourthquarterof2009.http://www.swfinstitute.org/research/transparencyindex.php

GAPP18.Principle TheSWF'sinvestmentpolicyshouldbeclearandconsistentwithitsdefinedobjectives,risktolerance,andinvestmentstrategy,assetbytheownerorthegov-erningbody(ies),andbebasedonsoundportfoliomanagementprinciples.GAPP18.1SubprincipleTheinvestmentpolicyshouldguidetheSWF'sfinancialriskexposuresandthepossibleuseofleverage.GAPP18.2SubprincipleTheinvest-mentpolicyshouldaddresstheextenttowhichinternaland/orexternalinvestmentmanagersareused,therangeoftheirac-tivitiesandauthority,andtheprocessbywhichtheyareselectedandtheirperfor-mancemonitored.GAPP18.3SubprincipleAdescriptionoftheinvestmentpolicyoftheSWFshouldbepubliclydisclosed.

Applicable

SOFAZinvestmentpolicyfollowstheseprinciples.

GAPP19.Principle TheSWF'sinvestmentdecisionsshouldaimtomaximizerisk-adjustedfinancialreturnsinamannerconsistentwithitsin-vestmentpolicy,andbasedoneconomicandfinancialgrounds

Applicable

SOFAZfollowsaverycarefulpolicy.Thefactthatitsprofitability,thoughsmall,wasnoticeableevenduringthecrisiscanbeexplainedbythispolicy.

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GAPP20.Principle TheSWFshouldnotseekortakeadvan-tageofprivilegedinformationorinappro-priateinfluencebythebroadergovern-mentincompetingwithprivateentities.

Applicable

GAPP21.Principle SWFsviewshareholderownershiprightsasafundamentalelementoftheirequityinvestments'value.IfanSWFchoosestoexerciseitsownershiprights,itshoulddosoinamannerthatisconsistentwithitsinvestmentpolicyandprotectsthefinancialvalueofitsinvestments.TheSWFshouldpubliclydiscloseitsgeneralapproachtovotingsecuritiesoflistedenti-ties,includingthekeyfactorsguidingitsexerciseofownershiprights.

Applicable

TheseprinciplesarefollowedduringSO-FAZactivitiesanditsinvestmentpolicy.

GAPP22.Principle TheSWFshouldhaveaframeworkthatidentifies,assesses,andmanagestherisksofitsoperations.GAPP22.1SubprincipleTheriskman-agementframeworkshouldincludereliableinformationandtimelyreport-ingsystems,whichshouldenabletheadequatemonitoringandmanagementofrelevantriskswithinacceptableparam-etersandlevels,controlandincentivemechanisms,codesofconduct,businesscontinuityplanning,andanindependentauditfunction.GAPP22.2SubprincipleThegeneralapproachtotheSWF’sriskmanagementframeworkshouldbepubliclydisclosed.

ApplicableThisissueatSOFAZisdealtwithbytheRiskManagementDepartmentthatisincludedintotheAssetManagementGroup.StateOilFundofAzerbaijanRepublic(SOFAZ)signedanagreementwithRiskMetricsSolutionsInc.thatwasthewinnerofthetenderonsoftwareforriskassessmentsystemconductedinaccordancewiththerequirementsoftheLawofAzerbaijanRepublicon“StateProcurements”onJanuary29,2010.Thevalueofthecontractonriskas-sessmentsystemisUSD160thousandannually.Thedurationofthecontractis5years.Thesystemisconsideredtobeimplementedwithin6months.

http://www.oilfund.az/az/news/267Asisseen,theinformationtakenfromtheofficialSOFAZwebsiteconfirmsthatinformationonriskassessmentandman-agementisdisclosedtothepublicwithoutanyproblems.

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GAPP23.Principle Theassetsandinvestmentperformance(absoluteandrelativetobenchmarks,ifany)oftheSWFshouldbemeasuredandreportedtotheowneraccordingtoclearlydefinedprinciplesorstandards.

Applicable

SOFAZhasbeenbothpreparingitsreportsandassessingitsassetandinvestmentactivitiesinaccordancewithInternationalFinancialReportingStan-dards.

GAPP24.Principle AprocessofregularreviewoftheimplementationoftheGAPPshouldbeengagedinbyoronbehalfoftheSWF.

Notapplicable

NosuchopinioninthisregardhasbeenstatedbySOFAZ.

Addenda 2. Santiago Compliance Index

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The National Fund of the Republic of Kazakhstan (NFRK): From stress-test to global future

Yelena KalyuzhnovaTheCentreforEuroAsianStudies,UniversityofReading,UK.

Acknowledgment: I would like to thank Gonzalo Pastor and Max Watson for their helpful comments of the earlier drafts of this paper. All errors remaining rest with the author.

Executive summary

SovereignWealthFunds(SWF)havedifferenttitles,goalsandrules,buttheyshare theunderlyingobjectiveofhelpinggovernmentsdealwith theproblemscreatedbylargeandvariablerevenuesfromenergy(orothercommodityrelated)sectors. In Kazakhstan, such a fund (the National Fund of the Republic ofKazakhstan (NFRK))wasestablished in2000,when theoilpriceswere risingandaneconomicrecoverywasonamapfortheKazakhstanieconomy.Thisfundoperatesasbothastabilisation and a savings fund.

The first test for theNFRKwas the 2007-2009 financial crisis, where theNFRK“saved”theeconomyandguaranteeditsspeedyrecovery.Itisimportanttoemphasizetheproactivestanceofthegovernmenttoprotectsomekeysectorsof the economy on the basis of their implications to the local economy. Theconsequencesofthecrisiswillclearlyresult inchangesin investmentportfoliostrategyaswellasinthegeneralrulesandprinciplesoffunctioningofthefund,although the full implications remain to be seen.TheNFRKhasnot escapedtheeffectsof theglobaldownturn,andalthoughits totalassetsfallasaresultofthedropinvalueinitsinvestment,itislikelythatthefundwillremainavitallyimportantsourceofcapital intheinternationalfinancialmarkets,andwillmakeimportantinvestmentsacrossallthedifferentassetclassesinthefuture.

ThereisacertainconcernthattheNFRKisnot,atthepresenttime,apartoftheSantiagoprinciplesinitiativeforSWF.ItisofparamountimportancethatthegovernmentofKazakhstanproducesomesubstitutegovernanceguidelines toSantiagoprinciplesfortheNFRK,especiallywithregardstothefund’sinvestmentstrategyintheyearsahead.

ThefinancialcrisishasshiftedtheemphasisinthepolicyoftheNFRKfromissuesofperformanceatthefirmleveltotheportfoliostrategyandtheinvestmenthorizonofNFRK. It isunderstandable that theconsequenceof thecrisis isamoreactiveinvolvementoftheKazakhstanigovernmentinthegovernanceoftheNFRK,whichwillbereflectedinamoresensitiveattitudetothesocialneedsoftheKazakhstanicitizens.

ThechallengeaheadfortheKazakhstanieconomyisclear:toensurethattheeconomicprogressinitiatedbytheseedcapitalofhydrocarbondevelopmentpriortothe2007-2009financialcrisisprovesstableandsustained.Thegovernmentof

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Kazakhstanhasdiscussedtheneedtohavealong-termvisionanddeterminationin pursuing their policies of management of the oil revenues, which shouldcontributetothesustainabledevelopment.

Oneimportantlessonisthatitsemphasisonliquidexternalsavingshelpedmoderate thedomesticboomandalsoallowedawhollycredible insuranceorcollateralroleduringthecrisis.Asecondisthattherewasthenscope–atleastfor a period – to use resources in the fund to help repair the damage to thedomestic economy.Timewill tell how efficient these latter involvements havebeen, andalsohow to restore the former insurance role bybuildingup liquidforeignassetsinthefuture.

Butunderalloptionsforitsinvestmentstrategy,thecasemadeinthispaperisthecoreimportanceinKazakhstanofcontinuingtoenhancegovernanceandtransparencyofthesovereignwealthfundinordertomaximizethechancesofsuccess.Inevitablythislimitsgovernmentdiscretionindisposingofthemineralwealthofthenation.Itis,however,essentialtobuildpublicsupportforthefunds,and to leverage their economic impact through a strong influence onmarketexpectations.

Thereareoverallrecommendationswhichwedrawfromtheanalysis:

Firstofall, it iscrucialthatinthefuturethegovernmentwillbedeterminedto achieve the non-resource fiscal balance with the robust programme ofdiversification.

Secondly,itwouldbebeneficialiftheKazakhstanigovernmentcouldestablishasystemofparticularindicatorsforthenon-resourcedeficitinordertomonitoraswellastoreduceresourcedependency.

Third,thefactthatdomesticinvestmentforeconomicdiversificationprovidesmorestabilityandeconomic resilienceshouldbe taken intoaccountwhen theKazakhstani government is designing the investment portfolio strategy of theNFRKforthenearfuture.

Fourth,althoughKazakhstandidnotaccept(noonefromtheofficialsintheKazakhstani government was invited to Santiago) the Santiago Principles, atransparentandaccountablegovernancestructureof theNFRKisrequiredforthefuturesuccessofthepoliciesconductedbythefund.

Fifth,wellmanagedoilwealthwouldbecentral infinancingthesereforms,andatthesametimeitwouldbeimportantnottomisusetheNFRKinstrategicallyorientedinvestmentratherthancommercialinvestment.

Sixth, in its investment strategy the NFRK has to arrive over time at adiversificationinitsassetallocationwhichwouldcorrespondtothelongertermneedsandwelfareofKazakhstanicitizens.

Finally,atthepresenttimeKazakhstanalreadyhasahistoryindesigninganeffectiveframeworkformanagingitshydrocarbonwealth;however,improvementinthepetroleumtaxationregimewouldberequiredasanadditionalinstrumentinmanagingtheoilandgasrevenues,namelyneutrality,captureofrent,stabilityand timing of revenue, progressivity and adaptability, administrative simplicityand enforceability as well as international competitiveness. The Kazakhstanigovernmentneedstoreassessitsriskpreferencesanditswillingnesstosharethemwiththeinvestorsintheoilandgassectoraftertherecentcrisis.

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1. Context and importance of the problem1

Oilrevenuesofferimportantopportunitiestoenhanceeconomicdevelopment.But they are also volatile, unpredictable, and ultimately exhaustible; and theycanthusgreatlycomplicateeconomicmanagement.InKazakhstan,thestartingassumptionmustbethatresourceendowmentispotentiallya“blessing”thatcanhelpovercometransitiondisruptions.Butthelessonofexperienceelsewhereisthatrealizingthispromise–andavoidingtheriskofnaturalresourcesbecominga“curse”–iscruciallydependentonpolicies,includingacommitmenttoenhancedpolicytransparency.

The recent literature on resource-rich economies supports the view thatoilandgasrevenuescanposeproblems forpolicy-makers,andhighlights thepossibilitythatnaturalresourceendowmentcanbeaneconomiccurseratherthanablessing(Auty,1998,2006,Gylfason,2001;Kalyuzhnova2008,Kalyuzhnovaet.el.,2006,Sachsetel.,2000,etc).Inarangeofcases,economicperformancehas indeed appeared to suffer rather than benefit from the impact of naturalresourceendowment(GylfasonandZoega,2003;Paldam,1997).

Asaconsequence,theinternationalcommunity,includingnotableinternationalfinancialinstitutions,hasbecomeincreasinglyconcernedabouttheeffectivenesswithwhichnaturalresourcerevenuesareused,andinparticularhowtheycanhelpfostereconomicandsocialdevelopmentinthelongrun.Thislatterconcernispartofawidertopic:thepoliticaleconomyofresource-drivengrowth.

Thegovernmentsof resource-richcountries face thechallengeofdevisingpolicies thatcaneffectivelychannel “incometransfers togovernmentsandtheinflowofforeignexchangefromforeigninvestments.”(Kalyuzhnova,2002:79).To tackle this challenge,many oil-producing countries are setting up nationaloilfunds.Suchfundshavebecomefashionableinthewakeofrecenthighandvolatileoilprices,andwithnewdiscoveriesofhydrocarbondeposits.

SovereignWealthFunds(SWF)havedifferenttitles,goalsandrules,buttheyshare theunderlyingobjectiveofhelpinggovernmentsdealwith theproblemscreatedbylargeandvariablerevenuesfromenergy(orothercommodityrelated)sectors. In Kazakhstan, such a fund (the National Fund for the Republic ofKazakhstan (NFRK))wasestablished in2000,when theoilpriceswere risingandaneconomicrecoverywasonthemapfortheKazakhstanieconomy.Thisfundoperatesasbothastabilisation and a savings fund.

Inlightofemergingexperience(especiallysince2007)withsuchfunds,thereisaneedtoexploreunderwhatcircumstancestheycanbecomepartofapolicysolution–ratherthanendingupasapartoftheproblem.ThecorequestioniswhethertheNFRK,generically,ispanaceaforthesocalled“paradoxofplenty;”whetheritseffectivenessdependsonspecificoperatingconditionsandrules;orwhether,morepessimistically, itdeliversresultsonly innationalcircumstancesthatareinanycaseparticularlybenign.

1SomeofthepartsofthispaperarebasedonarevisedversionofChapter2byY.Kalyuzhnova,“EconomicsoftheCaspianOilandGasWealth:Companies.Governments.Policies.”2008.PalgraveMacmillan,reproducedwithpermissionofPalgraveMacmillan.

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In this context,NFRK identifiesasa tool thatmayhelp inaddressing twospecificproblemsassociatedwithoilrevenues--theunpredictabilityandvolatilityofworldmarketprices,andtheconcerntosavepartoftherevenuesforfuturegenerations—“The Permanent Income Hypothesis” (PIH). In this context, thisfundmay serve as a form of “commitment mechanism,” thus substituting forthe IMFcommitmentmechanism.A further problemcould in principle alsobemitigatedbyoilfunds:“DutchDisease.”

The first test for theNFRKwas the 2007-2009 financial crisis, where theNFRK“saved”theeconomyandguaranteeditsspeedyrecovery.Itisimportanttoemphasizetheproactivestanceofthegovernmenttoprotectsomekeysectorsoftheeconomyonthebasisoftheirimplicationstothelocaleconomy.

Theconsequencesofthecrisiswillclearlyresultinsomechangesininvest-mentportfoliostrategyaswellasinthegeneralrulesandprinciplesoffunctioningofthefund,althoughthefullimplicationsremaintobeseen.TheNFRKhasnotescapedtheeffectsoftheglobaldownturn,andalthoughitstotalassetsfallasaresultofthedropinvalueinitsinvestment,itislikelythatthefundwillremainavitallyimportantsourceofcapitalintheinternationalfinancialmarkets,andwillmakeimportantinvestmentsacrossallthedifferentassetclassesinthefuture.Somepriorities in thisregardarediscussedbelow, includingthetrade-offsbe-tweengreaterdomesticinvolvementintheshortrunandtherequirementsofaresumed“insurance”roleinthefaceoffutureshocks.

Whateverinvestmentchoicesaremade,however,theissueoftransparencyiscrucialforanySWF,bothdomesticallyandbecausethefundshavebeenre-ceivingincreasedscrutinyduetotheirgrowingpresenceinglobalfinancialmar-kets.InthisrespectthereisacertainconcernthattheNFRKisnot,atthepresenttime,apartof theSantiagoprinciples initiativeforSWFalongwithother largeSWFlikeotherworld’slargestfundsofLibya,Brunei,Malaysia,HongKong,etc.It isofparamount importance that thegovernmentofKazakhstanwillproducesomesubstitutegovernanceguidelinestoSantiagoprinciplesfortheNFRK,es-peciallywithregardstothefund’sinvestmentstrategyintheyearsahead.

2. Critique of policy option(s)

InKazakhstan,theoilfund(theNationalFundoftheRepublicofKazakhstan(NFRK)) was established in August 2000. Legal aspects were defined byPresidentialDecreeN402of23August.TheNFRKismanagedbytheNationalBankofKazakhstanandisoverseenbyagoverningboardchairedbythePresidentofKazakhstan,PrezidentNazarbayev,andincludingtheprimeminister,theheadsofthetwochambersofparliament,theNationalBankchairmanandthefinanceminister.Informationonthefund'srevenues,expenditure,andtheauditresultispublishedinthelocalpress.Thefundissubjecttoanannualindependentaudit.

The NFRK invests in liquid foreign equities, and will be capitalized bycorporate income taxes, VAT, royalties, bonuses, and Kazakhstan’s revenuesfrom production sharing agreements. Initially, the Fund had a long-terminvestment function-savingportfolio (75%)andasmallerstabilisation function-saving portfolio (25%), and later these figureswere altered to 80% and 20%respectively.

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2.1 Economic context Therulesgoverningtheaccumulationanduseofresourcesinoilfundsdiffer

widely.Thedifferingfeaturesofthefundsmustbeunderstood,inpart,inlightoftheeconomicsituationofeachcountry,which results invaryingpriorities. It isusefultoanalysetherulesgoverningtheNFRK.

First, theKazakhstanigovernmentand the internationalagenciesconsidertheestimated lifeof thehydrocarbondepositsasadecisiveargument forandagainstplacing the funds’ investmentportfolioabroad,whence incomewill beaccruedonthePIH.Originally,giventhescaleandpaceofexhaustionofreservesinKazakhstan, the IMFhadoriginallyassumed theyear2045. However, thisprojectiondidnottakeaccountofthen-unprovenreserves.RecentexplorationinKazakhstanhasledtothediscoveryoftheKashaganfieldintheCaspianSea.Thisaloneisbelievedtoholdnearly40blnbblofoilreserves.Estimatesofhowlongthecountrywillremainasignificantoilproducerneedtotakeintoaccountanticipated future discoveries set against future rates of production. Theseproductionratesarebasedonextractionandtransportcostsatthecontemporaryandprojectedworldprice.Kazakhstan’sprovenreservesmaywellamountto18blnbbl(includingKashagan’sprovenreserves).

Second,investmentratiosintheKazakhstanieconomyhavebeenhigh,andexternalfinancinghasbeendrawnontodifferingdegreesinachievingthis.Prior2007financialcrisisKazakhstan,exhibitsahighshareofcapitalformationinGDP(27%),which iswellabove thatofother transitioneconomies.ThatKazakhstanhasdrawnheavilyfromabroadforitscapitalfinancemaybeimplied,inpart,byitshighratioofexternaldebttoGDP–in200468.9%,whichofcoursetriggeredKazakhstan’s exposure during the 2007-2009 credit crisis. At that time, themoratoriumondisbursementsfromthe”oilfund”wasinforce,hencetheKazakhstanigovernmentwasnotachievingitshighinvestmentratethroughtheuseofitsfund.

2.2 Mapping goals to national priorities

Thiseconomiccontext inKazakhstanhelpsonetounderstandthespecificdesign of the oil fund. The NFRK is designed to save resources for futuregenerationsandavoidunduepressureonthedomesticeconomy-andlayeredonthisisastabilizationfunction.PresidentNazarbayevmadeclearattheoutsetthat resources would not be spent on covering current expenses, but wouldaccumulate in theNFRKfor futuregenerations,aswellasfor thecontingencyof economic recession. Stabilization by the NFRK is achieved by means of“referenceprices”forgas,oil,andfourmetals(chrome,zinc,leadandcopper).Theninelargestoilcompaniesandthreefromthemetalssectoraresubjecttotransfersbasedonthereferenceprice.Whenthetargetsareexceeded,surplustaxpaymentsaretransferredtotheNFRK.Ontheotherhand,ifmarketpricesarebelowthereferenceprices,theFundprovidesrevenuetothegovernment.Thestabilizationportfoliomustconstituteatleast20%ofNFRKassets.

