Using Extractive Revenues for Sustainable Development

1. How to manage natural resource revenues to ensure fiscal sustainability

Key attributes of non-renewable natural resource revenues

There are three key attributes of non-renewable natural resource revenues. First, they are intrinsically temporary in that they result from the depletion of a finite stock of resources, with a greater or lesser production horizon depending on accessibility, quality of ores and technological developments (Fasano-Filho, 2000; Solow, 1986). Second, given that commodity prices can be highly volatile and prone to booms and busts, they are an unreliable source of income. Natural resource revenue windfalls may lead to a more-than-proportional increase in discretionary spending that magnifies the pro-cyclicality of the economy, leading to a deterioration of government accounts and subsequently to increased debt accumulation and higher borrowing costs (Tornell and Lane, 1999). Third, natural resource revenues, particularly in the context of large windfalls and strong global demand, can also place strong upward pressure on the national currency and domestic prices (Gylfason, 2001). Consequently, the inflationary pressures from natural resource production can constrain the competitiveness in global and regional markets of other sectors of the economy, such as manufacturing and agriculture. This distorts the economy and limits potential diversification, which may provide greater opportunities and a broader base for socio-economic development. This effect is generally referred to as “Dutch disease” (Corden, 1984).

The importance of a clear commitment to a coherent, consistent and disciplined fiscal policy and macroeconomic management framework

Given these attributes of natural resource revenues, two principal concerns underlie the challenge of effectively transforming natural finite assets into human, social and physical capital: 1) managing the counter-cyclical nature of resource revenue flows to ensure that there is a consistent level of resources available for spending; and 2) ensuring productive gains from the funds that are spent, in line with the 2030 Sustainable Development Agenda.

While experience varies across producing countries, a sensible approach for resource-dependent countries is to establish earlier rather than later a clear resource revenue management framework and fiscal policy that stabilises the budget and appreciates the country-specific trade-offs of more spending or more saving over time, and how doing so can support the growth of a more sustainable diversified economy.

Stabilisation funds as an integral part of the fiscal policy and macroeconomic management framework

Stabilisation funds are a possible tool to achieve budget stabilisation. According to the IMF, countries that would benefit from the establishment of stabilisation funds are those that are resource dependent as they derive at least 20% of their revenue from natural resources and need to counter the cyclical component linked to the commodity cycle (see e.g. Das et al., 2010). Indeed, the main challenge for policy makers in resource-dependent countries is dealing with the volatility of prices.

While stabilisation funds act to dampen volatility by smoothing out the revenues received by the government, they should not be expected to operate and achieve their policy objectives in isolation. Stabilisation funds are only effective and sustainable over time as part of a coherent and disciplined fiscal policy framework. Stabilisation funds are a tool in a broader macroeconomic management framework that needs to be coherent, consistent and disciplined. This means that stabilisation funds should be integrated with the budget through deposit and withdrawal rules and procedures on how much and when withdrawals can be made to the government budget, which are rigorously articulated and defined in the legislative mandate. Establishment of the fiscal policy framework and connected stabilisation fund should occur before production commences, or as soon as possible thereafter.

Chile demonstrates policy coherence, consistency and commitment with regard to managing the volatility of commodity prices (see e.g. Frankel, 2010). Authorised by the 2006 Fiscal Responsibility Law, Chile established in 2007 the Fondo de Estabilización Económica y Social (FEES), a stabilisation fund with the purpose of financing budget deficits that result from the economic cycle or international shocks that may affect the price of copper – the country’s main export (Frankel, 2010). Chile’s FEES achieves its policy objective through clearly defined deposit and withdrawal rules and complete integration with the budget.

Since its inception, FEES has mainly been used for financing the fiscal deficit in 2009 and as a countercyclical stimulus for addressing the external economic shocks that followed the 2008 global financial crisis. This reinforced public support for the fund and its mission to support the Chilean economy across society, countering previous pressure from different political actors to use the fund’s resources. Continued support was also shown in the new coalition government that assumed power in 2010 leaving the fiscal policy framework and fund’s operation unchanged. The FEES has thus performed well in its function of stabilising government spending across the economic cycle, while expenditure rules have limited the volatility of natural resource revenues from entering the budget.

