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Monday, February 4, 2008

Russia Gets a Sovereign Wealth Fund

On February 1, 2008, the world saw the official launch of another sovereign wealth fund (SWF), since Russia formally launched its National Welfare Fund (NWF). This fund is likely to become another large and important SWF, even though its birth weight – possibly tipping the scales at US$32 billion or so – is modest relative to China’s CIC. If oil prices remain supported, Russia will likely see this fund grow over time. In five years’ time, the NWF could be anywhere between zero and US$320 billion, depending on how much the budget and the pension fund draw on the NWF. Initially the fund will be probably be managed conservatively, in ways not dramatically different from how official reserves are generally managed in other countries. However, as the NWF gains experience and confidence, it is likely to have a broad portfolio of risky assets, just like the other SWFs.

Back in April 2007 Morgan Staley's Stephen Jen gave some basic background information on the fund:

The birth weight of the NWF will be around US$32 billion. On February 1, 2008, the Oil Stabilisation Fund (OSF) – which forms a part of the official reserves, including gold, of US$479 billion – will be tiered into a NWF and a Reserve Fund (RF). The latter will be kept at an amount that is equivalent to around 10% of Russia’s GDP, which is currently around US$1.27 trillion, with the rest being funneled into the NWF. As of end-2007, the OSF was US$156.8 billion. Subtracting out 10% of GDP (US$127 billion), this leaves some US$29 billion for the NWF as of end-2007. By February 1, this figure will have reached around US$32 billion. This is larger than the US$24 billion expected by the Russian government last April.

Governance structure. The NWF will be managed by the Ministry of Finance, though some asset management responsibilities may be delegated to the Central Bank of Russia. The MoF has the autonomy to recommend the currency composition and asset allocation of the NWF, subject to government approval. The MoF will publish monthly reports to the media, and will report quarterly and annually to the government on accumulation, investment and spending of the capital of the Fund.

The mechanism of fund accumulation. Going forward, all oil tax proceeds (including those from the first US$27 per barrel of Urals oil) will now be saved in the OSF. Further, tax receipts associated with natural gas transactions will also be diverted to the OSF. In addition, the budget can claim resources from both funds (the NWF and the RF), but the total transfer cannot exceed 3.7% of GDP; this cap will be effective in 2010, with the intermediate target being more flexible.

A conservative investment style to start out. When the notion of the NWF was first conceived, the intention was to make the Reserve Fund be invested in ‘risk-free’ sovereign bonds (like official reserves) and for the NWF to be invested like a SWF, i.e., in assets with higher expected returns, such as equities.

The Russian government recently announced that, for now, the NWF will initially be invested very conservatively, with the following guidelines:

(i) All holdings must be in foreign debt, denominated in USD, EUR or GBP, rated at least AA-, from Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Luxembourg, the Netherlands, Spain and the US.

(ii) At least 50% in foreign government debt, with the rest in foreign private/corporate debt.

(iii) Up to 30% in foreign agency debt and central bank debt.

(iv) Up to 15% in debt of international financial organisations (ADB, EIB, etc.).

(v) Up to 30% in foreign bank deposits.

The Ministry of Finance has until October 1, 2008 to propose a framework for wider investments, potentially including corporate debt, equity and investment funds, but actual investment in these assets will be at least another year away. Currently, the OSF is invested in AAA government debt.

Jen estimates that the fund could potentially grow to US$600 billion in a decade. The biggest question mark over this is the extent to which there are extraordinary withdrawals from the fund by the Russian government, above and beyond what is permitted under the 3.7% fiscal transfer rule. Jen feels that the likelihood of such extra withdrawals is reasonably high, and I tend to agree with him.

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