Fiscal Policy Formulation and Implementation in Oil-Producing Countries

12 Fiscal Policy and Petroleum Fund Management in Norway

Jeffrey Davis, Annalisa Fedelino, and Rolando Ossowski
Published Date:
August 2003
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Martin Skancke

I. Introduction

One of the challenges of policymaking is to illustrate complex ideas in a way that is easy to understand. Mundane as this may seem, it really goes to the core of policymaking. No policy can ever be implemented if it does not have public support, and no policy can build public support unless it is communicated in a clear and powerful way.

When I worked on fiscal policy and Petroleum Fund issues for the Norwegian Ministry of Finance, efforts were made to help the minister build support for a prudent and sustainable fiscal policy. Advocating fiscal restraint is not easy when the general government budget surplus is around 15 percent of GDP. Norway’s fiscal policy challenges were illustrated in a number of ways; Figure 12.1 below had the greatest impact. In the years since it was developed, it has become a standard feature of fiscal policy documents in Norway.

Of course, a graph that shows only one income component and one expenditure component for government cannot by itself give a meaningful picture of the sustainability of fiscal policy. But there are still two important lessons to be learned from this graph. One is that oil revenues are extremely volatile, so there is a need for some sort of mechanism to decouple government spending from oil revenues in the short term. The second is that the compounded effect of rising pension expenditures and declining oil revenues over the next decades will be considerable, so there is also a need for a mechanism to soften this blow to public finances.

Figure 12.1.Net Cash Flow from Petroleum and Pension Expenditure

(In percent of GDP)

Source: Government of Norway, Long-Term Program, 2002-05.

In short, the Petroleum Fund is the mechanism to address both of these concerns. It has the twofold purpose of smoothing out spending of oil revenues and at the same time acting as a long-term savings vehicle to let the Norwegian government accumulate financial assets to help cope with expenditures associated with the aging of the population.

This chapter will expand both on the guidelines for fiscal policy and on the guidelines for the Fund itself. It should be stressed, however, that while the accumulation of a petroleum fund probably is a necessary condition for coping with the challenges of an aging population, it is certainly not a sufficient condition. Several policy measures are required, the most obvious of which are:

  • encouraging people of working age to remain in the labor force through measures to reduce inflow into the disability pension scheme and by raising the average age of retirement;
  • improving the productivity of the labor force, inter alia by improving the quality of education; and
  • ensuring a high return on investments in the public and private sectors through attention to governance issues in the public sector and through an active policy to promote competition.

An interesting observation in this context is that the total value of Norway’s petroleum wealth (around 200 percent of GDP) corresponds only to around 6-7 percent of total national wealth. In comparison, the value of human capital is around 80 percent of total wealth. So reducing the size of Norway’s labor force by 10 percent through longer vacations, shorter working hours, reduced retirement age, etc., will reduce its future consumption possibilities by the same amount as a drop in the value of Norway’s oil wealth to zero. Clearly, maintaining the size of the labor force is the key economic policy challenge in the years ahead and the key lever to ensuring a sustainable fiscal policy.

II. The History of the Fund

The Norwegian Government Petroleum Fund was formally established in 1990 when the Norwegian parliament (Stortinget) adopted the Act on the Government Petroleum Fund (Act of June 22, 1990, No. 36).

However, the Fund mechanism (which will be discussed in greater detail below) entails that money will only be allocated to the Fund when there is a budget surplus. In the first half of the 1990s there were budget deficits due to the strong recession. Only in 1995 was the budget back in surplus, and the first transfer from the state budget to the Petroleum Fund was made in 1996 for fiscal year 1995. After that, however, the Fund has grown strongly. At the end of 2001 the Fund amounted to NOK 613.7 billion (about US$80 billion), or around 45 percent of GDP. Projections indicate that the Fund will grow to 120 percent of GDP at the end of 2010. Given the present guidelines for fiscal policy, the Fund is expected to stabilize at a level of around 160-170 percent of GDP in the years after 2030.

Until 1997, the entire Fund consisted only of fixed income assets. In the Revised National Budget 1997, the government put forward a proposal to allow the Fund to also invest in equities beginning in 1998. New guidelines were adopted providing for an investment of 30-50 percent of the Fund in equities. The background for this decision was that new estimates of the development of government finances indicated that more money would be allocated to the Fund, and that it would take longer before it would be necessary to start drawing on the Fund. This suggested that the investment universe should be expanded to also include equities.

In 2000, the investment universe was further expanded to include investments in emerging markets.

