Svein Gjedrem: Perspectives on managing the Government Pension
Fund Global
Speech by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the
Norwegian Polytechnic Society, Oslo, 2 November 2010.
* * *
The text below may differ from the actual presentation. This speech does not contain assessments of the
economic situation or current interest rate setting.
A thought-provoking finding in economics is what is called "the resource curse". In a 1995
study the economists Jeffrey Sachs and Andrew Warner1 demonstrated that resource-rich
countries generally do not become wealthier. Natural resource wealth is not necessarily a
blessing, but is more often than not a curse. They argue that spending this wealth crowds out
industries that are exposed to international competition, thereby reducing growth capacity
- the so-called Dutch disease.
Halvor Mehlum, Kalle Moene and Ragnar Torvik2 find that the relationship between
economic development and natural resources is more complex; many countries become
poorer after discovering abundant natural resources, others become wealthier. They
conclude that the quality of the institutional framework is decisive. Vast natural wealth can
often induce interest groups to devote considerable time and energy to rent-seeking,
weakening a country's productivity. High quality institutions rein in this tendency.
The oil fund, now called the Government Pension Fund Global, has helped Norway to
escape the resource curse. I shall first speak about how the mechanisms for the Fund were
developed.
I would also like to take the opportunity to express Norges Bank's views on how the Fund's
strategy can be further developed. The Fund's investment performance, which receives a
great deal of attention, is primarily determined by the allocation of assets across different
classes such as equities and bonds. Asset allocation is an important component of the
Fund's strategy.
Chart: Timeline for managing Norway's petroleum wealth
After Norway discovered oil in the North Sea in 1969, it became clear early on that this would
be a source of substantial wealth. The revenue would transform Norwegian society3. In 1983,
the Committee on the Future of Petroleum Activity4 - chaired by Hermod Skånland who was
appointed central bank governor in 1985 - launched the idea of an oil fund. The proposal
was to set up an equalisation fund. According to the Committee, government oil revenues
would be transferred to the fund. Each year, an average of the past years' oil revenues would
be transferred to the central government budget and spent on a par with other revenues.
The Committee had limited confidence in the government's ability to save: The Committee
stated the following concerning a savings fund:
"It is up to the political authorities to determine whether such a fund construction
designed to avoid a future decline in income is realistic. The Committee chooses
not to build on such an assumption."
The notion of a sovereign oil fund matured through the 1980s. The government, under the
premiership of Kåre Willoch, called for the establishment of such a fund in the Long-Term
Programme presented in spring 1986, and the Act on the Government Petroleum Fund was
passed in 1990.
The main rules are:
First: The totality of government petroleum revenues is transferred to the Fund.
Second: The Fund is integrated into central government budgets and accounts. The
non-oil deficit is covered by an annual transfer from the Fund. The government cannot
borrow to finance current expenditure as long as there is capital in the Fund.
Third: The capital in the Fund can only be used for domestic spending via general
budget transfers, and not for earmarked transfers.
Fourth: The Fund's capital must be invested abroad.
When the Act was enforced, the Norwegian economy was in a deep downturn, with high
unemployment and government budget deficits. Projections also indicated that offshore
production would pass the peak in the early 1990s5. Those working on the bill at the Ministry
of Finance at that time were probably in doubt as to whether any petroleum revenues would
ever be saved, and perhaps they also questioned the utility of such a fund.
Initially, the fund structure was merely an exercise in accounting. Government petroleum
revenues were deposited in the fund, but the entire amount was transferred back to the
central government budget to cover some of the non-oil deficit. However, the Norwegian
economy rebounded and transfers to the Fund started in 1996.
The Fund has since acted as a buffer between widely fluctuating oil revenues and public
expenditure. The decision regarding annual petroleum revenue spending can be made
independently of the size of the revenues. Thus, the fluctuations in government petroleum
revenues do not have an automatic impact on the Norwegian economy. The Fund also has a
stabilising effect on the krone exchange rate because capital outflows increase when
Norway's petroleum revenues rise.
The fiscal rule for petroleum revenue spending, which was adopted in 2001, states that the
government may spend - as an average over the business cycle - the expected normal real
return on the capital in the Fund over the central government budget. This return is estimated
at 4 per cent. The rule ensures that the capital in the Fund is not drawn on unless the real
return on the Fund is lower than 4 per cent. In this way, future generations will also benefit
from the oil wealth.
