Sovereign Wealth Funds
Contributors
Reid Broughton is currently a student at UChicago majoring in economics. His interests include trade policy, socioeconomic justice, and artificial intelligence.
Key things to know
Sovereign wealth funds (SWFs) are state-owned funds, typically investing in assets like stocks, bonds, real estate, and more. They are a common solution to Dutch disease.
Dutch disease occurs when an economy experiences a rapid increase in export revenue, such as the discovery of natural resource deposits like fossil fuels, iron deposits, or rare earth metals. The economy becomes less diversified as the new, highly-profitable export pushes out other industries. This results in job loss, as these new extractive industries, such as fossil fuels or mining, tend to depend on heavy machinery and equipment more than human laborers, employing less people relative to other sectors like manufacturing. As the economy becomes dominated by one new industry, it also becomes highly sensitive to price swings in the export, resulting in economic volatility in which something as narrow as a drop in oil prices can trigger a recession.
SWFs can manage this effect. An exports' revenues may be parked abroad in the foreign currencies it is purchased in by purchasing foreign assets. This prevents upward pressure on the economy's currency, which would cause other industries to struggle to compete with the export. SWFs can also ensure revenues are more evenly distributed. For example, instead of revenues flowing towards those employed directly in the export (e.g. oil riggers), it can be redistributed via dividends or social spending.
A rapid drop in a natural resource export’s price (e.g. oil price swings) can introduce hardship for an economy over-dependent on that export. SWFs can provide macroeconomic stability in such times. During economic booms, windfalls are invested in the fund, which can then be drawn upon during economic busts, promoting stability by providing funding for new infrastructure, social services, cash transfers, tax cuts, and other forms of economic stimulus.
Case study
In 2006, Chile enacted its Fiscal Responsibility Law, establishing the Economic and Social Stabilization Fund (ESSF) and Pension Reserve Fund (PRF) with the intention of taxing and investing copper windfalls to support macroeconomic stability and state pensions. During the 2009 financial crises, 9.28 billion USD (6% of Chile’s GDP) was withdrawn to fund payroll tax cuts, housing subsidies, and public works, helping cushion the recession. Chile's GDP contraction during that time was mild and stayed under 15% of GDP. The fund was again used to avoid fiscal spending cuts during the 2014-16 slump in copper prices. The fund was rebuilt during 2022-2024 to a size of about 3.5 billion USD as copper prices rebounded.
Chile’s SWF law mandates a "structural balance rule." In simplified terms, independent panels make projections on what long-run average GDP growth and copper prices might look like, excluding short-term fluctuations. The government's annual budget is built based on these long-run projections. If government revenues exceed that planned budget in any given year, the surplus funds must, by law, be invested in Chile's SWFs. Only when government revenues fall short of funding the planned budget is the government authorized to withdraw funds. Through strong institutions and prudent regulations, Chile’s SWF has become a great example of how SWFs can be used for the public good in a middle-income country.
Potential pitfalls
A successful SWF requires strong institutions and rule of law to prevent the fund from being raided by politicians seeking short-term gain. Nigeria’s 2011 attempt at a SWF failed, in part due to frequent emergency raids, political discord, and a lack of concrete regulation on when and how revenues were to be invested into the fund
SWFs may not be advisable in countries with pressing basic needs like healthcare, education, clean water, and poverty alleviation, where immediate investment in human services would yield higher returns in human development than saving for future generations
Conclusion
SWFs are often a crucial tool to combatting Dutch Disease, promoting long-term economic stability, and ensuring resource wealth is distributed evenly among a population instead of concentrating in the hands of the elite. They can be an excellent policy choice in countries that are well-endowed with natural resource wealth, but may only be effective if strong institutions and established rule of law are in place to ensure the SWF is managed prudently.
