Sovereign Wealth Funds As Means to Effective Development Strategy For Resource-Rich African Countries
John O. Ifediora.
Botswana has Sovereign Wealth Funds, and has used them admirably to develop its economy, reduce poverty, and continues to invest heavily in human capital through higher education. Nigeria has sovereign wealth funds, but they have been depleted and misallocated. At a time when the country needs the benefits of a functional sovereign funds the most – declining oil prices, erratic and undependable power generation, and an obscene unemployment rate, its Sovereign Wealth Funds exist in name only. This has left citizens and economists both within and without the country scratching their heads and each other’s head for plausible answers. While the country’s experience with its sovereign wealth funds is a sad commentary on the moral and work ethics of its extant political leadership, it must not discourage future governments, and other African countries rich in natural resources from implementing and using such funds for national development agenda. They have been shown to be extremely serviceable in Saudi Arabia, Kuwait, New Zealand, and South Africa.
In an excellent work by Alen Gelb, Silvana Tordo, Havard Halland, Noora Arfaa, and Gregory Smith on this subject entitled, “Sovereign Wealth Funds and Long-Term Development Finance: Risks and Opportunities,” the authors provide a guided tour of the risks and benefits of this useful development instrument:
Sovereign Wealth Funds (SWF) represent a large and growing pool of savings. Many are owned by natural resource exporting countries and have long-term objectives, including inter- generational wealth transfer. Traditionally these funds have invested in external assets, especially securities traded in major markets for a number of reasons including sterilization and lack of domestic investment opportunities.
Over time, and in part reflecting low returns in developed countries after the financial crisis, their investment holdings have broadened to include real property and investments in developing economies. Potentially competitive returns in developing economies and the sharp reductions in traditional sources of long-term financing after the financial crisis have contributed to fuel a growing interest among national authorities in permitting, and even encouraging, the national SWF to invest domestically, in particular to finance long-term infrastructure investments. Such pressure is inevitable, considering the fact that many countries with substantial savings, several of them recent resource-exporters, also have urgent needs. A number of existing SWFs now invest a portion of their portfolios domestically and more are being created to play this role.
Is it appropriate to use SWFs to finance long-term development needs? Does it matter whether these investments are domestic or foreign? This paper considers these issues, in particular the controversial question of using SWFs to finance domestic projects motivated, in part, by their perceived importance for development. In particular, the paper focuses on commercial or quasi-commercial domestic market investments by SWFs in resource-driven countries and explores the conditions that affect their ability to be an efficient and prudent investor while fostering local economic diversification and the mobilization of private capital.
At first sight the fit between the long-term goals of the SWF and the long-term investment needs of developing countries appear to align. As a specialized investor, a high-capacity SWF might also be able to bring appraisal skills to the table to help improve the efficiency of the investment program. However, domestic investment by a SWF pose potential risks to the domestic economy: (1) de-stabilize macroeconomic management and (2) undermine both the quality of public investments and the wealth objectives of the fund. The source of these risks is essentially that the SWF is owned by the same entity – the government – that seeks to promote the domestic public investments. These risks may be mitigated but not eliminated.
Naturally, no investment approach is risk-free. For example, the level of fiscal spending can be benchmarked by fiscal rules that emphasize sustainability, but may not be contained; spending may also be of low quality, especially if dependence on rents weakens the incentives for taxpayers to scrutinize expenditure. Building up large external savings funds runs the risk of their being raided by future governments, either directly (funds are used for purposes other than those originally intended or planned contributions are not paid) or indirectly (through unsustainable accumulation of public debt). On the other hand, in some views the risks of using SWFs to finance domestic public investments are so serious as to recommend that SWF portfolios should be confined to foreign assets with all public investment funding being appropriated through the budget.