It is also important that the government's portfolio of financial investments is constructed
without considering the financing needs of Norwegian enterprises. By the same token,
Norwegian companies can choose their funding structure independently of the government's
financial investments. The capital market serves as intermediary between the government as
investor and firms' capital needs, and this ensures the separation of public and private
choices. The Norwegian capital market is part of a Nordic market and increasingly part of a
larger international market. Capital markets are a very efficient tool for channelling savings
into investment.
Since capital started flowing into the Fund, the savings plan has remained intact. This
indicates that both the Fund mechanism and the fiscal rule are well anchored. This is a
prerequisite for escaping the resource curse.
On the other hand, only once in 2007 did the government budget bill call for spending below
4 per cent of the Fund. It later transpired that petroleum revenue spending was also lower
than 4 per cent in 2006 and 2008.
The Fund is in the process of becoming a major financing source for public expenditure for
the coming decades. The Fund has reached NOK 3 trillion, or 120 per cent of GDP, of which
NOK 600 billion are returns in foreign currency. The government can now spend
NOK 120 billion annually from the Fund without reducing its real value.
In ten years' time the Fund is projected to be twice as high as annual GDP6. Total public
expenditure accounts for somewhat less than half of GDP. The Fund may then become
about four times as large as total government expenditure. With Fund withdrawals in line with
the fiscal rule of 4 per cent, the return will be able to finance 15-20 per cent of government
expenditure in ten years. A large share of government spending will thereby be financed
without the functioning of the economy being exposed to tax disturbances.
Chart: Time line
Construction of the Fund
The first capital transfers to the Fund were managed in the same way as Norges Bank's
foreign exchange reserves, which are invested in government bonds issued by our main
trading partners.
The purpose of the Fund, however, is entirely different from that of foreign exchange
reserves and the operational management of the Fund must thus also be different. The main
difference is the investment horizon. The Fund is meant to span a long period, preferably
many decades.
Through 1996, about NOK 40 billion was transferred to the Fund and it became clear that the
Fund would be sizeable. It would be accurate to say that there were divergent viewpoints
within Norges Bank when it was discussed whether the Bank should take on the assignment
of managing the Fund. Three challenges were considered in particular.
First: Norges Bank could risk impairing its reputation by accepting this assignment.
Second: Would it be possible for a central bank to assume the role of a professional
investment manager?
Third: How could this activity be organised within the central bank?
Norges Bank's Executive Board, under the chair of former central bank governor Kjell
Storvik, chose to take on this task. The Bank solved the two other challenges by delegating
management to a separate unit for investment management - Norges Bank Investment
Management or NBIM. A key aim was to establish NBIM as a business unit with clear
financial objectives. Eventually, Chinese walls were erected between NBIM and the rest of
the Bank. NBIM does not participate in monetary policy deliberations and does not have
access to the Bank's work concerning other matters.
In winter 1997, Norges Bank wrote in a letter to the Ministry of Finance that the investment
horizon implies that a substantial share of the Fund - no less than 30 per cent - should be
invested in the international equity market. In the Revised National Budget for 1997, the
Ministry considered this matter and set the allocation to equities at 40 per cent7.
In the correspondence between Norges Bank and the Ministry, there is also support for the
fiscal rule's assumption of a real return of 4 per cent with an equity allocation of 40 per cent.
In 1998, the Fund started investing in listed equity in 21 countries, all of them featuring a
fairly well developed financial market. Other countries were later incorporated into the
benchmark portfolio. In 2007, small companies were included in the benchmark portfolio.
Today, the Fund has equity holdings in 8,000 companies in almost 50 different countries.
The bond portfolio was expanded from 10 to 18 countries in 1998. Since 2002, the Fund has
gradually moved into the corporate bond market and mortgage-backed securities.
Chart: Fund returns
In 1998, analyses indicated that returns would be higher than achieved to date. It should be
noted that the Fund is nevertheless considerably larger than expected 10-12 years ago.
High oil and gas prices have resulted in substantial transfers to the Fund. Sizeable returns on
oil in the ground have more than offset low returns on securities.