The Petroleum Fund’s average real annual return in the period from January 1998 to December 2001 was 3.6 percent.

Figure 12.2.Cumulative Return on Subportfolios in the Petroleum Fund

(The Fund’s currency basket at December 31,1997 = 100)

Source: Norges Bank.

Figure 12.2 shows cumulative rates of return for the whole Petroleum Fund since the beginning of 1998. The return up to June 2002 was 20 percent. Figure 12.2 also shows cumulative rates of return from January 1, 1998 for the fixed income and equity portfolios separately. In the 18 quarters since then, the cumulative nominal return on equity instruments has been somewhat lower than the return on fixed-income Investments, particularly due to losses in the equity portfolio in the second quarter of 2002. The return on the equity instruments has also varied a lot more during the period.

III. The Fund Mechanism

The Petroleum Fund can also be seen as a fiscal management tool to ensure transparency in the use of petroleum revenues. In the work preceding the act establishing the Fund, it was emphasized that the Fund’s resources must be included in a coherent budgetary process. When the Fund was established it was therefore emphasized that the accumulation of assets in the Petroleum Fund should reflect actual budget surpluses. This reflects an important point: running a budget surplus is the only way a government can accumulate financial assets on a net basis. If a fund is set up with an allocation rule that is not linked to actual surpluses, the accumulation of assets in the fund will not reflect actual savings.

Consider, for instance, a fund with allocations based on an actuarial calculation of pension liabilities in a situation with government budget deficits. As there is no link between allocations and actual savings, the accumulation of assets in this fund would not reflect an improving net asset base for the government. In fact, the government would be forced to borrow money to cover the allocations to the fund. From an asset management point of view, this would hardly make sense.

From a political economy point of view, the issue is more complex. Funding a pension system in the absence of a budget surplus means that more protection is given to future pension payments than to other public outlays. If future economic growth and government revenues are lower than expected, the burden of adjustment will fall primarily on public consumption. With a fund that is not earmarked for any specific purpose, there is more flexibility in fiscal policy, and more room to maneuver when coping with the effects of unexpected shortfalls in future revenue. Of course, it could be argued that even if pensions have a special protection through funding, that effect can always be counteracted through taxation if needed. But that would still leave inefficiencies, as high transfers from government to the private sector would have to be offset with correspondingly higher tax rates. On the other hand, it could be argued that pension payments for various reasons deserve special treatment, and that these payments should have some sort of special protection. In any case, it is probably useful to distinguish between the legal obligations the government has as an employer and the more political commitments that have been made to protect the benefits of the general pension system.

Another line of argument is that funding of pension liabilities or other ways of keeping a fund outside the direct reach of politicians increases legitimacy and public support for protection of the fund’s assets. An often-cited example is the high public support for protection of the assets in the Alaska Permanent Fund, which hands out real returns on the fund directly to the citizens of Alaska. True as this may be, the real issue is whether there is any higher public support for net, as opposed to gross, asset accumulation. It does not help much to protect the oil fund if debt is being accumulated elsewhere. Besides, if oil revenues are to be passed on to the private sector, it seems better to do this by reducing distortionary taxes rather than giving direct handouts. This requires oil revenues to be spent over government budgets to cover increasing non-oil deficits.

Figure 12.3.The Fund Mechanism

A full treatment of this issue would fall well outside the scope of this paper. Suffice it to say that there is no correct answer to the question of whether oil funds or other kinds of stabilization funds should be earmarked for special purposes. The main concern to economists should be to give a full account of the consequences of the various options. The Norwegian solution has—thus far—been not to earmark the Petroleum Fund to pensions or any other purpose, although the justification for building up the Fund is of course closely linked to the future development of pension expenditure.

The interaction between the Petroleum Fund and the fiscal budget is illustrated in Figure 12.3 below. The Fund’s income is the central government net cash flow from petroleum activities, and the return on Fund investments is added to the Fund. The Fund’s expenditure consists of an annual transfer to the Treasury corresponding to the amount of petroleum revenues used in the fiscal budget, to cover the non-oil deficit. In this way, money is accumulated in the Fund if, and only if, there is a government budget surplus including oil revenue.

The Fund mechanism is designed to provide a strong link between the accumulation of assets in the Petroleum Fund and fiscal policy, as described above. To understand the dynamics of asset accumulation, it is therefore necessary to turn to the guidelines for Norwegian fiscal policy.

