Interest in resource funds for the set-aside of a portion of resource revenues has grown significantly over the past several years. This interest is partially due to the discovery of new resource deposits, and partially of the recent dramatic increases in resource prices. There are now more than 21 petroleum funds in existence, and a growing number of mineral funds are under discussion.^[8]  Two reasons for the creation of funds have been suggested above: (1) they provide a place to ‘park’ funds, either in support of expenditure smoothing policies, and (2) they can help avoid overheating of the economy in the face of constrained absorptive capacity.

Also, as noted above, funds may be created as precautions against major negative resource shocks or to generate financial revenues for the future, replacing resource revenues when the resource itself is depleted. Finally, it is sometimes argued that resource funds, by their very existence, and depending on their formulation, can act as a brake on reckless spending and as a model for broader fiscal discipline. The two main types of funds, defined by their function, and alternatives to them are described and considered below, followed by a summary of the principal legal, operational, and governance features of funds.

Stabilization Funds. These funds are designed to address expenditure smoothing and precautionary objectives. When revenues or prices are high, payments are made into the fund and diverted from expenditures. Then, when revenues are unusually low, payments are made out of the fund to the budget, avoiding a collapse in expenditures. The size of a stabilization fund depends upon the magnitude of expected resource revenues, their relative importance in the budget, and the possible volatility of the revenues. The larger the possible variation in revenues relative to the total state budget expenditure, the larger the amount of precautionary assets in the fund should be. Given the objective of stabilization funds, the assets they contain are normally short-term, highly liquid, low risk and, foreign (to avoid putting pressure on the domestic economy).

Savings Funds.  Savings funds focus on the accumulation of financial assets and the generation of financial returns adequate to replace resource revenues as they decline, thus maintaining at a constant level of government expenditures attributable to the initial resource wealth. The desirable size of a savings going into a fund will depend on, among other things, the scale and expected life of the resource deposit. Generally, the shorter the life of the deposit, the higher the percentage of resource revenues going into it ought to be. The asset mix in a savings fund is typically longer term and higher risk than might be found in a stabilization fund.^[9] 

Many economists caution against accumulating large savings funds on the grounds that investment in domestic social and physical infrastructure can potentially yield much higher returns, and that the resulting incremental growth (if achieved for a sustained period) will, for most states, come to dwarf the income from holding resource wealth in financial assets. These arguments must be qualified, however, by taking into account the absorptive capacity of the domestic economy and institutions.  

Some states operate single funds with dual objectives, combining stabilization and saving funds. Others maintain two funds with clearly separate roles. Both fund types serve useful purposes. The share of revenues between them is dependent on national circumstances and to some degree a political question.

Alternatives to Funds. Hedging, through futures contracts, options, and other financial instruments (designed to ‘lock-in’ prices on future production) can be used in petroleum-rich and or mineral-rich states to reduce the risk of future adverse commodity price movements. Instruments of this kind stabilize expenditures, not directly as a stabilization fund might, but by stabilizing revenues first.^[10] 

To date, only a very few resource-rich states (such as Mexico) have tried reducing exposure to commodity price risk by these instruments. Deterrents include the expense of hedging, which can be considerable. Furthermore, they can expose states to asymmetric political costs where hedging results in losses. For example, this can occur when the hedged sales price turns out to be substantially less the actual future market price, and responsible authorities may find themselves out of a job; whereas they are likely to escape blame when non-hedged prices fall in line with a fall in market prices.  Limited use of the hedging alternative suggests that it is not a simple solution for dealing with commodity price volatility. Adjustment of production profiles is sometimes put forward as a second alternative to stabilization funds.^[11]         

Legal Frameworks for Funds. Funds may be either ‘virtual’ or ‘real.’ Funds are virtual where they are embedded in the normal budget process and require no special approval for their establishment of maintenance. Funds are real where accumulated funds are held in a separate managed and audited account, requiring a legal framework. The preference for one or the other may depend on the overall transparency of fiscal reporting to both the legislature and the public. Where resource revenue dependency and public interest in its use are high, the creation of a real fund may be desirable, highlighting the link between resource revenue generation and utilization. On the other hand, virtual funds might be desirable if it is important that all national funds remain fully integrated with the regular budget. If it is decided to establish a real fund, good practice would certainly argue for the closest possible coordination of their operations with the regular budget process.   

