Norges Bank submitted the following letter to the Ministry of Finance on 16 March 1999:

1. Introduction

In its letter of 22 August 1997 to the Ministry of Finance, Norges Bank discussed the Petroleum Fund’s investment strategy, and in particular the Fund’s allocation by country. Norges Bank recommended that the Fund be invested mainly in developed markets, but that up to 5 per cent of the Fund could be invested in emerging markets, which comprise developing countries and transition economies.

In its letter, Norges Bank stressed that emerging economies are characterised by rapid economic growth and steadily improving financial markets. It was pointed out that this may generate expectations of solid returns on investments in emerging markets. Moreover, it was stressed that if the economic situation in these countries is not synchronised with developments in other countries, investment in emerging markets may also contribute to reducing the variation in the Fund’s total return.

Norges Bank’s recommendation was provided on a general basis with reference to the objective of the Fund, which is to maximise future purchasing power, given an acceptable risk level. The Bank indicated that it was not certain that investment would take place in emerging markets in the Fund’s initial phase, nor did it propose any restrictions on eligible countries.

In the National Budget for 1998, it was stated that investing in emerging markets could be an interesting option for the Petroleum Fund, but that the building up of expertise on investments in these markets would have to be balanced against other high priority tasks. Following an overall assessment, the government concluded that it would not permit investment in emerging markets at that time.

In the Revised National Budget for 1998, the government announced that it would take a closer look at whether the Petroleum Fund’s country list should be expanded, and stated the following:

The purpose of this submission is to discuss the requirements that should be fulfilled before new countries are included in the Fund’s investment universe. The evaluations are based on the objective of the Fund, which is to maximise future wealth at an acceptable risk level. Norges Bank has not considered whether investing in emerging markets will contribute to promoting economic growth, democracy and human rights in emerging economies. Only new countries have been considered in connection with expanding; we have not evaluated whether investing in commodity contracts, unlisted equities or real property would be more appropriate in view of the Fund’s objective. Since it will be necessary to prioritise resources in the operational management, an overall evaluation of this nature should preferably be available before any investment in emerging economies takes place.

Three factors are of particular importance when an expansion of the country list is considered:

* Foreign participants must have access to the markets, and the markets must satisfy certain minimum requirements with respect to settlement systems, size, liquidity and regulation.

* A certain degree of political and macroeconomic stability is required in the countries considered in order to limit country risk.

* The effect of including new countries on the Petroleum Fund’s return and risk must also be considered.

The general principles for considering new countries are drawn up in the following, and specific examples given. However, Norges Bank does not aim in this submission to give concrete advice as to whether the country list should be expanded. Recent developments in emerging economies and recent literature have led to an increased focus on the risk of investing in emerging markets. Further work on evaluating which countries fulfil the various requirements is required before a recommendation can be made.

The settlement risk associated with emerging markets is greater than that in developed markets. At the same time, the legal framework in emerging markets is not fully adequate. Emerging markets also tend to be small, and to have poorer liquidity than developed markets. This makes it important to give careful consideration to settlement risk, liquidity and the legal system of the countries in question before permitting investment in these countries.

In general, developed economies are considerably more stable, both politically and economically, than emerging economies. The country risk associated with investing in emerging economies can be high, and it is therefore necessary to make thorough analyses of both the political and the macroeconomic stability of these countries.

Both the operational and the country risk of investing in emerging markets can change rapidly. It is therefore important that the minimum requirements are satisfied at all times. This presupposes that the use of resources in the follow-up phase is sufficient to reveal significant changes in risk.

At times, the return on investments in emerging stock markets has been higher than in developed markets, but also considerably more variable. At the same time, the covariation between the return in developed and emerging markets has been low, but recently there have been indications that this covariation has increased. The diversification gains are probably slightly smaller today than earlier, and at the same time it is uncertain whether the return on investing in emerging markets is satisfactory in relation to the risk. Before any expansion of the country list takes place, a thorough review should therefore be made of whether new countries contribute to reducing the risk or increasing the return of the Petroleum Fund.

