Minerals-Backed SWFs Show Their Mettle as Coal, Copper Prices Plummet

March 19, 2015 by Craig Mellow

Mineral-backed #SWFs are suffering as prices fall.
Can fiscal prudence see #commodities funded SWFs through a spell of low prices?
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State-owned investors funded by mineral and metals mining revenue are suffering as prices fall. Fiscal prudence may see them through.

As petroleum prices tumble, the world's attention is focused on those sovereign wealth funds associated with hydrocarbons. People are paying less heed to government-owned asset pools funded by revenue from nonoil commodities, such as metals, coal and diamonds. Prices for many of these exports have also declined over the past year, though less sharply than oil. Copper prices have fallen by 18 percent since crude started to tank last July, to their lowest value since mid-2009, according to NASDAQ data. Thermal coal has dropped 13 percent over the same period, and is also hovering near six-year lows, according to data provider InvestmentMine.

The state-owned investors coping with these downdrafts are much smaller than the oil-fueled giants like the Abu Dhabi Investment Authority , with about $600 billion under management, or even the $37.1 billion State Oil Fund of the Republic of Azerbaijan . The largest of the mineral-fueled state-owned asset pools are Chile's twin stabilization and pension reserve funds, with total assets of almost $23 billion.

Wiped Out

The minerals cohort is is a highly diverse group — geographically, in their countries' stages of economic development, and the particular sources of their wealth. Members stretch from Chile and Peru, with its $9.2 billion Fiscal Stabilization Fund, to the Western U.S., where the $7.1 billion Permanent Wyoming Mineral Trust Fund and the $20.2 billion New Mexico State Investment Council are domiciled. And from Botswana, with its $5.5 billion Pula Fund , to Mongolia's Fiscal Stability Fund with some $250 million in assets by a recent count.

Most such vehicles, like that of Peru, fall under the category of so-called stabilization funds — which are designed to insulate government spending from commodity price gyrations — and so don't necessarily fit the definition that qualifies a fund for inclusion in the Sovereign Wealth Center's roster.

Notably, Australia's $95.4 billion Future Fund isn't funded by revenues generated by mineral mining. It was seeded in 2006 and with a A$18 billion (then $13 billion) lump sum, cash from government fiscal surpluses, as well as proceeds and shares from the then-recently privatized telecommunications operator Telstra. But coal and metals account for some 45 percent of Australia's exports and during the mining boom there was political debate about establishing a fund to saving mining revenues for future generations. The Labour government refused, resulting in states like Western Australia setting up their own funds: the coal-fueled Western Australian Future Fund amounts to $700 million.

Mineral-based funds and the governments that control them have less room for error than the petrostates, experts say. Failure to exercise fiscal caution during this downturn could leave them depleted if not wiped out by the time prices rebound. Chile has cut its teeth on these matters before, particularly during the 2008-'09 financial crisis. 

Seeking Stability

But the countries involved are largely rising to this challenge, according to experts. Chile and Peru in particular have been models of fiscal discipline for more than a decade, piling up enough savings to get them through the current downturn. Both governments will probably manage without large-scale withdrawals from the national savings, says Edward Glossop, an emerging markets economist at Capital Economics in London. "These are the two stars of Latin America with tight deficits and very, very low debt levels," he says. "They should be able to borrow what they need without drawing down the sovereign wealth funds."

Chile's two sovereign investment vehicles are among the most transparently governed sovereign wealth funds. The government established the Economic and Social Stabilization Fund, known as ESSF, and Pension Reserve Fund in 2007, to offset the nation's dependence on copper exports. Chile, with a population of 18 million, is the world's dominant producer of the metal, with more than triple the output of its nearest rival, China. Chile depends on copper sales for one-third of government revenue, according to Glossop.

That's a powerful argument for a counter-cyclical fiscal stability fund. The proof: Copper prices plunged by more than 60 percent during the 2008-'09 financial crisis, and did not return to pre-crash levels until late 2010. The Chilean government withdrew $9.3 billion from the ESSF in two installments during 2009, one of the largest post crisis stimulus programs in the world on a relative basis.

The capital injection limited the shrinkage in the the nation's GDP to just 1 percent. Chile returned to nearly 6 percent growth in 2010, and the ESSF accrued another $3.6 billion between 2010 and 2013.

Welfare Programs  

"The ESSF withdrew money and refurbished it later," says Sven Behrendt, founder of consulting firm GeoEconomica in Geneva. "That's exactly what they were set up for."

In 2014, Chile withdrew a more modest $499 million from the ESSF. Economists expect any withdrawals this year to be similar in scope, leaving the roughly $15 billion buffer intact. The recent decline in copper prices has been much more gradual than the 2008 crash, and with sovereign credit ratings as good as China's, AA- by Standard & Poor's, Chile can easily borrow to fund budgetary shortfalls.

Chile has inspired funds in other mining-dependent economies, most notably its larger but poorer neighbor Peru. Fully 69 percent of that country's exports are metals and minerals, against Chile's 58 percent, according to a paper last year by Luis Felipe Céspedes, Eric Parrado and Andrés Velasco, though Peru's mining industry is more diversified, including gold, silver and lead as well as copper. Peru formed a stabilization vehicle, the Fiscal Stability Fund (FSF), in 2011, depositing $5.6 billion that had accumulated in other pools, switching its focus to budgetary prudence away from intergenerational wealth transfer.

