Economics of Sovereign Wealth Funds

Chapter 19 A Final Word: Views of the Sovereigns

Udaibir Das, Adnan Mazarei, and Han Hoorn
Published Date:
December 2010
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A. Alberta Heritage Savings Trust Fund: Looking Forward

Aaron Brown and Rod Matheson

Under the constitution in Canada, all natural resources belong to and are managed by the provinces. The province of Alberta is in the fortunate situation of being endowed with vast reserves of crude oil, natural gas, and heavy oil. As owner of those resources, Alberta collects economic rent in the form of a royalty when the resources are extracted and sold. In addition, Alberta collects corporate income taxes based on the net income earned by oil and gas companies operating in Alberta.

The Alberta Heritage Fund was established in 1976 with the purpose of setting aside a portion of the revenues the province was receiving from nonrenewable resources. The Alberta Heritage Savings Trust Fund Act establishes the fund’s mission as providing prudent stewardship of the savings from Alberta’s nonrenewable resources by providing the greatest financial returns on those savings for current and future generations of Albertans. Income from the fund forms part of the annual budgetary revenue used to support government spending.

From 1987 to 1994, when the province was running fiscal deficits, saving in the Alberta Heritage Fund was suspended. In 1995, Albertans were surveyed on whether the fund should continue and, if yes, how it should be managed. From that survey, the fund’s mandate was changed to be structured and managed like a traditional endowment fund with a long-term focus and an investment process independent of the government’s policy priorities. This structure remains in place today.

In 2005, when Alberta retired the debt accumulated during the 1980s and early 1990s, the government again began saving in the Alberta Heritage Fund. Savings took the form of new capital contributions from budgetary surpluses—the first since 1987—and a legislated inflation-proofing program to preserve the real value of the fund.

The government of Alberta, through the Minister of Finance and Enterprise, establishes the investment policies for the Alberta Heritage Fund but the execution of investments in accordance with those policies is accomplished through a crown corporation to ensure investments are made on an arms-length basis, independent of any interference by the government.

Sovereign wealth funds (SWFs) take on many different legal forms and structures. The Alberta Heritage Fund’s monies are fully consolidated on the province’s balance sheet and the investment income earned on the fund is included in the province’s annual income statement as revenue. Because of this, it is important to consider how the fund interacts within the broader fiscal framework and policies of the province.

An example of the need to consider the Alberta Heritage Fund in the context of the broad fiscal framework is the revenue volatility faced by the government of Alberta. The province’s revenue is significantly resource driven and, as such, is subject to large swings caused by changes in the market prices of oil and natural gas. Since 2000, natural resource revenues have accounted for, on average, about 30 percent of total annual revenues. The fund can be used as a tool in fiscal management by creating a countercyclical investment income stream.

A key component of the province’s revenue volatility is currency exposure. In 2008, a new asset allocation for the Alberta Heritage Fund with more non-Canadian assets was established. At the same time, the government’s investment manager began building capacity to increase direct investments in global infrastructure and real estate. As of the end of fiscal 2010 (March 31, 2010), the Alberta Heritage Fund’s total non-Canadian exposure was 36 percent. Although the exposure is to a broad range of foreign currencies, the predominant currency is the U.S. dollar, at about 20 percent. The foreign currency exposure is expected to rise over the next four years as the new asset mix is implemented.

Currency fluctuations are an issue for any fund that invests outside its home country and reports its results in the home currency. In the context of the Canadian institutional investor, the currency question may be fairly straightforward. For example, a Canadian pension plan can consider hedge ratios on the underlying foreign-currency-denominated assets and determine whether the short-term risks from volatility outweigh any potential long-term benefit from diversification. Canadian hedges against major world currencies are also fairly easy and inexpensive to implement.

For the Alberta Heritage Fund, and potentially any resource-driven SWF, the currency question is more complex. Alberta’s revenues are highly susceptible to fluctuations in the value of the Canadian dollar relative to the U.S. dollar. A Department of Finance and Enterprise analysis published in the 2010 budget shows that Alberta’s revenues are more sensitive to currency fluctuations than to any other single factor. Every one cent change in the US$/Can$ exchange rate results in a revenue change of Can$215 million. This can have a major impact on the budget, of Can$38 billion.

When viewing the Alberta Heritage Fund in the broader provincial landscape, in the first instance, the U.S. dollar-denominated investments amplify the risks of the natural resource assets, also typically denominated in U.S. dollars, which may be an argument for more extensive hedging. However, a second factor that must be considered is the correlation between the price of the resource commodities and the exchange rate. The Canadian dollar has significant positive correlation with the prices of oil and gas. Thus, a drop in the price of oil leads to a decline in the value of the Canadian dollar, which in turn increases the value of the U.S. dollar financial investments in the fund. Therefore, owning financial assets denominated in U.S. dollars may provide a natural hedge against declining commodity prices.

A thorough review of and decision on the currency risks facing both the Alberta Heritage Fund and the broader provincial revenue base is essential. The foreign currency exposure derived from a well-diversified global investment portfolio can be used as a tool in limiting revenue volatility.

Going forward, the Minister of Finance and Enterprise has made it a top priority to evaluate how the province saves and what role long-term savings instruments like the Alberta Heritage Fund play within a comprehensive fiscal and savings strategy. The minister and colleagues in the legislature will review when and how to add new money to the fund to benefit future generations while protecting the essential services that the fund’s income currently supports.

