Public Financial management of the Sovereing Wealth Funds

TESE DE DOUTORAMENTO PUBLIC FINANCIAL MANAGEMENT OF THE SOVEREING WEALTH FUNDS Akmaral Iliyas ESCOLA DE DOUTORAMENTO INTERNACIONAL PROGRAMA DE DOUTORAMENTO EN DESENVOLVEMENTO REXIONAL E INTEGRACIÓN ECONÓMICA SANTIAGO DE COMPOSTELA 2019 DECLARACIÓN DO AUTOR DA TESE Public Financial Management of the Sovereign Wealth Funds Dna. Akmaral Iliyas Presento a miña tese, seguindo o procedemento axeitado ao Regulamento, e declaro que: 1) A tese abarca os resultados da elaboración do meu traballo. 2) De selo caso, na tese faise referencia ás colaboracións que tivo este traballo. 3) A tese é a versión definitiva presentada para a súa defensa e coincide coa versión enviada en formato electrónico. 4) Confirmo que a tese non incorre en ningún tipo de plaxio doutros autores nin de traballos presentados por min para a obtención doutros títulos. En Santiago de Compostela, 15 de marzo de 2019 Asdo. Akmaral Iliyas AUTORIZACIÓN DO DIRECTOR / TITOR DA TESE Public Financial Management of the Sovereign Wealth Funds D. Manuel Fernández Grela INFORMA: Que a presente tese, correspóndese co traballo realizado por Dna. Akmaral Iliyas, baixo a miña dirección, e autorizo a súa presentación, considerando que reúne os requisitos esixidos no Regulamento de Estudos de Doutoramento da USC, e que como director desta non incorre nas causas de abstención establecidas na Lei 40/2015. En Santiago de Compostela., 15. de marzo. de 2019. Asdo. Manuel Fernández Grela ACKNOWLEDGMENTS I would like to acknowledge everyone who played a role in my academic accomplishments. First of all, I would like to express my deep gratitude to Professor Manuel Fernandez Grela, my research supervisor, for his patient guidance and encouragement of this research work. I would also like to thank colleagues at IDEGA, each of whom has provided advice and guidance throughout the research process. Thank you all for your unwavering support. I would also like to thank all of my friends who supported me and help me to strive towards my goal. I would like to dedicated this work to the memory of my parents who always believed in my ability to be successful, your belief in me has made this journey possible. 9 INDEX RESUMO .................................................................................................... 11 INTRODUCTION ...................................................................................... 23 1.1 The Natural Resource Curse .............................................................. 23 1.2 The Republic of Kazakhstan as a Resource-based Economy ............ 30 REFERENCES ........................................................................................... 43 CHAPTER 1 THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND ........................................................................................................... 47 1.1 Introduction ........................................................................................ 47 1.2 SWFs in the World ............................................................................ 50 1.3 The National Fund ............................................................................. 76 1.4 The Governance Mechanisms of the National Fund .......................... 93 1.5 A Proposal for Improving the Efficiency in the Management of the National Fund ............................................................................. 106 1.6 Conclusions ...................................................................................... 110 REFERENCES ......................................................................................... 113 CHAPTER 2 THE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN’S DIVERSIFICATION POLICIES (2010-2014) ..... 119 2.1 Introduction ...................................................................................... 119 2.2 Diversification Strategies in the Republic of Kazakhstan ............... 123 2.3 Financial Sources for Diversification .............................................. 133 2.4 Diversification through the National Fund ...................................... 136 AKMARAL ILIYAS 16 grandes investimentos e medidas sistémicas de política estrutural. Nun país que goza de ganancias imprevistas grazas aos recursos naturais, un fondo soberano pode considerarse como unha das alternativas para fornecer o financiamento preciso, o que acontece efectivamente co FNRK. Como outros países exportadores de recursos primarios, Kazajstán ten que tomar decisións acerca de que parte dos seus ingresos asignar ao investimento na economía nacional e acerca de como investilos. As dúas vías principais para diversificar a industria dun país rico en petróleo son o desenvolvemento de industrias baseadas no petróleo e a substitución de importacións. As industrias baseadas no petróleo comportan habitualmente a realización de proxectos a gran escala e intensivos en capital, moitas veces de titularidade pública. Polo contrario, as actividades que substitúen importacións son moi variadas, habitualmente pequenas e intensivas en traballo e a miúdo de titularidade privada. Aínda que as primeiras son moito máis acaídas á estrutura produtiva existente, e teñen un elevado potencial para crear e manter emprego no curto prazo, non resolven a cuestión básica da dependencia respecto do petróleo e o gas, polo que a substitución de importacións adoita converterse no obxectivo das reformas económicas nos países ricos en recursos. Porén, ten que facer fronte á escaseza de elementos cruciais de natureza privada, como o emprendemento e a asunción privada de riscos. De aí que o crecemento do sector privado sexa moi importante para a diversificación, tanto para crear emprego como para atraer investimento estranxeiro directo (IED) que poida aportar o tipo de capital e de coñecemento precisos para desenvolver industrias antes inexistentes. RESUMO 17 A política de diversificación industrial na RK púxose en práctica a través de diferentes “plans” ou “estratexias” de alcance nacional e ambiciosos obxectivos, incorporados na chamada “Estratexia para o desenvolvemento industrial e a innovación de Kazajstán”, aprobada en 2003. Porén, na práctica a maioría dos proxectos efectivamente desenvolvidos ao abeiro desta estratexia concentráronse nas industrias relacionadas cos sectores extractivos. Ademais, a crise financeira global iniciada en 2007 contribuíu a desviar unha parte importante dos fondos inicialmente destinados á creación de novas actividades cara o mantemento do emprego e o saneamento do sistema bancario. Por último, a capacidade do FNRK para financiar o programa de reformas coa parte dos seus activos non vencellada ao cumprimento das súas funcións de aforro e estabilización, depende crucialmente da evolución do prezo do petróleo. Xa que o custo medio de produción do petróleo en Kazajstán estímase en 50 dólares EEUU por barril, precísase un prezo de polo menos $60 por barril para que o Fondo poida sustentar o programa de industrialización. Como resultado de todos estes factores, non é posible detectar ningún efecto significativamente positivo do financiamento procedente do FNRK sobre os indicadores obxectivo do programa de diversificación industrial durante o quinquenio 2010-2014: non se produciron nin aumentos nas taxas de actividade industrial nin diminucións nos indicadores de concentración da produción nin das exportacións acordes coa magnitude dos investimentos do FNRK. Aínda que unha consideración das causas da inefectividade dos investimentos do FNRK é unha cuestión alén dos obxectivos fixados para esta tese, o feito de que o crecemento dos activos do Fondo dependa da evolución dos prezos do petróleo introduce serias dúbidas sobre a capacidade futura para reverter esta situación. Unha AKMARAL ILIYAS 18 extrapolación do comportamento dun dos prezos de referencia deste recurso primario, o do barril de petróleo tipo Brent, amosa que a tendencia previsible no curto e medio prazo deste prezo sitúase nun valor medio de $60 por barril, que é precisamente o valor considerado como limiar para a acumulación de activos por parte do Fondo. A elevada variabilidade deste tipo de predicións implica que dentro dun intervalo de confianza razoable, os escenarios máis pesimistas inclúen valores non compatibles coa consecución simultánea de todos os obxectivos do FNRK. O terceiro e último capítulo ten como obxectivo analizar o impacto sobre o sistema urbano da RK do traslado da capital da República dende a cidade máis grande da mesma, Almaty, a unha nova aglomeración urbana chamada Astana (“capital”, na lingua kazaja) construída a gran velocidade a partir dunha pequena vila chamada Akmola. Este proxecto, financiado parcialmente con fondos procedentes do FNRK é probablemente o máis ambicioso de todos os que se puxeron en marcha dende a declaración de independencia en 1990. A literatura sobre as diversas experiencias de relocalización de capitais que tiveron lugar no mundo despois da Segunda Guerra Mundial destaca o papel especial que estas xogan no sistema urbano como centros administrativos dotados dun valor simbólico adicional. O capítulo comeza por describir a estrutura territorial da RK. Esta ten unha configuración sinxela, axustada as peculiares características da República pero similar ás do resto das repúblicas ex-soviéticas de Asia Central. Kazajstán é un país moi extenso e pouco poboado, cunha taxa de urbanización relativamente baixa (arredor do 50-60% dende a independencia) e unha poboación asentada en rexións relativamente compactas, situadas moi lonxe unhas doutras e comunicadas por unha feble rede interna de custoso mantemento RESUMO 19 debido ás extremas condicións meteorolóxicas presentes na meirande parte do territorio. A estrutura urbana da RK está encabezada por un conxunto de dúas grandes áreas metropolitanas (a vella e a nova capital) e catorce cidades de tamaño pequeno-mediano que se atopan espalladas polo territorio nacional e actúan como cabeceiras administrativas (das dezaseis oblasts ou provincias nas que se divide a República) e localización das actividades industriais e de servizos. Por debaixo destas atópase unha rede de pequenas cidades e vilas, moitas delas vencelladas aos lugares onde se localizaron as factorías industrias nos tempos da URSS, e caracterizadas polo monocultivo industrial. A supervivencia destas cidades depende por completo da situación das factorías matrices, e cando estas teñen problemas económicos ou mesmo chegan a pechar, convértense en lugares de orixe dos fluxos de migración interna. A construción de capitales ex novo é unha importante medida de política de planificación territorial, aínda que as súas motivacións abranguen habitualmente cuestións tanto xeopolíticas como socioeconómicas. As motivacións demográficas resultan particularmente interesantes, xa que ao modificar substancialmente os fluxos migratorios internos e externos do país, afectan substancialmente a configuración do sistema urbano. Un dos obxectivos da creación dunha nova capital situada no centro-norte da RK era o de intentar re-equilibrar a composición étnica nesa ampla rexión, fronteiriza coa Federación Rusa e onde a maioría da poboación era de orixe rusa na época soviética. Para acadar este obxectivo estimulouse a migración interna dos excedentes de forza de traballo nas rexións agrícolas do sur da República cara a nova capital. Outra característica demográfica relevante de Kazajstán é a súa relativa despoboación con respecto dos países veciños. Neste sentido, a nova AKMARAL ILIYAS 20 capital púxose en marcha ao mesmo tempo que unha política de repatriación das importantes minorías de etnia kazaja distribuídas nos países fronteirizos (Uzbekistan, Mongolia, China, Turkmenistan,...), como parte dun ambicioso proxecto de fundar o crecemento da nación sobre o crecemento da poboación de orixe kazajo. Coa aprobación da lei de creación da nova capital, o territorio arredor da nova área metropolitana da capital declarouse como unha das nove “zonas económicas especiais” creadas no país para atraer investimentos que acelerasen o seu desenvolvemento. A cidade rapidamente converteuse na segunda máis grande do país, sobre a base dun gran número de proxectos arquitectónicos e urbanísticos. O goberno da RK seguiu unha política deliberada de ofrecer a súa capital como sede de organismos internacionais (Comunidade Económica Euroasiática, a Asociación Internacional de Capitais e Cidades dos países da Comunidade de Estados Independentes) e de grandes eventos (Xogos Asiáticos de Inverno, Exposición Internacional) para favorecer o seu crecemento. Contando co financiamento do FNRK, a través do “fondo de benestar” Samruk-Kazyna e liñas especiais de crédito, dotouse á administración local dos instrumentos financeiros requiridos para promover a creación e o desenvolvemento de pequenas e medianas empresas. Aos inmigrantes internos que desexasen instalarse na capital proporcionáronselles subvencións compensatorias polos desprazamos, así como aloxamento gratuíto e diversas medidas activas para facilitar a súa integración no mercado de traballo local. O impacto da creación e crecemento de Astana analízase dende dous puntos de vista diferentes: o dos fluxos migratorios e o da estrutura urbana. A capital converteuse rapidamente dende o intre da súa creación no principal foco de atracción dos fluxos migratorios tanto internos como externos, pero non pode atoparse evidencia RESUMO 21 concluínte de que contribuíse dalgún xeito a que estes fluxos fosen maiores do que serían de non ter existido. No referente ao segundo punto, o rápido crecemento de Astana reencheu un oco no sistema urbano da RK, xerado polo desproporcionado crecemento da antiga capital Almaty, que nos tempos da URSS funcionaba como cabeceira dun subsistema urbano máis amplo, que abarcaba territorios das actuais repúblicas de Kirguizistán, Uzbekistán e Tajikistán. Deste xeito, a creación da nova capital permitiu evitar que se detivese o proceso de urbanización na RK provocado polo colapso de parte da actividade industrial herdada da Unión Soviética, se ben non conseguiu evitar que evolucionase máis a modo. En conclusión, pódese afirmar, dentro das limitacións que impón a esta tese a falla de dispoñibilidade de datos suficientes para poder realizar unha análise de impacto cuantitativa, que os defectos no deseño e a estrutura de xestión do FNRK empecen decisivamente que este poida cumprir o papel na resolución dos problemas coñecidos baixo o nome xenérico da “maldición dos recursos naturais” para o que foi creado, aínda que en casos particulares como o financiamento das medidas destinadas a favorecer o crecemento da nova capital o seu impacto poida identificarse como positivo. Aínda así, é necesario profundar no futuro na procura de datos e métodos que poidan permitir a realización dunha análise contrafactual do impacto do FNRK. 23 INTRODUCTION 1.1 THE NATURAL RESOURCE CURSE The availability of natural resources, like oil and natural gas, should be valuable for a developing country. Extractive activities should generate employment and economic growth, and the revenues from their sale should provide the country with much-needed foreign exchange, as well as compensating the limited fiscal revenue that accrue to its government. However, many resource-rich economies underperform, a situation which following Auty (2002) is usually described as the “resource curse”. It is not difficult to find historical examples of this situation from the Spanish "Golden Age" that ruined Spanish producers with rising prices and taxes 1 through the more recent cases of oil-producing countries with dismal economic performance, like Nigeria. 2 In today’s global economy there is, in fact, a large group of countries where the bulk of the state budget revenues is generated by exports of commodities. For this group of countries, the budget revenues are largely determined by the world market prices for the exported resources. And the price for these product categories is extremely volatile and can only be predicted with very low precision. Accordingly, the budget revenues in such countries tend to fluctuate 1 See, e.g,. Álvarez Nogal & Prados de la Escosura (2007). 2 For a description of the situation in Nigeria, see Sala-i-Martin & Subramanian (2008). AKMARAL ILIYAS 24 significantly and, as a result, the price trend for commodities determines the situation and growth prospects of the national economies. Sachs & Warner (1995) used cross-section data to show that the countries with higher ratio of commodity exports to GDP in 1970 experienced slower growth in the following 20 years. Auty (2002) showed that natural resource rich countries have adverse experiences regarding to policies that close the economy to the outside world and create discretionary rents behind protective barriers that result in the cumulative misallocation of resources. The literature offers several explanations about the economic effects of natural resources. 