Sovereign Wealth Funds and Macroeconomic Stabilization

in the Home Economy

Sovereign Wealth Funds and Macroeconomic Stabilization

in the Home Economy

Ibrahim Elbadawi Raimundo Soto Hoda Youssef

ERF&WorldBankWorkshop“SovereignWealthFunds(SWFs):Stabilization,InvestmentStrategies&LessonsfortheArabCountries”

September9‐10,2016WashingtonDC

OUTLINE

1. Motivation, Objectives & Research Questions2. Data and Stylized Facts 3. Empirical Framework and Results

3.1 On Fiscal Procyclicality Evaluating the impact of SWFs Are GCC countries different?

3.2 On Fiscal StabilityEvaluating the impact of SWFs Are GCC countries (again) different?

3.3 The Choice of Exchange Rate Regime4. Conclusions and Way Forward

MOTIVATION

• Dramatic increase in the number and size of Sovereign Wealth Funds (SWFs) in the past 20 years.

• Much of the attention focused on the rise of SWFs as global investors, then on related governance issues.

• We don’t know much on whether SWFs help broader economic policy objectives in their home countries.

• Despite their high policy significance, there is still a significant lack of knowledge on the macro-stabilizing role of the funds, and on their link to different aspects of fiscal policy.

RESEARCH QUESTIONS

1. What is the role of SWFs in:

stabilizing fiscal expenditure enhancing fiscal surplus limiting fiscal balance instability

2. What is the role of SWFs in influencing the choice of fixed or highly managed exchange rate regimes?

3. Is this role different in the resource-rich GCC countries?

DATA AND STYLIZED FACTS

Data: A global panel of data field covering 133 countries over 35years-period: 1980-2014

Sovereign Wealth Funds Institute (SWFI) database.

Qualitative information on SWFs, their date of establishment,main purpose, assets holdings and ranking based on governanceindicators.

Macroeconomic variables: World Development Indicators 2016

Capital Account Openness: Chinn and Ito database (2014).

IMF Fiscal Rules Database, 2016

NumberofcountrieswithestablishedSWFs

• Notableincreaseinthenumberoffunds.

• Number more than doubled since the years 2000s.

SWFsbyType&Origin

The vast majority of these fundsare commodity based, inparticular from oil and gas.

Countries in gray shades have established SWFs

The main factor behind the rapid growth in SWFs numbers is theincreased sovereign asset holdings : the recent commodity price boom in commodity-exporting countries accumulation by emerging countries of persistent current account

surpluses

But despite the growing number, SWFs assets remain concentrated

The top fivefunds are hometo 63% of allassets and thetop ten havethe lion shareof 86%.

The rapid growth of assets under management has triggered another debate, on the degree of transparency and accountability of SWFs.

To date, only 35% of the funds have a Linaburg-Maduell transparencyscore of 8 or higher .

The recently established funds do not necessarily exhibit higher degrees oftransparency than the older funds

Transparency does not necessarily correlate with the size of the funds.

THE EMPIRICAL FRAMEWORK

From an empirical viewpoint, there are enormousdifficulties in assessing the impact of SWFs.

We are limited to information only about the existence of aSWF in a country (i.e., a dummy variable)

Given our interest in fiscal performance, we focus only innational SWFs and exclude regional or industry specificfunds.

We evaluate the impact of the treatment (SWFs) ondifferent outcomes (exchange rate stability or fiscalprocyclicality) over a population of individuals (countriesof the world).

Difference-in-differences

Period when SWF countries did not

have a SWF in place

Period when SWF countries have a

SWF in place

Country has implemented SWF

Country did notimplement a SWF

AgoodmeasureoftheeffectsofSWFonourvariableofinterestis

thediff‐in‐diffestimator

Methodology for Linear Models

= + + + ( · )+

Where istheoutcome,modeledinlinearform denotesthetimeevolutionoffundamentalsbycountry isarandomunobserved"error"term α is the country-specific effect β is the contribution of each fundamental is the treatment-group specific effect is the true effect of treatment.

RESULTS

1.On Fiscal Procyclicality

Fiscal Procyclicality I: Cyclical Component of Government Spending *

*Consideredasthediscretionaryresponseoffiscalpolicytobusinesscycle.

Model1: Gvt.spendingtendstobeprocyclical.

Naturalresourcerentsplayasmall,yetsignificant,effectonfuelingfiscalprocyclicality.

Fiscal Procyclicality I: Cyclical Component of Government Spending *

Model2: SWF dummy insignificant The two interaction terms suggest

that SWF help : Reduce procyclicality from BC

by 1/3 Eliminate procyclicality arising

from the cyclical component of natural resource rents.

Fiscal Procyclicality I: Cyclical Component of Government Spending *

Model extended to consider the different channels throughwhich SWF might affect fiscal procyclicality.

Financial integration to global markets (using the Chinn-Ito index of de-jure restrictions to capital flows as anindicator of the degree of openness of the capital account)

The role of the domestic financial sector (using the shareof private sector credit to GDP)

The size of government sector in the economy

Fiscal rules: a dummy variable indicating the presence ofany type of rules.

Fixed exchange rate regime, dummy variable.

