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Should Sovereign Wealth Funds Invest at Home?

Alan Gelb's picture

Sovereign Wealth Funds (SWFs) represent a large and growing pool of savings and an increasing number are owned by natural resource exporting countries. The funds have a variety of objectives, including intergenerational equity and macroeconomic stabilization. Traditionally they have invested abroad, increasingly in developing country assets, but always as part of a strategy to boost yields while remaining diversified. However, a recent trend sees an increasing number starting to invest in their domestic markets, including in infrastructure and other greenfield investments. Angola, Kazakhstan, Malaysia and Nigeria are examples; funds with a domestic investment mandate are also being established by Colombia, Morocco, Mozambique, Sierra Leone, Tanzania, Uganda and Zambia.

Why are governments looking to their SWFs for domestic investment?  Where are the opportunities – and the risks –and can the latter be mitigated?  We addressed these questions in a recent study jointly written with Silvana Tordo and Havard Halland (Policy Research Paper 6776).  They are rooted in the debate on how to apply the permanent income approach in countries benefiting from exhaustible natural resources. A traditional approach is to derive a rule for the sustainable non-resource primary fiscal balance, setting this equal to the long-run return on estimated resource wealth.  For example, if resource wealth W was estimated at twice the level of GDP and the long-run return was 5%, the sustainable non-resource deficit would be 10% of GDP.  But the rule breaks down if part of fiscal spending is on investment rather than consumption.  Why should poor, capital scarce resource exporters save abroad when they have many high-yielding investment opportunities at home?   High return domestic investments would not only add to the supply capacity of the country but increase fiscal space by boosting the return on wealth.    On the other hand, low-return investments, politically-driven and poorly managed, or current spending disguised as investment would have the opposite effect of launching the country into an unsustainable spending boom.  The source of the problem is that the SWF is owned by the same entity – the government – that seeks to promote the public investment program.  The risks can be mitigated but not eliminated; in some views they are so serious as to recommend that all SWF investments be in foreign assets with all public investment funding being appropriated through the budget.

Not too much is currently known about the domestic investment strategies of SWFs but the paper attempts to bring together the available information.  It sets out a number of suggestions as to how countries can mitigate the risks and possibly even derive benefit from the approach.  The first priority is to ensure that domestic public investments made by the SWF are considered in the context of the entire public investment plan and phased to ensure a sustainable flow of spending rather than a costly boom-bust cycle.  The second priority is to create a clear separation between the government as promoter of investments and as owner of the SWF, which needs to have the capacity to function as an expert and credible investor that can improve the quality of public investment.  Domestic investments must be screened for commercial or near-commercial financial return; for a SWF it is not enough to justify them by their economic or social externalities.  Returns should be benchmarked against those in foreign assets.  The SWF should invest in partnership with other institutions, possibly other SWFs as well as private financiers and development banks, to both spread the risks and increase scrutiny.   The governance structure of the SWF should be designed to insulate it from political pressures.  Transparent reporting is needed on investment and financial performance, with separate reporting for each large individual domestic investment.  These things are easier said than done.  As shown in the paper, the independence of public investment funds is sometimes tested even in countries with a solid governance tradition like New Zealand. 

Some of the elements outlined in the paper are included in good-practice principles for SWFs such as the Santiago Principles.  But these were not formulated with an eye to domestic investments, and may need to be strengthened in that area.  The next stage of the work is to understand more about the domestic investment strategies and practice of various funds, with a view to developing more operational guidance.