IV. Guidelines for Fiscal Policy

In the past, Norway has generally pursued a relatively prudent fiscal policy, with general government budget surpluses in the range of 2-4 percent of GDP. Only in the deep recession of the mid-1990s did the fiscal budget slip into deficit for a few years, as illustrated in Figure 12.4. These were actually the only years after World War II when Norway had budget deficits on a general government basis.

Looking ahead, there are substantial challenges in formulating and implementing fiscal policy in Norway, although the starting point is advantageous compared to that of other countries. The Long-Term Program for 2002-2005 presents macroeconomic projections illustrating these challenges.

The so-called baseline scenario describes a path for the Norwegian economy where growth in public employment is limited to achieve sustainable and balanced growth over the long term. This path provides room for growth in public employment that is largely consistent with maintaining current public welfare standards and coverage, including approved reforms. With a continuation of the current social security regulations, unchanged tax rates, and user fees for public services, the projections show a relatively small increase in the use of petroleum revenues, as measured by the structural, non-oil fiscal budget deficit in the period to 2020. However, the deficit shows a strong increase in the period between 2020 and 2040 as a result of an increase in pension expenditures and other expenditures associated with the aging of the population.

In this scenario, there is no room for any new reforms or enhancement of public welfare services. The baseline scenario illustrates that if policy is not revised in a way that contributes to increasing public sector efficiency or strengthening general government budgets, there will be no scope for using more petroleum revenues in the coming years than what follows from approved reforms. This result is in keeping with the generational accounts, which are now approximately in balance.

Figure 12.4.Fiscal Budget and Petroleum Fund Surpius

(In billions of Norwegian kroner)

Source: Norwegian Ministry of Finance.

Figure 12.5 compares developments in the baseline scenario with the developments in the “crowding-out” scenario and a scenario where the use of petroleum revenues over the fiscal budget is set equal to the expected real return on the Government Petroleum Fund. These scenarios are also presented in the Long-Term Program for 2002-2005. The crowding-out scenario looks fairly extreme, but it illustrates the consequences of continuing to increase public service employment in pace with actual growth over the past ten years, while continuing to pursue today’s policy in key areas such as the pension system and taxation.

Spending the real return on the Government Petroleum Fund over the fiscal budget implies a gradual increase in the use of petroleum revenues up to 2020. The projections in the Long-Term Program are based on the assumption that these revenues are used partly to increase public sector employment and partly to reduce taxes.

Figure 12.5 shows developments in the use of petroleum revenues over the fiscal budget and in public sector employment. Employment developments are illustrated by the difference between public employment in the various scenarios and the employment level necessary to implement approved welfare reforms and otherwise maintain current standards and coverage for public welfare services. The chart illustrates some of the mechanisms associated with the phasing in of petroleum revenues:

Figure 12.5.Non-Oil Budget Deficit and Local Government Employment under the Three Long-Term Program Scenarios

Source: Norwegian Ministry of Finance.

  • By allocating sufficient capital to the Petroleum Fund to meet future expenditure growth associated with the aging of the population and future pension expenditures, it is possible to ensure a steady growth in public welfare services without the need for tightening spending in other areas; refer to developments in the baseline scenario. This scenario implies that the use of petroleum revenues increases relatively slowly over the next 20 years, followed by a sharp increase.
  • With a continuation of growth in public sector employment in line with that of the 1990s, the non-oil deficit will increase rapidly and necessitate a sharp tightening in public finances some time ahead. This is reflected in the crowding-out scenario. Higher real-wage growth and a scaling back of exposed sectors will match the rapid increase in the use of petroleum revenues. This deterioration in competitiveness will subsequently have to be reversed. The petroleum revenues will in this case to a large extent have been spent over the next 20 years, and imports of goods and services must again be financed primarily through exports from the mainland economy.
  • Use of the expected real return on the Government Petroleum Fund implies a steady phasing-in of petroleum revenues. This scenario ensures that this part of government wealth is not depleted, while providing room for some expansion of welfare services and/or some reduction in taxes. However, such a phasing-in will also require the implementation of measures that contribute to limiting growth in general government spending or increasing revenues. The scale of the necessary tightening ensuing from this scenario is, however, substantially smaller than in the crowding-out scenario.

