Gross International Reserves

Sovereign wealth fund under consideration

That was the banner story of today’s BusinessWorld online.

Here is a direct quote from the article:

Economic managers are studying the possibility of setting up a Philippine sovereign wealth fund to maximize returns from the country’s foreign exchange holdings.
“As I understand, the national government is conducting a study on the possible operations of a sovereign wealth fund,” central bank Governor Amando M. Tetangco, Jr. said at the sidelines of yesterday’s Philippine Investment Forum.

Finance Secretary Cesar V. Purisima confirmed that the plan was being considered, although he said the review remained in the preliminary stages.

“We haven’t brought up the matter with [President Benigno S. C. Aquino III] yet. So far, it’s just look, see, study and evaluate,” Mr. Purisima said.

As readers of this space will be aware, I have been harping on this issue for over two years now. Before anyone in the upper echelons of policy making, whether fiscal or monetary, or within academia were even contemplating it, I had flagged the possibility here. The following is a compilation of the previous articles I have posted on the issue
Early this year, I developed a policy paper on this topic, which I enclose below

Fruits of Our Labour by Doy Santos

It’s good to see that after more than two years of writing and engaging with the issue, the idea is finally being seriously considered by both the Department of Finance and the Bangko Sentral as confirmed by today’s news item . Even more surprising is how prominent economists are now supporting the principle of establishing a sovereign wealth fund for the Philippines. If this should be included among the administration’s priority bills for the 16th Congress, it would be timely as the country is expected to receive investment grade status by the end of the year.

Establishing and Managing a Philippine Sovereign Wealth Fund

This is the second part of a series on this topic. In the first part, I discussed why we need a sovereign wealth fund or SWF in the first place. My main contention was that the Philippines is currently suffering from “Dutch disease” or the adverse effects of a sudden rise of income from its export of labour and from a rise of confidence in its domestic economy. In this second part, I will discuss how we could govern and operate our own SWF.

The Santiago Principles established by 26 countries with SWFs known as the International Working Group or IWG  in 2008 lays out a number of generally accepted principles and practices or GAPP to ensure that “the SWF arrangements are properly set up and investments are made on an economic and financial basis”. One of the main reasons for this is that as government-owned  entities, as SWFs continue to grow in importance to global capital markets and perform a bigger role in corporate governance, they need to demonstrate that their investment decisions are not politically motivated.

Traditionally, SWFs took the surplus foreign reserves accumulated within a resource exporting nation and invested them in long-term projects overseas. This allowed recipient countries that were often capital constrained and developing to benefit from such investment flows. The size and relative lack of transparency of some SWFs however caused many actors in the international community to cast a suspicious eye at these funds.

In the Philippine context, as discussed in the first part of this series, I propose that our SWF be confined to funding projects within the country given our chronic underinvestment in infrastructure and need to resuscitate our industrial sector. Given however our historically poor track record at ensuring that government owned and controlled companies manage their assets in a prudent manner, the main concern in establishing a SWF would be to ring-fence it from the influence of politics.

The Santiago Principles help to define a set of best practices for us in establishing our own SWF in the Philippines. The Carnegie Endowment for International Peace talked about what the effect of signing up to these principles is by saying that

(b)y voluntarily submitting to the Santiago Principles, IWG members ceded their autonomy to establish governance arrangements in line with their individual needs and preferences. In a way, they made a conscious decision to limit the reach of their “sovereignty.”

You might be tempted after reading that to draw an analogy between the IWG to the World Trading Organisation or WTO which implements the General Agreement on Trade and Tariffs or GATT. Unlike that body, the IWG and its successor the International Forum of Sovereign Wealth Funds or IFSWF is purely voluntary and has no powers to sanction its members. The Carnegie Endowment does draw this distinction. What our Philippine authorities should do in drawing up the framework for its SWF would be to hard code “the Principles” in its charter.

As shown in the table below, the Principles may be divided into three distinct parts. These cover the legal and macroeconomic policy framework of the fund, its institutional and governance arrangements and structures, and finally its methods for managing investment decisions and handling risk. I am adapting the Carnegie Endowment’s description of these parts here.