The first priority is to ensure that domestic investments made by the SWF are considered in the context of the public investment plan and phased to ensure a sustainable flow of investment spending rather than destructive and costly boom-bust macroeconomic cycles. The second priority is to create a clear separation between the government as promoter of investments and as owner of the SWF: domestic investment by the SWF should not be used to finance public expenditure bypassing budgetary controls. At the same time it is necessary to build capacity for the SWF to operate as an expert, professional investor that can contribute positively to the quality of the public investment program. Possible approaches include: (a) screening investments for commercial or near-commercial financial return; (b) investor partnerships, including possibly other SWFs and development lenders as well as private investors, to diversify risk, and increase implementation capacity; (c) institutional design of the governance of the SWF to credibly insulate it from political pressure, strengthen accountability, ensure oversight, and bring technical skills to bear on investment decisions; and (d) full transparency, in particular on individual domestic investments and their financial performance. Some of these elements are already included in good-practice principles for SWFs, in particular the Santiago Principles although these principles were not formulated with a particular focus on domestic investments and may need to be strengthened in that regard. Some countries may be able to mitigate the risks through such mechanisms. Others, with weaker governance, will find it an uphill struggle. Especially for such countries, the risks of using SWFs to finance development spending may outweigh the potential benefits.
Diversification of SWF Investments
Rich natural resource reserves, primarily hydrocarbons and minerals, offer great development opportunity but they also expose producing countries to difficult policy questions. How much to save for the long term and how to invest the savings? How much to set aside in precautionary reserves to cushion the potentially damaging impact of volatile resource markets? How to phase in large investment programs to avoid hasty and wasteful spending in the face of absorptive constraints? SWFs can be set up to play a number of roles but it is important to stress that they are only a mechanism to help address such issues, and their establishment is no substitute for strengthening fiscal management or improving governance (Dixon and Monk 2011). Unfortunately many countries have created funds only to undermine them or to render them irrelevant through poor or inconsistent policy.
Multiple objectives could be achieved through appropriate strategic asset allocation within one fund, or the assets could be separated into separate funds with distinct characteristics. For example, if the long-term portfolio has adequate liquidity a savings fund can do double- duty as a precautionary fund (van den Bremer and van der Ploeg 2012). The objectives of the fund impact its investment objectives and strategic asset allocation. The focus of a fund’s investment policy should not be on the performance of individual asset classes but on the performance of the portfolio as a whole comprising a balanced mix of various asset classes.
Sovereign Funds in Emerging Markets
For a number of years SWFs have been looking to investments in emerging markets to diversify their portfolios and boost returns. Examples cited by Santiso (2008) include Temasek’s holdings in India’s ICICI Bank and Tata Sky, the Kuwait Investment Authority’s profitable investments in China’s ICBC, the Abu Dhabi Investment Authority’s holdings in Egypt’s EFG Hermes and Malaysian land projects, and the Dubai Investment Corporation’s stakes in North African companies like Tunisia Telecom. Funds from the Gulf were estimated to hold 22 percent of their assets in Asia, North Africa and the Middle East. OECD’s sovereign funds were also looking to boost their exposure in emerging and frontier markets, including Africa and Latin America.
There appears to be a trend towards including domestic investment as part of the mandate of SWFs. Recent examples include the Nigerian Sovereign Investment Authority, and the Fundo Soberano de Angola; they are also being established by, or under discussion in, Colombia, Morocco, Tanzania, Uganda, Mozambique and Sierra Leone. Many have been created by governments of resource-exporting countries. In some cases their domestic investment role has emerged out of a broadening of the mandate of an existing SWF, but the emergence of public funds as active players in the development strategies of resource-rich countries, in particular to support strategic investments, represents a shift in thinking on the appropriate use of resource revenues.
Domestic Investments in Resource Exporting Countries
Countries dependent on natural resources face several policy questions on the use of their revenues. How much should be saved and invested to ensure long-term fiscal and economic sustainability rather than consumed when realized? Should part of the windfall be transferred to citizens rather than spent entirely by the state? In addition to holding shorter-run precautionary balances to help cushion volatile resource price movements, what types of longer-term investments are most appropriate?
Long-term fiscal sustainability for resource-rich countries is sometimes benchmarked against some version of Permanent Income (PI). In earlier formulations, this was used as a benchmark for the primary fiscal deficit excluding resource revenues, comparing it with the permanent income flow expected from the resource sector. This formulation has been called into question. To the extent that a part of fiscal spending is for productive investment, this should be counted as part of savings rather than as consumption. That opens up greater fiscal space for domestic investment spending, but only if the investment is effective in building up national wealth.
