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World Bank Submission
on Establishing a Petroleum Fund for Timor-Leste

November 2004

We thank the Government for the opportunity to comment on the Discussion Paper for the Timor-Leste Petroleum Fund, which provides a useful mechanism for discussing a prospective petroleum fund for Timor-Leste and also contains important insights into fiscal and savings policy as they relate to managing petroleum revenue.  The paper raises the key issues for Timor-Leste of the depletability and volatility of its main source of fiscal revenue and a major source of national income.  It notes the risks involved in being an oil dependent economy in a refreshingly frank way and discusses some of the ways to mitigate that risk, in particular as a means to enhance transparency in oil transactions.  The establishment of a Petroleum Fund  is one mechanism to help manage the revenue.  It correctly notes that such a Fund is neither necessary nor sufficient for avoiding the dutch disease or oil induced governance flaws, but that correctly implemented it can be a force for good.  The following comments are offered as a means to stimulate further debate on the issues raised by the paper:

Rules versus Flexibility.  There is a tension in the paper between the endorsement of flexible fiscal policy and a savings policy that maintains the real value of petroleum wealth.  If the government does not allow itself to borrow and has a firm savings target, then this automatically places a limit on the non-oil fiscal deficit -- and amounts to a fiscal rule.  So, while the paper has declared that fiscal policy will be flexible and transfers from the fund will be determined by the non-oil deficit, it appears to have opted for a rigid rule, i.e., maintaining the real value of the petroleum wealth. Such a rule determines how much oil revenue must be saved and how much can be transferred to the budget.  This automatically sets a limit on the non-oil deficit.    If the government decides to borrow, then it is not the fund that will determine government saving but rather government expenditure.  The net accumulation of assets is what counts.  Accumulation of assets by the fund can be offset by government borrowing.   In this case a fiscal rule would entail setting targets, limits or constraints on the fiscal deficit (i.e. public sector borrowing) or government (net) debt, rather than additional rules on the fund.  To sum-up, the government has set a firm target for the fund, maintaining its real wealth.  If it doesn't borrow this translates into a fiscal rule.  If the government allows itself to borrow then fiscal policy becomes flexible even though the fund rule is still rigid.  Thus, the flexibility or rigidness of fiscal policy is determined by the rules of the fund only in the absence of public sector borrowing.

Estimating Oil Wealth.  A difficult operational question will be how to determine the value of the country's oil wealth, or the permanent income from oil.  Besides the considerable uncertainty about production and reserves there is the major uncertainty of price.   The value of the reserves depends on the long-run or expected price.  Thus, when confronted with a price change the government has to decide whether the change is permanent (in which case saving/spending should change) or transitory (in which case the windfall should be saved and expenditure change only by the income on the additional assets).  Distinguishing between permanent and transitory is no small task and will have to be addressed at some time by the fiscal authority or the fund managers.

Unintended Adjustments to Spending.  A parallel issue relates to the possibility that the proposed saving policy could lead to unwarranted adjustments to spending.  For example, if oil prices increase and the change is judged to be permanent, adhering to the savings policy would imply increased government spending.  But if absorptive capacity remains a constraint, an artificial boost to spending is likely to reduce its efficiency and lead to waste.  Under these circumstances, the preferred policy may be to accumulate financial assets faster than warranted by the saving policy.  This example highlights the need for a degree of flexibility in setting fiscal policy.  The paper endorses this view but if our interpretation of the savings policy is correct, there may be a need to ensure that mechanisms to permit needed flexibility are provided for.

Savings Objective.  The saving policy goal of maintaining the real value of the country's oil wealth would be a reasonable objective if one could safely assume that per capita growth would be positive.  However, in light of Timor-Leste's very high fertility rate and the uncertain prospects for economic growth, it is possible that  per capita incomes do not increase over an extended period.  Under these circumstances, a more conservative savings strategy may be warranted.  The paper indicates one such option of keeping constant the value of the petroleum wealth per capita.  It may also be possible to design an intermediate objective that falls between these targets, or one that links saving policy to other economic variables.

Need for Legislation. Whatever the appropriate rule, the paper does not explore the issue of whether the rule should be a matter of policy or legislated.  While legislation can always be changed, the process of changing legislation would be more transparent and more likely to provoke debate. Policy on the other hand, is determined by the executive and implemented through the budget.  While the legislature can object, in practice it may be difficult for Parliament to object effectively to fiscal policy changes.  A strong case can therefore be made for legislating the savings policy.  If this principle is accepted, the question of what rule to legislate and how difficult the legislation should be to change needs to be debated.  If the Government wishes to consider the option of legislating a savings policy, there may be a need to mobilize an expert t provide an overview of the options.

Transparency and Accountability.  The discussion paper scores well under this heading.  Full transparency (regular, accessible reporting) is intended with respect not only to the Fund accounts and operations, but also with respect to inflows and outflows from the Fund.  Transparency typically translates into accountability, but practical procedures for oversight of the Fund will boost its effectiveness (below).

Implementation. While perhaps not relevant for a discussion paper intended to introduce the concept of a petroleum fund, the rules for the composition, selection, appointment, dismissal and reporting of both the Investment Advisory Group  and the Council of Eminent Persons will be essential to the success of the Fund in achieving its purposes. These criteria or rules will have to go into the legislation creating the Fund.  Finally, the suggestions from Global Witness/CAFOD on the means of enhancing transparency provisions are worthy of consideration.

Elisabeth Huybens
World Bank
Country Manager Timor-Leste
5675 - 301
670 723 0550

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