Outline of the Presentation

1. Do’s and Don’ts of Natural Wealth ManagementLeonor CoutinhoEuroprism ResearchSaturday, 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.

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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