6.1 The prospect of significant oil revenue is a blessing for the nascent economy of East Timor. The new government has few resources to fund its development needs and provide crucial public goods and services. At present, it is almost totally dependent on external donors. Oil revenue from the Timor Sea can help it to contain the tax burden on a poor population and reduce‑or even eliminate‑its dependence on aid or external borrowing. However, if experience from other countries is anything to go by, this happy prospect could easily sour. Resource‑poor countries have consistently outperformed resource‑rich countries in terms of growth and poverty reduction. This is especially true for oil exporting countries. (1) The challenge for East Timor is to avoid the errors of so many oil exporters and ensure that its oil wealth becomes a blessing for all its people and indeed for future generations as‑well. This chapter presents an overview of lessons from managing expenditure, revenue and savings from oil and gas flows that stem from the experience of other countries but may also be relevant for East Timor. (2)
6.2 There are many explanations of why oil (and more generally mineral) economies suffer. Most of these explanations are in some way related to the volatility of oil revenue and to fiscal mismanagement.
Mismanaging windfalls. There is tendency to over‑spend during booms caused by rising oil prices, often leaving the country even worse off than it was before the boom, when the boom turns to bust. One reason for this is that as spending rises during the boom (and especially government spending since the government is usually the main direct beneficiary of the boom), non‑traded goods prices rise. This draws resources from non‑oil traded goods sectors (including agriculture) or slows the increase in resource flows to these sectors. When the boom is over it is extremely difficult to resuscitate or restore growth to the affected sectors. (This is frequently called the Dutch disease.)
Absorptive capacity. Many governments believe that increasing public investment will help avoid the Dutch disease by increasing productivity. However, they frequently do not have the capacity to manage the increased investment efficiently and therefore much of the investment is simply wasted. (3) Also, the investments are often not chosen to meet the countries' development needs.
Volatility. The volatility of oil revenues often creates an unstable, stop-go, pattern of government investment and expenditure. These cyclical patterns will affect the entire economy and may make it more prone to business cycles.
Governance. Corruption and poor governance seem to be more common in oil exporting countries.(4) This too is the result of the concentration of the rents in the fiscal authority. In a nutshell, the presence of oil rents tends to cause an overexpansion of government leading to rent seeking and corruption and, consequently, to the misallocation of resources.
6.3 These problems are all relevant for East Timor; a key challenge for the government will therefore be to ensure that the oil windfall is not squandered and indeed is wisely invested or saved. (5)
6.4 The key to avoiding or at least minimizing some of the effects of the above resource or oil‑associated problems is to "smooth" expenditure. This will insulate (or sterilize) the economy from the deleterious effects of the "boom", and also help to contain the shift in resources towards non‑traded sectors. The benefits to the economy from its natural resources would derive from the income generated by the saving. These would be permanent, stable benefits and could be used to benefit the population as a whole‑and, importantly, provide a means of sharing the proceeds of the offshore revenue between current and future generations.
6.5 One can think of the oil as "capital". The consumption stream (i.e. the benefits) that is derived from the oil can only be realized by its extraction and sale. When that happens the stock of "capital" is gradually depleted and so over time it will generate less and less consumption. To ensure a smooth consumption stream it is necessary to replace the depleted "capital" with physical or financial capital. This has been called replacing the assets below the ground with assets above the ground. (6) This means calculating the maximum level of expenditure that can be sustained in perpetuity.
6.6 A fixed expenditure, based on permanent rather than transitory income, will prevent any precipitous rise in domestic prices and an unabated decline of the non‑oil traded goods sectors and industries. Because the East Timor economy has been so ravaged by conflict, even more of a concern than the "decline" of the traded goods sector is the slowing of the flow of resources to the traded goods sector, which is crucial to the development of the non‑oil economy. Stable government expenditure would also contribute to a more stable and predictable private sector investment climate. Of course, permanent production and price shocks or new resource discoveries could necessitate adjustments to the permanent level of expenditure. However, these adjustments will tend to be more moderate if the savings strategy is maintained. (7)
6.7 An expenditure smoothing strategy could also help match the level of public investment to the government's absorptive capacity. One could argue that investment in physical assets such as infrastructure also fulfills the requirement of replacing the assets below the ground with assets above the ground. The constraints, however, are the absorptive capacity of the economy, the recurrent costs of maintaining the physical assets, and the need to maintain or develop good governance. (8)
6.8 Avoiding a rapid build‑up in government expenditures can also contribute to maintaining good government. Although this is neither necessary nor sufficient, rent seeking and corruption are far less likely if "expenditure smoothing" rules are invoked. Government would remain more limited and investment would be built‑up gradually thus lowering the benefits to rent seeking and corruption. At the same time, independent efforts at maintaining fiscal transparency and accountability will be required. Indeed, there is a "chicken and egg" element to this: without good government it is unlikely that the government will be able to sustain a prudent expenditure policy; but, without a prudent expenditure policy good governance is very unlikely.
