Experiences with Sovereign Wealth Fund Management Eric LE BORGNE The World Bank (Beirut office) May 10, 2013

1. Experiences with Sovereign Wealth Fund Management Eric LE BORGNE The World Bank (Beirut office) May 10, 2013

2. OUTLINE • Challenges and policy instruments available for natural resource rich countries • SWFs objectives and associated design • SWFs’ best practices and challenges • Recent trends in SWF design

3. Resource Revenue Characteristics Policymaking Incentives CREATING A LEBANESE SWF MAY, UNDER CERTAIN CONDITIONS, HELP ADDRESS CHALLENGES RESULTING FROM NATURAL RESOURCES ABUNDANCE (Resource curse/paradox of plenty) Key Challenges • Volatile: as a result of natural resource price volatility • Excessive spending today: of resource revenues, at the expense of future generations, due to excessive discounting of the future, the assumption that future generations will be richer, and/or to gain political support • Rent-seeking, corruption • Uncertain: due to uncertainty of reserve volume and production potential ex ante • Exhaustible: due to the nature of the resource • Sizable: as a share of GDP and government revenues (which translates into the high magnitude of potential impact of volatility on the economy, and the incentives for rent-seeking) Policy Objectives Examples of Potential Policy Instruments • Spend commodity revenues efficiently within a sound macroeconomic framework • Ensure revenue stabilization to avoid boom and bust cycles • Guarantee revenue sustainability for future generations and/or generate alternative sources of income different from non renewable resources • Resource Sovereign Wealth Funds • Fiscal Rules • Fiscal Responsibility Laws • Budgetary oil prices • Extractive Industries Transparency Initiative • Etc.

4. KEY DESIGN ELEMENTS OF A SWF FOR LEBANON WILL DEPEND ON THE POLICY OBJECTIVE(S) THE FUND IS MANDATED TO ACHIEVE • Potential Policy Objective Description • Stabilization • To ensure counter-cyclical fiscal policy that can mitigate the impact of highly volatile commodity prices on fiscal revenues • Precautionary • To hedge against extraordinary shifts in the fiscal situation of a country (e.g. natural disasters, blow-outs, war, etc.) • Inter-generational Saving • To set aside revenue for future generations or future needs of current generations (e.g. future pension liabilities) • To ensure intergenerational equity • Investment • To develop long-term fiscal sustainability (generate alternative non-resource revenues) • To support local or national economic development • For lack sufficient current opportunities for domestic investment or consumption expenditure that provide the same current benefits as financial investment

5. Examples of Sovereign Wealth Funds

6. Examples of Sovereign Wealth Funds

7. SUCCESSFUL SWFs SUCH AS THE ALASKAN AND NORWEGIAN FUNDS HAVE ACHIEVED DISPARATE OBJECTIVES USING VARIED INSTITUTIONAL SETUPS • Alaska Permanent Fund Corporation • Norwegian Government Petroleum Fund Institutional Setup • Income Redistribution through direct cash transfers to households to improve the quality of life of all, and of the poorest families particularly • Fiscal Management through transfers to the state budget to cover non-oil budget deficits, through conservative saving and investment to (1) generate revenue when oil runs out, (2) manage oil revenue volatility, (3) reduce public debt, (4) reduce taxes, etc. • Consists of the Alaska Permanent Fund (APF) and the Earnings Reserve Account (ERA) • 50% of resource revenues are deposited in the APF and cannot be withdrawn, while the rest remains with Treasury • Income from APF investments is deposited in ERA and used for (1) inflation proofing of APF funds, (2) cash transfers to households, and (3) other uses as per Legislature’s discretion (e.g. budget support) • Consists of one fund which is managed by the Central Bank on behalf of the government • Oil revenues are deposited in the fund and are used for making financial investments overseas with a long term horizon • Oil revenues and income from their investment is used as necessary to finance deficits in the state budget as per Parliament decisions • Deposits and withdrawals adhere to fiscal policy guidelines • Safeguarding against pressures to spend revenue • Automatic stabilization • Insulation of investment policy from political arena • Contribution to increase in average income of the poorest families • Sterilization of oil revenues through overseas investment • Accumulation of liquidity buffer that can stabilize potential future fluctuations in oil revenue and fund investment income Achievements Objectives

