Ewart S Williams: Understanding the Heritage and Stabilisation Fund
Feature address by Mr Ewart S Williams, Governor of the Central Bank of Trinidad and
Tobago, to The South Trinidad Chamber of Commerce Annual General Meeting,
Port-of-Spain, 20 September 2007.
* * *
Let me thank the South Chamber for inviting me to speak at your Annual General Meeting.
As the Chairman indicated, my theme is the Heritage and Stabilization Fund and what I
would like to do is not only discuss the underpinnings and the specifics of the Fund .... in
addition I see this as the launch of a communication initiative geared to convince the
stakeholders, like you and the public at large, that this is their Fund over which they should
show the same interest and vigilance that they exercise over their pensions or their personal
savings.
The public must have an interest in how much money is placed in the Fund: how it is
invested and what returns are being generated. The HSF is a reserve for the people of
Trinidad and Tobago, their children and hopefully their children's children.
In the economic literature, funds like our Heritage and Stabilization Fund are called
Sovereign Wealth Funds and their distinguishing characteristic is that these are national
savings that are invested actively with the purpose of earning high returns - returns that
would provide an important source of revenue to the Government later. These sovereign
funds are different in nature and in purpose from the country's official reserves.
Every country holds official reserves that are managed by the Central Bank. However,
invariably rate of return is not the primary objective for holding reserves. Central Banks hold
reserves for prudential purposes, for example, for meeting government external debt
payments; to finance payments for imports and to be available for intervention in the foreign
exchange market, as needed. Countries like ours, that are heavily dependent on primary
products, also hold reserves for precautionary purposes - so that we could avoid any
disruption to international trade if there is a sudden fall in oil and gas prices.
Given these objectives, liquidity is perhaps the most important consideration in the foreign
reserve management policy of Central Banks. Consequently, central bank reserves are
invested in short to medium term low risk financial assets.
Sovereign wealth funds have assumed heightened popularity in the last few years, as
many emerging countries have seen a phenomenal increase in their international reserve
Most of these funds belong to commodity exporting countries that have benefited
holdings.
from the increase in the international prices of oil and gas (as in the case of Norway and the
oil producing Arab countries) but you also have Chile (where the commodity export is
copper) and (where the commodity export is diamonds).
Botswana
There are a few countries that are not commodity exporters that also have sovereign
wealth funds. These countries have accumulated significant foreign exchange reserves
from trade surpluses. The most notable of these are Singapore, China, Hong Kong, South
Korea and Malaysia.
As you know, Trinidad and Tobago is a commodity exporter, with heavy dependence on oil
and gas. The energy sector accounts for about 40 percent of GDP; about 90 per cent of
total exports and close to one-half of total government revenue.
All of you would, no doubt, recall the first oil shock in the late 1970's and early 1980's when
there was a significant increase in Government revenues consequent of the rise in oil prices.
Some of this windfall went to finance the start-up of the petrochemical platform, from
which we are now benefiting. However, the increase in government spending also
contributed to a rise in the non-energy deficit, from less that 10 percent of non-energy GDP
to over 40 percent by early 1980s.
When oil prices collapsed, the end of the oil boom brought about the need for a sharp fiscal
adjustment and total expenditure had to be reduced from an average of 56 percent of
non-energy GDP in 1980 - 1985 to 36 percent in the nineties. Output per capita declined
by about 33 percent between 1981 and 1992, and unemployment rose from 10 percent to 22
percent from 1987 - 1989.
Having learnt our lesson, when oil prices started to rise in the late 1990's, the Government
established an Interim Revenue Stabilization Fund. Annual contributions were made to the
Fund since 2000, but it became a formal legal entity, only in March 2007, with Parliament's
approval of the Heritage and Stabilization Fund.
For the record, we now have official reserves of about US$6 billion and by the end of this
month assets in the Heritage and Stabilization Fund are expected to be close to US$2
billion.
The Heritage and Stabilization Fund - is a joint account, firstly, to help deal with boom-bust
cycles, and secondly to generate savings for future generations.