6.9 These factors provide strong reasons for utilizing an expenditure‑smoothing rule once oil revenue exceeds the sustainable level of spending. They do not, however, preclude the need for judgment. Importantly, the prospective revenue flow will continually be subject to revision due to fluctuations in prices and production capability (production may also be positively correlated with price, adding to volatility), and the resulting adjustments in the evaluation of "permanent" income. Moreover, certain public investments may be lumpy, with rates of return that are time sensitive‑which could warrant an exception to the agreed upon spending rule.
6.10 Decisions on smoothing rules could also range from: conservative such as maintain a constant expenditure in perpetuity in real per capita terms; to the simplest such as adhering to constant nominal expenditure in perpetuity; to those which discount future spending. Selecting an expenditure‑smoothing rule therefore involves thorough debate of development objectives. There is, however, a simple argument for favoring a fixed dollar amount of expenditure: because that is the "permanent" income. If there is dollar inflation of x percent, then real income from the oil has gone down by x percent if the price of oil or proven reserves has not changed. If the price of oil changes, then, as noted, the estimate of "permanent" income would change commensurately, warranting an adjustment to prospective expenditure.
6.11 On July 5, 2001, representatives of UNTAET and Australia agreed to an arrangement on the division of oil and gas resources from the Joint Petroleum Development Authority (JPDA) of the Timor Sea. Under the so‑called Timor Sea Arrangement (TSA), which is subject to ratification by the East Timor and Australian parliaments, 90 percent of oil and gas revenue in the JPDA would accrue to East Timor, with Australia receiving 10 percent (excluding revenue from related onshore investments in Australia). (9) The Bayu-Undan liquids project was approved in 2000 and is due to begin production in 2004. Full gas development at Bayu‑Undan depends upon Australian regulatory approval of parts of understandings on fiscal terms reached between East Timor and Bayu‑Undan contractors in December 2001. Greater Sunrise is another large discovered gas‑condensate field, which lies partly in the JPDA as defined in the TSA, but a development concept for this field has yet to be agreed among the joint venture partners. The only fields that have been developed to date (Elang Kakatua) may close in 2002 or 2003.
6.12 In light of the above, there is still much uncertainty about revenue prospects from the Timor Sea, which extends beyond the usual volatility surrounding prices and production. Revenue flow estimates have been subject to significant changes‑both in aggregate and in their distribution over time‑reflecting the evolution of negotiations with the commercial operators. As a result, it is not yet possible to derive firm revenue projections of the oil and gas resources from the Timor Sea.
6.13 While there may be considerable uncertainty about Timor Sea revenue flows, it is clear that for at least the next two years such revenue under any scenario will be insufficient to finance government expenditure needs. Initial estimates indicate that revenue from the Timor Sea will rise sufficiently by FY06 to cover anticipated public expenditure needs but that large fiscal surpluses are unlikely before the end of the decade.
6.14 Based on currently available information, East Timor will experience a revenue windfall for some twenty years beginning in the middle of this decade. But there is less clarity on the viability of significant new fields, and hence offshore revenue at the end of this period could diminish sharply or cease.
6.15 Under these circumstances, and for the reasons discussed above, a strategy for allocating the revenue stream between public expenditures and saving needs to be developed. There will be ample time to develop such a strategy‑given that fiscal surpluses are not expected to emerge until FY06. Nevertheless, once there is greater assurance regarding revenue flows, it will be important to begin assessing alternative options‑to inform the public debate, and to develop the parameters with which to guide public investment decisions, fiscal policy and assessment of financing needs. (10)
6.16 A starting point for this analysis is to estimate the constant nominal dollar allocation in perpetuity to public expenditure that would be implied by a particular revenue stream (given an assumed rate of return on accumulated savings). Additional adjustments can then be made to accommodate alternative strategies: for example, a more conservative strategy would be to maintain spending levels constant in real or real per capita terms. Alternatively, a more aggressive spending strategy could also be developed, predicated on the need for greater public investment in the short term.
