Abstract
In an economy with a sovereign wealth fund (SWF), the government may draw on the fund to supplement other government revenues. If the fund is invested in risky assets, this introduces a new stochastic element into the government’s budget. We analyze the interaction between the draw from and risk taking in the SWF. Using non-expected utility preferences, we distinguish between intended changes and stochastic changes in the SWF draws over time. We show that the desire for smoothness in taxes and public services translates into smoothing of SWF draws and lower risk taking. It can even lead to procyclical rebalancing of the SWF portfolio. Future interest rates are associated with interest-rate risk. We show that this risk may lead to a higher optimal equity share in the SWF portfolio. Policy makers can use the draws from the SWF to smooth over time variation in risk-free rates.
Highlights
For a country with a large enough sovereign wealth fund (SWF), its financial returns can fund substantial parts of government spending
In a somewhat different vein, Van den Bremer et al (2016) focus on the interaction between the financial portfolio and the value of the natural resources that fund that portfolio. We find this issue important, we bypass it in our study, which can best be interpreted as an analysis of SWF management and spending once the natural resource has been depleted
Once an SWF of the type we study has been established, policy makers have to decide on at least three important issues: first, how much risk to assume in the asset portfolio, and second, how much to draw from the fund to support current spending
Summary
For a country with a large enough sovereign wealth fund (SWF), its financial returns can fund substantial parts of government spending. Parts of our analysis follows from results in the existing literature, but the generalization to the case of non-expected utility is, to the best of our knowledge, novel for the cases of habit formation and time-varying risk-free rates This generalization is important for decisions regarding portfolio allocation for SWFs and the use of such funds as budget revenues. If the equity premium is 4% and the equity share has been optimally chosen as 60%, we can conclude that the annuity component of the optimal draw is 1.2 percentage points higher than the risk-free rate or, equivalently, 1.2 percentage points lower than the expected return on the entire portfolio As a provision against risk, the annuity part of the optimal draw rate should be lower than the expected return on the portfolio
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