Commodity Endowment Funds Moscow March 9-10 Roberts L. Grava Jennifer Johnson-Calari World Bank rgrava@worldbank.org jjohnsoncalari@worldbank.org
Challenges of managing commodity revenues Macro issues Smoothing of government revenues Preventing boom/bust cycles Avoiding real appreciation of exchange rate Preserving capital and transforming of depleting resources into permanent income Coming to political consensus on use of revenues Domestic versus overseas investment Spending today versus spending tomorrow Micro issues Setting up governance structure and investment strategy so that risk/returns meet fund objectives Building institutional capacity to manage complex investment program
Budget focus DUAL FOCUS Savings and investment focus Stabilization Fund Commodity Endowment Fund Fund Fund for the Future Endowment funds--meet both current spending and capital preservation objectives
Stabilization fund Shifts money from one budget period to another Sterilizes foreign exchange inflows prevent appreciation of real exchange rate and protect tradable economic sectors Problems Funds subject to political raids Spending rules based on threshold prices-- not sustainable in non cycular markets No relationship between spending and total wealth Foregone income due to investment in low return investments
Fund for the future Transfers wealth to future generations Generates significant investment income Sterilizes excessive foreign currency inflows Problems Lock-box approach and lack of attention to current income needs Difficulty in garnering political support Small relative allocations (historically 90%/10% rule)
Commodity endowment fund Preserves capital while meeting minimum government revenue requirements for budgetary finance Generates significant investment income Smoothes revenue volatility (oil taxes plus investment income) through investment assets negatively correlated to oil and gas Sterilizes foreign currency inflows Provides an upper bound on annual spending based on total wealth Problems/challenges: Achieving political consensus on spending rules/guidelines Simulation modeling required to ensure spending rules/guidelines meet objectives Simulation is non water-tight and future market developments could still produce surprises
Commodity fund design: Form follows function Trade-off Capital preservation for future spending Meet current income needs Generating independent source of f/x income Smoothing of f/x revenues Sterilizing foreign currency (f/x) inflows Saving rule or guideline based on total wealth that assures minimum annual income to government and meets future spending needs Investment in diversified portfolio of risk assets for return Investment in financial assets with low or negative correlation to commodities Investment only in overseas assets Domestic investments flow through budget process
Commodity fund: balances capital preservation and spending requirements 160,000 140,000 120,000 100,000 80,000 Oil Production (bbl/day) 1400.0 1200.0 1000.0 800.0 600.0 Net Oil Revenues (Million USD) 60,000 400.0 40,000 20,000-2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 200.0 0.0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 Capital preservation: Size of Permanent Fund (Million USD) Annual spending: Available for Spending (Million USD) 400 10,000 350 From Oil Revenues From Capital Market Returns 8,000 300 6,000 250 200 4,000 150 2,000 0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 100 50 0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 The values expressed in these and subsequent figures are expressed in real terms (i.e. 2005 dollars). Example for region with 500 million barrels of oil expected to last from 2006 to 2024
Rules balance current and future spending: trade-off 1600.0 1400.0 1400.0 Real Oil Revenues Average Spending (3.5%) 1200.0 1200.0 1000.0 800.0 600.0 400.0 200.0 0.0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 Real Oil Revenues 2030 2032 2034 Average Spending (10%) Average Spending (20%) 1000.0 800.0 600.0 400.0 Real Annual Spending 200.0 0.0 For permanent income, spending rate should not exceed long term average rate of return on investments (guideline for Norway, Alaska) nassumed real rate of return on assets is 3.5% Example for region with 500 million barrels of oil expected to last from 2006 to 2024
Guidelines balance current vs future spending base on fund objectives 450.0 400.0 350.0 300.0 250.0 200.0 150.0 Available for Spending (Million USD) 100.0 50.0 Total Wealth Approach Bird in Hand Approach 0.0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040
