Khalid A. Alsweilem, Angela Cummine, Malan Rietveld & Katherine Tweedie
Sovereign wealth funds (SWFs) are playing an increasingly important role in the management of government windfalls and income surpluses from a variety of sources. The rise of SWFs is reflected not only in the increase in the size of assets under their management – now estimated at over $5 trillion globally – but also in the proliferation of new funds established over the past decade and the anticipated establishment of new funds in countries with recent resource discoveries. This report digs deeper into the roles, practices and governance structures of SWFs. The primary aim of the report is to identify the leading practices among existing funds and establish an analytical framework for assessing the critical policy and institutional aspects that legislators, policymakers and practitioners need to consider in establishing a new SWF or reforming an existing one.
Institutional and policy choices for managing sovereign wealth
Chapter one introduces a working definition of SWFs and discusses their place in the universe of sovereign investors. We discuss the major sources of sovereign wealth, the primary and ancillary functions performed by SWFs, and lay the foundation for the rest of the report by identifying the four critical elements of SWF design and implementation: savings rules, spending rules, investment policies and governance structures.
Accummulating, stabilising and spending sovereign wealth
The next section of the report investigates the economics of SWFs – specifically the challenge of striking an appropriate balance in the stabilisation, spending and saving of sovereign wealth and the revenue that is derived from it. Chapter two considers the extent of accumulated savings that resource-rich countries can generate by adopting simple rules which transfer a portion of the revenues that arise from temporary periods of elevated commodity prices or sharp increases in resource production (windfall revenues). The two overarching messages of the chapter are: (i) resource-rich countries are generally better off accumulating a critical level of assets with which to capitalise their SWFs before setting up such funds, and (ii) generating these savings are much easier to do – economically as well as politically – in periods of booming revenues.
In Chapter three, we consider a similar question for countries whose sovereign wealth arises not from natural resources, but from the accumulation of an excess of foreign exchange reserves. Countries that have accumulated such excess reserves have increasingly moved a portion of those assets into more long-term investment portfolios, with a higher risk tolerance and investment horizon. This chapter identifies a striking similarity in the operational and institutional structures for managing resource and revenue based forms of sovereign wealth: the stabilisation funds established by resource-rich countries have similar functions and investment objectives and practices as traditional central bank reserves, while the SWFs established from excess reserves are, in many respects, similar to the savings funds resource-rich countries. For a number of emerging market economies, the rapid, and now massive, accumulation of foreign exchange reserves has resulted in a deeper analysis of the related concepts of ‘reserves adequacy’ and ‘excess reserves’, both of which are critical to the decision-making process around when to establish a SWF and how much capital to transfer to it. Rule-of-thumb measures of reserves adequacy relate the minimum level of reserves a country should hold to; indicators of the cost of imports, the repayment of short-term debt and the size of the domestic financial system. More recent and complex models of reserves adequacy and the optimal level of reserves remain a work in progress and difficult to apply across countries – however, policymakers can use the ideas behind these models in assessing whether they hold excess reserves that can be used to set up an SWF.
Beyond the initial accumulation of assets with which to capitalise a SWF, long-term policy choices around the balance between the stabilisation, spending and saving of sovereign wealth need to be made in an integrated way, rather than in isolation from each other. These policy choices and the trade-offs they imply are more complicated in resource-rich countries, which typically face the challenges of revenue volatility and long-term declines in their underlying wealth. Chapter four (along with more detailed information in the Technical Appendix) presents a model that enables a country-by-country simulation of theimpact of different stabilisation, spending and savings policies. We apply the model to four contrasting country scenarios: Saudi Arabia, Nigeria, Azerbaijan and Ghana in order to demonstrate how it can be used in different contexts. The chapter concludes by drawing out a number of generalised implications from the four country scenarios.
Governing sovereign wealth
We then move to consider SWFs. Chapter five considers issues of implementation and governance, particularly the rules, institutional structures and internal structures. We examine the extent to which SWFs spending and savings policies are implemented through an adherence to rules – and, to the extent that such rules exist, how they are governed. The chapter, therefore, considers not just the rules required, but who determines them and who has the authority to review and potentially change them. We find that a number of funds have clear spending and savings rules, and that a broad range of public institutions are involved in the governance of those rules. Chapter six examines options and models within the broad public sector to position the management or operational authority with responsibility for the fund – for example, the central bank, the ministry of finance or an independent authority – given the wide variety of models observed in practice, it is important to understand the origins, advantages and disadvantages of each option. We take the need for clarity around roles and responsibilities as a given, and show how certain models promote clarity while others potentially reduce it. For a number of reasons outlined in the chapter, a clear separation of the management entity from the owner and policymaker may be desirable, although credible (and sometimes cost-effective) ‘second-best solutions’ do exist.
Finally, Chapter seven looks at various practical aspects of internal governance structures including: the composition of a fund’s highest governing body, the appointment process to that governing body and internal procedures around the investment process. Although a mix of approaches is again evident among SWFs in this area, generalised lessons on desirable practices that reinforce widely accepted principles of good governance include: (i) promoting diversity in the composition of the board, (ii) establishing minimum competency requirements for board members, (iii) limiting owner and operational representation on the board, (iv) promoting arms-length appointment processes, and (v) clearly defining the role of the investment committee. Chapter eight summarises the findings and recommendations of this report in greater detail than is possible here.