Since equity investment started in 1998, the annual average real return on the Fund has
been a good 3 per cent after expenses8. This figure is partly a reflection of the financial
crisis. The Fund's short history includes a lost decade in the stock market, with two periods
of sharp decline.
During financial crises of the type we have recently experienced, the government as investor
has no place to hide. Even though it is less visible, the return on government real
investments in Norway is also lower during economic downturns.
The estimated size of Norway's offshore oil wealth naturally varies widely with oil and gas
prices and frequent changes in petroleum reserve estimates. The Ministry of Finance now
assesses the value of the government's share of the remaining petroleum wealth at
NOK 3.6 trillion, which is about NOK 550 billion lower than the Ministry's estimate one year
earlier.
Chart: Ownership interests
In summer 2007, the Ministry of Finance decided to increase the allocation to equity from
40 per cent to 60 per cent and reduce the allocation to bonds correspondingly. Surging oil
and gas prices, high oil production and favourable economic conditions for the Norwegian
economy led to high transfers to the Fund in the course of 2007 and 2008. Equity prices fell
sharply through 2008.
It was against this background that the Fund purchased equities for more than NOK 1 trillion
between summer 2007 and summer 2009. With a fall in value of 23 per cent or
NOK 630 billion, it is understandable that the results in 2008 attracted considerable attention.
The most important development for the Fund was perhaps a doubling of its global equity
holdings. After earning high returns in the past year and a half, the Fund has also recovered
the losses.
Chart: Nominal interest rate level and cost of equity capital
As I mentioned earlier, the Fund has become larger than we expected a decade or so ago as
high oil prices have more than compensated for fairly low returns in international capital
markets. Looking ahead, market prices suggest that interest rates are expected to remain
low for many years. Real interest rates on long-term bonds have been depressed by central
bank government bond purchases. Let us nonetheless assume an average nominal return on
the Fund's fixed income instruments of 3 per cent ahead.
On the other hand, there are no signs that return requirements in equity markets are low.
Dividend payments are high in relation to companies' market value. Simple valuation
models9 indicate that shareholders require a rate of return between 8 and 10 per cent, a
fairly normal level.
This results in an overall nominal return of between 6 and 7 per cent. In addition, positive
contributions to the return are expected from non-government bonds, active management
and real estate. There is considerable uncertainty surrounding these estimates.
Nevertheless, Norges Bank's view is that it is still reasonable for the government to base its
withdrawals from the Fund on an expected annual real rate of return of 4 per cent. The
increase in the equity allocation from 40 per cent to 60 per cent does not provide a basis for
higher withdrawals from the Fund, but reflects prospects for somewhat weaker returns in
international markets today than was the case ten years ago.
Chart: Excess return, cumulative annual since inception and quarterly
The long-term return and the wide annual variations in the Fund's value are largely
dependent on financial market developments. The most important questions therefore relate
to the Fund's strategy. We have nevertheless continuously sought to exploit the scope for
profitable active management. The contribution from active management to the overall
annual return was set at 0.25 percentage point by the Executive Board in 2001, which may
appear to be neither considerable nor demanding. According to the Ministry's calculations,
the expected real return on the Fund rose by 0.4 percentage point when the equity allocation
was increased from 40 per cent to 60 per cent10. In this context, a contribution of
0.25 percentage point does not seem small.
It is also fairly demanding to achieve this. The degree of efficiency in financial markets is
generally high. In a model, Nobel prize winner William Sharpe divides investors into two
groups: passive and active investors. In this model, all passive investors will achieve a return
in line with the general market. The return earned by active investors will on average be
lower than the market return because of higher management costs11.
The idea that rational and profit-motivated participants should, on average, lose money is a
paradox, as pointed out by Sanford Grossman and Joseph Stiglitz in 198012. For investors
and managers to expend resources on gathering and analysing information, opportunities for
profit in the markets must be sufficient to cover their costs. The Grossman-Stiglitz paradox
prompted an adjustment of the efficient market hypothesis. In the modified version, financial
markets reach near-efficiency most of the time, but active management is necessary to
eliminate mispricing and increase market efficiency13.
When panic seized the markets in autumn 2008, prices simultaneously fell for many types of
securities that had previously shown a low degree of correlation. It came as a surprise that
there was a strong positive correlation between for example Japanese inflation-linked
government bonds, bonds issued by international institutions such as the European
Investment Bank, covered bonds issued by European banks and US mortgage-backed
bonds.
