Friday, October 24, 2008

Safeguarding Singapore's reserves

Oct 23, 2008

How did Singapore accumulate its reserves? Why is the Government spending more of it? Why should we be prudent? Prime Minister Lee Hsien Loong explained in Parliament on Tuesday.
Striking a balance between present and future needs

THESE reserves are a major resource for Singapore. They give people confidence that Singapore is able to cope with anything that may come its way. They are our nest egg and insurance for a rainy day. Even during tumultuous times like now, nobody has any doubt that we can weather the crisis.

Imagine if we did not have these reserves. Would anybody have taken us seriously if the Government had then guaranteed all the bank deposits in Singapore? Guarantee using what?

It's taken us more than 30 years to build up the reserves. We started accumulating in the 1970s. There was a favourable external environment that allowed Singapore to grow strongly year after year. We had a young population, we did not need high social spending, health care was a small proportion of our annual expenditure. The Government could and did adopt prudent and conservative fiscal policies. We ran budget surpluses over many years.

We collected the surpluses, we invested them carefully, they became our reserves. At first, the Monetary Authority of Singapore (MAS) managed them. But when the reserves grew larger than what MAS needed to protect the Singapore dollar, Dr Goh Keng Swee decided to create a separate organisation - the Government of Singapore Investment Corporation (GIC) - dedicated solely to managing the reserves for long-term growth.

GIC was the forerunner of today's sovereign wealth funds - not quite the first in the world but among the first. It began with two employees: the managing director and his secretary. It now has about 1,000 people working for it.

Besides GIC, we also built up government-linked companies: DBS, SIA, Sembawang, Keppel and so on. As they grew, we transferred them over to Temasek Holdings to be managed commercially. The ministries, we decided, should not be running companies.

So now we have two investment organisations: GIC and Temasek, both highly regarded around the world for their competence, their integrity, their track record. They pursue sustainable returns over the long term and they avoid excessive risk-taking for short-term gains.

As our reserves grew, we became conscious about the need to protect them. We saw other countries become bankrupt because of corruption, incompetence or populist measures. We understood the nature of electoral politics. There are strong pressures to spend more. Every election could be an auction of populist policies to spend the reserves.

The first generation of Singapore's leaders and voters had gone through life-and-death struggles and got out of poverty. We could rely on the Government's fiscal prudence and the people's good judgment to safeguard our reserves - to save, work, earn, not spend, relax, enjoy. But for the long term, we knew we had to institutionalise safeguards in the system, otherwise we would be in trouble.

We took the first step in 1991 when we amended the Constitution to create the elected president. The elected president has a number of functions but protecting the reserves is one of the most important. The first big move we took was to protect the principal sum of the reserves. Past reserves, all those accumulated by previous governments, that is locked up. What the present government accumulates, it can spend. But we allowed the present government to spend the dividend and interest income from past reserves.

It was a simple but not perfect approach. We were not putting aside part of the income to grow the nest egg. Also, when we said investment income, it was only interest and dividends, it didn't include capital gains or losses. And we didn't take inflation into account.

We debated for several years how to refine the balance between providing for present needs and building up for the future. Should we lock up some proportion of the net investment income (NII)? The question was hotly debated in the 1990s.

Then president Ong Teng Cheong had been part of these discussions when he was in the Cabinet. When he became president, he was in favour of changing the Constitution to lock up 50 per cent of the NII. But the government was cautious. We studied this for several years and eventually decided on a 50-50 split. We implemented the new rule in 2001 because we could see the pressures for more social spending.

So we went from 100 per cent to 50 per cent of NII. But we were not yet ready to change the interest and dividends framework. We continued to study how we could improve the system. We looked at other governments, like Hong Kong and Norway. We studied the Ivy League universities in the United States with huge endowments. They have robust and sophisticated spending rules to preserve the value of their endowments and generate a stable sustainable income flow year after year.

We were able to pick the brains of some of the people who operate these endowments. But we had to fit the ideas into the Singapore context. There were three things we had to consider:

First, economically, we needed a sound formula to overcome the inadequacies of the present system. Second, politically, we needed a simple and fair system which Singaporeans could understand and support - and most importantly, help withstand political pressures to spend more. And third, constitutionally, we needed a scheme which would fit into our system of checks and balances, where the authority is split between Parliament, which approves the money, the Government, which decides what it wants to spend on, and the President, who has custodial powers and can say no.

Finally, after many iterations, the result is this constitutional amendment, which has the President's support. This amendment retains the principle of safeguarding 50 per cent of our gains as past reserves. But it sets an important new basis for calculating the net investment returns. The key phrase here is 'long-term expected real returns'. Every word in the phrase means something.

Scheme designed to prevent casual squandering

THE net effect of this rule change is that it would allow us to draw somewhat more than under the old formula. But we need to be careful how we spend it.

Broadly, the additional money ought to be spent on investments in our future: infrastructure, education, R&D, increasing competitiveness, reducing direct taxes. We're going to draw a steady amount (from the reserves), so even in down years these long-term programmes can be funded.

But I should caution that our reserves are not a limitless resource. If you think that we're doing this because we just want more money, that's exactly what we're frightened about. That's the mindset against which this whole scheme is designed to protect, to prevent such casual, wrong-headed squandering of hard- earned reserves. Once gone, it's finished.

That is why when I proposed changing the NII formula two years ago, I also proposed raising the GST from 5 per cent to 7 per cent to fund increased social expenditure: health care, Workfare, help for the low-income and elderly. Social spending is something which is ongoing that the people ought to pay for. But investment in the future, that is something that can come from transforming the financial reserves into capabilities to generate new reserves. It's not a hard distinction.

We always must take a long-term view. Right now, the financial system globally is under severe stress. The problems will take more than a few months to clear - at least a year, quite possibly longer.

Singapore cannot avoid the fallout. Our economy is competitive, our banks are sound, but we are linked to the world. As Stephen Roach said: 'You either believe in globalisation or you believe in decoupling. You cannot be globalised and decoupled.' We are globalised; we are not decoupled; we have to be prepared for a rough time.

We are preparing measures to help businesses reduce costs, lighten the burdens of households, especially low-income households, and help workers tide over the downturn.

This is quite a different outlook from the one we had when we decided to make this constitutional amendment in 2006. Growth in 2006 was more than 8 per cent, the markets were booming, investments were doing brilliantly. The formula we have come up with has to work in both circumstances.

Supposing we had spent all the investment income in a good year. What would happen in bad years when returns may well be negative? Thus, our spending (of the reserves) will be based on long-term expected returns. In good years, spend less than what we actually earn, put aside more for the future. In bad years, try to preserve the value of our investments but draw on our accumulated surpluses at a prudent rate.

We didn't time the constitutional amendment to deal with this downturn. But it will put in place the right spending rule for this and future downturns as well as boom years.

Will we need to go to the President to spend more from past reserves in this recession? If, as a result of having to run a deficit, we need to ask the President's permission to draw on past reserves, we will do so. But fortunately, we have built up a comfortable buffer of current reserves since the last general election, which we can draw on if we have to run deficits over the next one or two years.

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