Following on from this argument, it has been shown that not every country will find it optimal to build up a SWF savings fund that invests abroad. If the domestic risk adjusted rate of return on investment is higher than that on foreign assets, the optimal strategy might involve boosting domestic investment rather than accumulating long-term foreign assets (Berg et al., 2012; Collier et al., 2009; van der Ploeg and Venables 2010). In principle, and for countries that are capable of effectively using funds for productive purposes, well chosen, planned and executed domestic investments, including some naturally within the scope of the public sector, can help the economy to grow and diversify away from risky dependence on a dominant resource.
In practice, even if these conditions are satisfied macroeconomic and institutional absorptive capacity constraints will require that a portion of the revenue is invested in liquid financial assets outside of the domestic economy, possibly for a number of years. There would also still be a need to hold precautionary reserves, sometimes for quite extended periods because of the nature of commodity cycles. If the sole objective of accumulating funds in a SWF is stabilization then no domestic investment within that fund is advisable.
However, the link between investment and growth is neither automatic nor guaranteed. Public investment poses significant management and governance challenges, including low capacity, weak governance and regulatory frameworks and lack of coordination among public entities. Furthermore multiple institutions can have overlapping investment mandates, leading to fragmented programs and inefficient use of public funds. Careful coordination is necessary when multiple entities carry out public investment programs.
Many resource-exporting countries have launched massive investment programs to little effect (Gelb 1988). On average, countries tend to be relatively stronger in the early stages of strategic guidance and appraisal, and weaker in the later stages of project implementation and especially in project audit and evaluation. An index of the quality of public investment management shows this to be markedly weaker in resource-exporting developing countries than in other countries (Dabla Norris et al. 2011). However, some resource-dependent countries, like Chile, offer good-practice examples (World Bank 2006).
Effective Public Investment Management
High-quality public investment is essential to growth (Gupta et al., 2011) but poor investment management may result in wasted resources and corruption. The risk is increased if investment is scaled up rapidly in the face of macroeconomic and institutional absorption constraints (Berg et al., 2012). Efficient public investment management can be divided into four consecutive phases, each with several individual components (Rajaram et al., 2010) and Dabla-Norris et al., 2011):
Strategic Guidance and Project Appraisal. Strategic guidance ensures that investment projects are selected based on synergy and growth outlook, and reflect development objectives and priorities. Projects that pass this first screening must then undergo scrutiny of financial and economic feasibility and sustainability. This requires several steps – financial and economic cost- benefit analyses, pre-feasibility and feasibility studies, environmental and social impact assessments — all undertaken by staff trained in project evaluation skills. Furthermore, creating potential project lists strengthen accountability.
Project Selection and Budgeting. Vetting proposed projects requires a politically independent gate- keeping function. The participation of international experts, together with national technical experts, can enhance the quality and robustness of the review. Linking the process of selecting and appraising projects to the budget cycle is necessary to take account of recurrent costs and to ensure appropriate oversight and consistency with long-term fiscal and debt management objectives. This requires a medium-term fiscal framework that translates investment objectives into a multi-year forecast for fund and budget aggregates.
Project Implementation. This covers a wide range of aspects, including efficient procurement, timely budget execution, and sound internal budgetary monitoring and control. Clear organizational arrangements, sufficient managerial capacity and regular reporting and monitoring are essential to avoid under-execution of budgets, rent-seeking and corruption. Procurement needs to be competitive and transparent, including a complaints mechanism to provide checks and balances and a credible internal audit function.
Project Audit and Evaluation. Ex-post evaluation is in many developing countries a missing feature of public investment management systems, as are adequate asset registers. Registers are necessary to maintain and account for physical property, and should be subject to regular external audits.
*Sources: Berg, Portillo, Yang and Zanna (2012) and Dabla-Norris, Brumby, Kyobe, Mills and Papageorgiu (2011).