Priorto2007,withtheKazakhstanbudgetinastrongposition,andoilpricesrisingintherecentpast,thisstrategyprovedentirelyworkable.DuringthefirstfiveyearsofitsexistencetheNFRKhasaccumulatedextrapaymentsmadetotherepublic’sbudget frommajorcompaniesoperating in therawmaterials(oilandgas)sector.In2003thefundbeganaccumulatingproceedsfromthesaleof

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stateproperty.In2008,thefund’sreservesexceededUS$27.4bln.(seeFigure1). However, since 2009, according to the National Bank of Kazakhstan theassetsinNFRKhavefallentoUS$26bln.Kazakhstanhasbeendrawingheavilyon its rainy-day fundas it attempts to stabilize its economy.Overall, in 2009,profitabilityofbothportfolioswas7.31%(wherestabilisationandsavingportfolioswere1.24%and10.19%respectively).(SeeFigure2)

Figure 1. NFRK, 2000-2009, US$ mln

Source: NFRK annual reports.

Throughout the years since the NFRK’s conception we could observe asteadyincreaseinitsmarketvalue(seeFigure2).

Figure 2. NFRK: The Main Indicators, Mln.KZ Tenge

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Thediffering rolesandobjectivesofnationalgovernmentsare reflected inthe investment strategy of their wealth funds. In Kazakhstan, the investmentstrategyoftheNFRKwasbased,fromitsconception,ontherulesgoverningtheforeignexchangereservesof theNationalBankofKazakhstan:eligibleassetswerelow-riskinterest-bearingsecurities(AA-gradeorbetter).AccordingtotheFitchRatingsagency “theNFRKoffersagooddegreeoffiscalandbalanceofpaymentssupport,butasitsassetsarestillnotespeciallylarge,thissupportisfinite.Assetsshould risemore rapidlyduring thecomingyears, inpart relatedtothetimingofadditionaloilproduction,althoughtheauthoritiesmightwishtorevisitthequestionofthetriggerpricetoensureregularandreliableinflowsintotheFund.”(FitchRatings,2003:12).Ofcourse,aprudentstrategyof investingresources in high quality external assets could be compatible with a morediversifiedportfolioapproachinthefuture.2Until2008KazakhstanhasbeenverycautiousonthisfrontandhasbeenpraisedbyIMF(seeIMF,2004:73)Priortothe2007-2009crisistheKazakhstanigovernmentcombinedaquiteconservativefiscalpolicywithrapidfinancialdevelopmentandexpansionofitsmonetarybase.The large reserves were saved abroad and private banks’ credit growth wastremendous,resultinginsignificantassetbubbles3.

Tosummarize,examiningtherecentoperationsoftheNFRK:

ItwasplannedthattheNFRKwouldnotbetouchedforthefirstfiveyearsofitsexistence.

IntermsofinvestmenttargetstheNFRKinvestedonlyabroad.

Totheextentthatsovereignwealthfundsserveausefulpurpose,thisisatonceamoremodestandmoreambitiousone.Modest,becausearealisticgoalistoachievesomedegreeofpragmatically-basedsmoothingandinter-temporalredistribution,withnopretenceofoptimality.Ambitious,becausetheirvaluecanlie in reinforcing the transparency, implementation,andcredibilityof keyfiscalrules–thusaddressingatthesourceanumberoftheinstitutionalweaknessesthatmayliebehindthepoorperformanceofmanyresource-richeconomies.

AsGlennester andYongseokh showed (2003), transparency is correlatedtoimprovementsininvestmentandgrowthperformance.Kazakhstanisalreadyknownasacountrywithalowleveloftransparencyandopportunitiesforfraudandcorruption(seeTransparencyInternational’sCorruptionPerceptionIndex).Withoutdoubt,thecountryneedstoimproveitsdisclosureofnegativepractices. KazakhstandidnotaccepttheSantiagoprinciples(fortheprinciples’descriptionpleaseseeAppendix2)whichprovidedthefurtherplatformforthetransparencydevelopmentfortheSWF.ThemainlimitationoftheSantiagoprinciplesisthat

2It is importanttonotethatalreadyat thepresentstagethemanagementof thefundcouldenvisagea longer-term investmenthorizonandabroaderdiversification.Although investments inequityinstrumentsinvolveahigherriskofexposuretoshorttermfluctuationsinmarketvaluecomparedtobonds,historicallytheyhaveprovidedabetteraveragereturn.Whetherrisk-adjustedreturnsarehigherdependsontheadjustmentmadeforriskandtheinvestor’srisk-aversion.Generallyonlytherichestcountries(e.g.Kuwait)investanymorethanaverysmallproportionoftheirassetsinequities.

3Later,whenthecrisisaffectedallareasoftheKazakhstanieconomythegovernmentdidnothaveachoiceasitbailedoutthebankingsectorbydepletingNFRKassets.

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disclosurerequirementsarelimited,“...afurtherenhancementofthePrinciplesandthesurroundinggovernanceframeworkwillbemandatoryinordertoalleviateprotectionist pressure in recipient countriesoncefinancial crisis isovercome”.(Beck,Fidora,2009:364)Table1showsthataround50%oftherichestSWFdonotrecognisetheseprinciplesastheirrulesoflife.It ispossibletodebateanddiscusstheimmaturityofthegovernmentsinvolved,butthereisstillalongwaytogobytheinternationalcommunityinordertoconvincethegovernmentsofsomeresourcerichcountriesthatthehigherleveloftransparencyisdesirableforthesuccessfulmanagementofthehydrocarbonrevenue.

However,thecircumstancesofKazakhstan’sfailuretoattendthemeetinginSantiagoareunclearandthereremainssomeambiguityaboutwhetherKazakhstanhasrejectedtheSantiagoprinciplesassuch.ThreeseniorgovernmentalofficialsrelatedtotheNFRKfromtheMinistryofEconomy,MinistryofFinanceandalsoNational Bank of the Republic of Kazakhstan were asked by the author whyKazakhstandidnotparticipate in theSantiago2008meetingsaswellaswhyKazakhstan does not recognise the Santiago principles and the answer wasunanimous:“NeverheardabouttheSantiagoprinciples.KazakhstanwasneverinvitedtojointheSantiagomeeting.”(InterviewswereconductedinMay2010).Moreover,theseniorrepresentativeofSorosFoundationinKazakhstanalsowasnotawareof theexistenceof theSantiagoprinciples. Inaddition,anumberoftheKazakhstanianalystswhoarestudyingtheNFRKwerealsoconfusedwhenaskedabouttheSantiagoprinciplesandKazakhstan’sperceptionofthem.Theconclusionisverystraightforward;theinternationalworkinggroupofsovereignwealthfunds(IWG)shouldmakecontactwiththeNFRKandestablishadialogueonSantiagoprinciplesandtheNFRK’sinvolvementintothisprocess.

Whatistruefortheeconomyatlargeistruefortheresourcesconcentratedin the SWF. Transparency in themanagement of oil revenues is essential toprevent a few interest groups from appropriating oil resources by allowing ademocraticdebateandavoidingcorruptionandwasteofpublicresources.Partof this initiative is to increase transparencywith respect to revenuesby thosehostcountrygovernments.Resourcerevenuetransparencyhasbeenadvocatedby internationalfinancial institutions, including the IMF (2004).Theconceptoftransparency is expected to focus initially on the transparency of the generalgovernment,butbecauseofthespecialneedsoftransitioneconomiesitshouldbeextendedalsotorelevantstakeholders(includingcompaniesinvestinginthesectorandfinancialandstrategicinvestorssupportinglending).

Five dimensions of transparency deserve particular attention in thisconnection: a clear definition of goals; rules-based operations; the publicavailabilityofinformation;andtheadequacyofinternalaccountingandauditingofthefunds;andarrangementsfortheappointmentofofficialsandmanagers.ExperienceinKazakhstanisconsideredbrieflybelowinlightofthesepriorities,illustratingthattransparencyisasignificantissueforthefund.

InthenexttwotothreeyearsthemanagementoftheNFRKwouldneedtore-assesstheassetclasslevelforthefund.Itwouldbeofparamountimportancetoidentifyalong-termportfoliostrategyandtheinvestmenthorizonofNFRK.

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2.3 Definition of goals

InKazakhstan themainobjective for themanagementofNFRK isdefinedtobethe investmentofcapital insuchawaythat the internationalpurchasingpoweroftheFundismaximized,takingintoaccountanacceptablelevelofrisk.“FollowingalsoIMFguidelines,theinvestmentportfolioofthe‘oilfunds’isbestplacedabroad.Insum,bothdomesticelectorateandtheinternationalcommunityshouldhaveconfidencethatthefundsarewell-managed,transparent,andusedforthepurposessetoutbylaw.”(Kalyuzhnovaet.al.,2005:16).

2.4 Rules-based operations

Astowhetherthefundsarerules-based,inamechanicalsensethisisbroadlysatisfied.InKazakhstan,muchofthelegislationandadministrativeinfrastructurewasborrowedfromNorway’soilfund.However,thecloserimplementationoftheNorway’smodelbasedonanon-oildeficittargetrulecouldbeawaytoenhancethe transparency of the NFRK. Broader recommendations for Kazakhstan toincreaseitsdegreeoftransparencyincludeconsolidationofthetreasuryreportsandbetterintegrationofallfiscalcostsandrisksassociatedwithextrabudgetingoperations(includingNFRKitself).

In2006,inordertoestablishalong-termstrategyfortheuseandaccumulationofoilrevenues,therulesgoverningtheNFRKwereredesigned(seeAppendix1).Underthecurrentsystem,fiscalpaymentsfromidentifiedcompaniesinthenaturalresourcessectoraresubjecttotransfertotheNFRK.In2004thenumberofcompanieswasreducedandthetransferoftheirfiscalpaymentsiscalculatedonthebasisofareferenceoilprice.However,themaincriticismoftheoriginalreferenceprice (US$19/bbl),whichwasestablisheda long timebefore theoilboom,isthatthisdoesnotreflectthetruesituation.4TheoriginalrulesforplacingresourcesintheNFRKallowedthegovernmenttodepletethebalanceifpricesweretofallsignificantlybelowthereferenceprice.Thepracticaldifficultyherewasthattheruleswerenotappliedvigorously,duetothefactthatthedefinitionsofoilincomeandoilenterprisescouldbeinterpreteddifferentlyandeasilychanged,dependingontheintentiontosavelessormorethantherulecurrentlycommitsthegovernmentto.

Overall, even if at first sight the rules look quite straightforward, practicehasdemonstratedthattherealitywasacomplexonewithallthecomputations,etc.So,inflowrulesinclude:saving:10%ofbaselinebudgetoilrevenuesfromidentifiedcompanies(forthelistseeMakhmutova,2008);stabilization:oilrevenueabovethebaselineprice;ad hocprivatizationandbonusreceipts.Outflowrulesareclearlystatedthattransferstostateandlocalbudgetsareallowedonlyaftertheapprovalby thepresidentof thecountry.TheKazakhstaniauthorities fullyintegratedtheNFRKwiththebudget.AllcentralgovernmentoilrevenueaccruestotheNFRK,from2007onwards,andflowsintothefundviathebudget.Priortothecrisisitwasanagreementthatsomefundswillbereleasedbacktothebudgettofinancedevelopmentspending.Therewastheintentiontosetclearlimitsonhowmuchcanbespentinanyoneyear.Inaddition,ceilingsweresetforthree-

4AtthepresenttimethispriceisaroundUS$80.

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yearperiods.Thesechangesaimtostrikeabalancebetweenmeetingcurrentdevelopmentneedsandprovidingasavingscushionforfuturegenerations.TheNFRKused to include “excess” revenuesnotonly from theoilsectorbutalsofromothersectorssuchasmetals.Asofmid-2006,all taxescollectedfromoilcompaniesaccruetothefund.

Fourmoregeneralconsiderationsarealsorelevant:

Itcanbearguedthattheprinciplesofoperationshouldbeformallyenshrinedinlegislationtoguaranteereliablefunctioningoftheoilfundoverthelongterm.Legitimacyandpermanencewouldbe improvedbyhaving the formationofoilfundscomefromnationalparliaments,ratherthanpresidentialdecrees,andthisistrueinKazakhstanasinothercases.

Issuesofimplementationmatter.Therelevantquestionineachcaseisnotjusttheprinciplesagreeduponattheoutset,butalsothequestionofhowtransparenttheimplementationislikelytobe.5

Itwasafearthatasaconsequenceofthe2007-2009crisis,theNFRKmaytendto investdomesticallywhendomesticequitypricesarerising,andonthecontrary,togoabroadifforeignpricesareattractive,althoughwithcaution,buttheKazakhstaniauthoritiestookadifferentview,thatbasictrade-offneedstobefacedandthatatrueinsurancerolewillrequireadequatestockofexternalandliquidassets.

Since the crisis began in 2007 the political establishment has beenmoreinvolvedingovernanceoftheNFRK.

2.5 Public availability of information

Intermsofpublicavailabilityofinformation,inthefirstyearsofestablishmentoftheNFRKthepopulationinKazakhstanwaslargelyunawareofitsexistence.6 But theyshouldhaveaprimaryvoice in theircountry’sdevelopmentsincethecitizensofKazakhstanwillfacetheeconomic,environmental,humanrights,andsocialimpactsofhydrocarbondevelopment.Byinvolvingthemintheprocesstheproblemofcorporateandgovernmentalaccountabilitycouldbepartiallysolved.TheKazakhstanicitizenshavetoknowhowmuchincomewastakenfromthefund,onwhatgrounds,andhowthatmoneywasspent.

ThequestionofawarenessabouttheexistenceoftheoilfundinKazakhstancomes from the2006and2010SurveyofHouseholds commissionedbyTheCentreforEuro-AsianStudies(UK)andcarriedoutbytheAgencyoftheRepublicofKazakhstanonStatistics(ARKS)on640householdsacrossall theregions,

5 InApril2003,KazakhNationalBankChairmanMarchenkoendorsedPresidentNazarbaev’sdecisiontodivertoverUS$1blnfromasecretaccountintotheNFRK,tellingjournaliststhat“thiswastherightdecisionfromtheeconomicpointofview,”althoughitmayhavebeenflawedfromapoliticalorlegalperspective.(ReutersandInterfax-Kazakhstan,2003).TheKazakhstaniofficialsclaimthatalmostUS$880mlnoftheUS$1blndepositedfiveyearsagoinSwissbankaccountswasusedtopayoffpensionarrearsandsupportthenationalbudget.Mr.Marchenkorefusedtorevealhowmuchmoneythegovernmentstillhasinforeignbankaccountsonthegroundsthatitisastatesecret.

6Author’sinterviewswithanumberofcitizensofKazakhstanin2002-2003.

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designedtobenationallyrepresentative.7 The survey also included questions relating to individual well-being8. The

questionsrelatedtolifesatisfactionaswellastheimpactthatthereformshavehadon individual perceptionsofwell-beingwhichallowsa clear picture tobedrawnandlinksbetweenindividualwell-beingandexistenceofoilfunds.

Fromthequestion Do you know about the existence of the National Fund of Republic of Kazakhstan?Welearnedthat45%oftheKazakhstanipopulationdonothaveanyideaaboutNFRK;however,inthe2010surveythisfiguredeclinedto 30%. In 2010 through the regional analysiswe found out that themajorityofunawarenessisconcentratedintheregionsofMangistau(54%),Karaganda(48%), and Akmolinskaya (43%). In contrast, Southern Kazakhstan has thehighestawarenessamongallregions,whereonly1%ofthepopulationdonotknowaboutNFRK.

Inanalysingtheeducationallevelofthepopulationwhichisnotawareoftheexistenceof theNFRK,we found that the largestpercentage(60%)ofpeoplewithprimaryeducationarenotawareoftheexistenceoftheNFRK,althoughthisresultisbasedontheinterviewsofasmallgroupofrespondents.

Overall we found a pattern of increasing awareness of the existence oftheNFRKwiththelevelofeducation(e.g.threequartersofpeoplewithhighereducationknewabouttheexistenceofNFRK,orbasedonasmallnumbereven86%withpostgraduateeducation).

TherespondentswhowereawareoftheexistenceoftheNFRKwereaskedTo what extent does the National Fund of Republic of Kazakhstan influence your standard level of living?OverallaverysmallpercentageofpeoplethinkthattheNFRKhasasignificantimpactontheirwell-being(17%in2010,whichisslightlyhighercomparedwiththesurveyof2006wheretherespectivefigurewas13.8%).Thestrikingfactfromthe2010surveywasthatalmosttwo-thirdsofrespondentseitherdidnotknoworgaveanon-validanswertothisquestion.

MorepeoplewithahighereducationthoughtthattheNFRKhasapositiveeffectonthestandardsofliving(19.2%).Similarly,morealsothinkthatthereisnoinfluence(28.5%).Ingeneral,thosewiththelowestlevelsofeducationwerealsoleastinclinedtogiveavalidanswer.Intermsofregions,AtyrauskayaandKzyl-OrdaregionsthoughttheNFRKhadapositiveinfluenceonstandardsofliving(40.7%and69.4%, respectively).Respondents inKustanai regionandAstanacityweremostinclinedtothinktheNFRKhadnoimpactonstandardsofliving(40.6%and37.5%,respectively).

Inabroadercontextofassessingtheoilwealthofthecountry,therespondentswere asked where, from their point of view, the oil money should be spent9.From the 6 possible answers (health care, economy, oil and gas, agriculture,welfare,andpopulation)whichcouldbechosenassingleaswellasmultiple,themost popular answerswere in 2010 “health care” (48.2%), “social sector”

7ForthemethodologyofthesurveypleaseseeChapter1inKalyuzhnova(2008).8Itincludesinformationonincome,expenditures,thenatureandqualityofhousing,andother

household characteristics such as number and age of household members, labour force status,educationalattainment,healthstatus,etc.,acrossalltheregionsofKazakhstan.

9Theactualquestioninthesurveywas:Fromyourpointofviewwhatforoilmoneyshouldbedistributed?

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(38.6%),“economy”(32.9%)and“population”(11.7%).Thisprovedthepointthatthepopulation thinksabout thepresentdayandperceives theoilwealthasablessingoftodayratherthantomorrow.Inparticular,aninterestingfactisthattheanswer“oilandgassector”receivedthesupportofonly4.9%ofthepopulation.

In theAkmolinskaya region, respondentswanted toputoilmoney into theeconomy (37.5% in 2006 and 45.3% in 2010) from the total of respondents’answersfortheregion).ThepopulationsofKustanairegion(40.6%fromthetotalofrespondents’answersfortheregion)aswellasEasternKazakhstan(30%in2006and45.7%in2010fromthetotalrespondents’answersfortheregion)hadthesameopinionasrespondentsintheAkmolinskayaregion.Withregardtohealthcare,thepopulationofAlmatinskaya,KostanaiandKaragandinskaya,SKO,andAstanaregions(53.5%,60.4%,59.6%,68.2%,62.5%ofthetotalrespondents’answers for the region) strongly supported this option.The respondents fromthe Mangistau region in particular wanted to distribute oil money among thepopulation (57.5%; 37.5% in 2010 from the total respondents’ answers of theregion). The respondents from the agricultural regions of Kustaniskaya andAlmatiskaya(45.8%and45.6%)Kyzyl-OrdaandSouthernKazakhstanstronglysupportedtheinvestmentofoilmoneyintoagriculture,with25%,19.4%,44.1%23.3%in2010ofrespondents,respectively,favouringthis.

Theinvestmentin“welfaresocialsector”wassupportedinKaragandinskaya,AstanaandAlmatiskayaandSKO(53.7%,54.2%,48.2%and47%respectively).Thisshouldperhapsnotbesurprisingsincetwo-thirdsofrespondentsarenotsatisfied with the provision of unemployment benefits. Similarly, 70% are notsatisfiedwiththefunctioningofthehealthsector.

