Natural Resource Booms and Fiscal Responsibility

Eric Parrado Universidad Adolfo Ibez

Sovereign Wealth Management for Mongolia - A YPAD Focus Mongolia YGL Learning Journey Terelj Hotel, Mongolia September 10, 2011

Agenda
Motivation Fiscal rules Fiscal stabilization in Chile:
Institutional arrangement and investment policy A commitment to transparency Common and unique features of Mongolia Fiscal Stability Law (FSL) Some lessons that I learned regarding SWFs Concluding remarks
Management of flows Management of stocks

Motivation: Importance of copper

In terms of Chilean GDP, copper has represented more than 6% of GDP in recent years, while the mining sector accounted for almost 7.5%
In terms of exports, copper contributed with almost 30% of total exports In terms of fiscal revenues, copper accounted for more than 15% of governments revenues. Internationally, Chilean copper production represented more than 35% of global production.

March 2011 US$ per pound

0,00
Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

1,00

1,50

2,00

3,50

4,00

4,50

Real Copper Price (Jan.90-Dec.03)

0,50

2,50

3,00

5,00

March 2011 US$ per pound

0,00

1,00

2,00

3,00

4,00

5,00

0,50

1,50

2,50

3,50

4,50

Real Copper Price (Jan.90-Apr.08)

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

1,50

2,00

2,50

3,00

5,00

March 2011 US$ per pound

0,00
Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Real Copper Price (Jan.90-Dec.08)

0,50

1,00

3,50

4,00

4,50

0,50

1,50

2,50

3,00

4,00

5,00

March 2011 US$ per pound

0,00
Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Real Copper Price (Jan.90-Mar.11)

1,00

2,00

3,50

4,50

Fiscal Rules
They anchor expectations for sustainable public finances In early 1990s only a few countries adopted fiscal rules: 7 countries. Right now more than 80 countries had in place these rules: 21 advanced, 33 emerging markets, and 26 low income countries The use of fiscal rules is associated with improved fiscal performance: contribution to prudent fiscal policy

Fiscal Rules
A rule has to be credible with regard its ability to help deliver the required adjustment and put debt on a sustainable path But it should also have adequate flexibility to respond to shocks

Fiscal stabilization: Chiles fiscal policy framework

Flow management:
The fiscal structural surplus rule

Stock management:
Fiscal asset funds:
Pension Reserve Fund (PRF) Economic and Social Stabilization Fund (ESSF)

10

Fiscal stabilization: the fiscal structural surplus rule

The fiscal rule aims to protect Government spending from the effects of the economic and copper price cycles

Structural (i.e. medium term or trend) government income is calculated for the following year
This requires the input of three key parameters: the medium term price of copper, the economys long term output, and the returns of financial assets Yearly fiscal expenditure is then set so that
Structural Revenue Fiscal Expenditure = X% of GDP
11

Fiscal stabilization: the fiscal structural surplus rule

Example: All income comes from copper

Copper Price

Savings

Lon-term copper price

Use of savings

The long-term copper price defines permanent income, contributing to have a countercyclical policy

% of GDP

10%

Fiscal stabilization: fiscal balance and copper price

-6% 2% 4% 6% 8%

-4%

-2%

0%

1990

1991 1992
1993 1994

effective
1995 1996
1997

1998 1999 2000

2001

structure
2002 2003
2004

copper price -3 -2

2005 2006 2007

2008

2009 2010 (P)

0
-1

Copper price (US$ per pound)

Fiscal stabilization: the fiscal responsibility Law

Complements Fiscal Rule by focusing on the management of the stocks of financial assets generated by the Rule

Provides for the creation of two funds:

the Pension Reserve Fund (Feb. 11: US$ 3.9 billion) and the Economic and Social Stabilization Fund (Feb. 11: US$ 12.8 billion)

These government funds are separate from Central Bank reserves, which are managed by the independent Central Bank Permits the re-capitalization of the Central Bank over 5 years
14