Since the inception of the Alberta Heritage Fund in 1976, Alberta has had a strong tradition of saving, both in the fund and in other savings vehicles. At the moment, aside from annual inflation proofing, new funds for the Alberta Heritage Fund are contributed on an ad hoc basis, and income from the fund is used to maintain a low-tax environment and provide essential services. There is wide consensus among Albertans that the government should save for our future. How that is accomplished is the question.

The first challenge for Alberta is to create a savings policy that is in the best interests of Albertans and flexible enough to be relevant in a variety of economic situations. The province will look at a variety of savings recommendations from private industry, public think tanks, and stakeholder groups, as well as a report from a Financial Investment and Planning Advisory Commission, established by the government in 2008. Among other things, the commission encouraged the government to grow the size of the fund so that significant investment income would be generated and available to replace the reduced revenues derived from diminished (or obsolete) natural resources in the future. A range of options for a savings policy will be considered. Important considerations include the trade-off between the discipline provided by an “off the top” revenue capture strategy and the flexibility provided with an “off the bottom” budget surplus allocation plan.

A second challenge will be finding the right balance between the need for short-term savings to manage fiscal imbalances—which may occur for relatively short periods (say three to five years), caused by declines in the market price of the commodity—and long-term savings to achieve the objective of providing significant investment income to replace the income when the commodity has been depleted or is worth much less.

Regardless of what decisions are eventually made on these issues, the Alberta Heritage Savings Trust Fund is and will continue to be an outstanding legacy for Albertans. The government will do its utmost to maintain the fund’s mandate of providing prudent stewardship of Alberta’s savings and providing the greatest benefit to both current and future generations of Albertans.

B. Managing Chile’s SWFs Beyond the Global Financial Crisis

Eric Parrado


During the last decade, Chilean governments have followed a countercyclical fiscal policy that seeks to decouple government spending from the effects of economic and commodity-price cycles, and to ease business cycle fluctuations. In 2001, a structural surplus rule was introduced for the central government budget. Under the rule, annual fiscal expenditure is calculated in accordance with the central government’s structural income, independently of fluctuations in revenues caused by cyclical swings in economic activity, the price of copper, and other variables that determine effective fiscal income. This implies that the government saves during upswings, when it receives significant transitory revenues, and can avoid the need for a drastic tightening of fiscal spending during downturns, thereby stabilizing the growth of public expenditure over time.

The fiscal rule was complemented by the introduction of a Fiscal Responsibility Law in 2006 that created two sovereign wealth funds (SWFs) as vehicles for managing the surpluses resulting from the application of the structural policy rule. The Pension Reserve Fund (PRF) was designed to help fulfill fiscal obligations in the areas of pensions and social security. Specifically, the fund is earmarked as backing for the government’s guarantee to basic old-age and disability solidarity pensions and solidarity pension contributions for low-income pensioners. The Economic and Social Stabilization Fund (ESSF) was created to finance fiscal deficits that may occur during periods of weak growth or low copper prices; it can also be used to pay down public debt and finance the PRF. In this way, it helps to reduce cyclical variations in fiscal spending, ensuring long-term financing for social programs.

Capital Contributions

The minimum annual amount paid into the PRF is equivalent to 0.2 percent of the previous year’s GDP, although if the effective fiscal surplus exceeds this amount, the contribution can rise to a maximum of 0.5 percent of the previous year’s GDP. The transfer of resources must be made during the first half of the year.

Under the Fiscal Responsibility Law, the government was authorized to recapitalize the Central Bank of Chile (CBC) during five years beginning in 2006 by an annual amount of up to the difference between the government’s contributions to the PRF and the effective fiscal surplus, with an upper limit of 0.5 percent of GDP. In 2006, 2007, and 2008, this recapitalization was equivalent to 0.5 percent of GDP.

The remainder of the effective surplus, after payment into the PRF and recapitalization of the CBC, must be paid into the ESSF. Repayments of public debt and advanced payments into the ESSF during the previous year can, however, be subtracted from this contribution (see Figure 19B.1).

Figure 19B.1Fiscal Savings Rule

Source: Ministry of Finance.

Institutional Framework

Investment of the assets of the PRF and the ESSF calls for a clear and transparent institutional framework that provides the necessary structure for making and implementing decisions, monitoring risk, and controlling investment policy. The basis for this framework was established in the Fiscal Responsibility Law. In addition, in 2006 the Finance Ministry appointed the CBC—subject to the approval of its governing board—as the fiscal agent for the management of both funds and established the general framework for their administration. The Finance Ministry also created the Financial Committee in 2007 to advise the Finance Minister on the investment of the assets of the ESSF and the PRF (see Figure 19B.2).

Figure 19B.2Governance Structure

Source: Ministry of Finance.

Investment Policy

The investment policy, defined when the PRF and the ESSF were created, involved asset classes similar to those used by the CBC for international reserves. This choice was based mainly on the CBC’s vast experience managing these asset classes. In the first quarter of 2008, a new investment policy more closely aligned with the funds’ characteristics was drawn up, but its implementation was postponed as a result of the global financial crisis, and the original investment policy remained in force throughout 2008.