“Unfinished higher education” as well as “higher education” groups ofrespondents would like to invest the assets from the NFRK into the socialsector(50%and41.9%,respectively).Basedonverysmallnumberssome60%of respondentswith “primary education” onlywould like to invest theNFRK’smoney in thesocialsector.With respects tohealthcare, there is ingeneralahighconsensuswithregardstoinvestinginthissector(allareabove50%).The“postgraduates”group ismostsupportiveof investing theassetsof theNFRKintothe“oilandgassector”(14.3%).Theinvestmentintoagricultureisrelativelyuniformlysupportedacrosstheeducationalgroups(approximatelyaquarter).

2.6 Accounting and auditing

Intermsofadaptationofbestpracticesinaccountingandauditing,theNFRKreportsquarterlytothepressonthetotalamountsofassets, inflowsreceived,expenditures,andinterestearnedbythefunds.Thefundhasitsownwebsite.These visible attributes of transparency are themain arguments used by themanagementofthefundinthedebatesabouttransparency.

Since its inception,externalauditsof theNFRKhavebeenconducted (by Ernst &Young), and themost recent one is currently underway.Although theNFRKhasawebsite,itonlygivesinformationonthetotalNationalFundassets,brokendownbyportfolio.Commentatorshavecriticizedthispointandclaimthatitdemonstratesalackoftransparency.

An annual audit of the fund is prima facie evidence of transparency, but

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it isonly the tipof the icebergas regardshighstandardsofgovernance. It isencouraging that in Kazakhstan increasing emphasis is being laid at presentonthetransparencyandefficiencyof investmentprocesses in thefund.Closeattention should be paid to compliance with the rules under which the fundwassetupandtodiversificationofinvestmentprojectswithintheareasoffundoperations.

2.7 Appointment of officials and managers

Analysis of the NFRK highlights some structural weaknesses. The fundhasbeencharacterisedasrepresentativeandparticipatory.TheruleisthatthePresidentapprovesallthemembersoftheboardandallofthemaregovernmentofficials.This strongcontrol by theexecutivebranchhasenabledusesof thefundthatarecontrarytoitspurposes.Theofficialexplanationforthisisthatthematurity of the society is quite rudimentary and by allowing other people (forexampletheparliament)todecidethestrategyforusingtheoilfund,controlovertheoilwealthcouldbe lost. If transparencyof theoil fund is tobeestablishedinacrediblemanner, thestructureof the fundmanagementneeds tobecomemorerepresentativeandlessdominatedbythegovernment.Onlythroughsuchastructurecanthehighlevelofpoliticalinfluencebeovercome.

By2003Kazakhstansaved63%ofitsoil-windfallintheNFRK,whichbyallstandards demonstrates a remarkably prudent fiscal stance and gives rise tohopeforcautiousoptimismforthefuture.However,withtheonsetoftheglobalcrisis,circumstanceschangeddramatically,andwiththemtheoperationsoftheNFRK.

2.8 NFRK and recent financial crisis

TheimportanceoftheNFRKfortheKazakhstanieconomyhasbeenraisedconsiderablysincetherecentglobalfinancialcrisishitthecountry.“Thefinancialcrisishasservedasa’stresstest‘onthesturdinessoffiscalinstrumentsinthefaceofeconomicshocks,andtheirrelevancetoeconomicdiversificationinresourcedependenteconomies”(HeutyandAristi,2009).By2008NFRKbecameoneoftheworld’slargestsovereignwealthfundsalongsidetheoil-producingcountriesof theMiddleEast andRussia (seeTable 1). Initiallywhen the crisis started,theKazakhstanigovernmentwasreluctanttousetheassetsoftheNFRK,butsincethecrisiswasbecomingdeeperanddeeperthegovernmentofKazakhstan“opened” theNFRKand took the$10bln (9.5%per centofGDP)whichwasusedforstabilizationofthefinancialsystem,supportofthehousingprogramme,SMEs and industrial innovation development (anti-crisis plan) (see Table 2).Thus, alreadyby theendof the first quarter of 2009 theassets of theNFRKdecreasedby20%andwerearound$22bln.UnfortunatelyforKazakhstanthebankingsystemwasfairlyopentoglobalfinancialmarketswithweakregulation.Theanti-crisisplanwascombinedwiththeeffortsof thegovernment,NationalBankofKazakhstanandFinancialSecurityAuthority,withSamruk-Kazynaactingasthemainbodyforcrisisrelief.Overall,theNFRKhasdistributedUS$10bln,ofwhichUS$9blnwereprovidedtoSamruk-Kazynaintheformofdebt(US$5

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bln)andacapitalinjection(US$4bln).KazAgroNationalHoldingreceivedtheremainingUS$1blnforthesupportoftheagriculturalsector.ItislikelythattheKazakhstanigovernmentcouldbeexposedtosomecontingentliabilitiesfromtheanti-crisisprogrammethroughSamruk-Kazyna(IMF,2009:8).

TheNFRKincurredlossesonitsinvestmentsintheeconomicandfinancialdownturn,withtheequityportfolioamongthosehit.Therearenodataavailableon theNFRKyet,butby theauthor’sestimations, theequityportfolioheldbyNFRKmayhavelostapproximatelyUS$1mlnsince2008,reducingtheoverallportfoliobyaround0.64%.Thereareclearlyanumberoffactorsposingpotentialrisk to the growth of the NFRK in the near future, namely: commodity pricefluctuations, changes toglobal capital flowsalongwithpotential protectionismintheNFRKrecipientcountries,andexchangeratemovements.ItisinterestingtonotethatKazakhstanhasleveragedmorefundstoitsNFRKthanitsforeigncurrencyexchangereserves,whichreflectsmoreaaggressivepolicytoreceivehigher returns.By theendof2009, totalassetswerearound$26.2bln.WhatarethegrowthprospectsfortheNFRK?BasedonthedatafromtheMinistryofEconomyin2009-2012thereceipts to theNFRKareexpectedtobe$9.3bln;$10.7bln;$11.2bln, respectively,which reveals that theNFRKwillbestillanimportantplayer in theyearsaheadbothdomesticallyand in the internationalfinancialmarket.

The financial crisis has shifted the emphasis in the policy of the NFRK(whetherthemanagementofthefundlikesitornot)fromissuesofperformanceatthefirmleveltotheportfoliostrategyandtheinvestmenthorizonofNFRK.Intheshortterm,theimpacthasbeentoreconsidertheinvestmentstrategy,whichwill remainanexternalonerather thanbeingoriented towardsmoredomesticinvolvement(aswasinitiallythoughtbysomeanalystsandobservers).Overtimetheexternalinsurancerolewilldoubtlessneedtoberebuiltalso,toguardagainstthe impactof future shocks. It isunderstandable that theconsequenceof thecrisisis(andwillbeforthenextseveralyears)amoreactiveinvolvementoftheKazakhstanigovernmentinthegovernanceoftheNFRK,whichmightbereflectedinamoresensitiveattitudetothesocialneedsoftheKazakhstanicitizens.Inotherwords,thegovernmentcouldbeinthepositiontoacceptinvestmentsnotwithhighersocialreturns,butlowprivateones(investmentsintheindustrieswithlowereconomicperformance).Overall,atthepresenttimetheinvestmentpolicyoftheNFRKisbasedonRulesonInvestmentOperationsoftheNFRK(RulingofNationalBankoftheRepublicofKazakhstan,N65,26July2006);however,itwasindicatedbyoneoftheNationalBankseniorofficialsthatitismorelikelythattheNFRKinvestmentstrategywillbemorecloselyfocusingontheAsianmarket(includingAustralia).

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Table 1. The world’s largest SWF

Sovereign Wealth Fund Country Assets in USD bn

Accepted Santiago

PrinciplesOil-Exporters 1240-2220AbuDhabiInvestmentAuthority UAE(AbuDhabi) 400-800 YesGovernmentPensionFund-Global

Norway 373 Yes(observer)

SAMA SaudiArabia 300 Yes(observer)KuwaitInvestmentAuthority Kuwait 213 YesInvestmentCorporationofDubai UAE(Dubai) 20-80 YesQatarInvestmentAuthority Qatar 20-60 YesLibyaInvestmentAuthority Libya 20-60 NoBruneiInvestmentAgency Brunei 10-50 NoFutureGenerationsFund Russia ~24 YesGovernmentPensionFund-Norway

Norway ~20 Yes

NationalFund Kazakhstan ~22 NoKhazanahNasionalBerhad Malaysia ~18 No

East Asia ~585ChinaInvestmentCorporation China ~200 YesGovernmentInvestmentCom-pany

Singapore ~130 Yes

ExchangeFundInvestmentPortfolio

HongKong ~112 No

TemasekHoldings Singapore ~108 YesKoreaInvestmentCorporation Korea ~20 NoNationalStabilisationFund Taiwan ~15 No

Others ~138GovernmentFutureFund Australia ~49 YesAlaskaPermanentFund US ~38 NoPermanentUniversityFund US ~20 NoNewMexicoStateInvestment US ~16 No

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AlbertaHeritageSavingsTrustFund

Canada ~15 Yes

Total 1963-2943

Source: The classification is taken from R. Beck and M. Fidora, “The Impact of Sovereign Wealth Funds on Global Financial Markets”, Review of European

Economic Policy (2008).

“ThebankingcrisesinKazakhstan,Kuwait,Qatar,NigeriaandRussiaraisequestions about the effectiveness of stabilization mechanisms in resourcerich countries, and calls for a fresh look at domestic investment to financeeconomic diversification and development strategy of resource rich countries”(HeutyandAristi, 2009:23).Did theNFRK fulfill its purpose in the2007-2009crisis?Todaywecouldsaythat theNFRKworkedforKazakhstan,despitethefact that institutional qualitywas not as high.This reflected in part the strongleadershipof thepresident of the country in favorof prudentpoliciesand thelimitedinvolvementofthepublic.AnotherfactorwhichmadetheuseoftheNFRKarelativesuccessisthatKazakhstanisanupper-middle–incomeeconomy;thislevel of developmenthelped the country toovercome the crisis in a relativelyshortperiodoftime,althoughatthesametimetheloosemonetarypolicyledtoafinancialbubblewhichexaggeratedtheconsequencesofthecrisisandultimatelythecountryneededthemassive injection intoeconomytorescuethefinancialsector.Inbroadterms,onecansaythattransferstothefunddidhelpmitigatethepressureon resources inKazakhstan’seconomyduring theupswing,andleft itbetterpreparedfortheexternalshockthatfinallycame.Moreover,itwascruciallyimportantthatthebulkofthefund’sassetswereinvestedexternallyinliquidassets,andthatitthuswasabletoserveasariskbufferandasaformof“collateral”fortheeconomyduringthecrisis.Inthisregard,thefavorableimpactofthefundfarexceededtheactualdrawingsmadetosupporttheeconomy.

Fromthe2010CEASSurveywefoundthat70%ofrespondentssupportthefactthatthemoneyfromtheNFRKwasusedduringtherecentcrisis,only4%ofrespondentsthoughtthatitwasabadidea,and25%wereundecided.

With regards to the educational level, respondents with a low level ofeducationweregenerallymoreinfavoroftheKazakhstanigovernmentspendingmoney from theNFRKduring the2007-2009crisis period (70-75%);whereastherespondentswithahigherlevelofeducationwerelesssupportiveofthis(60-65%).

Across the regions, respondents in Kostanaiskaya region were verysupportiveofthegovernmentaldecisionofspendingfundsfromtheNFRK;ahighlevelofsupportwasalsoregisteredintheSKO,AktubinskayaandPavlodarskayaregions(92.4%,74.5%and75%,respectively).Theleastsupportforthispolicywas found in theAlmatyinskaya,Akmolinskaya andMangistau regions (52%-58%).

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Table 2. Summary of the Anti-Crisis Plan in the Republic of Kazakhstan

Amount (US$, bln)Comment

Allocated Disbursed Support to:

Financialsector 4.0 4.0 Capitalanddepositsprovided.Mortgageloanrefi-nancing

1.0 1.0Providedtobankstorefinanceexistingmortgages.

Constructionsector 2.0 0.0Tofinishuncompletedhousingprojects.

Agriculture 1.0 0.0 ProvidedtoKazAgro.

SMEs 1.0 1.0Providedtobanksforonlend-ing.

Infrastructure/Industry 1.0 0.0TOTAL: 10.0 6.0Financingfrom:

NBRK 10.0 10.0US$9bln.AlreadytransferredtoSamruk-KazynaandUS$1bln.toKazAgro.

Memoitems:DistressedAssetFund 1.0 0.6 Capitalprovidedfrombudget.Taxcuts 4.0 … ImplementedJan1,2009.Lowerreserverequire-ments

3.0 …

Source: Kazakhstani authorities and the IMF, 2009.

Overall,the2010SurveyhighlightedthattheKazakhstanipopulationfeltthattheimpactofthecrisiswasrelativelylimitedasfortheeconomyasawholeandtheirpersonallives(58%-59%).Thiscouldbeexplainedbythe“cushion”whichthe NFRK provided to the Kazakhstani economy during 2007-2009 crisis.AninterestingimplicationofthesuccessoftheuseoftheNFRKbytheKazakhstaniauthoritieshasbeenexpressedinthestrongopinionofsupportbytherespondentsacross the regions for the greater governmental (state) prominent role in theeconomic lifeofKazakhstan (theactualquestionwasTaking into account the recent financial crisis, do you consider that the Kazakhstani economy requires stronger government control?) Almost 90% of respondents supported greatergovernmentcontrolinbanking,oil&gas,manufacturingandeducation.

There are some doubts in the country about the complete effectivenessofusingUS$10bln;mainly thatnotall themoney isstill “implemented” to theeconomy.ThereiscertaincriticismthattheNFRKwas“forced”tobuysecurities

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intheKazakhTengedenomination(5blnKZTenge)issuedbySamryk-KazynaandKazAgro,andby this theNFRKhasnowtwoparts (aKZTengepartandahardcurrencypart),although theTengepart isnot largecomparedwith thecurrencypart.So,at theendof2009,according to theNFRKAnnualReport,thetotalmarketvalueoftheNFRKportfoliowasUS$26bln,includingcurrencyportfolioUS$24blnandsecuritiesportfolioSamrykKazynaandKazagroUS$1.8bln.

3. Policy recommendations

3.1 Future challenges for the NFRK

TheNFRKisnewandthereforeit isnecessarytokeepthisfactinmindinorderto judgeitsperformance,successandfailures.Theestablishmentofthesovereignwealthfundisitselfamajorchangeinfiscalpractice,astheNFRKwasrequiredtoaccumulatefundsforfiveyearswithoutspendingfromit.Therecentmarketcontextofhighoilpricesprovidedsometestastowhethertheexistenceofthefundswillresultingreaterfiscalrestraint.

Inparallelwiththispublicsectorrestraint,however,theeconomyexperiencedamassiveprivatesectorboom, fuelledbycapital inflows through thebankingsystem, andmuch of this activity centred on the real estate sector. By 2007commercialbankforeignborrowingreachedaround70%oftotalfundinginsomecasesandatthesametimetheloan/depositratiosatsomebanksweaccountedat400%.TheprivatesectorissignificantlymuchmoreexternallyexposedthantheKazakhstanieconomy.By2007netforeignassetsofcommercialbankswerearound 35% of Kazakhstani GDP. In addition, Kazakhstan has accumulatedreserves abroad, which made the country attractive to foreign lenders. As aconsequencethebankingsectorbecameparticularlyvulnerabletotheliquiditycrisisstartedintheUSandEurope.

“Theoilwealthaccumulated in theoil fundswascentral to theauthorities’response to the 2008-09 global financial crisis” (Goldsworthy and Zakharova,2010:3). In order to preserve its banking sector and boost the economy theKazakhstanigovernmentdidnothaveachoicebuttouseUS$10blnfromNBRKto support theeconomyand recapitalize thebankingsystem, to shoreup thedomestic equitymarket, and to push credit to small andmediumenterprises.Overall,Kazakhstanwasable tomobilize resourcescreatedduring theperiodofraisingoilpricestofindtheoptionstorespondtothecrisisandtofinancethesignificantfiscalstimulusin2009inordertosupportdomesticdemand.ThereisnodoubtthatKazakhstanmadetherightdecisiontousetheNFRK’smoneytosavethebankingsystem.ItisclearthattheKazakhstanieconomywouldhavesufferedamuchmoreserious“meltdown”withouttheoilfund,andthatitwouldalsohaverecoveredmuchmoreslowlyafterthecrisis.

ThechallengeaheadfortheKazakhstanieconomyisclear:toensurethattheeconomicprogressinitiatedbytheseedcapitalofhydrocarbondevelopmentpriortothe2007-2009financialcrisisprovesstableandsustained.Theexperiencetodateof resource-richcountries inoperatingoil fundsdemonstratesempiricallythat these are no panacea for the “paradox of plenty,” but the Kazakhstani

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governmentwhichprudentlybuiltupthelargeSWFdisburseditsfundsundertheanti-crisisplan.Thepathofoilpricesovertimedoesnotencourageaviewthatfundscanbedesignedtoachieveanoptimalsmoothingofincomeorassuranceofinter-temporalequity.

ThegovernmentofKazakhstandiscussedtheneedtohavealong-termvisionanddeterminationinpursuingtheirpoliciesofmanagementoftheoilrevenues,which should contribute to the sustainable development.Among these goals,greater confidence in the transparentmanagement of theNFRK, and greaterpublicunderstandingof itsobjectivesandoperations,areessential inorder tosafeguardthesustainabilityandefficiencyofthefuturefortheNFRK.

So,alreadyinMarch2010,Kazakhstandecidedtorestricttheamountstate-ownedcompaniescanborrowfromtheNFRKbyimposingcaps.AccordingtoEconomicDevelopmentandTradeMinisterZhanarAitzhanova,annualspendingonservicinggovernmentdebtmustnotexceedtheNFRK’s“annualconditionalsetinvestmentincome”of4.5%.TheamountofmoneyintheNFRKwhichcannotbe usedmust be equal to at least 20% of plannedGDP. The government isconfidentthatthesemeasureswillhelptheNFRKtogrowtoUS$90blnby2020,equaltoabout30%ofGDP(Bloomberg.com;16March2010).

Alongperiodoftimeisneededtodeterminetherealimpactofthefund.Oneimportantlessonisthatitsemphasisonliquidexternalsavingshelpedmoderatethedomesticboomandalsoallowedacredibleinsuranceorcollateralroleduringthecrisis.Asecondisthattherewasthenscope–atleastforaperiod–touseresourcesinthefundtohelprepairthedamagetothedomesticeconomy.Timewilltellhowefficienttheselatterinvolvementswillhavebeen,andalsohoweasyitistorestoretheformerinsurancerolebybuildingupliquidforeignassetsinthefuture.

Butunderalloptionsforitsinvestmentstrategy,thecasemadeinthispaperisthecoreimportanceinKazakhstanofcontinuingtoenhancegovernanceandtransparencyofthesovereignwealthfundinordertomaximizethechancesofsuccess.Inevitablythislimitsgovernmentdiscretionindisposingofthemineralwealthofthenation.Itis,however,essentialtobuildpublicsupportforthefunds,and to leverage their economic impact through a strong influence onmarketexpectations.

By establishing periodic auditing and analysis of the managementperformance, it is possible to ensure the sustainability and efficiency of themanagement revenue.The fund’sassetsshouldbeplacedabroad (toprovideprotection from thepopulist ideas tohelp the localeconomywith investmentsfromthefund)andgreaterdiversificationoftheassetsportfolioisrequired(asitwasdemonstratedincaseoftheNFRK).TodateitisdifficulttoconfirmwhethertheNFRKhasgainedpublicsupport.Thepublicishardlyawarethatsuchfundsexist.