The variable performance of countries in managing their public investment programs points to the fact that not all have strong central management of the level and quality of public spending, properly integrated into the budget and subject to oversight by parliament. Off- budget flows are often substantial. Sub-national governments or line ministries may have considerable scope for independent action, with little effective oversight. In many countries state-owned enterprises, including powerful national resource companies, may take on fragmented responsibility for a wide range of development activities, again often with little effective oversight, either from the market or from the state.
In addition, few resource exporters have managed to sustain countercyclical fiscal policy in the face of large swings in resource markets. This leaves their economies vulnerable to destructive “boom-bust” cycles, which have a direct impact on investment quality and returns. On the upside of the cycle, spending outruns management capacity, raising the prospect of poor-quality spending as well as creating bottle-necks that raise costs for all investors. On the downside, sharp fiscal consolidation leaves partly-completed projects in limbo and may also cut the utilization of completed investments by constraining operational spending. Chile, again offers a good-practice example, of the use of fiscal rules to sustain countercyclical fiscal policy (De Gregorio and Labbe 2011).
Opening up a separate window for domestic investment by the country’s SWF has the potential to exacerbate these risks. It can further fragment the public investment program, and may even provide an avenue to bypass parliamentary scrutiny of spending. With its resources provided from resource rents and not from the capital market the SWF is not subject to oversight by market actors and institutions. Furthermore, even if the fund is restricted to commercial investments or investments with near-commercial returns, it could exacerbate macroeconomic and asset-price cycles by investing heavily when resource prices are booming. Therefore, it can only offer potential benefits relative to alternative approaches if, as a high-capacity expert investor, it operates in coordination with the government’s macro-fiscal policy.
Investment Rules and Institutional Models to Mitigate Risk
While it is not possible to eliminate all of the risks of a SWF investing in the domestic economy, it may be possible to mitigate some of them and at the same time ensure that the SWF’s engagement plays a constructive role in strengthening the quality of public investments by acting as a high-quality, commercially driven investor. This would require: (i) ensuring that its investments are not destabilizing to the macro-economy, (ii) limiting the scope of domestic SWF investments to those appropriate for a wealth fund; (iii) investing through partnerships with entities that bring credible standards for project quality and governance; (iv) establishing credible governance arrangements to ensure that the SWF operates with independence and professionalism, and clear accountability mechanisms; and (v) mandating full transparency, particularly on each domestic investment and its performance.
As a wealth fund, the SWF should not invest in projects that are justified primarily by their economic or social externalities. Such investments should be funded through the normal budget process, which should also make provision for the future recurrent costs necessary for operations and maintenance. By preserving the value of its assets over time through commercial or quasi commercial investments the SWF would perform an inter-generational wealth transfer function, compatible with the modified PI approach. Moreover, SWF investment not warranted on commercial grounds would greatly complicate the accountability of the fund as its management could no longer be benchmarked on financial returns. The fund may also not be accountable for the wider social and economic impacts of investments that may depend on factors outside its control. For example, a sectoral ministry may choose not to provide the recurrent inputs to operate the assets (such as schools) built by the fund. This dilution of accountability leaves the fund vulnerable to political manipulation.
Investing to Bring Down Power Costs
SWFs can use a variety of instruments to support domestic investment, including equity (ordinary or preference shares), debt (including subordinated or syndicated loans) and guarantees (commercial or political risk). Projects can also be implemented through Public- Private Partnerships (PPPs), contracts between public and private parties in which the latter provides a public service and assumes substantial financial, technical and operational risk. The SWF might co-invest on purely commercial terms, or it could modify the terms of its engagement to reflect clearly identified economic or social benefits. For example, the national market could be unable to support a market price for power that is high enough to justify the construction of a generation plant on commercial terms. A SWF could co-finance the project with a private company, accepting a positive but below-market return and a long investment horizon to enable an acceptable return for the private partner with lower power tariffs. A similar approach has been used in Mauritania, as well as other countries. PPPs can be attractive vehicles for SWFs that seek to promote developmental objectives while still generating reasonable financial returns. But experience shows that proposals need expert assessment to ensure that they will deliver their social and development objectives and that the balance between risk and profitability is not heavily tilted in favor of the private partners.