The rationale for setting aside funds for stabilization is as follows: (notwithstanding the
prolonged increase in oil prices since the turn of the current decade), oil and gas prices are
inherently volatile and even the most optimistic projections suggest that at some time oil
prices will revert to a more normal long term equilibrium level. Given our economy's heavy
dependence on oil and gas, a sharp fall in prices will affect government revenue and could
require a drastic cutback in government spending. By putting aside some resources for
stabilization, the Government would have the ability to cushion the impact on its spending
and consequently on the level of economic activity.
The rationale for setting up a savings fund is a bit more complex and incorporates
both economic and ethical considerations. It says that natural resources are an
exhaustible sovereign asset, the benefits of which should be spread over generations. And
therefore what a savings fund does is to transform the assets under the ground (in our case
oil and gas) into a diversified portfolio of financial assets, which are managed so as to yield
a high rate of return, which will flow back into the budget as revenue - not now-but
when the oil resources have dwindled or have run out.
Thus, future generations will be benefiting from the oil resources (not in cash transfers), but
by not having to face expenditure cutbacks because the oil and gas resources would have
been depleted. Future generations will thus be enjoying the benefits of oil and gas resources
even when the oil and gas resources are gone.
The flow of investment income from a commodity fund can go on for a very long time after
the oil resources are gone, if you have built up sufficient assets and if the country's
fiscal position is sustainable over the long term.
A recent study done by the IMF suggests that, given the expected trend in oil prices over the
next two decades, the HSF could possibly build up assets of up to US$40 billion by 2020, if
we could move to a non-energy fiscal deficit of 10 per cent of GDP (we are currently at
15 per cent of GDP). And this is a fairly conservative scenario since it assumes a rate of
return on investment of 4 percent in real terms - which is considered average for sovereign
funds.
The HSF Act approved by Parliament in March of this year, is very much consistent with best
practice legislation for Sovereign Wealth Funds. The legislation provides for clear deposit
and withdrawal rules; a governance structure that incorporates checks and balances
and a number of provisions to ensure adequate transparency and accountability.
In terms of the basic deposit and withdrawal rules, the Act provides:
•
That on the deposit side, a minimum of 60 per cent of the excess between actual
and budgeted revenues must be credited to the Fund (where actual revenues are
based on long term projected prices).
•
The withdrawal rule allows the Government to tap into the Fund to cover 60 per
cent of revenue shortfalls, provided that the shortfall is of
at least 10 per cent
budget revenues. This is a maximum entitlement and the Government could
elect to cover the entire shortfall through reductions in expenditure. As
indicated earlier, there is a cap on the amount of the Fund that could be used for
stabilization.
There are some other significant provisions in the law or in the principles underlying the
Fund. Thus, for example:
•
HSF deposits are to be invested in foreign assets with a medium to long term
focus.
•
The Fund cannot be used to directly finance capital expenditure or as collateral for
government borrowing.
•
In principle, the Fund should be invested in assets not directly related to oil and gas
(so as to avoid contagion).
•
The Act comes up for review every five years.
An appropriate is critical for the smooth and optimal functioning of the
governance structure
Fund. Best practices require that the structure provides a clear division of responsibilities
and an effective system of checks and balances with investment decisions based on
professionalism in a clear line structure.
The HSF meets these criteria by defining clear roles for the major players - Minister of
Finance, the Board of the HSF, the Central Bank, and the Parliament, which represents
the people, as the ultimate authority.
The Minister of Finance is responsible for approving the deposits and withdrawal from the
Fund.
The HSF Board decides on the investment objectives of the Fund and approves the
Strategic Asset Allocation - which in effect is the definition of the overall risk-return
profile of the portfolio. In the final analysis the Board is answerable for the overall
performance of the Fund but it delegates this function to the Central Bank, which is given
responsibility for the day to day management of the Fund. To fulfill its function the Bank
will make extensive use of external fund managers which it will help to select and oversee.
The Bank is also available to give technical advice to the Board as required.
The Parliament, as representative of the people has the ultimate oversight role of the Fund,
exercised through review of the annual reports and the audited financial statements.
The credibility of the HSF depends importantly on the degree of transparency and
information disclosure that is practiced. The legislation provides for:
•
Quarterly Reporting by the Central Bank to the Board;
•
Quarterly and Annual Reporting by the Board to the Minister of Finance;
•
Annual Reporting by the Minister of Finance to the Parliament;
• Annual auditing by the Auditor General.
