Without appropriate rules and adequate oversight…Sovereign Wealth Funds no guarantee for prosperity, Analyst warns

Jun 11, 2018 News

By Kiana Wilburg

Governments are often open to creating Sovereign Wealth Funds (SWF) with the intention of squirreling away excess money made on their natural resources. This money can help to support budget shortfalls, can be used for international investments or simply serve as a savings for future generations.

Economic Analyst, Consultant at NRGI, Andrew Bauer

But economic analyst Andrew Bauer has cautioned that SWFs by themselves cannot guarantee future prosperity, and may even impede growth.
Bauer is attached to the prestigious Natural Resource Governance Institute (NRGI).
The consultant cited the example of the Alberta Heritage Savings Trust Fund in Canada, which was designed in part to save oil revenues for future generations. Yet, it failed to save anything in all but two years between 1987 and 2012.
As for Trinidad and Tobago, Bauer said that this country’s Heritage and Stabilization Fund’s mandate to mitigate the negative effects of oil revenue volatility on the country’s budget, actually led to worse public investment decisions. He said that it even led to slower growth.
Elsewhere, as in Kuwait and Libya, the NRGI official highlighted that SWFs became channels for corruption and patronage, diverting billions of dollars away from social service and infrastructure spending.
Bauer emphasized that SWFs by themselves do not guarantee sound macroeconomic management. In fact, the economic analyst said that these Funds may complicate budget processes and make public spending less accountable.
Bauer said, “SWFs can be useful, but only if they help fulfill at least one macroeconomic objective, such as mitigating the impact of oil or mineral revenue volatility on government spending, or ‘parking’ oil windfalls until they can be spent more efficiently.”
The economic analyst said that a global study of natural resource funds by the NRGI and Columbia Center for Sustainable Investment (CCSI) found that there are two pre-conditions for funds to function as planned: Appropriate rules must be enacted, and there must be adequate oversight and enough broad-based consensus to ensure compliance with those rules.
APPROPRIATE RULES
While there is no one-size-fits-all solution, Bauer said that the joint study of the two institutions offers guidance.
With regard to deposit and withdrawal rules, the analyst said that these determine the timing, amount and conditions for the sovereign wealth fund’s inflows and outflows, either to or from the government’s main bank account.
Bauer said that withdrawal and deposit rules must be tight enough to constrain government spending but loose and flexible enough to withstand political pressures to spend more.
“For instance, Timor-Leste enacted a rule that only allowed its government to spend three percent of petroleum wealth in any given year. This rule was too restrictive given the country’s capital scarcity, high poverty levels and the high social rate of return on domestic investment. As a result, the rule has consistently been broken. Further guidance on deposit and withdrawal rules can be found here.”
Bauer then turned his attention to investment risk limitations. In this regard, he pointed out that SWFs hold public assets to improve macroeconomic management or for safekeeping. As such, he noted that governments should not be allowed to gamble with these funds and their asset portfolios should reflect their purpose.
“For example, a petroleum fund designed for stabilizing budget expenditures would require more liquid assets than a savings fund designed to benefit future generations since the government might need to draw on these assets if oil revenues collapse unexpectedly…Regardless of the asset allocation used, SWFs should be explicitly prohibited from investing in certain high risk assets, such as junk bonds.”
Bauer said that Governments must also monitor conflicts of interest and set clear investment guidelines. Where there is inadequate oversight and rules are unclear, he said that it is often too easy for investment managers to invest with political allies, family or friends.
“Equally, following the precedents set by Abu Dhabi (UAE), Botswana, Chile, Kazakhstan and Norway, among others, legislation should strictly prohibit SWFs from investing domestically. Spending directly out of the SWF could bypass the normal budget process, including parliamentary, auditor, media or citizen oversight.”
Bauer said that this could result in inconsistencies with the budget and circumvention of controls and safeguards such as project appraisal, public tendering and project monitoring. In Angola, Azerbaijan, Iran and Russia, Bauer said that SWFs have been used as secondary budgets, becoming easy sources of patronage or financing for investments that support the political goals of fund managers.
As for institutional structure, Bauer made the point that there should be a clear division of responsibilities between the legislature, president or prime minister, the fund manager, the operational manager and external managers to help funds meet their objectives and prevent corruption. Again, he noted that there is no standard solution, but guidance from those who have studied the area is always recommended for consideration.
TRANSPARENCY
On the issue of transparency, Bauer stressed that disclosure requirements should be legislated. He said that bodies like parliaments, fiscal councils, and the media cannot perform their oversight functions unless they have access to adequate and verifiable information. Bauer noted that the Alaska Permanent Fund (USA) is a model of transparency, which has helped to reduce conflict over the distribution and management of Alaska’s petroleum resources.
Bauer said, “But even the best rules will not be followed unless there is ex ante broad-based consensus on these rules and ex post effective and independent oversight of SWFs. Rules established only between governments, international financial institutions and expert advisors alone are not likely to survive a political transition or even minor pressure to break the rules. Compliance is ultimately a political problem, and as such requires a political response.”
“Cognizant of this reality, the Ghanaian government took the initiative when, prior to the enactment of the Petroleum Revenue Management Act, it carried out extensive public consultations, including a national survey on how Ghana should manage its petroleum revenues, regional town-hall meetings, and appeals to experts, civil society and the diplomatic community for technical advice. These consultations gave Ghanaians and internationals a sense of buy-in and stewardship over the law. A similar exercise is currently underway in Canada’s Northwest Territories, which has just established a Heritage Fund to invest mineral revenues.”
Bauer emphasized that oversight with teeth, once all the rules are in place, is equally important for compliance. In this regard, he noted that external audits and constant monitoring by parliament, the media and formal bodies like Norway’s Supervisory Council or Ghana’s Public Interest and Accountability Committee, are not nice-to-have additions but rather essential components of successful fund governance.
Additionally, Bauer said that independent oversight bodies can encourage good financial management by praising compliance with the rules. He opined that they can also discourage poor behaviour by managers by imposing punitive measures ranging from naming-and-shaming to fines or imprisonment. Ultimately, Bauer said that the effectiveness of independent oversight will depend on the power of the supervisory bodies’ carrots and sticks.