Economic theory suggests that there are a number of advantages arising from the establishment of an oil fund. These include the opportunity to create sustainable wealth, facilitate economic development over the long-term, enhance economic stability and ensure that the benefits of a country’s natural resources are shared between current and future generations. However, the establishment of an oil fund necessarily implies a commitment to limit current consumption in favour of investment over the longer term. This can be challenging, particularly in periods where the public finances are subject to other pressures.
The potential value of an oil fund for Guyana could be substantial. The actual value of such a fund would depend upon a number of factors, including the level of initial investment, the number of years of investment, the returns received on the fund’s investments and the extent of any withdrawals from the fund. The operation of oil funds in other countries offers a number of important insights for the possible establishment of a similar fund for Guyana. International evidence shows that most funds attempt to preserve the real value of the principal by imposing guidelines on how much can be withdrawn from the fund. More widely, key options include whether to set-up the fund independently or as part of the government of the day and how transfers both in and out of the fund should be arranged.
Successful oil funds tend to share key characteristics: the rules for the funds are generally simple and transparent; there is a commitment to invest in the fund on a regular basis; the fund managers operate a diverse investment strategy with a focus on long-term wealth creation; and, all those involved in the operation of the fund, from managers to policy makers, are accountable to the relevant legislature and the general public. Public support for the fund is viewed as critical to its success.
There are a number of important policy choices which must be made when establishing an oil fund. These include:
-
the management structure of the fund;
-
the proportion of tax revenue transferred to the fund;
-
how the revenue transferred to the fund should be invested; and
-
managing withdrawals from the fund and what the fund income should be used for.
There are seven important policy choices for a Guyanese oil fund:
-
Establishing the fund;
-
Aims and objectives;
-
Basic framework and management;
-
Investment strategy;
-
Investment portfolio;
-
Transfers from the fund; and
-
Using the fund income.
Establishing the Fund
The creation of an oil fund for Guyana would require appropriate legislative and legal authority. The experience of other countries suggests that full financial and/or political independence is not a necessary pre-requisite for the creation of an oil fund.
Aims and Objectives
Once agreement has been taken in principle to establish an oil fund for Guyana, basic parameters would be required setting out the overall aims and objectives of the fund. For example, should the fund be used as a long-term investment fund to provide a permanent income stream, or as a short to medium term funding source to assist economic development?
The Norwegian and Alaskan funds are good examples of the primary focus being on the establishment of long-term investment funds so as to maximise the stock of financial wealth held in the fund. The constitution in Alaska explicitly prevents the running down of the Permanent Fund’s asset base (i.e. the principal), while in Norway the long-term motivation of the fund is to create a pot of sustainable wealth that can be used to finance the country’s future social security obligations. In both cases, growing the underlying asset value of the fund and ensuring that it continues to exist on a permanent basis are widely seen as the central objectives.
In contrast, the Province of Alberta, Canada, initially put a greater emphasis on using the fund to assist economic development. Over the past thirty years, billions of dollars have been transferred from the fund to the government’s general-purpose budget for spending on government programmes and in particular to pay for investment in infrastructure and in human and physical capital formation (Alberta Heritage Savings Trust Fund 2009). No restrictions were placed on withdrawals from the fund, and in fact the opportunity to take revenues directly from the fund’s asset base was a clear objective of the fund from the outset. Following a major restructuring in 1997, the fund has adopted a strategy more comparable with that of Norway and Alaska. The objective of the fund is now “to provide prudent stewardship of the savings from Alberta’s non-renewable resources by providing the greatest financial returns for current and future generations of Albertans”.
Using oil funds as development mechanisms remains popular in emerging countries where the goal of short-term economic growth and development lies above, for the moment, that of creating long-term financial wealth. International experience offers two main alternatives for the aims and objectives for a Guyanese oil fund. The approaches are not mutually exclusive and indeed a hybrid approach, combining short and long-term priorities, could be adopted.
Basic Framework and Management
Having set out the broad aims and objectives of the fund, a basic framework setting out the fund’s operation and governance would need to be established. The International Monetary Fund (2007) have concluded that the “quality of institutions in the creation of an oil fund are important determinants of successful outcomes.”
One option would be for the government of the day to set out the fund’s objectives and overall investment strategy, but to delegate operational management to an institution independent or quasi-independent of government. A key challenge with this approach would be to maintain a balance between independence and accountability. A system of checks and balances, including independent audit and detailed reports could be created to maintain transparency and political accountability.
One approach is to have the fund managed by a quasi-independent state entity. A management team, government-appointed Board of Trustees oversees and is ultimately responsible for the performance of the fund. A third of the Board’s members can be incumbent Government Ministers, the remainder are appointees from the private sector selected for their competence and expertise in finance and investment management. To maintain independence, appointments can be staggered over various interval terms.
The balance of independence and accountability could be maintained through a number of channels including the requirement that the fund report to various audit and financial committees of the Guyanese legislature. There should be a legal requirement that the fund presents detailed reports setting out its operations, costs and performances in a manner that is readily accessible to the general public.
A slightly different structure could be that the basic framework for the fund’s operation to be set by the Guyanese Parliament. The fund’s auditors would also report directly to the Parliament, ensuring Parliamentary oversight of the fund’s operations.
It is generally accepted that the establishment of near independent institutions to manage the oil funds have been a success (Hannesson 2001). An alternative option would be for the fund to be managed and operated by officials and Ministers within the Guyanese Government. Such funds are known as informal funds.