Chile’s FEES, for example, receives any effective fiscal surplus beyond 0.5% of GDP from the previous year. The FEES may also receive resources from the issuance of debt or other resources that may be contributed by law. Moreover, annual fiscal expenditure is contingent on permanent fiscal revenues and the balanced budget rule. The estimation of permanent fiscal revenue is based on the forecast of the price of copper (the average for the next ten years) and the growth trend of the Chilean economy. Two expert committees that are independent of government carry out the forecasts of the price of copper and of the inputs to estimate the growth trend of the economy. This limits any potential manipulation. Legislation authorises the Chilean Minister of Finance to define the timing and the amount of withdrawals, and then publicly disclose this information. Withdrawals are publicly disclosed in a clear manner and must be authorised by decree by the Minister of Finance. They are implemented by the Central Bank and the General Treasury and are subject to review by the Comptroller General’s Office.

Consistency over time, commitment and policy alignment support the effectiveness of the stabilisation fund at fulfilling its policy objective, namely budget stabilisation. This means that other policies and financial commitments should not overlap with the policy purpose of the stabilisation fund. For example, there is no economic sense in putting aside natural resource revenues in a stabilisation fund and then increasing government debt if the risk-adjusted returns of the stabilisation fund are lower than the interest costs of the government debt. Finally, as one of the main aims of stabilisation funds is to reduce the effects of commodity price volatility and address the exhaustibility of natural resource revenues, this calls for consistency and commitment across multiple years in the establishment and maintenance of the fiscal rules and procedures that underwrite the policy objectives.

Withdrawal rules may not, however, be able to account for all contingencies where withdrawals are legitimate. Large and unexpected negative shocks can arise from economic sources and natural disasters. Making extraordinary withdrawals to mitigate and stabilise the effects of unforeseen events is a justifiable use of a stabilisation fund. Although extraordinary and unforeseen events by their nature cannot be planned for, the process and procedural rules by which extraordinary spending is decided can be (Ang, 2010). As such, this provides an additional commitment mechanism by forcing the justification of discretionary withdrawals and requiring that they be tied to extraordinary events.

The size of the stabilisation fund

The amount of resources to be put in stabilisation funds depends on the exhaustibility of resources and the price formula which varies across countries. There is no absolute size for a stabilisation fund. Rather, the size will reflect the policy choices that determine how much revenues should be saved and for how long (see also the first section of part two of this report on the trade-off between saving and spending natural resource revenues).

The investment policy should be aligned with the budget stabilisation policy objective

Stabilisation funds are sponsored by governments with the purpose of stabilising the regular inflow of natural resource revenues into the government budget. The policy objective of budget stabilisation should dictate the investment policy, as evidence shows that alignment of the investment policy with the policy objective supports the effectiveness of the investment function. The investment policy that the government sets acts to guide the asset allocation of the fund, setting performance benchmarks, the level of risk that can be taken, and the assets in which the fund can be invested. The investment policy can be defined by strict rules, or it can be based on principles such as the prudent person rule. The investment policy could also be a combination of strict rules and principles.

Stabilisation funds by design should have an investment policy that limits investment to low-risk and highly liquid fixed-income securities and cash. In fact, the key objective of the stabilisation fund is not to maximise returns, but rather hedge fiscal revenues against fluctuation of commodity prices. For stabilisation funds, investing in safe foreign assets is necessary to ensure sufficient liquidity to counter price volatility. Stabilisation funds are not effective vehicles for helping satisfy domestic capital needs, particularly in capital-starved developing economies where domestic assets are likely to be highly correlated with commodity prices given the structure of resource-dependent economies. In such contexts, the formula for allocating natural resource revenues (the deposit and withdrawal rules) can be designed in such a way to favour current spending via the budget over the accumulation of savings beyond what is necessary to support stabilisation and short to medium-term precautionary savings.

Resource-dependent developed and developing economies alike may be exposed to criticism for pursuing a conservative investment policy when returns on investment are low (e.g. depreciations of foreign currencies) or in capital-starved contexts. In this respect, transparency is an important tool, not just to report on performance, but more importantly to build trust among citizens and educate the public and stakeholders on what and why conservative investment policies have been put in place in the first instance (see Box 1.2).

Investment management of stabilisation funds

The effectiveness of a natural resource fund as an institutional investor is supported by a portfolio asset allocation that reflects the weight and risk profile of the fund’s policy objective(s). For example, some governments have tasked natural resource funds with achieving multiple policy objectives. This could pose problems, as different policy objectives can have different organisational resourcing needs and a different investment focus and time horizon. As such, a fund that is designed to deal efficiently with one objective may not be able to adequately and efficiently handle problems and challenges (or opportunities) that arise from another set of objectives, such as having sufficient short-term liquidity to fulfil a stabilisation mandate while also maximising the risk-adjusted return on intergenerational savings. Hence, some governments avoid this dilemma by limiting the investment scope and organisational structure of a fund to a single policy objective. For example, Chile created two funds, namely the Pension Reserve Fund and the Economic and Social Stabilization Fund. Before the crisis the stabilisation fund had accumulated assets for USD 20 billion. Almost half of the fund was used to counter the consequences of the financial crisis.