3 Some of them highlight the deindustrialization processes brought about by the appreciation of the real exchange rate, the so-called "Dutch disease", following Corden & Neary (1982) and Corden (1984). Others, like Sachs & Warner (1985) and Gylfason et al. (1999), point to the negative effects on growthrelated externalities, like those linked to "learning by doing" processes, triggered by the decline in manufacturing activities. Still other authors, like Ramey & Ramey (1995), identify the volatility of commodity prices (especially for localized resources, like oil) as the main cause of adverse growth effects caused by natural resources. A different strand of the literature is focused on the effects of the abundance of natural resources on the quality of social and political institutions. Thus, Acemoglu & Robinson (2006) argued that natural resources make the blocking of institutional improvements attractive for political elites interested in preserving their own power, while Murphy et al. (1989) considered how natural resources favour the 3 For a complete survey of the literature on the resource curse see Van der Ploeg (2011). INTRODUCTION 25 pursuit of rent-seeking instead of productive activities. 4 One different perspective on the same topic is that natural resource wealth can induce governments to pursue unsustainable economic policies, like excessive borrowing as in Mansoorian (1991). A successful use of nonrenewable natural resources requires investment in assets that will be productive over time and with high social return, but these may be difficult to identify. For this task, placing revenues in investment vehicles may be appropriate, even if it does little per se to boost economic development. Ultimately, resource management has to be done in a manner that will support private sector investments. The literature usually identifies two main principles for revenue management: high saving and building of domestic assets by the government. However simple these principles may seem, their actual implementation can still go wrong because of a series of reasons, like lack of fiscal discipline (too many bad projects), increased corruption and slows reforms (transparency and centralized financial control may help), patronage politics and increased conflict risk. The historical record of managing resource revenues has been reviewed by Collier et al. (2010), who arrived to the conclusion that resource revenues have positive effects on economic growth in countries with good governance, while the effects are negative on average in countries with poor governance. A good part of the literature on revenue management starts from elementary economic analysis based on the Permanent Income Hypothesis (PIH). This hypothesis provides a solution for a society 4 There is also an ample empirical literature showing high correlation between natural resource wealth and corruption levels. See Ades & Di Tella (1999). AKMARAL ILIYAS 32 1. The overcoming of the negative consequences of the collapse of the old economic system, and the creation of the preconditions for growth based on the stabilization of the financial and economic situation in the country. Thus, in 2000-2003 cumulative GDP growth was 42.3% (Kazstat, 2004). 2. The completion of the regulatory framework adapted to the standards of a market economy. This was a period of high legislative production regulating the securities market, financial system, labor market, taxation, accounting, equity relationships, and many other sectors of the economy. 3. The completion of the main part of the process of denationalization and privatization of the economy and the creation of a mixed-type economy with a thick layer of private businesses. The government tried to develop small and medium enterprises (SMEs), which are specially linked to the rapid development of services, whose share in GDP grew continuously during the period. 4. The achievement of stability in the financial sector, regarding public finance, the national currency, the banking system, and the foreign exchange reserves of the National Bank of Kazakhstan (NBK). This stability was reflected in the dynamics of inflation, interest rates, money markets and government securities markets, and helped to increase significantly the scale of banks' lending to the real economy. Throughout the period from 1998 to 2004, household deposits at banks grew by 14 times. (Kazstat, 2004). 5. The intensification of investment and production processes in virtually all sectors of the economy - industry, agriculture, transport and communication, trade, etc. For the first time since independence, INTRODUCTION 33 and starting in 1999, there was a positive trade balance (subject to adjustments for non-organized trade). 6. The orientation of the economic system for real structural change. In particular, Kazakhstan took the lead among CIS countries in measures such as pension reform, the system of guaranteeing bank deposits, the early repayment of debt to the World Bank through the NBRK, the formation of the National Fund, the state compensation to depositors of banks and pension funds for foreign exchange losses due to currency devaluation, or the denial of mandatory sale of foreign exchange earnings by exporters. Thanks to these outcomes, Kazakhstan was the first CIS country to be recognized by the European Union (EU) and United States of America (USA) as a market economy in 2001 and 2002 respectively, and to reach investment grade status. In January 2005 the Organization for Economic Cooperation and Development (OECD) upgraded Kazakhstan’s country export risks rating, moving it from the 5th to the 4th group of risks. The main feature of the third stage in Kazakhstan’s history of reforms is the design of grand development strategies, like the ones labeled as "Kazakhstan-2030" first, and “Kazakhstan-2050” later. The main economic priorities stated in these policy documents are to avoid overdependence on its oil and gas and minerals sectors, and to use the abundance of natural assets to build a modern, diversified, highlytechnological, flexible and competitive economy with a high valueadded component. Already in 2003, the Strategy for Industrial and Innovation Development of Kazakhstan was approved. The main objective of this strategy was to achieve sustainable development through economic AKMARAL ILIYAS 34 diversification. This Strategy envisaged the creation of institutions such as the Kazakhstan Investment Fund, the Kazakhstan Development Bank, and the Innovation Fund and Export Insurance Corporation. The functioning of these institutions should promote the development of innovative capacity and prospective high-tech projects through direct funding jointly with private investors, and the establishment of the basic elements of an innovation infrastructure. 8 The Strategy started to be implemented in 2005, and it set a task to the creation of regional "locomotives" of economic development. 9 An attempt was made to strengthen the measures included in the Strategy by adopting the program "30 corporate leaders". This program was focused on the implementation of major investment projects initiated mainly by private companies. 10 The global financial crisis of 2007-2008 put all these strategies at risk from a very early phase. The main purpose of the anti-crisis program in 2008 was the mitigation of the negative effects of the global financial crisis on the social economic situation in Kazakhstan. Overall, the program provided an infusion into the economy of Kazakhstan of about 2.2 trillion tenge, which was about 20% of the country's GDP at the time. 8 Starting from 2005 Kazakhstan has been implementing in practice the UK’s Extractive Industries Transparency Initiative with the aim to deliver a clear signal to the international investors community and to financial institutions that the Government of Kazakhstan commits itself to greater transparency to further improve the investment climate. 9 Adress by the President of the Republic of Kazakhstan, Leader of the Nation N.Nazarbayev «Strategy Kazakhstan – 2050» New political course of the established state. December 12, 2012. 10 Of the 45 investment projects considered, more than 70% were proposed by mining companies and were aimed primarily at the expansion and modernization of production. By early 2009 only two projects were really implemented. INTRODUCTION 35 In 2010, then, it was necesary to set again a new industrial and innovative development strategy based on diversification and improvement of the economy’s competitive ability, the so-called State Program of Accelerated Industrial and Innovative Development. 11 This Program was presented as a logical continuation of the previous diversification policies and it contained the main provisions set beforehand by the Industrial-innovation Development Strategy for 2003–2015, the Program "30 corporate leaders of Kazakhstan" and other strategic documents in the sphere of industrialization. The new course of industrialization involved not just the extensive growth of the economy, but looked to boost innovative growth by deepening diversification and trying to develop a modern high-tech industry structure (in the sense of replacing the old one inherited from the Soviet period). The strategy defined that the promoters of big projects would be a newly created fund, JSC National Welfare Fund “Samruk-Kazyna”, strategic companies in the fuel-energy and metallurgical sectors of the economy, and also strategic foreign investors. Simultaneously, the strategy contemplated as a priority the development of the sectors of the economy which are not related to the raw materials sectors, but oriented to internal and regional markets (the countries of the Eurasian Customs Union and Central Asia). The main formal objectives of this industrialization strategy were: (1) ensuring the sustainable and balanced growth of the economy through accelerated diversification and increased competitiveness of 11 The State program of forced industrial and innovative development has been approved by the Decree of the President of the Republic of Kazakhstan No.958 dated March 19, 2010. The goal of the program is to guarantee the stable and well-balanced economic growth by means of diversification and improvement of its competitiveness. AKMARAL ILIYAS 36 the national economy; (2) the formation of centers of economic growth on the basis of a rational territorial organization of the productive capacity; (3) ensuring the effective interaction between government and business in the process of implementation of investment projects and the development of priority sectors of the economy. The wider perspective of this strategy was the attempt to further integrate Kazakhstan’s economy into international economic relations, not just through the utilization of the ample reserves of energy and mineral resources, but also by increasing possibilities to export industrial and agricultural products. The departure point of all these development strategies is the abundance of natural resources that makes the economy of RK resource-dependent. The estimated constant international prices of raw materials, calculated on the basis of conservative growth forecasts of world prices are used directly in the development and approval of national and local budgets. Endowed with abundant mineral resources, Kazakhstan is in the top oil-producing countries list. Its crude oil reserves are ranked 12th in the world, and second only to Russia among former Soviet states. BP (2015) estimated Kazakhstan’s proven reserves at 30.0 billion barrels in 2015, accounting for 1.8% of proven world reserves. For the sake of comparison, note that Kazakhstan’s reserves are in the range of smaller OPEC members like Libya or Nigeria. 12 At current production levels, its reserve-to-production (R/P) ratio is estimated at 49.3 years, broadly similar to the world average. 12 Kazakhstan also had proven reserves of 1.9 trillion cubic meters of natural gas in 2007 (comparable to Iraq’s), but natural gas production is much lower than oil production. INTRODUCTION 37 Figure 1. Caspian region oil and natural gas infrastructure The main oilfields in Kazahstan are Tengiz, developed by a joint venture with Chevron, Exxon Mobil and LukArco, Karachaganak, developed by a production sharing agreement (PSA) with ENI, British Gas, Chevron and Lukoil, and the largest one, the Kashagan field, where production started briefly after long delays in 2014 and has been postponed due to technical problems since, to be developed by a PSA with Exxon Mobil, KMG, Shell, Total, ENI, Conoco, and Impex, AKMARAL ILIYAS 38 all of them located in the western part of the country, close to or within the Caspian shelf. The ownership structure of the oil industry in Kazakhstan is characterized by an extensive involvement of multinational companies, as a product of the fast and large-scale privatization process followed after independence and described above. In April 1993, the government of the RK signed a 40-year joint-venture agreement with Chevron and other minor parties to develop the onshore Tengiz field (considered at the time the fifth largest in the world). Later, in 1997, two PSAs were signed with international consortia to develop the Karachagank (onshore) and Kashagan (offshore) fields. Residual shares in each of these contracts were given to the state-owned company KazMunaiGaz (KMG, formerly KazakhOil). Chart 1 shows the importance of oil exports for total exports and the trade balance. International experience shows that the dependence of the economy on the oil factor will be persistent in time. The current exploitation plans of Caspian shelf oil forecast output to reach 150 million tons in 2015-2020, which will allow Kazakhstan to enter the top ten exporters of oil, along with Iran, Mexico, Norway and Venezuela. INTRODUCTION 39 Chart 1. Oil and exports in Kazakhstan Data source: World Bank. World Development Indicators According to the IMF (2010), the oil sector dominates Kazakhstan's economy. For example, oil and gas account for about a quarter of GDP, 60% of total exports, 40% of all revenues and about three-quarters of foreign direct investment (FDI). It is expected that these ratios will rise significantly when eventually production will be restarted at the giant Kashagan field. It is predicted that after this deposit reaches peak capacity, domestic oil production will double from current levels. Chart 2 illustrates the recent evolution of the main figures related to oil production and sale in the RK. Data from Kazstat, the Agency of Statistics of the RK, shows that the driving force of the economy is the mining industry, which provided a significant share in the formation of GDP and export earnings. In 2012, the contribution of the mining industry to Kazakhstan's GDP was about 17%, where the share of oil and gas account for almost 90% of this volume. There is an extremely high AKMARAL ILIYAS 40 correlation between economic growth and indicators of the mining industry. 13 The share of manufacturing in GDP remains low. Despite all the diversification policies described above, there remains in the RK a lack of investment attractiveness for non-extractive industries, of adequate state mechanisms to ensure a favorable business climate, and of opportunities for participation of small and medium-sized businesses in the manufacturing sector. 14 Chart 2. Oil supply and consumption in Kazakhstan Data source: US Energy Information administration The share of manufacturing in GDP remains low. Despite all the diversification policies described above, there remains in the RK a 13 Between the level of nominal GDP and the price of oil the correlation coefficient is above 0.9. 14 See Newspaper: A New Decade – New Economic Growth – New Opportunities for Kazakhstan. Message of the President of Kazakhstan N.Nazarbayev of Kazakhstan / Kazakhstan Pravda, January 27, 2012. INTRODUCTION 41 lack of investment attractiveness for non-extractive industries, of adequate state mechanisms to ensure a favorable business climate, and of opportunities for participation of small and medium-sized businesses in the manufacturing sector. 