Savings guidelines limit spending as percentage of wealth Nigeria Venezuela Azerbaijan Kazakhstan Trinidad Norway Alaska Sao Tome No limits or guidelines Spending guideline: Amount available for spending should not exceed earnings on fund Amount available for spending should not exceed agreed percentage of total wealth in any one year Spending ceiling: Amount available for annual spending capped as a percentage of total wealth
Generating investment income: US Treasury bill returns versus portfolio of equities/bonds 30.00% 16.0 20.00% 14.0 Annual Real Return 10.00% 0.00% -10.00% -20.00% 12.0 10.0 8.0 6.0 4.0 2.0 Cumulative Real Return -30.00% 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 Real Return on 3-mo T-Bills Real Return on 50% Stocks/50% Bonds Cumulative Real Return on 3-mo T-Bills Cumulative Real Return on 50% Stocks/50% Bonds 1992 1994 1996 1998 2000 2002 2004 0.0
Value of investment portfolios
Smoothing of f/x revenues through investment in financial assets with negative correlation to oil/gas 0.5 0.3 0.1-0.1-0.3-0.5 Oil Price Changes Real Return on 50% Stocks/50% Bonds -0.7 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Financial assets have low or negative correlation with oil and gas 0.4 0.3 0.2 Diversifying Oil and Natural Gas Resources Oil Natural Gas 0.1 0-0.1-0.2-0.3-0.4-0.5 TIPS Govt. Bonds Corp. Bonds Stocks Real Estate Correlations based on annual return series from 1952-2004, except TIPS and Real Estate (1971-2004). Real Estate is US REITs, TIPS return series are hypothetical before 1997 and actual after 1997
Sterilizing foreign currency inflows Investment Income Income FUND Commodity revenues Liquidity (ruble) Investments Finance Budget: domestic investments (forex)
Simulation Model
Model objective: test robustness of fund design under uncertainty OBJECTIVES Fiscal budget requirements Fiscal smoothing TEST KEY DESIGN FEATURES SPENDING GUIDELINES RISK SCENARIOS OIL PRICE stochastic mean reverting OUTCOMES Assess distribution of outcomes versus objectives Capital preservation Future spending needs STRATEGIC ASSET ALLOCATION INVESTMENT RETURNS COVARIANCE MATRIX Adjust rules if necessary Retest Model is also a fiscal planning tool for medium term planning
Oil price scenarios
Total real revenues from extraction taxes & export Duties, RUB thsd.
Value of investment portfolios
Russia: Oil prices influence sustained spending % of Real GDP 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Real Oil Price Remains Steady at 55 USD/bbl 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 Spending From Oil Spending From Fund Spending Shortfall % of Real GDP 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Real Oil Price Declines to 30 USD/bbl 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 Spending From Oil Spending From Fund Spending Shortfall
Russia: Financial asset returns influence sustained spending Fund Invested in "Risk-Free" Assets % of Real GDP 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 Spending From Oil Spending From Fund Spending Shortfall % of Real GDP 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Fund Invested in Balanced Portfolio 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 Spending From Oil Spending From Fund Spending Shortfall
Russia: Saving vs. spending windfall % of Real GDP 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Excess Income Saved to Fund 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 Spending From Oil Spending From Fund Spending Shortfall 12.0% Spend Excess Windfall Income 10.0% % of Real GDP 8.0% 6.0% 4.0% 2.0% 0.0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 Spending From Oil Spending From Fund Spending Shortfall Windfall Spending
Governance Structure
Delegation of authority ensues from fund owners to trustees to managers Government Legislation Financial Advisory Custodian Contract Trustees (Investment Committee) Central Bank (Agent) Investment policy and strategic asset allocation MOF-Central Bank Contract Investment Management Agreement (IMA) Global Custodian Asset Manager(s)
Summing up Commodity endowment fund can meet multiple objectives through careful design Development of spending guidelines based on total wealth important for capital preservation and to meet future spending needs Strategic asset allocation should seek to maximize foreign currency income while diversifying away from oil and gas Simulation and risk models are crucial for the design of spending guidelines and strategic asset allocation We live in a world of risk. No decision is a decision. Important to design solutions that encompass risk parameters rather than ignoring it.
Oil price scenarios
Total real revenues from extraction taxes & export Duties, RUB thsd.
Value of investment portfolios