Fiscal stabilization: Funds objectives

Pension Reserve Fund : supplement the financing of future contingent liabilities related to pensions Economic and Social Stability Fund: to finance potential fiscal deficits and to amortize public debt

15

Fiscal stabilization: virtues of the fiscal policy framework

n Counter-cyclical effect on the business cycle: under the rule Government spending is counter-cyclical n Ensures the financial sustainability of government policies, allowing for long-term planning, reduced spending volatility, and secure financing of ambitious social agendas n Protects export competitiveness during copper price booms by avoiding unsustainable fiscal spending increases and the resulting transitory exchange rate appreciations n Boosts public saving, reducing the need for historically volatile external financing in times of crisis or recession, thus eliminating a source of macroeconomic risk
16

US Millon

15000

20000

25000

10000

5000

0
14.916 15.223 17.192 17.251 17.132 18.770 19.771 19.460

Fiscal stabilization: Accumulation of assets - ESSF

Source: Ministry of Finance

19.268 18.791 19.164 20.211 19.541 19.334
19.618 17.980 17.507 15.767 15.015 14.343 13.709 12.928 12.604 5.257 6.097 6.937 7.777 8.337 4.377 200 1.750 2.700

Cumulative Withdrawals Fund Balance

11.285 11.257 11.237 11.130 11.100 10.888

10.799 11.104 12.472 12.852 12.988 12.582 12.720 12.792 12.834

9.278 9.278 9.278 9.278 9.278 9.278

9.428 9.428 9.428 9.428 9.428 9.428 9.428 9.428 9.428

Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Ago-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Ago-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Ago-10 Sep-10 Oct-10 Nov-10 Dic-10 Ene-11 Feb-11

US Millon

1000

1500

2000

3500

4000

4500

2500

3000

1.506 1.537 1.574 1.543 1.525 2.452 2.452 2.414

500

Fiscal stabilization: Accumulation of assets - PRF

Source: Ministry of Finance

2.390 2.331 2.376 2.507 2.423 2.398
2.458 2.448 2.515 2.503 3.367 3.407 3.457 3.472 3.536

3.421 3.413 3.406 3.374 3.365 3.300

3.319 3.759 3.763 3.877 3.918 3.795 3.837 3.859 3.871

Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Ago-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Ago-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Ago-10 Sep-10 Oct-10 Nov-10 Dic-10 Ene-11 Feb-11

Fiscal stabilization: Reduction of gross debt (% of GDP)

35% 30% 25% 20% 15% 10% 5%

0%
1992 1994 1995 1996 1997 1998 1999 2000 2002 2003 2004 2005 2006 2007 2008 2010
1993 2001 2009

Source: Ministry of Finance

Fiscal stabilization: the accumulation rule (% of GDP)

3.5 3 2.5
Contributions

ESSF

CBC's capitalization

PRF

2 1.5 1 0.5 0 -0.5 -0.2 0.1 0.4 0.7 1 1.3 1.6 1.9 2.2 2.5 2.8 Effective fiscal balance

Institutional arrangement
Investment Policy definition Minister of Finance

Financial Committee
Investment guidelines

Execution

Central Bank Custodian

Investment policy
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Initial
Sovereign and agency bonds Inflation-linked bonds Equities
66,5% 45% 30% 20% 15% 5% 3,5% 15%

Proposed
Liquid assets Corporate bonds

A commitment to transparency
The funds have operated in a very transparent manner since their establishment in 2006 To ensure that the public has access to the relevant information, the ministry of finance has created an exclusive website that holds all of the funds monthly, quarterly, and annual reports, the legislation pertaining to the funds, and the recommendations of the Financial Committee and its annual reports

A commitment to transparency
Chile has actively engaged in international initiatives to foster the transparency of SWFs
In particular, the SWFs of the world reached its transparency landmark agreement in Santiago in 2008 The so-called Santiago Principles reflect the commitment to enhance transparency with regard to the policies and activities of sovereign wealth funds

A commitment to transparency
Chile gets the maximum ranking in international transparency index elaborated by Sovereign Wealth Funds Institute (first quarter 2011)