15 Government revenue from the oil industry typically fluctuates with the world market price. The annual budget of most governments is a process often still driven by accounting pertaining to finance and public revenue that says little about the impact of annual flows on a government’s or a country’s total assets and liabilities. Hence, there is a scope for institutions that can help to guide fiscal decisions to account for the volatility of revenues and the eventual depletion of the resource that generates them 16 Oil-related revenues determine the level of expenditures that can be financed sustainably. If revenues turn out to be higher than expected, the windfall should be saved and drawn down whenever revenues fall below expectations later. 17 Oil revenues contribute to the economy mainly through deficit spending, as well as through secondary effects on services related to oil. The main channels of transmission of the impact on the domestic economy are budgetary accounts, in the form of annual transfers from the National Fund and the regional and local taxes in oil producing regions. Additional channels are surveys, exploration and maintenance. Oil-related revenues for local firms, especially for 15 See Newspaper: A New Decade – New Economic Growth – New Opportunities for Kazakhstan. Message of the President of Kazakhstan N.Nazarbayev of Kazakhstan / Kazakhstan Pravda, January 27, 2012. 16 The average cost in the major producing countries varies: in Saudi Arabia is estimated around $25, the average for OPEC countries falls around $40, in the Russian Federation it is estimated around $45, in the USA and Kazakhstan around $50, and in Venezuela around $77.6. Please note that oil transactions are always denominated in US dollars ($). 17 See Luecke (2011). AKMARAL ILIYAS 48 reserve management to sovereign wealth management. According to a speech by John Lipsky (2008), effective wealth management has become an important responsibility for the public sector, and as a result many countries have responded by creating sovereign wealth funds. There is a large literature devoted to the problems of sovereign wealth funds in general, and in particular their place in the securities market. Recent research, like Mehlum et al. (2006) explains that the countries with well-governed and designed institutions are more likely to use their resources to improve economic and social outcomes, as a function of institutional quality. Natural-resource producing countries trying to transform resources into sustained improvements in living standards utilize SWFs to manage government revenue from exhaustible natural resources with the aim of improving development outcomes. 18 In fact, there has been a focus among policymakers on upgrading and innovating the institutional toolkit at hand for recourserich countries where governments want to transfer some or all of the revenue from natural resource extraction to their citizens through universal, transparent and regular payments. 19 Particular attention has been given, e.g. by Rodriguez & Sachs (1999) to institutions that can help to mitigate resource revenue volatility, to support sustainable government spending, to manage currency appreciation, to minimize political temptation and to facilitate inter-generational wealth transfers. Various aspects of the problems associated with the operation of sovereign wealth funds have been raised in studies by Fasano (2000), Jen (2007), Eschweiler & Fernandez (2008), Mezzacapo (2009), etc. 18 See, e.g., Gould (2010). 19 As reported by Das et al. (2010), or Dixon & Monk (2011). CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 49 For example, Davis et al. (2003) classify non-renewable resource funds in proper stabilization funds and savings funds. In the former, the aim is to reduce income volatility for the government and the economy, while in the latter the aim is to provide a reserve of national wealth for future generations. Zolotareva et al. (2001) consider stabilization funds as insurance institutions created by the government specifically for the purpose of smoothing costs in circumstances where it is impossible for reliable third-party institutions to insure the risks associated with changes in income. Besides, issues addressing the impact of sovereign investment funds on the financial markets are considered by, among others, Daems (1978), Beck & Fidora (2008), Flaherty (2008), Jen & Bindelli (2008), Maslakovic (2008), Braunstein (2009), and Truman (2010). In summary, we can say that sovereign wealth funds are created by central or regional governments as investment funds for the revenues obtained from the export of non-renewable natural resources, nonprimary budget surpluses of the foreign exchange reserves, or other incomes. They are managed and used in order to ensure the stability of national economies. To achieve their objectives, the funds' assets are invested in foreign financial assets. Despite the above mentioned differences between stabilization and saving (also called future generations) funds, in general they are focused on smoothing costs (with stabilization funds focused on the short term, saving funds on the long term). Several authors like, e.g., Truman (2008 and 2010) discuss transparency issues relative to sovereign wealth funds. According to the Generally Accepted Principles and Practices (GAPP), usually known as the Santiago principles, SWFs are special purpose investment funds that are owned by the government for AKMARAL ILIYAS 50 macroeconomic purposes. SWFs hold, manage, or administer assets to achieve financial objectives, and use a set of investment strategies that include investing in foreign financial assets. From this wide perspective, then, SWFs are a heterogeneous group, comprising fiscal stabilization funds, reserve investment corporations, savings funds, pension reserve funds without explicit pension liabilities and development funds. 20 The GAPP include the following as guiding objectives for SWFs: to help maintain a stable global financial system and the free flow of capital and investment; to comply with all applicable regulatory and disclosure requirements in the countries in which they invest; to invest on the basis of economic and financial risk and return-related considerations; and to have in place a transparent and sound management. 1.2 SWFS IN THE WORLD The International Working Group of Sovereign Wealth Funds was established in 2008 at a meeting of countries with SWFs in Washington, D.C., facilitated and coordinated by the International Monetary Fund. The IWG has reached agreements on a set of optional practices and principles within three key areas: the funds' legal and macroeconomic framework (established by the general government for macroeconomic purposes, SWFs are created to invest government funds to achieve financial objectives); governance and institutional 20 The definition of SWFs according to the Santiago principles explicitly excludes foreign currency reserve assets held by monetary authorities for the traditional balance of payments or monetary policy purposes, operations of state-owned enterprises in the traditional sense, government-employee pension funds, and assets managed for the benefit of individuals. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 51 structures (SWFs are owned by the general government, which includes both central government and subnational governments); and investment and risk management practices (the investment strategies include investments in foreign financial assets, so it excludes those funds that solely invest in domestic assets). Table 2. SWFs market share by country and region. Data source: SWF Institute The main key considerations about the workings of SWFs are reflected in the Santiago Principles, agreed to by the SWFs in 2008 following extensive consultation. The standing implementation of the Santiago Principles underscore the positive impact that SWFs can make to global prosperity and stability. AKMARAL ILIYAS 52 Figure 2. World map of the Sovereign Wealth Funds. In practice, strategic and development funds, a number of reserve funds and even active stabilization funds place investments in national assets. These domestic investments may be performed on a regular basis, and funds can even place investments in domestic bank deposits to contribute to finance budget deficits. The policy objectives of SWFs vary, depending on the broad macro fiscal objectives that they aim to address. Their organizational structure needs to have a clear separation of responsibilities and authority. As such, a well-defined structure builds a decision-making hierarchy that limits risks by ensuring the integrity of and effective control over SWF management activities (Santiago principles, GAAPs 1-16). From the current top 50 sovereign wealth funds, 22% of them were launched before 1990, 14% in the 1990-1999 period, and 64% were launched in 2000-2012. From the start of 2008 till the end of CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 53 2012, SWFs assets grew by 59.1% and more than 32 SWFs were created from 2005 to 2012. SWFs are usually distinguished by their funding sources and purpose. In terms of funding, three types of sources stand out: Table 3. Ranking of the largest SWFs. Source: SWF Institute 1. Commodity Funds (e.g. Norway Government Pension Fund formed from oil revenues; Social and Economic Stabilization Fund and Pension Reserve Fund in Chile formed from the proceeds of AKMARAL ILIYAS 54 copper; Reserve Fund and National Welfare Fund of Russia formed by revenues from oil, gas and petroleum, etc.). Commodity Funds are largely oil and gas related, although some funds are also based on revenues from metals and minerals. Most commodity revenues are generated either directly through state-owned companies or commodity taxes. Commodity revenues are viewed as a “source of wealth” as they represent net national saving by their sponsor government and are usually established for budget stabilization and wealth sharing across generations. 2. Non-commodity Funds (e.g. GIC, KIC, HKMA Exchange Fund). According to Fernandez (2008), they are based mainly on fiscal sources and foreign reserves. Fiscal sources can come from fiscal surpluses, proceeds from property sales and privatizations (e.g. Estonia) or transfers from the government’s main budget to a special purpose vehicle. Most fiscal sources are “real wealth”, although some have liabilities. (e.g. China is funding the transfer of foreign reserves from the central bank to CIC by issuing government bonds). Foreign reserves represent often “borrowed wealth” as the reserve build-up in many countries stems from sterilized foreign exchange interventions, in which case the central bank issues interest-bearing liquidity notes to fund the interventions and mop up the excess liquidity (e.g. Chad). However, part of the foreign reserves may also represent “real wealth”, thanks to asset appreciation and the accumulation of interest income. The share of foreign reserves managed by SWFs is typically viewed as “excess” reserves as it exceeds the portion of foreign reserves deemed necessary for the conduct of foreign exchange policy and precautionary reasons. To tackle the challenges associated with the use of revenues from natural resources, several countries have introduced stabilization funds CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 55 – a fiscal instrument to save and set aside a certain amount of revenues for the future when they are needed in stabilizing their economies – since the first establishment in 1953 in Kuwait. Indeed, several definitions of stabilization fund are used in the literature. Balding (2012), for example, define it as “a government account designed to smooth pubic expenditures and compositions by setting aside revenue during periods of rapid growth that then could be drawn on during economic contractions”. In general, the purpose of stabilization funds, especially in resource – rich economies, is to buffer negative shocks on government expenditure caused by sharp declines in resource prices and the subsequent resource-related revenues. Against this background, a key issue is whether or not a stabilization fund works in practice as a cushion to mitigate the fluctuations in government spending. It is often discussed in the literature that having a stabilization fund in itself does not address the issue of expenditure smoothing, so what matters is its design, including clear rules on asset accumulation and investment, and institutional arrangement to enhance transparency and accountability of the fund (Valdés & Engel, 2000; Bacon & Tordo 2006; Asfaha, 2007; Le Borgne & Medas, 2007). Morever, in theory, if a resourcerich country maintains sound and appropriate fiscal policy to manage natural resources, the country might not need to establish a stabilization fund to separate the revenue and expenditure cycles. The establishment of stabilization funds is not a requisite to smooth expenditures. Indeed, empirical evidence on the effectiveness of stabilization funds on fiscal policies in general, and expenditure volatility in particular, is rather inconclusive (Devlin and Lewis, 2005; Barma et al. ,2012). AKMARAL ILIYAS 56 The estimate result based on the main specification indicates that the volatility of government spending in countries with stabilization funds is 13 percent lower than that in countries without such funds. In most cases, robustness tests also show the negative relationship between the presence of stabilization funds and the spending volatility. The impact are found to be around 15 to 20 percent. The impact of stabilization funds is assessed with other potential factors of expenditure fluctuations taken into account. Use of different indicators, specification and estimation methods in analysing the role of stabilization funds. (a wide range of indicators, for instant, the ones related to economic structure, real sector management and financial markets). This classification is highly conditional, because very often these public funds are mixed, solving several problems at once. For example: stabilization-saving funds in Azerbaijan, Botswana, the US (Alaska), Kuwait, Trinidad & Tobago and Norway; saving-pension reserve in Australia, or stabilization-saving-development in Kazakhstan. At the same time, within the same fund separate branches may be allocated to separate specific purposes. As different structures in the liability side of SWFs balance sheet result in different restrictions and constraints on SWF assets’ management, it is interesting also to classify SWFs according to a liability approach in: - Contingent Liability Funds, established to smooth out budget revenues and expenditures; sterilize excess liquidity, protect economy from overheating, Dutch disease and boom-bust cycles, designed for macroeconomic stabilization purposes by countries with budgets that are highly dependent on natural resources. