In February, Kenya’s government released a draft law that would establish a new sovereign wealth fund. The fund would channel the nation’s petroleum and mineral revenues to three “components”: one for savings, one for budget stabilization and one for domestic spending and investment.
Kenya’s expected non-renewable resource revenues are modest, both in absolute terms and relative to general government revenues. Based on independent estimates, petroleum revenues are unlikely to exceed 5 percent of fiscal revenues, even at peak production (estimated to be in 2022 at the earliest). Mineral revenues totalled USD 16.5 million last year, a drop in the bucket in terms of government revenue.
Still, the proposal incorporates many of the key elements in sovereign wealth fund bills that promote effective, accountable and transparent management of natural resource revenues. Among the strongest of these are clear fund objectives, clear deposit rules, significant public disclosure requirements and open, competitive and transparent selection of external managers.
At the same time, the draft law introduces risks to public money that did not previously exist. We highlight five of the risks here.
Risk 1: Excessive risk-taking
While the draft incorporates constraints on some types of asset purchases, it permits investment in the riskiest asset classes, such as derivatives, private market instruments and commodities. This is mainly due to three clauses in Schedule 2 of the draft. These allow the cabinet secretary (the equivalent of a minister of finance appointed by the president) to prescribe “any other instrument” as a qualifying instrument for the fund. We recommend tightening the restrictions on purchases of highly risky assets, which are unnecessary for high long-run returns and susceptible to corruption and high management fees, as we have seen recently in Angola, Libya and Malaysia.
Risk 2: Inadequate independence and oversight
The draft concentrates significant powers over fund management in the hands of the executive. All board members are either directly or indirectly nominated by the office of the president, as is the sole oversight actor, the auditor-general. While the transparency requirements can act as a safeguard to prevent mismanagement, international experience suggests that transparency is not enough. We recommend ensuring at least three board members be nominated by non-executive bodies—whether by parliament or by professional associations—and that parliament, the parliamentary budget office and an independent external auditor review the fund’s performance on a regular basis.
Risk 3: Borrowing while saving
In its latest Eurobond issue, the Kenyan government was charged 7.25-8.25 percent annual interest on its sovereign debt. In comparison, the expected long-run rates of return on portfolio investments at moderate risk levels is 3-5 percent. Until interest rates for Kenyan sovereign debt decline, intergenerational equity objectives would be best served by debt reduction rather than financial savings. We would therefore recommend that debt repayment take priority over savings in the early years of oil production.
Risk 4: Domestic investment outside the budget process
The draft proposes the establishment of an “Infrastructure Development Component” that would absorb 60 percent of resource revenues. Based on the proposal, this amount can be distributed in two ways: (1) through the budget by allocating it as part of an Appropriations Act, following best practices in public financial management; or (2) it can remain as a component balance and be invested in Kenyan assets as delineated in Schedule 2.
Schedule 2 specifically mentions that debt instruments denominated in local currency, securities listed at the Nairobi Securities Exchange, secured bonds and treasury bill and bonds issued by any of the central banks of the East Africa Community member states are eligible assets. Thus, in theory, the fund could be used to purchase Kenyan debt as well as invest in domestic securities.
The domestic investment mandate raises a number of risks, specifically that home financial investment through a sovereign wealth funds could: (1) undermine the public financial management system, creating a less accountable parallel budget with its own appraisal, procurement and monitoring systems; (2) undermine public accountability by bypassing legislative oversight; and (3) lead to poor investment decisions, because financial managers specializing in maximizing financial returns are usually not trained in identifying or managing assets with a social objective in mind.
While we are supportive of the need to channel most if not all of Kenya’s natural resource revenues into domestic projects, the evidence suggests that a sovereign wealth fund may not be the most effective means of doing so. Channeling spending through the normal budget process or establishing specialized development banks might be more effective options. Should the government maintain Schedule 2 as is, we would recommend that all domestic asset purchases via the fund be approved by parliament in a manner identical to other government domestic investments, e.g., public-private partnerships.
Risk 5: Failing to achieve the goals of the fund
While the draft proposal provides a list of priorities in determining how to spend oil revenues domestically, the fund can only help achieve fiscal stabilization and sustainable spending objectives if combined with fiscal rules that constrain overall government spending.
The Ghanaian experience is pertinent to the Kenyan context. Ghana established sovereign wealth funds in 2011, directing approximately 70 percent of oil revenues toward domestic capital spending and the remaining 30 percent into savings and stabilization. While these allocation rules were generally observed in subsequent years, the overall trends in public finances did not reflect the intent of the law. Spending on recurrent expenditures grew most rapidly as a result of large wage increases, outpacing any additional capital spending from oil revenues. Ghana’s experience is an important reminder that all revenues are fungible; any measure to control the use of petroleum revenues for one purpose can be offset by decisions related to the rest of the budget.
Kenya faces an infrastructure and education financing deficit which can be partly addressed by channeling resource revenues to domestic investment. But a risky fund might leave Kenya worse off than no fund at all.