Under the original policy, 66.5 percent of the funds’ assets are held as nominal sovereign bonds, 30 percent as money market instruments—such as short-term highly rated bank deposits and treasury bills—and 3.5 percent as inflation-indexed sovereign bonds (see Figure 19B.3). This is a conservative policy given that it does not include asset classes with higher levels of risk such as equities, corporate bonds, and alternative investments.

Figure 19B.3Asset Allocation

Source: Ministry of Finance.

In addition, a reference allocation by currency has been established, specifying 50 percent in U.S. dollars, 40 percent in euros, and 10 percent in yen, with a restriction of up to a 5 percentage point variation on these values. These guidelines also allow investments in instruments in other currencies but require exchange-rate coverage tied to one of the three other currencies.


The Chilean government’s commitment to developing and improving all aspects of the funds’ management includes the transparency of their decisions and access to relevant information. To this end, it systematically prepares and publishes reports about the SWFs’ situations, provides information about the main issues discussed in each meeting of the Financial Committee and about its recommendations, and discloses all significant decisions about the SWFs’ management adopted by the Finance Ministry.

To guarantee public access to all relevant information about the ESSF and the PRF, the Finance Ministry has created special Web sites in Spanish and English containing all monthly, quarterly, and annual reports about the funds; the recommendations of the Financial Committee and its annual report; the legal and institutional framework for the funds; and press releases and other information. This commitment to effective and opportune access to information was particularly important in 2008 when the global financial crisis and the liquidity problems experienced by different financial institutions around the world meant increased demand for information about the position of the institutions in which the funds’ assets were deposited as well as about the intermediaries and custody services used. This led to a decision to publish quarterly reports about these institutions, rather than the annual report issued through September 2008.

As part of Chile’s commitment to best SWF practices, the government decided to participate actively in initiatives launched by several international organizations in a bid to establish an operating framework for SWFs and promote their transparency. Both the Finance Ministry and the CBC have taken an active role in the International Working Group of Sovereign Wealth Funds (IWG). The IWG concluded its discussions with a broad agreement on best principles and practices of SWFs. This agreement is known internationally as the “Santiago Principles.” Chile’s active role in this meeting reflects its government’s commitment to promoting transparency in the management of resources that belong to all Chileans and to the creation of a permanent forum for the exchange of views and information among different SWFs and the countries in which they invest.

Chile’s efforts to improve transparency have been internationally recognized. In a ranking published by the Peterson Institute for International Economics in April 2008 the ESSF was awarded 82 points out of 100 for transparency and accountability, taking sixth place out of 34 SWFs. In the overall ranking, which also included other aspects, such as fund structure, objectives, fiscal treatment, organization, corporate governance, and use of derivatives, the ESSF ranked eighth. Similarly, in 2009, Chile obtained a perfect score in the Sovereign Wealth Fund Institute’s global ranking of transparency and good administration of the world’s 45 major sovereign funds.


When the global financial crisis hit, Chile’s economy was in an excellent position to mitigate its effects. The country’s preparedness was, to a great extent, the result of lessons learned from previous crises. After a 1982 banking crisis, Chile began to implement prudent and modern financial regulations with high standards of supervision. This allowed Chile to face the recent global credit crunch with a solid and well-capitalized financial system. Likewise, after the Asian crisis in the late 1990s, Chile implemented macroeconomic policies that included accumulating financial capital in boom periods to be used during periods of greater difficulty. This improved Chile’s credibility.

The 2007–09 global financial crisis was the first crisis Chile had confronted with a flexible exchange rate. That policy helped it avoid building up currency exchange imbalances and facilitated the application of countercyclical policies.

Chile’s public sector has been known for saving its surpluses. For the first time in its modern history, the Chilean Treasury is a net creditor. This was possible thanks to a framework of rules stipulating that public expenditure levels in each period must be in line with the treasury’s structural or permanent income. These policies isolate public expenditure decisions, particularly those related to social spending and investment, from the economic cycle and from fluctuations in the prices of copper and molybdenum.

Aside from the favorable fiscal situation, the inflation-targeting framework implemented by the CBC led naturally to an easing of monetary policy in the context of plummeting inflationary expectations resulting from the softening of the business cycle and the collapse of oil prices. The flexible exchange rate provided a natural cushion to accommodate fluctuations in external conditions. The CBC also accumulated a prudent quantity of international reserves that, together with treasury assets, helped Chile face the liquidity restrictions that began to arise in the latter months of 2008.

The first policy reaction was oriented toward moderating the concern associated with the initial shock and any possible impact on the local financial system. Following this rationale, in October 2008, the Finance Ministry and the CBC implemented a number of measures to ensure the economy’s liquidity in both national and foreign currencies. The CBC put an end to a program of buying U.S. dollars that it had begun in April to accumulate reserves; opened a window for US$500 million auctions of 28-day currency swaps, which it later expanded to 180 days; eased collateral requirements for repo operations; and temporarily loosened bank reserve rules. For its part, the government auctioned off US$1.05 billion of treasury assets in U.S. dollars for deposits in the local banking system.

Chile’s government put in place opportune, substantial, and temporary fiscal measures. In January 2009, Chile became one of the first countries to react to the global crisis by announcing an extraordinary fiscal stimulus plan. Close to US$4 billion, equivalent to 2.8 percent of GDP, was assigned to this package from the ESSF. At the time it was announced, this 2009 fiscal reactivation plan was the world’s second largest as measured by resources committed relative to the economy’s size.