Where a distinct legal framework is required to set-up a real fund(s), a purpose-designed law or amendment to existing legislation (or even the constitution) may be required.  Decisions on the level of specificity in the law will involve trade-offs between ensuring the financial integrity of the scheme (for instance, prevention of its reversal or perversion, and providing adequate administrative or executive flexibility to address unforeseen circumstances).  

Payments into and Withdrawals from Funds.  Procedures for payments into, and withdrawals from, funds may differ depending on the type of fund. For stabilization funds, good practice would link these to the annual budget process and near-term revenue forecasting since the intent is to allow expenditure smoothing.  For savings funds, as suggested above, the focus should be on the long-term sustainability of resource revenue spending. Parliamentary or presidential approval may be required to authorize such transfers to and from the fund(s).

In many states, however, rules have been introduced to make amounts added to or withdrawn from the fund(s) automatic. Rules have the perceived advantage of reducing discretion, but may themselves create serious tensions when their operation proves inappropriate to actual state circumstances or developmental priorities. For example, it may be desirable near-term to spend in excess of long-term sustainable levels in order to take advantage of investment opportunities expected to yield high developmental returns; or to spend less than the long-term sustainable amount where near-term absorptive capacity constraints apply. Agreeing to guidelines, rather than fixed rules, may be helpful in addressing this issue, provided fund administrators are obliged to publicize and defend any deviation from the adopted guidelines.^[12]  

Financial Management.  Financial management of resource funds requires asset management, and decisions on asset classes in which funds will be invested.. Decisions on asset classes will depend, to a large extent, on attitudes towards risk and time horizon. However, in this regard, decisions will differ considerably between stabilization and savings funds. Additional considerations such as portfolio diversification and avoidance of Dutch Disease argue for investing in assets outside the EI sector and outside the domestic economy. Fund management in most cases is assigned to the central bank, which typically engages third-party custodians and specialist asset managers for safekeeping and investment of the assets.  A set of asset management mandates based on risk and return objectives provide benchmarks for the assessment of performance by government selected fund trustees or their delegates.  

Governance Features of Funds. Past experience with resource funds has underscored the critical importance of oversight and governance features. These are ideally spelled out in legislation. Independent regular audits are also essential. Good governance practices include both vertical and horizontal accountability. Vertical accountability comes with fund management reporting lines that leads ultimately to a minister. Horizontal accountability is provided by regular reporting on performance to elected officials independent of government, and widely available and readily accessible public information on the fund.  Transparency with respect to all aspects of fund operation and performance is generally regarded as indispensable to achieving good governance (see Chapter 4 above).    

Interest in resource funds for the set-aside of a portion of resource revenues has grown significantly over the past several years in part as a result of the discovery of new resource deposits, and in good part because of the recent dramatic increases in resource prices. There are now more than 21 oil funds in existence, and a growing number of mineral funds are under discussion. Two reasons for the creation of funds have been suggested above – they provide a place to 'park' funds, either in support of expenditure smoothing policies, or to avoid overheating of the economy in the face of constrained absorptive capacity. Also, as noted above, funds may be created as precautions against major negative shocks or to generate financial revenues for the future, replacing resource revenues when the resource itself is depleted. Finally, it is sometimes argued that resource funds, by their very existence, and depending on their formulation can act as a brake on reckless spending and as a model for broader fiscal discipline. The two main types of funds, defined by their function, and alternatives to them are described and considered below, followed by a summary of the principal legal, operational and governance features of funds.

Stabilization Funds. These funds are designed to address expenditure smoothing and precautionary objectives. When revenues or prices are high, payments are made into the fund and diverted from expenditures; when revenues are unusually low payments are made out of the fund to the budget, avoiding a collapse in expenditures. The size of a stabilization fund depends upon the magnitude of expected resource revenues, their relative importance in the budget, and the possible volatility of the revenues. The larger the possible variation in revenues relative to the total country budget expenditure, the greater should be the amount of precautionary assets in the fund. Given the objective of stabilization funds the assets they contain are normally short term, highly liquid, low risk and, to avoid putting pressure on the domestic economy, foreign.

