Sovereign Wealth Funds in Commodity-Rich Fragile States

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    May 13, 2013

    Fragile states that are rich in profitable natural resources often struggle to protect their economies from the “resource curse” that retards their development and puts them at risk of backsliding on economic growth, social equity, and poverty reduction. Their banking and financial institutions are already weak, lacking the ability to absorb and manage price shocks from external crises. Their economies need protection from volatile price changes and investments that are sustainable and capable of benefiting future generations.

    Developed and developing countries alike have established sovereign wealth funds (SWFs) to manage surplus state income. These funds have great potential to help fragile states manage high revenue inflows from lucrative natural resources and protect their economies from volatility and unsustainable investments. But governments of fragile states that have recently established an SWF or are considering creating one should proceed with caution: to be successful, SWFs must be well managed, subscribe to international standards, make wise investments, and adhere to strict regulatory frameworks. Not all fragile states are capable of doing those things.

    SWFs are state-owned investment funds that are established to manage, dispense, and invest surplus national income, usually from lucrative natural resource exports. SWFs are meant to be run by an independent and apolitical board that determines how the money should be invested. Although financed primarily with foreign currency, SWFs are managed separately from a country’s official foreign currency reserves. By putting excess revenue into a fund, rather than allowing it to enter the economy, the government can smooth and manage market prices over the long term, which is a major challenge for resource-rich states.

    SWFs can benefit a fragile country in several ways. They can promote internal balancing and diversification by investing in an array of projects both at home and abroad. A major component of the resource curse comes in the form of rapid appreciation of the exporting country’s currency as resource rents flow in, a phenomenon known as “Dutch Disease.” SWFs can counteract this by holding foreign income outside the domestic consumption economy. They can invest in projects or assets that are usually perceived as risky by other investors because they are not meant to be bound by creditors and are not concerned with maximizing returns in the short term. A diverse economy is more equipped to manage financial crises or sudden rises or falls in the price of a commodity, which have hit some countries hard in the past. When oil prices fell in 2008, Angola was forced to take a $1.3 billion loan from the IMF to offset the loss in revenue. As sub-Saharan Africa’s second-largest producer of crude oil, Angola had relied on the revenue from oil for 80 percent of its annual revenue and almost half of its GDP. Following the example of other commodity-rich countries in Africa, however, Angola established a SWF to manage oil revenues in October 2012 with the hope of making it operational by mid-2013.

    By investing in economic and social development internally, SWFs can balance an economy and protect it from both internal and external economic crises. Resource rents and currency appreciation can distort the local production economy, as exports become less competitive and labor shifts into the extractive industry. By investing strategically in the domestic economy, an SWF can encourage a more diversified export sector. These investments also encourage the governments of fragile states to save and invest excess revenue in a sustainable, long-term way, leaving money for future generations and capitalizing on projects that match long-term development goals. The Nigerian Sovereign Investment Authority, for example, has created a Future Generations Fund within its SWF, a reserve of money that will grow and be available to support Nigerians should resources exports decrease.

    Despite the potential that SWFs have to stabilize fragile economies and promote long-term investment strategies, they are not immune from maladministration, corruption, and a lack of transparency, any of which could make them less effective in preventing the resource curse. Fragile countries considering an SWF should be aware that they are only useful for a fragile state if certain standards are upheld.

    First, countries with an SWF should subscribe to international principles on SWFs. The Santiago Principles, a product of the IMF, promulgate best practices for SWFs with the hope of maintaining a stable global financial system and promoting transparency, government standards, and accountability. The Principles push especially for public access and disclosure of policy and investments. Although 25 nations have signed the Santiago Principles, only three signatories are developing or fragile: Botswana, Equatorial Guinea, and Libya. Nigeria, Angola, and Ghana, all of which are considered fragile, have established SWFs in the past two years but are not signatories. They should strongly consider subscribing to international norms to increase public trust in their funds.

    Second, fragile states with SWFs should be careful about the advice they receive regarding investments and management choices. When the United States lifted sanctions on Libya in 2004, the Libyan Investment Authority (LIA) allowed Western banks to manage some of the fund’s assets. But a 2010 audit by the British firm KPMG showed that those Western banks poorly managed the LIA’s nearly $40 billion in assets, charging tens of millions of dollars in fees and generating low returns. The LIA also made poor investment choices based on cronyism: the fund invested nearly $300 million in a fund headed by the son-in-law of the head of Libya’s state oil company.

    Third, SWFs should place an emphasis on transparency, accountability, and public access. SWFs have a reputation for being secretive, and many are perceived as lacking accountability for risky investment decisions. Some of the least transparent SWFs are those that already exist in fragile and poor states, which also suffer from high levels of corruption: Nigeria, Mauritania, Brunei, Algeria, Libya, and Kiribati. One way to combat this is to maintain strict regulatory frameworks. In the mid-1990s, Chile, which struggled with chronic inflation and high poverty levels, created two SWFs for pensions and economic stabilization. With rigorous rules and codes, the funds quickly made Chile an example for other unstable countries and set the funds on a par with those of the most developed countries, including Norway. The government of Chile adopted a stringent fiscal responsibility law in 2006, requiring that 0.5 percent of GDP of the previous year’s surplus be allotted to the pension fund, the next 0.5 percent to the central bank, and the remaining surplus to the stabilization fund. Strict rules such as these can safeguard SWFs from politics and create standards that prevent politicians from raiding funds in the future.

    Another way to increase transparency and accountability is to maintain truly autonomous bodies to run the funds. This is perhaps the area where U.S. policy experts and international financial institutions such as the IMF can best help commodity-rich fragile states manage the resource curse. U.S. officials have the capacity and technical knowledge to help governments draft the legislation for SWFs and oversee their implementation. Given shrinking aid budgets and a changing aid environment, U.S. policymakers must refocus development efforts toward spending less money but having a greater impact, and this offers a possibility for doing so. Once an SWF is established, U.S. officials could contribute to oversight management and provide investment advice. International oversight would also protect funds from swaying political will. Although safeguards are usually put in place, they are highly dependent on political will, and if a short-term issue becomes pressing for future politicians of a fragile state, little prevents them from dipping into the fund in the future.

    Sovereign wealth funds have great potential to help fragile countries with lucrative commodities manage high revenues and invest in sustainable development. With proper management, and drawing on the examples of successful funds, a SWF in a fragile state could stabilize an economy, protect it from price shocks, and assist the government in investing in long-term development goals. U.S. policymakers and the international community now have the chance to help existing funds overcome the issues of transparency and misuse through oversight and technical assistance and to help countries set up new funds that adhere to international standards of operation.

    Sadika Hameed is a fellow with the Program on Crisis, Conflict, and Cooperation at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Kathryn Mixon is the program coordinator and research assistant for the CSIS Program on Crisis, Conflict, and Cooperation.

    Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

    © 2013 by the Center for Strategic and International Studies. All rights reserved.

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