Saving the Future: Sovereign Wealth Funds as a tool for stability
"Virtù and luck are best friends—or maybe business partners. You need both to make stuff happen” - Machiavelli
By the time Norway was able to see the first drop of oil come out of the North Continental Shelf in 1971, after struggling for years of trial and error since 1962, the country realized that oil had to have a purpose and not be a purpose in itself. Little did the country know that the first oil shock would take place 2 years after making its entrance in the profitable business of oil production.
In spite of this, this country of 3.9 million inhabitants in 1973 managed to repress the desire of irrational expenditure and favor the creation of a mechanism that changed the meaning of diversification for the country.
In the 1990s, with the establishment of the Government Pension Fund Global (GPFG), Norway assured itself a bright future when compared to its other oil-producing peers who were threatened by the same economic perils. In practical terms, Norway took advantage of profit surpluses to purchase equity, bonds and real estate worldwide. To date, the fund is the proud owner of properties in several countries, including apartments along the Champs Elyssées in Paris, corporate and government bonds from a multitude of countries, and stocks in companies worldwide in fields ranging from finance to oil and gas. In total, the fund´s market value today reaches NOK 6,859 billion (USD 825.9 billion).
The question is: why didn’t Latin-American countries emulate Norway when they had the chance?
As a matter of fact, they did. In November 1998, Venezuela created the Fund for Macroeconomic Stabilization (FIEM, in Spanish) with the purpose of managing oil-revenues to smooth economic fluctuations. A very similar initiative was taken in 2003 in Ecuador, with the creation of the Fund for Stabilization, Social and Productive Investment and Public Debt Reduction (FEIREP). However, in 2005, both Venezuela and Ecuador challenged the fund’s usefulness in their own countries. Venezuela made use of the resources of the FIEM in order to create a new fund (The National Fund for National Development, FONDEN). The FONDEN became a finance mechanism for social projects in the country, with expenditures exceeding cash inflows. Similarly, Ecuador´s then Minister of Economics, now President Correa, decided to use the resources of the FEIREP to correct budget imbalances, reduce public debt and finance social programmes. Coincidentally, both countries were holding the elections that gave Correa the presidency and eased the reelection of Hugo Chávez in Venezuela.
There appears to be a correlation between oil prices and popularity in these two Latin American countries. For instance, if we look at the change in public support for Rafaél Correa and Nicolás Maduro in the period between January 2014, when oil prices averaged USD 102.1 per barrel, and compare it with that of June 2015, with the price at USD 61.3 per barrel, we can notice how popularity plummets considerably. In a country such as Ecuador, in which oil represents 52% of exports, public approval decreased by 21 percentage points. In Venezuela, with an overwhelming dependency of 93%, it experienced a decrease of 25 percentage points. In contrast, Norway followed a different trend during this period. The recently elected Prime Minister Mrs. Erna Solberg won the elections with a third of total votes and maintained her popularity--all this taking into account that oil revenues represented a central topic during the campaign in a country where exports are dominated by oil (64% of total export). This does not mean that oil prices are the sole driver of popularity, but it seems to play a more important role in countries where planning and management are poorly addressed.
In practice, countries wanting to maintain sovereign wealth funds operational require a few crucial inputs. The first one is to set guidelines for the use of resources. The fund should only be able to finance projects or provide resources to the government from the generated interests in times of expansion and only allow a slight portion of capital to be used in the case of even a severe economic contraction. Moreover, the government needs to be capable of implementing austerity policies to reduce dependency from the fund. In order to make this possible, certain conditions need to be in place.
Creating a sovereign fund is not a popular measure. The best natural moment to propose such a policy is when public debt is at low levels and the economy is experiencing an expansion. At this point, domestic pressures are manageable and directing funds to safeguard the future is an easy-to-sell idea to the public. However, this situation does not occur very often. To achieve this, governments need to find as many allies as possible in order to manage the expectations of the population and have the political will to accept the trade-off between popularity and long-term benefits, even if these are not perceived in the next 15 years.
Another highly effective mechanism to manage the public’s expectations is transparency. If the population feels that the fund can be easily dissolved, change its purpose or abused, trust will vanish and long-term plans will lose their compass. As we can see in the Norwegian Fund’s website, all investments made by the Fund are listed in a detailed manner. It is possible to know what is the percentage in shares held, the properties owned, the interests collected annually and the amount of money supplied to the government. On the other hand, other countries have taken the approach of opacity, generating mistrust with fears of corruption in the population and even hiding the real value of having this instrument in place.
Strong and independent institutions such as the Central Bank or the Parliament are peremptory in the process of keeping similar initiatives in place. These institutions need to be financially literate in order to be able to determine an investment strategy if a sound and diversified portfolio is to be built. Independence is important because an executive branch with the power to bend institutions and easily overturn long-term policies can obtain short-term gains at the expense of the policy itself, making citizens the first victims of the lack of counterbalances. Politicians in democratic countries with weak institutions have the incentive to break their commitments when they see their re-election or popularity endangered, preferring to secure a victory through boosted government spending. This was the case in Ecuador and Venezuela in 2005, where candidates took advantage of their influential positions to alter the nature and accessibility of resources at the expense of public funds.
In the end, anyone who throws a million dollars from a plane with his name on it will most certainly be a very popular person for a few days. The problem is: you do not have a million dollars all the time. The decisions of institutionalizing a sovereign wealth fund is a wise one, otherwise, resource-dependent countries will have to endure the adverse consequences of deflated oil prices while balancing the temptation of raising taxes or enforcing tax-collection mechanisms when the population is at maximum vulnerability. The last option that distressed leaders in this trap resort to is borrowing, either by issuing debt or approaching other countries or international institutions. However, the country is at the worst possible moment to pursue these goals. The deals obtained end up being far more bitter than having traded-off popularity for the future of the nation in the first place. Evidence shows that well-managed sovereign wealth funds can create the basis for stability, ultimately allowing the whole economy to progress. Countries could do well to take advantage of these opportunities.
Norges Bank, “Government Pension Fund Global”, http://www.nbim.no/en/the-fund/, viewed October 25, 2015
Sovereign Wealth Fund Institute (SWFI), “Fund Rankings”, http://www.swfinstitute.org/fund-rankings/, viewed October 25, 2015.
Cedatos, “Indices de aprobación a la gestión y crtedibilidad del Presidente Correa, a agosto 2015”,http://www.cedatos.com.ec/detalles_noticia.php?Id=205, viewed September 27th, 2015.
Croes, Gutierrez & Asociados, “Venebarometro Junio 2015”, http://edgutierrez.com/?p=1463, viewed September 27th, 2015.
United Nations Commodity Trade Statistics Database, “UNCOMTRADE Database”, http://comtrade.un.org/db/default.aspx, viewed September 27th, 2015.