In principle, an expansion of the country list may apply to the Fund’s equity and bond investments alike. However, much of the discussion in theoretical and empirical literature is concentrated on the equity markets in emerging economies, and it is easier to obtain good benchmark indices for equity investment. This means that there is generally somewhat better information available on emerging equity markets than bond markets. Better equity market data make it easier to estimate the effect on the Petroleum Fund’s return and risk when including new equity markets rather than emerging bond markets. At this stage, Norges Bank has therefore decided to focus on emerging equity markets.

Section 2 of the submission presents the current country list. Emerging markets are delimited in section 3. Section 4 discusses minimum requirements for settlement systems, legislation, size and liquidity, while section 5 discusses country risk. Section 6 discusses new countries in the light of the effect on the Petroleum Fund’s return and risk. This is followed by a summary.

2. Current country list

In the Revised National Budget for 1997, it was pointed out that estimates of the size of the Fund had been revised substantially upwards, and a longer horizon for investments was applied. It could therefore be questioned whether the country allocation, which was based on import weights, resulted in an optimal country allocation. It was argued that import weights could result in over-investment in small countries such as Denmark and Sweden, that the import pattern could change over time, that real imports from a country could differ from direct imports, that vulnerability to economic downturns in Europe could be undesirably high, and that the profitability of large international companies was associated primarily with global economic developments; moreover, that in the long term there might be grounds for expecting that exchange rate risk would be smaller because the real return on investments in different currencies would converge over time.

In principle, the country allocation can be based on three different sets of weights: GDP weights, import weights and market capitalisation weights. GDP weights provide an indication of the relative importance of an economy, while import weights provide a direct indication of the existing import pattern. Market capitalisation weights reflect the relative size of securities markets. In the National Budget for 1998, the Ministry of Finance refers to the evaluations concerning choice of country weights in the Revised National Budget for 1997, and to a letter of 22 August 1997 from Norges Bank, in which the Bank recommends that primary emphasis be placed on GDP weights, but that some emphasis should also be placed on Norway’s import pattern. These considerations were consequently used as a basis for the regional allocation:

It was decided to handle equities and bonds differently in the individual regions. In order to limit transaction costs and avoid large holdings in individual companies, it was considered appropriate to use market capitalisation weights for equities. However, these weights were not regarded as an appropriate alternative for bonds, as they may entail that investments automatically increase in countries with growing debt. It was therefore decided to use GDP weights as the basis for distributing bond investments within each region.

In selecting countries, emphasis was placed on investing the capital in the Petroleum Fund in countries with smoothly functioning financial markets and sound securities legislation. Other factors emphasised were satisfactory size and liquidity of financial markets and no restrictions on the access of foreign participants to the markets. In order to ensure that country selection was based on objective criteria, the indices for developed markets of one of the large investment banks was used as a basis. These indices are constructed on the basis of criteria that are relevant to the management of the Petroleum Fund, since they distinguish between countries precisely on the basis of the size and liquidity of securities markets, the legislation governing them and access by foreign investors.

The current country list is identical to the list of developing countries in the equity index of Morgan Stanley Capital International (MSCI). The following countries are currently included in the investment universe:

* Canada and the US

* Belgium, Denmark, Finland, France, Italy, Ireland, the Netherlands, Portugal, Spain, the UK, Switzerland, Sweden, Germany and Austria

* Australia, Hong Kong, Japan, New Zealand and Singapore

3. Emerging markets

There is no clear-cut set of criteria for defining emerging markets. The International Finance Corporation (IFC), which is part of the World Bank, uses a general economic criterion: the average income in the country (measured as GDP per capita). If the country’s average income does not exceed the World Bank’s limit for a high-income country, the country is defined as an emerging economy. This is a commonly used method for defining emerging economies.

The IFC has introduced a third category of markets, designated frontier markets. These frontier markets are described as small, illiquid and with poor information flows even by the yardstick used for emerging markets. The IFC does not regard these equity markets as a suitable investment option for foreign investors. Equity markets in Bangladesh, Botswana, Estonia and Lithuania are examples of this type of market.

