Taking Stock: Stabilization Fund Looks for a New Investment Strategy

Although Russia reaped much criticism recently for consolidating its energy sector under state control, its management of windfall oil revenues has been more politically and economically correct.

The value of Russia’s Stabilization Fund, created to prevent petrodollars from entering the economy and boosting inflation, stood at $76.6 billion on Nov. 1, up from $44 billion on Jan.1, an increase of 74 percent during the first 10 months of the year.

Speaking in Beijing on Oct. 14, Russian Finance Minister Alexei Kudrin said he expected the Fund to reach $93.3 billion, or about 8.5 percent of GDP, by the end of 2006, while Deputy Prime Minister Alexander Zhukov said in late October that the fund would continue to increase over the coming years and would exceed $149 billion by late 2007 and about $260.4 billion by the end of 2009.

The dangers of an economy heavily dependent on windfall revenues from high commodity prices and exports have been known ever since the Netherlands discovered natural gas in 1959. As major gas exports began, cash flooded in to the country, resulting in an appreciating currency and falling competitiveness.

The risk of catching “Dutch disease” later prompted Kuwait, Oman and Chile to establish stabilization funds while the Canadian province of Alberta and the state of Alaska set up Energy Revenue Funds.

Then, in 1990, Norway set up its Government Petroleum Fund, which has since become not only one of the biggest funds of any kind in the world, but also the model for other stabilization funds.

More recently, Azerbaijan and Kazakhstan have also set up oil stabilization funds, while Trinidad & Tobago’s Oil Price Stabilization Fund was renamed the Revenue Stabilization Fund and now manages both oil and gas revenues.

Many economists also point to a strong link between abundant natural resources and long-term economic deterioration when commodity revenues are spent unproductively. In the 1980s, Margaret Thatcher was frequently accused of squandering Britain’s North Sea oil revenues while unemployment levels rose due to her own government’s economic policy and retrenchment.

But this phenomenon is more common outside the West, where institutions are weaker and high commodity revenues frequently lead to rent-seeking, severely impairing the long-term growth of economies that benefit suddenly from valuable new resources.

Although rent-seeking became rampant in Russia in the early 1990s, the government set up Russia’s Stabilization Fund on Jan. 1, 2004 while energy prices maintained their high after recovering from the Asian crisis in 1997-8.

The idea was to balance the federal budget when the oil price fell below a certain cut-off level Рnow set at $27 per barrelСsoak up excess liquidity and insulate the economy from the unpredictability and volatility of raw material earnings.

So far, the government has resisted pressure to spend the money “unproductively.” Kudrin, like all monetarists, believes that inflation is the root of all evil, so he supports an “economically correct” policy, insisting that the money remain in the Stabilization Fund, an approach that seems to have the full backing of President Vladimir Putin.

Kudrin’s two main exceptions are paying off most of Russia’s various debts and topping up the Russian Pension Fund from the Stabilization Fund, which under Ministry of Finance rules can only be done when the Fund’s capital exceeds 500 billion rubles ($18.6 billion), a threshold which was passed in 2005.

Redeeming Russia’s external debt is not only non-inflationary, but also saves the country billions of dollars in annual interest payments. During 2006, the Russian government made repayments to the IMF and World Bank, as well as repaying the bulk of its outstanding debt to the Paris Club of Creditor Nations. This debt, which totaled $23.7 billion on Jul. 1 had been decreased to $1.9 billion as of Oct. 1.

As a result, Russia’s foreign debt declined 31.3 percent between July and September, falling to $50.1 billion by Oct. 1, according to the Finance Ministry. Zhukov said Russia’s foreign debt will gradually be reduced to $40 billion over the next three years.

In line with its mandate and in common with other “heritage” funds for future generations, such as that of Norway, which renamed its Government Petroleum Fund the Government Pension Fund, Russia’s Stabilization Fund can also be used to plug the deficit of the Russian Pension Fund, which in 2005 received 30 billion rubles ($1.1 billion) from the Stabilization Fund.