The points above illustrate that the question is not really whether to use more petroleum revenues over government budgets, but when this should take place. In the assessment of how petroleum revenues should be phased in over the years ahead, the following considerations are central:

  • The need for steady growth in public services implies, in isolation, substantial restraint in the use of petroleum revenues over the next two decades. The petroleum revenues saved can then be used to cover higher future expenditures, particularly after 2020. A strong increase in the use of petroleum revenues in this period could, however, lead to strong price and cost inflation during these years and to considerable restructuring problems for the internationally exposed sector in this period.
  • The need to achieve stable economic developments over time, both before and after 2020, points to a fairly steady phasing-in of petroleum revenues. The more the use of petroleum revenues is increased over the next ten years, the greater the need will be to strengthen government budgets at a later stage in order to achieve steady growth in public services.
  • The aim of maintaining an internationally exposed sector and avoiding wide-scale restructuring in the economy is of particular importance. Increased use of petroleum revenues may increase economic activity. In a situation with high-capacity utilization, this could lead to a weakening of internationally exposed industries. When phasing in petroleum revenues, particular emphasis must be placed on maintaining a strong internationally exposed sector with a view to promoting long-term balanced growth in the Norwegian economy. Both Norway’s experience and that of other countries show that an excessive use of petroleum revenues can result in substantial restructuring costs and unemployment problems. (This is the so-called Dutch disease. We should not forget the lesson the Dutch learned in the 1970s, even if they were later generally very successful in their economic policies)
  • The uncertainty associated with future petroleum revenues suggests that considerable caution should be applied to their use.
  • Norwegian economic policy should probably not be based on further tax increases. Tax levels are generally high by international standards, and there seems to be agreement—at least in principle—that some of the room to maneuver coming from an increased use of petroleum revenues should be used over time to reduce taxes and excise duties to increase the efficiency of the mainland economy.

Wehere does all of this leave us? It turns out that using the annual expected real return on the Petroleum Fund over the fiscal budget neatly balances these considerations—it is in a way a “middle road” between the baseline and crowding-out scenarios. This, it might be added, is pure coincidence, and not a general result that can be applied indiscriminately to other countries. But the use of the annual expected real return on the Fund is an attractive option for several reasons:

  • It is a simple rule, which is easy to communicate.
  • It provides a reference for the budget process.
  • It guarantees sustainability of fiscal policy under oil revenue volatility since the use of revenues is based on realized revenue flows from petroleum activities, and not on uncertain future revenues.
  • It provides a commonsense solution to the intergenerational distribution question, since all generations will “harvest” their share of oil revenues through spending the real return of the Fund while the real value of the Fund itself will be protected. (But since GDP is growing over time, the real return of the Fund will of course constitute a lower share of total income in the future.)

In 2001, the use of petroleum revenues over the fiscal budget is close to 2 percent of GDP, as measured by the structural, non-oil budget deficit.1 The guideline for fiscal policy implies an estimated increase in the use of petroleum revenues over the fiscal budget of about 0.4 percent of mainland GDP in each year up to 2010, taking the non-oil budget deficit to about 5 percent of mainland GDP in 2010. At this point, the capital in the Government Petroleum Fund will be around 120 percent of GDP.

V. Organization of the Fund

The Petroleum Fund law states that the Ministry of Finance is responsible for the management of the Petroleum Fund. When setting up the system for management of the fund, there were three major requirements to be met:

Professionalism. In practice, this implied the need to ensure full use of the capabilities of Norges Bank (the Norwegian central bank), while also building skills and capabilities in the Ministry. It also implied extensive use of external fund managers for those assets that Norges Bank previously had little experience with.

Accountability. A system of checks and balances was set up to ensure accountability and a clear division of responsibilities between the Ministry and Norges Bank.

Transparency. This is a key issue. If there is a need to build a consensus around saving over 100 percent of GDP in financial assets, policymakers should be prepared to tell the public exactly how they are going to invest the money, and what the returns on the investments are.

As the formal owner of the fund, the Ministry is responsible for defining the long-term investment strategy. This includes the strategic choices made in the management of the Fund regarding currency and country distribution and the distribution between asset classes and between securities in different market segments.2

These strategic choices are reflected in a benchmark portfolio. This portfolio is a “virtual” fund, consisting of equity and bond indices for the various markets in which the Fund is invested. The benchmark serves two purposes:

  • The Ministry has defined limits for the maximum variations permitted relative to the benchmark portfolio. The limit is defined as a maximum expected tracking error of 1.5 percent.3 The benchmark is thus an integrated part of the risk control system for the Fund.
  • The benchmark is also used to assess Norges Bank’s performance. Actual returns are compared with returns on the benchmark portfolio and performance differences are reported and explained in the Fund’s reports.