The key advantage in setting up an oil fund as an independent institution is that it can help insulate the fund from short-term political pressure and allow the day to day management of the fund to be conducted by experts in the field.
Furthermore, creating a separate institution challenged to meet specific long-term goals can provide a clear focus for the operation of the fund and facilitate maximum public support. The key advantage of an internal management model is the direct element of accountability in the operation of the fund via the political process. The degree of transparency in the operation of oil funds is thought to play a vital role in their long-term success and it is claimed that one of the main reasons for the success of the Norwegian oil fund is its high level of transparency.
Investment Strategy
A key decision in the operation of an oil fund for Guyana would concern when and how transfers would be made into the fund.
Ad hoc transfers
Under this approach, payments would be made to the fund on an informal basis. For example, if there was an unexpected ‘windfall’ in any given year, perhaps due to an unexpected increase in the price of oil and gas, this money could be transferred into the fund.
Invest when budget is in surplus
An alternative would be to commit to invest any proceeds from a budget surplus directly into the fund. This ensures that revenues are not invested into a fund at the expense of reduced spending on other government programmes or the creation of government debt. It also means that investment in the fund responds to changes in the business cycle, with greater revenues invested when the economy is performing strongly and less being invested during periods of economic downturn.
By setting up a fund, Guyana will have an explicit choice as to whether to use its oil revenue to fund current services or invest in the fund. Such a choice does not exist or is not offered to the public in a country without an oil fund.
A possible downside with this investment strategy is that through time, the level of oil and gas reserves may themselves become a driver of the overall size of the public sector budget, which may well be undesirable.
Invest a fixed proportion of oil revenue
Another approach would be to allocate a fixed proportion of oil and gas revenues to the oil fund each year, irrespective of the government’s wider fiscal position.
These options each have their advantages and disadvantages. Committing to invest a certain proportion of natural resource revenues each year guarantees a consistent transfer of resources to the fund. However, this rigidity can be a disadvantage in that it does not account for short-term fluctuations in oil and gas prices and/or the economic cycle. In contrast, undertaking ad hoc payments and/or only investing when in surplus ensures that payments are made only when it is economically and financially prudent to do so. However, short-term pressures may result in less money being allocated to the fund than is optimal, while the level of oil and gas reserves may themselves become a driver of the overall size of the public sector budget.
A possible variant on these approaches would be to combine a rigorous medium to long-term commitment to investing a certain share of oil and gas revenues while allowing for short-term flexibility in the amount actually transferred each year. For example, a framework could be adopted whereby the government is required to invest a fixed proportion of oil and gas revenue over the economic cycle (or a specified fixed time period), but annual payments could vary depending upon the economic and fiscal climate (a form of ‘oil fund golden rule’).
Investment Portfolio
The over-arching investment strategy of oil funds is to achieve high financial returns subject to moderate risk. The aim of this strategy is to ensure that the fund’s operations do not feed through to the local economy and create fluctuations in the exchange rate and interest rate.
The ultimate responsibility for the investment portfolio of a Guyanese oil fund would lie with the fund’s managers. However, from the experience of other countries it is likely that the government/parliament would determine the benchmark performance and target asset allocation of the fund. As with any investment strategy, a balance would have to be struck between risk and return.
Transfers from the Fund
No withdrawals
-
One option would be to prevent any withdrawals from the fund unless under exceptional circumstances. This would allow the value of the fund to increase significantly.
Variable transfers
-
An alternative would simply be to allow the transfer of money from the fund as and when the fund’s trustees, government or parliament deem appropriate.
Nominal returns
-
In most years, the fund would be expected to make returns on its investments. These returns could be transferred from the fund for spending on government programmes.
Real returns
-
A downside with transferring the nominal returns is that without ‘inflation proofing’ the real value of the fund would decline. To maintain the real value of the fund, one option would be to draw down no more than the real returns from the fund each year and reinvest the remaining returns in the fund to ensure the purchasing power of the fund remains constant.
Expected real returns
-
Transferring only the real returns from the fund can lead to fluctuations in the annual payments out of the fund each year with higher revenues being transferred during successful years and lower revenues during economic downturns. Unfortunately, this mechanism tends to work in exactly the opposite direction to when the income could be used most effectively.
-
To ensure a degree of predictability, one option would be to transfer the annual expected real returns from the fund – i.e. a fixed proportion each year.
There may be an advantage in limiting transfers from the fund in the period immediately following the establishment of the fund, to ensure maximum growth in its value prior to oil and gas reserves being exhausted.
In practice withdrawals are made from all funds. Given this, there are clear advantages in transferring out from the fund no more than the real returns, whether this is conducted on an ad hoc basis or part of a formal commitment. This would ensure that the underlying asset value of the fund is maintained. As the real return will vary year to year depending on the performance of the fund’s investment portfolio, the management of the fund must ensure stability by focussing either on the expected real return or the average return over a number of years. The potential risk is that if the actual returns are persistently below the expected return then the real value of the fund could be diminished.
Using the Fund Income
General expenditure
-
One option would be to transfer the income from the fund to the general government budget for non-ring fenced expenditures.
Ring-fenced expenditure
-
An alternative would be to ring fence the revenues for particular expenditures, such as the development of infrastructure or the expansion of human and physical capital stocks.
-
Revenue from the fund is used to help pay for priority programmes in areas such as health care, education and public infrastructure.
Endowment Fund
-
In addition to ring fencing expenditure from its oil fund, Guyana could create a number of subsidiary funds for specific purposes.
