Sovereign Wealth Funds: Current Standards, Practices, and Reforms Peter Kunzel, IMF Trinidad

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Sovereign Wealth Funds Current Standards,
Practices, and ReformsPeter Kunzel,
IMFTrinidad Tobago, November 5, 2008
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Overview

• What are SWFs definition and characteristics
• Current practices the SWF Survey
• Standards Generally Accepted Principles and
  Practices and the International Working Group of
  SWFs (IWG)
  
• Recent reforms and future developments

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1. What are SWFs

• Definition
• Special purpose investment funds or arrangements
  owned by the general government
  
• whose purpose is to hold, manage, or administer
  assets to achieve financial objectives
  
• employ investment strategies which include
  investing in foreign financial assets
  
• are commonly established out of BOP surpluses,
  official foreign currency operations,
  privatization proceeds, fiscal surpluses and/or
  commodity export receipts.

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1. Characteristics of SWFs

• 38 SWFs matching definition with assets over
  0.5bn in 34 countries
  
• per capita incomes vary considerably

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1. Characteristics of SWFs

• many operating for a long time, but more than
  half established since 2000
  

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1. Characteristics of SWFs

• Public Sector Financial Assets in EMKts 800
  bio to 1 tio per year
  
• SWF activities one such manifestation assets
  under management 2.2-3 trillion
  

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2. Current Practices
2. Current Practices

Source SWF Survey.
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2. Current Practices Legal Basis

• Legal basis varies
• Either SWFs are separate legal entities
  established under specific constitutive law or a
  private corporation governed by company law.
  
• Or they are not separate legal entities and are
  managed as an agency within the government or by
  the central bank.

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2. Current Practices - Objectives

• Primary Objectives of SWFs differ
• Most SWFs are set up to provide savings for
  future generations or fiscal stabilization or
  both. Their primary objective is long-term
  returns / effective management of entrusted
  assets
• For some SWFs with future expected expenditures
  (i.e. pension reserve funds) the primary
  objective is to provide for these future costs.
  
• Policy objectives are
• usually publicly disclosed
• Generally do not engage
• directly in macro polices.

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2. Current Practices - Rules

• Funding and withdrawal rules are specific to the
  SWF
  
• for pension reserve funds these are specified in
  relation to future pension expenditures
  
• for other funds funding and withdrawal rules are
  usually tied to the source of the funds (i.e.
  revenue contingent rules for fiscal stabilization
  funds or reserve adequacy requirements for
  reserve investment funds).
• Other differences exist
• retention of capital and returns versus dividend
  payments
  
• local investment

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2. Current Practices - Statistics

• Economic and financial statistics are produced on
  a regular basis
  
• either to the public or relevant national agency
  
  
• A majority of SWFs make data available to
  compilers of macroeconomic statistics
  
• most SWFs indicate that data is included in BOP,
  IIP and/or GFS statistics
  
• though SWF data cannot be distinguished as a
  result of consolidation
  

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2. Current Practices Institutional

• Investment policies are often centralized within
  the SWF
  

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2. Current Practices Institutional

• Many SWFs indicate need for operational
  independence while ensuring accountability. How?
  
• separate legal entity with comprehensive
  disclosure requirements
  
• ensure independent Board
• long term Board appointments
• limiting seats of officials on Boards
• removal from Board under exceptional
  circumstances
  
• require any Ministerial direction to SWF to be
  reported to Parliament
  

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2. Current Practices Institutional

• Financial statements are prepared according to
  prescribed accounting standards, though these may
  differ
  
• Auditing practices also differ
• internal auditing may be carried out by internal
  division or independent auditor
  
• external audits carried out by independent
  commercial auditors or by statutory auditors
  

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2. Current Practices Institutional

• Public disclosure varies significantly
• for non-separate legal entities, asset, revenues
  and expenses are usually published
  
• separate legal entities publish more detailed
  information
  

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2. Current Practices Investment/Risk

• Most SWFs have specific investment objectives

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2. Current Practices Investment/Risk

• Investment Strategies vary
• SWFs that are not separate legal entities have
  relatively traditional asset allocations (i.e.,
  highly rated government securities).
  
• Others use more alternative asset classes

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2. Current Practices Investment/Risk

• Risk management practices are in line with modern
  practices
  

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• SWFs generally do not use leverage, and have
• other investment constraints

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• Operational risk is controlled through
• separation of responsibilities (front, middle,
  and back office)
  
• back up facilities
• operational guidelines
• regular review of guidelines

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2. Current Practices Summary

• Current practices of SWFs vary considerably,
  reflecting the diversity of these institutions.
  
• Practices within various groupings or types of
  SWFs tend to be more similar (i.e., pension funds
  vs stabilization funds, legally-separate vs
  non-legally separate)
• SWFs as a group also share some broader common
  practices (i.e., macro-policies, data for
  statistical compilation, audit arrangements,
  public disclosure of institutional structure)
• Fundamental objectives of different types of
  SWFs will continue to shape their practices going
  forward
  

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3. Standards and the IWG
The International Working Group of SWFs (IWG)

• Growing importance of SWFs In October 2007 IMFC
  expresses need to engage in dialogue with SWFs,
  including on establishing best practices
  
• In May 2008 high level officials from countries
  with SWFs establish IWG and begin work on
  Generally Accepted Principles and Practices
  (GAAP) Santiago Principles
• Guiding principles for SWFs
• ensure free flow of capital and investment
• comply with regulatory requirements in recipient
  countries
  
• invest on economic and return-related basis
• ensure transparent and sound governance
  structures
  
• IWG comprised of 26 IMF member countries with
  SWFs. Development of Principles facilitated by
  the IMF in close coordination with recipient
  countries.
• On October 11 2008 Santiago Principles
  presented to the IMFC and published
  

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3. Standards Santiago Principles
The Santiago Principles

• Comprised of 24 Broad Principles and additional
  Sub-principles
  

Broad Categories

• Legal Framework, Objectives and Macroeconomic
  Linkages
  
• Institutional Framework and Governance
• Investment Policies and Risk Management
  Frameworks
  

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3. Standards Santiago Principles
Main Issue Governance and Accountability

• Checks and balances are important to ensure that
  an SWF is run efficiently and in accordance with
  the policy objectives of their owners.
  