An important issue related to the future development of the NFRK (itssustainablegrowth)isthefiscalregimethatwouldbedesignedinordertosecurethegovernment’smaximumhydrocarbonrevenueandatthesametimetoprovideanoptimalregimefortheinvestorstoundertakethehydrocarbonactivities.Thekeypointhereisprovisionbythegovernmentofanadequatereturnassociatedwith the risk to the investors. “The country experiences of Azerbaijan andKazakhstansuggestthataggregatefiscaldisciplineisessentialfortheeffective

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managementofoilrevenues”(Usui,2007:11).In2009KazakhstanintroducedtheNewTaxCode,accordingtowhichthe

renttaxoncrudeoilandgascondensateexports(between7%and32%)istobepaidbyallphysicalpersonsandlegalentitiesthatexportcrudeoilandgascondensate.ExemptwerecompaniesthatenjoyastabletaxregimeunderPSAssignedwiththegovernmentofKazakhstanbeforeJanuary1,2009.However,inJanuary2010statementsmadebyKazakhstanPresidentNursultanNazarbayevandMinister ofEnergy andMineralResourcesSauatMynbayev suggest thatKazakhstanwilltakestepstoimplementnewlawsregardingthetaxesanddutiesthatIOCswillbeobligedtopay,cancelingtheoriginalagreements(PSAs)thatwerenegotiatedinthe1990s.AccordingtothePSAs,theinternationaloilcompanies(IOCs)wereforthemostpartallowedtodevelopandexporthydrocarbonsunderexemptionfromnormalcustomsprocedures.

PresidentNazarbayevsaidatagovernmentmeetingon22January2010thatforeigncompaniescurrentlyenjoyingaspecialstatuscouldlosethisprotectiveimmunityifadjustmentsaremadetothecountry’staxlaws.“Wehaveto…departfromthisarrangementofimmunitysothateveryoneworksinlinewiththesamelegislativechangesthatwillhappeninthefuture,”hesaid,accordingtotheSRI newsagency.“Allthecontractscurrentlyoperateinaccordancewiththelegislationthatwas inplaceat the timeof theirsigning…Timesarechangingand life ischangingtheentireworld,andstateinterestsarepushingusinthisdirection.Wehavetoworkmorethoroughlyandconstructively.”EnergyMinisterMynbayevtoldtheKazakhstaniparliamenton26January that following thepresident’sorderwouldnotbeasimplematter:“Abandoningtaxexemptionsisabigquestion.Wewillseparatelydiscuss…howwewillimplementitthroughconcretesteps,takingintoaccounttheorder.”(MiddleEastEconomicSurvey,http://www.mees.com/cms/category/oil-gas/)ThisnewstepbytheKazakhstanigovernmentisconsideredasanotherattempttodrawlargerfinancialbenefitandconsolidatemoreinfluenceoverthehydrocarbonsectorofthecountry,andnowtherearedoubtsthatinthefuturethisstepwillhaveitsimplicationsontheassetsoftheNFRK.

In2010theKazakhstanigovernmentpresentedadraftofa“NewConceptofFormingandUsingAssetsoftheNFRK”accordingtowhichthestabilisationfunctionof the fundwillbe implemented through theguarantee transfer to theRepublicanBudget,whichwill be fixed on a level ofUS$8 bln instead of thepreviousruleof1/3oftheassetsoftheNFRK.Therestoftheassetswhichshouldbenotlessthan20%oftheGDPforecastedaredefinedfortheimplementationofthesavingsfunction.TheKazakhstanigovernmentrealisedthatthemanagementoftheNFRKisplayingakeyroleinthesustainabledevelopmentofthecountryand isoneof themost important factors in thegovernmentaleconomicpolicy.Therefore theNewConcept contains the following restrictionswith regards tousingtheassetsoftheNFRK:annualexpendituresforservingthestatedebtonaverageduringthedecadeshouldnotbemorethan15%oftheincometothebudget, including the transfer from theNFRK.Loans to thequasi-statesectorfromtheNFRKandotheradditionaltransfersareprohibited.

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3.2 Recommendations

What should be the core of the long-term strategy for the Kazakhstanigovernmentbasedonthelessonsofthe2007-2009financialcrisis?Firstofall,itiscrucialthatinthefuturethegovernmentbedeterminedtoachievethenon-resourcefiscalbalancewiththerobustprogrammeofdiversification.

Secondly,itwouldbebeneficialiftheKazakhstanigovernmentcouldestablishasystemofparticularindicatorsforthenon-resourcedeficitinordertomonitoraswellastoreduceresourcedependency.“Trackingthenon-resourcebalanceallows fora solid senseof theavailabledevelopment financing,which shouldalsohelpcalibrate themediumand long-termfiscal framework.Thisapproachassumesthatgovernmentshavethecapacitytodetermineandadjustlongtermcommoditypricesindependentfrompoliticalpressures”(HeutyandAristi,2009).

Thirdly, the fact that domestic investment for economic diversificationprovidesmore stability and economic resilience should be taken into accountwhentheKazakhstanigovernmentisdesigninganinvestmentportfoliostrategyof theNFRK for thenear future.Thispolicywill requireamedium termfiscalframeworkthatstepbystepincreasestheshareofresourcerevenuesusedforpublicinvestmentuntil investmentrepresents100percentofresourcerevenuespending.

Fourth, although Kazakhstan did not accept the Santiago Principles, atransparentandaccountablegovernancestructureof theNFRKisrequiredforthefuturesuccessofthepoliciesconductedbythefund.Aneffectivestrategywillalsorequirethatfiscalinstrumentsareintegratedintothebudgetprocessinordertoprovideaguaranteeintermsoflong-termdevelopmentstrategyofthecountryaswellasoptimalmanagementofhydrocarbonwindfalls.Thisstrategyalsorequiresclosecoordinationwithfuturemonetarypoliciesinordertoavoidthecreationofassetbubbles like thoseKazakhstanexperienced in therecentpast.Kazakhstanand theNFRKneed to reconsider theirperception toGAPPandifnotacceptthem,at leastgetamorepragmaticbasisfortheinvestmentstrategyoftheNFRKintheshortterm.

In light of the recent crisis it is unlikely thatKazakhstanwill soon join theSantiagoPrinciples;however,itiscrucialthattheKazakhstanigovernmentandsociety would be able to recognise the importance of transparency towardsinternationalmarketsrather thandomesticaccountability tocitizensaswellasastraightforwardframeworkwithoutroomfordifferent interpretations.Itshouldbeanormal practice that theNFRK is systematicallymonitoredagainst goodpracticeandinternationalbenchmarkstomakesurethattheKazakhstanicitizensbenefitfromtheirhydrocarbonsectorintheoptimalway.

It would be desirable that the international working group of sovereignwealthfunds(IWG)makecontactwiththeNFRKandestablishadialogueontheSantiagoprinciplesandtheNFRK’sinvolvementinthisprocess.

Fifth,itisclearthathydrocarbonwealthisgoingtoplayavitalroleinensuringeconomicstabilityandsustainabilityofpublicfinanceofKazakhstan.ThismakeKazakhstanfocusedonreducingrawmaterialsdependencyinordertomitigateDutchdisease,whilefinancingcrucialpublicsector reforms.Well-managedoilwealthwouldbecentralinfinancingthesereforms,andatthesametimeitwould

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beimportantnottomisusetheNFRKinstrategically-orientedinvestmentratherthancommercialinvestment.

Sixth, in its investment strategy the NFRK has to arrive over time at adiversification in itsassetallocationwhichwouldcorrespond to the longer-runneedsandwelfareofKazakhstanicitizens.Thiswillmeancarefullyreviewinghowefficientitsrecentdomesticresourceallocationhasbeen,followingthecrisis,andlearning lessonswhereneeded.But itwillalsomeanconsideringhow farandhowfastthefundcanrebuilditsroleasanexternalbufferfortheeconomy,aswellasaninstitutionthatdampensdomesticpressureswhenenergypricesarerisingsharply.Bothoftheselattergoalswouldseemtoimplyareturn,overtime,toarolewhereincreasesinthefund’sresourcesarequitestronglyallocatedtoexternalliquidassets.

Finally, at thepresent timeKazakhstanalreadyhasahistory indesigningan effective framework for managing its hydrocarbon wealth; however, theimprovementinthepetroleumtaxationregimewouldberequiredasanadditionalinstrumentinmanagingoftheoilandgasrevenues;namelyneutrality,captureofrent,stabilityandtimingofrevenue,progressivityandadaptability,administrativesimplicityandenforceabilityaswellasinternationalcompetitiveness(basedonGoldsworthy and Zakharova, 2010). The Kazakhstani government needs toreassessitsriskpreferencesanditswillingnesstosharethemwiththeinvestorsintheoilandgassectorafterrecentcrisis.

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Sources consulted or recommended

1. «StatementoftheKazakhNGOCoalitionOilRevenuesUnderThePublicOversight,»Oslo,October16,2006.

2. Seewww.openbudgetindex.org,Kazakhstancountrysummary.3. Svetlana Tsalik, Caspian Oil Windfalls: Who Will Benefit? (NY: OSI,

2003),p.146.4. NationalFundConceptPaperoftheGovernmentofKazkahstanathttp://

www.government.kz/ru/doc/U051641__RUS.html5. See Annual Reports of National Bank of Kazakhstan at http://www.

nationalbank.kz6. IMF,«RepublicofKazakhstan:ConcludingStatementof the2006 IMF

Mission,»October20,2006,Para2.7. HumanRightsWatch,«KazakhstanCountrySummary»January2007.

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World Bank (2005) Republic of Kazakhstan: Getting Competitive, StayingCompetitive: The Challenge of Managing Kazakhstan’s Oil Boom. Report N.30852-KZ.June.WorldBank,WashingtonDC.

World Bank (2004) Civil Society and Private Sector DiscussWorld BankcountryPartnershipStrategyforKazakhstan.NewsReleaseNo.2004/004/KZ.Astana.

Wright,GavinandJessieCzelusta(2004),“TheMythoftheResourceCurse”,Challenge,47,2,6–38.

Yeager,Timothy (1999). Institutions,TransitionEconomies, andEconomicDevelopment.Oxford:WestviewPress.

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Appendices

Appendix 1. New Rules of NFRK

From July 2006 changes took place in the NFRK’s rules. New mid termstrategywithformalisedmethodofthebalancedbudgetisoutlinedbelow:

E=GNO+Go+D,where (1.1)

E-nationalbudgetexpendituresGNO-non-oilsectorrevenueGo-guaranteedtransferfromthefundestimatedbasedontheaveragevolume

ofexpendituresforbudgetarydevelopmentprogrammesforacertainperiodD-netpublicborrowings,forwhichtheannualaveragevaluelimitfora5year

periodissetthelevelof1%ofGDPforarespectiveyear.

Go=A+bNFRKt-1e (1.2)

A-constapprovedbythelawandsetinTengeb-coefficientequaltotheaveragelevelofinvestmentincomeforacertain

periodNFRKt-1-assetsoftheNFRKasofthebeginningofafinancialyeare-Tengeratetothereferencecurrencyofthefund

So,asyoucouldsee fromequation (1.2) themainconcern isconstantA,which is set up by the parliament.Although “by selecting various parametersfor the rule” there isahope that theselectionwillbedrivenby “howmuchofthevolatility inpricesandquantitieswillbetransferredtotheeconomyviathefiscal framework” (World Bank, 2005:35), themain concern is remained: howindependentlyandbasedontheeconomicsenseratherthanonapoliticalonethisprocesscouldbe.

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Appendix 2. Generally Accepted Principles and Practices (GAPP)—Santiago Principles

Principle General Description

GAPP1ThelegalframeworkfortheSWFshouldbesoundandsupportitsef-fectiveoperationandtheachievementofitsstatedobjective(s).

GAPP1.1.Sub-principle

ThelegalframeworkfortheSWFshouldensurethelegalsoundnessoftheSWFanditstransactions.

GAPP1.2.Sup-principle

ThekeyfeaturesoftheSWF’slegalbasisandstructure,aswellasthelegalrelationshipbetweentheSWFandtheotherstatebodies,shouldbepubliclydisclosed.

GAPP2ThepolicypurposeoftheSWFshouldbeclearlydefinedandpubliclydisclosed.

GAPP3

WheretheSWF’sactivitieshavesignificantdirectdomesticmacroeco-nomicimplications,thoseactivitiesshouldbecloselycoordinatedwiththedomesticfiscalandmonetaryauthorities,soastoensureconsis-tencywiththeoverallmacroeconomicpolicies.

GAPP4Thereshouldbeclearandpubliclydisclosedpolicies,rules,proce-dures,orarrangementsinrelationtotheSWF’sgeneralapproachtofunding,withdrawal,andspendingoperations.

GAPP4.1.Sub-principle

ThesourceofSWFfundingshouldbepubliclydisclosed.

GAPP4.2.Sub-principle

ThegeneralapproachtowithdrawalsfromtheSWFandspendingonbehalfofthegovernmentshouldbepubliclydisclosed.

GAPP5TherelevantstatisticaldatapertainingtotheSWFshouldbereportedonatimelybasistotheowner,orasotherwiserequired,forinclusionwhereappropriateinmacroeconomicdatasets.

GAPP6

ThegovernanceframeworkfortheSWFshouldbesoundandestab-lishaclearandeffectivedivisionofrolesandresponsibilitiesinordertofacilitateaccountabilityandoperationalindependenceintheman-agementoftheSWFtopursueitsobjectives.

GAPP7TheownershouldsettheobjectivesoftheSWF,appointthemembersofitsgoverningbody(ies)inaccordancewithclearlydefinedproce-dures,andexerciseoversightovertheSWF’soperations.

GAPP8Thegoverningbody(ies)shouldactinthebestinterestsoftheSWF,andhaveaclearmandateandadequateauthorityandcompetencytocarryoutitsfunctions.

GAPP9TheoperationalmanagementoftheSWFshouldimplementtheSWF’sstrategiesinanindependentmannerandinaccordancewithclearlydefinedresponsibilities.

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GAPP10TheaccountabilityframeworkfortheSWF’soperationsshouldbeclearlydefinedintherelevantlegislation,charter,otherconstitutivedocuments,ormanagementagreement.

GAPP11

AnannualreportandaccompanyingfinancialstatementsontheSWF’soperationsandperformanceshouldbepreparedinatimelyfashionandinaccordancewithrecognizedinternationalornationalaccountingstandardsinaconsistentmanner.

GAPP12TheSWF’soperationsandfinancialstatementsshouldbeauditedan-nuallyinaccordancewithrecognizedinternationalornationalauditingstandardsinaconsistentmanner.

GAPP13ProfessionalandethicalstandardsshouldbeclearlydefinedandmadeknowntothemembersoftheSWF’sgoverningbody(ies),manage-ment,andstaff.

GAPP14DealingwiththirdpartiesforthepurposeoftheSWF’soperationalmanagementshouldbebasedoneconomicandfinancialgrounds,andfollowclearrulesandprocedures.

GAPP15SWFoperationsandactivitiesinhostcountriesshouldbeconductedincompliancewithallapplicableregulatoryanddisclosurerequirementsofthecountriesinwhichtheyoperate.

GAPP16Thegovernanceframeworkandobjectives,aswellasthemannerinwhichtheSWF’smanagementisoperationallyindependentfromtheowner,shouldbepubliclydisclosed.

GAPP17

RelevantfinancialinformationregardingtheSWFshouldbepubliclydisclosedtodemonstrateitseconomicandfinancialorientation,soastocontributetostabilityininternationalfinancialmarketsandenhancetrustinrecipientcountries.

GAPP18

TheSWF’sinvestmentpolicyshouldbeclearandconsistentwithitsdefinedobjectives,risktolerance,andinvestmentstrategy,assetbytheownerorthegoverningbody(ies),andbebasedonsoundportfoliomanagementprinciples.

GAPP18.1.Sub-principle

TheinvestmentpolicyshouldguidetheSWF’sfinancialriskexposuresandthepossibleuseofleverage.

GAPP18.2.Sub-principle

Theinvestmentpolicyshouldaddresstheextenttowhichinternaland/orexternalinvestmentmanagersareused,therangeoftheiractivitiesandauthority,andtheprocessbywhichtheyareselectedandtheirperformancemonitored.

GAPP18.3.Sub-principle

AdescriptionoftheinvestmentpolicyoftheSWFshouldbepubliclydisclosed.

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GAPP19TheSWF’sinvestmentdecisionsshouldaimtomaximizerisk-adjustedfinancialreturnsinamannerconsistentwithitsinvestmentpolicy,andbasedoneconomicandfinancialgrounds.

GAPP19.1.Sub-principle

Ifinvestmentdecisionsaresubjecttootherthaneconomicandfinan-cialconsiderations,theseshouldbeclearlysetoutintheinvestmentpolicyandbepubliclydisclosed.

GAPP19.2.Sub-principle

ThemanagementofanSWF’sassetsshouldbeconsistentwithwhatisgenerallyacceptedassoundassetmanagementprinciples.

GAPP20TheSWFshouldnotseekortakeadvantageofprivilegedinformationorinappropriateinfluencebythebroadergovernmentincompetingwithprivateentities.

GAPP21

SWFsviewshareholderownershiprightsasafundamentalelementoftheirequityinvestments’value.IfanSWFchoosestoexerciseitsownershiprights,itshoulddosoinamannerthatisconsistentwithitsinvestmentpolicyandprotectsthefinancialvalueofitsinvestments.TheSWFshouldpubliclydiscloseitsgeneralapproachtovotingsecu-ritiesoflistedentities,includingthekeyfactorsguidingitsexerciseofownershiprights.

GAPP22TheSWFshouldhaveaframeworkthatidentifies,assesses,andman-agestherisksofitsoperations.

GAPP22.1.Sub-principle

Theriskmanagementframeworkshouldincludereliableinformationandtimelyreportingsystems,whichshouldenabletheadequatemoni-toringandmanagementofrelevantriskswithinacceptableparametersandlevels,controlandincentivemechanisms,codesofconduct,busi-nesscontinuityplanning,andanindependentauditfunction.

GAPP22.2.Sub-principle

ThegeneralapproachtotheSWF’sriskmanagementframeworkshouldbepubliclydisclosed.

GAPP23Theassetsandinvestmentperformance(absoluteandrelativetobenchmarks,ifany)oftheSWFshouldbemeasuredandreportedtotheowneraccordingtoclearlydefinedprinciplesorstandards.

GAPP24AprocessofregularreviewoftheimplementationoftheGAPPshouldbeengagedinbyoronbehalfoftheSWF.

Source: IWG (2008) Sovereign Wealth Funds. Generally Accepted Principles and Practices. “Santiago Principles”. http://www.iwg-swf.org/pubs/eng/santiago-principles.pdf

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Russian Sovereign Wealth Funds

Sergey DrobyshevskyHeadofMacroeconomicsandFinanceDivisionoftheGaidarInstituteforEconomicPolicy

(Moscow,Russia)

Russia hasa relatively longbut rather peculiar history of sovereign fundsdevelopment.Havingstartedin2004withonefund-theStabilizationFundoftheRussianFederation-thecountryhadtwofairlylargefunds,includingtheNationalWelfareFund,in2008onthevergeofthecrisis.However,attheendofthecrisisinthemediumterm,bothfundsmayceasefunctioning,havingmetonlyapartoftheirobjectives.

Short History, Mission and Type

Creation of the firstRussian sovereign fund, theStabilizationFund of theRussianFederation,wasrelated to the ideaof institutionalizing federalbudgetsurplusgeneratedintheformofbalancesonthebudgetaccountswiththeCentralBank of Russia since 2000. Understanding the situational nature of budgetrevenuesinthebackgroundofrisingoilpricesintheworldmarket,andwishingtoavoidaproportionalgrowthofthebudgetexpenditurecommitments,theRFgovernment in 2003 proposed establishment of the Stabilization Fund, whichwouldbeformedfromtheexcessiverevenuesfromoilproductionandexports(ascomparedwiththeestimatedlong-termoilprice,cut-offpriceorbaselineprice).

