Unlocking more of the reserves’ returns

In a downturn, tax receipts dip even as the Government needs to spend more to support those on lower incomes. Where will the funds come from? A proposed change to the Constitution, first floated two years ago and tabled by Finance Minister Tharman Shanmugaratnam last month in Parliament, will mean the Government can tap on more of the returns from investing the reserves. Insight looks at what the change means.

This story was originally published in The Straits Times print edition on Oct 11, 2008.

IT WILL pave the way for the Government to spend more of the returns from investing the reserves, in each year’s Budget.

Currently, it spends only up to half of the investment income from interest and dividends paid out each year. These make up only a small share of total investment returns.

That has led to calls over the years for an easing up of the law on the use of the reserves, so that more can be spent on items like social support.

After two years of careful study, the Government is finally ready to amend the Constitution so as to better tap on returns for more immediate needs, while preserving the real value of the reserves and growing them over time for the benefit of future generations.

If Parliament approves the change, it will mean the Government can, in future, tap on up to half of the total returns from investing the reserves.

The new spending rule employs a new concept called Net Investment Returns or NIR, in contrast to the current concept of Net Investment Income or NII.

NII includes only interest and dividends earned from investing the reserves.

But NIR includes such gains as well as capital gains and losses, that is, changes in the value of investments as prices change.

The new spending limit will be set at 50 per cent of the expected long-term real rate of return.

Dr Chua Hak Bin, Citi’s head of research for Singapore, says the move to include capital gains in the spending rule will result in a more accurate reflection of the market value of the returns from Singapore’s investments. Moreover, many companies do not pay dividends, he notes.

In first floating the prospect of a spending rule change in 2006, Prime Minister Lee Hsien Loong told Parliament that relying on dividends and interest alone was “not quite right”, as “a significant part of the returns on our reserves are capital gains”.

Total returns should therefore be considered as the basis for deciding how much the reserves had grown, he added.

Since the spending limit is set at half of NIR, the rest will be ploughed back into the reserves to augment their value.

No government can touch past reserves without the President’s consent.

Why the change?

WITH spending set to rise in the years ahead as the population ages and the income gap grows, there is uncertainty over whether government revenue from taxes and fees can keep up with the increases.

For the five years from 2006 to 2010, for example, the Government has set aside $8.3 billion to strengthen the social security system. The measures include short-term assistance packages for lower-income households and the elderly.

Nanyang Technological University (NTU) economist Tan Khee Giap says of the Government’s approach: “Setting up a welfare state is a no go, but what can be done, on a case-to-case basis, is to help those who are not doing well. The money has to come from somewhere.”

Already, the Workfare Income Supplement is a permanent fixture to boost the incomes of some 400,000 older, low-wage workers in the bottom 30 per cent of income earners. The cost: $400 million a year, and that figure could go up.

Spending on health care, now at over $2 billion a year, is expected to increase as the population greys.

At a dialogue last month, Health Minister Khaw Boon Wan said it was unrealistic to expect national spending on health care not to increase in future.

It is now at a low 4 per cent of gross domestic product (GDP), but could more than double to below 10 per cent of GDP, he said.

Beyond social spending, the Government also intends to pour large sums into investments to ensure Singapore keeps its competitive edge well into the future.

In terms of software, it now spends $8 billion a year on education. It also expects to spend $500 million a year on continuous education and training for adults.

It will increase its overall spending on research to $7.5 billion a year by 2010.

Large sums are also needed to enhance the city’s hardware.

Take the land transport system.

The new Thomson and Eastern Region MRT lines, scheduled to be ready by 2020, and extensions to existing lines will cost some $20 billion.

This is over and above the $20 billion already committed for the Circle Line, the Downtown Line and extensions to the East-West Line past Boon Lay.

While expenditure is headed up, the situation on the revenue side is a lot more volatile and uncertain.

Last year’s Budget surplus of $6.45 billion was possible thanks to a buoyant economy and booming property market.

These swelled government coffers.

Stamp duty alone rose to a record $3.8 billion. Contributions from NII totalled $2.3 billion.

This year, the Government has projected an $800 million deficit, with $2.2 billion expected in NII contributions.

NTU’s Associate Professor Tan points out that without NII contributions, Budgets in previous years, from 2001 to 2006, would not have been balanced.

In 2005, then-second finance minister Raymond Lim was asked by then-MP Wang Kai Yuen if the Government used the full 50 per cent of NII, as allowed under the Constitution.

Mr Lim replied that in recent years, the Government would have run up a deficit without contributions from NII.

“So we have been using the full 50 per cent,” Mr Lim said.

Although the new spending framework was not planned with today’s financial crisis in mind, Prof Tan says it is fortuitous that it comes at a time when tax collections could be hit by an economic downturn.

“In a bad economic situation, revenue can be less than expected,” he says.

There is also a longer-term trend of countries slashing personal and corporate income tax rates to attract talent and foreign investors to their shores.

Singapore’s corporate tax rate has gone down significantly since 2002, from 24.5 per cent to the current 18 per cent.

The top personal income tax rate stands at 20 per cent for income earned in 2006 and beyond.

The Government has not ruled out further cuts to the income tax rates.

It has also sought to raise revenue from the goods and services tax (GST), which went up by 2 percentage points to 7 per cent last year.

But such hikes are deeply unpopular. In spite of rebates, shares and cash top-ups to offset their impact on lower- and middle-income Singaporeans, each round of GST hikesseems to exact a political price on the Government.

How much more will the Government have?

ANALYSTS say the changes can yield potentially large sums.