These measures were proportional to the shock the country was facing. The 2009 fiscal impulse (drop in tax collection plus increased spending) was similar in magnitude to the estimated decline in nonmining exports, which would help stabilize available private income.

The fiscal plan was enhanced in March 2009 with 20 additional measures to stimulate the credit market—known as the Pro-Credit Initiative—and one month later with an unprecedented pro-employment agreement among the government, workers, and businesses. To implement this expansive fiscal policy, Chile opted for a diversified strategy, complementing increases in public investment with transfers, employment subsidies, credit subsidies and stimuli, capitalization of state enterprises, and tax discounts. Special emphasis was placed on transitory measures, giving economic agents greater incentives to increase their short-term demand to take advantage of these stimuli.

The implementation of the stimulus plans and the drop in tax collection led the government to use the ESSF again in June 2009, drawing down US$4 billion on top of what had already been withdrawn in the first half of the year. Given the objectives of the funds, countercyclical fiscal policy triggered disbursements from the ESSF and not from the PRF (see Figures 19B.4 and 19B.5).

Figure 19B.4ESSF Market Value

Source: Ministry of Finance.

Figure 19B.5PRF Market Value

Source: Ministry of Finance.

Despite the financial turbulence, the Chilean SWFs had among the highest returns of all the world’s SWFs with data available in 2008. In 2009, international markets displayed a boom in riskier asset prices, so many SWFs enjoyed strong recoveries in their market values; meanwhile, Chile stayed with the same prudent portfolio with consequent lower returns in the year. On average, the rates of return of the Chilean funds in the 2007–09 period were still higher than those of their peers.

Expansive countercyclical policies were aided by an aggressive reduction in the CBC’s monetary policy rate, taking advantage of lower inflationary perspectives and a widening output gap. The 775 basis point rate decrease over the course of 2009 brought the CBC’s interest rate to a historic low of 0.5 percent.

To enhance the monetary policy stimulus, in mid-2009 the CBC adopted unconventional monetary policy measures, mostly by establishing a term lending facility for the banking system at the current monetary policy rate. The CBC stated that monetary policy would remain at that level until at least the second quarter of 2010.

One of the more notable ways in which Chile confronted the crisis was by coordinating its fiscal and monetary policies. Coordination between the Finance Ministry and the CBC meant more efficient decision making. Chile stood out as the country with the most aggressive countercyclical policies, which substantially eased credit conditions (see Figure 19B.6).

Figure 19B.6Fiscal and Monetary Stimulus

Source: Bloomberg; author’s calculations.

Note: MPR = Monetary Policy Rate.

Banco Estado—Chile’s state-owned bank—played an important role in providing credit during the crisis. While the financial system’s total loans outstanding declined in key areas, credit provided by the state-owned lender grew significantly, especially in the commercial and consumer segments, allowing BancoEstado to increase its market share. The most recent data reveals changes in patterns of consumer lending, as other banks have begun to adjust to BancoEstado’s relative aggressiveness.


When the global financial crisis hit, Chile’s Finance Ministry had done its homework, especially regarding fiscal policy. The government coped with the crisis with resources saved during the good years. All fiscal surpluses reached US$42 billion during the 2004–08 period. These surpluses helped to diminish gross public debt from almost 45 percent of GDP in 1990 to 5.2 percent on average in 2006–09 and accumulate resources in the Chilean SWFs of more than US$20 billion when the global financial crisis started. Moreover, these funds were prudently invested, so did not have losses during the crisis as compared with most SWFs of the world.

Economic measures implemented by Chile were timely and substantial. It was one of the first countries to react to the crisis in January 2009 with a fiscal stimulus plan of close to US$4 billion (2.8 percent of GDP). The country opted for a diversified strategy: public investments, transfers, job subsidies, subsidies and stimulus to credit, capitalization of state-owned companies, and tax benefits. Temporary measures received special emphasis. The measures above were complemented by the CBC’s significant decrease in interest rates.

The appetite for risk changed dramatically. Severe losses experienced by other SWFs provided considerable insight into actual risk tolerance within their home countries. In 2007, the Chilean Financial Committee recommended a gradual modification of the funds’ investment policies on the grounds that they have longer investment horizons than international reserves and should, therefore, be permitted a higher level of risk in a bid to achieve higher returns. The Financial Committee’s recommendation envisaged a reduction in the proportion of nominal sovereign bonds and money market instruments in favor of an increase in inflation-indexed sovereign bonds and the inclusion of equities and corporate bonds. As a result, it was hoped that the funds would be able to achieve higher long-term returns (see Figure 19B.7).

Figure 19B.7Current Investment Policy vs. Financial Committee Recommendation

Source: Ministry of Finance.

The Finance Minister accepted this recommendation and the new policy was scheduled to come into force at the end of 2008. However, its implementation was postponed in view of the exceptional level of uncertainty seen in international markets in the last quarter of the year. The new assessment provided a better understanding of investment parameters: a shorter investment horizon for the stabilization fund and lower risk tolerance in each fund (high reputational risk).

Prudence, transparency, and good results improve credibility. The full cycle of the savings and expenditure process legitimized the implementation of the Chilean SWFs. The government’s credibility and approval rate improved, especially with regard to its fiscal policy. The ESSF has been fundamental in mitigating the impact of the global financial crisis. Finally, it was learned that transparency is crucial to educating the public, especially about more aggressive asset classes, but considerable effort is necessary to explain short-term volatility.