8. OTHER SWFs, SUCH AS THOSE IN THE ASIA PACIFIC ISLANDS, HAVE NOT BEEN AS SUCCESSFUL IN ACHIEVING FISCAL GOALS • Fiscal Challenges Facing Many Asia Pacific Economies Lessons Learned Causes of Fiscal Challenges • Without consistent overall fiscal framework (incl. strong spending controls and cash management), a SWF is unlikely to achieve its objectives of limiting size and volatility of spending. • Rigid operational rules limit • ability to use funds for stabilization, • ability to adjust to changing circumstances, and • may result in need for costly borrowing • Asset mgtstrategy (incl. chosen level of risk-return tradeoff) must be consistent with SWF policy objectives (e.g. stabilization vs. income generation) • Volatile government spending and fiscal deficits • Weak spending controls • Poor cash management • Rigid SWF operational rules • Accumulation of expensive debts and/or payment arrears • Poor / fragmented cash management combined with rigid SWF withdrawal rules (e.g. Marshall Islands and Tuvalu) • Depletion of cash reserves due to required contribution to SWF’s (e.g. Marshall Islands) • Significant or complete depletion of SWF funds • Use of SWF funds as collateral to finance fiscal deficits (e.g. Papua New Guinea, Nauru*) • Risky and/or undiversified investment, mismanagement and poor governance (e.g. Nauru) * This led to the closure of the SWF and the depletion of almost all SWF assets, respectively Source: Le Borgne and Medas, 2007, “Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages”, Working Paper 07/297, International Monetary Fund, Washington, DC

9. GLOBAL TRENDS IN SWF DESIGN ARE SHIFTING TOWARDS FUNDS THAT ARE FELXIBLE, TRANSPARENT, AND INTEGRATED WITH FISCAL SYSTEMS AND COUNTRY INVESTMENT STRATEGIES Description • Design Feature • Integration of resource revenue expenditure with the budget system ensures spending decisions are aligned with fiscal policy and addresses fungibility challenges (e.g. Financing Funds in Norway, Timor Leste) • This, however, eliminates SWF role in enforcing fiscal discipline in resource revenue expenditure Integration with Budget Systems Flexible Operational Rules • Flexible rules (for deposit and withdrawal) facilitate use of funds for stabilization, avoid need for costly borrowing or arrears in asset accumulation period, and permit adjustment to changing circumstances (e.g. Norway) Limited Earmarking and/or Extra-budgetary Spending • Limited earmarking and/or extra-budgetary spending using SWF funds ensures • Flexibility to adjust to changing conditions and priorities, • Efficiency of spending through competition for resources between priority areas • Simpler liquidity management Investment Coherence with Country Investment Strategy • Integration of SWF investment policy in country’s broader fiscal and asset management strategy avoids simultaneous accumulation of public debt and SWF financial assets • Choice of portfolio geared towards maximizing (risk-adjusted) financial return, conditional on underlying fiscal objectives (e.g., stabilization, long-term fiscal sustainability) Transparency & Accountability • Fund oversight (including performance reports, external audits, standards for disclosure of information) can promote better performance, limit corruption, and build public confidence in the management of resource revenues and in turn foster public support for the fund Source: Le Borgne and Medas, 2007, “Sovereign Wealth Funds in the Pacific Island Countries: Macro-Fiscal Linkages”, Working Paper 07/297, International Monetary Fund, Washington, DC

10. Thank You http://worldbank.org/Lebanon

11. Extra Slides

12. COMMON FEATURES OF OIL FUNDS Special dissemination programs, limited public debate • Prior information campaign • Establishment • Accumulation and Withdrawal • Management and Investment • Governance Constitutional amendment, parliamentary act, presidential decree Rigid rules, budget support, mixed Special fund strategy body, investment advisers, external managers, target returns and benchmarks, permitted investments Autonomous body, multilevel oversight, published audits and performance reports,

13. Withdrawal Rules Accumulation Rules OVERVIEW OF ACCUMULATION AND WITHDRAWAL RULES AMONG SWF’S AROUND THE WORLD Description • Direct Transfers: • Price or revenue contingent deposit rules (Algeria, Iran, Mexico, Russia, Trinidad and Tobago, Venezuela, etc.) • Pre-determined share of oil revenue is deposited into the fund (Equatorial Guinea, Gabon, Kazakhstan, Kuwait, etc.) • All government oil revenue (Chad, Sao Tome et Principe, Timor Leste, etc.) • Indirect Transfers:Oil revenues are first paid to the treasury, then a part is transferred to the fund (Norway, etc.) Each method has pros and cons. Whatever the methodology, operational rules need to be consistent with actual fiscal policy. Oil fund gross assets should not detract attention from the government’s overall net financial position. • Fully specified mechanisms: • Price or revenue contingent withdrawal rules • Earmarking for specific uses (Alaska, Azerbaijan, Chad, Ecuador, ..) • Financing funds: Budget needs (e.g. Norway, Timor Leste)