Work is in progress in the IFC to change the definition of emerging markets. One reason for this work is that average income can be substantially influenced by exchange rate fluctuations, and that average income can grow rapidly in some countries without a corresponding development in the stock market. Moreover, a number of qualitative features of emerging markets, such as the quality of regulation, surveillance, transparency and accounting standards, are important features which should be emphasised when drawing a distinction between developed and emerging markets.

The emerging markets’ share of aggregate world GDP in 1996 was about 19 per cent, while their share of the world population was 84 per cent. The market value of the emerging stock markets amounted to 9 per cent of aggregate world stock market value in 1997(1). Measured as a share of Norwegian imports, emerging economies are weighted at about 15 per cent.

The market values of emerging stock markets included in the IFC Investable Index (IFC-I)(2) are presented in Table 1. IFC-I is an index constructed such that it reflects foreigners’ actual options for investing in emerging stock markets. These countries are thus appropriate candidates for investment.

4. Minimum requirements regarding settlement systems, legislation and market size and liquidity

Natural minimum requirements are that securities markets are open to foreigners, have satisfactory size and liquidity and are subject to an adequate regulatory regime with appropriate legislation and satisfactory surveillance. They should also have an efficient settlement system.

It is difficult to stipulate objective requirements regarding these areas, and there may be relatively small differences between the markets of some countries. In our evaluations, we have chosen to use the Norwegian equity market as a basis for comparing some of the factors under consideration. The Norwegian market is relatively small in an international context. An alternative yardstick could be the smallest markets included in the existing country list.

i) Openness, settlement systems and legislation:

At end-1997, only some of the emerging markets included in the IFC-I placed restrictions on foreigners’ maximum holdings in individual companies. Restrictions on foreigners’ holdings of individual equities in relevant emerging markets therefore do not seem to represent any effective obstacle to an international investor such as the Petroleum Fund.

It is natural to impose a number of requirements with respect to the settlement systems in countries in which the Petroleum Fund invests. In the remainder of this section, a brief review will be given of key elements of settlement systems, and it is stressed that the settlement systems in emerging securities markets are more risky than those in developed markets.

It is important that the process of linking trades includes all participants in the transaction, ie the local custodian, the global custodian, investors and local intermediaries. This area is not as well organised in emerging markets as in developed markets.

In some emerging markets, physical settlement systems are used. In such systems, the probability of fraud, theft, loss of securities and delays due to limited settlement capacity is greater than in electronic systems.

Many emerging markets lack centralised ownership registers, such as that of the Norwegian Central Securities Depository. The risk in the settlement system increases with the number of decentralised ownership registers.

It is a definite advantage for securities ownership to change at the same time that cash settlement takes place, that this cannot be reversed, and that the process is finalised in no more than three days. Developed markets normally have more efficient procedures in this respect than emerging markets.

Errors in trades or settlements occur regularly, and it is therefore necessary to have procedures to ensure the correction of errors which are enforced consistently by an independent body such as a stock exchange or supervisory body. Risk in this area is also normally smaller in developed markets than in emerging markets.

Standardised and automated information and reporting systems reduce the possibility of error and also reduce the time it takes to discover and locate errors. SWIFT is an international reporting and information system that is used widely, and it will be an advantage if the participants in the securities market use either SWIFT or a similar system. Such information and reporting systems are not as common in emerging markets as in developed markets.

It is important that provisions established to ensure transparency of market transactions are enforced, that a competent supervisory body with broad powers is established, and that regulations are interpreted and enforced consistently. Key areas must be subject to adequate legislation. In particular, property law, contract law, securities legislation, bankruptcy legislation, tax legislation and court and arbitration systems are important components in an assessment of the legal framework. There is reason to believe that emerging markets lag behind developed markets in these areas.

