Do’s and Don’ts of Natural Wealth Management Leonor Coutinho Europrism Research Saturday, 26 November 2011 Presentation for the Conference “The Hydrocarbon Wealth of Cyprus: Equitable Distribution and Regional Politics”, organized by the Friedrich Ebert Foundation (FES) and the PRIO Cyprus Centre (PCC), Nicosia Buffer Zone, Chateau Status, Cyprus.

Outline of the Presentation Risks of Natural Resource Exploitation Optimal Natural Resource Management Principles The Don’ts Some Examples (Don’ts) Nigeria Saudi Arabia Mexico Selected Success Stories Botswana Indonesia Chile

The Risks of Natural Resource Exploitation Problems of associated with hydrocarbon wealth are shared by other types of natural resource wealth. Malaises associated with natural resource exploitation: The Dutch Disease: contraction of other tradable sectors of the economy Deterioration of governance: the “Voracity Effect” Poor investment decisions (e.g. overcapacity in infrastructure) Under investment in human capital Underdeveloped financial markets: too much government weight Macroeconomic instability: output volatility correlated with ups and downs of resource prices; amplified economic cycles

Optimal Natural Resource Management Principles Consumption smoothing and inter-generational equity: take into account the volatility of prices and the resource exhaustibility => base expenditures on measures of permanent income National revenue funds as vehicles for savings Fiscal rules to control government expenditures The optimal amount of savings and the control of government budget deficits requires measures of permanent income: Independent forecasts Use of hedging instruments to reduce risks Optimal investment strategies: maximize returns Government vs private decisions (distribute dividends) or a combination of both Independent investment council

The Don’ts Allow expenditures to be highly correlated to resource prices real exchange rate appreciation and exchange rate volatility amplification of business cycles sudden cuts in investment Borrow on natural resource collateral: Debt Overhang macroeconomic instability nominal devaluations undermined by price inflation Large governments: crowding out of the private sector Lack of economic diversification Short sighted investment decisions

Some examples… Nigeria (oil) Collapse of agriculture and failure to industrialize Migration to urban areas: desertification and inequality Accumulation of unsustainable debt Saudi Arabia (oil) Poor diversification: real exchange rate overvaluation Public sector expansion as the main mechanism for job creation Overinvestment in infrastructure Mexico (oil) Public overinvestment in infrastructure: crowding out of private sector Large current account imbalances; accumulation of government debt Nominal devaluation undermined by inflation Currency crisis

Selected Success Stories of Natural Resource Exploitation Botswana (diamonds) Revenue Stabilization Fund Medium term expenditure plans based on long-term projections Mineral revenues used mostly for planned investment and the rest saved Currency peg to South African rand has worked as an anchor for inflation Relatively open trade policy Some diversification achieved through manufacturing, but limited Still risks are always looming: Investment policy did not prevent unproductive public investment Social tensions and inequality HIV prevalence

Selected Success Stories Indonesia (oil) Accumulation of de-facto government surpluses (although formally there is a balanced-budget rule that could have meant high volatility of expenditure) Control over the borrowing of state-owned oil companies Expenditure focusing on non-oil exporting sector, specially agriculture (R&D, and infrastructure), and health and education Private investment and development of labour-intensive industry Reduction of poverty and inequality Nominal devaluations Special conditions: Role of technocrats Strong non-oil interest groups

Selected Success Stories Chile (copper) Copper Stabilization Fund Fiscal Policy Rules: target for structural budget balance; independent forecasts for the trend price of copper and trend output Mixed of public and private ownership in copper sector guarantees that some profits are re-invested in the country but also attracts FDI with positive spillovers Contained inflation and relatively good business climate allowed for diversification: fisheries, wine, tourism Special conditions: Role of technocrats Competitive RER policy via a PPP crawling band-rule (and occasionally through significant discrete nominal devaluations) and capital controls from some time; recently inflation targeting and floating with possibility of intervention