Table 1: Santiago Principles*

Section What “the Principles” state there should be GAPP #
Legal framework, objectives, and coordination withmacroeconomic policies
  • disclosure of legal framework
  • definition and disclosure of policy purpose
  • public disclosure of funding and withdrawal arrangements
Institutional framework and governance structures
  • clearly defined roles and responsibilities of the principal/owner (the government) and the agent (SWF’s governing body, officers and executives)
  • a limited role for the principal which is to set the broad  objectives, appointment of governing body or board, and oversight of operations
  • a clear mandate to the fund’s governing body to set strategy for achieving its objectives along with being accountable for its performance
  • delegated authority for independently implementing strategies and handling operations for officers and executives under clearly defined roles and responsibilities







Investment and risk management frameworks
  • disclosure of investment policies
  • information about investment themes, investment objectives and horizons, and strategic asset allocation, including:
    1. disclosure of investments that are subject to non-economic and non-financial considerations
    2. whether they execute ownership rights to protect the financial value of investments
  • a framework that identifies, assesses, and manages the risks of its operations and measures to track investment performance employing relative and/or absolute benchmarks
GAPP 18 



GAPP 19.1




*adapted from Sven Behrendt (2010). Sovereign Wealth Funds and Santiago Principles: Where do they stand? Carnegie Papers No. 22, Carnegie Endowment for International Peace.

The policy aims of setting a SWF in the Philippines are clear: to channel excess foreign reserves in a productive way and to cope with the developmental needs of the country. As I stated in the first part of this series, existing legislation tasks the Bangko Sentral with ensuring an adequate supply of currency to meet our international obligations. It does not contemplate our current predicament where the annual flows of remittances and portfolio investments have made our gross international reserves (GIR) rise rapidly.

This has caused the appreciation of the peso which has put a strain on our exporters. Even our burgeoning business process outsourcing industry is beginning to feel the pinch of the currency’s upward trajectory. As I previously stated, the GIR is now sufficient to cover twelve months of imports and to meet all our external obligations with a comfortable buffer left over.

And it will keep rising especially if our government earns an investment grade credit rating as is expected next year. Our GIR should only be allowed to rise in proportion to our external commitments. As our economy becomes less dependent on foreign borrowing these external debts won’t rise as rapidly as they have in the past.

Once a targeted level has been reached, the Bangko Sentral should be authorised to declare any additional funds in excess of its requirements. The existing Central Bank Act should be amended to explicitly state this. The monetary board should be given the task of setting the appropriate benchmarks for making such declarations and for transferring excess funds into a SWF.

The nature of such a transfer, as I have suggested, should be in the form of a sovereign loan issued to the national government, which will own the SWF. This would help ensure that the projects which the SWF invests in will have a sufficient return to cover its borrowings and operating costs. It would also ensure that the value of the Bangko Sentral’s assets is preserved.

As to the appointment of its board and officers, the SWF would be subject to the same rules covering government owned and controlled corporations or GOCCs. The reforms carried out by the new GOCC law which created a commission that regulates the appointments, compensation and accountabilities of such officers would apply as well. This would include the need to provide audited financial statements and management reports.

In terms of the type of projects it would fund, I have suggested four potential areas or themes. This includes public infrastructure (such as the ones eyed for Public-Private Partnerships) aimed at both social and economic development, joint minerals exploration in consortium with private mining firms, industry cluster development projects, and clean, renewable energy projects.

The allocation of resources across these themes could be based on national priorities. Let’s be clear: the main purpose of this SWF would be to support the development priorities of the nation, and that should be stated unapologetically. But for specific projects, a set of solid business cases needs to be presented. When entering into joint ventures or consortia with private players, the SWF should also be allowed to exercise ownership rights over the project to protect its investments.

Just as with government financial institutions or GFIs, the SWF should be guided by proper prudential management principles that would monitor its risk exposure. Unlike the conservative treasury management practices of government banks and pension funds, the risk-return equation is different for an equity investor like the SWF. The risk tolerance would be higher while its returns need not necessarily be as big given its lower cost of borrowing. Its risk adjusted return on capital would thus be lower compared to commercial banks.

Some PPP bidders have expressed concern over political interference in the Philippines affecting their ability to set fees independently of the government. This has limited the appetite for actually managing the operations of the utilities and transport oriented projects. They have therefore chosen to participate only in building contracts. Takashi Ishagami of Marubeni Corporation has been quoted as saying that “the Filipino PPP is far away from our standard”. It has partnered with a local firm to jointly bid for a $1 billion railway project in which it would be merely supplying equipment.