Indices(3) have been developed for some important emerging markets which measure the risk in the settlement system. This type of index makes it possible to compare the efficiency of settlement systems in different countries in terms of the overall costs incurred by market operators as a result of transactions that have to be reversed. Another type of index measures the security linked to dividend and coupon payments, repayment of withholding taxes and protection of rights in connection with corporate events. These two indices are combined into a third index (operational risk index), in which account is also taken of other operational factors such as compliance with international organisations’ recommendations concerning the organisation of settlement systems, the complexity and efficiency of the regulatory regime and legislation, counterparty risk and force majeure risk. Table 2 below shows the countries that achieve satisfactory values (higher than 65)(4) using this index.

Criterion 1: Score on Operational Risk Benchmark over 65, data not available for other countries

Criterion 2: Total market value more than USD 53bn

Criterion 3: Circulation rate per year more than 5.3%

Criterion 4: Daily turnover more than USD 133m

Criterion 5: Number of companies for potential investment higher than 15

ii) Size and liquidity:

Criteria that are relevant in an assessment of the size and liquidity of markets are discussed under this point. The criteria that are most important in our view are discussed towards the end.

It is important that markets be of a certain size in both an absolute sense and in relation to the Petroleum Fund’s investments. It therefore seems sensible to rank markets according to total market value, with a view to excluding the smallest markets in each region. There are considerable differences in size. Seven markets are larger than the Norwegian equity market (see Table 2).

Because market values (in USD) fluctuate widely as a result of changes in the dollar exchange rate, and because market values in local currencies can also be relatively volatile, one should consider whether the requirement should refer to an average of the market values at the end of each month, for example for the past year, or the past 2-3 years.

Another obvious requirement is that market liquidity is high, ie not significantly poorer than in industrial countries. Measures of liquidity are annual trading volume, the relationship between turnover and market value (turnover rate) and the difference between bid and offer prices. Data on trading volume and turnover rate are available, but it is difficult to determine where the limits should be set.

The rate of turnover on the Oslo Stock Exchange was about 5.3 per cent in September. This means that total turnover in the month was equivalent to 5.3 percent of the average market value during the month. Table 2 shows markets with a turnover rate of at least 5.3 per cent.

The daily turnover on the Oslo Stock Exchange in September 1998 was about USD 133 million. Table 2 shows which countries satisfied a criterion of a daily turnover of at least USD 133 million in September 1998.

In some countries, there are very few companies that are open to foreign investors and at the same time feature sufficient size and liquidity. One rule of thumb is that there should be at least 15 companies in a portfolio to ensure that company-specific risk is reduced through diversification. This is risk associated with the individual company, and not related to general market movements. Table 2 shows which markets consist of at least 15 companies in which foreigners can invest.

It is possible to differentiate between countries on the basis of the criteria (or a combination of criteria) outlined in this section. It is more difficult to arrive at natural critical values, and an evaluation of a reasonable weighting of the various ratios. Table 2 shows which emerging markets are on at least the same level as the Norwegian market for the various criteria. The operational risk index was not available for the Norwegian market, so the limit here is based on an absolute evaluation. The countries that satisfy minimum requirements are indicated by an x in the table.

In our view, one prerequisite for even considering investment in emerging markets is that operational risk is not too high (criterion 1 in Table 2). Next, it seems natural to require that the market, measured by total market value, be of a certain minimum size (criterion 2). Further, it should be required that the liquidity of the market is good, both measured in terms of daily turnover (criterion 3) and turnover rate (criterion 4). Each market should also contain a sufficient number of companies representing real investment options for foreigners (criterion 5).

5. Country risk

Country risk is a function of political and macroeconomic stability. Political risk materialises when the authorities of a country expropriate property, introduce foreign exchange or trade restrictions, change tax legislation or introduce other rules that restrict payments of dividends and interest and which reduce the value of equities and bonds. Macroeconomic stability is partly linked to the stance of fiscal and monetary policy, and to a country’s vulnerability to economic shocks.

Country risk associated with investments in emerging markets is substantially greater than that associated with investments in developed markets. In consequence, individual assessments must be made of country risk. This risk often materialises in the form of event risk(5), which is not always reflected in historical rates of return.