14. OVERVIEW OF SWF INVESTMENT POLICIES Increasing tolerance for short term risk and decreasing need for liquidity

15. SANTIAGO PRINCIPLES FOR MANAGING INSTITUTIONAL RISKS FACED BY SWF’S Key Institutional Risks facing SWF’s… …can be managed using Santiago Principles • The main problem that SWF’s face over time is the potential conflict between their strategic objectives and short term political objectives. • This conflict may result in • Direct raiding: funds are used for purposes other than originally intended, or ex-ante contributions are not paid • Indirect raiding: unsustainable fiscal behavior e.g. excessive debt accumulation on the back of fund’s resources • Inefficient management of funds: constraints on investments that are inconsistent with the fund’s long-term objectives because of reputational risk concerns • Sound legal framework to enable SWF to accomplish its stated objectives • Clearly defined and publicly disclosed SWF strategic objectives (in particular for the procedure that governs accumulation and withdrawals) • Institutional arrangements for fund management shielded from political interference and supportive of efficient management of funds to achieve SWF objectives

16. The Case of Alaska Alaska Constitution Article IX, Section 15 Alaska Permanent Fund. At least twenty-five percent of all mineral lease rentals, royalties, royalty sale proceeds, federal mineral revenue sharing payments and bonuses received by the State shall be placed in a permanent fund, the principal of which shall be used only for those income-producing investments specifically designated by law as eligible for permanent fund investments. All income from the permanent fund shall be deposited in the general fund unless otherwise provided by law [Effective February 21, 1977].

17. What are the key features of this fund? • Established by constitutional amendment • Managed by autonomous body with clear mandate and objectives • The capital (inflation proofed) cannot be withdrawn. • Rule to determine the cash transfers to households. Most Alaskans thought the Fund should be considered a public trust and that the paramount concern should be protection of the principal

18. Flows in and out of the APF Eligible Revenues 1 Treasury APF Corporation 50% of Eligible Revenues General Fund 2 Alaska Permanent Fund 3 Income Inflation proofing 5 50% of Income available for distribution 1 Earnings Reserve Account Dividend Fund 4 Note: The Legislature decides the use of the balance remaining in the Earnings Reserve Accounts (budget support, back to the Fund, keep it on ERA to stabilize future low income.

19. Macroeconomic effects What has the Alaska Permanent Fund achieved? Description • Safeguard against pressures to spend the oil revenue; • Insulate the investment policy from the political arena; • Equal sharing of the revenue from publicly owned resources • Build a strong constituency in support of the fund Achievements • No evidence of impact on current labor force supply • Contributed to increase the average income of the poorest families • Served as automatic stabilizer

20. What is the future of the Alaska Permanent Fund? The earnings of the fund could help to address the fiscal problem of Alaska but so far no consensus has been reached on the issue….. In practice, the dividends have come to be seen as entitlements, making changes in rules a challenging proposition.

21. The Case of Norway • The Petroleum Fund was established in 1990 after a decision by the legislature to counter the effects of the expected decline in income and to smooth out the disrupting effects of highly fluctuating oil prices. • The broad objectives of the fund were to: • safeguard the long-term use of oil revenues, • manage the government’s net cash flow from oil, and • transfer money to the fiscal budget to cover the non-oil deficit. In 2006 the government established the Government Pension Fund consisting of two parts: "The Government Pension Fund - Global", which is a continuation of the Petroleum Fund, and "The Government Pension Fund - Norway", which invests in domestic companies quoted on the stock market.

22. What are the key features of this fund? • The fund can be used only for transfers to the central government budget following an annual resolution by the Storting. • The minister of finance controls the management policies of the fund: limitation of the investment universe. The fund cannot be used to provide credit to the central government or private sector entities, or to raise loans • Norges Bank invests the capital in its own name (directly/external managers) in financial instruments and cash deposits denominated in foreign currency. • Annual audit reports, and performance reports are published.

23. Flows in and out of the GPFG Source: VidarOvesen (2013), Presentation at the International Conference on Effective Sovereign Wealth Fund Management, titled “How to agree on why, when and how much to save – Norway’s experience”

24. Was the fund successful in shielding the economy from fluctuations in prices and extraction rates in the petroleum sector? • By investing abroad the fund has effectively sterilized oil revenues … but the effects of the new investment strategy are untested • Given the size of the fund, future governments should be able to cope with fluctuations in revenue (and returns). • The true long term benchmark is the pension liabilities • Given diversified portfolio, all limits on expected volatility of the returns impose costs. The Fund allows petroleum revenues to be gradually phased into the economy, and provides resources to face future pension liabilities of an aging population. Given its large size, it becomes more and more difficult to reduce volatility of the returns through investing in uncorrelated assets.

25. Conclusion • Oil funds with best management practice are subject to certain common principles: • Strong governance • Clearly defined goals and transparency • Integration with the state budget • Sound asset management strategy Broad political support for the pursued objective is an important ingredient for the efficient use of oil revenue.