FederalLaw«OnAmendmentstotheBudgetCodeoftheRussianFederationregardingtheestablishmentoftheStabilizationFundoftheRussianFederation”No.184-FZ,onthebasisofwhichtheStabilizationFundoftheRussianFederationwascreatedin2004,wasadoptedDecember23,2003.

Thepurposeof theStabilizationFundofRussiawastoensurethefederalbudget balanceduringadecrease in oil pricesbelow thebaseline.Accordingto theRFMinistryofFinance, “theFundcontributes tostabilityandeconomicdevelopment;itisoneofthemaininstrumentsofbindingtheexcessiveliquidity,which is reducing inflationary pressures and the dependence of nationaleconomy from adverse fluctuations of revenue from commodity exports.”Thus,at the initialstageofestablishment, theFund isaclassicversionof thecommodityfund,designedtosuppressfluctuationsofthemarketrevenueofthefederalgovernment.TheFundassetscouldbeusedtocoverthefederalbudgetdeficitonlyinthecaseofoilpricesdroppingbelowthebaseline.However,iftheaccumulatedamountoftheFundexceeded500billionrubles,theexcesscouldbeusedforotherpurposes.

FromJanuary1,2004 thebasepricewassetat$20perbarrel forUrals,andonJanuary1,2006,thecut-offpricewasraisedto$27.Despitecontinuedgrowthinoilprices,therewasnofurtherincreaseinthe«cut-offprice»becauseoftheriskofrisinginflationandincreasingbudgetdependenceontheexternal

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economicsituation.Since in 2005 the Fund exceeded the level of 500 billion rubles (RUR

1,387.8bln),apartoftheassetswasaddressedtootherpurposes,namelyforthepaymentofexternal debtof theRussianFederation (RUR643.1bln)andreplenishmentofthedeficitofthePensionFundoftheRussianFederation(30billionrubles,seeTable1).

Table 1. RF Stabilization Fund Assets: Dynamics in 2004-2007 (RUR bln)

Year

Proceeds Utilization

BalanceasoftheendoftheyearTo

tal

Exportduty

Royalty(oil)

Balances ofFed-

eralBudget

Externaldebt

reco

very

Development

Institutions

financing

RFPension

Funddeficit

replenishm

ent

2004 522.3 240.8 175.5 106.0 – – – 522.32005 1387.8 663.4 507.3 217.1 643.1 – 30.0 1237.02006 1708.6 991.2 646.7 47.8 604.7 – – 2346.92007 1895.9 918.9 674.7 156.7 33.7 300.0 – 3849.1Total 5514.6 2814.8 2004.1 527.6 1281.5 300.0 30.0

Source: RF Federal Treasury

In2005,attheexpenseoftheStabilizationFund,repaymentofexternaldebtofRussiawasmadeintheamountof643.1bln,including:

• 93.5 billion rubles (equivalent to USD 3.3 billion) - the debt to theInternationalMonetaryFund;

• 430.1billionrubles(equivalenttoUSD15billion)-thedebttothemembercountriesoftheParisClub;

• 123.8 billion rubles (equivalent to USD 4.3 billion) - the debt toVnesheconombankundercreditgrantedbytheMinistryofFinanceoftheRussianFederationin1998-1999fortherepaymentandservicingofexternalgovernmentdebtoftheRussianFederation.

In2006,604.7billionrublesandin2007,33.7billionrubleswerespentforexternaldebtredemption.In2005,30.0billionrubles(equivalentto1.04billionU.S.dollars)wereallocatedtocoverthedeficitoftheRFPensionFund,andin2007–300.0billion rubles to financedevelopment institutions (Rusnano - 30billionrubles,VEB-180billionrubles,InvestmentFund-90billionrubles).

BythetimetheFundsplitin2008,theassets’totalvolumewas3,851.8billionrubles(157.38billionU.S.dollars),reachingapproximately11.6%ofannualGDPofRussia(Fig. 1).

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Figure 1. The total volume of the RF Stabilization Fund

Source: RF Ministry of Finance

StartinginFebruary1,2008theStabilizationFundofRussiawasdividedintotwoparts:theReserveFund(withaninitialvolumeofRUR3069.0bln)andtheNationalWelfareFund(initiallyRUR782.8billion),hereinafterreferredtoasFNB.

TheReserveFund,liketheearlierStabilizationFund,isapartofthefederalbudget.TheFundisintendedtoassistthegovernmenttoupholdbudgetspendingcommitmentsintheeventoflowoilandgasrevenues.ThenormativevalueoftheReserveFundisestablishedatalevelequalto10%ofGDP.IncontrasttotheStabilizationFundof theRussianFederation, inaddition to federalbudgetrevenuesfromoilproductionandexport,thesourcesformingtheReserveFundalsoincludefederalbudgetrevenuesfromgasproductionandgasexport.

Figure 2. Reserve Fund Total Assets Volume

Source: RF Ministry of Finance

 

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TheNationalWelfareFundisapartofthefederalbudgetsubjecttoseparateaccounting and management to ensure co-financing of voluntary retirementsavingsof theRussiancitizens,aswellas tocover thedeficitof thePensionFundbudget.

Figure 3. National Welfare Fund Total Assets Volume

Source: RF Ministry of Finance

TheReserveFundactuallybecameafunctionalsuccessoroftheStabilizationFundasapartofthefederalbudgetwithseparateaccountingandmanagementfor thepurposeofoilandgas transfers in theeventof insufficientoilandgasrevenuesforthefinancialsupportofthistransfer.Thereservefundisfinancedbyexcessoilrevenuesofthefederalbudgetinthescopeauthorizedforthefinancialyearintheamountofoilandgastransfers,providedthattheaccumulatedamountof the Reserve Fund does not exceed its established value, as well as fromrevenuesderivedfromthemanagementoftheReserveFund.Inotherwords,itisaclassiccommodityfund.

Inturn,theFNBisclosetothesovereignfundsorfuturegenerationsfundsinnature,andisaccumulatedfromoilandgasrevenuesofthefederalbudgetexceedingtheamountofoilandgastransfersapprovedforthefinancialyear,inthecasethattheaccumulatedamountoftheReserveFundreaches(exceeds)itsestablishedvalue,aswellasrevenuesderivedfromFNBmanagement.

AsofJune1,2010theReserveFundofRussiahasbeenreducedtoRUR1,197.66billion(USD39.27billion).ThevolumeoftheNationalWelfareFundisRUR2,616.54billion(USD85.8billion).

Legal basis, accountability and reporting

Asmentionedabove,in2003theFederalLaw“OnAmendmentstotheBudgetCodeoftheRussianFederationregardingtheestablishmentoftheStabilizationFund of theRussian Federation” of 23.12.2003No. 184-FZwas adopted, onthebasisofwhichin2004theStabilizationFundoftheRussianFederationwasestablished.The lawhas introducedChapter 13.1 in theBudgetCode,which

 

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stipulatedfundamentalsoftheStabilizationFundanditsmanagementprocedure.According to the law, theStabilizationFund isapartof the federalbudget

assets,formedfromtheexcessofoilpricesoverthebaselineprice,subjecttoseparateaccounting,managementanduseinordertobalancethefederalbudgetincaseofadecreaseinoilpricesbelowthebaseline.

ThesourcesoftheinitialformationoftheStabilizationFundwere:• federalbudgetsurplusrevenues,whichareassessedasanexcessoil

pricesoverthebaselineprice;• balancesof the federalbudgetassetsat thebeginningof the relevant

fiscalyear,includingtheproceedsfromtheStabilizationFundassetsallocation.AdditionalfederalbudgetrevenuestobecreditedtotheStabilizationFundin

thecurrentmonthwereassessedasthesumof: • actual revenue to the federalbudget from theexportcustomsdutyon

crudeoilobtainedinthecurrentmonth,multipliedbytheratioofthedifferencebetweentherateofexportdutyoncrudeoileffectiveinthecurrentmonthandtheestimatedrateofthatdutywiththebaselinepriceforoiltotherateofexportcustomsdutyoncrudeoileffectiveinthecurrentmonth;

• actualrevenueofthefederalbudgetfromseverancetax(oil)obtainedinthecurrentmonthmultipliedbytheratioofthedifferencebetweentheseverancetaxrateeffectiveinthecurrentmonthforoilextractionandtheestimatedrateofthistaxwiththebaselinepriceoilextractiontaxrateeffectiveinthecurrentmonthonextractionofminerals(oil).

Onlyone targetwas foreseen in theRFBudgetCode for theStabilizationFund,namely-financingofthefederalbudgetdeficit“inthecaseofadecreaseinoilpricesbelowthebaseline,aswellasforotherpurposes,iftheaccumulatedvolumeoftheStabilizationFundexceeds500millionrubles.”

AccordingtoArt.96.4BCRF,theMinistryofFinanceofRussiawasauthorizedtomanagetheStabilizationFund,butsomerelevantfunctionscouldbeperformedbytheCentralBankoftheRussianFederation.ThelistoffunctionsperformedbytheCBRwasnotspecifiedintheBudgetCode.

AsaneffectofChapter13.1oftheRFBudgetCode,amendmentsweremademainlyinregardtothebaselineforoilprices,butnotaffectingthemanagementoftheFundortheirtargetuse.Attheexecutivelevel,themanagementprocedureof the Stabilization Fund was governed by a number of legal acts, themostimportantofwhichare:

• TheRFGovernmentRegulationsNo.508of30.09.2004andNo.229from 21.04.2006 “On the Procedure of the Stabilization Fund of the RussianFederationManagement”

• TheRFGovernmentRegulationNo.31of23.01.2004“OnApprovaloftheRulesoftransfertotheStabilizationFundoftheRussianFederationoftheadditional federal budget revenues, balances of the federal budget as of thebeginningofthefiscalyear,andrevenuesfromtheallocationoftheStabilizationFundoftheRussianFederation”

• OrderoftheRFMinistryofFinanceNo.20of28.01.2004“OnApprovalofRules of assessment and transfer to theStabilizationFund of theRussianFederation of the federal budget surplus revenues and fund balances of thefederalbudgetbythebeginningofthefiscalyear,”and

• OrderoftheRFMinistryofFinanceNo.158of22.05.2006“Onapproval

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of theminimumandmaximumtimelines for repaymentof thedebt liabilitiesofforeign countries, in which the Stabilization Fund of the Russian Federationassetscanbeinvested.”

Of particular interest are the RF Government Regulation No. 508 of30.09.2004, “On theorderof theStabilizationFundof theRussianFederationassets management,” and No. 229 from 21.04.2006 “On the order of themanagementoffundsoftheStabilizationFundoftheRussianFederation.”Oneof the key tasks in the first stagewas to set conditions for investment of theRFStabilizationFundbytheCentralBankabroadandtoprovideatleastsomesafeguards toprotect them fromclaimsof foreigncreditors.As investments inforeignfinancial instruments,federalfundslosethestatusofpublicfundsand,accordingly,anystatejurisdictionalimmunity.

The Regulation No. 508 of 30.09.2004 stipulated the following allocationof investments. The Fund assets were legally separated from the assets ofthe Central Bank1 and were legally considered “commercial” investments oftheRussianFederationasa legalentity.Thiscreatedcertain risks for foreigninvestmentsoftheStabilizationFund,sincetherewasnojurisdictionalimmunityof theRussian Federation in regard to those funds.As a result, therewas apossibilityofforeclosureontheStabilizationFundfromforeigncreditors.

The government feared the risk of foreclosure on these funds2, and theadoptionof“ontheprocedureformanagingtheStabilizationFundoftheRussianFederation”No.229from21.04.2006triedtogivethemthestatusoffundsusedfor “governmental and non-commercial” purposes3, which are protected withjurisdictionalimmunity.Tothisend,theassetsplacedabroadweretransferredtothestatusoffundsbelongingtotheCentralBankofRussia.

TheRegulationprovidedthefollowingprocedureforinvestingtheStabilizationFundassets:theypassedtotheFederalTreasury,andtheTreasurythenplacedtheminaspecialaccountwiththeRFCentralBank,notonthebasisoftheassetsmanagementcontractasitwasbefore,butonthebasisofacontractforabankaccount. Since the funds deposited in an account with the bank are formallytransferredtoitsownership,itallowedtheCentralBanktoinvestthemabroadasitsownfundsusedfor“publicnon-commercialpurposes.”Herewith,theMinistryofFinancehasretainedthekeyresponsibilityformanagementoftheinvestmentprocessforallocationoftheStabilizationFundassets4.

Inparticular,theMinistryofFinancewasauthorizedtodefine:• thestandardcurrencystructureoftheStabilizationFund,theprocedure

ofpursuingthestandardcurrencystructure;• standardsofminimumandmaximummaturityofdebtsecurities,

1Theassetsweretransferredunderthemanagementcontract,concludedbetweentheRussianFinanceMinistryandCentralBank,anddidnotlegallybecomethepropertyofRFCentralBank.

2See,forinstance,UnitedNationConferenceonTradeandDevelopment.WorldInvestmentReport:TransnationalCorporations,ExtractiveIndustriesandDevelopment.newYorkandGeneva,2007.P.XVII.;McKnightA.TheLawofInternationalFinance.OxfordUniversityPress,2008.P.368,369.

3 Immunity to this category of funds is provided under theUnitedNationsConvention “OnJurisdictionalImmunityoftheStatesandtheirProperty”from02.12.2004.

4ThisDecreestipulates“managementoftheStabilizationFundbytheMinistryofFinanceoftheRussianFederation”.

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• theprocedureforaccountingandcreditinginterestaccruedonbalancesoftheStabilizationFundaccounts,aswellasotherconditionsofthebankaccountcontract;and

• the procedure of interactionwith the FederalTreasury in carrying outtransactionswiththeaccountsoftheStabilizationFund.

Monitoring of theRussianFinanceMinistry control functions over the useoftheStabilizationFundwaslimitedtothedutiesofprovidingquarterlyannualreportstotheGovernmentofRussiaonthestatusofthefollowingindicators:

• the amount of authorized foreign currency purchased and foreigncurrencyplacedontheaccountsoftheStabilizationFund;

• estimatedinterestratesfortheallocationoftheStabilizationFundassetsintheaccounts;

• estimated income for theallocationof theStabilizationFundassets intheaccounts;

• names and basic characteristics of foreign countries’ debt liabilitiesacquiredwiththeStabilizationFundassets;

• incomederivedfromtheplacementoftheStabilizationFundassetsintobondsofforeigncountriesbytypeofdebtliabilitiesofforeigncountries;

• informationonbalancesof theaccountsof theStabilizationFund(peryear);and

• detailsofinterestpaidoverthepastyearfortheuseofStabilizationFundassetsplacedintheaccounts(peryear).

In2007,theprocedurefortheformationoffunds,accumulatingoilandgasrevenuesof the federalbudget,and theprocedure tomanage the fundswereradically amended. Relevant amendments were made with the Federal LawNo.63-FZof26.04.2007“OnAmendmentstotheBudgetCodeoftheRussianFederation in terms of regulating the budgetary process and bringing certainlegislativeactsof theRussianFederation in linewith thebudget legislationoftheRussianFederation.”UnderthisAct,theStabilizationFundwassplitintotwoparts,andthefollowingwereestablished:

1.aReserveFundinordertominimizetherisksoftheRussianeconomyinthecaseofasharpdropinenergysources’pricesintheworldmarkets(Art.96.9oftheRFBudgetCode)

2. a National Welfare Fund, in order to ensure co-financing voluntaryretirementsavingsoftheRussianFederationcitizens,aswellastoensurethebalance (cover the deficit) of the budget of thePension Fund of theRussianFederation(Art.96.10BCCode).

Inaddition,startingfrom2007,apartoftheoilandgasrevenuewasusedasapartofthefederalbudgettoimplementinparticularlarge-scalesocialprogramsandreplenishmentofthefederalbudgetdeficitthroughtheso-called“oilandgastransfers”(Article96.8oftheRFBudgetCode).

Reserve FundThe reserve fund is formed from the oil revenues of the federal budget

exceedingthelevelofoilandgastransfersauthorizedfortherelevantfinancialyear,providedthatthecumulativeReserveFunddoesnotexceeditsestablishedvalue,aswellasfromrevenuesfromthemanagementofthereservefund.

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Item 2 of art. 96.9 of the RF Budget Code established a procedure forestimationof thenormativevaluesof theReserveFund.Under this item, it isassigned an absolute amount, assessed on the basis of 10 percent of GDPplannedfortherelevantfiscalyear.

However,alargepartoftheprovisionsofArt.96.9oftheRFBudgetCodewerenot set tobeput intoeffectuntil 2013.The relevantdecisionwas takenaspartoftheanti-crisismeasuresandapprovedbytheFederalLawNo.314-FZof17.12.2009 “OnAmendments toCertainLegislativeActsof theRussianFederation”inconnectionwiththeFederalLaw“Onthefederalbudgetfor2010andtheplannedperiodof2011and2012.”

Before2013,while the revenue from theReserveFundmanagementwasallocated to financing the budget expenditures, the procedure for the fundassessment,stipulatedbyItem2ofArticle96.9,couldbeignored.Also,before2013, the RF Government could, without amending the federal law on thefederalbudget,makedecisionsontheuseof theStabilizationFundandotherbalances of the federal budget for the implementation of payments, reducingdebtliabilities,borrowing,andtobalancethefederalbudgetexecution(includingfinancial support of oil and gas transfers), including the excess of the totalfederalbudgetexpenditureswithinincreasedbudgetaryallocationsofthefederalbudgettoprovideintergovernmentaltransfersinordertobalancethebudgetsofstateextra-budgetary fundsof theRussianFederation,with thecorrespondingamendmentstothebudgetregistry5.

National Welfare FundAccordingtoArt.96.10oftheRFBudgetCode,theNationalWelfareFund

is formed fromoil revenuesof the federalbudgetexceeding theamountofoilandgastransfersapprovedforthefinancialyear,iftheaccumulatedamountoftheReserveFundreaches(exceeds)itsestablishedvalue,aswellasfromtheincomederivedfromtheNationalWelfareFundmanagement.Thelatter,aswellas income from theReserveFundmanagement from2009 through2013,areallocatedtothefinancingofthebudgetexpenditures6.

Art.96.11oftheRFBudgetCodeestablishestheprocedureformanagingtheFunds’assets,aswellassettinguprequirementsfortheassetsoftheFundsthatcanbeusedforinvestments.Theserequirementsarespecifiedindetailonthesub-lawlevel.Accordingtothisarticle,theReserveFundandNationalWelfareFundaremanagedbytheMinistryofFinanceoftheRussianFederationinthemanner established by theGovernment of theRussian Federation.Herewith,some responsibility formanaging theReserveFundcanbeperformedby theCentral Bank of theRussian Federation, and some of those in regard to theNationalWelfareFund-bytheCentralBankoftheRussianFederationandbyspecialfinancialinstitutions,inaccordancewithagreementswiththeMinistryofFinanceoftheRussianFederationinthemannerprescribedbytheGovernmentoftheRussianFederation.