Considerable resources are required to perform in-depth country analyses for short investment horizons, and this is even more difficult for longer time horizons. Countries regarded as risky in the short term may be acceptable in the longer term, and vice versa. The Petroleum Fund has a long-term investment horizon, and its long-term strategy should be as fixed as possible. Consequently, it is not easy to distinguish between countries at one point in time on the basis of assessments of political and economic stability criteria. Country analyses require substantial resources. One possible solution may be to base evaluations on work done by other institutions and incorporated, for example, in country risk indices. Several institutions are developing risk indices with a country ranking based on a weighting of political and economic indicators. Indicators that measure political tension, the stability of the regime, income distribution, inflation, current account deficits and foreign debt are used.

It is relatively simple to point to shortcomings in most of the country risk evaluation systems, and it is particularly difficult to place a limit on acceptable risk. The fact that index values may change within a relatively short space of time is also a problem. Table 3 shows JP Morgan’s country risk index and Moody’s and Standard and Poor’s credit rating of the same countries. JP Morgan’s country risk index focuses on economic criteria, such as GDP growth, average income, inflation, budget balance, balance of payments and credit growth. Standard and Poor’s and Moody’s use both political (qualitative) and economic (quantitative) factors as the basis for evaluating the risk associated with government bond investments in the various countries. Norges Bank uses these two credit rating institutions to determine which bonds the Fund can invest in.

Sources: JP Morgan, Moody’s and S&P

Poorest score on the JP Morgan index is 140.

The best score is 0. A low value thus implies low risk In Moody’s system, `Aaa’ means lowest risk and `C’ highest. Baa1′ implies less risk than `Ba1′, while `Ba1′ is less risky than `B1′.

In S&P’s system, `AAA’ means lowest risk and `CC’ highest risk, Here `BBB’ imples less risk than `BB+’, while `BB+’ is less risky than `CCC+’.

If one decides to use country risk indices as an aid when selecting new countries, index producers must be chosen, and a maximum requirement for acceptable country risk must be stipulated. The literature provides no clear recommendations pertaining to either the first or the second question. However, there is reason to believe that a relatively objective framework is better than an alternative without a framework. Norges Bank therefore recommends that a thorough evaluation be made of the use of country risk indices as a basis for selecting potential investment countries.

6. A better trade-off between risk and expected return

In portfolio theory it is assumed that an investor makes a choice based on the expected return and risk, measured as the standard deviation of the return. A high expected return is positive, while a high standard deviation (risk) is negative. This theory formed the basis for Norges Bank’s previous work on choosing a benchmark portfolio.

In this section, investment in emerging equity markets is considered on the basis of traditional portfolio theory. An array of articles has been published which document historical rates of return in emerging markets and the covariation between rates of return in equity markets in industrial countries and emerging economies.

Reference is made to key findings in the literature and Norges Bank’s own analyses. An account is first given of historical returns in emerging markets, and then the risk of this type of investment is considered. Finally, special features of the Petroleum Fund are discussed.

i) Return

Historically, it has been possible to achieve a high return by investing in emerging equity markets. Recently, however, returns have been substantially higher in developed markets than in emerging ones. Chart 1 shows developments in MSCI’s emerging markets index (EMF) from 1988 up to the end of 1998. The chart also shows how the value of an equity portfolio with the same country allocation as the Petroleum Fund’s equity portfolio would have developed during the same period. This index is based on MSCI’s indices for developed markets.

[Chart 1 OMITTED]

The historically high return in emerging markets may have reflected both structural changes that have increased demand for equities, and high economic growth. A number of emerging economies have opened up securities markets to make it easier to buy and sell equities, and at the same time accounting rules and the rules and regulations for new issues have been improved. Parts of the public sector have been privatised, important economic reforms have been carried out, and programmes to stabilise exchange rates and prices have been implemented. Moreover, emerging markets have been underrepresented in the portfolios of investors in industrial countries.

Future returns on investments in emerging markets will depend among other things on the future economic growth of the emerging economies. This growth will depend on growth in the labour force and structural changes in the business and public sectors that improve the efficiency of the economy.

