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Commodity Prices, Sovereign Wealth Funds, and Fiscal Policy: Lessons from Chile and Norway Klaus Schmidt-Hebbel Catholic University of Chile kschmidt-hebbel@uc.cl Getúlio Vargas Foundation and VALE Conference on The Economics and Econometrics of Commodity Prices, Rio de Janeiro, Brazil, 16-17 August 2012

Key Issues Resource-rich economies (RREs) at critical juncture: Decade of high commodity prices resource boom Most RREs lack appropriate fiscal institutions Fiscal stance: often weak and ineffective in promoting macro-financial stability, growth, and equity Fiscal position vulnerable to commodity price reversal Chile and Norway: two RREs with decade-long experience of fiscal reform and good performance They show the way forward in four key fiscal policy areas

Outline 1. Chile s Fiscal Institutions and Policy 2. Norway s Fiscal Institutions and Policy 3. International Evidence on Fiscal Policy and Macroeconomic Performance in RREs 4. Lessons on Fiscal Institutions for RREs 5. Conclusion

1. Chile s Fiscal Institutions and Policy

Chile s Fiscal Policy Institutions in International Comparison (1) Institution Fiscal Responsibility Law Financial Management of Budget Budget Horizon Fiscal Rule Sovereign Wealth Funds Marks X

Chile s Fiscal Policy Institutions in International Comparison (2) Institution Management of Gov. Balance Sheet Marks X Budget Accountability + Transparency External Control and Auditing Fiscal Ad hoc Committees Fiscal Council X

Chile s Fiscal Rule Cyclically adjusted government balance rule implies a-cyclical government spending (automatic tax stabilizers are still counter-cyclical) Unique: targets government spending to cyclicallyadjusted revenue, adjusting for cyclical revenue due to cycles in GDP and mineral prices Has been in place since 2001 Strong governance and political economy / support Has generally worked well Except in 2009-10: rule was overruled because of insufficient counter-cyclicality; reestablished 2011 Yet requires technical and institutional refinements

A Simple Rule (1) Cyclical net saving (cyclically adjusted balance minus actual balance) is determined by cyclical revenue (c.a. revenue minus actual revenue): B * t - B t = (R t * -G t )-(R t -G t ) = = NMTR t * - NMTR t + MTR t * - MTR t +CR t * -CR t + MR t * - MR t Non-mining Tax Rev* = NMTR* = f (output gap) Mining Tax Rev* = MTR* = f (trend mineral prices) Mining Transfers* = CR*+MR* = f (trend min prices)

A Simple Rule (2) Actual overall government spending equals trend structural revenue net of structural balance: G = R* - B* Hence government spending G is a-cyclical Government sets target for c.a. balance B* (net c.a. saving) Committees project trend GDP and mineral prices required for estimating c.a. revenue R* (strong political economy)

GDP Growth: Committee Forecasts and Actual Growth (%) 6% 5% 4% 3% 2% 1% 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011-1% -2% GDP Growth Commi ee's Projected Average Trend GDP Growth Average Actual Future Growth

Copper Prices: Committee Forecasts and Actual Prices ($/lb) 4.5 4.0 3.5 US$/Copper pound 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 PCu Commi ee's Long Run PCu Projec on Average Actual Future PCu

Chile: Actual and cyclically-adjusted Gov. Balance (% of GDP) 9% 7% 5% Ra o to GDP 3% 1% -1% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010-3% -5% Cyclical Balance Component Actual Balance Cyclically Adjusted Balance

Chile: Gov. Revenue and Expenditure Growth Rates (%) 25% 15% Real rate of growth 5% -5% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009-15% -25% Central Government Revenue Central Government Expenditure

Chile: Gross Assets, Gross Liabilities, and Net Assets of the Government, 1990-2010 (% of GDP) 30% 20% 10% Ra o to GDP 0% -10% -20% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009-30% -40% Gross Assets Gross Liabili es Net Assets

Chile: International Country Risk Guide Index (0-100) and EMBI Spread (in bp), 1990-2010 85 83 81 79 77 75 73 71 69 67 65 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 250 230 210 190 170 150 130 110 90 70 50 EMBI Chile ICRG Composite

Chile: Assets held in SWFs, 2001-2010 (% of GDP)

Rule s Fiscal and Macroeconomic Effects Reviews and research suggest Chile s fiscal rule has: Lowered pro-cyclical bias of fiscal policy Contributed to fiscal sustainability and credibility, lowering the sovereign risk premium Reduced macroeconomic uncertainty Lowered volatility of GDP, interest rates, and exchange rate Reduced dependence on foreign financing during downturns Improved protection of social programs during cyclical downturns