The trigger mechanisms of the Peruvian fund are not strictly objective. It simply accumulates excess budgetary funds, and can be tapped when state revenues fall by more than 0.3 percent, relative to gross domestic product (GDP), from an average of the preceding three years. The Peruvian government can draw down a maximum of 40 percent of the FSF, and must use the money for social welfare programs. The fund also has its own ceiling of 4 percent of GDP, or $13.6 billion. (It currently stands at about half that level.)

Oil Prices

But similarities in the two economies outweigh the differences in their funds, analysts say. Like Chile, Peru has secured an investment-grade credit rating, and should make up an expected 2 percent-of-GDP deficit this year in bond markets rather than raiding its wealth fund.

Peru, with population around 30 million and gross domestic product of $340 billion, has increased its stabilization fund's assets to $9.2 billion. Neighboring Brazil's Fondo Soberano do Brasil (FSB), it should be pointed out, isn't a resource fund at all. The National Treasury issued debt of $6.1 billion to fund it in 2008. Brazil, whose 202 million citizens produce $2.4 trillion in annual output, is of course a big exporter of iron ore, oil and agricultural products.

It helps that Chile, Peru and other mineral exporters are also big oil importers. Cheaper hydrocarbons help offset falling metals and mining sales and ease the financial squeeze. The U.S. state funds are bolstered by a somewhat  different dynamic: Oil production has risen in Wyoming and particularly New Mexico thanks to shale drilling, filling the coffers despite falling oil prices.

At the other end of the spectrum come tiny developing nations like Botswana (population 2.0 million) and Mongolia (2.8 million), which are trying to reap the benefits of their natural resources. Botswana is the world's largest producer of diamonds and exports large quantities of copper and nickel. Mongolia draws one-third of its export income from coal, another third from copper and iron.

Past Mistakes

Both countries have saved less and on less transparent terms than advocates would like. Assets at Botswana's Pula Fund, are down sharply and are basically offset by increased government debt, says Keith Jefferis, director of Gaborone, Botswana-based economics analyst Econsult.

Mongolia had saved just $250 million in its Fiscal Stability Fund as of May 2013, according to a March 2014 International Monetary Fund Country Report , despite booming commodities output. "The government has basically been spending most of the windfalls from mining in recent years, with very much a pro-cyclical spending pattern," according to Dorjdari Namkhaijantsan, who represents the New York-based Natural Resources Governance Institute in Mongolia.

Both show improvement. Botswana proposed a fiscal rule that would channel 40 percent of mineral revenue directly to future-generations savings. And Mongolia is cutting its budget to protect the Stability Fund. "The new decline in revenues presents an opportunity for some governments to learn from mistakes made in the past," says Andrew Bauer, the NRGI's senior economic analyst.

Indeed, echoes of the Chilean sovereign wealth fund model can be found in Mongolia. Mongolian authorities created several vehicles for windfall revenues after the price shocks of 2008-'09. The Mongolian FSF, launched in 2011, which gets a share of mineral export earnings when prices move above long-term projections. Governing legislation forbids active management of the fund until it reaches 10 percent of GDP, according to the IMF report. Its 2013 assets of $250 million comes to just 2 percent, the report added.

Raiding Funds

Unfortunately, according to Namkhaijanstan, the FSF is only second in line for Mongolia's raw material receipts. Seventy percent of mining revenue goes into a Human Development Fund, which spent it all on cash transfers to the population during prosperous years, 2010-'14, and has borrowed money too. "Mongolia's revenue distribution system is complex and has not yet obtained a stable form," Namkhaijanstan concludes.

Still, the circumstances of a new minerals slump may be forcing longer-term thinking in Mongolia, he says, and may yet enable the Central Asian country to develop a substantial fiscal buffer. With its credit already strained by past borrowing, the government is looking to shrink its budget by 15 percent.

Botswana, an unlikely early example for the rest of the world, established its Pula Fund in 1994. But its savings and transparency practices deteriorated, and the fund only now seems to be trying to catch up, local economist Jefferis says.

The Pula Fund has been heavily raided twice in its 20-year history — first in 2001, to create a public employee pension facility, then in 2008-'09 to counteract plunging state revenue. As a result, the fund shrank from 89 percent of GDP in 1998 to 20 percent in 2011, according to an Econsult report.

"Stable Democracies"

Botswana's net national savings shrank to less than 3 percent of annual output as the Southern African country took on new debt during this time period. "The current situation is that the financial assets accumulated by government are insufficient to fulfil the intergenerational savings objective that SWFs in mineral economies are often designed to achieve," the 2013 report concludes.

One bright facet for Botswana is that the value of its key export — diamonds — is holding up well compared to other minerals. Raw diamond prices rose by 7 percent last year, according to De Beers Group. Longer term, the government has begun discussing a new fiscal rule that would funnel 40 percent of mining revenues directly into a new intergenerational savings vehicle, forcing the budget to rely more on domestic tax collections.

But this new rule did not make it into the 2015 budget, passed last month. "The budget did not include any details of the new fund, which seems to have been postponed for a while," Econsult's Jefferis says.

For the most part metals- and minerals-backed sovereign wealth funds proved their mettle in the 2008-'09 crisis, and are prepared for the current commodities downturn. Smallness has benefits. The minerals-related funds spring more from policy choices and discipline than their oil-fueled cousins, and so tend to display more fiscal responsibility. NRGI's Bauer points out another virtue. "Almost all the minerals funds are connected with stable democracies," he says.  

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