Within the strategic guidelines set by the Ministry, the operational management of the Fund has been delegated to Norges Bank. In addition to the Ministry of Finance’s guidelines for the Petroleum Fund, an agreement has been drawn up that regulates the relationship between the Ministry and Norges Bank in connection with management of the Fund.

Formally, the Petroleum Fund is a deposit account denominated in Norwegian kroner at Norges Bank, owned by the government. As such, it is a liability for Norges Bank. However, the guidelines state that Norges Bank is to acquire foreign securities in its own name for a value corresponding to the krone bank account. The return on these foreign investments, less Norges Bank’s management fee, is defined as the return on the Petroleum Fund.

Norges Bank delivers detailed annual reports on the management of the Petroleum Fund. These public reports describe how the Fund is managed and include a list of the companies in which the Fund’s capital has been invested. The reports provide figures on total return, benchmark return, attribution of the excess return, and management costs. The annual reports also contain articles on the investment philosophy behind the operational management, information on the process of selecting external managers, and so on.

Figure 12.6.Organization of the Fund

In addition, Norges Bank submits quarterly reports to the Ministry of Finance containing the main return and cost data. Norges Bank also reports to an independent company hired by the Ministry to make calculations of Fund returns and attribution analysis of differences between actual and benchmark returns. The reports from this company are public and are published on the Internet, as are the reports from Norges Bank.

The management system outlined above is illustrated in Figure 12.6. In addition to the structure illustrated in this figure comes the auditing of the Fund and its management, which is done by the Office of the Auditor General. The Auditor General is appointed by and reports directly to Parliament, ensuring parliamentary control on Fund operations.

VI. Managing the Fund—operationsal Issues

Until 1998, Norges Bank had no experience in managing portfolios of international equities. Drawing on the bank’s expertise in managing large portfolios in international government bonds, a project group started in spring 1997 to prepare for investing part of the Petroleum Fund in equities. A new department, Norges Bank Investment Management (NBIM), was established in January 1998. The board of the bank delegated to NBIM the operational management of the Petroleum Fund (€14 billion at that time), the long-term portfolio of the foreign exchange reserves (€12 billion), and the Norwegian Petroleum Insurance Fund (€1.2 billion). At the end of 2001, the combined assets under management were over €100 billion.

NBIM is organized with Chinese walls to the ordinary central bank functions. The head of NBIM reports to the governor of Norges Bank but takes no part in the internal discussion on monetary policy. All investment decisions are delegated to NBIM according to clearly defined guidelines, and NBIM reports to the governor and his staff on a monthly basis. Within NBIM, investment decisions are delegated to three front office units: Equities, Fixed Income, and Tactical Asset Allocation. The head of NBIM defines investment mandates and sets risk limits for each front office unit. There are no committees making investment decisions.

The staff of NBIM has grown from 71 at year-end 1998 to just over 100 now. During the first half of 1998, the portfolio of the Petroleum Fund was transformed from 100 percent fixed-income instruments in 8 countries to a diversified portfolio of 60 percent fixed income and 40 percent equities in 21 countries. Four external index managers carried out all investments in equities. Since autumn 1998, NBIM has also farmed out external mandates for active equity management. In 1999 NBIM started with internal active equity management, and in 2000 small portfolios for indexing and enhanced indexing were also put in place. By spring 2001 large external index mandates were transformed to internal enhanced index portfolios. About 50 percent of the equity portfolio is now managed in-house, while 15 external managers oversee the rest. The external active managers do the bulk of active risk taking.

The primary goal of Norges Bank’s management of the Petroleum Fund is to outperform the benchmark portfolio defined by the Ministry of Finance. The strategy for surpassing the performance of the benchmark portfolio was presented in the annual report for 1999. The following are vital components of the strategy: spreading active management over several types of positions, combining external and internal management, and specializing internal management in areas where there is a good chance of predicting price movements better than the average market participant. Special emphasis is also placed on risk management, portfolio analysis, and efficient trading in the market. By spreading active management over a large number of independent decisions, NBIM seeks to make effective use of the clearly defined risk limits set out by the Ministry of Finance.

Distinguishing between index management and active management is an important aspect of the management strategy. The risk limits defined by the Ministry of Finance state that management of the Fund must, by and large, closely follow the benchmark portfolio. A number of effects are achieved by “earmarking” a portion of the portfolio to closely follow the benchmark portfolio. Management costs for this portion of the portfolio are kept low since this type of management can be achieved using simple techniques. This also results in a sharper focus on the portion of the portfolio that can be managed actively. A broader overview is obtained, which makes it possible to assess the merits of the different types of management, and to make use of the special strengths of the various managers.