This dilemma could be accounted for if, however, the investment mandate and in turn the asset allocation of the portfolio clearly reflects the weight and risk profile of each policy objective. For instance, a long-term savings fund could still hold a percentage of highly liquid low-risk assets in its portfolio, which allows the fund to double as a precautionary savings fund. Or, the fund could simply have two distinct portfolios. The National Fund of the Republic of Kazakhstan (NFRK) is an example of a natural resource fund that covers two policy objectives (stabilisation and savings) via two distinct portfolios of different time horizons, instead of two distinct funds. The stabilisation portfolio, accounting for 32% of the total market value of the NFRK assets, has a short time horizon and is invested in highly liquid assets (e.g. US Treasury securities). The savings portfolio has a long time horizon and is invested in developed capital markets with 80% in fixed income and 20% in equities. Investments in Kazakhstan are prohibited.

Although stabilisation funds are by design cautious and risk-intolerant institutional investors, the alignment of the investment mandate with the policy objectives is no less critical to effective performance than a more sophisticated institutional investor. Chile demonstrates adherence to this principle. The main goal of the investment policy of Chile’s FEES is to maximise the fund’s accumulated value in order to partially cover cyclical reductions in fiscal revenue, while maintaining a low level of risk. The investment policy explicitly states that the investment should be passive, tracking widely used market benchmarks, and that the portfolio managers should not deviate from those. The asset allocation set in the investment policy is 55% sovereign bonds, 34% money market instruments (15% in bank deposits and 19% in sovereign securities), 7.5% in equities and 3.5% in inflation-indexed sovereign bonds. No securities should be emitted by a Chilean entity. The currency composition is specified as 40% in dollars, 25% in euros, 20% in yen and 7.5% in Swiss francs for the fixed-income portfolio, expressed as a percentage of the total portfolio. Each asset class is benchmarked to a widely used market benchmark.

Since the creation of the FEES in 2007, only one review of the investment policy has been carried out (in 2013) with a view to improving its consistency with the goals of the fund. Review of the investment policy is expected to take place every three or four years. The investment policy proved to be successful in the wake of the global financial crisis, as the fund was invested in securities denominated in reserve currencies that benefited from flight-to-quality effects and that were highly liquid, which facilitated the withdrawal when the government needed the resources. Put simply, the clear alignment of the investment policy with the policy objectives set for the FEES meant that the fund could fulfil its objective function of providing precautionary savings in a time of crisis.

With savings funds, in contrast, the longer time horizon inherent to the policy objective in principle affords a lower liquidity preference and a greater risk tolerance. For example, a savings fund that aims to maximise the value of accumulated natural resource wealth for future generations would have a time horizon that, in theory, spans decades or even into perpetuity. In that case, the fund would be in a position to invest for the long and very long term (i.e. decades). This means that the fund would not be under pressure to sell assets during periods of poor market performance and it would be able to invest without concern for short-term liquidity. In brief, the fund could invest in asset classes that are more volatile and riskier in the short term (e.g. equities) but that yield a greater long-term return (see, Dimson, Marsh, and Staunton, 2002; Fama and French, 2002; Goetzmann and Ibbotson, 2006). This rationale underpins the investment strategy Norway’s Government Pension Fund–Global, which has a portfolio that is heavily invested in global equities markets (Chambers, Dimson, and Ilmanen, 2012). The understanding is that although equities markets are more volatile in the short term, they are mean reverting and higher yielding over time than lower-risk fixed-income securities. Evidence shows that long-term value creation is contingent on the management of risk and uncertainty. Poorly governed investment institutions rarely take risk planning seriously and they insufficiently resource (with time and expertise) the investment decision-making process in relation to the level of risks that the fund is taking (Clark and Urwin, 2008). Good investment governance practices, in contrast, generate positive financial returns (see e.g. Ambachtsheer, Capelle, and Scheibelhut, 1998; Ammann and Zingg, 2010; Iglesias and Palacios, 2000; Mitchell and Hsin, 1997). The level of acceptable risk taken should be contingent on the organisational and human resources capabilities.1

Governance of natural resource funds

As pools of financial assets, natural resource stabilisation and savings funds are institutional investors. As such, there are important considerations as to how they are governed as financial institutions. Weak investment governance can lead to significant financial losses, while undermining the stabilisation function of the fund (see Box 1.1).