The Norwegian Petroleum Fund is recognized as the benchmark for transparency and
disclosure of information. The Norwegian Ministry of Finance reports to Parliament on all
important matters relating to the Fund such as the size of petroleum revenues; the
outlook for fiscal sustainability, any planned changes in investment strategy and the Fund's
performance, risks and costs. The HSF Board and the Ministry of Finance will need to
work out the scope of our information and disclosure policy.
I would like to dwell a bit more on the concept of the strategic asset allocation and its
importance in meeting the objectives of the Fund.
Let's recall that unlike the official reserves administered by the Central Bank, a main
objective of the HSF is to maximize the risk/return equation or put another way, to
maximize long-term returns at an acceptable level of risk. In the case of our official reserves,
where the main objectives are safety and liquidity, the Strategic Asset Allocation
emphasizes money market instruments (including deposits), short to medium term
government securities of G-7 countries and other investment grade securities.
I am not in a position to say what the Strategic Asset Allocation for the HSF will look like.
That's a decision for the Board. What I can say is that typically, sovereign wealth funds
choose from a wider range of diversified asset classes which could include equities,
commodities, emerging market stocks and bonds, real estate, and private equity. In practice,
most funds focus on longer term fixed income securities and equities. In fact, the proportion
of assets invested in equities is usually considered the main parameter in determining the
risk assumed by the Fund.
Norway, which is unquestionably, one of the most successful of sovereign funds,
for a long
time had a strategic asset allocation of 60 per cent fixed income securities and 40 per
cent equities, before increasing the share of equities to 60 per cent. There is an abundance
of evidence to suggest that over the long term an appropriately diversified portfolio,
comprising bonds and equities, could yield significantly higher real returns than one of purely
fixed income assets.
Since the HSF Act was approved, much has been done to prepare for its active
implementation.
Pending the appointment of the HSF Board and its instructions with respect to the investment
of the portfolio, the Ministry of Finance authorized the maintenance of the Fund "in
accordance with the Investment Guidelines and Procedures used in respect of the
Interim Stabilization Fund". This meant maintaining the Fund in US dollar short term
deposits, in institutions with high credit ratings.
You would have seen on yesterday's newspapers that the HSF Board is now in place.
The Bank is currently making arrangements for the longer-term management of the Fund.
We are working with the World Bank to develop the alternative scenarios, as a basis for
recommending a Strategic Asset Allocation (SAA) to the Board.
After the SAA is approved, the Preparation
next step will be to select External Managers.
for this latter stage has already begun with identification of a broad group of potential
External Managers. The process of engaging external managers can be relatively long,
largely because of the contract negotiation phase. We are hoping that this could be done in
six to nine months.
Due to the length of time that could elapse between the approval of the SAA and the
selection and engagement of the external asset managers, the Bank will develop an interim
investment policy for recommendation to the Board of the HSF.
Work is well advanced in the preparation of the Instrument of Delegation which is a legal
contract that details the duties and responsibilities of the Bank as it pertains to the
management of the HSF.
A public education programme is also being developed to inform and prepare the public
for the Fund.
Let me end with a few words about the critical importance of a public education and
communication programme, for the success and credibility of the HSF. As I said earlier, it is
important that the public understands what is involved in the HSF in order to get buy-in. For
example some people need to be convinced of the need to put aside savings for future
generations rather than to pursue expenditures to meet current needs.
It is important that we counter mis-information and misperceptions by, for example,
explaining the rationale behind the transfers to the Fund and withdrawals from the Fund,
when they become necessary. It is important that we explain the procedures behind the
selection of external managers so as to underscore transparency and avoid the perception of
special deals.
We need to manage expectations in line with market realities, since there are going to be
questions about whether we are taking too little of too much risk, or the Fund is earning
enough. A successful long term investment strategy is not incompatible with one or two years
of low returns. In such circumstances, open communication could serve to maintain support
for the Fund and its objectives.
Let me repeat that this is neither the Government's Fund nor the Central Bank's Fund; it is
the - for you and for your children and perhaps for your children's children.
country's Fund
In addition to ensuring that the purpose and the operations of the Fund are well understood,
it is important that the public feels social ownership for the Fund as this will foster
In the final analysis,
vigilance and ensure accountability, transparency and compliance.
this is a precondition for the Fund's success.