An important means of keeping costs low is to allow the active managers, who cost more, to invest only in what they specialize in. In the contracts entered into with active managers, a target area is established for minimum and maximum risk relative to the benchmark indices. Part of the fees of most managers is based on how successful they are in achieving an excess return. This provides them with an incentive to use their own expertise to take active positions. If, alternatively, NBIM had delegated the entire equity portfolio to external active managers, the total management fee would have been considerably higher than that resulting from a division into index and active management.

A common feature of the equity managers selected up to the present is that, in general, their investment strategy is to analyze and choose from among individual companies with the aid of a range of valuation models, and without any restrictions on country or sector positions. This means that their results (excess or deficit return) will normally show less covariation with more general market trends than if the strategy had placed most of its emphasis on analyses at a macro-level. On the allocation side, the emphasis has been on achieving a low correlation among the external managers.

It is not only the number of independent decisions that is of importance, but also how wide price-trend variations are among the securities from which selection has taken place. There were very large differences in the performances of comparable companies in the autumn of 1999. There was a broad spread between the price trends of companies that performed well and those that fell behind, particularly in the technology and IT sectors. Under such conditions, the potential for excess return is greater for managers who select individual equities than it is in periods of substantial covariation in the return on individual equities. This suggests that the degree of risk taking may vary over time as the potential for excess returns changes. In other words, it is also important to predict risk, not just prices and returns.

Another important element of the strategy for keeping management costs down is a keen focus on transaction costs. Over time, transaction costs will be of considerable importance for the net return, particularly for the Petroleum Fund, which enters the market each quarter with large amounts of new capital. The question of which transaction pattern will result in the lowest overall transaction costs is considered each time.

When purchasing external services, NBIM has attempted to create as much competition as possible between potential suppliers, for example by placing an invitation for tenders on the Internet. The activities of Norges Bank’s own management are subject to its internal budget and accounting regulations, and are monitored by the bank’s control system in the same ways as the other departments in Norges Bank.

In summary, in setting out to achieve an excess return, a fundamental choice has been made to take many small positions against the benchmark index rather than a few large positions. The strategy reflects that spreading active management over many different types of positions (diversification of risk taking) can result in a more robust excess return in the face of general fluctuations in the market. Unless one is particularly skilled at forecasting market trends, a conscious strategy of spreading risk in position taking results in the best trade-off between excess return and risk.

VII. Some Policy Conclusions

The main message of this paper is that the first priority for fiscal authorities in any country should be developing a prudent and sustainable long-term strategy for fiscal policy. Only if that fiscal policy strategy entails the accumulation of government funds should rules for a “Petroleum Fund” be developed. It will usually not make much sense to accumulate government capital in a fund while debt is being built up in other parts of government. The rules for allocation of capital to the Fund should reflect this.

Successful implementation of a fiscal policy strategy that implies large-scale accumulation of government funds requires a high degree of consensus, transparency, and accountability. In the case of Norway, it was possible to build on an existing and well-functioning institutional framework when the Petroleum Fund was established. The central bank already had extensive experience in managing its ordinary currency reserves, and systems of reporting and control were well established. Furthermore, there was a long tradition of transparency, both with respect to the government’s fiscal policy strategy and the operations of the central bank. The guidelines for management of the Petroleum Fund draw up a clear division of responsibilities between the Ministry of Finance as “owner” of the Fund and Norges Bank as manager.

Some oil-producing countries may still have to make substantial progress with respect to governance and transparency before a Nor-wegian-style petroleum fund can be established. These countries should focus on building democratic institutions with transparency, accountability, and good budget procedures if attempting to implement a fiscal policy strategy that implies a substantial accumulation of government funds.

Appendix. Investment Guidelines

The main elements of the current investment guidelines are:

  • equity portion: 30-50 percent;
  • regional distribution: Europe 40-60 percent, the Americas 20-40 percent, Asia/Oceania 10-30 percent;
  • investment area: 28 countries (of which 7 are emerging markets as of January 31, 2001);
  • maximum ownership share in any one company: 3 percent;
  • benchmark portfolio for bonds and equities: based on well-defined market indices (FTSE All World Index for equities and Schroder Salomon Smith Barney’s World Government Bond Index); and
  • duration of the fixed-income portfolio: 3 to 7 years.