5SeeFederalLaw№58-FZof09.04.2009“OnamendmentstotheBudgetCodeoftheRussianFederationandsomelegislativeactsoftheRussianFederation”

6SeeFederalLaw№58-FZof09.04.2009“OnamendmentstotheBudgetCodeoftheRussianFederationandsomelegislativeactsoftheRussianFederation”

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Currently,theprocedureforthemanagementoftheFundsisgovernedby:• TheRFGovernmentRegulationNo.892of17.12.2007“Ontheestimates

andtransferoffundsinconnectionwiththeformationandusageofoilandgasrevenuesofthefederalbudget,oilandgastransfersandtheassetsofReserveFundandNationalWealth;”

• TheRFGovernmentRegulationNo.955of29.12.2007“OntheprocedureoftheReserveFundmanagement;”

• TheRFGovernmentRegulationNo.18of19.01.2008“OntheprocedureoftheNationalWelfareFundassetsmanagement;”

• The Order of the RF Ministry of Finance No. 3 of 16.01.2008 “Onapprovalof theauthorizedshares inthetotalvolumeoffinancialassetsof theReserveFundandtheprocedureforassessmentoftheactualauthorizedshareof financial assets in the total assets of theReserveFund to bring them intoconformitywiththeestablishedrates;”

• The Order of the RF Ministry of Finance No. 26 of 24.01.2008 “Onapprovalof theauthorizedshares inthetotalvolumeoffinancialassetsof theNationalWelfareFundandtheprocedureforassessmentoftheactualauthorizedshareoffinancialassetsinthetotalvolumeoftheNationalWelfareFundtobringthemintoconformitywiththeestablishedrates;”

• TheOrderoftheMinistryofFinanceN517of21.10.2008“OnamendmentstotheOrderoftheMinistryofFinanceoftheRussianFederationN26onJanuary24,2008;”

• The Order of the RF Ministry of Finance No. 24 of 24.01.2008 “Onapproval of the established foreign currency structure of theNationalWelfareFund and the Procedure to bring the actual foreign currency structure of theNationalWelfareFundintocompliancewiththeestablishedrates;”and

• The Order of the RF Ministry of Finance No. 5 of 16.01.2008, “OnapprovalofthelistofforeigngovernmentagenciesinwhichthedebtliabilitiesoftheReserveFundcanbeallocated.”

Ingeneral,themanagementprocedureoftheFunds,establishedonthebasisoftheStabilizationFund,isgovernedbythelogiclaiddownbythegovernmentintheRegulationNo.229issuedin2006.Accordingtothe“new”OrderNo.892of 17.12.2007, the key functions associated with management decisions areperformedbytheMinistryofFinance,whiletheCentralBankcarriesouttechnicalworkrelatedtoensuringtheir implementation.RelationsamongtheMinistryofFinance,TreasuryandCentralBankarebasedonthebankaccountagreement.TheAgreement, as before, is reachedbetween theRFCentralBankand theTreasury.

• AccordingtotheMinistryofFinanceOrderNo.25Hof14.02.2008,theoilandgasrevenuesofthefederalbudget,theReserveFundandNationalWelfareFund are registered in special accounts of the federal budget opened for theFederalTreasurywith theCentralBank of theRussianFederation. For thesepurposes,inaccordancewiththeBankAccountAgreemententeredintobytheFederalTreasuryandtheCentralBankoftheRussianFederation,onthebalanceofaccountNo.40105“Thefederalbudget,”separateaccountsareopened:

• toaccountforoilandgasrevenuesofthefederalbudget;• toaccountfortheReserveFundassetsinthenationalcurrencyofthe

RussianFederationinthespecialaccountoftheReserveFund;

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• toaccountfortheNationalWelfareFundassetsintheRussiannationalcurrencyandaccountfortherecordingoftheNationalWelfareFundassets.

Transferoftheoilandgasrevenuesofthefederalbudget,theReserveFundandNationalWelfareFund in thenationalcurrencyof theRussianFederationis performed by the Federal Treasury upon instructions from the Ministry ofFinanceoftheRussianFederationtoconducttransactionsontheaccountsfortheaccountingofoilandgasrevenues,theReserveFundandNationalWelfareFund,aswellaspaymentdocuments.

All the above-mentioned laws provide for the minimum requirements inrelationtothecontrolprocessoverinvestingtheReserveFundandtheNationalWelfareFundassets.

ControlarisesfromthefactthattheFinanceMinistryprovidesquarterlyandannualreportsonthemanagementoftheFundsassetstothegovernmentoftheRussianFederation.ThereportsprovidedtotheGovernmentcomprise:

• informationonthebalancesoftheFunds;• informationonthevolumeoftheboughtandsoldassets;• informationontheestimated interest rates for theusageassetsof the

Fundallocatedtotheaccounts;• informationontheestimatedamountsofincomederivedfromtheuseof

thefundsallocatedtotheaccountsoftheFunds;• the names and basic characteristics of financial assets, in which the

Funds’assetswereplaced;• detailsofincomereceivedfromtheplacementoffunds.Inaddition,nolaterthanonthe20thofeachmonth,theMinistryofFinance

compiles and publishes in its website monthly summary reports available forpublic use. Published reports provide an overview of the total assets of theNationalWelfareFundasof thebeginningof the reportingmonth, aswell asinformationon theassetscredited to the fund, theirplacementanduse in thereportingmonth.

Theserequirementsonthecontroloverinvestmentofoilandgasrevenuesare limited.Speakingof controlling theuseof the funds,oneshouldalsopayattentiontothefactthattherepresentativebodiesofthestatepowerarevirtuallynotinvolvedinthecontrolofthefunds’investments,anddonotmakemanagementdecisionsontheseissues.

Moreover,asnotedabove,from2009to2013thedecisionsontheuseoftheReserveFundweremadebytheRFGovernmentwithnochangestothelawonthefederalbudget;thatis,thefundnotonlyinvests,butalsopartlyspendstheFundassetswithouttheapprovaloftheParliament.Therefore,themanagementoftheFundsisvirtuallybeyondtheParliament’scontrol.

OnMay6,2010theRFGovernmentRegulationNo.267of21.04.2010“OnthesuspensionoftheactsoftheRFGovernmentontheformationanduseofoil and gas revenues of the federal budget, income frommanagement of theReserve Fund andNationalWelfare Fund” came into effect, underwhich thefollowingrequirementsfortheMinistryofFinancearecancelled:

• publishing of information on the Russian Ministry of Finance websiteaboutthecollectionanduseofoilandgasrevenuesofthefederalbudget,theirenrollmentintheReserveFundandNationalWealthFund,andtheadmissionofincomefrommanagementoftheReserveFundandNationalWealthFundtothe

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Fund(beforeFebruary1,2012);• submissionofreportstotheGovernmentofRussiaontheformationof

theReserveFundandNationalWelfareFundandontherevenuefromtheuseofoilandgasrevenuesofthefederalbudget(beforeJanuary1,2013).

Inaddition,issuesoftheformationandusageoftheoilandgasrevenuefrombefore January 1, 2013 are excluded from the review for the formulation andapprovalofthefederalbudgetforthenextfiscalyearandtheplannedthree-yearterm.

Thus,thisRegulationestablishesadeparturefromtheconceptofseparationofthebudgetbyoilandgasandnon-oiland-gascomponentsandofoilandgastransfer as a source of funding the non-oil budget deficit, andmakes theRFMinistryofFinanceandtheGovernmentofRussiavirtuallyunaccountabletotheStateDumaintermsofbothFunds’assetsmanagement.

However, it should be noted that theRFMinistry of Finance continued topublishinformationonthestatusoftheFundsonitswebsiteasofJune1,2010.

Institutional base and institutional quality

CreationoftheRFStabilizationFundin2004,althoughitgoesbeyondthechronologicalframework,shouldbeconsideredinthecontextoftheoveralllogicofeconomic reformsofV.V.Putin’s first term inoffice (2000-2003),of theso-called “Gref Program”7 or “Strategy-2010.” In the framework of this program,radical tax reformwas carried out, the foundationwas laid for the new fiscalpolicy (transition to three-year budget planning), and the contours of majorinstitutionalreformswereoutlined(administrativereform,judicialreform,reformofnaturalmonopolies),although the latterones,unfortunately,have remainedlargelyunimplemented.Inaddition,whenmakingeconomicpolicydecisions,thethen-recenteventsof thecrisis thathappened inAugust1998weretaken intoaccount,leadingtothenationalcurrencydevaluation,theenlargeddebtburdenonthebudgetandthefearofuncontrolledgovernmentdeficit.Inparticular,thedynamics of oil prices in the worldmarkets, even in the short term, seemedextremelyvolatile,astherewasahighprobabilityofanewdeclinethereoftothelevelof$9-10perbarrel,aswasobservedin1998-1999.

Inthiscontext,theauthorsoftheconceptoftheStabilizationFundfacedthetaskofdevelopingareliable,sustainablemechanismfortheprotectionofexportrevenuestothebudgetfromtheirusageforthecurrentbudgetcommitmentsandemergingnewbudgetarycommitments in thecaseofashort-term increase inoilprices,aswellasminimizationofthenegativeimpactoftheinflowofexportrevenueson theeconomy ingeneral (namely, preventing theaccumulationofliquidityintheeconomy,thesituationofadeficitofinvestmentprojects,andthewillingnessofbusinessesandbankstoinvestintherealsector).

Thus,asstatedabove,ininstitutionalterms,theRFStabilizationFundwasapartofthefederalbudgetassets,subjecttoseparateaccounting,managementandutilization.Inotherwords,theFundassetswereaccountedforandplacedinaspecialaccountoftheRFMinistryofFinancewiththeRFCentralBankofRussia.Theplanned revenue to theFund for the relevant fiscal yearand the

7 NamedaftertheMinisterofEconomicDevelopmentG.O.Gref.

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amountoftheFundasoftheendofeachfinancialyearwereapprovedbytheFederalAssembly(Parliament)ofRussiabythelawonthefederalbudgetforthenextfiscalyearandtheplannedthree-yearterm.

Managementof theFundwasexecutedby theRFCentralBankunderanagreementwiththeRFMinistryofFinance.Herewith,theBankofRussia,infact,actedasthemanagementcompany,andtheRFGovernmentandtheRussianMinistryofFinancedefinedthestrategyforthemanagementoftheFundandascopeofpermissibleassets.

TheRFReserveFundofRussiaandtheNationalWelfareFundalsomakeupapartofthefederalbudgetsubjecttoseparateaccountingandmanagement.Atthesametime,theyare(atleastuntilthebeginningofMay2010)subjecttothesameinstitutionalconstraintsandconditionsastheStabilizationFundofRussia.

AssessingtheoverallqualityoftheinstitutionalenvironmentoftheRussiansovereignfunds,onecandistinguishthefollowingadvantagesanddisadvantages.

Advantages• Strong legal status of the Funds through the addition of individual

ChapterstotheBudgetCode,whichbeforethecrisiscreatedareliablesystemforprotectingtheFunds’assetsfrompoliticalandsituationaltemptationsonthepartofboththeRFGovernmentandrepresentativesofthepowerauthorities.

• FormationofthefundsinspecialaccountsoftheRFGovernmentintheBank of Russia, whichminimized the effect of additional situational revenuesfromoilexportsnotonlytothebudgetsystem,butalsoonmonetary-creditandexchangeratepolicies.

• AnadequatelinkingofthesourcesoftheFunds’formationwiththemarketrevenuesfromoilexports.Calculationsshowthatin2005-2008,whenthelevelofoilpricesintheworldmarketwasabove$35-40perbarrelversusthenationalmarket,upto95%ofthesurplusincomefromoilexportswereaddressedtotheStabilizationFundintheformofexportdutiesandmineralextractiontax.

• Splittingof theStabilizationFund into theReserveFundandNationalWelfareFundin2008.EvenduringtheworstcrisissituationinRussia,in2008-2009, and the high budget deficit in the subsequent years, the institutionalconditionsallowedtheNationalWelfareFundtobesavedasasovereignfundforfuturegenerations,usingitforfinancingthefederalbudgetdeficit.Obviously,if onlyoneof theStabilizationFundshadbeenmaintainedduring thisperiod,its fundswouldhavebeen fullyspent for thesolutionof thecurrentbudgetaryproblems.

Shortages• TheconservativemanagementschemeoftheFunds.Managementofall

Fundassetsremainsinthehandsoftheagencies,forwhichthisissueisoutsidetheir main objective (RF Central Bank and the Russian Ministry of Finance).Involvementofprivateprofessionalmanagementcompanies(Russianorforeign)inthemanagementoftheFundsremainspoliticallyunacceptable.

• The lackofa legal framework for targetedparametersof theNationalWelfareFund.DespitethefactthattheobjectiveoftheNationalWelfareFundwasdeclaredthe“co-financingofvoluntaryretirementsavingsofRussiancitizens,”

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aswellas“recoveringofthe(deficit)budgetofthePensionFund,”therequiredparameters are not in place to link to the pension fund reform. Under thesecircumstances,theNationalWelfareFundcouldexclusivelybecomeasourceoffundingforthecurrentdeficitofthePensionFund,andnotatoolforsolvinglong-termproblemsofthepensionsystemintheRussianFederation.

• The lack of institutional capacity to develop individual strategies formanagingtheassetsofthetwoexistingFunds,notonlybasedonprinciplesofriskmanagement,butalsotoensuremaximumyieldatagivenlevelofrisk.

Investment Portfolio and Asset Management

Intheperiodfrom2004to2006,thefollowingrequirementswereappliedtoassetsthatcanbeinvestedintheStabilizationFund:

a)theissuerofthedebtliabilitiesshouldhavealong-termcreditratingofnotlower thanthe level“AAA”bytheclassificationofFitchRatingsorStandard&Poor’s,ornotbelowthelevelof“AAA”undertheratingagencyMoody’sInvestorsService;

b)maturityofdebtsecurities isfixed; thetermsof issueandcirculationdonotprovidetheissuertherighttoaffecttheirearlyredemption(maturity)ortherightoftheownertosubmitthemforredemption(maturity)bytheissuerofdebtinstrumentsaheadofschedule;

c)thecurrentmaturitydateofissuedoesnotexceedoneyearfordiscountliabilitiesor10yearsforcouponbonds;

d)couponratepaidoncouponbondsisfixede)thebondvalueisdenominatedinoneoftheauthorizedforeigncurrencies

and payments toward the debt liabilities are made in the currency of itsdenomination;

f)thevolumeofthedebtliabilitiesissuedincirculationisnotlessthanUS$1billionforthedebtliabilitiesdenominatedinU.S.dollars,Euro1billionfordebtliabilitiesdenominated inEuro,orGBP1billion for thebondsdenominated inpoundssterling.

From2006to2007therequirementsunderwentminimalchangeswherebythevolumeofdebt liabilities incirculationanddenominated inpoundssterlingwasreducedfromGBP1billionto0.5billion.

Also in theResolutionNo. 229 of 21.04.2006 there appeared a clarifyingrequirementthattheissuanceofdebtliabilitiesinwhichinvestmentsaremadeshouldnotbeissuesintendedforprivate(non-public)placement.Inaddition,itwasstatedintheRegulationthatthestandardsoftheminimumandmaximumtermtomaturityofthebondissuesareestablishedbytheMinistryofFinance.

Thedistributionofsharesamongthevarioustypesofinvestmentinstrumentsused for placement of the Fund assets was established by the Order of RFMinistry of FinanceNo. 157 of 22.05.2006, providing for the following foreigncurrencystructureoftheStabilizationFund:

• U.S.Dollar-45%;• Euro-45%;• PoundSterling-10%.The limits of permissible deviations of actual monetary structure of the

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StabilizationFundfromtheestimatedforeigncurrencystructurewere: • fortheStabilizationFundinU.S.dollars-+/-5percentagepoints;• fortheStabilizationFundinEuro-+/-5percentagepoints• fortheStabilizationFundinBritishpoundssterling-+/-2percentage

points.In2007,theFinanceMinistryalsoclarifiedtherequirementsfortheminimum

andmaximummaturityofdebtbytheOrderoftheRFMinistryofFinanceNo.737of05.12.2007“OnapprovalofstandardsfortheminimumandmaximummaturitytermofbondissuesofforeigncountriesinwhichtheassetsoftheStabilizationFund of the Russian Federation may be located.” For the debt instrumentsdenominatedinU.S.dollarsandEuro,theminimumtermtomaturityhasbeensetat2months,andthemaximum-15months.FortheliabilitiesdenominatedinBritishpoundssterlingtheminimumtermtomaturitywassetat3monthsandthemaximumterm-36months.

During thefunctioningperiodof theStabilizationFundtheprocedureof itsinvestment policy had been developed only in general and was insufficientlydetailed8.TherewerenorulesgoverningtheformationoftheinvestmentpolicyoftheRussianMinistryofFinance.Inparticular,therewasnoclearregulationoftheorderofinformationinteractionbetweentheMinistryofFinanceandTreasury,althoughtheneedforsuchaprocedurewasmentionedintheregulationsoftheGovernment.

Once theStabilizationFundwassplit into theReserveFundandNationalWelfare Fund, the regulation of matters related to investment of their assetswas detailed9. In particular, the order of the RFMinistry of Finance No. 25Hfrom14.02.2008regulatedtheissuesoftheinformationexchangewiththeRFTreasury.

AccordingtoResolutionsNo.955andNo.18,theRussianMinistryofFinanceestablished:

a)astandardforeigncurrencystructureofassetsofbothfunds,theprocedureforbringingtheactualforeigncurrencystructureoftheFundsintoalignmentwiththeestablishedstandards;

b) the share of financial assets authorized for allocation in the total Fundassetswithin the prescribed requirements and procedure for estimates of theactualshareoffinancialassetsauthorizedforallocationinthetotalFundassets(bringingthemintoconformitywiththenormativeshares);

c)standardminimumandmaximummaturitytermsofdebtliabilitiesofforeigncountries,foreigngovernmentagenciesandcentralbanks,andofinternationalfinancialorganizations,includingthoseinsecurities;

d)alistofforeigngovernmentagenciesintothedebtinstrumentsofwhichtheFundassetscanbeplaced;

e)standardminimumandmaximumtermsofplacing the fundsondepositwithforeignbanksandcreditinstitutions;

f)proceduresforestimatesofcreditsandinterestearnedonfundsdepositedintheFundaccountsandotherprovisionsofthebankaccountcontracts;

8 Thesewereprovided in theRFgovernmentRegulationNo.508of30.09.2004and in theAnnextotheRFgovernmentRegulationNo.229of21.04.2006.

9Listofnormativeactsregulatingthemanagementofinvestmentfundspolicyisgivenabove.

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g) procedures of interaction with the Federal Treasury in carrying outtransactionswiththeFundaccountsinthemanagementoftheReserveFund;

h)proceduresofinteractionwithFederalTreasuryindeterminingthetermsofthecontractwithbankaccountsinthemanagementoftheFundsassets.

In addition, the twoRegulations (in the annexes) have approved detailedrequirementsforfinancialassetsinwhichtheNationalWelfareFundandReserveFundassetsmaybeplaced.

Thus, the regulation of issues related to the process of the Funds’managementhasbecomemoredetailedingeneral.However,theproceduresarestillinsufficienttoregulatehowindividualauthoritiesmanagetheFunds’assetsbymeansofspecializedfinancialinstitutions,aswellastheirinvolvementintheimplementationofthosepowers10.

There is a lack of clarity in the issues related to the implementation ofinvestmenttransactionsbytheCentralBankthatcarriesouttheactualallocationofthefunds.Currently,therearenointernalCentralBankregulationsgoverningsuchfunctionsinthisarea.

Thus, in 2004 and 2005 there were no investment transactions of theStabilization Fund assets. During the period from July 24, 2006 (the startingdateof investmentof theStabilizationFund) throughDecember15,2007, thetotal income from the investmentsamounted to174.8billion rubles. (Over theyearfromDecember15,2006toDecember15,2007therevenuereached151.9billionrubles).Therefore,thereturnsfrominvestmentsinU.S.dollarsfortheyearamountedto10.94%perannumandinrubles-about5%.Giventheannualrateofinflation(respectively11.7%and10.9%),wecanseeanegativereturnontheFund.

Table 2. Stabilization Fund Growth Rate in RUR1) and in USD2), %

01.09.2006

01.10.2006

01.11.2006

01.12.2006

01.01.2007

01.02.2007

01.03.2007

01.04.2007

01.05.2007

01.06.2007

01.07.2007

01.08.2007

01.09.2007

01.10.2007

01.11.2007

01.12.2007

01.01.2008

1 -21.6 9.4 8.2 6.8 7.2 12.8 2.3 3.8 3.9 3.6 3.8 3.9 4.5 3.2 3.7 -3.6 9.42 -21.2 9.3 8.3 8.6 7.1 11.9 3.8 4.4 5.2 2.8 4.1 4.8 4.3 6.1 4.6 -2.1 8.6

Source: RF Ministry of Finance

10TheneedforsuchregulationisexpresslyprovidedbytheResolution№18,whichobligedtheMinistryofFinancejointlywithotheragencies(MinistryofEconomicDevelopment,FederalFinancialMarketsService,theMinistryofJusticeandCentralBank)to“developandsubmittotheGovernmentoftheRussianFederationthedraftRegulationintheestablishedprocedure.”

