Chile, which is relatively small, with a population of 17 million and a $282 billion economy, has three SWFs. As well as the $15 billion economic and social stabilization fund (ESSF), there is a $6.4 billion pension reserve fund (PRF) and a $4 billion education fund (EF).
The ESSF was 100% invested in overseas fixed-income assets, but recently shifted some into bank deposits as part of its strategy during the past two years to gradually adjust its asset allocation. Corporate bonds and variable-income investments have been added since 2011. This year the fund changed its asset composition again and now invests 15% in bank deposits, 19% in non-indexed sovereign bills, 55% in non-indexed sovereign bonds, 3.5% in inflation-indexed sovereign bonds and 7.5% in equities.
Chile’s SWF is ranked the third best for transparency and accountability in the world after Norway and New Zealand, according to a scorecard developed by Edwin Truman, a senior fellow at the Peterson Institute for International Economics, a Washington DC-based think-tank. The strengths of the Chilean SWF system make it well placed to serve as a model for many countries.
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Peru has already established a $4 billion fiscal stabilization fund; this has invested mostly in domestic assets, but the Peruvian government indicated in August that it might follow Chile’s example and invest more in foreign assets for higher yields. Colombia, Brazil and Panama are closely watching the performance of Chile’s fund and are using it as a template to set up their own funds. “In many ways, Chile is the economic model for other countries in Latin America,” says Joydeep Mukherji, managing director and senior sovereign analyst for Latin America at Standard & Poor’s. “Its fiscal policy, which is designed to generate a government surplus, is an example for other countries in the region. The country has demonstrated prudent and forward-looking management of its finances. The success of the sovereign wealth fund stems from the fiscal policy.”
Santiago Mosquera, director for Latin America sovereigns at Fitch Ratings, says: “Chile’s SWF is highly transparent, and in that sense scores very well in surveys of sovereign wealth funds around the world. Certainly it can work as a model for similar funds that are set up by other Latin American countries.”
Chile’s fiscal policy was designed to contribute to macroeconomic stability and since 2001 has been underpinned by a structural-balance rule, which aligns current spending with the trend of long-term revenue flows of the central government. The country is the world’s biggest copper producer, and state-owned miner Codelco is a big contributor to the state’s revenues.
The fiscal policy is intended to iron out cyclical fluctuations in economic activity and the copper price and to avoid drastic adjustments in government spending in the case of adverse economic circumstances.
In September 2006, a fiscal responsibility law was enacted that enshrines the basic rules of the country’s fiscal policy. This created the PRF and ESSF funds, which were officially established in February 2007. The PRF’s main purpose is to supplement the financing needs of future pension contingencies. In ESSF’s case, its objectives are to finance potential fiscal deficits and to amortize public debt.
During 2009, Chile drew down $9.27 billion from ESSF to help weather the storm around the Lehman Brothers collapse and the global financial crisis. Since 2010, $3.6 billion has been injected back into the fund.
According to the law, contributions to the PRF must be made each year of a minimum amount equivalent to 0.2% of the previous year’s GDP. If the actual fiscal surplus exceeds 0.2% of GDP, the PRF receives a contribution up to a maximum of 0.5%. The law also allows the government to make annual capital contributions to the central bank equivalent to the difference between its contributions to the PRF and the effective fiscal surplus, with an upper limit of 0.5% of the previous year’s GDP. Lastly, the ESSF receives the remainder of the previous year’s effective surplus.
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| Klaus Schmidt-Hebbel, president of the Fiscal Council of Chile and president of the advisory committee of the country SWFs |
“The pension reserve fund was set up to help people on very low pensions,” says Klaus Schmidt-Hebbel, president of the Fiscal Council of Chile and president of the advisory committee of the country SWFs. “It subsidizes their pensions and is able to invest over a very long time horizon.” Mosquera adds: “Many people were in public pension schemes before the government decided to privatize them; in 1980 it set up a fully funded capitalization system run by private-sector pension funds. However, many people were caught up in the old system and their pension plans start to mature during the next few years. PRF partly covers these costs.”
