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. Last Updated: 07/27/2016

Zero Returns Not the Best Stabilization Option

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The government's financial strategy has been a common subject for discussion at high levels of late. At a government session three weeks ago, President Vladimir Putin floated the idea of investing money from the stabilization fund in the domestic securities market. The logic behind the suggestion is that it would simultaneously solve two problems. First, it would contribute to stock market growth. Second, it would put the fund to use for achieving long-range financial objectives. By the time Putin made the comments, the markets had already begun to bounce back, but the question of long-term objectives still stands.

Alas, the proposal met with little sympathy from the main defenders of the country's financial stability -- Alexei Kudrin's Finance Ministry. They saw the idea as a basic threat to controlling inflation and maintaining stable domestic financial markets. But the idea remains on the agenda as one that deserves consideration in a broader context. What is at stake is a strategy for long-term economic development, something the economic leadership has yet to formulate or even bother to consider, it seems.

By proposing to put the stabilization fund money in stocks, Putin intuitively identified the primary instrument for dealing with the country's most serious long-term challenge: pension reform. This is not to be confused with the botched pseudo-reform implemented so far. This has to be a reform that will address the gap between incomes for different generations of pensioners and meet the social responsibility of providing for those who are unable to save enough money for their senior years on their own.

Facing this responsibility will clearly require significant state funding. The middle of the next decade will see the beginning of a 20-year period in which pension deficits will reach the equivalent of about 75 percent of gross domestic product. To make up a deficit of this magnitude will require more than the contents of the stabilization fund, which currently equals less than 10 percent of GDP. One option would be to cover the deficit by issuing debt, but this will only mean a higher tax bill down the road.

The problem could also be solved by using the money from the stabilization fund, but only if it is transformed from a static reserve operating at a loss into a full-fledged fund for future generations. This will require a restructuring of the system to manage and formulate precise long-term targets and restrictions. Financial theory long ago provided the solution to this problem -- a diversified investment portfolio weighted according to global indexes that allows for investment in commodities, international shares -- including Russian securities -- and real estate funds.

But the country's financial policymakers aren't even considering the idea. Their traditional focus has been on sterilizing excess money in the economy. The recent move to a three-year budgetary cycle changes little, as the main indicators for planning are still generated only on an annual basis. In developed countries, governments tend to focus on 10- to 20-year periods. This horizon could be extended in Russia as well, by sticking with the old one-year budget system but shifting the accent to the management of long-term financial assets. This option remains outside the Finance Ministry's realm of possibilities. Despite the new budget system, the structure of the savings remains unchanged.

That the stabilization fund is being used to siphon off "excess" money is a useful myth, used to cover incompetence or laziness. These funds, as part of the national wealth, need rational management. Its absence has resulted in significant losses. Inflation has remained high, even though the nominal value of the ruble has risen rapidly. The main cause of this paradoxical occurrence has been the need to substitute monetary policy for fiscal policy as a result of a shortage of instruments for the sterilization of excess money supply. A loss of economic competitiveness has been the result.

Of all the possible ways to deal with "excess" money, the authorities have opted for the least effective by keeping the lion's share of state savings in a so-called "safety net," in the form of the reserve fund. This is purely an accounting solution. It dodges the need to make portfolio decisions and, as a result, take responsibility for associated risks. The price of such a policy has already become too high.

There has been much study of this question, but according to moderate estimates provided by the Investment Finance Institute, losses incurred as a result of current stabilization fund management amounted to between $5 billion and $7 billion last year alone. This is the result of treating the funds as an excess burden and nothing more than a source of inflation.

The policy of investing just 10 percent of the reserves, and then only in government bonds from developed countries, is entirely unjustified. These instruments not only generate low returns, but are riskier in real terms than a diversified portfolio weighted according to global indexes. Inflationary fluctuations mean, in the medium term, that the real returns on government bonds fall to zero. The price movements of shares and commodities correspond to those for inflation, allowing for the elimination of this risk.

There are a multitude of success stories of the long-term management of state assets. These are not limited to state funds of the type set up in Norway and the United Arab Emirates, which deliver annual returns of 8 percent to 10 percent through strong diversification. There are also endowments, which, in the case of Yale University, have generated an average return of 17.2 percent over the past 20 years. The key to effective investment is an orientation toward long-term targets and global diversification of sectors and instruments.

To provide a sense of what could be gained, a 10 percent annual return means a minimum of a tenfold increase in the original assets, roughly from $100 billion to $1 trillion in the space of 25 years. At returns of 17 percent, the entire impending shortfall in Russia's pension system could be covered in less than 15 years.

How can such returns be realized? For the most part, endowment by highly qualified financial specialists, with access to an academic base, and for whom long-term targets are more important than current accounting considerations.

If it had been managed properly, the capitalization of the stabilization fund could have already filled the long-existing gap in the pension system. Positive results are still within reach, but a new organization of functions and alignment of priorities are needed now. Many countries running budget surpluses already invest their money according to weighted diversified global indexes. They are already earning money by using their heads and not depending on fortuitous external economic conditions. While Russia has been frivolously wasting this chance, they have been providing real, rather than imaginary stability in their financial systems.

This kind of discussion has been going on for a while, and the government has been offered plans of this type on more than one occasion. If there were such a will, it would be easy to put these ideas into practice.

Andrei Vavilov is head of research at the Institute for Financial Studies and a member of the Federation Council. This essay appeared in Vedomosti.