Nigeria Infrastructure Fund
The Nigeria Infrastructure Fund (NIF) is one of three pools of the recently established Nigeria Investment Authority (NSIA), and the only one that will invest domestically. The NIF holds a 32.5 percent share of the NSIA’s US$1 billion seed capital, the other shares being held by the future generations fund and the stabilization fund. The NSIA’s stated objectives are to “build a savings base for the Nigerian people, enhance the development of Nigerian infrastructure, and provide stabilization support in times of economic stress”. The NSIA, which commenced operations in October 2012 and made its first investment in September 2013, relies heavily on international partnerships, and this maiden investment consisted of a transfer of $200m to UBS, Credit Suisse and Goldman Sachs, for external management of a fixed income portfolio.
International partnerships are also a key part of the NSIA’s domestic investment policy. The Nigeria Infrastructure Fund will invest in sectors including power, transport, agriculture and health care, and has signed memorandums of understanding with the Africa Finance Corporation and the International Finance Corporation to work together on transactions. For power sector investment, there is an agreement with General Electric, and another one being discussed with Power China. At least, these were the publicly stated activities and goals.
*Sources: Financial Times, September 16th, 2013 and NSIA website
External governance relates to the relationship between the SWF and the state as its owner. Ownership provides certain rights and obligations, including voting on matters defined by law and by the SWF’s statutes; electing, appointing, and removing board members; and obtaining information on the performance of the SWF, its board and its management. For SWFs, the Minister of Finance usually acts as owner on behalf of the state. However, dual responsibility is possible, for example where the fund is given public policy objectives in specific sectors or spending is earmarked for specific uses. This is the case for the Nation Building Funds in Australia – a group tasked with enhancing the Commonwealth’s ability to make payments in relations to public investment in transport, communication, energy, education, health and hospitals. Particularly where several representatives act as owner, competing interests may dilute accountability and weaken the incentives for performance of the board. Therefore, clarity of roles and responsibility, transparency, as well as separation between ownership and regulatory/supervisory functions are important to prevent conflict of interests, and to ensure accountability and operational independence in the management of the SWF. Having an explicit ownership policy can reinforce the authority and responsibility of the owner and provide guidance to the board (OECD, 2006). The ownership policy defines the overall objectives of state ownership, the state’s role in corporate governance and the manner in which the policy will be implemented, including the extent of government participation (priority or strategic sectors, controlling or non-controlling share), and the policy with regard to the exercise of voting rights in equity investments (active or silent owner.
Examples of ownership arrangements
The objectives and mandate of the SWF provide the framework for the definition of investment strategies by the fund’s management, and the measurement of performance of the fund. It is therefore important that objectives and mandate be clear.7 Translating objectives into performance targets is among the tasks of the shareholder representative. These should include overall financial performance targets, and operational targets to guide business practice and monitor efficiency, and clear public policy targets to measure the fund’s contribution to local economic development whenever a home bias exits. Targets should be clear and a methodology for measuring them should be made explicit in the shareholder compact or similar agreement between the owner and the board of the fund. Since policy priorities and market conditions change over time, it should be possible to review and update these targets periodically. Benchmarking with targets and results of similar institutions can facilitate performance assessment and help to define realistic targets.
Institutional Arrangements and Independence of the Board: Lessons from New Zealand
The New Zealand Superannuation Fund is governed by a separate Crown entity called the Guardians of New Zealand Superannuation with a Board of at least five and at most seven members. Each Board member is appointed for a term of up to five years and is eligible to be reappointed. Board members are appointed by the Governor General on the recommendation of the Minister of Finance. The Minister’s recommendation follows nominations from an independent nominating committee. On receiving those nominations the Minister must consult with representatives of other political parties in Parliament before recommending the Governor General appoint a person to the Board. Board members are chosen for their experience, training, and expertise in the management of financial investments. The Guardians are responsible for establishing investment policies, standards and procedures for the Fund, including determining the proportion of money allocated to various types of investments and appoint external investment managers to manage different parts of the Fund. The Fund is authorized investment in a full range of asset classes, including domestic asset, and is required to invest on a prudent, commercial basis.