The single most frequent question about the investment guidelines is how Norway “calculated the optimal equity share of the Fund.” The answer is: “This cannot be done.” Up to a certain point, of course, moving from a 100 percent bond portfolio—as Norway did—to a mixed portfolio of equity and bonds will give a diversification gain that will offset the isolated effect of taking on more equity risk. So expected returns can be increased and risk can be reduced at the same time by including some equities in the portfolio. But this effect is depleted once about 5 or 10 percent equity share is reached, depending on the time horizon and how risk is measured. Beyond that, higher expected returns are being traded off for higher risk.

No economist or analyst can tell what the “correct” equity share is—apart from stating that, to the extent that higher expected returns and lower risk can be obtained at the same time, this is an offer that should not be refused. Nor could civil servants tell their politicians what the “correct” equity share for the Petroleum Fund would be. What was done in Norway was to illustrate the trade-off in the best possible way by answering questions like “What is the probability of negative return in one year for different equity shares?” and “What is the accumulated effect of x percent higher average return on the Fund over the next y years?” Of course, typical equity ratios for international institutional investors were also looked at as references. But in the end, the choice of equity share in the Fund is a political decision, reflecting the subjective trade-off between risk and expected return that the politicians have made on behalf of the people they represent.

The second most frequent question is why the Petroleum Fund is only invested outside Norway. There are several reasons for this:

  • The need to stabilize the Norwegian economy. The corollary to substantial surpluses on the current account will be a considerable outflow of capital in the years to come. If the private sector were to contribute to this capital outflow to any considerable extent, interest rates in Norway would have to be lower than abroad in order to entice private investors to invest abroad rather than at home. Norway would then risk financial market bubbles in periods of high oil revenues. By investing the Petroleum Fund directly abroad, the central government will contribute to the substantial capital outflow and thereby shelter the domestic economy from the effects of high petroleum revenues more effectively.
  • The need for a varied industry structure. This is closely linked to the argument above. The investment of the Petroleum Fund abroad helps to avoid excessive real exchange rate appreciation, which in turn would lead to an industry structure that cannot be sustained when oil revenues start to decline.
  • The need to use the Petroleum Fund as a buffer. For the Fund to function as a financial buffer that can be drawn on to finance budget deficits, it is important that the size of the buffer can vary without affecting the rest of the economy to any extent. Substantial and strongly fluctuating central government financial claims on domestic sectors would not satisfy such a requirement.
  • Domestic investments could result in a lower Fund return. The optimal level of domestic real investments for a country as a whole is given by the return on these investments compared with the return on alternative financial investments. Since a country as a whole can only save financially by accumulating claims on other countries, it follows that the relevant interest rate in this case is the international rate. The optimal level of real investments should then be independent of the income level. Of course, if a country faces an effective credit constraint this argument will not hold, but for Norway it probably does.
  • Diversification. The risk of the Fund’s investments would be greatly increased if one did not take full opportunity of the diversification gains of international investments.
  • Domestic investments could undermine the fiscal budget as a management tool. The Petroleum Fund consists of that part of petroleum revenues that are not used in the fiscal budget, and the return on this capital. In the budgetary deliberations, Parliament decides the extent of central government expenditure. If, in addition, the Petroleum Fund were used to finance domestic investments in, for example, infrastructure, the Fund would effectively become fiscal budget number two. This would weaken the position of the fiscal budget as a political management tool.

When the original currency distribution of the Petroleum Fund was determined, emphasis was placed on the need to maintain the international purchasing power of the Fund. On this basis, Norway’s import weights were used to determine the Fund’s currency distribution.

However, as the Fund grew in size and it became apparent that the Fund’s investments would probably have a very long time horizon, the question was raised as to whether import weights provide the most appropriate currency distribution:

  • Investments in line with import weights may mean that the Fund becomes too dominant in small markets where Norwegian imports are considerable (e.g., Sweden and Denmark).
  • Import patterns can change over time.
  • For some countries, real import weights may be higher or lower than the level implied by direct trade between Norway and the country. This will be the case if, for example, Norway’s imports from third countries contain substantial factor inputs from the respective country or if the country itself imports considerable factor inputs from third countries.
  • The long time horizon of the Fund’s investments increases the risk that recessions, and at worst war, disasters, etc., will at some point have an impact in market countries. Such events often affect a number of countries in the same region. Investments based on import weights may thus result in excessive exposure to regional shocks in Europe.
  • For equity investments in major enterprises, it is meaningless to talk about a distribution of investments in different markets. The global operations of large, international companies are often more extensive than their national activities, and their profitability is therefore primarily linked to global economic trends.
  • The use of import weights as the basis for the currency distribution of the Petroleum Fund was aimed at reducing the exchange rate risk associated with changes in exchange rates between the currencies in which the Fund has invested. This exchange rate risk, however, is usually reduced in the long term. By investing in different currencies, the total real return (when exchange rate movements and differences in interest rates and price inflation between countries are taken into account) will have a tendency to converge over time. Empirical studies provide some support for this mechanism, but primarily in the long term.