That’s fine. If the SWF were to finance such partnerships, our excess foreign reserves would leak out of the country (as intended) through the purchase of foreign equipment. This will help temper the peso’s rise since these projects will no longer be financed through overseas assistance or equity from abroad. What could leak in, however, is foreign technology and know-how because as an equity investor, with a long time frame, the SWF would also have greater leverage to request that suppliers provide technology transfer to local partners. This should unapologetically be part of its investment prioritisation framework.

An Alternative to Charter Change

Rather than relaxing the maximum capital requirements on foreign participation in certain industries contained in our constitution, the government should instead be looking to accelerate the flow of funds into productive activity with the SWF as one of its prime vehicles. Where private players are too small to generate sufficient scale to participate in large projects, the government should encourage them to form a cluster and fund them to be able to compete with multinationals.

This incidentally was the vision of the late-Senator Benigno “Ninoy” Aquino for the Philippine economy which he explained in a speech delivered in Los Angeles back in 1981 while he was in exile. He sought to counter the Marcos regime’s formula of encouraging multinational firms to engage in extractive activities and to commercially fund projects like the Bataan Nuclear Power Plant. Juxtaposed to Marcos’ “crony capitalism”, Ninoy termed his philosophy “Christian socialism”.

Don’t be turned off by the name. As his remarks suggest, what he really meant was essentially a form of capitalism more akin to Northern Europe’s brand than to the English version as espoused by Adam Smith. The last time I checked, the German and Scandinavian economies seemed to be weathering the present crisis well, while maintaining one of the highest levels of income and social well-being compared to their Anglo-American counterparts.

Under President Benigno “Noynoy”Aquino’s rubric of good governance, the stage is now set to pursue that economic philosophy and vision for the country.  As the Carnegie Endowment for International Peace found, sound democratic institutions best explains a nation’s compliance with the Santiago Principles.

With the government now facing the prospect of receiving investment grade status in the coming year, it must prepare for any unintended adverse consequences this might have as more short-term investors flock to our shores, boosting the peso’s value and putting more of an already unbearable strain on our exporters of goods and services.

For good governance to yield economic benefits to the people, it needs to be used to address the developmental challenges facing the nation. If we act soon, we won’t have to face these same challenges in the future. The country is already in a gradual demographic transition that will lead us from an excess supply to an excess demand for labour over the next decade.

While we still send our surplus workers overseas, we need to channel the wealth they are creating for our nation into projects that would increase economic opportunities for our people back home. This presents our policy makers with a once in a generation opportunity to get things right. Given the discussion covered in this series, it would seem apparent that a SWF would be the way to go.

A Philippine Sovereign Wealth Fund

The Philippines is suffering from a rare form of “Dutch disease”, the negative consequences of a rapid rise in income normally associated with the export of natural reserves. In our case, the income comes from our export of labour. Overseas remittances rising every year swell our foreign currency reserves. The peso appreciates as a result. This diminishes the global competitiveness of our manufacturing sector with adverse implications for domestic employment.

Meanwhile government keeps borrowing from international markets to finance its chronic budget deficits. This contributes to the upward pressure on the domestic currency as more dollars flow in to purchase government securities. To keep its borrowing down and make credit rating agencies happy, government constrains its spending. It wants to rely on public-private partnerships (PPP) to provide infrastructure which are both time-consuming to arrange and limited in scope.

As it postpones development spending credit rating upgrades keep coming. Each time this happens, fund managers around the world increase the flow of “hot money” into the stock market, thus contributing to more upward pressure on the peso. Property developers also cash in as the value of residential and commercial assets appreciates with the rising peso, which creates even more demand for new development.

The families that receive remittances on the other hand suffer as the purchasing power of the dollar declines. And due to their dependence on these transfers, the income that families receive goes mostly to household expenditures. Very little is invested in productive activity. And when it is, the investment normally goes into retail or transport enterprises, which earn very marginal returns.

For the rest of the population, finding a job is a struggle. Life is hard as there are not enough opportunities that come by due to a dearth of fixed private capital expenditures on plant and equipment let alone research and development. Most of the inflows go to short-term investments, i.e. the stock market, or to fund property purchases, which results in very little job generation outside the construction industry which demands casual employment due to the seasonality of its activity.