Savings Funds. Savings funds focus on the accumulation of financial assets and the generation of financial returns adequate to replace resource revenues as they decline, thus maintaining at a constant level of government expenditures attributable to the initial resource wealth. The desirable size of a savings going into a fund will depend on, among other things, the scale and expected life of the resource deposit. Generally, the shorter the life of the deposit the higher the percentage of resource revenues going into it the fund ought to be. The asset mix in a savings fund is typically longer term and higher risk than might be found in a stabilization fund. Many economists caution against accumulating large savings funds on the grounds that investment in domestic social and physical infrastructure can potentially yield much higher returns and that the resulting incremental growth if achieved for a sustained period will, for most countries, come to dwarf the income from holding resource wealth in financial assets. These arguments must be qualified, however, by taking into account the absorptive capacity of the domestic economy and institutions.   

Some countries operate single funds with dual objectives, stabilization and saving, while others maintain two funds with clearly separate roles. Both fund types serve useful purposes. The share of revenues between them is dependent on national circumstances and to some degree a political question.

Alternatives to Funds.Hedging, through futures contracts, options and other financial instruments, designed to  ‘lock -in’ prices on for future production, can be used by oil and/or mineral-rich countries to reduce the risk of future adverse commodity price movements. Instruments of this kind stabilize expenditures, not directly as a stabilization fund might, but by stabilizing revenues first. To date only a very few resource-rich countries (e.g., Mexico) have tried reducing exposure to commodity price risk by these instruments. Deterrents include the expense of hedging, which can be considerable, plus asymmetric political costs – where hedging results in losses, e.g., when the hedged sales price turns out to be substantially less the actual future market price, responsible authorities may find themselves out of a job, whereas they are likely to escape blame when non-hedged prices fall in line with a fall in market prices and, as they might explain it, “everyone is in the same boat”. Limited use of the hedging alternative suggests that it is not a simple solution for dealing with commodity price volatility. Adjustment of production profiles, and so revenues and possible expenditures, is sometimes put forward as a second alternative to stabilization funds.    

Legal Frameworks for Funds. Funds may be ‘virtual’, where they are embedded in the normal budget process and require no special approval for their establishment of maintenance, or ‘real’, where accumulated funds are held in a separate managed and audited account, requiring a legal framework. The preference for one or the other may depend on the overall transparency of fiscal reporting to both the legislature and the public. Where resource revenue dependency and public interest in its use are high, the creation of a real fund may be desirable, highlighting the link between resource revenue generation and utilization. Arguing in favor of a virtual fund is the fact that decisions with respect to their its use are by definition fully integrated with the regular budget. If it is decided to establish a real fund good practice would certainly argue for the closest possible coordination of their its operations with the regular budget process.   Where a legal framework is required this may be met by a purpose-designed law or by amendment to existing legislation, or even the constitution.  Decisions on the level of specificity in the law will involve trade-offs between ensuring the financial integrity of the scheme, i.e., prevention of its reversal or perversion, and providing adequate administrative or executive flexibility to address unforeseen circumstances.         

Payments into and Withdrawals from Funds.  Procedures for payments into and withdrawals from funds may differ depending on the type of fund. For stabilization funds, good practice would link these to the annual budget process and near term revenue forecasting since the intent is to allow expenditure smoothing.  For savings funds, as suggested above, the focus when considering deposits and withdrawals is on the long term sustainability of spending out of resource wealth. Parliamentary or presidential approval may be required to authorize such transfers to and from the fund. In many countries, however, rules have been introduced to make amounts added to or withdrawn from the fund automatic. Rules have the perceived advantage of reducing discretion, but may themselves create serious tensions when their operation proves inappropriate to actual country circumstances or developmental priorities. For example, it may be desirable near term to spend in excess of long term sustainable levels in order to take advantage of investment opportunities expected to yield high developmental returns; or to spend less than the long term sustainable amount where near term absorptive capacity constraints apply. Agreeing guidelines, rather than fixed rules, may be helpful in addressing this issue, provided fund administrators are obliged to publicize and defend any deviation from the adopted guidelines.

Financial Management.  Financial management of resource funds requires decisions on asset classes in which funds will be invested and on asset management. Decisions on asset classes will depend to a large extent on attitudes towards risk and time horizon and, in this regard, as described above, will differ between stabilization and savings funds. Additional considerations such as portfolio diversification and avoidance of Dutch Disease argue for investing in assets outside the resource sector and outside the domestic economy. Fund management in most cases is assigned to the central bank which typically engages third-party custodians and specialist asset managers for safekeeping and investment of the assets.  A set of asset management mandates based on risk and return objectives provide benchmarks for the assessment of performance by government- selected fund trustees or their delegates. 

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