While accountable to Government, the Guardians operate at arm’s length from Government. Under the law, the Minister of Finance may give directions to the Guardians regarding the Government’s expectations as to the Fund’s performance (overall risk and return), but must not give any direction that is inconsistent with the duty to invest the Fund on a prudent, commercial basis. The Guardians must have regard to any direction from the Minister. But they are free to enter into investment arrangements that best suit the Fund’s purpose with minimum agency risk. Any direction given by the Minister must be tabled in Parliament. In addition to reviews by the Office of the Auditor General, an independent review of how effectively and efficiently the Guardians are performing their function is carried out every five years. This independence was tested in 2009 when the Ministry of Finance sent a request to the Fund to increase the Fund’s domestic investments citing national interests. The request stated the Government’s expectations that the Fund should increase domestic investments to 40 percent of the total portfolio. The Government’s objective was to increase investment in New Zealand’s productive sector, and further the development in domestic capital markets. This was to be done consistently with the Fund’s duty to invest “on a prudent, commercial basis”, in accordance with the relevant legislation.
The Guardians, however, considered the request at odds with the Fund’s mandate to maximize return over a long-term horizon without undue risk and consistent with best practice portfolio management. If allocation to New Zealand assets were to substantially increase beyond the then-current 18 percent share of the total portfolio, the Fund would run the “risks associated with asset concentration, the relative illiquidity of New Zealand assets, and other relevant idiosyncratic risks associated with investing in any single location.” Consequently the Guardians did not offer “an assurance as to how much, if at all, the Fund’s New Zealand assets will increase” based on “the unpredictable nature of future commercial, prudent, investment opportunities”. It was noted that in order “to guarantee an increase to a prescribed percentage would require a modification to the Fund’s commercial objectives” in the relevant legislation. The Guardians concluded that “while local investment activities may produce positive benefits (externalities) in assisting developing New Zealand’s capital markets, we cannot take these externalities directly into account when making an investment decision under our current Act”.3 Specialized committees are often used to improve performance of the board. These include the audit committee, the remuneration committee, the risk management committee, the corporate governance committee, and the ethics committee. While most SWFs have established audit and executive committees, remuneration, risk management, and corporate governance committees are a relatively new trend.
Though not entirely novel, SWFs that are permitted or mandated to invest domestically are emerging on a wider scale. They have not been systematically surveyed so that much remains to be understood about their processes and activities. The emergence of SWFs with domestic investment mandates represents a shift of emphasis on the role of natural resource rents in development towards domestic investments. About 20 sovereign funds now have at least some specific mandate in this area, including some that traditionally have invested abroad. As resource markets stay strong and more countries make discoveries, more domestic investment mandates are being established.
While information on the policies and performance of domestic portfolios is incomplete, experience indicates that a SWF that is permitted or mandated to invest domestically, like a development bank, risks being influenced by the political economy of the country. The downside risks are large, and in some views prohibitive. Many resource-rich countries flush with funds have invested but seen little payoff. Sometimes this has been due to accelerating investment beyond the limits of macroeconomic or management capacity. Investment programs have also often been politically captured, used to distribute patronage and undermined by corruption. Unlike development banks that need to obtain market-based funding, SWFs are endowed by budget transfers or by direct payments from resource sectors. They are not subject to similar market discipline, increasing the downside risks. Only if a SWF is allowed to operate as a professional expert investor can it strengthen the management of the public investment program and contribute to building national wealth.
The experience of similar institutions suggests a number of considerations that a country contemplating allowing a SWF to invest domestically might consider. The overall objective is to create a system of checks and balances to help ensure that the SWF does not undermine macroeconomic management or become a vehicle for politically driven “investments” that add nothing to national wealth. The difficult environments in which some SWFs are being established suggest that these will often be major concerns. The main priorities concern the criteria for selecting investments, partnerships, external and internal governance clearly separating responsibilities for the choice of investment between the SDF and its owner. This is particularly important for a SDF that is mandated to invest in rescuing ailing SOEs, particularly when private capital is not involved in the transaction.