GAPP elements Efficient Governance is promoted by

• A clear policy objective for the SWF (GAPP 2)
• A sound legal framework which sets out clear
  allocation and separation of responsibilities
  (GAPPs 1 and 6-9)
  
• Adequate reporting systemsincluding audited
  annual reports and financial statements (GAPPs 7,
  10-12, and 23)
  
• Professional and ethical standards, and clear
  rules for dealing with third parties to ensure
  integrity of operations (GAPPs 13, 14)
  
• Public disclosure of the SWFs policy objective,
  legal and governance framework to enhance checks
  and balances and promote a clear understanding of
  the SWF (GAPPs 1, 2, 16).

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3. Standards Santiago Principles
Main Issue Macroeconomic Policy Challenges

• SWFs assets, returns, and operations can have a
  significant impact on a countrys macroeconomic
  framework.
  

GAPP elements SWF operations consistency with
macro promoted by

• Appropriate coordination between the SWFs
  operation and macroeconomic authorities (GAPP 3)
  
• Clear rules on the SWFs funding and withdrawal
  that are consistent with its policy objective
  (GAPP 4)
  
• Macroeconomic datasets incorporating SWF data to
  facilitate economic policy analysis (GAPP 5).

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3. Standards Santiago Principles
Main Issue Management of the Nations Wealth

• Robust investment strategies and risk management
  frameworks guard against the mismanagement of
  funds and poor portfolio performance
  

GAPP elements SWF performance is enhanced by

• A clear investment policy showing commitment to
  disciplined investment plan and practices (GAPP
  18)
  
• Prudence and diligence in SWFs investment
  practices (GAPP 19)
  
• Execute ownership rights in a manner consistent
  with the SWFs investment policy (GAPP 21)
  
• A robust framework to identify, assess, and
  manage the risks of its operation (GAPP 22)
  
• Public disclosure of the key elements of the
  SWFs investment policies and risk management
  framework to promote accountability (GAPPs 18,
  21, 22).

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3. Standards Santiago Principles
Main Issue Commercial Behavior

• Recipient countries want reassurance that SWFs
  invest on a commercial basis and not for
  political objectives or in areas perceived to be
  of strategic importance.

GAPP elements SWFs aim to reassure commercial
orientation by

• Public disclosure of its policy purpose and
  governance framework, and relevant financial
  information (GAPP 2, 16, 17)
  
• Refraining from pursuit of objectives other than
  maximization of risk-adjusted financial returns
  (GAPP 4, 19)
  
• Public disclosure of its overall approach to
  voting in public companies it invests in (GAPP
  21)

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3. Standards Santiago Principles
Main Issue Fair competition in markets
Other investors are interested in ensuring that
SWFs do not have an unfair advantage for example
from privileged access to information.
GAPP elements SWFs commit to not gaining unfair
market advantage by

• Respecting and complying with all applicable
  host country rules, laws, and regulations (GAPP
  15)
  
• Not seeking advantages of privileged information
  or governments inappropriate influence (GAPP
  20).

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3. Standards Santiago Principles
Main Issue Financial market stability
Actual or rumored shifts in asset allocations of
large, and unclear, positions of SWFs could cause
volatility in certain markets and asset classes.
GAPP elements SWFs promote financial market
stability by

• Disclosing relevant financial information and
  key elements of its investment policy (GAPP 17,
  18)
  
• Describing the use of leverage or disclosing
  other measures of financial risk exposures (GAPP
  18)
  
• Exercising voting rights (GAPP 21)
• Having in place a transparent and sound
  operational control and risk management systems
  (GAPP 22).

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3. Standards Santiago Principles
Summary Santiago Principles

• Improves transparency and understanding
• Provides for a better informed and globally
  oriented sovereign investment community
  
• Strengthens domestic policy framework and
  institutions
  
• Furthers macroeconomic and financial stability
  interests
  
• Helps ease concerns about SWFs in recipient
  countries

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4. Recent Reforms
SWFs practices are evolving as we speak

• SWF Survey shows that 1/3 are reviewing or
  adapting organizational structure or operational
  practices
  
• Some SWFs are changing legal frameworks as a
  result (i.e. Qatar).
  
• Upgrades have come in terms of transparency as
  well
  
• new or improved websites (CIC, ADIA, KIA)
• GIC publishing Annual Report for first time

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4. Future Developments
Some outstanding Issues

• Some areas could still be strengthened
• public disclosure
• ex post disclosure of how ownership rights are
  exercised
  
• Santiago Principles may need to be revisited as
  operations evolve and markets and recipient
  country policies develop
  
• Importance of monitoring implementation

A Standing Group for SWFs

• To address some of these outstanding issues
• Formation Committee looking into constitution
  and terms of reference
  
• Proposal expected by year-end

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4. Future Developments
Some concluding thoughts

• Impact of profound changes in global economy and
  financial markets
  
• Are high commodity prices and revenues
  sustainable?
  
• What will be impact of current crisis on foreign
  exchange reserves?
  
• Exchange rate policywill reserves continue
  accumulating?
  
• Implications for Strategic Asset Allocation
• SWFs role in public sector balance sheet
  management are key to domestic and international
  financial stability
  
• SWFs will continue to play an important role in
  the global financial system