An investor such as the Fund can survive a liquidity squeeze for a period. We were prepared
to maintain positions in fixed-income securities to maturity and the vast majority of borrowers
appear to be honouring their debt obligations. The crisis nevertheless revealed that the
exposure to underlying systematic risk was greater than we perhaps realised at the outset.
In the hearing before the Storting (Norwegian parliament) in 2009, directly after the reporting
of substantial losses in 2008, I indicated that unless the economic outlook went from bad to
considerably worse, active management would deliver substantial excess returns in the
coming years. Even though there was probably an underlying fear of a collapse in the
financial system, it was fairly clear that the main factor behind the decline was limited market
liquidity. Since the second quarter of last year, book values have increased even faster than
we dared to hope. Returns have also been good as a result of a restructuring of the portfolio.
The Fund continued to pursue active management through the crisis. It has proven important
that active management could be pursued.
Active management has on the whole delivered good results, contributing an average
0.3 percentage point to the overall annual return. All in all, active management has increased
the value of the Fund by several tens of billions of Norwegian kroner.
Chart: Key components of the design of the Fund's investment strategy
The Ministry of Finance sets out the investment strategy for the Fund, while Norges Bank as
manager provides advice on a regular basis.
This past summer, we proposed several important changes to the Fund's investment
strategy14. The proposal illustrates the relationship between the various components of the
strategy. We have also pointed to possible improvements to the investment guidelines for the
Fund.
The fixed income portfolio has a number of weaknesses. We have learned that we should
not necessarily invest most in those companies and states that are the most eager
borrowers. Large borrowers thus have a high weight in the portfolios.
Our assessment is that the fixed income portfolio should instead be weighted based on the
income that is to service the debt. The GDP-weighted alternative is the most relevant
alternative for government debt.
Both the equity and fixed income portfolios are constructed using regional weights. Today's
distribution was partly determined using Norwegian import weights from the mid-1990s. It
should be considered whether the regional weights should no longer be used so that the
Fund's holdings across all companies and recognised markets are of equal size. If regional
weighting is discontinued, the share of the Fund's European equity and bond holdings will be
reduced. Investments in the Americas and Asia will then increase. With such a revision, the
stability of economic and political systems must also be assessed.
When equity prices increase rapidly, the equity allocation will exceed the strategic weight of
60 per cent. Rebalancing rules are then applied to bring the equity allocation back to 60 per
cent. These rules are more important than many perhaps believe. Many investors waited for
a long time, probably too long, to rebalance their portfolios during and after the crisis, when
equity allocations fell sharply. It should also be considered whether the rules should be
designed to provide for a greater degree of automaticity, less judgement and probably also
greater transparency.
It is important to take into account the Fund's particular features, that is to say a long-term,
large investor without short-term liquidity needs, when evaluating which investment strategy
is most appropriate.
In the spring 2010 Report to the Storting on the Fund, the Ministry of Finance suggested that
the level of less liquid assets should be increased: "Further development (of the strategy) will
seek to diversify the risk further and increase the weight of investments that benefit from the
Fund's size, long-term perspective and ability to hold less liquid assets."
Today the Fund's assets are divided into two classes: equities and bonds. Going forward, a
division into three asset classes may better enable the Fund to achieve its long-term
objectives.
The first asset class is equities. This class features the highest risk exposure and the highest
expected return. It accounts for 60 per cent of the Fund, which reflects the risk willingness of
the Fund's owner. Today, the Fund can only invest in equities that are listed on a recognised
stock exchange. Unlisted shares, so-called private equity, could be included in the
investment universe. The Fund could invest in companies with plans for an imminent listing
on the stock exchange. Successful private equity firms can provide an excess return, but I
doubt that the Fund will become a big investor in private equity firms in the near future.
Selecting good companies is demanding and management fees are high. Many are highly
leveraged and the sector's behaviour is procyclical.
The second class is nominal fixed income securities. Over time these securities are expected
to provide a lower return than equities. They are also less exposed to risk and are often
easier to sell at short notice.