This in a nutshell is the problem that confounds the Philippines.

Foreign remittances for the twelve months to January 2012 hit $20 billion according to the World Bank. Remittances for the first ten months of 2012 have already equaled that amount according to central bank figures (with the Asian Bankers Association estimating the real amount to be in the order of $27 billion). This was close to 90 per cent of the Bureau of Internal Revenue”s total tax collections for 2011, and would have been enough to finance that year’s budget deficit four times over. As of November 2012, the country’s gross international reserves (GIR) stood at $84 billion exceeding the BSP’s full year estimate of $78 billion.

This was enough to cover our imports for a full year or to settle all short-term debt obligations 12 times based on original maturity and 6.8 times based on residual maturity (that is short-term loans based on original maturity plus principal payments on medium- and long-term loans of both private and public sectors falling due in the next 12 months).

In fact back in June 2012 when the GIR stood at $76.1 billion, the country’s external debts belonging to both the public and private sectors stood at $62.5 billion. That means the BSP had enough to settle all external obligations and still have roughly $14 billion left over.

The two charts below show what has happened over the past decade. The first one shows that after a rocky first half, the country has been producing consistent balance of payments (BoP) surpluses averaging about 3.8 per cent of GDP from 2005-2011. That is the inward flow of foreign currency exceeded the outward flow by the said ratio. A quick rule of thumb is that 1 per cent of GDP is roughly $2.5 billion or Php100 billion.

So on average, the annual surplus has been about Php380 billion during the past six years. The average BoP surplus is therefore more than enough to accommodate government’s annual revenue shortfall averaging 1.11 per cent a year. The second chart shows the effect these surpluses have had on our GIR. From 2001 to 2011, it has grown on average by 16.7 per cent. Up until 2005, you can see that the line is pretty flat. Afterwards it rises steeply. This means that a tipping point in the flow of overseas remittances occurred back then which placed our BoP structurally in surplus territory from that point on.

Surpluses and deficits, in per cent of GDP

No wonder bond markets have had such confidence in the Philippines. As the saying in business goes, banks will only offer you credit when you don’t need it. The question is do we just keep accumulating these reserves knowing the problems they create for our economy? Or do we actually put the excess funds to good use by investing in the country’s development?

As the title of the piece suggests, we could set up a sovereign wealth fund (SWF) with our excess reserves. The $14 billion mentioned above, which by the end of the year will probably be $15 billion would be the seed money. That is enough to double our infrastructure spending which is currently 1.5 per cent of GDP to 3 per cent, much closer to the recommended 5 per cent, over the next four years. With that added spending, the government could easily meet its aspirational stretch target of growing the economy by 7-8 per cent a year.

Every year, depending on how well our balance of payments performs, we could just keep adding to the SWF. Assuming that the government’s new revenue measures and fiscal consolidation will mean an annual deficit of about 1 per cent of GDP and that the annual BoP surplus remains at 3 per cent of GDP, there would be enough to fund government’s deficit and set aside another 1 per cent to augment the SWF, with the remaining 1 per cent going to GIR.

But we are getting ahead of ourselves. Let us first define what is a SWF? According to the Sovereign Wealth Fund Institute, it is

a state-owned investment fund or entity that is commonly established from balance of payments surpluses, official foreign currency operations, the proceeds of privatisations, governmental transfer payments, fiscal surpluses, and/or receipts from resource exports.

The Institute cites some “interesting facts” about SWFs, namely that some of them “invest indirectly in domestic industries” and that “they tend to prefer returns over liquidity, thus they have a higher risk tolerance than traditional foreign exchange reserves. Most often SWFs receive their initial capital through “commodity exports, either taxed or owned by the government” or through “transfers of assets from official foreign exchange reserves”.

There are about US$5.1 trillion invested in SWFs globally. About three of every five dollars come from oil and gas exports, the remainder from other sources. The size of funds varies from as little as US$300 million for Indonesia to as large as US$664 billion for Norway. Of the 64 SWFs that currently exist, 39 were established since 2000.

Some have argued that the Bangko Sentral is restricted by its charter, RA 7653, the Central Bank Act, from investing in instruments other than Triple-A rated bonds of foreign governments. At the time this law was passed, the problem facing the country was chronic balance of payments deficits. More transfers out rather than in were being made.

