Sovereign Wealth Funds

In the midst of the turmoil in international financial markets and national economies, Sovereign Wealth Funds are coming into closer focus.

For the first time since the breakout of the financial crisis, the financial mandarins of China intervened to shore up confidence in the country’s four largest banks by increasing its holdings in them through its Sovereign Wealth Fund. The banks’ shares prices had come under pressure partly due to concerns on the opacity of available data in the public domain on their debt and earnings.

In resource-rich Kazakhstan, the son-in-law of President Timur Kuliyabev is the Chairman of the US$ 80 billion Kazakh Sovereign Wealth Fund – Samruk-Kazyna. Kazakhstan is Central Asia’s most successful economy.

The world’s top oil majors, such as Chevron, the BG Group and ENI, have flocked to the country, drawn by the promise of its mineral wealth. The International Energy Agency estimated the Kazakh proven oil reserves at 40 billion barrels. FDI currently is more than $ 100 billion. Recently the fund has been in the news due issue regarding the sanctity of contracts entered into with the oil majors.

Relevance to Sri Lanka

The concept of a Sovereign Wealth Fund is relevant to Sri Lanka in the context of the announcement by the President at a political meeting in Kandy, of a natural gas find in the Mannar Basin, which has prompted the explorer Cairn Lanka (Pvt.) Ltd. to issue a Discovery Notification on the discovery of a hydrocarbon column found to be predominantly gas bearing with additional liquid hydrocarbon potential. The company said that further drilling would be required to establish commercial viability.

Cairn says it drilled almost a mile down offshore in the Mannar Basin. On this basis it is hoped that there would be better bids for the remaining blocks in the Mannar Basin, enabling the country to raise more funds.

Discoveries of such resources may not always bring about positive results. Abundant resources, mismanaged, could end up being a curse – indeed it has been labelled as the ‘Resource Curse’. Nigeria’s mismanagement of its crude oil and gas resources is a case study.

Dutch Disease

The term Dutch Disease, which is one way in which the Resource Curse is branded, was popularised, may be even invented, by the Economist newspaper in 1977, in an article on the mismanagement of Dutch natural gas reserves. The inward flow of funds from this resource caused the Dutch currency to appreciate and the country’s exports became non-competitive.

Australia’s recent financial bonanza caused by mineral exports, mainly to China, has had a similar effect on the Australian dollar; it has lifted the Aussie dollar by more than 43% since the start of 2009, weighted by trade and adjusted for inflation.

Surging commodity prices have in the same way pushed up Brazil’s currency to a 12-year high against the US dollar in July 2011. Switzerland is blessed with a commodity prized more than iron ore or soya beans; in uncertain times, the safe reputation of the Swiss franc.

This creates a situation that the Swiss franc strengthens when American share prices weaken, bond prices rise or currency markets wobble. However, Swiss exporters are negatively affected. In July 2011, Swiss exports fell by 3% in real terms. The Swiss authorities had to take quick remedial measures.

The moral is that if a country enjoys a windfall of foreign money from a source other than its existing traditional exports it sells to the world or the safe reputation of its currency, it means that the traditional exports have less to offer to that country and the exporters of traditional products should look for alternative areas of business.

A country faced with the potential of a Dutch Disease situation has another alternative – to tax the foreign earnings of the commodity, in the Dutch case, gas exports and place the proceeds in a Sovereign Wealth Fund that invests in foreign assets, thereby insulating the national economy from the boom income.

The sovereign wealth fund of Kazakhstan has already been mentioned. The Norwegians have done this with their oil and gas income. They have put the windfall funds into a Government Pension Fund, which will not impact the economy immediately.

Sovereign Wealth Fund

The word Sovereign Wealth Fund (SWF) was first used in 2005 by Andrew Rozanov in an article in a Central Banking journal entitled ‘Who holds the wealth of nations?’

The Kuwaiti SWF was created in 1953. For Kiribati, when it obtained independence from the UK, a Revenue Equalisation Fund was set up to hold revenue from a special levy imposed on the exports of phosphates used in fertiliser.

SWFs are typically utilised when governments have a budgetary surplus and have little or no international debt. These surpluses cannot be held as cash and channelled into immediate consumption.