Not everyone in Russia agrees that the Stabilization Fund is such a good idea, and many people would like to see the people benefit more from Russia’s oil wealth. Moscow mayor Yury Luzhkov and Communist Party leader Gennady Zyuganov, for instance, have argued that money would be better spent on improving Russia’s ailing infrastructure, which has suffered from decades of underinvestment.

In fact, Russia would probably be unable to cope with such a huge influx of cash into the economy and has initiated four National Projects – health, education, agriculture and affordable housing – to help alleviate some of the more pressing problems. Putin has also expressed an interest in repairing and developing Russia’s transport system.

There are other criticisms, however, that carry more weight. The government has decreed that in line with the Fund’s objectives, its capital must be invested in foreign sovereign debt securities rated at the highest investment grade of AAA/Aaa by at least two of the big three rating agencies.

In practice, this means investing in U.S. and European treasury securities. At the moment, 45 percent of the assets are therefore invested in dollars, 45 percent in Euros and 10 percent in British pounds.

The investment in U.S. treasuries is anathema to many Russians, who still think in terms of the Cold War, regard the United States as the enemy and do not want to see Russia subsidizing American growth. A more serious problem, however, is the low return Russia earns from this conservative bond portfolio. AAA/Aaa Treasuries are highly rated because they are considered default-free, but they offer a correspondingly low yield compared to riskier instruments offering higher returns, whether these are corporate bonds or equity.

Many in Russia have therefore rightly argued that a higher-risk equity portion would enhance yield and point to Norway’s fund as the way forward.

Rather than being structured as a 100 percent low-yielding bond portfolio like the Russian Stabilization Fund, Norway’s fund has a much more flexible investment policy, allowing it to invest between 30-50 percent of its total assets in equity. It also has a much broader regional distribution, with between 40-60 percent of the fund invested in Europe, 20-40 percent in the Americas and 10-30 percent in Asia/Oceania. Its investment area covers 28 countries, including seven emerging markets.

The Norwegian Ministry of Finance is responsible for defining the long-term investment strategy of the Petroleum Fund, while the Central Bank (Norges Bank) handles the operational management, with the primary goal to outperform the benchmark portfolio defined by the Ministry of Finance.

Russia has plans to adopt a more aggressive approach to managing its Stabilization Fund. At a round table in March this year, Kudrin pointed out that the right way to manage the Stabilization Fund was under discussion, in particular, how much of it should be invested in foreign assets.

“We hold that a significant part of the stabilization fund, while it is still growing, should be invested in dependable high-liquidity foreign state securities,” Kudrin said. “But until the fund reaches a certain size, there is no need to develop a system for investment in corporate securities. That is the next stage. We can begin developing it, but there is one limitation: A number of lawsuits pending against the administration. Until those cases are settled, we have to act very cautiously.”

However, Kudrin added that the proposals made by the Finance Ministry with the Federal Service for Financial Markets, the Central Bank and the Ministry of Economic Development and Trade would most likely be approved in their entirety. Zhukov then announced in May that the government was prepared to invest in higher-yielding equity, but that the amount would not exceed 10 percent of the fund’s total assets.

In July, Mikhail Kopeikin, deputy head of the government staff, told reporters he thought that documents outlining the infrastructure for managing this part of the fund would be submitted to the government in the fall, saying that the government had already decided to divide the Stabilization Fund into two parts: financing for future generations, or an untouchable government reserve, and funds to be invested in more profitable but risky operations. He said the share of the fund to be invested, the investment instruments and the manager of the operations remained to be decided. “At the moment, the preferred option is the Central Bank using external management and major investment funds,” Kopeikin said.

So while Russia’s Stabilization Fund seems to be moving towards a more aggressive investment policy, it remains to be seen whether it will emulate Norway’s Pension Fund in outperforming its benchmark portfolio over the long term. Norway not only has the model fund, but is also widely regarded as the only energy-rich country to have escaped the curse of corruption and poverty.

Special to Russia Profile, an online and monthly print magazine dedicated to Russia and published jointly by RIA-Novosti and Independent Media, Moscow.

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