"Under the current government, transfers from the fund to the fiscal budget have been at – or below – 3 pct. of the fund’s value (2014 to 2017). In the budget for 2017, the transfer is estimated to equal 3 pct. The actual use of fund revenues is now in accordance with the expected real return going forward", the Minister of Finance Siv Jensen said at the press conference.
Equity share in the Government Pension Fund Global (GFPG)
The equity share is the single most important decision affecting expected risk and return in the fund. This share was last time assessed in a broad-based manner in 2007, when it was increased from 40 to 60 pct. Fund investments are divided between equities, bonds and unlisted real estate. With the new regulation of real estate introduced this year, the equity share in the strategic benchmark index is 62.5 pct.
Expected return on equities is higher than on bonds. Equities will as such contribute more to the fund's purchasing power. At the same time, equities carry higher risks. Realised return will therefore fluctuate more. Historically, equities have paid significantly higher returns than bonds over time, at the cost of intervals of lower returns. The trade-off between expected risk and return must also take into consideration; inter alia, the total risk in Norway’s petroleum wealth and the role of the fund in fiscal policy.
The government has initiated a thorough process. We have taken advice from a broadly composed public commission (the Mork commission). The commission report has been subject to public consultation. In addition, Norges Bank has provided recommendations and assessments.
The government intends to increase the equity share
Two questions are central when evaluating the equity share of the GPFG. First, what is the risk-bearing capacity of the government as owner of the fund? Second, what is the trade-off between expected risk and return?
The Mork commission was comprised of academics, finance experts, as well as two former ministers of finance. The majority, made up of all members but the chair, recommended to increase the equity share to 70 pct. The reasoning was that the risk-bearing capacity was higher now than at the previous assessment of the equity share, ten years ago. Such assessments must take a number of considerations into account.
The commission makes reference to the financial crisis, emphasising that even in times of high market turbulence there was broad political support for the fund's investment strategy. It also points out that a far higher share of the petroleum wealth has been converted into financial assets, allowing more diversified wealth allocation. On the other hand, as argued by the commission, the fiscal budget has become more dependent on transfers from the fund.
Norges Bank has recommended that the equity share be increased to 75 pct. Among other aspects, the Bank emphasises that the expected equity premium is somewhat higher and that the risk in the overall petroleum wealth is much lower.
When the government now proposes to increase the equity share to 70 pct., we base our decision on a thorough evaluation of the recommendations and assessments made by the Mork commission, Norges Bank and submissions from the public consultation.
One prerequisite for increasing the equity share is broad political support. A second prerequisite is that the long-time horizon of the fund can be maintained. In principle, as long as we limit withdrawals from the fund to the expected real rate of return, we can expect to uphold the real value of the fund. This hinges on how we conduct fiscal policy and how large transfers are made from the fund to the fiscal budget. Therefore, the government intends to adjust the estimate of expected real return of the fund, which plays an important role in the fiscal framework.
Prospects of lower real return ahead
The figure shows how interest rates have evolved in recent decades, here illustrated by inflation-indexed bonds issued by large countries with high credit ratings. For many years, interest rates have decreased. After academic discussions on whether this decline was temporary or more permanent, there has in recent years been increasing agreement that a major part reflects structural changes in the world economy, and is therefore considered more permanent.
With an equity share of 70 pct. the expected real return on the fund is estimated to 3 pct., in contrast to 4 pct. previously. The estimate is based on a real return on bonds between 0.5 and 1 pct. and an equity premium of 3 percentage points, broadly in line with estimates from the Mork commission as well as Norges Bank. It is emphasized that these are long-term estimates. In a given year, realised returns might be considerably higher or lower.
A lower estimate for the real return must have consequences for withdrawals from the fund. This will support the capacity to bear stock market risk, but also the ability of the fund to benefit future generations.
Fiscal policy guidelines
According to the Norwegian fiscal rule, the spending of fund revenues over time shall follow the expected real return of the fund. The fiscal rule in itself is unchanged, whereas spending now will have to be in accordance with the new estimate of 3 pct. expected real return.
In a given year, fiscal policy should help to stabilise economic activity in order to support high capacity utilisation and low unemployment and can therefore deviate from the 3 pct. path. In the event of large fluctuations in the fund’s value, consequences for fiscal policy shall be phased in over several years.
Estimate of expected real rate of return adjusted to 3 pct.
In fact, fiscal policy has already been adjusted to an expected rate of real return below 4 pct. Under the current government, transfers from the fund to the fiscal budget have been at – or below – 3 pct. of the fund’s value (2014 to 2017). In the budget for 2017, the transfer is estimated to equal 3 pct. The actual use of fund revenues is now in accordance with the expected real return going forward.
Fund revenues will continue to be an important source of income for the government. However, going forward, the annual increases in spending from the fund will be much smaller than in the period after 2001. This is, inter alia, due to lower oil revenues and lower accumulation of capital in the fund. The consequences for public finances will be discussed in the coming white paper on Long-term Perspectives for the Norwegian Economy. This issue was also discussed in the National Budget 2017.
In response to the decline in oil prices, the government has used fiscal policy to support economic activity and employment, and to counteract unemployment. This is in line with our fiscal framework. As part of the fiscal budgets, measures have been targeted towards those geographical areas hit hardest by the fall in petroleum prices.
The government has given priority to growth-enhancing tax reductions, as well as investments in education, research and infrastructure. In combination with low interest rates and improved competitiveness, these budget policy measures have provided substantial support for the current upturn in the Norwegian economy. Fiscal policy will continue to aim at smoothing fluctuations in production and employment, also in the years to come.
Enhancing the growth capacity of the Norwegian economy
Fiscal policy is not only about the level, but also the composition of spending. In 2001, parliament was unanimous in pointing to tax policy and spending on infrastructure, education and research as important for supporting a more well-functioning economy.
The current government's strong efforts to strengthen transport and communication, as well as the priorities given to education, research and growth-enhancing tax relief, are not only important in themselves, but also a follow-up of the intentions from 2001.
The same priorities will facilitate necessary structural adjustments in the Norwegian economy, given the outlook for permanently lower growth contributions from the petroleum sector. The white paper on Long-term Perspectives for the Norwegian Economy will deal with this issue in depth.
The government's proposal
To conclude: the proposed adjustments to the asset allocation of the GPFG, and to the fiscal rule, lay the foundation for a continued sound management of accumulated petroleum wealth in the fund, benefiting both current and future generations.
The recommendation to increase the equity share of the GPFG will be presented to parliament on 31 March 2017, in the annual white paper on the management of the Government Pension Fund. Further background on the downwards revision of the estimated real rate of return on the fund, as well as long-term implications for government finances, will be submitted to parliament the same day in the white paper on Long-term Perspectives for the Norwegian Economy.