In emerging economies, the labour force will increase substantially, whereas it will stagnate in developed economies. This may lead to a sharper rise in the production capacity of emerging economies than in developed economies. This is used by some as an argument for the view that the equity markets of emerging economies will show a stronger performance in the future than those of developed economies.

ii) Risk

If there is low covariation between the return on securities in different countries, an investor will be able to improve the relationship between the return and risk of the portfolio. Low covariation between rates of return in different countries may be due to a desynchronisation of the economic cycles in the various countries. Emerging economies often have a business cycle that deviates from that of developed economies. For an international investor, investments in emerging markets may therefore contribute to reducing the overall risk associated with the portfolio.

A number of factors may explain the lack of synchronisation of economic cycles: national factors, different industrial structures, different monetary and fiscal policy, different institutional and legal regimes and asymmetric shocks. These differences may cause country-specific variation in rates of return. A priori, it may be expected that covariation in rates of return is high given geographical proximity, participation in institutional exchange rate arrangements, extensive trade in the region, and many cultural and economic similarities. In the following, some general observations are made regarding risk associated with investments in emerging markets.

In isolation, there is substantially higher risk associated with investing in emerging markets than in developed markets. Chart 1 shows clearly that there has been considerably higher volatility in emerging markets than in developed markets. However, the covariation between the return in developed and emerging markets has long been considered so low that international investors have been able to reduce risk by investing in emerging markets.

Recently, however, there have been indications that the covariation between the return in developed and emerging markets has increased slightly. This would mean that diversification gains are now lower than previously.

There are, moreover, indications that covariation increases in periods of rising risk. This implies that diversification gains are smallest when the need is greatest.

Calculations carried out by Norges Bank using monthly data for the period 1993-1998 show that it can be difficult to reduce the risk of a portfolio consisting of shares issued in developed markets by investing in emerging equity markets. This also applies to an equity portfolio that has the same country weights as the Petroleum Fund.

It has been demonstrated that the covariation between weekly rates of return is less than that between monthly rates of return, which in turn is smaller than the covariation calculated using annual data. For the Petroleum Fund, long-term structures are relevant. It may be that diversification gains are smaller for investors with a long investment horizon than for investors with a short horizon. However, it is difficult to draw definite conclusions on this point, since we do not have enough data to calculate correlations for long investment horizons.

The covariation between returns in emerging markets in the same region is generally relatively low. For this reason it may be advisable to invest capital in more than one country in each region. At any rate, the standard deviation of the return on market-weighted regional portfolios is substantially lower than the standard deviations of the returns in the equity markets of the various countries.

The covariation between the return on market-weighted regional indices is also relatively low. One implication of this may be that it is sensible to invest in several regions in order to reduce region-specific risk.

The above discussion shows that further work must be done to determine whether investments in emerging markets may contribute to reducing risk in a portfolio which is only invested in developed markets. Special emphasis should be placed on studying possible gains for investors with a long investment horizon.

iii) Special features of the Fund

In addition to traditional portfolio model analyses, it may be natural to examine more closely special features of the Petroleum Fund. The first is that the objective is to maximise the Fund’s international purchasing power. The second is that in principle the management of the Fund should be viewed in connection with Norway’s other national wealth.

The purpose of the Petroleum Fund is to maximise future international purchasing power, given an acceptable level of risk. Significant changes in the exchange rate may reduce the purchasing power of the Fund, and therefore represent a type of risk that it may be advisable to limit. But although the exchange rates of emerging markets have shown wide fluctuations, it is not a foregone conclusion that investments in these countries will increase the Fund’s risk. This is because exchange rate risk must be viewed in the light of the objective of the management of the Fund, which is to maximise the Fund’s international purchasing power. One way of limiting risk may consequently be to invest capital in countries from which we know we will be importing goods and services when the Fund’s capital is to be used. We do not know today which countries these will be, but it is reasonable to assume that a certain share of Norway’s imports in the future will come from emerging economies (today this share is 15 per cent). Viewed in isolation, this means that exchange rate risk can be reduced by investing parts of the Fund in these countries. Norges Bank has argued in the past that exchange rate risk is less important when there is a long investment horizon, but that this does not mean that it can be ignored altogether. Consequently, it can be argued that investing portions of the Fund in emerging markets may contribute to reducing the Fund’s exchange rate risk.

