Government debt and wealth in the Global South
8 The intertemporal smoothing problem the other way around: Sovereign wealth funds
It may seem counter-intuitive initially, but the intertemporal smoothing problem faced by low- and middle-income countries is not always about accumulating debt to bring to the present some expected income that the country will have in the future. Sometimes countries, including middle- and low-income economies, face the opposite problem: they suddenly have an enormous income boost in the present that they are tempted to spend, but they know that they may need some of those resources in the future. They know that they should save, but they are tempted not to.
The problem is similar to the conflicts of interest, but the other way around). In Figure 15 we start with the same country as we examined in Figure 6, that has very low income in the present and higher income in the future. The country is initially very poor and has an expected trajectory of present income \(C_\text{p}^\text{A}\) and future income \(C_\text{f}^\text{A}\). It is taking debt to finance an increase in fiscal spending and social policies in the present and servicing that debt in the future.
Suddenly there is an unexpected rise in present income from \(C_\text{p}^\text{A}\) to \(C_\text{p}^\text{C}\) because the country discovers a natural resource (or resolves the political and institutional challenges involved in exploiting it). Assume that the country understands that it is either a non-renewable resource or one that will not be as profitable in the future as it is today. It is similar to the case of a poor person that wins a lottery or receives an unexpected and substantial cash bonus at work.
Remember that at point B the marginal rate of substitution and the marginal rate of transformation (the interest rate) are the same: \(\rho=i\). Consider point C, which represents the country consuming its new endowment without any intertemporal smoothing whatsoever. The country is better off (on a higher indifference curve) than at point B—it has greater present consumption and is undertaking no debt commitments. However, at point C, the marginal rate of transformation, \(i\), is greater than the marginal rate of substitution, \(\rho\). This means that international markets are actually paying more for savings than it costs the country to supply them. The country is abundant in cash today and international markets are hungry for those resources. It makes sense to save and use those funds and the returns that they will generate in the future. The country will choose point D on the higher indifference curve, \(\text{CIC}^\text{D}\).
Figure 15 A transitory commodity boom.
This situation usually arises as a result of the discovery of a natural resource or the unexpected rise in prices of commodities that form part of the export structure of an LMI economy. For example, a country suddenly finds itself rich in oil or gas, or is surprised by the increase in the price of a mining resource that it has had for a long time—as happened to lithium exporters recently as a result of the increased demand generated by the electric vehicle industry. If this is so, suddenly the country has a windfall and must decide how much of it to move to the future. If the future is heavily discounted because of high levels of impatience, it may decide to save less. If it believes that the increase in commodity prices is permanent, it may convince itself that it is not necessary to save. But if it can garner a precautionary and pragmatic approach, it may decide to set up a fund with part of the excess revenues and save it for the future.
If spending more of this windfall increases the possibility of being re-elected, the government’s preferred amount of spending may mean that the country ends up saving less than it should (from the citizens’ perspective). Moreover, since there is a significant probability that somebody else will be in charge in the future, the welfare of the country in the future could be less important in the eyes of whoever is deciding today. This problem can be worsened by the asymmetry of information between government officials and voters. Most citizens are not aware of the fiscal or debt situation of the government and only realize the consequences of bad fiscal decisions after some time. So, a decision that a voter may find an expression of ‘good government’ in the short term may end up increasing debt levels exponentially and being, overall, a bad policy.
Figure 16 Short-termism in a transitory commodity boom.
In Figure 16 we start with the same commodity boom of Figure 15. The citizens’ preferred choice (which maximizes consumption in both the short-term and long-term) is point D on indifference curve \(\text{CIC}^\text{D}\), but the policymaker’s preferences are more skewed towards the present. The policymaker prefers point G on indifference curve \(\text{PMI}^\text{G}\), which is on a lower indifference curve for the citizens (\(\text{CIC}^\text{G}\)). Figure 16 shows that the policymaker’s short-termism causes the country to end up taking a loan and increasing its debt, whereas (if the citizens could choose) it should be saving and accumulating sovereign wealth funds (SWFs).