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Requirements for placing assets of the Reserve Fund

Ingeneral,therequirementsfortheFundassetsarestipulatedinArt.69.11oftheRFBudgetCode,andalsogivenindetailatthesub-lawlevel11.TheArticlepresentsvariousrequirementsfortheinvestmentofthetwoFunds.

OptionsforallocationoftheReserveFundassetsaremuchmorelimitedthanthosefortheplacementoftheFundofNationalWelfareassets.ReserveFundassetsmaybeplacedinforeigncurrencyandinthefollowingtypesoffinancialinstrumentsdenominatedinforeigncurrency:

• debtliabilitiesofforeigncountries;• debtliabilitiesofforeigngovernmentagenciesandcentralbanks12;• debt liabilities of international financial organizations, including

securities13;• depositsandbalances inbankaccountswith foreignbanksandcredit

organizations;• deposits and account balances with the Central Bank of Russian

Federation.RFGovernmentRegulationNo. 955 of 29.12.2007 «On themanagement

procedureofadministrationoftheReserveFund»clarifiestheserequirements,settingminimumandmaximumsharesoftheallocatedassets,aswellasmoredetailedrequirementsforthem.

Thus, the share of foreign countries’ debts should be from 50 to 100%.Herewith,suchassetscanbeinvestedexclusivelyindebtinstrumentsin:Austria,Belgium, Britain, Germany, Denmark, Ireland, Spain, Canada, Luxembourg,Netherlands,USA,Finland,FranceandSweden.

TheRegulationcontainsanopenlist14ofrecommendedinternationalfinancialinstitutionswhosedebt liabilities canbeused for investment.Theyare:AsianDevelopmentBank,ADB;CouncilofEuropeDevelopmentBank,CEB;EuropeanBankforReconstructionandDevelopment,EBRD;EuropeanInvestmentBank,EIB;Inter-AmericanDevelopmentBank,IADB;InternationalFinanceCorporation,IFC; International Bank for Reconstruction and Development, IBRD; NordicInvestmentBank,NIB;andInternationalMonetaryFund,IMF.

The right to define the currency structure of both Funds, as before, wasprovidedtotheMinistryofFinance.AccordingtotheSub-ItemA,Item4oftheRegulation No. 955, «On management of the Reserve Fund, the Ministry ofFinance approves ... normative currency structure of theReserve Fund» and

11SeetheRFGovernmentDecree№955of29.12.2007“OnthemanagementprocedureoftheReserveFund”andtheRFGovernmentDecree№18of19.01.2008“OnthemanagementprocedureoftheFundofNationalWelfare”.

12 The share of foreign government agencies and central banks assets should not exceed30%.SeetheRFGovernmentDecree№955of29.12.2007“OnthemanagementprocedureoftheReserveFund”.

13 The shareof theseassets should be15%.See theRFGovernmentDecree№955 of29.12.2007“OnthemanagementprocedureoftheReserveFund”

14 The regulation uses the following wording: “the debt liabilities of international financialorganizations,inwhichtheFundsassetscanbeinvestedincludethedebtliabilities,securitiesamongthem,ofthefollowingfinancial institutions....”Thatis,otherinstrumentsbesidesthoseamongthelisted“includingthesecurities”arelikelytobeused.

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theprocedureforbringingtheactualcurrencystructureoftheReserveFundintoaccordancewiththeestablishedstandard.

Currently the currency structure of the Reserve Fund is governed by theOrderoftheRFMinistryofFinanceNo.3of16.01.2008.TheOrderestablishedthefollowingauthorizedsharesinthetotalamountoftheReserveFund:

• debtliabilitiesofforeigncountries-95%;• debtliabilitiesofforeigngovernmentagenciesandcentralbanks-0%;• debtliabilitiesofinternationalfinancialorganizations,includingsecurities

-5%;• depositsinforeignbanksandcreditinstitutions-0%.Thislimitsthepermissibledeviationsofactualsharesofthefinancialassets

inthetotalamountofallocatedfundsfromtheReserveFundfromtheestablishedsharesasfollows:

• forthedebtliabilitiesofforeigncountries-+/-5percentagepoints;• for the debt liabilities of international financial organizations, including

securities,-+/-5percentagepoints. Inaddition,theMinistryofFinancehasapprovedtheformulaforassessment

oftheactualshareoffinancialassetsoftheReserveFundanddeviationsoftheactualshareoffinancialassetsfromtheestablishedshareoffinancialassets.

TheRegulationNo.955of29.12.2007imposesthefollowingrequirementsforthedebtinstrumentsfortheinvestmentoftheReserveFund:

• theissuerofthedebtinstrumentsshouldhavealong-termcreditratingnotlowerthan«AA-accordingtotheclassificationofFitch-RatingsortheStandard&Poor'sratingagenciesornotbelowthe«GaAs»byclassificationofMoody'sInvestorsServiceratingagency.Iftheissuerofdebtliabilitiesisassigneddifferentlong-termcreditratingsbythoseagencies,thelowestassignedlong-termcreditrating is selected.Comparedwith the requirements to the selection criteria inrelationtoassetsusedtoinvesttheStabilizationFundassets,therequirementscontainedintheRFGovernmentRegulationNo.955of29.12.2007werereduced.Asmentionedabove,previousrequirementstotheassetswere«AAA»15levelor«AAA»16ratings;

• Maturitytermsofthedebtliabilitiesarefixed;theconditionsofissueandcirculationdonotprovidetheissuertherighttocarryouttheirearlyredemption(maturity)andtherightsoftheownerofthedebttosubmitthemforredemption(maturity)bytheissueraheadofschedule;

• standards of theminimumandmaximummaturity terms for the bondissues, established by theMinistry of Financeof theRussianFederation, aremandatory;

• couponyieldrateoncouponbonds,andthenominalvalueofthedebtliabilities,arefixed;

• denomination of debt is expressed in U.S. dollars, Euro and PoundsSterling, and payments under debt liabilities are made in the currency ofdenomination;

• thevolumeofdebtliabilitiesissuedincirculationisnotlessthanUS$1billionfordebtliabilitiesdenominatedinU.S.dollars,notlessthanEUR1billion

15AccordingtoclassificationsofFitch-RatingsorStandard&Poor’sratingagencies.16AccordingtoclassificationsofMoody’sInvestorsServiceratingagency.

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forthedebtliabilitiesdenominatedinEuro,andatleastBSP0.5billionfordebtliabilitiesdenominatedinpoundssterling;

• debtliabilityissuanceisnotintendedforprivate(non-public)placement;• thenominalamountofdebtliabilitiespurchasedfromoneissueshould

notexceed15percentofthenominalamountoftheissue;• the total volume of the Reserve Fund invested on deposit in foreign

banksorcreditinstitutionsshallnotexceed25percentofthetotalReserveFund.

Requirements for placing assets of the National Welfare Fund

AccordingtoArt.96.11oftheRFBudgetCode,theNationalWelfareFundmay also be allocated in all of the above instruments, except for deposits inforeignbanks.However,theFundassetsmayadditionallybeinvestedin:

• depositsandbankaccountbalanceswithbanksandcreditorganizations,aswellasintheStateCorporation«BankforDevelopmentandForeignEconomicAffairs(Vnesheconombank);»

• debtsecuritiesandstocksoflegalentities;• shares(stakes)ofinvestmentfunds.Inaddition,theNationalWelfareFundassetscanbetransferredtothetrust

managementofspecializedfinancialinstitutions.17ProvisionsoftheBudgetCodearedetailedintheRFGovernmentRegulation

No.18of19.01.2008«OntheprocedureofmanagementoftheFundofNationalWelfare.”Toalargeextent,theyrepeattherequirementsforassetsusedfortheplacementoftheReserveFund.Thus,theResolutionNo.18hasstipulated:

• asimilarlistofcountrieswhosedebtliabilities(aswellastheliabilitiesoftheiragenciesandcentralbanks)maybeusedforallocationofassets;

• asimilarlistofinternationalfinancialorganizations,• similarrequirementsforlong-termcreditratingofforeignissuersofdebt

liabilities.However, since the listofassetsused to invest theNationalWealthFund

assetsisbroader,theRFGovernmentRegulationNo.18of19.01.2008mentionsanumberofspecificrequirements.Thus:

-amongotherthings,theRegulationincludesthefollowingrequirementstothedebt liabilitiesoftheRussiancompanies.Russianissuersofdebt liabilitiesshould have a long-term credit rating not lower than the “BBB-” level by theclassificationofFitchRatingsorStandard&Poor's,ornotlowerthanthelevelof“Baa3”bytheclassificationofMoody'sInvestorsServiceratingagency.IftheRussianissuerisassigneddifferentlong-termcreditratings,thelowestassignedisselectedasthelong-termcreditrating.

Thus, the requirements for the debt liability rating of foreign issuers18 are higherthantherequirementsfortheRussianones.

17ThefounderoftheoftheNationalWelfareFundtrustmanagementistheRussianFederation.TheMinistryofFinanceoftheRussianFederationisinchargeoflegalrelationsinconnectionwiththeestablishmentoftheNationalWelfareFundtrustmanagementonbehalfoftheRussianFederation.

18 Asmentioned above, their rating has to be at least level “AA-” under the classificationofFitch-RatingsorStandard&Poor’s, or at least level “АаЗ” under the classificationofMoody’sInvestorsService.

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-inrelationtosharesandstocks(sharesofparticipation)ofinvestmentfunds,thefollowingrequirementsareestablished19:

• sharesoflegalentitiesshouldbeincludedinthequotationlistofatleastonestockexchange;

• sharesofforeignissuersshouldbeincludedinthelistsofsecuritiesusedtoestimatethestockindicesofMSCIWorldIndexandFTSEAll-WorldIndex;

• sharesofRussiancompaniesshouldbeincludedinthelistsofsecuritiesusedtoestimatethestockindicesofRTSorMICEX;

• the structure of the assets of investment funds,whose issued shares(stakes)shouldincludeonlytheauthorizedfinancialassets.

-inrelationtodepositsandaccountswiththebanksandcreditinstitutions,thefollowingrequirementsareestablished.Thebankorcreditorganizationshouldhavealong-termcreditratingnotlowerthan“AA-”accordingtotheclassificationof Fitch-Ratings or Standard & Poor's rating agencies or not below the levelof “Aa3” by the classification ofMoody's InvestorsService rating agency. If abankorcreditorganizationisassignedadifferentoflong-termratingbyofthoseagencies,thelowestratingisassignedasalong-termcreditrating;

-inrelationtodepositsoftheStateCorporation«BankforDevelopmentandForeignEconomicAffairs (Vnesheconombank), the following requirementsareestablished:

• thefundscanbeplacedondepositinRussianrubles,U.S.dollars,EuroandPoundsSterling;

• themaximumtotalamounttobeplacedondeposits inRussianrublesis655billionrubles.Atthesametime,upto175billionrublescanbeplacedondeposit,theamount,termandotheressentialprovisionsofwhicharedeterminedbytheMinistryofFinance.

WithregardtotheNationalWelfareFund,theMinistryofFinance20hasalsoestablished the authorized standard shares of the total assets of the Fund inforeigncurrencytobeinvestedinfinancialinstruments,denominatedinforeigncurrency:

• debtinstrumentsofforeigncountries-80%;• debtliabilitiesofforeigngovernmentagenciesandcentralbanks-15%;• debtliabilitiesofinternationalfinancialinstitutions,includingsecurities-

5%;• deposits and balances in the accounts with foreign banks and credit

institutions-0%;• stocksandshares(stakes)offoreignlegalentities-0%;• debtliabilitysecuritiesofforeignlegalentities-0%.• theOrderoftheRFMinistryofFinanceNo.24of24.01.2008approves

thefollowingnormativecurrencystructureoftheNationalWelfareFund:• U.S.Dollar-45%+/-5percentagepoints,• Euro-45%,+/-5percentagepoints;

19Ifacquiredsharesoflegalentitiesorstocks(sharesofparticipation)ofinvestmentfundsdonotmatchanyoftheaboverequirements,suchsharesorstocks(sharesofparticipation)ofinvestmentfundsaretobesoldwithin3monthsfromthedateofinconsistencyarising.

20SeetheOrderoftheMinistryofFinanceNo.517from21.10.2008“OnAmendingtheOrderoftheMinistryofFinanceoftheRussianFederationNo.26ofJanuary24,2008”.

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• PoundSterling-10%,+/-2percentagepoints.Thus,thecurrencystructureoftheNationalWelfareFundisnodifferentfrom

thecurrencystructureoftheStabilizationFund.DuringthefirstyearaftertheReserveFundandtheNationalWelfareFund

formation(fromFebruary1,2008toFebruary1,2009),theirmanagementhadnegativeUS$ returns,whichamounted to -2.47%.Given thosedynamics, theRussianMinistryofFinancehasproposedanewindex--theso-calledaggregateprofitability--whichdoesnottakeintoaccountthefluctuationsoftheEuro,PoundSterlingandUSdollar.Theaggregatedindexofreturninthecurrencybasketfortheyearamountedto5.41%(see Table. 3).

Table 3. Annual Revenue from the Reserve Fund and National Welfare Fund management (over the year from 02.2008 to 02.2009),%

Currency Account currency In USD In RURUSD 3.9 3.9 35.14Euro 5.94 –4.99 23.67GBP 9.58 –19.8 4.57Total 5.41 –2.47 26.92

Source: RF Ministry of Finance

WhenconvertedintoEuro,thetotalgainwouldamountto9.3%perannum,and into rubles -more than26%perannum.Themain reason for the lossoffunds indollar termswastheU.S.dollar’sstrengtheningagainst theEuroandBritishpoundsterling in2008.Settingatight limitoncurrenciespreventedthecompensationforthenegativeimpactofweakeningcurrencies,inwhich55%ofbothfundsweredenominated.

Macroeconomic and fiscal linkages; highlights of political economy

Intermsofmacroeconomiceffectsandimplicationsofthesovereignwealthfunds’formationinRussia,therearethreenoteworthyaspects:

1.Intertemporalstabilizationofthefederalbudget.2.Support to theRFCentralBank’santi-inflationarypolicyandpoliciesof

limitedRURappreciation.3.Fundingofanti-crisismeasuresin2008-2009.

Budget PolicyAs mentioned above, the main objective of the RF Stabilization Fund

establishment was institutionalized accumulation of surpluses of the federalbudget under the circumstances of the external environment due to the highoil revenues. Oil and gas revenues include proceeds from taxes on mineralextractionofhydrocarbons,exportdutiesoncrudeoil,naturalgas,andgoods

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producedfromcrudeoil.Some oil and gas revenues are addressed toward financing current

expendituresof the federalbudget (oilandgas transfer),and thebalancecanbesaved.Toassesstheshort-termrisksintermsofstabilityofpublicfinances,thenon-oildeficitindicatorisimportant,representingthedifferencebetweenthenon-oilrevenueandthetotalbudgetexpenditures(seeTable.4).Accordingly,theamountofthefundisincreasing(see Figs. 4).

Table 4. Revenues and Expenditures of the Federal Budget in 2000-2009. (% of GDP)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Expenditures(1)

14.2 14.8 18.9 17.8 15.8 16.3 15.9 18.1 18.2 24.7

Revenues(2) 15.5 17.8 20.3 19.5 20.1 23.7 23.3 23.6 22.3 18.8Includingnon-oilrevenue(2.1)

11.7 13.1 15.1 14.1 13.5 13.6 12.7 14.6 11.8 11.2

Oilrevenue(2.2)

3.8 4.7 5.2 5.4 6.6 10.1 10.9 9.0 10.6 7.6

RFfederalbudgetsur-plus(3)=(2)–(1)

1.4 3 1.4 1.7 4.3 7.4 7.5 5.5 4.1 –5.9

Non-oildeficit(4)=(2.1)–(1)

2.5 1.7 3.8 3.7 2.3 2.7 3.4 3.5 6.4 13.5

Note: when assessing the non-oil deficit in 2009, income from the man-agement of the Reserve Fund and National Welfare Fund, which amounted to

respectively 0.8% of GDP, were taken into account.

Source: Federal Treasury of Russia

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Figure 4. Stabilization Fund, Reserve Fund, the National Welfare Fund in 2004-2009, % of GDP

Note: The Stabilization Fund is a hypothetical fund equal to the amount of the Reserve Fund and National Welfare Fund

Thus,duringtheperiodofafavorableexternalmarketsituation,thepresenceof theStabilizationFundwasaserious institutionalconstraint to thegrowthofbudgetaryexpenditures.Atthesametime,evensuchaconstrainthadalimitedeffect,andin2007-2008,duringinthepeakinoilprices,amarkedincreaseinthefederalbudgetexpenditureswasobservedinrealterms.

Inturn,in2009-2010,theReserveFundbecamethemainsourceoffinancingthe federalbudgetdeficit, formeddue toreductionof thebudget revenues,aswell as due to adoption of thepackageof anti-crisismeasures.However, thescopeofthebudgetdeficit intheRF(likeinmanycountriesaroundtheworld)clearlyexceedsexpectations.Forexample, if the initiallyestimatedscope theStabilizationFund,andthentheReserveFund,wasassessedbasedontheneedtofinancethedeficitof3%ofGDPforthetermnotexceedingthreeyears,whenin2009thedeficitofthefederalbudgetamountedto5.9%,in2010itisexpectedtoamountto6-7%ofGDP,whichmeansacompleteexhaustionoftheReserveFundalreadyinthecurrentyear.BecauseinthefuturethegovernmentofRussiaexpectsthefederalbudgetdeficittobesustained(withagradualdecreaseto2%ofGDPin2013withanaverageoilpriceofnotbelow70dollarsperbarrel),thereisariskofneedingtheinvolvementoftheNationalWelfareFundforthebudgetdeficitfinancingaswell.

Monetary and Exchange Rate PolicyTheavailabilityofbudgetarysovereignfunds,aswellastheirallocationinthe

internationalreservesoftheBankofRussia,hasimportantimplicationsforthe

 

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

14,0%

16,0%

18,0%

20,0%I II III I I II III I I II III I I II III I I II III I I II III I

2004 2005 2006 2007 2008 2009

% G

DP

Stabilisationfund Reservefund

Fundofnationalwell-being Stabilisationfund'

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monetaryandexchangeratepolicyinRussia.Thus,thetotalvolumeofmonetarysupply,withdrawnfromtheeconomyand

allocatedtotheaccountswiththeRFCentralBankasofJanuary1,2009,wasapproximately120%ofthemonetarybase(high-poweredmoney)at thattime.Savingthisvolumeofmonetarysupply in theeconomyover2004-2008wouldincrease the rate of the monetary supply growth by about 15-20 percentagepointsperyear.Theinflationaryconsequenceofthiscouldbetheincreaseoftheaverageannualinflationratefrom11.35%perannum(whichisoneofthehighestratesintheworld)to13.5-14%perannum.