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 57 - Fixed liability funds, established to meet a fixed long-term sovereign liability mainly represented by the projected shortfall in public pension systems (e.g. French pension reserve, Ireland’s National Pension Reserve Fund, Australian Future Funds and New Zealand Superannuation Fund); - Mixed Liability Funds, that should follow a fiscal (spending) rule, and thus have a fixed obligation to make regular payments into the sponsor country’s budget but without targeted terminal value. They have a relatively high degree of freedom on the asset side, lower than a newly launched fixed liability fund but higher that a mature one (e.g. Russia National Wealth Fund); - Open-Ended Liability Funds: essentially investment corporations which can have longer investment horizons, greater risktaking attitude and broader assets diversification. According to Jen (2007), current funds based on income from oil and gas exports account for over 65% of the total volume of all sovereign wealth funds in the world, and the rest comes from foundations in Asia, formed by the surplus trade balance of noncommodity exports. The legal framework of SWFs is required to promote sound institutional and governance arrangements for effective management. The legal framework should among other things (1) provide the legal form and structure of the SWF and its relationships with other state bodies including the ministry of finance and central bank; (2) be consistent with the broader legal framework of the government’s budgetary processes; (3) ensure the legal soundness of the SWF and its transactions; (4) support the effective operation of the SWF and the achievement of its stated policy objectives, which should be economic AKMARAL ILIYAS 64 need to save for future generations. Considering the above, in our opinion, it is appropriate to follow the conservative approach, focusing on the low probability of revenues to the fund in the future or reducing the investment horizon. For successful investment fund must determine the acceptable level of risk tolerance. Preferences of a particular level of risk can be described as the maximum deviation of the actual financial results of the investment fund as expected in moments of withdrawals from the fund at the end point of the investment horizon. Or, if the investment horizon is one year, the daily fluctuations of investment income should not be a cause for concern for fund managers. However, in practice the short-term volatility of the investment income can cause problems in sovereign wealth funds. For example, especially funds who are newly established. Typically, strategic control newly established funds seek to preserve capital fund necessarily in real or nominal terms that corresponds to an acceptable level of risk is zero. In result, after receiving certain income from fund management and, consequently, reducing the "reputational" risk funds can afford to raise the acceptable level of risk when investing. Media coverage of the negative financial results sovereign wealth funds in the short term and do not affect the level of income in the long term, often facilitated by the provision of fund managers to pressure from the owners in order to adjust the investment strategy. Ability to this situation in a professional environment is called "headlines risk". When choosing an investment strategy most sovereign wealth funds determine for themselves quantitative benchmarks of risk and return of investments. These indicators are not necessarily reflected in CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 65 the regulations, or at least publicly documented, but fund managers are guided by them when choosing financial instruments and their combination in the aggregate portfolio, as well as the choice of passive or active modes of implementation of the investment strategy. Main quantitative reference points of profitability and risk portfolios sovereign wealth funds are the indicators: 1. The minimum rate of return is determined by examining the implied yield on the investment portfolio and established investment horizon is usually defined as the real interest rate. For example, minimum return on a portfolio of New Zealand Pension Fund established at the risk-free rate of interest on the New Zealand Treasury securities, plus 2.5 annual interests. According to another example of the sovereign funds of Alaska and the Canadian province of Alberta to the possibility of these funds on the generation of future cash flows have not deteriorated, income from investment should cover domestic inflation and to maintain the real value of the investment at the same level. This requirement for reserve Alaska Permanent Fund for 10-year investment horizon minimum benchmark yield is the rate of inflation plus 5% per annum, and for the Alberta Heritage Saving Trust Fund 20-year horizon - CPI Estimate plus 4.5% per annum. According to Norway fund the calculations on long-range real rate of return on the portfolio of investments of the fund stands at 4% per annum. Because income from fund management can be used to replenish the budget, according to the established rule, the value of the structural deficit of the state budget, calculated excluding inflows market revenues should not exceed the expected value of the annual income fund. AKMARAL ILIYAS 66 2. The maximum duration of the portfolio is set to limit the interest rate risk of the portfolios, which form the sovereign funds of bonds. In order to effectively manage portfolio duration of the portfolio must equal the length of the investment horizon. 3. Limiting the magnitude of following error is set in order to minimize transaction costs associated with the need to copy and index all the changes in structure. But within limits such that the deviation of the actual yield of the investment portfolio of the index return does not lead to undesirable losses as a result of market risk. For example, the following error can be reduced by means of control of the Norway fund, when the Ministry of Finance of Norway following error limit value is set at 1.5% return of the benchmark portfolio. Research on the effectiveness of the index management strategies indicate that the establishment of a following error at this level cannot lead to a significant leading or lagging income duplicated portfolio compared with the yield index. The third stage of determining fund's investment strategy is developing a strategic asset allocation that mean distribution of the fund asset classes, currencies, countries or regions, credit ratings and terms of investment. When choosing a strategic asset allocation fund targets measure with the expected ratio of "risk-reward" for various asset classes, including the correlation between the assets and liabilities of the Fund. Expected results from investing in certain types of financial assets should be consistent with macroeconomic projections and restrictions. Through a combination of asset classes with low or negative correlation may benefit from diversification. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 67 Result of a strategic asset allocation is a set of weights of various asset classes in the investment portfolio, consistent with the objectives and funds an acceptable level of risk. According to experts, based on the activities of pension funds in the U.S., the yield on these funds 90 - 95% depend on the parameters of the distribution, the remaining 5 - 10% is the range of financial instruments to efficiently manage. In accordance with the Capital Asset Pricing Model (CAPM) making a choice in favor of a strategic asset allocation, founder of management assumes a systematic or market risk ‘beta–risk’ or ‘beta’, which cannot be eliminated through diversification. Operations manager (deviating from the strategic allocation in a strategic manager allowed limits) seeking excess returns in relation to the ‘beta’ the socalled ‘alpha’. In result, strategic asset allocation is based on long-term forecasts and is the opposite of tactical asset allocation based on the adjustment of shares of individual asset classes on the basis of short-term weather conditions in financial markets. A short investment horizon causes a high proportion of reliable fixed-income instruments in the investment portfolio. It is typical for stabilization funds, which have forced conservative strategic asset allocation with a low acceptable level of risk. Stabilization funds are intended to serve as insurance against risk insurance adopted budgets of different levels. Management of funds provided by the latter in order to ensure maximum safety and liquidity of the invested funds and receive at the same income from the investment is a secondary consideration. Thus, the rule of the sovereign wealth fund management is largely identical to those foreign exchange reserves of central banks. The AKMARAL ILIYAS 68 rules are intended to ensure the maximization of the value of foreign exchange reserves in accordance with the restrictions on the magnitude of the risk. However, investments are made so as to ensure the availability of funds in case of need. In this regard, in sovereign wealth funds, with a clear stabilization function are severe limitations specified in their investment policy. Based on the purpose of stabilization funds the traditional types of investments their funds are money market instruments, highly reliable bank deposits, and treasury bills maturing within one year, government bonds and investment credit rating with a maturity of over one year. Funds with a long investment horizon, as a rule, funds for future generations, focused on multiplication its size, saving increase over time and therefore use a much wider range of financial assets. In order to maximize the income from the investment of these funds placed a significant portion of its assets in more risky and profitable financial assets, including equities, corporate bonds, real estate and other alternative investments. The main categories of alternative investments are investments in real estate (including infrastructure), venture capital firms, hedge funds, mutual funds, commodities, etc. Shares of asset classes characterize the investment strategy of the fund in terms of the desire to maximize returns and risk appetite. The investment strategies of sovereign wealth funds are also using derivative financial instruments. This strategy is called portable alpha in which using derivatives in their portfolios reproduce investments in traditional asset classes traded on the open market, and the released funds are placed in alternative assets with higher potential level of additional income. It should be noted that investments in financial CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 69 instruments with high yield, especially under the category of alternative, high-risk financial losses in the short term. To discuss the investment of SWF funds in domestic assets, let's consider briefly the example of Norway and Nigeria. In Nigeria, the growth of budget expenditures at high oil prices subsequently led to the accumulation of imbalances associated with the inability to finance the whole amount of the increased budgetary commitments during sudden and prolonged downturns in response to the external economic environment. The combination of these imbalances with a policy of using budgetary funds generated through oil revenues to finance domestic investment, including development projects, contributed to originate the deep economic crisis in which Nigeria found itself in the years 1990-1994. Based on data from the Federal Ministry of Finance of Nigeria, GDP growth was 8.4% in 1988-1990, and during the following five years GDP growth decreased to 2.4%. As a result, the country entered a deep debt crisis, which ended only after commercial lenders and the member countries of the Paris Club agreed to condone about 60% of the external debt the country had accumulated. On the opposite side, Norway Government Pension Fund Global restricted budget expenditures and achieved positive results for the economy. The availability to tap the Fund led to a reduction of the inflation rate; reduced fluctuations in domestic demand, promoted high growth rates and a budget surplus. The Norwegian experience suggests that the presence of sovereign wealth funds cannot replace sound fiscal policy and that the lack of restrictions on budget spending leads to the loss of benefits from the operation of the funds for the budget, and for monetary policy. AKMARAL ILIYAS 70 Assets of sovereign wealth funds are allocated to: securities with fixed income (35-40%), shares in the open market (50-55%), and alternative investments such as hedge funds and private equity (810%). The significant growth of sovereign wealth funds proved that they have become an influential class of investors in global financial markets, surpassing the volume of investment private equity funds and hedge funds, and catching up on the central banks. According to Eschweiler & Fernandez (2008), SWF assets account for something less than 2% of global financial assets and slightly less than 5% of the assets of all private pension, insurance and mutual funds. As a result, due to the huge volume of these funds their activities have a significant impact on certain types of financial assets, exchange rates and, as a whole the global financial system. The strategic asset allocation problem is solved in different ways, depending on the conditions for the creation, updating and use of funds in accordance with: 1. The structure of import of the country in which the fund is established; 2. The structure of the external debt of the country; 3. The share of GDP of the country or region in financial instruments that invest in global GDP; 4. The share of the national market of financial instruments on a regional or global market for these instruments. To minimize risks and increase investment income sovereign wealth funds seeking to diversify their investments when the majority of the funds performed primarily portfolio investments rather than CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 71 direct (strategic) investments. For example, the investment policy of sovereign wealth funds in Asia and the Middle East provides an active direct investment. In 20072008 the sovereign funds of these countries have acquired a stake in a foreign company in the amount of 1 to 100% of the share capital amounting to more than US$77 bn. At the same time in the company of the financial sector (banks, asset management companies, stock exchanges) had US$57.7 bn., representing more than 74% of the total of these investments. As a rule, these shareholdings were acquired from issuers not on the secondary market. In some cases, the condition of the transaction for the purchase of shares in these companies is the consent of the investor on the waiver of the right to vote and nominate representatives to the board of directors. According to reports from the IMF, countries exporting natural resources continue to save and invest abroad more than they consume and invest domestically. According to Davis et al. (2003), oilexporting countries have reduced domestic consumption and investment to an average of 30% of the windfall revenues from exports. This is considerably less than in the 70s and early 80s of the last century, when for the above purposes these countries spent about 75% of such income. The rest of the money goes to repay external debt or is saved and invested abroad in the form of assets of sovereign wealth funds. Sovereign wealth funds are institutional investors. Their main activities are associated with the accumulation of money and its placing in financial assets. They are similar to central banks, pension funds, insurance companies, mutual funds, private equity funds, and hedge funds, all institutions that also accumulate large sums. Nevertheless, the operation of sovereign wealth funds as investors AKMARAL ILIYAS 72 have certain specific features. Most of these funds do not have strong obligations and maintain a high share of foreign assets in their portfolios. The total volume of resources accumulated in all sovereign wealth funds in the world went from $2,6 trillion in 2008 to a projected $9,5 trillion by the end of 2015. Since 2014 it exceeds the aggregate amount of the world's gold reserves. Thus, sovereign wealth funds have become influential categories of investors in global financial markets. Due to the significant amount of funds accumulated in sovereign wealth funds, their performance has a significant impact on certain types of financial assets, exchange rates, and in general on the domestic and global financial system. Sovereign wealth funds have a positive impact on the global financial system. SWFs are mostly long-term investors and follow the most conservative investment strategies: carrying out large investments in shares in the fall of stock markets; investing in strict accordance with the laws of recipient countries, guided primarily by economic rather than political motives. The operation of sovereign wealth funds does not prevent competition in the financial markets, but instead creates a powerful business partner for companies that serve them from the private sector. Finally, the investments of these funds, as they exist mainly in countries with economies in transition, contribute to a partial compensation of global imbalances in the world economy, financing budget deficits and making up for the lack of investment resources in developed countries. There are a series of potential links between SWFs and several factors driving economic growth that attract close attention. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 73 1. As the asset pool of SWFs continues to expand in size and importance, so does its potential impact on various asset markets. 2. Some countries worry that foreign investment by SWFs raises national security concerns because the purpose of the investment might be to secure control of strategically important industries for political rather than financial gain3. The inadequate transparency of SWFs is a concern for investors and regulators. They want to know, for example, the size and source of funds, investment goals, internal checks and balances, and a disclosure of relationships and holdings in private equity funds. 