Chile has followed a long path in a few years to construct a strong institutional arrangement for its funds. The task now is to consolidate its institutions and avoid any complacency arising from its strong results in recent years. This is an everyday task. The benefits of these efforts are reflected in the positive valuation of Chile’s citizens, the owners of the resources of the funds. This is the real sovereign success.

C. SWFs and Recipient Countries: Toward a Win-Win Situation

Jin Liqun

The China Investment Corporation (CIC) was established in September 2007 as a wholly state-owned company with the objectives of diversifying and obtaining higher long-term risk-adjusted returns on China’s foreign exchange holdings. As a sovereign wealth fund (SWF), CIC was born concurrently with the arrival of the daunting challenges that accompanied the 2007–09 global financial crisis. Its managers have tried their best, however, to navigate the rough-and-tumble waters of global finance and to draw important lessons and inspiration for the future. It is these lessons that are most important for long-term investors like SWFs. Since its launch, CIC has steadily built up its institutional capacity to strengthen its governance and risk-management framework, improve its strategic asset allocation, and optimize its operating mechanism.

Many challenges, however, remain, as economies recover and risk appetite returns. During the 2007–09 global financial crisis, capital flows from SWFs were a welcome source of funding for the financial sector and other industries in many western countries, which lifted, at least temporarily, some of the barriers to foreign direct investment. SWFs were increasingly recognized as mature and credible institutional investors, playing an important role in the international monetary and financial system. Paradoxically, as their relevance to international financial and economic stability increased, their existence became a cause for concern rather than a source of comfort to some recipient countries. Keeping economies open is a challenge. Short-termism tends to prevail in difficult times, when protectionism may be perceived as a convenient policy instrument. As an example, during the crisis, many countries that previously had relaxed SWF inflows introduced support measures that favored domestic industries and domestic jobs over foreign competitors. The risk of financial protectionism is one of the key challenges that has to be addressed through concerted efforts by SWFs and recipient countries alike.


It is encouraging that both SWFs and recipient countries—at least as a group—are aware of the potential implications of protectionism for both sides and have demonstrated a willingness to address the issues. Two milestones, discussed in detail in earlier chapters of this book, were the publication of the “Generally Accepted Principles and Practices, ‘Santiago Principles’” by the International Working Group (IWG) of SWFs, and the Organisation for Economic Co-operation and Development’s “OECD Guidance on Recipient Country Policies towards SWFs,” which were completed nearly simultaneously. Each addresses the threat of protectionism, as well as many other topics, from a different angle. Protectionism is mentioned explicitly in the OECD guidance as an issue to be tackled in line with the OECD’s general investment policy principles and its broader Freedom of Investment process. The guidance calls on recipient countries to refrain from erecting protectionist barriers to foreign investment, including investments from SWFs, while acknowledging legitimate needs to protect national security interests.

It is gratifying to note that the OECD is committed to remaining a strong advocate of the free movement of capital and its long-term benefits. This policy stance is important for the smooth operations of SWFs, particularly at a time when protectionism is poised to disrupt global economic stability. Protectionist barriers set up to block the free movement of capital pose the risk of setting the economic recovery in reverse at a critical time. The OECD recognizes the key role that SWFs have been playing in the globalized economy and the immense benefits they have brought to home and host countries.

The Santiago Principles were a landmark achievement in the efforts toward best practice by SWFs, especially given that this voluntary code was endorsed by all 26 IWG member and observer countries. The principles reflect appropriate governance and accountability arrangements, as well as the conduct of investment practices by SWFs on a prudent and sound basis. They set the standards for SWFs’ operations. SWFs should help maintain a stable global financial system and the free flow of capital; comply with all applicable regulatory and disclosure requirements in the countries in which they invest; invest on the basis of economic and financial risk-and-return-related considerations; and have in place transparent and sound governance structures that provide for adequate operational controls, risk management, and accountability. Although the Santiago Principles do not deal with protectionism specifically, compliance with the principles should reassure recipient countries that SWFs’ investment decisions are not driven by political motives and, hence, should reduce the perceived risks that recipient countries may tend to try to abate through resort to protectionism.

The publication of the Santiago Principles and the OECD guidance are important first steps, but it is crucial that they are implemented and adhered to by all SWFs and recipient countries. Shortly after the publication of the Santiago Principles, SWFs established the International Forum of Sovereign Wealth Funds (IFSWF), which acts as a platform for sharing views on the application of the Santiago Principles. Progress toward implementation of the Santiago Principles is being made by members of the IFSWF, which is an encouraging, albeit slow, process.

Adherence to the OECD guidance is monitored through a peer review process. It is helpful that nonmembers participate in this peer review, and it is hoped that the majority of countries subscribe without further delay to the OECD’s 1976 Declaration on International Investment and Multinational Enterprises. At present, only 30 members and 12 nonmember countries have endorsed the declaration. Moreover, invoking the national security clause appears to be tempting for some recipient countries, even if their arguments are stretched. This author has, for instance, difficulty understanding why taking an equity share of more than 10 percent in a financial institution could be a problem for national security in the recipient country. Therefore, future work by the OECD on the Freedom of Investment process, including the surveillance of national policy developments, will be welcome.