Box 1.1. Learning from investment governance failures

An exemplary case of poor investment governance is the Libyan Investment Authority (LIA), as documented by Khalaf et al. (2011) and Saigol and O’Murchu (2011). Established in 2006 with USD 65 billion, the LIA set out to be a world-class institutional investor investing across asset classes and international markets. What resulted was a series of opaque and high-risk investments in hedge funds and complex derivative transactions. Although the LIA had committed financial professionals, evidence suggests that a close-knit group with close ties to Seif Gaddafi (Muammar Gaddafi’s son) decided most deals. Many deals were loss making. Some investments were run through or advised by firms of Libyan elites that were well connected to the Gaddafi family, who were also paid large management fees, indicating possible corruption and misappropriation.

Governance as it relates to institutional investment funds refers to the structure, process and practices that establish the relationship between the owner/sponsor of the fund, the board of directors, the management, and any third-party asset manager, and the criteria that guide investment decision making. In short, the governance architecture dictates how external and internal authority is utilised and how financial capital is distributed and mobilised in pursuit of institutional objectives (i.e. the policy objectives set forth in its establishment and their associated investment criteria).

Evidence shows that investment decision making shielded from short-term political cycles drives better performance. It is crucial for the success of natural resource funds, as with any public institutional investor (e.g. a public pension fund) that they are free from unwarranted political interference and influence. Indeed, research has shown that political interference in investment decision making can result in financial damage (see e.g. Romano, 1993). This is distinct from the sponsoring authority’s (e.g. the parliament, Ministry of Finance, etc.) role and responsibility in establishing the broader aims, objectives and restrictions as defined in the investment mandate.

Interference is mitigated by leaving investment decision making, such as specific decisions on asset allocation and manager selection, to an independent board that is charged with operationalising the investment mandate and any other guidelines that the sponsor has established. This also means that appointments to key decision-making bodies are decided on the basis of one’s domain-specific expertise and experience, and not on the basis of one’s personal connections (Clark, 2007). Investment decision making should be guided by independent and professional experts that are free of direct political influence, and with clear boundaries defining the separation, and the roles and responsibilities of the fund’s sponsor, the board, and the fund’s manager, with a view to ensuring that the funds are insulated from the short-term political cycle and political interference, especially when conservative and risk intolerant asset allocation shifts towards more diversified investment strategy in order to maximise long-term risk-adjusted returns.

Disclosure mechanisms that provide key information on key decisions (e.g. manager selection, board appointments, asset allocation) and financial performance, which are regularly and independently audited for consistency and reliability, are also important for driving better performance. Transparency and accountability, which are operationalised through regular reporting and auditing practices, are crucial for efficient budgetary and investment functions of the natural resource fund. Good practice entails extensive (and duplicative) internal and external oversight across all levels (see Box 1.2). This drives better decision making and better behaviour among those that have been tasked with managing a country’s national wealth. Disclosure and regular auditing help prevent mismanagement and potential malfeasance.

For example, Mexico follows good practice in the governance of its new natural resource fund established in 2015, the Fondo Mexicano del Petróleo para la Estabilización y el Desarrollo (FMP). Mexico has placed significant emphasis on ensuring that the members of the technical committee, which is the board of the FMP, possess sufficient domain-specific expertise and experience.2 Although the technical committee is composed of three government representatives, the Minister of Finance (president of the committee), the Minister of Energy and the Governor of the Central Bank, the technical committee also has four independent members that are appointed by the federal executive and ratified by two-thirds of the senate. To be eligible, the independent members must have a professional title (bachelor’s degree) no less than ten years old at the day of the appointment in any of the following areas: law, management, economics, finance, accountancy, actuarial science, engineering or subjects related to the FMP. And, they must have served for at least ten years in activities that provide the necessary experience and are related to the functions of the committee, either in the professional, educational or research areas. Independent members are elected for staggered eight-year terms with the possibility of re-election. Moreover, independent members must not have been a public servant at any level of government, have held elective positions, or have been directors of any political party during the two years prior to appointment. They must not hold other positions in government and may not develop activities in the private sector, which involve a conflict of interest. They must not hold simultaneous positions or employment that prevent the exercise of their function as independent members. Moreover, they must not have been a shareholder, partner or owner, officer, director, legal representative or advisor of any assignee or contractor in the two years prior to their appointment or have pending litigation with any assignee or contractor at the day of the designation.