Some lessons that I learned regarding SWFs

SWFs are mechanisms for attaining and retaining fiscal discipline They are a mechanism for selfinsurance in a volatile and unfriendly world economy

Common and unique features of Mongolia FSL

The current draft of the FSL includes these best international practice features:
Structural revenue of major minerals Expenditure rule Fiscal consolidation:
Reduction of government deficits Sustainable debt accumulation

Structural revenue of major minerals

Example: All fiscal revenues come from copper

Price of copper Long term price of copper

Savings

Use of savings Long term price of copper defines fiscal returns in the long term (permanent income hypothesis) and foster a countercyclical fiscal policy

Structural revenue of major minerals

Alternatives:
Council that estimates long-term price of minerals Formula that takes the possible subjectivity out

Structural revenue of major minerals

Formula option:
A combination of both historical data and projections long-term trend

The estimation of long-term price of minerals should consider credible data sources:
IMF Commodity Prices database (history) Bloomberg (projections)

Structural revenue of major minerals: Comparison

Long-term price of copper
7000 6000 5000

US$ per ton

4000 3000 2000 1000 0 Current Price Formula Chile Council

Expenditure rule
Alternative: Total budget expenditure growth shall not be more than the GDP growth rate of a particular year It sounds very prudent, but it has a problem when GDP growth is weak Key idea: keep fiscal expenditure despite the business cycle (countercyclical fiscal policy)

Expenditure rule
The rule should tackle two issues:
Having a sustainable fiscal expenditure Avoiding sudden jumps in the transition period

Proposal: Total budget expenditure growth of a particular year shall not be more than the maximum between non-mineral GDP growth and non-mineral GDP growth trend (average)

Expenditure rule

Non-mineral GDP growth

Non-mineral GDP growth trend

Rule: Expenditure should be less than the Max (actual GDP growth; GDP growth trend)

Expenditure rule
Rate of growth Non-mineral GDP growth Maximum fiscal expenditure Non-mineral GDP growth trend Years

Rule: Expenditure should be less than the Max (actual GDP growth; GDP growth trend)

Fiscal consolidation: fiscal deficits

Reduction of government deficits
2% or surplus later from 2013

Fiscal consolidation: debt accumulation

Sustainable debt accumulation Alternative: Hump shaped debt accumulation
40% from 2013

Some lessons that I learned regarding SWFs

Keep it legitimate!
Main risk of any fiscal discipline device: political illegitimacy Investment policy: shared decision, with autonomous body playing lead role Government does not administer a penny! Financial insurance needs political insurance!

Some lessons that I learned regarding SWFs

Keep it transparent!
Everyone should know what is going on, all the time Report a lot Obligatory, regular and external audits

Some lessons that I learned regarding SWFs

Keep it simple!
Boring but useful principle: one instrument, one target If macro stabilization is the goal, then must have simple, safe and relatively liquid portfolio Invest everything outside the country: avoid Dutch disease

Some lessons that I learned regarding SWFs

Keep it fiscal! Avoid overload of tasks: social programs, public infrastructure, socially-responsible investments are desirable goals: that is why they should be funded out of budgets

Concluding remarks
The successful Chilean experience to manage commodity booms has contributed to reduce economic volatility and increase the resilience of the economy An important general lesson of this process is that governments should avoid short-term temptations to spend significant temporary surpluses Paradoxically, this policy gains legitimacy in the rainy days when governments need additional resources to support their economies

Concluding remarks
If natural resource booms are well managed they must be a blessing for any country
Today many nations have recently developed or are developing SWFs To them a simple message:
Keep it legitimate! Keep it transparent! Keep it simple! Keep it fiscal!

Natural Resource Booms and Fiscal Responsibility

Eric Parrado Universidad Adolfo Ibez
Sovereign Wealth Management for Mongolia - A YPAD Focus Mongolia YGL Learning Journey Terelj Hotel, Mongolia September 10, 2011