Fiscal Procyclicality I: Cyclical Component of Government Spending *

Fiscal Procyclicality I: Cyclical Component of Government Spending *

In the presence of SWF, impact on procyclicality

Fiscal Rules

Fixed Exchange Rate

Resource-dependent Economy

Aggravate Reduce

Non-Resource-dependent Economy Reduce Aggravate

ARE GCC COUNTRIES DIFFERENT?

• Strict adherence to the currency peg raises the question ofwhether SWF in these economies operate in a differentmanner or whether they have any role at all.

• We extend our model to include a dummy variable for GCCcountries and interact it with the exchange rate and SWF.

GCC countries ARE indeed different (Model 6)

When controlling for the GCC effect: SWFs by themselves

have no impact on gov. spending.

SWFs in GCC were found to be more effective, as they tend to ameliorate the pro-cyclicality of both the business cycle and the resource rents cycle.

RESULTS

2. On Fiscal Stability

The recent interest in fiscal procyclicality has somewhat overshadowedthe important issue of fiscal instability.

Previous research: economic theory alone cannot explain persistence offiscal deficits political & institutional elements could provide a moresatisfactory answer.

The analysis of the role of SWFs could provide interesting insights onfiscal instability; it has not been done before.

We use five‐year averages of fiscal balances (% of GDP). Each country hasa minimum of 3 and a maximum of 8 non‐overlapping five‐yearobservations spanning the years 1980–2014 (evidently, panel isunbalanced).

We use the generalized method‐of moments (GMM) estimator.

The model includes the following determinants: Economic development Trade volumes and export concentration Political participation (Polity2) Govt. size

Different sources of govt. income:- loans from PS (financial

development proxy- inflation tax - taxing resource rents

FiscalBalance

Baselinemodel(1)confirmsthefollowing

associations:

‐ Economicdevelopment&largeexternalsector(+)

‐ Democracy,govt. size & financing (-)

Model(2)and(3)checktheroleofSWFs:

‐ Model2:nodirectimpactforSWFs

‐ Model3:indirectly,SWFstendtopromote

counter‐cyclicalityincountrieswithhigher

standardsofdemocracy,largegovernmentsor

moreopentraderegimes.

FiscalInstability Baselinemodel(4)confirmsthefollowingassociations:‐ Economicdev.(explainedbyemergingeconomies)andexportconcentration(economiesrelyingonhydrocarbonsorminerals) (+)‐ dependenceonresourcerents,govt.size,recoursetoinflationtaxanddemocracy(‐)‐Model(4)and(5)checktheroleofSWFs:- SWFs have no direct effect on fiscal instability

- More developed countries and high resource rents with SWF display higher instability

- Suggest the exogeneity assumption in the diff-in-diff estimator has been violated; results possibly driven only by high-income non-developed countries where SWF would be a response to –rather than the cause of – fiscal instability.

ARE GCC COUNTRIES (AGAIN) DIFFERENT?

We differentiate between two subsets of high income countries.

Industrialized countries

..where devpmt. levels are high and resource rents are:- largely absent

(continental Europe) - or play a minor,

subdued role (Australia or Norway).

Resource rich, hydrocarbons based

economies

…… where the

industrial based is

absent and resource

rents play a decisive

role (GCC countries).

Model3and3(a):fiscalbalance

GCC countries are indeed very differentfrom other high income economies(economic development, openness totrade, others…)

Model4and4(a):fiscalinstability

Comparison of the results identifiesinteresting contrasts.

Contrary to non-GCC, SWFs in GCCcountries are associated with:

significant decrease in fiscal instability increased instability from open trade Lowered instability from resource

rents Lowered instability from financial

development

RESULTS

3. The Choice of Exchange

Rate Regime

Probabilityofchoiceofafixedexchangerateregime

Probit model for fixed exchange regimes.Right hand side: variables typically considered inthe three theories behind adopting a fixed regime(OCA, financial, and political).Larger, more open and those with more politicalparticipation economies have a lower probabilityof having their currencies pegged.Novel result: countries with higher levels ofresource rents per capita prefer flexible exchangerates (threshold effect?).SWFs have a direct and highly significant negativeeffect; effect further reinforced in financiallyopened economies.Indirect effects of SWFs (size and trade) partiallyameliorate the direct negative impact of SWFs.

CONCLUSIONS

1. In the vast majority of cases, we fail to find direct stabilizing effect ofSWFs on fiscal outcomes.

2. Rather, the impact of SWFs operates indirectly through an associatedeffect with overall business or resource cycles, trade and capital accountopenness and exchange rate regimes.

3. The effect of SWfs in GCC countries seems to be different from otherhigh income economies, possibly due to the high dominance of theresource base.

4. The presence of a SWF was found to decrease the probability ofadoption of pegged exchange rate regimes, especially in financiallyopened economies.

5. The indirect effects of SWFs associated with large economies or thosewith higher volumes of trade operate in the opposite direction:enhancing the probability of choosing pegged regimes.

WAYFORWARD

Accounting for more nuanced features of SWFs, beyond just the

qualitative indicator of whether or not a SWF exists.

Control for SWFs governance indicators, possibly at the cost of

reduced country coverage.

Interpretation of some of the estimation results requires better

understanding of the channels and the underlying institutional

structures, especially with regards to the few new results that

diverged from those obtained in the received literature.