4. SWFs do not face the same investment restrictions as central banks or public pension funds. The experience of the sovereign wealth funds around the world shows that the fact of their creation does not solve the problems associated with the stabilization of public finances. Such funds are not an alternative to quality management of public finances and the success of their operation depends largely on the state of fiscal policies. Financial stabilization will be effective if the creation of these funds results in a reduction of budget expenditures depending on the price of oil or other raw materials. Budget expenditures should be based on income, not on temporary price increases. However, it is worth noting the positive results achieved in countries that accompanied the creation of sovereign wealth funds with limits to budget expenditures, or introduced rules restricting the size of the budget deficit and public debt. AKMARAL ILIYAS 80 5. The stabilizing function Norwegian Fund is aimed at maintaining the achieved high standards of living, which is expressed at considerable public expense. The stabilizing function of the National Fund of Kazakhstan is aimed at the average level of public spending provided by a conservative forecast of prices for Kazakhstan's raw materials. 6. The Norwegian fund pays great attention to the environmental aspect of its activities. The Norwegian Environment Facility is a part of the fund with the main goal of improving the environment. In Kazakhstan, measures for environmental protection are financed on a residual basis, as a consequence of the state focusing on social issues 7. The Norwegian fund is open to the public and its quarterly and annual reports are published on the Internet at the National Bank of Norway. The openness of the Kazakhstan stock is difficult to judge, as the report on the activities of the fund is not fully published. Besides, the National Fund of Kazakhstan has substantial differences from other similar funds. The National Fund was established at a time when Kazakhstan was only at the beginning of the oil era. With a huge reserve of natural resources, Kazakhstan has not yet emerged at a fairly high level of its development. In Alaska, Alberta or Norway, the level of oil and gas production has almost peaked, and viewed the prospects for its reduction. U.S., Canada and Norway belong to the group of developed countries that have achieved economic prosperity, so the standard of living of these countries is very high. National Fund of Kazakhstan was created when Kazakh society was in a deep crisis – poverty; unemployment; lower life expectancy; migration had been a hallmark of the social situation in the country. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 81 Alaska Permanent Fund Corporation was established on the basis of a constitutional amendment adopted by referendum, which was attended by the entire population of Alaska. Funds in Norway and the Alberta were established pursuant to the statute of their parliaments. National Fund of Kazakhstan was established by a decision of the President of the Republic of Kazakhstan. The Parliament of the Republic was faced with a fait accompli, and it was simply asked to enact legislation to amend the budget law of the country, coupled with the creation of the fund. The population of Alaska, Alberta and Norway took part in organizing the fund, and there is an understanding of goals and objectives established funds and a high degree of agreement on their organization. In Kazakhstan, the population almost did not take part in discussions on the establishment of the fund and its operation is carried out in an atmosphere of indifference and apathy on the part of most people. Attention is drawn to the fact that the choice of model for the National Fund was not discussed publicly and dared actually a small circle of high-ranking officials. Economic reform is at heart of our understanding of establish the wealth fund in Kazakhstan. The first few years of Kazakhstan’s independence were characterized by an economic decline that mostly due to the destabilizing force of disintegration of the Soviet Union. In this period is created of legal framework to regulate relations in the field of taxation, budgeting, banking, foreign trade, systems attracting foreign capital and customs, market development and market infrastructure. The formation of the National Fund of Kazakhstan was in 2000, when the oil prices were rising and an economic recovery was on a AKMARAL ILIYAS 82 map for Kazakhstan's economy. The main purpose of the National Fund according to legal aspect were defined by Presidential Degree N402, 2000, has been defined as "... the provision of a stable socioeconomic development, the accumulation of financial resources for future generations (saving function), reducing the dependence of the economy from the impact of adverse external factors (stabilizing function)". During the years of its operation mechanism, the development of the National Fund of Kazakhstan proceeded in three stages. First stage, from 2001 to 2005, when the legal basis of the functioning of the National Fund of Kazakhstan was launched. The following basic mechanisms of formation, management and use of the National Fund of the Republic of Kazakhstan were established: 1. The Fund's assets are concentrated in the account of the Government of the Republic of Kazakhstan in the National Bank of the Republic of Kazakhstan. 2. The National Bank of the Republic of Kazakhstan is to manage the Fund’s assets 3. The volume and use of the Fund will be established by the President of the Republic of Kazakhstan, on the proposal of the Government of the Republic of Kazakhstan. 4. The Government of the Republic of Kazakhstan shall report annually to the approval of the President of the Republic of Kazakhstan's annual report on the formation and use of the Fund. In accordance, legal aspects were defined by Presidential Degree N543, 2001, with the rules of formation and use of the National Fund CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 83 of the Republic of Kazakhstan, where the main principles of the fund were stated as part of its main objectives: 1. Saving function is to create a state savings. 2. Stabilization function is expressed in reducing dependence republican and local budgets on the world prices. The implementation of the stabilization function transferred to the Fund the excess tax and other obligatory payments to the budget from the extraction sector approved in the republican and local budgets. On this stage of the National Fund his sources were in surplus tax payments from extraction sector, official transfers from the national budget, the investment income from the management of the fund, other receipts and income not prohibited by the legislation of the Republic of Kazakhstan and the funds from the sale of state agricultural land in private ownership. The first payment to the fund was of $660 million paid by the U.S. company "Chevron" for a 5% stake in Kazakhstan's oil-production. At the end of 2005, the Fund had accumulated assets worth about 8.1 billion U.S. dollars, accounting for 14.5% of GDP. For the implementation of the savings function, savings were formed by the following income flows:  Official transfers from the republican and local budgets, calculated at the rate of 10% of planned in the republican and local budgets, the amounts of income taxes and other obligatory payments to the budget;  Investment income from the management of the Fund;  Other revenues and income not prohibited by the laws of the Republic of Kazakhstan. AKMARAL ILIYAS 84 The Fund’s asset management was carried out on the basis of formed portfolios. Thus, the first phase of development of the stabilization portfolio assets were placed in money market instruments and bonds. While the assets of the savings portfolio (68.91%) of the fund were placed in money market instruments, in securities and shares. It should be borne in mind that for the calculation of return applies the basic currency of the National Foundation - the U.S. dollar, according to a report to the Budget Code is generated in KZT. As part of the five-year indicative plan for socio-economic development of the Republic of Kazakhstan shall establish the estimated constant international prices for crude oil, copper and other commodities (these are the goods that make up a significant share of Kazakhstan's exports). On this basis, the average prices of the commodities Kazakh producers and their corresponding state budget revenues from the commodity sector used directly in the development and approval of national and local budgets. Calculated at constant prices for commodities are set by the basis of conservative growth forecast of world prices. High world prices for hydrocarbons stimulate the expansion of oil production. During the period from 2001 to 2005 the amount of the annual oil production rose from 40 million tons to 65 million tons, export - by 32.4 million tons to 54.6 million tons. The share of revenues from the oil sector in the state budget and the National Fund for the period amounted to about 30% of total revenues. The rules recognized three main lines of spending for the Fund: 1. To compensate for losses determined as the difference between approved and actual amounts of taxes and other obligatory CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 85 payments to the budget from the extraction sector on the special list; 2. In the form of earmarked transfers from the Fund to the republican and local budgets for the purpose defined by the President of the Republic of Kazakhstan; 3. To cover costs associated with the management of the fund and the annual external audit. Moreover, the rules set the injunction to use the fund for lending to private or public organizations, and as security for liabilities. The Fund shall be placed in safe and liquid foreign financial assets for its savings and investment return. The National Fund was created in fact as an independent entity operating under the trust agreement, independently carries out investment fund, including the transfer of the management of its external manager, develops and approves the rules on investment operations Second stage: The period of "balanced budget" from 2006 to 2009. In 2006, the "Concept of formation and use of the National Fund for the medium term", that changed the procedure for the formation and use of the Fund, was adopted. In order to ensure the optimal balance of the distribution of oil receipts between the republican budget and the National Fund a method of balanced budget was developed, in which the revenues of the oil sector fully were forwarded to the National Fund, and the revenue part of the republican budget is formed only at the expense of the non-oil sector (Sartbayev & Izbasarov, 2007). AKMARAL ILIYAS 86 From the middle of 2006, the way to channel funds from the National Fund for the economy was through guaranteed and targeted transfers to the state budget, as well as long-term investments in domestic securities. Figure 4. The mechanism of formation and use of the National Fund in the second stage. Source: Own elaboration based on Sartbayev & Izbasarov (2007). To avoid depleting the Fund, guaranteed transfers were limited to no more than one-third of the assets of the fund at the end of the year preceding the development of the national budget. Note that under Presidential Decree No. 1641, guaranteed transfers were only be used to finance the government’s development programs and not current CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 87 budget expenditures. The amount was determined using the following formula: 21 G = A + bNFRKt-1 * E, where: G was the transfer amount; A was a number set by law every three years based on the budget’s development programs’ average costs over a given period of time; b was also a number set by law every three years based on the Fund’s average investment income over a given period of time; NFRKt-1 was the value of National Fund assets at the beginning of the fiscal year; One-off withdrawals called “targeted transfers” were permitted in 2008-2009 to finance Samruk-Kazyna, a holding company for stateowned companies, and KazMunaiGas, the national oil company, during the global financial crisis. Targeted transfers totaled approximately $7 billion. 22 The advantages of the balanced budget are that on the one hand, there is sterilization of excess money supply, and on the other there is accumulation of financial resources for the benefit of future generations. At the same time, the country may face the problem of investing these funds. The low profitability of invested assets may no longer cover the administrative costs of managing the fund. 21 Decree of the President of the Republic of Kazakhstan No. 1641 September 1, 2005. 22 http://www.nationalbank.kz/index.cfm?docid=285 AKMARAL ILIYAS 88 The sterilization of excess foreign exchange inflows reduces pressure on the exchange rate of the tenge and inflation. Financial reserves have been established for the active anti-crisis policy, under which the National Fund used funds of $ 10 billion and observed accumulation policy. Funds at the end of 2009 amounted to $ 4.5 trillion tenge, of which 750.0 billion tenge placed in domestic assets (bonds of "National Welfare Fund" Samruk-Kazyna "JSC and" National Holding "KazAgro") of U.S. $ 24.4 billion - in foreign assets. Return of the National Fund from the beginning of creation (from June 2001 to December 31, 2009) in the base currency of the Fund (U.S. $) was 55%, which in annual terms was 5.2%. However, it is necessary to turn our attention to the disadvantages of the consolidation of the National Fund with the budget after 2006, which include: (1) instability of the revenue part of the National Fund due to changes in the concept of ‘oil revenues’ and the manipulation of the National Fund income and budget through the modification of the list of payers after the approval of the budget; (2) the government attracts loans at a higher rate than the return of National Fund investments; (3) under-investment in human capital, to allow the National Fund to save ‘for future generations’; and, (4) a high level of deterioration of infrastructure in the country due to lack of investment, which creates a risk of accidents with irreversible consequences. Third stage: The period of the fixed transfer, from 2010 to the present. Starting in 2010, Presidential Decree No. 962 introduced fixed annual transfers at $8 billion per year, which can be used to fund current budget expenditures in addition to development programs. The transfer amount can be adjusted by 15 percent through legislation CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 89 depending on the state of the economy. 23 . In this case, the guaranteed transfer was directed to finance the costs of current budgetary programs and programs development, providing investing in projects to implement measures to improve the lives of citizens, prevent the growth of unemployment, industrial and innovative development, support for small and medium businesses, and the development of agro-industrial complex among others. Figure 5. The current mechanism of formation and use of the National Fund. Source: Own elaboration. According to a law passed in 2012, the amount of the transfer was increased to approximately $9 billion for 2013. 24 The balance of the Fund cannot fall below 20 percent of GDP in a given fiscal year. If it does, the shortfall is to be covered by cutting the fixed annual transfer by the amount needed to cover the difference. A portion of the Fund is also withdrawn to cover the Fund’s operational expenses and to pay for annual external audits. According to the 2010 New Concept, National Fund assets must be placed in financial instruments traded in foreign financial markets and included in the list of permitted financial instruments, except for 23 Decree of the President of the Republic of Kazakhstan No. 962 April 2, 2010. 