The Government’s reserves include assets managed by the Government of Singapore Investment Corporation (GIC), as well as those owned by the Monetary Authority of Singapore (MAS) and Temasek Holdings.

As of last month, MAS’ foreign exchange reserves were valued at about $240 billion.

The total amount of assets managed by GIC remains a closely guarded secret but its portfolio is valued at “well over US$100 billion (S$148 billion)”.

Temasek Holdings’ portfolio is worth $185 billion but its assets are not covered by the constitutional amendment on NIR.

It is likely that the bulk of the reserves are managed by GIC.

The GIC’s annual rate of return over a 20-year period up to March this year was 5.8 per cent in Singapore dollar terms, or 7.8 per cent in US dollar terms.

After accounting for global inflation, the real rate of return was 4.5 per cent a year.

If $100 billion worth of investments grow at this rate, capital gains would amount to at least $4.5 billion a year, notes Citi’s Dr Chua.

Half these gains would bring in between $2 billion and $3 billion.

But the amount of reserves managed by GIC is likely to be much more. A commonly cited unofficial figure is US$300 billion (S$443.8 billion).

Financial advisory firm chief Joseph Chong estimates the reserves could be worth as much as $500 billion today.

Assuming a real rate of return of 4 per cent, capital gains can add some $10 billion to the Budget - over three times what NII has contributed to previous Budgets.

Does the change in the spending limit mean the Government will save less for the future?

IT DEPENDS, says Mr Liang Eng Hwa, an MP for Holland-Bukit Timah GRC.

The Government is shifting from a more conservative approach of just accumulating reserves to a more balanced one in favour of current spending - while still growing the reserves, he explains.

“It may mean we will save less for the future than before but if this extra spending is to further strengthen our economic capability, then there is no cause for concern,” says the managing director at a local bank.

Ang Mo Kio GRC MP Inderjit Singh notes that if the current Government can grow the reserves, it deserves to use part of the gains.

Moreover, with the 50 per cent spending cap on NIR, “they will not be draining the reserves but will still be adding to them”.

Mr Liang notes that Singapore’s reserves have grown to a “very significant size” in the last two decades, and investing the entire reserves and their returns solely in financial assetsmay not be the optimal strategy, going forward.

“There are only so many compelling investment opportunities available, and they are often keenly sought after by a long list of global investors across the globe, including other huge funds,” he says.

Allowing more investment returns to be freed up would instead facilitate investments in non-financial assets, such as education, infrastructure and capacity building.

These investments, he says, could reap solid - if less easily quantifiable - returns in the long run.

What is being done to manage the risks?

CAPITAL gains are inherently volatile, as asset values can rise and fall sharply at little notice.

Granted, GIC’s assets are widely distributed among public and private equities, bonds, real estate and cash, among other things.

They are also geographically spread out to balance risk, with 40 per cent of GIC’s portfolio in the Americas, 35 per cent in Europe and 23 per cent in Asia.

But in a global downturn like the present one, the market value of assets can dip sharply.

Conversely, in a bull run, capital gains from investments in the stock market can be huge.

If capital gains are assessed on a year-to-year basis, they could be negative in some years and larger than usual in others.

That leads to budgetary uncertainty, which is undesirable.

To avoid such uncertainty, the new spending rule is based on expected long-term real rates of return.

Each year, the Ministry of Finance (MOF) will set out what it expects will be the real rate of return over a stretch of 15 to 20 years, long enough for two or three business cycles.The constitutional amendment requires the Government to seek the President’s concurrence on its expected rate of return before the start of each financial year.

Mr Singh, who chairs the Government Parliamentary Committee for Finance and Trade and Industry, says employing an expected long-term rate of return will mitigate against the effects of outlier years of poor or even negative returns.

It will allow the Government to plan on the basis of a steady stream of income, instead of over-spending in a boom and under-spending in a bust.

A similar framework is adopted by top American universities like Yale and Harvard in designing spending rules on their endowment funds.

Mr Singh tells Insight that given the current turmoil, the Government can expect a reduction in the capital value of the reserves in the short term.“But if we follow strictly the proposed measure of long-term expected return, then all the ups and downs would be taken care of,” he says.

In terms of safeguarding the reserves and making sure the Government does not overspend, Mr Singh says what is key is for the President’s office to have the capability to scrutinise what the MOF projects as the long-term real rate of return.

“The President’s office must have the ability to measure and determine the rationality of the projection, especially since the whole global financial industry is about to be re-baselined when the dust settles after this current crisis,” he says.

The GIC recently noted that its portfolio’s returns in recent years were dampened by episodes of market turmoil, including the 1997 Asian financial crisis and the current credit crisis.

However, the annualised 20-year rate of return dipped only slightly.

Further, the long-term expected rate of return will be adjusted for inflation.

Mr Liang notes that currently, NII is based on nominal returns. If inflation rates are high like at present, this in effect reduces the purchasing power of the reserves.

He sees using real returns as a prudent move to strengthen the reserves management framework and safeguard the value of Singapore’s assets.

NTU’s Prof Tan feels the change also underlines how important it is for the GIC to have people who can continue to identify assets of value so the Government can continue to tap on a stream of income from the reserves.

“With the cash we have, we should take the opportunity to create more value at times like the present,” he says.

But the added income stream may have other implications for the man in the street, who is concerned about rising costs.

Dr Chua notes that as Budget calculations are conservative, and the Government is cautious about what it spends on, the money will go a long way.

“The probability of a future GST hike any time soon might be severely diminished,” he says.