2. Norway s Fiscal Institutions and Policy

Norway s Fiscal Policy Framework Oil production peaked in 2005 and is projected to decline significantly in coming years 2001: Norway adopted new fiscal framework aiming at macro stability, fiscal sustainability, intergenerational equity, and resource use efficiency Three institutional pillars: (i) Structural fiscal rule (ii) Sovereign wealth fund (iii) Full integration of SWF into government budget

Norway s Past and Projected Oil Production, 1970-2030

Norway s Fiscal Rule (1) Oil rents are transferred to SWF Cyclically-adjusted non-oil budget deficit financed by average transfer from the SWF at an (imputed) 4% real return on SWF investments Annual deviations of the latter transfer are allowed for further discretionary government spending geared at counter-cyclical stabilization and expenditure smoothing

Norway s Fiscal Rule (2) Therefore government spending is equal to: trend values of government tax revenue and excise duty revenue and of Norges Bank transfers minus: trend values of unemployment benefit payments and of net interest payments and transfers plus: 4% real return on SWF investments plus or minus: discretionary spending adjustment for cyclical stabilization and to avoid excessive spending volatility Hence Norway s fiscal rule: 1. is consistent with c.a. balance measure (like Chile) 2. is consistent with inter-generational rent sharing (not Chile) 3. allows for additional counter-cyclical spending (not Chile) 4. allows for additional spending smoothing (not Chile) Hence Norway has an outstanding rule in place with outstanding results since 2001

Norway s Sovereign Wealth Fund Norway established Gov Petroleum Fund in 1990, renamed Gov Pension Fund Global (GPFG) in 2006 GPFG is managed by Norges Bank Investment Management, under investment guidelines issued by MoF GPFG investments are highly diversified internationally with 56% equity share of outstanding total investments valued at 275% of mainland GDP in 2010 Actual government surplus the consolidated surplus of GPFG and the non-oil government budget are transferred to GPFG, at the tune of circa 20% since 2005

Norway: Government Budget and Pension Fund Performance Fiscal policy A. Expected rea l return on the Government Pension Fund a nd structura l non-oil deficit. Bn. NOK (consta nt 2012 prices) 175 Structural deficit 150 4 pct. real return 175 150 B. Rea l underlying expenditure growth in the Fiscal Budget. Percent 6 5 6 5 125 125 4 4 100 100 3 3 75 75 2 2 50 50 1 1 25 25 0 0 0 2001 2003 2005 2007 2009 2012 0-1 -1 2015 1985 1990 1995 2000 2005 2012 C. Average annual change in use of oil revenues and pension expenditures. Per cent of mainland trend GDP. 0,5 Increased use of oil revenues 0,4 0,3 Increased expenditure on old-age and disability pensions 0,5 0,4 0,3 D. Consolidated surplus in the fiscal budget and the Government Pension Fund. Percent of mainland GDP 40 40 Consolidated surplus in the 30 fiscal budget and the Government Pension Fund 30 20 10 Non-oil budget surplus 20 10 0,2 0,2 0 0 0,1 0,1-10 -10 0,0 2001-2012 2012-2025 0,0-20 1986 1991 1996 2001 2006 2012-20

Norway: Government Pension Fund Global (GPFG) Investment Portfolio, 1997-2011 (ratio to GDP, %) 300% 250% 200% 150% 100% 50% 0% Equity Fixed Income Real Estate

3. Fiscal Policy and Macroeconomic Performance in RREs

Findings on Fiscal Policy and Outcomes in RREs 1. Natural resources: curse or blessing? curse where initial institutions are weak (Robinson et al.) curse where taxes on non-resource sectors are low, corrupting institutions (Salti; Bornhorst et al.) 2. Fiscal pro-cyclicality World evidence: fiscal policy is pro-cyclical (deepening cycles) when governance and institutions are weak, corruption is widespread, fiscal credibility is low, financial markets are under-developed, and international financial integration is weak (Végh et al., Calderón and Schmidt-Hebbel, others) Oil-producing countries: high fiscal pro-cyclicality in 2003-2009 (Villafuerte and Lopez-Murphy) GCC countries: spending follows resource rents, hence fiscal policy is pro-cyclical with a lag (Fasano and Wang)