6.17 Selecting an expenditure strategy should involve a number of criteria, including evaluation of absorptive capacity for implementing new projects and the prospects for donor financing. More fundamentally, the allocation of revenue between savings and expenditure should be linked to an assessment of development potential in the non‑oil sectors: if non‑oil growth prospects in the long term are assessed as poor or uncertain, a conservative spending strategy may be warranted; if strong growth opportunities were to emerge in the non‑oil sector, a case could be made for a more aggressive spending strategy on the assumption that the non‑oil economy would provide a stronger base for future tax revenue.
6.18 Any smoothing scenario will need to be reviewed and updated on a regular basis to reflect changes in production, prices and returns on investment, particularly in response to major developments such as energy price shocks or the discovery of new exploitable reserves. It will also be important to make available to the public accurate information about revenue flows to develop a national consensus behind the savings strategy, and to minimize the scope for diverting resources from public priorities.
6.19 Good revenue management will not guarantee a stable expenditure pattern but it can help. Oil revenue is typically volatile owing mainly to volatile international prices. If volatility affects expenditure then, as noted, the instability of oil markets will be transmitted to the rest of the economy. These considerations have led many natural resource exporting countries to establish natural resource funds to manage the revenues. There are essentially two main categories of funds (though one could think of combinations and variations of these): stabilization funds and savings funds (or funds for the future.) The former focuses on the problem of volatility and the latter on the questions of exhaustibility (11) and "windfalls."
6.20 Stabilization funds. These funds try to stabilize the flow of revenue to the government by "borrowing" from the fund when the price is low and accumulating funds when the price is high. Thus stabilization funds may have a role where the output stream is a steady‑state feature, with income depending mainly on price volatility. But since volatility in East Timor's case has as much to do with volume as price, and the windfall is expected to last some 20 years followed by zero income, at least on current assumptions, the use of a stabilization fund would appear to be less relevant to East Timor's current situation. (12)
6.21 Savings funds. These funds focus on the inter‑temporal questions discussed above. Examples include Norway, Kuwait and the State of Alaska. Typically, such a fund would be managed by professionals and invest part of the current revenue offshore in order to sterilize the effect of windfalls on the economy and smooth the revenue to the budget over time. For this type of fund to be effective in smoothing expenditure it is necessary for the fiscal authority to feel bound by the "rules." Thus, if expenditures were to rise with a windfall, even as revenue from the fund to the budget was constant, then the government may have to borrow to finance a resulting deficit. The net asset position of the government would be unchanged, as the increased borrowing would offset the accumulation of assets by the fund (particularly if the borrowing is external, which is the relevant case for East Timor). But the inter‑temporal objectives of the fund would be undermined. As in the case of stabilization funds, fiscal discipline is essential to prevent the government from "raiding" the fund. Sometimes, the funds are "implicitly raided". This happens when the existence of the fund gives legislators or fiscal authorities a false sense of security and so they tend to run higher deficits than they otherwise would have. In this way they undermine the rules of the fund without actually dipping into its capital. (13)
6.22 The savings fund is therefore not a panacea. It can, however, help mitigate some of the problems discussed above in the following ways:
It could serve as an institutional mechanism to reinforce fiscal prudence. Although the government can always break the rules, the existence of a fund created by it may make it somewhat more difficult to do so.
A properly established fund can be an institutional mechanism to enhance transparency. Since the fund can be required to adhere to pre‑arranged rules and accountability standards it can serve as a good example to the country and the fiscal authority, as well as ensuring that the resource revenues are well accounted for. An improperly constituted fund could have exactly the opposite effect, however.
6.23 Institutional framework for the fund. The establishment of either category of fund also requires an institutional framework to deal with three central aspects of fund management: integration within the fiscal framework, an asset management strategy and insurance mechanisms for transparency and accountability. (14) Once the decision has been taken to implement a fund, it should be integrated within the budget process to maintain unified control of fiscal policy and avoid the emergence of two budgets, namely the traditional budget and a separate expenditure program financed by the fund. It is important to ensure that spending decisions are taken within the context of the budget and that the expenditure is included in the budget in a comprehensive way so that fund resources are spent through the normal budgetary approval process.
