Should Sovereign Wealth Funds Finance Domestic Investment? The Opportunities and the Risks
Sovereign Wealth Funds (SWFs) now own over US$6 trillion in assets, about half of which belongs to resource-exporting countries. Responding to the funds’ objectives to sterilise large export windfalls, saving for future generations, and balance risks and returns, their holdings have traditionally focused on external assets, primarily securities traded in major markets but also property and other investments. Some SWFs with long-term investment horizons have invested in infrastructure projects, but these have mainly been in other countries - high-return existing infrastructure and low-risk new bankable projects in Europe and Asia. The motivation for these investments has been overwhelmingly commercial.
Some funds do invest domestically. In one study, domestic holdings constituted 16% of investments for a sample of 60 funds, although these included some pension funds (1). Comparing existing SWFs, we found at least 13 with mandates to invest domestically. Until recently domestic greenfield infrastructure investment has remained largely uncharted territory. But in the light of pressing infrastructure needs, several resource-rich developing countries have established, or are establishing, SWFs with an expanded role as a national investor, including in “strategic” projects. Angola, Nigeria, Papua New Guinea and Mongolia are among the most recent examples. More are in the making, including Colombia, Morocco, Tanzania, Uganda, Mozambique and Sierra Leone. Many of these recent and planned funds are in resource-rich countries.
Why the trend towards domestic investments?
Several factors are encouraging governments to turn to their SWFs to finance new infrastructure. Needs in these countries remain high, so that popular sentiment pushes governments to spend part of their accumulated financial wealth at home. Some have also seen constraints on access to traditional sources of infrastructure financing since the global financial crisis. Also, public investment in resource-rich countries often poses significant management and governance challenges, including low capacity, weak governance and regulation and lack of coordination among public entities. Some governments may see the SWF as a means to improve the quality of public spending, and to crowd in private investors to strengthen investment discipline.
Relaxing fiscal rules?
The trend has also been encouraged by new thinking on fiscal rules. For many years experts and International Financial Institutions (IFIs) have urged resource exporters to base public spending on some version of a permanent income approach. Broadly speaking, the non-resource fiscal deficit (total spending less non-resource tax revenue) should equal the sustainable income from resource wealth, r x W, where ‘r’ is the long-term return on investments and ‘W’ is total resource wealth. This places a cap on public spending, especially when resource markets are booming or the country has only a few years of reserves. More recent thinking, initially in the context of Ghana, relaxes this constraint in cases where public spending includes domestic investments with high economic and social returns. These domestic investments, it is argued, contribute to national wealth and perhaps also offer higher returns than investments abroad, especially in poor African countries (2). This opens up scope for the SWF to invest at home as part of its wealth management strategy.
A risky proposition
All options for managing resource rents have advantages and risks. The traditional approach helps to stabilise spending in the face of uncertain resource rents and to maintain budget discipline. This increases the likelihood that spending will be scrutinised for quality. On the other hand, some high-return domestic investments might not be funded as quickly as they could be. Also, a large SWF is vulnerable to being raided by future, less prudent, governments. If the fund has, or engages, the necessary expertise it could also act as a specialised investor, helping to crowd in private investors through well-designed public-private partnerships.
On the other hand, opening the door to domestic investment introduces very serious risks. The owner of the SWF – the government, on behalf of the nation - is also the promoter of the investments. The quality of the fund’s portfolio can then be undermined by politically driven decisions, with “investments” contributing neither to growth nor to increasing the wealth of the nation. The SWF could be used to bypass parliamentary scrutiny of spending, resulting in even more inefficient and fragmented public investment programs. SWFs are particularly vulnerable to these risks because, unlike pension funds or development banks, they have no creditors able to exert due diligence in an independent manner. Governments could reclassify much recurrent spending as investments, which in some sense many are – education, health, early childhood development to name just a few. Bypassing the budget means that there is then no effective fiscal rule to constrain spending, increasing the possibility of destructive boom-bust economic cycles.