Politicians are tempted by the political benefits of spending most of the windfall. They also manage to convince themselves that the windfall is not transitory at all, but rather permanent, and there is, therefore, no reason for saving. And if they choose to believe that, then the reasons for saving suddenly disappear. Political leaders may find it quite appealing to convince themselves, and then public opinion, that the probability of the positive shock to income being permanent or lasting longer is higher than a dispassionate analyst would estimate.
In panel a of Figure 17 we show a permanent commodity boom. The difference from Figures 15 and 16 is that the endowment moves from A to H instead of from A to C. As we should expect, the expansion in the feasible set is substantial and the new preferred choice of intertemporal consumption is I (on a higher indifference curve than point H), where the country ends up taking out a loan. The reason this makes sense is that, originally, before the commodity boom, the country had expected more resources in the future than in the present (point A) so now, with the boom, the difference between available income in the future and the present is very large. It makes sense to anticipate some of that consumption and take a loan. There are no sovereign wealth funds, only more debt.
Panel b of Figure 17 shows what happens when the commodity boom unravels in the second period. Since the country has already consumed in the first period as if the commodity boom was permanent, it must service the debt from the original future endowment of \(C_\text{f}^\text{A}\). The result is that it goes all the way down from where it expected to be at point I to point J, and ends up on indifference curve \(\text{CIC}^\text{J}\), which is lower than what the country would have achieved if they had just consumed the transitory commodity boom in the first period (point C).
Figure 17 A supposedly permanent commodity boom that turns out to be transitory can make the country worse off than it was before the boom.
This dilemma of administering a windfall from dramatic export price increases was faced by many LMI countries during the first two decades of this century as a result of what has become known as the ‘commodities boom’. And, in fact, during these years many commodity-exporting countries set up what have come to be known as sovereign wealth funds. For example, in 2007, Chile established its Fondo de Estabilización Económico y Social; in 2008, Kazakhstan, a major oil, gas, and mineral exporter, set up its Samruk-Kazyna national fund; in 2012, Angola, an oil and gas exporter, set up the Fundo Soberano de Angola; in the same year, Bolivia, a tin and gas exporter, set up the Fondo para la Revolución Industrial Productiva; and in 2016, Mongolia, a gold and coal exporter, set up its Future Heritage Fund. In fact, so many low- and middle-income commodity-exporting countries felt the need to establish SWFs that in 2008 a group of countries involved in these sorts of policies met in Chile under the auspices of the IMF and established the ‘Santiago Principles’, a set of 24 best-practice guidelines for the establishment of SWFs.
What happened was that the dynamics of the world economy during the final decade of the twentieth century (including the expansion of the Chinese economy) significantly expanded the demand for natural resources. This expansion of demand outpaced the possibility of expanding world supply for most commodities and, hence, increased their prices, as would be expected when demand expands quickly and supply cannot. So, the prices of minerals and fuels, foodstuffs and organic materials shot up during the first fifteen years of the twenty-first century. This windfall, of course, was welcomed by LMI countries across the Global South, many of which have been commodities exporters for a long time. In fact, it allowed some of these countries to expand social programmes and the size of their welfare states to a degree that was previously inaccessible to them.
Setting up a SWF basically requires establishing rules that force governments to save part of a windfall as fiscal reserves so that the government builds an endowment that it can invest in some way (usually following some rules or governance system that is located in an ad hoc institution) and use the returns to finance expected future expenditures such as pensions for an increasingly elderly population.
The politics of sovereign wealth funds is subject to the same sort of problems we have discussed so far in this Insight. However, in a world of increasingly frequent crises, large fluctuations, and boom and bust dynamics, it seems very likely that more and more LMI countries will inevitably face this problem of unexpected windfalls, the need to save part of them, and the challenge of giving some governance to sovereign wealth funds.
