Part II: Sovereign Resilience Funds and Sovereign Development Funds
Over the next decade resource-rich, low-income income countries face an enormous opportunity to harness the revenues from resource extraction for development. The historical record is not encouraging. For ‘this time is different’ to be a reality public decisions must be systematically different: the best hope of this is that new rules are designed and enshrined constitutionally. For new rules to stick they need to be embodied in public organizations that are tasked to implement them. Here I propose the two new organizations that are appropriate.
The meltdown in commodity prices over the last two months perfectly illustrates the volatility inherent in these global markets. Resource-rich low-income countries are typically highly dependent upon the tax receipts from resource exports for government revenue. The rents on commodity extraction are highly geared on the price and so are even more volatile than prices. Since taxes are designed to capture the rents, government revenue is thus deeply unpredictable. Yet public spending cannot be permitted to be as unstable as revenues: large abrupt changes in spending are a recipe for inefficiency. There is thus a need to smooth spending in the face of unpredictable volatility in revenues. Smoothing is only possible if in boom times there is a degree of spending restraint: since this is inevitably politically difficult, there is a need for the package of rules, implemented by a public organization, and supported by citizen understanding that I set out in last month’s blog. The organization I propose for this task is a Sovereign Resilience Fund (SRF).
In principle, the best way of protecting against unpredictable shocks is insurance. In the present case, the specific insurance device would be to hedge revenues, buying an option that guarantees a floor to revenue for a specified quantity of commodity exports. In practice, the markets for hedging are only sufficiently deep for a short horizon, such as a year and so hedging cannot be the sole strategy. It is probably the most efficient way of managing short term risks, such as protecting the revenue for the next annual budget, but beyond this it will usually be best to protect by means of accumulating liquid savings. One purpose of a SRF is to make this decision as to the balance between hedging and accumulating liquidity internal to the management of the fund, rather than a day-to-day political decision. An important reason for shifting the decision from politicians (typically the Finance Minister) to technocrats is that the former usually find hedging politically too dangerous. As with any insurance, the nature of a hedge is that usually it will not be exercised, so that ex post money has been spent with nothing to show for it. Since all ministers have political enemies, a Finance Minister who has taken the decision to hedge must anticipate being attacked for wasteful spending rather than congratulated for prudence. Hence, it is better to shift this decision to a technocratic, rule-governed institution tasked with ensuring that expenditure is protected from fluctuations in revenue.
Managing volatility is only half the task of managing resource revenues. The other half is offsetting resource depletion by the accumulation of other assets. In a poor and therefore capital-scarce country, the assets accumulated should ultimately be real domestic investment rather than foreign financial assets. However, until the country has built the capacity to invest effectively savings should indeed be placed abroad rather than squandered on poor projects. Further, until domestic investment has increased, resource-financed consumption should be delayed so as to avoid Dutch disease. Getting these difficult decisions right calls for another rule-based institution, the Sovereign Development Fund (SDF).
Like the more familiar Sovereign Wealth Funds an SDF has rules that determine inflows from resource revenues. It is important for the SDF and the SRF to be different institutions because necessarily a SRF has a two-way door: money flows into the fund rather than being used for consumption when times are good, and out of the fund to sustain consumption when times are bad. In contrast, a SDF must have a one-way door: the core purpose of the fund is to lock revenues into assets only the income from which can be consumed. However, whereas a SWF invests only in foreign assets, a SDF retains within the fund the decision whether to invest domestically or abroad. In effect, it polices sound investment practices.
Although the SRF and the SDF need distinct rules, they do not need distinct staffing. Both are most appropriately lodged within a central bank where they can draw upon existing expertise.