China is the world’s largest holder of foreign exchange reserve assets. Size seems to matter, at least from the perception of the recipient country. In the aggregate, size is an important factor for central banks and SWFs, because in the last five years the total amount of official reserves has exceeded the supply of short-term government debt in the major reserve currencies.1 Hence, official institutions need investment opportunities beyond those offered by traditional asset classes.

It must be stressed, though, that like any other SWF or financial institution, CIC is defined by its behavior, which is determined by its governance and mandate, not by its size. Any individual SWF’s behavior is far more relevant than its size, so far as recipient countries are concerned. There should not be any cause for concern when an SWF is committed to making long-term investments in a recipient country to achieve a win-win situation for both sides. CIC aims to maximize the return on investment for its shareholders, under a risk-management framework consistent with its investment strategy and portfolio requirements. As a long-term investor, CIC is committed to contributing to the financial stability of the host countries, which is also in its own interest.

CIC participated in the full-scale deliberations in the process of drafting the Santiago Principles, and did a great amount of work toward the establishment of the IFSWF. Implementation of the principles is in full swing in CIC, although it is just two years into operation. Transparency is important and CIC believes in transparency. As an illustration, in 2009, CIC published its Annual Report 2008, upon completion of its first accounting year since inception. CIC has also set up an international advisory council in an effort to seek guidance on the conduct of its global investment activities, which enables CIC to assimilate the experience of well-established SWFs and other institutional investors.

CIC’s managers believe that mutual trust between SWFs and the recipient countries is the key to promoting prosperity and financial stability through cross-border capital flows, particularly long-term investments. For a variety of reasons, a high level of mutual trust and cooperation remains an aspiration rather than a reality. It will take time to attain this goal and the journey may not be smooth. However, it can be achieved. CIC is a young institution, and is working hard toward that objective, and it is gratifying to see that CIC is not alone.

D. The New Zealand Superannuation Fund: Surviving Through and Seeing Beyond the Global Financial Crisis

Adrian Orr

The New Zealand Superannuation Fund is a pool of assets purposed with reducing the taxation burden on future taxpayers of the cost of retirement benefits paid by the government of New Zealand to all eligible New Zealanders when they reach age 65. The Guardians of New Zealand Superannuation is the organization set up to manage the fund.

The cost of retirement benefits is expected to double over time as New Zealand’s population ages. The fund smoothes the associated tax burden by investing government contributions—and the returns on those investments—now, to be withdrawn later (foreseen to begin in 2031) as the tax burden rises. The fund is therefore characterized as a sovereign wealth fund (SWF) because the Guardians as its manager are a wholly government-owned asset manager without explicit liabilities.

The job of the Guardians is to invest so as to maximize returns without undue risk, according to best practice and without prejudice to New Zealand’s reputation globally. The long horizon for the investment of the fund means the portfolio is significantly biased toward growth (the ratio of growth to income assets is roughly 80:20) and seeks returns from illiquid investments. The Guardians also actively invest.

Such a long horizon and tolerance for illiquidity bring their own challenges, especially when it comes to weathering and profiting from volatile market conditions. The significant challenge is to maintain the focus on the long-term goal, and avoid being “stopped out” of investments because of concerns about marked-to-market losses in down times.

The legislative framework for the fund facilitates a long-term investment perspective. Board members are selected for their investment expertise, arms-length from political influence. And both the legislation and funding arrangements make the fund’s purpose and operational independence clear.

The Guardians also operate the fund in arguably the most transparent manner of all SWFs. Returns are reported monthly, as are much of the underlying investment rationale and asset holdings. This transparency brings significant strength because it is easy for the public to discover, understand, and have confidence in the Guardians’ investment activity.

A crucial element of this public insight is that the Guardians manage the fund relative to a notional passive alternative fund, the structure and performance of which is published. Thus, stakeholders can see both the fund’s absolute performance, as well as the value added from actively investing. Both measures of performance are important to maintaining stakeholder confidence over relevant medium-term periods.

The fund is young, with investment having commenced in late 2003. In the first four years of its existence, given its heavy growth-biased portfolio and the booming financial markets of the era, the fund earned almost twice the risk-free rate of return and experienced significant gains. It was then hit by the collapse in asset prices in late 2008 and 2009 in addition to significant correlated behavior across all asset types. Since mid-2009, fund performance has recovered strongly.

Naturally, the significant swings in investment performance during the global financial crisis resulted in a careful examination of every aspect of the Guardians’ investment practices and how they might be improved. Most important, the examination caused investment beliefs to be revisited to ensure they were well-founded and supported by the investment team and the board.

Every investment activity undertaken by the Guardians is supported by a clearly articulated investment belief, a clear strategy to exploit that belief, and a clear assessment that the fund’s resource capacity can exercise the investment strategy successfully on an ongoing basis. If these three components do not exist, the investment is not made.

During and after the global financial crisis, the following were confirmed:

  • Diversification is absolutely necessary to mitigate risk.
  • Capacity in both skills and experience to take advantage of opportunities is highly complementary to diversification.
  • Be wary of investing where the crowd does. Even good ideas can turn out to be not so good if everyone piles in at the same time.
  • It is important to ensure sufficient liquidity to remain focused on the long term and not be put in “fire sale” situations.
  • When choosing an investment manager, ensuring that the market in which it operates is conducive to excess return is as important as the manager’s ability.
  • Operational due diligence on managers is crucial, and standards need to be applied consistently to external managers.
  • Having some spare capacity in access to external managers and counterparties is critical because identifying new relationships during down times is very difficult.
  • Finally, communicating clearly and often with stakeholders—in particular, the board and the government—is conducive to a strong relationship and sound investment.