Atthesametime,thetotalamountoffundsplacedintheforeigncurrencyisabout35-40%ofthetotalsurplusoftheRussianbalanceofpaymentsfrom2006through thefirst sixmonthsof2008.Accordingly,ademandwas formed fromtheRussianMinistryofFinanceforsuchinflowofthecurrencytothedomesticmarket,whichhashelpedtheBankofRussiatokeeptherublerateatalevelnohigherthan23.5-24.0rublesperdollar.Modelingasituationwherein2006-2008therewasnoneed toallocate the funds in foreigncurrencyshows that in thiscase,thenominalrubleexchangeratecouldrisetothelevelof13-15rublesperdollarbyAugust2008.Accordingly,therealeffectiverubleratebythebeginningofthecrisisinautumn2008wouldhaveamountednotto116.5%ascomparedwithJuly1998(themaximumvalueof therealexchangeratebeforethe1998crisis),butto180-200%,whichwouldmeanacompletelossofcompetitivenessofdomesticproducersandasharpslowdownineconomicgrowth,evenagainstthebackgroundofhighpricesforoilandotherRussianexportgoodsin2007.

Anti-crisis measures funding in 2008-2009Financingoflarge-scalemeasuresforthesupportofthenationaleconomy

withouttheinvolvementofexternalborrowingin2008-2009waspossiblethanksto the reservesaccumulatedduring theeconomicgrowth. In fact, oil andgasrevenuesbecamethemainsourcestosupportthebalanceofthefederalbudgetin2009. Inparticular, tofinance thebudgetaryexpenditures fromtheReserveFund,aboutRUR2.964trillionwasallocated.Thisfactallowsustoconcludethattheideaofforminganoilandgasfundwasfullyjustified,andcanberegardedasanadvantageinthenationalfiscalpolicy.

Table 5. Dynamics of Formation and Use of Oil and Gas Assets in 2009(RUR bln)

FundBalanceasoflate2008*

Revenueover2009:

Expenditureover2009:

Balanceasoflate2009*Oiland

gasrev-enue

Revenuefromassetsmanage-ment

Supportofthefederalbalancesolvency

Supportofoil

andgastransfer

ReserveFund

4027.6(9.8%of

GDP)488.5 205.0 2964.8 179.4

1830.5(4.7%ofGDP)

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NationalWelfareFund

2584.5(6.3%of

GDP)– 92.5 – –

2769.0(7.1%ofGDP)

Total6612.1

(16.0%ofGDP)

488.5 297.5 2964.8 179.44599.5

(11.8%ofGDP)

* Balances are estimated at the exchange rates of January 1, 2009 and January 1 of 2010, accordingly.

Source: Federal Treasury

Formally,theassetsoftheNationalWelfareFundwerenotusedtofinancethe federal budget deficit and the financing of anti-crisismeasures.However,starting fromOctober 13, 2008, theRFPresidentDmitryMedvedev signed apackageof lawspreviously enactedby theStateDumaandapprovedby theFederalCouncilonthestabilizationof thefinancialsystemduringthefinancialcrisis: inparticular, legislativeamendmentsallowedplacementof theNationalWelfareFundassetswith theVnesheconombankdepositsuntilDecember31,2019,totalingnomorethan450billionrublesattherateof7%perannum.

Thus,therewasonlyachangeintheportfoliooffixedassetsfortheallocationof the NationalWelfare Fund; it was replenished with the ruble-denominateddepositsoftheRFVnesheconombank.Inthefuture,theuseofthoseresourcesfor the implementation of anti-crisis measures was already implemented bytheRFVnesheconombank. Inparticular,404billion rublesweregranted to14Russiancommercialbanksintheformofsubordinatedloansand30billionrublesweretransferredtothe“RussianDevelopmentBank”forcreditingSME.

Ingeneral,analyzingtheroleoftheReserveFundasasourceoffinancingofthefederalbudgetdeficitinRussiaover2009-2010,oneshouldtakeintoaccountthreeissuesrelatedtotheproperunderstandingofthe“reserve”natureofthesefunds:

1. On the one hand, the use of the Reserve Fund assets to cover thebudget deficit is a commonmonetary emissionof theCentralBank, since inpracticesuchanoperationmeanstheflowoffundsintheRFCentralBankfromthespecialaccountsoftheRFGovernmenttothemonetarybase(throughthecurrentaccountoftheGovernment).Thenon-emissionnatureofthisoperationcouldtakeplaceiftheBankofRussiaatthesametimewouldsellforeigncurrency(whichisformallyacounterpartoftheReserveFund),butafteradownfalltoitslowest level inJanuary2009, the international reservesof theBankofRussiahaveconsiderablygrown.Thus, intermsofmonetarypolicy, theFundisnotareserve,butisaseparatechannelforthemoneyinflowintheeconomy.

2. Ontheotherhand,thedescribedeffectofmonetaryemissionfromthebudget account is observed every timewhen the government spendsmoneyon the basis of the existingRF systemof theTreasury,which has budgetaryaccountswiththeBankofRussia,i.e.thosewithdrawnfromthemonetarysupply.

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Irregular fluctuations are observed within the year (e.g., the sharp growth ofmonetaryassetsinDecember,whenthebudgetexpensesareperformedwhenthemoneybaseisreducedeachmonthinthelastdaysofthemonth,whentaxesarepaid),butbyvirtueofthebudgetreportingterm,namelythefiscalyear,asarule,onlythefinalimpactofthebudgetexecutiononthemoneysupplyistakenintoaccount.If,however,weextendtheperiodofconsiderationfromoneto,forexample,5years,thentheuseoftheReserveFundshallceasetobeamereemission,sincethemoneyaccumulatedinitwithinsuchatermmayberegardedastemporarilywithdrawnandreturnedtotheeconomyassets.

3. Fromanotherperspective,intermsoffiscalanddebtpolicy,theReserveFundassetscertainlycanberegardedasareserveoftheRFGovernment,astheymakeitpossibletoreplenishthebudgetdeficitwithoutborrowinginthedebtmarketandavoidingtheincreaseofthegovernmentdebt.Atthesametime,astheexperienceofEUcountries,USA,Japan,UKandothersshows,thegrowthofpublicdebttofinancetheanti-crisismeasurespackagehasbecomeoneofthekeychallengesfortheeconomicpolicyatthestageofrecoveryfromthecrisis.Inthisregard,theexistenceoftheReserveFundinRussiacanberegardedasapotentialallowingthecountrytoavoidthegrowthofdebtburdenandtoshiftcurrentbudgetexpensesforthefuturegenerations.

The impact on poverty eradication, social policy and labor marketFromthepointofviewofthecurrentsocialeffectsandsupportoftheliving

standardsofthepopulationofRussia,thesovereignwealthfundsprovidelimitedand,forthemostpart, indirecteffects.It isextremelydifficulttodistinguishtheimpactofeachoftheexistingfunds.

Fromourpointofview, themost important impacton thepopulation livingstandards is the provision of an anti-inflationary effect of theRFStabilizationFund(seeabove).Weestimatethetotalincreaseinincomeinrealtermsduetolowerinflationintheperiodof2004-2008atabout20percentagepoints.

AnotherimportantconsequenceoftheReserveFund’sexistenceisfundingofthefederalbudgetdeficitin2009.Thesocialprojectsinparticular,whichallowedagrowthinrealincomesby2.3%inthesituationofaseverecrisis(declineinrealGDPin2009by7.9%),reducedthenegativeimpactoflowerdomesticdemandandensuredthegrowthofhouseholdsavings.Herewith,asnotedabove,thoseexpenditureshavebeenfinancedwithoutincreasingthenationalborrowingand,consequently,thegrowthoftheborrowingputsaburdenonthefuturegenerations.

TheroleoftheNationalWelfareFundinsolvingthesocialproblemsatthemomentisextremelysmall.Moreover,theNationalWelfareFundobviouslydoesnotplaytherole imposedon it--butnotensured in institutionaland legislativeterms-- as an instrument for the long-term solutions of thepension system inRussia.WewillconsiderthetentativeoptionsoftheNationalWelfareFundinthisareainthefinalsectionofthismemo.

Compliance with Santiago PrinciplesTable 6showsourexpertassessmentofcomplianceoftheRFReserveFund

andNationalWelfareFundwiththeGenerallyAcceptedPrinciplesandPractices(GAPP),orSantiagoPrinciples.Compliancewith theseprinciples ispresented

155

for each fund separately, although, as shown above, the legal provisions oftheiroperation,managementsystemandtherequirementtoinvestmentsofthefundsarepractically identical.Nevertheless,basedonthedifferentnatureandpurposesofeachofthefunds’formations,theextentoftheircompliancewiththeSantiagoPrinciplesvaries.

Table 6. Santiago Principles and Implementation thereof for the Rus-sian Sovereign Wealth Funds

Principles RF Reserve fund RF National Welfare FundGAPP1GAPP1.1GAPP1.2

+++

+++

GAPP2 + –GAPP3 + +/–GAPP4GAPP4.1GAPP4.2

+++

+++/–

GAPP5 +(?) +(?)GAPP6 +/– –GAPP7 +/– –GAPP8 +/– –GAPP9 – –GAPP10 +/– +/–GAPP11 + +GAPP12 – –GAPP13 – –GAPP14 – –GAPP15 + +GAPP16 +/– +/–GAPP17 + +/–GAPP18GAPP18.1GAPP18.2GAPP18.3

+/–+/–++/–

––+/–+/–

GAPP19GAPP19.1GAPP19.2

+/–++/–

–+/––

GAPP20 + +GAPP21 – –

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GAPP22GAPP22.1GAPP22.2

––+/–

––+/–

GAPP23 +/–(?) +/–(?)GAPP24 – –

Therefore, as seen from the above estimates for the RF Reserve Fund,compliancewith theSantiagoPrinciples isobserved inninepositions (andsixsub-positions),andpartialcomplianceineightpositions(foursub-positions).Insevenpositions(andonesub-position)thereisnocompliance.

FortheNationalWelfareFund,thesituationlooksevenworse:• compliance-in6positions(3sub-positions)• partialcompliance–in5positions(5sub-positions)• inconsistency–in13positions(3sub-positions).Itshouldbenotedthat forbothFundsfullcompliancebyonepositionand

partialcompliancewiththeotherpositionsareinquestionbecauseoftheabove-mentioned decision of theRFGovernment,which has refused to provide theinformationontheFunds’statusforpublicdisclosuresinceMay2010.

Perspectives and Predictability after the Global Economic CrisisAsstatedabove,thesituationwiththedynamicsofbothRussiansovereign

funds during the recent crisis is ambiguous.At the beginning of the crisis intheRussianFederation inautumn2008 (October1,2008), thevolumeof theStabilizationFundofRussiaamountedtoabout141billionUSdollars,andtheNationalWelfareFund–48.7billionUSdollars.AllassetswereplacedinhighlyreliablesecuritiesdenominatedinUSdollars,Euro,poundssterlingandJapaneseyen.Thus,fromthebeginningofthecrisisdespitethedevaluationoftheruble,aswellaslowerinterestratesintheleadingglobaleconomiesfortheruble,assetsbegantogrow.Incontrasttotheassetsofothersovereignfunds,intheRussianfundstherewerenoassetsincorporatesecurities(stocks),sothedownfallinthestockmarketdidnothaveseriousconsequencesonthem.

At the same time, the growth of the federal budget deficit and the RFGovernment'sneedforadditionalfinancialresourceshaveresultedinattractingthefundstomeetcurrentfinancialdemands.Fallingoilpricesintheworldmarketsandthereducedinflowofexportearningstothecountryledtothedisappearanceoftheincomepartofbothfunds.ByearlyJune2010,thebalanceintheReserveFundshouldnotexceed40billionUSdollars,andallthemoneyfromthefundshouldbeallocated to finance the federal budget deficit in 2010.However, inourview,theutilizationofthefundin2009-2010cannotberegardedasalossbecausetheassetswereusedfortheimplementationofthefund’smainobjective-torecoverabudgetdeficitthataroseinconsequenceofshort-termandcyclicalswingsinrevenues.Inaddition,availabilityofthissourcetofinancethebudgetdeficitallowsRussiatoavoidthetrapintowhichothereconomiesoftheworldfall,namelytherapidaccumulationofpublicdebt.TherenewalofrevenueinflowtotheReserveFundofRussiaisexpectednotearlierthanin2012-2013(inthecaseofthemoderatelyoptimisticscenario,revivingtheglobaleconomyandthe

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preservationoftheglobaloilpricesatnotlessthan70USdollarsperbarrel).NationalWelfareFundassetswerenotdirectlyusedtofinancethefederal

budget deficit, and the assets spent in the context of an anti-crisismeasurespackage for operations in the stockmarket of Russia and the support of thebankingsysteminRussiawereprovidedastheconversionoffundsfromforeigncurrency intorublesandtheirallocation inrubleassets(approximately20%oftheNationalWelfareFund).ThoseRURinvestmentsarepotentiallylost,butduetotheirlong-termnaturetheywillbereflectedinanexplicitformlater.Thus,withregardtotheeffectoftherubledevaluationandthefactthatbuyingtheRussiancompanies’shareswascarriedoutatclosetoaminimumprice,specifically intimesof crisis, theFundhasnot suffered losses in ruble terms. Losseswererecordedin2010,asthenominalexchangerate,andconsequently,rubleratingswerereduced,affectingthefundassets.Similarlosseswereobservedinthepre-crisisperiod,when the rublewasalso rapidlystrengtheningagainst themajorworldcurrencies.

However, in the absence of fiscal consolidation in 2011-2013, the RFgovernmentwillbecompelledtofinancethefederalbudgetdeficitattheexpenseoftheNationalWelfareFund,downtoitsfullexhaustion(exceptfortheamountofthelong-termruble-denominatedinvestmentsmadeintheframeworkofAnti-CrisisMeasures).Accordingly,onecanmentionthefollowingmainrecommendationstoimprovethefunctioningoftheRussiansovereignfunds:

1.Withrespecttothe Reserve Fund of Russia–thesoonestreturntotheaccumulationoftheassetsatthehighprofitabilityinthelongtermperiod.

2.WithrespecttotheNational Welfare Fund–theRFGovernmentshouldclearlydefinethestrategicobjectivesoftheFund.CurrentlytheFund,inessence,isaseparatefundoftheRFGovernment,protectedfromspendingtocoverthebudgetdeficitfinancing(sofar!),whichhasnoclearpurpose.Forthepurposesof the Fund, one can propose its transformation into a savings pension fund(for example, like theGovernmentPension Fund ofNorway), i.e., it could beaddressedtoresolvetheshortageinthepensionsystemovertheprospectofatleast15-20years.ItisthereforenecessarytoreverttotheaccumulationofassetsintheNationalWelfareFund.

CurrentvolumeoftheFund(lessthan10%ofGDP)isclearlyinsufficienttosolveanyseriousproblem.Inadditiontotheshort-termrevenuesfromexportsofrawmaterials,themostobvioussourceforthereplenishmentoftheFundmaybetheproceedsofprivatizationofthestateassetsandrealassetsownedbythestate.Asof2007(priortothecrisiseventsintheglobaleconomy),assessmentofsuchassetsandpropertyisnotlessthan57%oftheRussianGDP.InthecaseoftransferofthesefundstotheNationalWelfareFund,witharealreturnontheinvestmentsoftheFundatthelevelof4.5%peryear,theamountoftheFundbytheendof2015shouldamountto70.6%ofGDPandbytheendof2025–80.5%,whichisenoughtokeepthereplacementrateofretirementpensionat30%until2025.

3. With respect to both funds-principlesandapproachestomanagingthefunds’assetsshouldbedifferentiated. Inparticular, theNationalWelfareFundshould bemanaged essentially on different terms than theReserve Fund. Inother words, an authorized structure of assets and management mechanismshouldberevised.

158

First,theNationalWelfareFundhasalongerprospectusforinvestmentthantheReserveFund,andtheNationalWelfareFundassetscanbeinvestedinmorevolatileandprofitablefinancialinstruments.

Secondly,theNationalWelfareFundshort-termliquidityhasalowervalue,andconsequently,itispermissibletoinvestitinnon-marketableassets.

Third,internationalexperienceshowsthattoimproveefficiencyofmanagementandprofitabilityofsuchasovereignfund,itisreasonabletotransfermanagementofsuchasovereignfundtoprivateprofessionalmanagementcompanies,ratherthantotheCentralBankoraspecializedstateagency.

Therefore,achangeintheinstitutionalandlegalbasesofbothfunds’functionsisrequiredtoimprovetheircompliancewiththeSantiagoPrinciples.

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About authors

Ingilab AhmadovIngilab Ahmadov obtained a Doctor of Economics degree from Saint-

PetersburgStateUniversityofEconomicsandFinance(Russia)in2000.In2008hestudiedinthe“EconomicsofEnergy”courseinReadingUniversity(UK)asaCheveningFellow.

His research interests aremanagement of oil revenues and impact of oilrevenuesoneconomy,Caspianenergy resources,andeconomicbasesofoilcontracts. Prof.Ahmadov hasmore than 30 research papers and books. HejoinedtheSchoolofEconomicsandManagementatKhazarUniversity(Baku)in2008.ThemainsubjectsheteachesareOil&GasEconomyandCaspianEnergyDevelopment.

During2009-2011heservedontheInternationalBoardofExtractiveIndustriesTransparencyInitiative(EITI).

Prof.AhmadovbecamedirectorofEurasiaExtractiveIndustriesKnowledgeHubandDeanoftheSchoolofEconomicsandManagementatKhazarUniversityin2010.

Yelena Kalyuzhnova After working as an Economic Adviser to the President of Kazakhstan,

ProfessorYelenaKalyuzhnovafoundedandisDirectorof theCentreforEuro-Asian Studies at the University of Reading. She has a wide knowledge oftransitionandemergingeconomies.Herresearchinterestsincludehydrocarbondevelopment, particularly development of resource funds; energy economics(particularly oil andgas) and corporategovernance in resource-richemergingeconomies. Yelena’s teaching interests are in the economics of emergingmarketsaswellasenergyeconomics.YelenaisaneconomicadviseronCaspianissues to theRt.Hon.LordFraserofCarmyllie,Q.C.,HouseofLordsandaneconomicadvisertoAll-PartyParliamentaryGrouponKazakhstan(2006-2010).Since 2009 Yelena has been Senior Visiting Research Fellow of the OxfordInstituteforEnergyStudies.

Stella TsaniDr. Stella Tsani is amember of theCentre for EuroAsian Studies at the

UniversityofReading,UnitedKingdomandoftheE3MLab/ICCSattheNationalTechnical University of Athens, Greece. Her academic background includesresearchongovernanceand institutions in resource-richcountriesandon theroleofoil-basedSovereignWealthFundsincombatingthe“resourcecurse.”ShehascontributedtoseveraleconomicstudiesundertakenbytheCentreforEuro

160

AsianStudiesintheUK,thePublicFinanceMonitoringCentreinAzerbaijan,theInstituteofEnergyforSouthEastEuropeandtheE3MLab/ICCSinGreece.

Drobyshevskiy Sergey MikhailovichSergeyDrobyshevsky,DoctorofEconomics,isHeadofMacroeconomicsand

FinanceDivisionof theGaidar Institute forEconomicPolicy(Moscow,Russia)andSeniorResearchFellowattheRussianAcademyforNationalEconomyandPublicServiceunderthePresidentoftheRussianFederation.HegraduatedfromtheHigherSchoolofEconomics(Moscow)andErasmusUniversity(Rotterdam).In 1996 he joined the Institute for Economy inTransition (since June 2010 –GaidarInstituteforEconomicPolicy)andworkedintheDepartmentofMonetaryPolicy.In2000-2002heworkedasanexpertattheRussian-EuropeanCentreforEconomicPolicy.

Kenan AslanliKenanAslanliisapolicyanalystexaminingfiscal,macroeconomicandenergy

issuesatthePublicFinanceMonitoringCenter(PFMC)basedinBaku,AzerbaijanandalocalcontractorfortheInternationalBudgetPartnership(WashingtonDC,USA).He isalsopartof the researchprojectentitled “Internaldiscoursesandforeign policy-making in theCaspian region: export pipelines, geopolitics andcultural orientation inAzerbaijan,KazakhstanandTurkmenistan” (2011-2013),conductedbytheResearchCentreforEastEuropeanStudiesattheUniversityofBremen.