6.24 Integration into the budget process. Ideally, the fund's operations should be incorporated into the fiscal accounts with transfers to and from the fund requiring parliamentary approval. Proper integration of the fund and the budget helps to maintain a unified control of fiscal policy and avoid problems in expenditure coordination. The fund should have no independent spending authority and there should be no targeting of fund resource for certain items of expenditure, ensuring that all revenues and expenditures from the fund are on‑budget. In the case of Norway's State Petroleum Fund, for example, transfers to and from the fund need parliamentary approval and the fund's operations are incorporated into the fiscal accounts. In the case of the Alaska Permanent Fund, the principal is the permanent part of the fund which cannot be spent without a majority vote of the state's residents while the income or money earned from the investment of the principal is designated towards inflation proofing the principal, increasing the size of the principal and paying dividends to each Alaskan citizen. Any leftover surplus from the income is put into the Earnings Reserve Account until the state legislature decides what to do with it.
6.25 Asset Management. Given weak capacity within East Timor, managing of the accumulated savings could be contracted out to two or three top‑rated international fund managers, with each assigned to invest half or a third of the available funds with the objective of maximizing the yield subject to carefully chosen investment criteria including prudential investment rules, published guidelines of the desired risk‑return combination, the proportions to be invested in different types of assets, etc. Performance could be monitored frequently and following periodic reviews, the worst performer could be replaced. Box 6.1 provides an example of successful management and investment outcomes for a country with little investment expertise.
6.26 Ideally the asset management strategy for the fund should reflect a consolidated portfolio of the government, with short‑term asset operations conducted in a manner coordinated and consistent with the debt management operations of the ministry of finance, the treasury's management of government cash flow and the financial assets already held as part of the government's balance sheet.
6.27 Countries with pressing infrastructure needs may be tempted to undertake investment in domestic physical assets as well as to promote the growth of the non-resource sectors. However, there are few successful examples of expenditures of oil money in this regard. Spending of this type tends to rise to unsustainable levels, with rapid increases leading to poor quality projects. Investment should ideally be guided by medium‑term recurrent implications rather than the availability of resources in the fund. Furthermore, this strategy tends to worsen rent seeking activities and make the fund prone to abuse, while making it difficult to achieve and assess real returns to such activities.
6.28 Transparency. Clearly defined rules, purposes and objectives for the Fund are important for improving transparency and establishing the legitimacy of fund operations. Regular and frequent disclosure and reporting on principles governing the fund, its inflows and outflows and the allocation of assets is also recommended, as is regular notification to the legislature and the general public. A detailed annual report can also serve to provide important information such as asset allocation, summary statistics on the performance of the portfolio and retrospective of activities of the fund during the year. The Norwegian State Petroleum Fund and the Alaska Permanent Fund are best practice examples in this regard.
6.29 Transparent management of both funds is accomplished by a number of requirements. For example, the Norges Bank, which manages Norway's State Petroleum Fund, is required by law to provide information concerning the fund's management to the public, and comprehensive accounts and data on the SPF's operations are readily available on the Internet on a timely basis. In the case of the Alaska Fund an annual dividend is paid to each permanent citizen from the earnings of the APF and public oversight of the Fund balances with respect to dividend payments helps to improve transparency.
6.30 Finally, there has been some discussion regarding a proposal to establish a government owned oil company. Before any decision is taken on such a move, its rationale should be carefully considered, given the mixed record of equivalent entities in other countries‑including on governance issues. The government clearly needs expertise in keeping track of oil technology to develop an independent view and to be able to negotiate on equal terms with commercial firms, but the creation of a new firm for this purpose may not be warranted.
6.31 The key to ensuring that the oil revenue is a blessing will be a prudent fiscal policy‑the subject of the next chapter‑which can integrate in a sustainable manner all revenue prospects, expenditure needs and financing availability. In this context, the involvement of IFI and donor finance in the medium term can reinforce fiscal discipline. Donors and IFIs should not be put off by the reluctance of the government to spend its oil revenue in the medium term. On the contrary: the objective of external involvement in the medium term should be to ensure that fiscal policy meets the development objectives of the country; and, to allow the government to save a large part of the oil revenue thereby creating a permanent stream of stable income.
6.32 A savings fund may be useful if it can enhance transparency and fiscal prudence. If managed by professionals it could also relieve the pressure on the institutional capacity in East Timor.