So it seemed reasonable to make a “compromise” between import weights and global GDP weights. From January 1, 1998, the share of Asian currencies was set to 10-30 percent, American currencies to 20-40 percent, and European to 40-60 percent. This implied a shift out of European currencies compared with what pure import weights would have given.

When it was decided that portions of the Petroleum Fund could be invested in equity instruments, a choice had to be made between strategic investments in the form of large investments in individual companies on the one hand, and financial investments on the other, which involve smaller investments in a large number of equities.

Several factors indicated that the Petroleum Fund should be exclusively invested as financial investments:

  • The Petroleum Fund is a fiscal policy instrument devised for the purpose of promoting the long-term objectives of fiscal policy. Based on the purpose of the Fund, it is natural that the Fund’s capital be invested in a way that best safeguards the considerations linked to state finances. This means that the guiding principles should be to safeguard government resources and to ensure a maximum return at an acceptable level of risk.
  • By spreading the investments on a number of equities, the Fund will achieve a diversification of the portfolio. If the Fund were instead to purchase large stakes in selected companies, it would be assuming a company-specific risk. This risk does not increase the expected return on the investment. Such strategic investments result in a less favorable portfolio diversification.
  • Empirically, only a broadly diversified portfolio will yield an excess return when investing in equities. There is little reason to believe that strategic investments over time yield a higher return than financial investments.
  • An important purpose of the Fund is to serve as a buffer against economic downturns that affect state finances and/or the external account. This requires a certain degree of liquidity of the investments. strategic investments are long term and cannot easily serve as a buffer.
  • Strategic investments abroad, e.g., in the form of purchases of distribution channels to secure markets for Norwegian produets, may from an economic viewpoint be viewed as tantamount to providing financial support to enterprises that benefit from such investments. The Petroleum Fund is not a suitable instrument for providing support of this nature.
  • If the Fund acquires large equity stakes in foreign companies that subsequently are confronted with financial problems, the Norwegian government may come under substantial pressure to help find solutions to enable the enterprise to continue operations. This could easily conflict with the guideline that the Fund’s capital shall be invested on the basis of commercial considerations.
  • If the Fund were to act as a strategic investor, it would be much more difficult to evaluate management performance because it may be difficult to find an adequate basis of comparison. For example, it would be difficult for the authorities to criticize the performance of a manager who has been instructed to invest in a company whose results subsequently deteriorate. By acting as financial investor it is in principle easier to assess whether the return is satisfactory based on comparison with observable benchmark portfolios. For purposes of transparency and control, it is essential that the results can be properly assessed.
  • Strategic investments require a completely different budget procedure, tighter control by the authorizing agency, a specified division of political responsibility, and a completely different type of expertise and evaluation than in the case of financial investments. It was thus concluded that the Petroleum Fund should exclusively act as a financial investor so that the ownership stakes in individual companies are small. The Fund’s investments in equities shall be composed to yield a return that is in line with broadly diversified portfolios of equities listed on various international stock exchanges.


The best sources for reading more about the Norwegian Petroleum Fund are the Ministry of Finance and Norges Bank websites:

  • contains material on the history of the Fund, formal guidelines, and all public documents relating to its management. It also contains material on the guidelines for fiscal policy and the Long-Term Program.
  • contains information on Norges Bank’s management of the Fund, including all annual reports, letters from the bank to the Ministry of Finance, and various articles on fund management issues.

Also highly recommended is the book written by professor Rögnvaldur Hannesson at the Norwegian School of Economics and Business Administration on experiences with oil funds in various countries: Hannesson, Rögnvaldur, 2001, Investing for Sustainability (Boston: Kluwer Academic Publishers).


Adjustments have been made for variations in tax revenues associated with economic activity, accounting factors, and some extraordinary, temporary revenues and expenditures.


The investment guidelines for the Fund are in the Appendix.


The tracking error is defined as the standard deviation of the difference between the benchmark and the actual portfolio.

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