Box 1.2. Employing disclosure mechanisms for transparency and accountability

Externally, transparency and accountability are vital for sustaining on-going public confidence in the fund’s policy objectives and the investment mandate, particularly in the context of democratic governance. Transparency is also important for ensuring international legitimacy, allowing natural resource funds unconstrained access to global financial markets and potentially investment partnerships necessary for achieving target financial returns and sufficient risk management opportunities. Without unconstrained access to investment and risk management opportunities, the fund may not be able to achieve its return targets and therefore the policy objectives it is supposed to support. Transparency is also critical to the internal operations of the fund and its relationship with the sponsor. The sponsor must be clear in the expectations it sets for the fund, otherwise those charged with executing the investment mandate may not be able to align the investment mandate with the policy objectives it is supposed to serve, thus reducing its effectiveness. Likewise, the fund and its managers must be transparent to the sponsor so that the sponsor is able to monitor effectively that the fund is meeting the objectives and expectations that the sponsor has set for the fund and that the fund continues to align with wider public financial management and fiscal policy. Transparency and accountability are crucial in preventing mismanagement and potential malfeasance. Consequently, a robust disclosure and audit framework is necessary for guiding functional efficiency, and policy and operational alignment and commitment over the long term (Gelpern, 2011).

Natural resource revenue management in Chile demonstrates good practice in terms of transparency and accountability, which underpins the functional efficiency and continued public legitimacy of the FEES. In order to ensure a proper and effective accountability framework, a range of reports are prepared by the different bodies and stakeholders involved in the FEES’s management. The Ministry of Finance is required by law to provide the Finance Commissions of both houses of Congress and the Joint Budget Commission of Congress, monthly and quarterly reports about the fund. The Financial Committee supporting the Ministry of Finance also prepares a publicly available annual report about its activities and recommendations, which is presented to the Minister of Finance, the Finance Commissions of both houses of Congress and the Joint Budget Commission of Congress. The Central Bank provides the Ministry of Finance with daily, monthly, quarterly and annual reports about the portfolios under their management, and the services provided by the custodian. External managers must also provide the Ministry of Finance with daily and monthly reports about the portfolios under their management. As of 2011, the General Treasury, which is a dependent organisation of the Ministry of Finance, prepares the financial statements according to International Financial Reporting Standards (IFRS). The financial statements are independently audited in keeping with Chilean auditing standards. As of April 2014, the General Treasury is also responsible for monitoring compliance with the FEES’s investment guidelines, validating external managers’ fees, and other back office tasks. In addition, the Comptroller General’s Office, an autonomous body, is responsible for auditing all public sector finances and, therefore, the FEES. In addition, and although not mandated by law, the Finance Ministry publishes an annual report about the FEES, which is publicly available.

Notes

← 1.  For example, the typical portfolio of a stabilisation fund is not significantly different from a foreign exchange reserve portfolio managed by a central bank. For this reason, stabilisation funds are often managed within existing government agencies, often with the central bank acting as the asset manager for the Ministry of Finance. Conventional government agencies are not, however, normally designed and resourced to invest directly or delegate investment management contracts in a larger range of asset classes of different risk profiles in public and private markets. For natural resource funds with longer investment time horizons and a greater short to medium-term risk tolerance, a special-purpose investment agency may be better placed to access and to maximise risk-adjusted returns over the long term.

← 2.  The FMP is a public trust of the Ministry of Finance and the Central Bank is appointed to act as a trustee. Under this scheme, the corporate governance of the FMP rests with the technical committee that performs various duties related to the receipt of hydrocarbon revenues, investment management, and spending. The committee appoints an executive co-ordinator of the FMP who manages the financial aspects of the contracts, including the calculation and execution of the payments derived from them to different parties. The committee determines the investment and risk-management policies for the long-run reserve. The committee instructs the staff to execute the transfers to the federal government. The committee approves its annual budget and working programme. If and when the long-run reserve exceeds 3% of GDP, the committee proposes to the congress an allocation of additional transfers amongst several pre-specified purposes (e.g. amount to the universal pension system vs. investments in science). The committee must also comment on the federal government’s proposal for the size of the state dividend from Pemex (the national oil company).