The oldest SWF in the world is the Kuwait Investment Authority (KIA) that was founded in 1953. It is currently one of the world’s largest SWFs, managing almost 1 trillion US dollars, which it invests all over the world. Its mission is to manage the enormous surpluses generated by the oil exports of this economy with a long-term perspective.
The reason for the establishment of the KIA was that Kuwait was, in the 1950s, an oil-rich economy that was still very poor. Today Kuwait is a very rich country, but in those times it had a significant proportion of its population living in poverty with very low levels of education and access to health. There is very little reliable data for the time but, for example, we know that life expectancy was only slightly over 50, which was the world average at the time. In countries similar to Kuwait, around 50% of the population was living in extreme poverty. On the other hand, Kuwait has around 6% of world oil reserves but only 0.06% of the world population. The country needed to invest heavily, but also, not to spend the money in an irresponsible or unsustainable way. Moreover, even in the 1950s, most oil-rich countries understood that, at some point, their reserves could run out or technological developments and environmental needs would restrict their ability to cash in their natural resource reserves. They needed to use oil revenues with a long-term perspective.
Today, the KIA principally manages two major funds: the Kuwait General Reserve Fund (GRF) and the Future Generations Fund (FGF). Each one receives 10% of all state revenues and has a rule: the government commits to never spend the fund itself but only the revenue and income generated by the fund’s investments. It has a board and is incorporated and managed as a private company despite the fact that it is completely owned by the state of Kuwait. At this point the KIA manages total funds that are above 500% of Kuwait’s GDP and is a sought-after investor by companies and countries who need long-term and large-scale capital investments.
According to the Sovereign Wealth Funds 2023 report, as of 2023, 72 countries had SWFs: 28 high-income countries (such as Oman and Brunei) according to the World Bank lending groups classification, 18 upper-middle-income countries (such as Equatorial Guinea and Indonesia), 17 lower-middle-income countries (such as Morocco and the Philippines), and 5 low-income countries (such as Ethiopia). Two countries or territories with a SWF do not have a World Bank classification.
At the time this Insight was written, over 70 countries had SWFs. Most SWFs are related to revenues from oil and gas exports, but there are some based in mining revenues, and a substantial number that are related to general fiscal revenues (not associated to a particular export). Most of them have a corporate structure similar to the KIA and rules defining what percentage and type of fiscal revenues are contributed every year as well as what part of the revenues and profits generated can be spent. The largest SWF in the world belongs to Norway, which is rich in gas and oil, and is explicitly called the Statens pensjonsfond, or government pension fund, reflecting its core purpose. The largest non-oil-and-gas SWF in the world is GIC, Singapore’s Government Investment Corporation, which invests government surpluses derived from its maritime, port, logistics, and financial services.
Question 15 Choose the correct answer(s)
Which of the following ways of spending money saved in a SWF is an Odyssean solution?
- This solution is not Odyssean because the government cannot credibly commit to stop spending (it is unclear when the ‘present needs’ no longer require debt to be issued).
- This solution is Odyssean because it does not spend the wealth accumulated but only the profits of the investments made, so the country can continue relying on the profits generated by the fund.
- This solution is not Odyssean because the revenue from commodity exports can be very volatile, which exposes social spending to high variability.
- Future commodity export prices are uncertain so if these prices change unexpectedly, a country may end up overspending.
Exercise 8 A transitory commodity boom
Consider a commodity-rich country that has an initial intertemporal endowment that is relatively balanced in time (the same income now and the future) and faces an international interest rate, \(i\), at which it can save or take debt. Suddenly the country faces a commodity boom (sharp increase in prices) that is assumed to be transitory.
- Use appropriate diagram(s) to show how the country could transition from not having a SWF to having a SWF.
- Explain how the abundance of money in international markets (many LMI countries saving in SWFs) can lower international interest rates.
- How does this fall in international interest rates affect your answer to Question 1?
- How does your analysis for Questions 1 and 3 change if the commodity boom is assumed to be permanent?