24 The Law of the Republic of Kazakhstan No. 52-V November 20, 2012. AKMARAL ILIYAS 96 One basic requirement for transparency and effectiveness of the National Fund of Kazakhstan is a transparency mechanism for generating income for the National Fund. The cash flows that enter the National Fund should be sustained and easily predictable, to ensure their accountability to society in the face of the country's parliament. As a result, greater transparency in Kazakhstan would contribute to creating a stable investment climate. Laws and regulations 25 should provide guarantees about the transparent management of resources and accumulated wealth through the budget process The Kazakhstan Country Updates provide information about recent developments, decisions, and civil society activities related to activities of the International Financial Institution’s (IFIs) in Kazakhstan, including that of the World Bank (WB), International Finance Corporation (IFC), International Monetary Fund (IMF), European Bank for Reconstruction and Development (EBRD) and the Asian Development Bank (ADB). In international practice, the main basic documents and initiatives to ensure transparency are:  «The Lima Declaration of guiding principles of control" International Organization of Supreme Audit Institutions 25 The Bill "On Budget System" in 1996, laid the foundation for the reform of fiscal devices. The Bill "On Information" (on May 8, 2003 № 412-2) regulating relations in the field of information, development and protection of information resources and information systems, establishing the competence of government, rights and responsibilities of individuals and entities in the field of information. The Bill "On the access of citizens to public information" will be adopted in 2012, the draft law offers such items as guarantees the rights of information users and duties of information about the formation and control of the republican and local budgets, information on privileges, compensations and benefits, provided by the government and corporations, information on the size of assets of the National Bank of Kazakhstan, and the National Fund of Kazakhstan and the government (budget provision). The Bill "On accounting and financial reporting" On approving the list of forms and annual financial statements for the publication of public interest (other than financial institutions). CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 97 (INTOSAI, 1977). The Declaration proclaims as a basic principle of the independence of supervisory authority, which is perceived as independent control bodies, as the independence of the members and staff of the body, such as financial independence of regulatory authority.  Organization for Economic Co-operation and Development’s "Best Practices for Member States to ensure transparency of the state budget" are designed for use as a reference guide. Where it is recommended to carry out timely and systematic full disclosure of all relevant fiscal information, which represents a set of principles of best practice on the main budget report, the disclosure of specific information, quality and reliability.  The Arusha 2003 Declaration of the World Customs Organization provides guidance on key elements needed to support effective national programs to ensure the impartiality and integrity of customs officials. It includes a special section on transparency, on customs laws, rules, procedures, management, assessment mechanisms and standards activities.  «The Code of Good Practices on Fiscal Transparency" (IMF, 2007) by its nature is voluntary. The Code provided a comprehensive framework to ensure transparency in fiscal, and focuses on the definition of roles and responsibilities, transparency of budget processes, public availability of information and guarantees of reliability.  The Open Budget Index (OBI) presents ratings of openness of budget materials for 94 countries. According to the OBI 2010 Kazakhstan ranks 38th and applies to a country that offers AKMARAL ILIYAS 98 minimal or incomplete information. OBI evaluates the availability of key budget documents, the completeness of their content, the level of control by the legislature and the Supreme Audit Institutions, as well as participation in the budgetary process Creating of open budget systems can enhance the credibility and prioritization of policy decisions, limit corrupt and wasteful spending, and facilitate access to international financial markets. The (OBI) assesses the availability in each country of eight key budget documents, as well as the comprehensiveness of the data contained in these documents. The International Budget Partnership’s (IBP) Open Budget Survey also examines the extent of effective oversight provided by legislatures and Supreme Audit Institutions (SAI), as well as the opportunities available to the public to participate in national budget decision-making processes.  The Extractive Industries Transparency Initiative (EITI) is an initiative of a number of different stakeholders, designed to promote the publication of regular reports on revenue generated by the state and paid by the extractive industries sector, in relation to specific types of natural resources. Kazakhstan joined the EITI in 2005, signing a Memorandum of Understanding in 2006, which was followed by the establishment of the National Council of stakeholders including civil society representatives, companies and governments. In total, around 97 companies participate in EITI, including KazMunaiGas, the state oil and gas company. The Coalition “Oil Revenues - Under Public Oversight” has proposed an increase in the scope of EITI, known as EITI Plus. EITI Plus envisions reports of disaggregated data, public involvement in revenue management, and the inclusion of local social CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 99 investments in EITI. Kazakhstan published its first EITI report in January 2008. However, the report did not include all oil-producing companies operating in the country. Still, the first EITI report opened up opportunities for further development on this issue. However, participation in the EITI implementation in Kazakhstan has not yet extended to all mining companies. Low public awareness about EITI is also a major problem for the fuller realization of transparency in the Republic of Kazakhstan. There must be mandatory and timely publication of annual and quarterly financial reports of companies providing information on the web sites of the Finance Ministry and the available sites of the companies. In 2010, the EITI Board reviewed Kazakhstan's validation report and designated the country as an EITI “Compliant Country” meeting all requirements in the EITI standard. The most recent IMF Report on the Observance of Standards and Codes in Kazakhstan commended the government for its efforts to improve fiscal transparency and data dissemination. The report also indicated that there is room for further progress in budget data processing procedures. Kazakhstan has sought to expand EITI principles to public expenditures and bring accountability measures. In sum, the NFRK makes daily, monthly, and annual reports that it submits to the Council on February 1st of each year. The Council prepares an annual report with the collaboration of the national Bank of the Republic of Kazakhstan. Then, report is submitted to the President along with a report from an independent external auditor, which was selected by the President. Information on the report and the audit is to be released to the national media. All reports go to the President, who decides the contents of their release. AKMARAL ILIYAS 100 The Santiago Principles have developed in an attempt to ease the accountability and transparency of the SWFs from an international perspective. Transparency and accountability improvements of the SWFs remain a core aspect of their effectiveness and their success. This is related to the international welcoming of the SWFs, and to the benefits for the domestic economies and the citizens of the respective host countries. The developed rankings and the suggested sets of best practices should be considered, acknowledging their methodological limitations and their international perspective. The involved parties and policy makers should actively work in improving these scoring attempts and identified best practices. Kazakhstan did not take an active part in the international forum of independent funds that promotes the Santiago Principles to increase transparency and accountability in the activities of SWFs. Kazakhstan did not accept the Santiago Principles, but a transparent and accountable governance structure of the NFRK is required for the future success of the policies conducted by the fund. In light of the recent crisis it is unlikely that Kazakhstan will soon join the Santiago Principles; however, it is crucial that the Kazakhstani government and society recognize the importance of transparency towards international markets. Ultimately, the government was able to improve its position in the transparency case. Resource rents are difficult to measure directly. For example, according to Nuttall (2010), the ratio of government oil revenue to registered oil exports provides an indication of the relative shares of governments versus oil companies across countries. According to Luecke (2011), Norway, which is often considered the global benchmark for a high government share, reached a ratio of 46% in 2008, compared to Kazakhstan’s 24%. These numbers are not directly CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 101 comparable because cost structures of oil production differ and Norway and Kazakhstan are at different points in their life cycles as oil producers. Nevertheless, these numbers suggest that oil companies investing in Kazakhstan will still receive a large risk premium as compensation for entering a challenging region, in terms of political risk as much as physical geography. The Truman index is a transparency and accountability index for SWFs. In his study (Truman, 2007), he tried to design a blueprint for SWFs in order to be able to classify them. The Truman scoreboard contains 33 elements, constructed as questions and organized in four categories. The first category is the structure of the fund, including its objectives, fiscal treatment, and indicating if it is separated from the country’s international reserves. The second one concerns the governance of the fund, the roles of the government and the managers, and if the fund follows guidelines for corporate responsibility and ethical investment behavior. The third category focuses on the investment behavior of the funds. The fourth one focuses on the accountability and transparency of the fund in its investment strategy, investment activities, reporting, and audits. The Truman blueprint provides a basis for evaluating the results of the IMF sponsored dialogue on SWF best practices. Adoption of this blueprint for SWF best practices should allay many of the reasonable concerns about SWFs that have been articulated by citizens and politicians of both their home countries and the countries in which they invest. In the process, SWFs would be demystified, calming the political environment in countries receiving their investments. Moreover, the environment for SWF owners and managers would become more stable and predictable. AKMARAL ILIYAS 102 Other indices concerning the transparency of SWFs are available, like the Linaburg-Maduell Transparency Index that was developed at the Sovereign Wealth Fund Institute (Linaburg, 2008). This index is simple and only includes 10 principles that depict sovereign wealth fund transparency to the public. The minimum rating a fund can receive is one. In the SWF Institute Linaburg-Maduell Transparency Index, for each principle assessed there are different levels of depth and the judgment of the latter reflects the judgments and the discretion of the Sovereign Wealth Fund Institute. The SWF Institute recommends a minimum rating of 8 in order to claim adequate transparency. The Fund has been actively working towards the provision of higher standards of transparency and accountability leading to significant improvements in the respective ranking attempts such as the Linaburg-Maduell transparency index. Of course, this is a result of the willingness of countries (governments) to disclose information about (1) scale of the fund, (2) learning and harmonization with transparency tools, and (3) cooperation with suitable regional and global organizations and initiatives. In result, we see the scores of the different funds are a good starting point in evaluating SWFs’ transparency. However, since 2008 SWFs have worked in order to increase their level of transparency and reduce the concerns of the recipient countries of their investments. In this sense, it would be interesting to recalculate the scores and analyze if there has been a real improvement. According to Tsalik (2003), weak governance along poor transparency and accountability make the funds and the respective countries less likely to convert social expenditures into improved income. In many countries SWFs are set up following increasing CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 103 surpluses from exports of natural resources. Most of the economists discussing resource-rich economies support the view that natural wealth can pose problems for economic management. The international community and major international financial organizations have become growingly concerned about the effectiveness with which natural resource revenues are used. In particular they are concerned with the question of how funds can contribute towards long run economic and social development. Transparency has been greater in Azerbaijan, which fully complies with the Extractive Industries Transparency Initiative and plays an active role in the International Forum of Sovereign Wealth Funds that promotes the "Santiago Principles" of transparency and accountability. Kazakhstan has not so far been involved in the International Forum although its candidacy for the EITI initiative may indicate an interest in promoting transparency. In sum, transparency increase popular confidence and a sense of ownership in the resource fund and generate popular support for a strategy to save substantial resource revenues to sustain government expenditures in the long run. According to Tsani et al. (2010), the available rankings and benchmarks are largely developed based on the available public information on the SWFs. Nevertheless in some cases these facts have been confirmed with the funds themselves. In this respect the funds are called to comment on their own constituents. Hence the conflict of interests that may emerge for the assessed SWFs might bias the provided information and the derived estimation results, rankings and scoreboards. Oil funds in Kazakhstan applied international accounting standards, as a consequence of the possibility of checking accounts by AKMARAL ILIYAS 104 international auditing companies. Best practices are compiled in the “OECD Corporate Governance Principles” (Gordon, 2010). The main characteristic of transparent regulatory measures is the existence of clearly defined objectives for policies based on sound legal basis with minimal duplication of functions of regulatory bodies, and that they are non-discriminatory and open to review and publicly available. According to the IMF, procedures for internal government oversight, parliamentary oversight, judicial review, periodic regulatory impact assessment, and requirements that important decisions (including decisions to lock an investment) should be taken at high government level must be considered to ensure accountability of the implementing authorities. All countries share a collective interest in maintaining international investment policies that are open, legitimate and fair. Through various international standards, governments recognize this collective interest and agree to participate in related international accountability mechanisms. Vertical accountability is a typical feature of fund management in both countries where the ultimate decision-making power and accountability rests with the President. Ultimately, the decisions over uses of the funds revenues become political. In case of Azerbaijan internal supervision functions are entrusted to the Supervisory Board implementing general oversight over the composition of the Oil fund assets and compliance with expenditure rules. According to Petersen & Budina (2002), in the case of Azerbaijan, internal supervision functions are entrusted to the Supervisory Board implementing general oversight over the composition of the Oil fund assets and compliance with expenditure rules, and the Oil Fund’s budget has to be approved by the President. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 105 On the contrary, in the case of Kazakhstan, vertical accountability is very strong despite the fact that the management council of the NBRK is formally entrusted with the management of the Fund. In practice, the President has ultimate decision-making control over the activities involving fund decisions for asset allocation, and can also decide on the uses of the Fund’s assets. Some degree of horizontal accountability is present through transparency and independent audit provisions. The main drawback, however, is that the President can decide on the uses of the fund’s assets without having any medium term fiscal framework approved by the Parliament. Auerbach et al. (1998) developed generational accounting as a method for estimating the economic impact of fiscal policy. Generational accounting is an alternative to deficit accounting. One of the important motivations to do generational accounting is for the government to act as the collective guardian for future generations. Assessing public financial management and accountability in the context of transparency in Kazakhstan using the aggregate generational accounting method would help to understand better the extent to which government fiscal policies mitigate or exacerbate the economic risk facing different generations. In Kazakhstan, oil fund investment strategies emphasize government bonds and other fixed income securities. It is necessary to note that fund assets are modest, compared with the volume of global financial markets, and the potential for risk diversification is limited. As a result, both countries reasonably invest in very low-risk assets (to protect the real value of their assets in the short to medium term). AKMARAL ILIYAS 112 difficult in transitional economies, where central planning traditionally blurred the distinction between the private and public spheres. Accordingly, the NFRK is not a proactive institution regarding the diverse international initiatives focused on the transparency of SWFs. The Fund publishes a large number of periodical reports about its activities, but these are redacted by the Presidential administration before being disseminated among the general public in a significantly incomplete form. International SWF transparency indicators describe the NFRK as less transparent than similar funds located in post-soviet transition economies like Azerbaijan. Improvements in the design of the NFRK have to be based on two main axes: functional separation between its savings portfolio and its stabilization portfolio and increased transparency about the use of its assets. Transparency can be increased mainly in two ways. First, by publicly tracing the source and the use of the transfers from the Fund to the national and local budgets. Second, by publishing complete and unredacted reports about the Fund’s activities in order to facilitate the transmission of information to the citizens and to increase public participation. CHAPTER 1. THE DESIGN OF KAZAKHSTAN’S NATIONAL FUND 113 REFERENCES Al-Hassan, A., Papaioannou, M. M. G., Skancke, M., & Sung, C. C. (2013). Sovereign wealth funds: Aspects of governance structures and investment management (No. 13-231). International Monetary Fund. 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In Workshop on petroleum revenue management, World Bank, October (pp. 23-24). Zolotareva, A., Drobyshevskii, S., & S Sinel’nikov, P. K. (2002). The prospects for creating a stabilization fund in the Russian Federation. Problems of Economic Transition, 45(2), 5-85. 119 CHAPTER 2 THE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN’S DIVERSIFICATION POLICIES (2010-2014) 2.1 INTRODUCTION Over time, the structure of the Kazakhstan economy has gradually shifted away from agriculture and mining industry towards services, with the manufacturing growing in importance recently. In the international division of labor, the country is an exporter of raw materials and products. In recent times, Kazakhstan is trying to overcome its economic dependence on natural resources and looking for integration in the global production system in a role different from the traditional one as a supplier of raw materials, that will allow the country to adapt gradually and more swiftly to changes in the global economy. Kazakhstan’s economy needs to diversify through restructuring, in order to be able to integrate in the global production system in a different capacity than the current one as supplier of raw materials, and eventually to cope with the exhaustion of its natural resources. Kazakhstan is important to world energy markets because it has significant oil and natural gas reserves and has become one of the AKMARAL ILIYAS 120 world's largest oil producers and exporters. In the international division of labor, the country is an exporter of raw materials and mining products. More than half its exports are crude oil, and metallic products are its biggest exports after oil products. This natural windfall is not an unambiguous boon for the country, because it has its own problems attached. In accordance with the US Energy information administration database, the volume of proved and probable reserves in the Caspian basin the part of Kazakhstan is estimated at 31.2 billion bbl. Thus, at current extraction levels, Kazakhstan’s reserves will be depleted somewhere in the decade starting on 2050. This poses a final horizon for the windfall revenues generated by oil extraction, and makes diversification a pressing concern, even if not immediate, given the current lack of symptoms of Dutch disease in the RK’s economy 26 , due to currency depreciation. But this lack of current symptoms does not mean that Kazakhstan is and will be free from the bad effects of Dutch disease. In the long term, the key factor is the response of the non-oil manufacturing sectors. Oil prices are highly volatile and unpredictable. Volatility, especially regarding export revenues is a factor that tends to slow economic growth, because of its effect on fiscal revenues, the exchange rate, and asset prices (e.g. real estate prices). If output and employment decline in non-oil manufacturing sectors this leads, in the end, to deindustrialization. Investment in non-oil, non-metal products in Kazakhstan is difficulted by the volatility of oil prices, and thus economic policy has to deal with the problems of confronting cumulative causation processes, because one of the main motives that 26 See Égert & Leonard (2008) and Égert (2012). CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 121 call for diversification policies is also one of the main obstacles to their implementation. The shrinking of the non-oil manufacturing sector that gives rise to boom and bust economic cycles, because during the downturn phase of the oil price cycle the non-oil manufacturing sector is unable to compensate for the decline in oil production, and thus oil price fluctuations are strongly reflected in economic fluctuations. This is sometimes called the long-term Dutch disease. In contrast, diversification usually promotes efficiency and openness to trade, two factors usually associated with rapid long-run economic growth. There is evidence about a positive relationship between development and participation in a larger number of industries and markets. This evidence shows that economic growth is faster in countries and regions that export a diverse set of products grow (Herzer & Nowak-Lehnmann, 2006; Hausmann et al. 2007; Saviotti and Frenken 2008; Hausmann & Hidalgo 2011). Kazahstan’s integration in the global production system is dictated by the enormous share (above 50%) of crude oil in its exports. Oil is a mature industry, with all its main technologies having been developed over many years (Bridge, 2008). With the exception of some specialty chemicals at the refining stage, oil is a commodity produced in bulk for a general market. The key production units in the oil industry are large firms, usually located upstream in a value chain comprising the following processes: exploration, extraction/ refining, distribution, and consumption. The oil global production system is not especially complex, and an important part of the value resides on the bottleneck stages of transportation and refining. Thus, the problems arising from excessive concentration of economic activity in a particular industry AKMARAL ILIYAS 128 the following sectors: energy, oil and gas, petrochemical, metallurgical and mining, transport and communication (land, air transport, telecommunications), agriculture and social services (health, education, culture, tourism and sport). -The final fourth stage has been realized under "The program of privatization and efficiency of state property for the years 1999-2000", in which the transfer of ownership took place not only at the national, but also at the municipal level, which led to an increase in revenues of local budgets. Diversification is a complex, capital-intensive and large-scale task, requiring huge investments, which calls for systemic structural policy measures. The component elements of structural policy are the development strategy of industry, agriculture, transport, etc. Together, these strategies have the goal of increasing the share of industry in GDP, increasing the share of final products in total output, increasing the share of small and medium-sized businesses in the amount of the final product, etc. All these strategies should be connected together in order to be capable of leading to economic restructuring which will result in improvement of living standards and employment. But structural change is a long-term task. Over the years, the country's income from oil and gas sector will fall, leading to a reduction of financial resources and pressing on the economy for transformation. The decrease in production in specific industries will subsequently release labour, thus possibly leading to migration processes, as part of the labour surplus can emigrate to neighbouring countries. Therefore, the coordination of the structural policies with neighbouring countries will be a pressing issue. Limited financial resources, force to look for the least capital-intensive and the most effective changes in the structure of the economy. CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 129 Two main avenues of manufacturing diversification can be distinguished (Beblawi, 2011): oil-based and import substitution industries. Oil-based industries (including refineries, petrochemicals, and energy-intensive industries such as aluminium, are usually largescale and capital-intensive projects, generally state owned. For an oil exporting country they are a very natural way of expanding manufacturing production. In contrast, import substitution industries, including a diverse set of activities, like food processing and the manufacture of construction materials, are usually small, labour intensive and often privately owned, and thus less suited to base their development on the existing production structure of an oil-producing country. But diversification confined to the oil industry will not reduce dependence on oil and gas, even if it can be useful to reduce the risks associated with fluctuations in international oil prices, and to create and maintain jobs in the short term. Thus, diversification through import substitution industries is usually the goal of economic reform in resource-based states, but it has to deal with the scarcity of key elements, like entrepreneurship and private risk taking, in these economies. Private sector involvement is important for diversification as a way to create jobs for the population of the country in the required scale, but also as a way to attract foreign direct investment (FDI), that can provide the type of capital and knowledge required to spread economic activity to previously non-existent industries. In 2003, the Strategy for Industrial and Innovation Development of Kazakhstan was approved. The main objective of this strategy was to achieve sustainable development of the country through economic diversification, at the expense of shifting from extraction and preparing of conditions for transition to the long perspective to service AKMARAL ILIYAS 130 and technological economy. That was the first attempt at a major restructuring of the economy and industry of Kazakhstan. The strategy envisaged the creation of institutions such as Kazakhstan Investment Fund, Kazakhstan Development Bank, Innovation Fund and Export Insurance Corporation to promote the development of innovative capacity through direct funding jointly with private investors and perspective high-tech projects and participation in the establishment of the basic elements of the innovation infrastructure. This strategy brough generally positive changes in the planned structure of the industry, initially increasing the share of manufacturing industries. However, after five years, it became clear that the industry structure did not change in the desired direction. On the contrary, the industrial specialization on raw materials was strenghtened. The share of manufacturing industries decreased to 11.8% at the end of 2008, while the share of mining industries increased to 18.7%, leaving virtually unchanged the structure of exports at a 75% of raw materials, of which 2/3 are oil and gas condensate. The Strategy 2005 set a task to the creation of regional "locomotives" of economic development through the formation of regional corporations. An attempt was made to strengthen the Strategy by adopting the program "30 corporate leaders", focused on the implementation of major investment projects initiated mainly by private companies. But of the projects proposed, more than 70% came from mining companies and were aimed primarily at the expansion and modernization of production. Very few of these projects were finally implemented, anyway. 27 27 Kazhiken (2011). CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 131 The main purpose of anti-crisis program in 2008 was the mitigation of the negative effects of the global crisis on the socioeconomic situation in Kazakhstan. USD 10 billion were allocated from the NFRK in 2009-2011, about 20 percent of the country's GDP. The main activities financed from the NFRK were: 1. The stabilization of the financial sector. 2. The support of the housing and mortgage markets. 3. The support for small and medium-sized businesses. 4. The development of the agricultural sector 5. The implementation of innovative, industrial and infrastructure projects. By reducing the NBRK reserve requirements, second-tier banks increased their resource base at 350 billion KZT. At the same time, a Stress Assets Fund was created in the amount of 122 billion tenge. Unfortunately, the pace of innovation development and implementation of promising projects in the manufacturing industry remained relatively low, and there were no big structural changes in the economy of Kazakhstan. The oil and gas industry, whose share in total GDP increased, plays a vital role in Kazakhstan's GDP structure. The driving force of the economy remained the mining industry, which provided a significant share of export earnings. In 2012, the contribution of the mining industry of Kazakhstan's GDP was about 17%, where the share of oil and gas account for almost 90% of this volume. In the structure of foreign trade of the country, dominated by commodities, 60% of its exports are oil and oil products. Today is an extremely high correlation between economic growth and indicators of the mining industry between the level of AKMARAL ILIYAS 132 nominal GDP and the price of oil is over 90%. The slow pace of development of science delays the introduction of new technologies. The diversification of the economy did not become a real priority for governments at all levels, due to the lack of investment attractiveness of non-extractive industries, adequate state mechanism to ensure a favorable business climate and opportunities for participation of small and medium-sized businesses in the manufacturing sector. During the global financial and economic crisis, there was a significant reduction in the volume of banking finance to the real sector of the economy of Kazakhstan, due to the increasing threat of default by the financial institutions. In 2010 a new programme was established, as a logical continuation of previous diversification policy, containing the main provisions of the Industrial-innovation Development Strategy for 2003–2015, the Program "30 corporate leaders of Kazakhstan" and other program documents in the sphere of industrialization. The new course of industrialization involved not just the extensive growth of the economy, but the bust innovative growth with further diversification and development of modern high-tech industry structure. The initiators of big projects promotion should be JSC National Welfare Fund “Samruk-Kazyna”, strategic companies of fuel-energy and metallurgical sectors of economy and also strategic foreign investors. Very few of the projects implemented under this programme were directly related to the production of finished products, and most investment funds were still directed to the oil and gas and mining sectors and infrastructure. 