The Petroleum Fund constitutes part of the country’s national wealth. Ideally, Petroleum Fund investments should be considered taking into account Norway’s total wealth, which could produce results that differ from those generated by traditional portfolio models. It may be argued that the portfolio should be spread among regions that are not subjected to the same type of shock at the same time, and that attempts should be made to reduce the covariation between developments in the Norwegian economy and the return on the Fund to an even greater extent than implied by traditional portfolio models. The latter implies that investment should take place in countries that are relatively different from Norway. Emerging economies will have a different economic and demographic structure, and be located in other regions than our typical trading partners. Important features distinguish emerging economies from Norway, and investing in the stock markets in these countries may contribute to reducing the covariation between developments in the Norwegian economy and the return on the Fund.

7. Summary

Norges Bank has considered in this submission what criteria should form the basis for investment in equity markets in emerging economies.

An evaluation of relevant countries should be based on the IFC definition and delimitation of emerging markets. These markets must then be evaluated in terms of the requirements that should be applied with respect to settlement systems, size and liquidity. Some relevant criteria are outlined at the beginning of this submission, and markets that satisfy certain minimum requirements are identified. The general impression is that the risk is greater than that associated with investment in developed markets.

After narrowing the possibilities on the basis of an appraisal of the openness, settlement risk, legislation and liquidity of the various markets, Norges Bank recommends that the remaining countries be evaluated against a requirement of political and economic stability. Such assessments may be based on country risk indices, as described above in this submission.

To ensure consistency with the existing portfolio, remaining country candidates should then be evaluated according to their contribution to the Petroleum Fund’s return and risk.

The risk associated with investing in emerging markets is greater than that associated with investing in developed countries. In the opinion of Norges Bank, further work should be done to determine the degree of risk, and how it can best be handled. This will require a substantial amount of work, since there are several types of risk that must be investigated more thoroughly: settlement risk, country risk, market risk and exchange rate risk. An evaluation of whether investment in emerging markets should be permitted should be based on the results of this work. This means that the individual country should be evaluated on the basis of its settlement systems, legislation and political and economic stability. Moreover, potential markets must be evaluated on the basis of their size, liquidity, and effect on the Petroleum Fund’s return and risk.

If the country list were expanded, the question of whether the same countries should also be included in the benchmark portfolio would also have to be considered. The selection of countries and asset allocation are strategic decisions based on the objective of the management of the Petroleum Fund. Among other things, the establishment of benchmark portfolios should contribute to ensuring that the management is closely in line with the strategic objective of the portfolio. It therefore seems logical that any expansion of the country list should be accompanied by a change in the benchmark portfolio. If the benchmark portfolio is changed, the manager will have a strong incentive for including the new countries in the actual portfolio.

Before Norges Bank can invest capital in new countries, systems must be adapted and expertise acquired. Investing in emerging markets is more demanding in terms of a continuous assessment of whether the countries in question fulfil the various criteria at all times. It may therefore take some time before Norges Bank is operationally in a position to invest in emerging markets. If a decision is made to expand the country list, it could mean that Norges Bank would have to give lower priority to some other areas in its operational management. This implies that, in principle, an expansion of the country list should be considered in the light of other important responsibilities associated with the management of the Fund.

(1) IFC: Emerging Stock Markets Factbook 1998

(2) The IFC defines the stock market in Portugal as emerging, while the MSCI includes Portugal in its index of developed stock markets. Thus Portugal is already included in the Petroleum Fund’s investment universe.

(3) Source: GSCS Ltd. IFC Emerging Stock Markets Factbook 1998.

(4) GSCS Ltd describes values over 70 as strong and solid. We have set the requirement at 65 in order to avoid excluding too many countries.

(5) I.e. risk of large, discontinuous price jumps as a result of rare events or shocks.