The BSP is tasked under the law with maintaining international monetary stability in the country. Part of this according to Article II, Section 64 of the law is “to preserve the international value of the peso and to maintain its convertibility into other freely convertible currencies”.

To maintain such stability, Section 65 says that “the Bangko Sentral shall maintain international reserves adequate to meet any foreseeable net demands on the Bangko Sentral for foreign currencies”. It would have to judge for itself the adequacy of these reserves based on “prospective receipts and payments of foreign exchange by the Philippines”.

Finally, Section 66 lays out the composition of such reserves which it says “may include but shall not be limited to” gold and other assets that took the form of “documents and instruments customarily employed for the international transfer of funds; demand and time deposits in central banks, treasuries and commercial banks abroad; foreign government securities; and foreign notes and coins”.

So why did the central bank governor offer in September of 2011 to purchase Philippine treasury using its dollar reserves given that these notes are not Triple-A rated? Well, he had probably realised as I had back in November 2010 that the Bank already had an adequate supply of reserves to meet international obligations.

Given that the law says nothing about what to do if the Bank were to have more than a sufficient level of reserves we can say that the Bank is sailing in unchartered waters. If the law does not specify what it should do in such a situation, then it should be left to the discretion of its board to decide on how best to deal with it.

Currently, the return on short-term US treasury notes is between 0 and 0.25 per cent, negative in real terms, meaning that the Bank is paying the US government to borrow from its reserves. And the Fed has said that it plans to keep interest rates as low as they are for the foreseeable future until the US unemployment rate goes under 6.5 per cent (it is currently at 7.7 per cent). If the BSP lent its excess reserves to the Philippine government, it would gain a better return and preserve the value of its assets.

Now that we have cleared the financial viability and legality issues, what would be the purpose of a Philippine SWF? The nature and purpose of SWFs are varied, but in the Philippines it might be to do the following (as adapted from the SWF Institute):

  • Protect and stabilise the budget and economy from excess volatility in revenues/exports
  • Diversify our industry sector to make growth more inclusive and robust
  • Earn greater returns than on foreign exchange reserves
  • Assist monetary authorities dissipate unwanted liquidity
  • Increase savings for future generations, or
  • Fund social and economic development.

Given the need to boost productivity and improve competitiveness, addressing the infrastructure backlog would be the most obvious answer. The public-private partnership projects would be a good initial source of demand for funding as these projects are designed to earn a market rate of return for the investor. Another possibility would be for the SWF to enter into joint-ventures with mining firms for the joint-exploration and production of oil and other commodities. This would ensure that we received a larger share of the benefits from such operations.

A third possibility would be to fund innovation through government procurement, business incubators, industry clusters, and competitions aimed at the commercialisation of ideas. Government could serve as a catalyst in the germination of new activity around key areas of specialisation that the country has already exhibited proficiencies in. The expansion of our semiconductor and electronics industry into higher value adding activities could be one priority. The growth of agribusinesses into higher yield crops and again value adding processes could be another. A fourth priority could be the generation of clean technology and renewable energy.

Finally, beyond just the economic, financial, legal and commercial viability, there is the political viability of doing this. Creating a Philippine SWF would be politically astute as it would be seen as the Aquino administration’s unique contribution to the development of the country. The vice president has also expressed his support for the concept of using foreign reserves for development. This means that the measure would have the support of both leaders and their coalition partners in both houses of Congress.

Beyond that, the consensus formed by our leaders would mark the first time a remittance dependent nation’s government deliberately leveraged the income derived from its work force overseas to channel resources into highly productive activity back home. It would be a shift in the development paradigm of such countries and provide a model for them to follow. Just as conditional cash transfers were forged through a consensus among Mexico’s and Brazil’s leaders as a way to alleviate poverty, the Philippine consensus would provide a path for low income households out of poverty and into the middle class by providing jobs to people of low skills through the fruits of their countrymen’s sacrifice overseas.

If we don’t recognise the opportunity that lies before us in this regard, then when our overseas workers return home, all their hard work may come to nothing as their children will then have to go abroad because there would be no jobs left for them here. With the Aquino government’s good governance credentials, it should be able to shape the probity and prudential measures needed to ensure that the SWF is properly managed and its funds transparently and judiciously utilised for public benefit. This would prove that good governance is indeed good economics and that the righteous path can create in the Philippines opportunities not just for some but for all.