Sidebar: Tuvalu Trust Fund
1 See Auty and Miksell, "Sustainable Development in Mineral Economies", 1999; Sachs and Warner, "Natural Resource Abundance and Economic Growth," 1995; Gelb et al, "Oil Windfalls: Blessing or Curse," (1988).
2 Reference to oil and gas in this chapter is frequently shortened to oil alone.
3 A related issue concerns the nature of the investments. Frequently, governments use the oil revenues to establish inefficient state enterprises which can be nourished so long, as the boom continues but become unmanageable burdens afterwards. Similarly, oil revenues are often used to promote so‑called downstream petrochemical industries. However, the presence of oil and gas does not necessarily mean that a country has a comparative advantage in petrochemicals, which tend to be highly capital intensive. Hence, this kind of industrial policy often turns out to be a huge mistake and an unsustainable fiscal burden.
4 See Kaufmann et al, "Governance Mattes ", Finance and Development, June 2000. Also, oil exporting countries tend to be clustered in the bottom one‑third of the countries listed in Transparency International's annual Corruption Perceptions Index.
5 East Timor's leaders have recognized both the promise and the problems of the oil revenue: "...(oil revenue) can mean the difference between one teacher for every 100 students, and one for every 40. It can allow the country to extend basic health care, such as malaria prophylaxis and immunization of children, to its people. It will not make East Timor rich. However, if the money is well spent, it will give the people of East Timor the opportunity to escape the grinding poverty that is the legacy of occupation and war." (Mari Alkatiri and Peter Galbraith in The Age, July 7, 2001. Jose Ramos‑Horta strikes a cautious note: "The danger of wealth, the danger of the dollar, the petro-dollar ‑ it is obvious. It is clear that we must have solid and democratic institutions. We must work with great transparency and with a great sense of responsibility, otherwise we could have all the oil in the world but the country would still not develop. There are so many examples of this." BBC Monitoring Service, July 5, 2001. In the same interview Alkatiri added: "Until a system is set up to ensure that the money, these resources, will indeed benefit the whole population and not just some bank accounts, it will be a good idea to take great care. And above all we must develop a transparent, solid, effective system to absorb this money and spend it positively to develop the whole country."
6 See Corden, W. Max, "Booming Sector and Dutch Disease Economics: Survey and Consolidation," Oxford Economic Papers, 36 (Nov. 1984).
7 A stable nominal expenditure level would mean a decline in per capita terms and in terms of income, as the economy grows. This is appropriate as the development process, by definition, involves the accumulation of productive assets for the benefit of future generations. Thus, the assets accumulated from this windfall will become increasingly insignificant as time goes by.
8 Collier (2001) suggests that aid flows to East Timor may already be above levels that can be efficiently absorbed. Excessive spending from oil revenue could also be inefficient and bequeath unsustainable subsequent spending commitments. See "East Timor: Development Challenges for the World's Newest Nation", ISEAS.
9 Oil and gas resources in the Timor Sea had been governed by the 1989 "Zone of Cooperation" Treaty between Australia and Indonesia, which partitioned the "Timor Gap" into three areas, of which the JPDA was one. Oil production in the Timor Gap is subject to production‑sharing contracts between the commercial operators and the Joint Authority, which was established as an executive organ representing the two countries. In October 1999, UNTAET assumed Indonesia's rights and obligations relating to the ZOC. The Timor Sea Arrangement is due to apply following East Timor's independence.
10 Based on information received from the CFA following the initialing of the Timor Sea Arrangement, the Bank had outlined a number of illustrative expenditure smoothing options. These are not reported here as the underlying revenue estimates are being revised.
11 This is somewhat of a simplification. In particular, the savings type fund is also motivated by the problem of limited government investment capacity. It aims therefore to "diversify" the government's assets so as not to over‑extend the public sector investment program at the time of the windfall. This is likely to be very relevant for East Timor.
12 A thorough assessment of both types of funds with a discussion of country cases is given in: IMF (2001), Stabilization and Savings Funds For Nonrenewable Resources, Occasional Paper No. 205.
13 Corden has remarked that most countries tend to treat positive shocks as permanent and negative shocks as transitory.
14 This section is based on IMF (2001), op cit.
The_Problems_with_Oil (notes 1-5)
Expenditure_Management (notes 6-8)
Management of Revenue and Saving (notes 9-14)