Author:Gjedrem, Svein

Norges Bank submitted the following letter to the Ministry of Finance on 16 March 1999:

  1. Introduction

    In its letter of 22 August 1997 to the Ministry of Finance, Norges Bank discussed the Petroleum Fund's investment strategy, and in particular the Fund's allocation by country. Norges Bank recommended that the Fund be invested mainly in developed markets, but that up to 5 per cent of the Fund could be invested in emerging markets, which comprise developing countries and transition economies.

    In its letter, Norges Bank stressed that emerging economies are characterised by rapid economic growth and steadily improving financial markets. It was pointed out that this may generate expectations of solid returns on investments in emerging markets. Moreover, it was stressed that if the economic situation in these countries is not synchronised with developments in other countries, investment in emerging markets may also contribute to reducing the variation in the Fund's total return.

    Norges Bank's recommendation was provided on a general basis with reference to the objective of the Fund, which is to maximise future purchasing power, given an acceptable risk level. The Bank indicated that it was not certain that investment would take place in emerging markets in the Fund's initial phase, nor did it propose any restrictions on eligible countries.

    In the National Budget for 1998, it was stated that investing in emerging markets could be an interesting option for the Petroleum Fund, but that the building up of expertise on investments in these markets would have to be balanced against other high priority tasks. Following an overall assessment, the government concluded that it would not permit investment in emerging markets at that time.

    In the Revised National Budget for 1998, the government announced that it would take a closer look at whether the Petroleum Fund's country list should be expanded, and stated the following:

    "In the view of the government, it will be natural to review this list with a view to increasing the number of countries in which the Petroleum Fund can invest. First, it is conceivable that in due course more countries will fulfil the criteria established with respect to company, securities and stock exchange legislation. Second, it may prove appropriate to include some countries that are on their way to becoming fully developed, well regulated markets. It will be relevant to consider in this connection South Africa and some countries in Eastern Europe, South America and Asia. The government also stresses that investing some of the Fund in these countries may make a positive contribution to their economic development, thereby promoting democracy and human rights." The purpose of this submission is to discuss the requirements that should be fulfilled before new countries are included in the Fund's investment universe. The evaluations are based on the objective of the Fund, which is to maximise future wealth at an acceptable risk level. Norges Bank has not considered whether investing in emerging markets will contribute to promoting economic growth, democracy and human rights in emerging economies. Only new countries have been considered in connection with expanding; we have not evaluated whether investing in commodity contracts, unlisted equities or real property would be more appropriate in view of the Fund's objective. Since it will be necessary to prioritise resources in the operational management, an overall evaluation of this nature should preferably be available before any investment in emerging economies takes place.

    Three factors are of particular importance when an expansion of the country list is considered:

    * Foreign participants must have access to the markets, and the markets must satisfy certain minimum requirements with respect to settlement systems, size, liquidity and regulation.

    * A certain degree of political and macroeconomic stability is required in the countries considered in order to limit country risk.

    * The effect of including new countries on the Petroleum Fund's return and risk must also be considered.

    The general principles for considering new countries are drawn up in the following, and specific examples given. However, Norges Bank does not aim in this submission to give concrete advice as to whether the country list should be expanded. Recent developments in emerging economies and recent literature have led to an increased focus on the risk of investing in emerging markets. Further work on evaluating which countries fulfil the various requirements is required before a recommendation can be made.

    The settlement risk associated with emerging markets is greater than that in developed markets. At the same time, the legal framework in emerging markets is not fully adequate. Emerging markets also tend to be small, and to have poorer liquidity than developed markets. This makes it important to give careful consideration to settlement risk, liquidity and the legal system of the countries in question before permitting investment in these countries.

    In general, developed economies are considerably more stable, both politically and economically, than emerging economies. The country risk associated with investing in emerging economies can be high, and it is therefore necessary to make thorough analyses of both the political and the macroeconomic stability of these countries.

    Both the operational and the country risk of investing in emerging markets can change rapidly. It is therefore important that the minimum requirements are satisfied at all times. This presupposes that the use of resources in the follow-up phase is sufficient to reveal significant changes in risk.

    At times, the return on investments in emerging stock markets has been higher than in developed markets, but also considerably more variable. At the same time, the covariation between the return in developed and emerging markets has been low, but recently there have been indications that this covariation has increased. The diversification gains are probably slightly smaller today than earlier, and at the same time it is uncertain whether the return on investing in emerging markets is satisfactory in relation to the risk. Before any expansion of the country list takes place, a thorough review should therefore be made of whether new countries contribute to reducing the risk or increasing the return of the Petroleum Fund.

    In principle, an expansion of the country list may apply to the Fund's equity and bond investments alike. However, much of the discussion in theoretical and empirical literature is concentrated on the equity markets in emerging economies, and it is easier to obtain good benchmark indices for equity investment. This means that there is generally somewhat better information available on emerging equity markets than bond markets. Better equity market data make it easier to estimate the effect on the Petroleum Fund's return and risk when including new equity markets rather than emerging bond markets. At this stage, Norges Bank has therefore decided to focus on emerging equity markets.

    Section 2 of the submission presents the current country list. Emerging markets are delimited in section 3. Section 4 discusses minimum requirements for settlement systems, legislation, size and liquidity, while section 5 discusses country risk. Section 6 discusses new countries in the light of the effect on the Petroleum Fund's return and risk. This is followed by a summary.

  2. Current country list

    In the Revised National Budget for 1997, it was pointed out that estimates of the size of the Fund had been revised substantially upwards, and a longer horizon for investments was applied. It could therefore be questioned whether the country allocation, which was based on import weights, resulted in an optimal country allocation. It was argued that import weights could result in over-investment in small countries such as Denmark and Sweden, that the import pattern could change over time, that real imports from a country could differ from direct imports, that vulnerability to economic downturns in Europe could be undesirably high, and that the profitability of large international companies was associated primarily with global economic developments; moreover, that in the long term there might be grounds for expecting that exchange rate risk would be smaller because the real return on investments in different currencies would converge over time.

    In principle, the country allocation can be based on three different sets of weights: GDP weights, import weights and market capitalisation weights. GDP weights provide an indication of the relative importance of an economy, while import weights provide a direct indication of the existing import pattern. Market capitalisation weights reflect the relative size of securities markets. In the National Budget for 1998, the Ministry of Finance refers to the evaluations concerning choice of country...

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