The third - and new - class is real assets excluding equities. Real assets will provide a cash
flow that is assumed to track inflation. Such investments thus deliver a long-term and fairly
secure return in line with the Fund's objective. Real estate purchases, an example of assets
in this class, will commence in the near future. The dividing line between real estate and
infrastructure is not very clear, and looking further ahead, it may be natural to invest in assets
that can be classified as infrastructure. In addition, the Fund's investments in inflation-linked
bonds could be included in this class.
The two latter classes combined will make up 40 per cent of the Fund. Many real assets are
fairly illiquid. A rapid build-up or sell-down of positions is therefore not profitable even if
prices change. Over many years ahead, the amount of nominal fixed income investments will
exceed the amount of real assets. In the long run, it is conceivable that investments in the
two classes may be more equally distributed.
In the development of the investment strategy that I have presented, weight has been given
to exploiting the Fund's long-term investment horizon and size. The strategy is based on
objectives and expectations regarding the Fund's overall real return over time. Moving
forward, Norges Bank's operational management of the Fund should probably shift towards
absolute return and absolute risk.
Transparency and accountability
A clear division of responsibility between the Ministry of Finance as owner and Norges Bank
as manager is an important component of the Norwegian model. Moreover, it is important
that transparency and accountability are prominent features of the model. Management
objectives have been clearly defined.
Norges Bank and the Fund's owner have always given weight to transparency with regard to
the management of the Fund. The standard was set at an early stage when the Executive
Board decided that an exhaustive list of the Fund's investments should be published at the
turn of each year and the first complete list was published in the annual report for 1998. This
decision has paved the way for all the subsequent discussions about various individual
investments.
Norges Bank submits extensive reports to the Ministry and Storting on the results and
activities of the Fund. Our annual report is submitted as an appendix to the Ministry of
Finance's annual report to the Storting on the management of the Government Pension
Fund. Norges Bank appears before the Standing Committee on Finance and Economic
Affairs of the Storting at annual hearings. The Bank advises the Ministry on important issues
related to the management of the Fund. Norges Bank's Supervisory Council submits its own
report to the Storting concerning its oversight activities. The Office of the Auditor General
carries out - as our owner has expressed it - an important function through its responsibility
for monitoring the Ministry's exercise of authority in relation to Norges Bank and auditing the
item in the government accounts that refers to the Government Pension Fund Global.
The Fund's accounts and notes to the accounts contain a growing body of information. As
from the 2011 accounting year, Norges Bank will shift to International Financial Reporting
Standards (IFRS).
Transparency is important for the Fund's foreign investments. Some authorities are sceptical
of other countries' sovereign wealth funds. This scepticism is reflected in an annual survey
conducted by Edwin Truman, senior fellow at the highly renowned Peterson Institute of
International Economics in Washington. His survey is by far the most thorough and
systematic - the most authoritative - assessment. Truman's criteria were also included in the
basis for the Santiago Principles which, facilitated by the IMF, were introduced in 2008 and
implemented by a number of sovereign wealth funds.
To quote Truman:
"Sovereign wealth funds (SWFs), large pools of government-owned funds that
are invested in whole or in part outside their home country, burst upon the policy
consciousness only three years ago. Their explosive growth up until 2007 fanned
widespread anxieties about shifts of global economic wealth and the roles of
governments in managing that wealth. On the other hand, SWF investments
helped some major Western financial institutions weather the recent financial
crisis."
Chart: Truman's ranking
In Truman's most recent study on the transparency of sovereign wealth funds, the
Government Pension Fund Global was ranked in first place. The Fund has also improved its
score since the 2009 survey. We note with satisfaction that such a young fund has come out
ahead of established US and European funds15.
As I mentioned by way of introduction, the economic literature points to two factors that can
turn riches into rags.
One is the risk of inducing interest groups and economic agents to engage in rent-seeking
behaviour. It can safely be said that the framework for the Fund has fended off this risk.
Chart: Relative wages in Norway
The second is the risk of Dutch disease. Strictly speaking, the jury is still deliberating.
Productivity growth and labour force participation have been satisfactory over the past
decade while relative labour costs and prices have reached yet higher levels. It remains to be
seen whether the real krone exchange rate will gradually fall back when increases in
petroleum revenue spending can no longer be sustained and the relative size of the oil
supply industry decreases.
Thank you for your attention!
BIS Review 145/2010
BIS Review 145/2010
BIS Review 145/2010
BIS Review 145/2010
BIS Review 145/2010