Under the ESSF fund, the average duration of sovereign investments is almost six years, whereas that for bank deposits is just a few months. Since its inception the fund has had an annual return of 3.54% in US dollar terms and 2.72% in Chilean peso terms. However, during the 12 months to August this year, it returned minus 1.2% in US dollar terms and had a positive return of 5.13% in Chilean peso terms.
In August, the PRF’s asset allocation stood at 48.1% in sovereign and government-related bonds, 16.8% in inflation-indexed sovereign bonds, 19.9% in corporate bonds and 15.2% in equity. Since inception, this fund has returned 3.23% in Chilean peso terms, although the return was up to 5.86% in local currency for the 12 months to August. Over the same period, the return on the sovereign and government-related bonds component was down by 5.76%, whereas inflation-indexed sovereign bonds were down by 2.06%, corporate bonds were up 0.13% and equities increased by 16.31%.
The financial advisory committee headed by Schmidt-Hebbel makes recommendations to the finance minister about how the funds should be allocated. The minister normally accepts these recommendations; in the case of fixed-income investments, a team at the central bank is in charge of managing the portfolio on a day-to-day basis, whereas in the case of variable-income investments external financial advisers manage the money.
The education fund was established last year during fiscal reforms carried out by the government of Sebastian Piñera. The administration set it up to try to pacify high school and university students who were protesting against the cost of education. The government has already injected $2 billion into the fund; a further $2 billion is supposed to be added to it by the end of the year. It is designed to support an increase in the government’s education budget and the fund will start to be drawn down gradually next year. It is intended to be a testament to the government’s long-term commitment to the country’s educational system.
Chile’s sovereign wealth funds system is becoming a model for funds around the world: most are being set up to avoid Dutch disease, whereby a country becomes too dependent on one commodity and is liable to boom and bust with every swing in the commodity price.
The nation was so committed to transparency in the management of its funds that it was one of the countries that spearheaded the development of the Santiago Principles in 2008: a set of 24 voluntary guidelines to achieve best practice. The standards were established through a joint effort between the IMF and the International Working Group of Sovereign Wealth Funds (now the International Forum of Sovereign Wealth Funds). So far, 25 countries have signed up to the principles. They are followed by some of the biggest SWFs in the world, including Norway’s government pension fund (with $720 billion in assets under management) and the Abu Dhabi Investment Authority (with $627 billion).
Among Latin American countries, Peru has a fund already but wants to introduce a similar institutional arrangement to Chile’s and implement the Santiago Principles. Colombia has already set up a $1 billion fund based on royalties from the country’s expanding oil and gas sector. It is looking at setting up a financial committee similar to Chile’s, but the committee would include government members (in Chile’s case it is only top economists and academics). It, too, will implement the Santiago Principles, which the country has passed into law.
Brazil is also working on setting up a fund; in its case with the objective of mopping up excess dollar liquidity through overseas investments. It has already used financial instruments to do this, but now wants to institutionalize the system along Chilean lines. Panama already has an SWF, called Fondo de Ahorro de Panamá (the Panamanian savings fund), which has up to $1 billion under management. This will be funded from revenues from the Panama canal.
For many years Trinidad and Tobago has also had an SWF, called the heritage and stabilization fund, with $4 billion under management. Mexico has an oil stabilization fund, but it does not yet operate in the style of a fully fledged SWF.
Eric Parrado, an adviser to the Chilean finance ministry and a member of the financial committee of the country’s SWF, has advised Peru, Colombia, Panama and Brazil about how to set up SWFs. He has also been advising Nigeria and Mongolia on the establishment of funds implementing the Santiago Principles. Nigeria has already enacted a fiscal responsibility law along Chilean lines. Israel is considering a SWF modelled on Chile’s.
“The Chilean model is very strong in terms of transparency,” says Parrado. “From the start, we have considered all of the fund’s stakeholders and wanted to keep them fully informed about the fund’s performance and investment policy. It has become a benchmark.”