28 The trends attracting investment capital into the mining industry perpetuated the raw material orientation of 28 President of the Republic of Kazakhstan N.A. Nazarbayev January 27, 2012 at an expanded meeting of the Government of the Republic of Kazakhstan. CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 133 the economy. As a consequence, it became unstable with respect to external influences. The analysis of the implementation of the above programs indicates that the task of increasing the share of non-oil exports in the total volume of Kazakhstan's exports to at least 40% was not accomplished. All these strategies did not led to the qualitative industrial change announced in the priorities of diversification. E.g., agriculture remains unattractive for investment, and lack of financial resources is a deterrent to the introduction of modern technologies, leading the country to a high level of dependence on food imports. The growth rate of agricultural production, raw materials and food in recent years remain below the rate of increase in food imports, which is a threat to food security. 2.3 FINANCIAL SOURCES FOR DIVERSIFICATION The total fixed investment of manufacturing from all sources of financing for the period 2010-2014 was 2 876.8 billion tenge, being 70% of this amount own funds (money and assets of the business owners: land, buildings, etc.) and 30% loans. At the same time, as we have seen, fixed investment in manufacturing amounted to just 2.4 billion tenge. The volume of foreign investments and loans exceeded $5 billion, which is more than the volume of foreign investments in the manufacturing of Kazakhstan in all previous years, apparently because of tax breaks. Being the most successful reformer in the Commonwealth of Independent States (CIS) and based on its strong macroeconomic performance and financial health, Kazakhstan became the first former Soviet republic to repay all of its debt to the International Monetary Fund (IMF) in 2000 (7 years ahead of schedule). This contributed to AKMARAL ILIYAS 134 receiving an investment-grade credit rating from major international credit rating agencies. But the global financial crisis that started at the end of 2007 had multiple implications on Kazakhstan’s economy and exposed underlying vulnerabilities. With lower oil and commodity prices and adverse conditions in international capital markets, new challenges surfaced for emerging economies: decline in public revenues, liquidity shortages, problems for the stability of the national currency, and the dependence of financial institutions on external funding, all affected negatively investors’ confidence and capital outflows. In these circumstances the Government quickly stepped in to regulate and stabilize the situation. A set of policies were introduced under the so-called Anti-Crisis Program (ACP) to help mitigate economic vulnerabilities and establish a basis for the resumption of growth. As a part of this policy Kazakhstan’s monetary authorities devalued the currency and vastly expanded their role in the financial sector by entering into the capital of the four largest banks. In the end, Kazakhstan’s financial system proved itself solid enough to avoid market collapse. In order to realize the ACP, the government decided to allocate 1.196 billion tenge (about 10 billion US dollars or 35% of the Fund's assets at the time of the decision) from the NF to the special accounts of JSC " Samruk-Kazyna ", JSC "Development Bank Kazakhstan "and JSC "KazAgro". The banking sector received almost half of the targeted transfers from the NF. Nevertheless, according to National Bank the volume of loans as % of GDP decreased from 44.9% in 2009 to 33.1% in 2013. 29 29 http://nationalbank.kz/?docid=342&switch=russian CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 135 The ability to finance the steps towards industrialization, diversification of the economy and increased competitiveness of local enterprises in Kazakhstan’s manufacturing sector depend very much on the situation of the oil market. The average cost of oil production in Kazakhstan is estimated around $50 per barrel, so a minimum price of at least $60 per barrel is required to be able to support the industrialization programme. Prolonged periods of ultra-low prices dramatically reduce the possibility of financing the process of economic diversification. Kazakhstan's GDP growth reached a low point in 2015 but gradually recover thereafter. Based on an oil price assumption of $53 per barrel, growth is expected to be slow, leading to deficits in both the current account and the consolidated fiscal balance. The outlook is highly sensitive to oil price assumptions. Our baseline scenario assumes that if oil prices start to recover to the $60 range export earnings and domestic demand would gradually recover. Government’s projections used a conservative assumption of a $50 per barrel oil price for 2015-17, which translated into GDP growth of 1.5 percent in 2015, 2.2 percent in 2016, and 3.3 percent in 2017). This scenario assumed that oil production would remain almost flat until the end of 2017, when the off-shore Kashagan oil field was expected to come on line and boost production. Total government debt was expected to go up but remain low; with ample reserves in the National Fund to cover it. External debt was expected to increase because the government borrowed US$7–10 billion from IFIs as part of the Partnership Framework Arrangement, to support the Kazakhstan-2050 development strategy. Although domestic indebtedness increased from 11% of GDP in 2014 to over 13% in 2017 because of the budget deficit, Kazakhstan’s net financial AKMARAL ILIYAS 136 asset position will remain solid, as the NF’s foreign exchange reserves will continue to vastly exceed total government debt. The ratio of total external debt to GDP and the debt service ratio are expected to stay steady and sustainable over the medium term. 2.4 DIVERSIFICATION THROUGH THE NATIONAL FUND One of the most important decisions to modernize the country's economy is to increase the level of credit activity of Kazakhstani banks, because for many businesses and individuals loan servicing is expensive. According to the National Bank of Kazakhstan the industry structure of lending has been stable in the last two decades. In order to progress in the diversification and modernization of Kazakhstan's economy this lending should not be limited only to the support of big business and strategic enterprises. Instead, it should create conditions for development of small and medium-sized businesses, increasing its share in the total GDP and activating bank lending to small and medium industrial projects. The Fund invests the revenues received from asset sales, together with other finance sources, to the creation of new strategic advantages for the country and further diversification and modernization of the economy. Since 2012, the State redirects annually $8 billion 30 in the form of a transfer from the NF to the budget. Of this amount, all entities overseen under the state program of the industries, including the construction, were sent 3.7 trillion tenge. About 1.8 trillion tenge came to the industry in the form of fixed investment, and of this only 2.87 billion (0,2%) came in the form of fixed investment in manufacturing enterprises. 30 Statement of receipts and application of the National Fund CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 137 Chart 8. Financial sources of industrial activities. Data source: National Bank of the Republic of Kazakhstan. The share of manufacturing in the gross inflows of foreign direct investments (FDI) increased substantially during the period. The government attempted to build an integrated system of strategic planning led by the state program, but started as a result start to "engage in" almost all sectors, washing away the main focus. The scheme had to be rebuilt, assigning to each branch its own development program. The total weight of all sectors at the beginning of the program was about 60% of GDP, but in 2014 the share of manufacturing in GDP after the implementation of the first five-year state program decreased to 10.4% compared to 11.8% in 2008. 31 31 Although most of this variation is due to the change in the sectoral classification of GDP in 2011, in ordert to adapt to the NACE international classification. AKMARAL ILIYAS 144 Chart 12. Number of HS-6 products with exports of at least $100,000. Data source: World Bank. World Integrated Trade Solution. In both cases, it can be observed that there was no definite change in the measure of concentration/diversification during the period 2010-2014, just a slight increase in exports concentration, according to the Herfindahl index and a moderate increase in the number of products exported, that would point on the contrary to an increase in diversification. In both cases, decreases in concentration/increases in diversification were much more clear in the subsequent period, coinciding with a sharp decrease in oil prices. This negative oil shock, in a country where more than half the exports are oil-related, is strong enough to deflate oil production and export flows in such a magnitude to trump any other factor influencing the computation of concentration/diversification measures. While this may colour favourably the apparent effects of industrial strategies, it poses a serious problem for their sustainability, as the CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 145 cost of oil extraction acts as a threshold for the ability to accumulate windfall revenues. Let us try to understand and estimate the possible impacts and model the receipt of the Fund. To do this, we will try to make a simple prognosis scenario for receipt and assets of the National Fund with oil price equal to USD 50 per barrel. We will consider the changes in oil prices on the basis of two factors: oil consumption and oil production. The general trend is of a definite increase in demand for oil, taking into account the impact of periodic global economic slowdowns. Consider the commodity composition of oil consumption in order to understand the processes occurring in the oil market. About 70% of consumed oil is accounted for by fuel for transport (light distillatesgasoline, middle distillates-kerosene and fuel oil-diesel), while the remaining 30% of consumption comes from the petrochemical industry. Chart 13. Evolution of oil price. Data source: QUANDL. AKMARAL ILIYAS 146 Consider the automobile industry, as the main consumer of fuel. Due to new technologies cars are becoming more economical and environmentally friendly, and perhaps in the future, electric cars put traditional cars out of the market. But it is hardly possible to consider this option in the medium term. Assume change be progressive, as it is necessary to create the necessary infrastructure (gas stations, service stations, etc.), with the aim of reducing the consumption of motor fuel in the future. However, according to IMF forecasts, the increase in per capita income only in China and India will be enough to continue increasing the number of cars. Suppose that the increase in the number of cars block the decrease in demand for motor fuel in the developed countries due to the use of new technologies in the automotive industry. All other things being equal, this factor only will increase fuel consumption. Consider the petrochemical industry ,that accounts for 30% of consumption. The increase in world population and the replacement of traditional materials from the sphere of direct consumption (construction materials everyday chemistry, etc.) also results in an increase in petrochemical products by 60%. According to the analysis of time series of oil consumption there is a linear increasing trend in oil consumption, that we can safely assume that it will continue in the medium term. CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 147 Chart 14. World oil consumption. Data source: BP Statistical Review of World Energy. Consider the behavior of the main oil producing countries which are Saudi Arabia, Russia and the United States, which together provide about a third of world production. Production grew in all of them during the period 2008-2016, especially in the US. The average cost of traditional production in the major producing countries varies: in Saudi Arabia is $25, in Russia $45, in the US $50, as well as in Kazakhstan, and in Venezuela is $77.6. When the price of oil falls within the range of the average cost of oil extraction in the Caspian Sea, estimated at around $50 per barrel, the assets of the NFRK cannot grow, making impossible to satisfy simultaneously its savings, stabilization and development objectives, as any funds spent in financing industrial projects will detract from the savings for future generations and/or the transfer to national and local budgets. AKMARAL ILIYAS 148 According to Bloomberg EIA, increases in oil production in the US lead to reductions in market prices and increases in losses of oil companies operating in the oil shale sector and the growth of lost profits on traditional deposits. The usual assumption is that Saudi Arabia producers expect to increase market share at the expense of reserves and low production costs, but they are unlikely to continue to increase production in the case of production decline in the US. However, maintaining growth in supply by US oil is only possible in the short term, because of the financial instability of shale oil companies. The main aim of Saudi oil policy seems to be the holding of oil prices near $60 a barrel. A projected level of hold price of $60- $65 per barrel would prevent significant negative impacts to the economies of these three main producers. Chart 15. Oil production. Data source: BP Statistical Review of World Energy. Is this assumption justified by the data? The Brent oil price series seems clearly non-stationary, and in fact, the Augmented Dicket- CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 149 Fuller (ADF) tests has a value of -1.91 that does not allow to reject the null hypothesis of non-stationarity. Chart 16. Rolling mean and standard deviation of oil price series. Data source: QUANDL. One simple way to make a time series stationary is to difference it. One-week differences in the average weekly price of the barrel of Brent oil show, in fact, a stable mean and a standard deviation slightly increasing with time. The ADF test of the differentiated series shows a value of -11.10, which allow to reject comfortably the null hypothesis of non-stationarity. AKMARAL ILIYAS 150 Chart 17. Rolling mean and standard deviation of differentiated oil price series. Data source: QUANDL. A standard decomposition of the original oil price time series provides also stationary residuals, and shows the inexistence of identifiable seasonal patterns: CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 151 Chart 18. Decomposition of the weekly oil price series. Data source: QUANDL. Time series like this one, with one unit root, can be modelled as an autoregressive integrated moving average (ARIMA) process. The required number of terms (lags) for the autoregressive and moving AKMARAL ILIYAS 152 average parts of the process can be ascertained with the help of autocorrelation and partial autocorrelation charts, respectively. Chart 19. Autocorrelation and partial autocorrelation charts for the weekly oil price series. Data source: QUANDL. CHAPTER 2. T HE IMPACT OF THE NATIONAL FUND ON KAZAKHSTAN ’ S DIVERSIFICATION POLICIES (2010-2014) 153 Using the heuristic procedure of observing the number of lags where the autocorrelation and partial autocorrelation lines cross the 95% confidence upper bound, the pair (2,3) can be selected as the terms for the autoregressive and moving average parts of the process, making it an ARIMA (2,1,3) that can be estimated following standard Box-Jenkins methods. 34 With the help of the estimated process, and using the last year of the sample (April 2017-April 2018) as testing set and the rest of it as training set, it is possible to obtain shortand medium-term forecasts of the evolution of the weekly average Brent oil price. These forecast turn out to locate around a central value of $70. 35 Chart 20. Short-term forecast of the weekly oil price based on an ARIMA(2,1,3) process. Data source: QUANDL. The high volatility of oil prices indicates than within a reasonable confidence band, the price of oil in the shortand medium-term can be 34 See Enders (2008). 35 See Kilian (2009), Ahmed & Shabri (2014), Baumeister & Kilian (2014).