Findings on Fiscal Policy and Outcomes in RREs 3. Weak fiscal sustainability Fiscal positions weakened in oil-producing countries duirng 2003-08 oil boom (V and L-M) 4. Fiscal vulnerability to commodity price reversals Fiscal positions are highly vulnerable to oil-price reversal in oil-producing countries (V and LM) 5. Macroeconomic volatility and Dutch Disease Fiscal policy pro-cyclicality has amplified business cycles in oil-producing countries (V and L-M, Abdih et al.) Pro-cyclical government spending leads to Dutch Disease during revenue booms -- hence RER misalignment, loss of competitiveness, and large non-resource curr. account deficits

Findings on Fiscal Policy and Outcomes in RREs Weak fiscal-policy institutions have adverse effects beyond policy pro-cyclicality and Dutch disease Opaque budgetary management and external control, lack of transparent fiscal policies and budgets, and poor budgetary accountability lead to ineffective and inefficient government spending, misuse of government resources, and corruption Adoption of modern institutional framework for fiscal policy makes major contribution to lessen adverse impact of commodity bubbles and strengthen good use of government resources

4. Lessons on Fiscal Institutions in RREs

Lessons on Fiscal Institutions in RREs Frontier fiscal framework is key for the triple goal of fiscal policy: fiscal solvency (or budgetary sustainability) macroeconomic stability inter-generational equity International experience in general and successful development of sound fiscal policy frameworks in Chile and Norway since 2001 suggest lessons in four key policy areas to strengthen fiscal policy institutions and conduct in RREs

1. Strengthen Fiscal Institutions Adopt / reform Fiscal Responsibility Laws Strengthen government s budget initiative and mgmt Extend budget horizon from 1 year to multi-year planning Maximize fiscal policy transparency and accountability Strengthen external control and auditing of budget execution and government accounts Strengthen fiscal analysis and monitoring by relying on richer set of key fiscal indicators

Government Budget Transparency in International Comparison, 2010 South Africa New Zealand UK France Norway Sweden US Chile Brazil South Korea Germany Peru Spain Colombia Portugal Argen ne Mexico 52 72 71 71 68 65 63 61 58 56 83 83 82 92 90 87 87

2. Adopt a Fiscal Rule Adopt a fiscal rule based on cyclically-adjusted balance of the government Adjust for both domestic GDP cycles and commodity price cycles key budget variables Make rule consistent with a-cyclical or, preferably, counter-cyclical spending and spending smoothing Preferably based on assumptions and forecasts of key variables provided by independent committees Possibly anchored in Fiscal Responsibility Law

3. Start/develop a Sovereign Wealth Fund Key complement of cyclically-adjusted balance rule Effective and transparent corporate governance Transparent information of transfers between budget and SWF Investment portfolio composition set by maturity preference (length of commodity-price and GDP cycles, inter-generational sharing), and risk aversion Investment management bound by transparent guidelines and close public monitoring

Transparency of Sovereign Wealth Funds in International Comparison, 2011

4. Adopt Committees and Fiscal Council Special Independent Committees: focus on narrow tasks, like key budget forecasts or fiscal reforms Independent Fiscal Councils: based on ad hoc law, Board members voted by Congress. Responsible for following tasks and recommendations: Budget assumptions, projections, monitoring, and recommendation of corrective actions Medium and long-term fiscal projections and assessment of fiscal sustainability and corrective actions Assessment of macro-financial effects of fiscal policy Assessment and recommendations on government asset and liability management Technical advice and public hearings (Congress) on budget management and fiscal reforms

5. Conclusion

Conclusion The world has made much progress in some areas of macro-financial institutions and policies e.g., independent central banks and the conduct of (conventional) monetary policy Yet fiscal institutions and fiscal policies face major challenges to strengthen sustainability of fiscal policy, its counter-cyclicality, and its transparency in industrial and emerging economies alike RREs face a particularly serious challenge to break out of the vicious circle between fiscal policy weaknesses and commodity cycles It can be done.

Rule s Fiscal and Macro Effects: New Findings Which is the response of government saving and Chile s macroeconomy to a copper price shock under the rule (since 2001-2010) compared to before the rule (1990-2000)? I use impulse responses from VAR estimations to simulate the response to a 10% copper price shock Before the rule: no effects on fiscal balance and EMBI, while RER appreciates and growth declines After the rule: fiscal balance improves, EMBI declines, RER appreciates, and growth rises

Response to a Copper Price before the Fiscal Rule (1990-2000) Figura 2: Impulse Response pre-fiscal Rule

Response to a Copper Price under the Fiscal Rule (2001-10) Figura 3: Impulse Response post-fiscal Rule