How to mitigate the risks?
The basic conflict-of-interest posed by state ownership cannot be eliminated but it can be mitigated by good policies.
Coordinate strategic investments
If operating as a purely market-driven investor the SWF might be seen as no different to any private investor. But this changes with domestic investments, especially those of a “strategic” nature, that need to be considered in the context of the public investment program and the implementation of macroeconomic policy. Massive fund investments in times of high resource prices could otherwise destabilise the economy even if budgetary spending is contained.
Finance the right investments for a wealth fund
Public investments can be evaluated from two perspectives: their private or financial returns and their broader economic or social returns. An infrastructure project may provide economic externalities, such as the stimulation of private investments and jobs, that are not fully captured by its financial return. While social and economic returns should be high, wealth fund investments must also yield “acceptable” financial returns. Some development finance institutions offer examples, such as rates of return that exceed inflation (Financiera Rural of Mexico and Credit Bank of Turkey), or that at least equal the government’s long-term borrowing costs (Business Development Bank of Canada) or provide an explicit target return on capital, ranging from 7 to 11% annually (Development Bank of Samoa, EXIM Bank of India, Kommunalbanken of Norway).
Investments should be competitive
Allocations to domestic investment should not be in the form of a mandated share but determined on the basis of competition with the returns on foreign assets. When domestic returns are low or there are indications of asset bubbles, investment should be channeled abroad. This will need to take into account the policy on benchmark rates of return as discussed previously.
Investing with private investors, pooling with other SWFs and co-financing with the regional development banks could help the SWF to reduce risk, bring in additional expertise and enhance the credibility of the investment decision. Some SWFs, such as Nigeria’s, have signed cooperation agreements with major international investors. Limiting investments to minority shares would serve to reduce risks of politically motivated allocations.
Strong corporate governance
There is a large body of knowledge on effective external governance (between the State and the SWF) and internal governance (the composition and functioning of the board of directors or trustees and the management processes of the SWF), including the Santiago Principles, the Revised Guidelines for Foreign Exchange Reserves, as well as general principles of governance practices including for state owned enterprises, put out by the OECD. The following aspects are most relevant for SWFs mandated to invest domestically:
- Independent board. This can be facilitated by independent nominating committees as well as clear skill requirements. Ownership and supervisory roles should be clearly separated.
- Professional staffing. To operate as an expert investor, the SWF needs to be staffed with qualified professionals, just like any investor in the financial sector. Strategic and greenfield investments require special expertise.
- Transparent reporting, especially on strategic investments. Consistent with good practice, SWFs investing domestically should issue accessible public reports covering activities, assets and returns. Where part of the portfolio is invested in “strategic” projects or projects with returns expected to be below market, these should be reported on separately.
- Independent audit. Internal audit should report directly to the board and external audit be undertaken by an internationally reputable firm that is independent of the owner.
The emergence of SWFs as strategic domestic investors, including in infrastructure, has important implications for the use of resource rents in the years ahead. Hopefully they can inject a degree of discipline into the use of these resources, and help their countries avoid the “resource curse”. However, they also have the potential to exacerbate the mismanagement of resources that has plagued so many oil and mineral-exporting countries. It remains to be seen how the political economy of this story plays out in the future.
Alan Gelb is a Senior Fellow at the Center of Global Development in Washington DC. Silvana Tordo is Lead Energy Economist for the Energy and Extractives Global Practice, and Håvard Halland is a Natural Resource Economist for the Governance and Inclusive Institutions Global Practice, both of the World Bank.
Source: Sovereign Wealth Funds and Long-Term Development Finance: Risks and Opportunities. 2014. Policy Paper 041, Center for Global Development. May.
The view expressed in this paper are those of the authors and not necessarily those of the World Bank.
This article was published in GREAT insights Volume 3, Issue 8 (September 2014).