There are two types of SWFs, savings funds and stabilisation funds. Stabilisation SWFs are created to reduce the volatility of government revenues, to counter boom and bust cycles, especially of commodity prices and its negative effect on government spending. Savings SWFs are intended to build up savings for future generations.

The Government Pension Fund of Norway, into which revenue from the oil and gas fields are paid in, is such a fund. A properly-managed savings fund can be an antidote for what is termed the ‘Resource Curse,’ where governments go on a spending binge using funds generated by the exploitation of a natural resource, such as crude oil or natural gas, and causes the economy to overheat and the economic indicators to go south in an accelerated manner; such as Chavez’s Venezuela and Shah-era Iran.

On the other hand, SWFs such as Kuwait’s Investment Authority are of strategic value, which during the Gulf War managed excess financial reserves, well above the level needed for the Central Bank’s day-to-day needs. Singapore’s Investment Corporation and Tamasek Holdings and Korea’s Invest Corporation are SWFs which are intended to bolster the standing of the country as an international financial centre.

Oil exploration

As mentioned this issue is relevant to us in Sri Lanka at the present time due to the test wells being drilled, at the present time in the Mannar basin, for crude oil and/or natural gas.

There is something wondrously coincidental about oil exploration in our blessed isle. The discoveries curiously happen just before elections.

In 1976, a grand show was staged about black gold at Pesalai, Talai-mannar, discovered by a Soviet drilling team. It was a major campaign issue in the 1977 elections.

Discovering Pesalai crude was then proclaimed as a panacea for all our known and unknown ills. The rest is history!

Today it is Cairn India, whose Sri Lanka subsidiary has discovered a hydrocarbon column. At the time of entering into the agreement to drill test wells in the block they were assigned, Cairn said: “The search for oil is a risky and long-drawn-out process, requiring much patience and persistence.” Contrast that with the words of the then Minister for Petroleum: “Tell the world Sri Lanka would soon find oil and gas. By 2011 the first oil well would be drilled. Hopefully, by 2013 or 2015 we would get our first barrel of oil” – similar to the hosannas of the government in 1976/1977.

The Minister, after his first ebullient outburst, after listening to more restrained comments from the drilling firm, later seemed more pragmatic: “Oil exploration is a risky business and we are waiting for Cairn India to be successful as it would encourage others to invest in oil exploration in Sri Lankan waters.”

This is oil said to be found in the Mannar Basin, the basis for exploration are the resources currently being exploited, across the maritime boundary, in the Cauvery Basin by India.

The local exuberance was later tempered by stating that it would take at least 24 months more to determine whether the deposits were commercially viable. There is also the not-so-small matter of determining the disputed maritime boundary with India.

Not always positive

As has been explained, finding crude oil or natural gas is not always a positive thing. The sudden increase in revenues from natural resources which will raise the country’s real exchange rate to such an extent that manufactured exports from the country will become uncompetitive, i.e. the Dutch Disease or Resource Curse, leading to a current account deficit and even a greater dependence on commodities.

As has been explained this is not some detritus of the Dutch VOC occupation of Sri Lanka, although Mannar was certainly a focus of their presence, due not to crude oil, but the more mundane pearl oysters, the salt monopoly and the trade route to India, due to which the Dutch built a fort there.

If we actually discover anything worthwhile in the Mannar Basin, one way of avoiding the Dutch Disease would be to sterilise the boom revenues, not bring it into the economy all at once and to save some off shore in a special fund and bring them in slowly, as Kuwait has done with its Future Generations Fund.

Corruption and protectionist policies for lagging industries are also symptoms of the Dutch Disease and for the broader Resource Curse, Nigeria is the classic example.

But in our populist democracy, where even a potential has been and is sold as a certainty, do we have the discipline to take this antidote for the Dutch Disease? If we ever actually find crude or gas in commercially exploitable quantities and have the potential to catch the disease, that is!

(The writer is a lawyer, who has over 30 years experience as a CEO in both government and private sectors. He retired from the office of Secretary, Ministry of Finance and currently is the Managing Director of the Sri Lanka Business Development Centre.)