In the past six years, the Guardians have grown their capabilities, both through attracting and developing passionate and talented people, and through building and sharing knowledge through frequent engagement with peer organizations globally. Consistent with these stronger capabilities, the Guardians have widened their investment strategies.

In building and maintaining its international reputation, the Guardians participated in the International Working Group of Sovereign Wealth Funds, are represented on the International Forum of Sovereign Wealth Funds, and are a founding signatory to the United Nations Principles of Responsible Investment. The Guardians’ team is regularly invited to address experienced international audiences on every aspect of fund management.

The Guardians’ clearly articulated vision, value set, culture, investment beliefs, and investment strategies have proved necessary and invaluable to remaining a long-term and successful investor.

E. Norway: Dealing with Risk in an Uncertain World

Thomas Ekeli AND Martin Skancke

Much has been written about the value of good governance of sovereign wealth funds (SWFs). Good governance is the foundation of the Santiago Principles, which have received broad support from international observers and have proved useful to many SWFs in improving their governance systems.

A crucial aspect of a sound governance system is the way in which the SWF deals with risk. The first topic that normally springs to mind is management of the SWF’s financial and operational risks. Recent history has shown shortcomings in the construction and use of quantitative risk models, as well as in the qualitative understanding of risk at a more senior level in many organizations.

There are areas that SWFs and other institutional investors now have on their radar screens. For SWFs there is also the need to focus on risk management at the national level, in addition to risk management within the SWF’s investment operations. Many SWFs were set up specifically to mitigate risk associated with income from natural resources. These funds are the cornerstones of macroeconomic policies in their respective countries. By transforming natural resources into diversified portfolios of financial assets, the funds contribute directly to spreading risk. But the SWFs also support policies designed to diversify the economic structures of their home countries, for example, by avoiding crowding out production of tradable goods and services (Dutch disease). Thus, SWFs are risk-management tools in themselves.

Management of sovereign wealth spans financial, macroeconomic, and political issues. Risk management for an SWF thus needs to take all these issues into account to improve the chances of a good outcome for the country, both in the present and in the future. Only by securing support from the owners can sovereign wealth management be sufficiently robust to withstand the tests of time.

This book’s examination of the developments of recent years has highlighted the importance of dealing with uncertainty and risk. Financial market optimism and faith in elaborate risk-management systems evaporated as evidence surfaced of the inherent instability of the global financial system and the inadequacy of many risk models. As commodity and energy prices swiftly retraced their previous climbs, and economic activity shifted from stable growth to sharp contraction, it also became clear that the concept of risk management needs to stretch beyond the financial and operational risks associated with the investment activities of an SWF.

Many SWFs saw sharp drops in net inflows as export revenues shrank and domestic outlays rose. Those events, coupled with abysmal market returns on risky assets in the midst of the global financial crisis and the operational challenges arising from a financial system in distress, made it clear that the robustness of many SWFs’ governance arrangements would be seriously tested. Although attention before the crisis may have been focused on the management of financial and operational risks, recent events provided a backdrop that could threaten stakeholders’ confidence in the SWF arrangement itself. The implicit contract entrusting the state with the task of managing sovereign wealth on behalf of its citizens could be in danger if stakeholders no longer have sufficient trust in the sovereign and its ability to deliver public services and prudent asset management. Addressing such concerns has become an important task for many SWFs, since recent experience has highlighted the importance of strong support from stakeholders in times of crises.

SWFs are a heterogeneous group with different organizational structures, governance models, and transparency arrangements. Nonetheless, to secure long-term management of sovereign assets and to develop robust investment strategies, they share the need for strong support from their owners. Insufficient trust and confidence in the SWF arrangement by the owner can, in a period of turmoil, result in major changes that may not be conducive to the long-term interests of the sovereign or its stakeholders. For an SWF to fulfill its objective and deliver sound financial risk-adjusted returns over time, it must have in place both a robust investment risk-management framework and strong support from its owners to allow it to stick to the right strategy through changing circumstances.

Building support and trust of owners and stakeholders is a continuous process, the results of which often lag far behind the inputs to the process. Despite the many similarities between managing public money and managing private money, such as the need to enlist owners’ support for the chosen investment management strategy to ensure the necessary robustness through a business cycle, sovereign funds often bear a higher degree of public scrutiny and therefore need to participate more actively in the public deliberations.

Enabling political representatives to debate and decide key strategic issues about the management of sovereign wealth can be a demanding process, but is in many instances a precondition to achieving a good, sustainable outcome. Despite the temptation to confine the risk-management discussions to a professional group concentrating on the SWF’s investment and operational risks, ultimate goals will be best served by a broadening of the assessment to include those economic and political aspects of risk relevant to the SWF. Transparency will, in most cases, be an important part of a risk-management strategy at the national level.

The Santiago Principles offer a good starting point for work on these issues in individual countries, with the focus embodied in the principles of coordination with macroeconomic policies, governance systems, reporting, and risk management.

F. The Russian Federation: Challenges for a Rainy Day

Peter Kazakevitch AND Alexandra Trishkina

Since 2000, the Russian Federation has experienced booming oil prices. The country took advantage of the situation and accumulated substantial resources in its sovereign wealth fund (SWF), known as the Stabilization Fund (SF). Establishment of the SF in 2004 reflected the government’s will to shield itself from external forces that could not be handled in alternative ways, to accumulate reserves to pay off foreign debt, and to curb inflation. Eventually, the SF turned out to be a significant tool among the government’s economic policy measures. In the period 2005–07, the SF and other budget sources were deployed for early government debt repayment of US$47 billion in total, saving at least US$13 billion in interest payments and smoothing budget expenses.

In 2008, the SF was split into the Reserve Fund (RF) and the National Wealth Fund (NWF). As of March 1, 2009, the RF and the NWF had reached US$136 billion and US$84 billion, respectively, in assets under management. The objective of the RF is to finance federal budget expenses in periods of fiscal deficit, and the NWF’s mission is to cofinance the voluntary pension savings of Russians and to maintain a balanced budget for the Pension Fund of Russia.

In 2009–10, the Russian government used, for the first time, a sizable part of the assets of its SWFs to overcome the effects of the global financial crisis. Some US$117 billion was withdrawn from the RF to cover budget deficits.2 In addition, the government placed US$22 billion of NWF assets in long-term ruble deposits with Vnesheconombank to implement a number of unprecedented crisis measures, supporting the banking system and financial markets as well as several other sectors.

According to the federal budget law, the RF could be exhausted in 2010. Moreover, in 2010–12, the government may spend US$56 billion from the NWF to cover a deficit in the Pension Fund of Russia. Meanwhile, the government is exploring alternative means to cover a budget deficit, including internal and external borrowing and privatization, in addition to oil and gas revenues. Careful use of SWF assets permits state borrowing at more favorable terms than without these reserves.

“The crisis is unprecedented, the kind the world never faced before. In such conditions, the Reserve Fund will save Russia and protect us from the most severe and dramatic outcomes,” underscored Minister of Finance Kudrin.3 The SWFs provide the Russian Federation with a competitive advantage, adding stability to the economy. The RF and the NWF have allowed the government to continue to fulfill social commitments and to implement anticrisis measures. At the same time, however, expenditures from the funds should be monitored to ensure they are justified and effective.

In his budget speech to the Parliament on May 25, 2009, President Medvedev pointed out that the crisis demonstrated the importance of avoiding or minimizing future shocks to the Russian economy. Unfortunately, not only commodity budget revenues but other budget inflows are still highly dependent on commodities. Therefore, budget planning should be based on conservative forecasts for the prices of oil and other commodities. Windfall revenues must still be accumulated in sunny days. The president also stressed the need for rational containment of increases in budget spending.

Since their inception, Russian SWFs have mainly invested in low-risk and thus low-yield foreign fixed income instruments. Assets with higher risk, such as equities or corporate bonds, were never used. This approach resulted from the high liquidity requirements imposed on the funds. In 2009, the Ministry of Finance (MOF) excluded bonds issued by foreign state agencies, central banks, and supranationals from the funds’ investment universe, leaving only foreign government bonds. That made the Russian government, as owner of the RF, an extremely conservative investor. In 2008–09, this strategy ensured substantial investment income for the SWFs.

At the same time, the MOF realized that a diversified investment portfolio would give it more opportunities to manage risks carefully, even on the relatively short-term horizon. Therefore, the MOF is looking ahead and setting the groundwork for diversification of the SWFs’ investment strategies toward assets more profitable than foreign sovereign bonds and deposits placed with Vnesheconombank. The MOF is currently limited in implementing the funds’ investment strategies by regulation of the central bank, because the Bank of Russia is the only agent allowed to work with the MOF with regard to SWF management. The Bank of Russia is not allowed to invest in either corporate securities or alternative assets. It also cannot hire external managers. The feasibility of creating a vehicle for such investments directly at the MOF is limited for business and legal reasons.

This situation requires that a specialized financial institution with adequate capacity and expertise be set up under state control. President Medvedev confirmed this requirement in the above-mentioned speech to the Parliament. In April 2010, the MOF introduced a draft law on the Russian Financial Agency (RFA) to the government. The agency’s primary function would be management of the NWF and public debt. Further responsibilities may be added, including RF and Pension Fund of Russia money management, and Federal Treasury cash management. This leads to the concept of asset-liability management with the intent of managing risks that arise from mismatches between assets and liabilities of the state. It is expected that the RFA will be an efficient tool for public asset and debt management and at the same time a responsible advisor to the government in relevant fields.

After the breakup of the Soviet Union, the Russian Federation went through two periods: a period of rapid increases in debt followed by a period of substantial asset accumulation. Both conveyed significant lessons and now the country is at the beginning of a third period—a period of prudent asset-liability management with a Russian financial agency as the main implementing tool.


See the IMF’s International Financial Statistics for reserves, and BIS’ Securities Statistics for shortterm debt. Included in the calculation of short-term government debt are the major and most liquid issuers in currencies of the Special Drawing Rights basket, that is, the United States, Japan, and the United Kingdom, and for the euro area, Germany and France. Short-term is defined as securities with a remaining maturity of less than one year.


As of May 1, 2010.


RIA Vesti, April 22, 2009.

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