Thank you to the organisers of this conference for the opportunity to speak to you today1.
I have spoken on a number of occasions about the implications of the once-in-a-lifetime boom in the terms of trade that Australia is currently experiencing.
The aspect I will address today is the idea of establishing a sovereign wealth fund (SWF) as a response to the challenges posed by the boom, which has attracted a number of supporters as the boom has proceeded. The purpose of this talk is not to argue either for or against setting up a fund, but to provide some analysis to inform the debate.
To be specific, what we are talking about here is the idea that some portion of government revenues arising from high commodity prices be quarantined from the current budget and invested in financial assets through a fund that operates at arms-length from government. Australia already has a SWF in the Future Fund — which the Sovereign Wealth Fund Institute ranks as the world's 13th largest — but it is not linked to resource-related revenues.
Proponents of an arrangement of this kind have in mind various objectives, with the main ones being to:
- ensure a larger share of unusually high incomes is saved for longer-term benefit rather than being used for current consumption;
- avoid pro-cyclical fiscal policy by quarantining increased revenues from being recycled back into the economy;
- protect the fiscal position against exposure to commodity price risks; and
- ease pressure on trade-exposed sectors by dampening the appreciation of the exchange rate arising from the boom (in particular, by investing in foreign assets).
Norway's Fiscal Regime
The arrangements in place in Norway are often put forward as a model in this regard. While the rise in Australia's terms of trade has been remarkable, Norway has experienced an even larger rise in its terms of trade since the late 1990s (Chart 1). Further, at least thus far, Norway's boom has been longer-lasting, as the surge in prices of oil and gas, Norway's principal resource exports, began about five years before the surge in prices of Australia's key resources, iron ore and coal.
Chart 1: Terms of trade
Source: ABS and OECD.
A comparison of the experiences of Australia and Norway through this period should therefore help shed light on this issue.
The Norwegian regime comprises two central elements:
- Since 1996, Government revenues from oil and gas have been hypothecated to a sovereign wealth fund, the Government Pension Fund Global (GPFG), which invests solely in offshore financial assets.
- Since 2001, the medium-term objective for the non-oil budget deficit has been set at 4 per cent of the GPFG, which is its assumed long-run real rate of return. This ensures that the real (inflation-adjusted) value of the fund — the accumulated revenues from exploiting non-renewable resources — is preserved.
Many discussions of a possible sovereign wealth fund for Australia focus on the first element, but the second is the critical one. By quarantining oil and gas revenues from current spending it ensures that government saving rises in line with these revenues. Accumulation of financial assets is simply the result of this decision.
The principal argument for raising government saving in response to the commodity price boom is that part of current income is considered likely to be temporary and/or subject to greater than normal risks. A rise in saving is therefore required to smooth consumption over time and for precautionary reasons.
By contrast, establishing a sovereign wealth fund without a change in fiscal rules would not alter future levels of government saving or net financial worth. The only effect would be to shift the composition of the assets and liabilities on the government's balance sheet over time. Anyone who thinks that the establishment of a sovereign wealth fund per se would make a difference is arguing implicitly that such a shift could have significant macroeconomic impacts. As I will argue later, this seems unlikely in the Australian context.
In Norway's case, the fiscal rule requiring oil and gas revenues to be saved has delivered a massive increase in government saving. Budget surpluses have averaged 13 per cent of GDP since 2000, up from an average of less than 3 per cent of GDP over the 1990s (Chart 2). In Australia, by contrast, fiscal balances (consolidated across all levels of government) have not differed significantly between the pre-boom and boom periods.
Chart 2: General government financial balance
As a result, the Government Pension Fund Global has grown to nearly 130 per cent of Norway's annual GDP, with a commensurate rise in the Norwegian government's holdings of financial assets over time (Chart 3).
Chart 3: General government financial assets
Some key differences between Australia and Norway
Before examining how Norway's regime may have affected outcomes during the recent boom, it is worth noting some relevant differences between Australia and Norway.
First, Norway's estimated remaining reserves of oil and gas are much more limited than estimated reserves of Australia's key resources, with a weighted-average resource life only one-fifth as long (Table 1).2 This implies a stronger case for saving these revenues to smooth consumption over time and for inter-generational equity reasons: indeed, the recognition that petroleum revenues would last for only a relatively short time was the primary motivation for Norway establishing its regime.
Table 1: Remaining reserves of key resources (years of current production)
|Share of exports
|Share of GDP
Note: Export and GDP shares in 2010 for Norway and 2010-11 for Australia. GDP shares are for commodity exports. Resource life is based on production in 2008 for Norway and 2009 for Australia.
Source: Bureau of Resources and Energy Economics, Geoscience Australia, Norwegian Petroleum Directorate, ABS, Statistics Norway.
Second, Norway's economy and public finances are much more dependent on the resource sector than is the case in Australia, which means there is stronger precautionary motive to save these revenues. Oil and gas accounts for one-fifth of the Norwegian economy, up from around 12 per cent in the 1990s (Chart 4). By contrast, mining accounts for only 9 p
er cent of the Australian economy, even though this share has doubled since 2003-04.
Chart 4: Resource sector shares of GDP
Source: ABS and StatBank Norway.
The relative dependence of government revenues in Norway on the resource sector is even greater. Revenues from the oil and gas producers have accounted for around one-third of Norwegian government revenues over recent years. In Australia, equivalent revenues from mining provided 6 per cent of government revenues in 2008-09 (the latest year for which we have company tax data by industry), up from only 2½ per cent in 2004-05.3
This comparison points to a third key difference: the Norwegian government captures a much larger share of resource sector revenues than governments in Australia. Norway's government revenues for the oil and gas sector over recent years have averaged about two-thirds of total factor incomes for this sector, compared to an average share of less than one-fifth in Australia (including revenues accruing to both Commonwealth and State governments).
The high share in Norway reflects partly the 50 per cent resource rent tax applying to oil and gas, but also the government's substantial equity interests in this sector. Around 40 per cent of net government cash flow from petroleum activities comes from the government's direct financial interests.4 The Norwegian government has made the active decision to save a large share of the boost to national income arising from high resource prices.
A fourth difference is that the resource sector in Norway is no longer in its expansion phase, reflecting its more limited reserves. Oil and gas production in Norway peaked in 2003-04 and has since been declining steadily (Chart 5). In contrast, mining output in Australia has continued to grow and is set to expand much further as investment in new capacity comes on stream.
Chart 5: Resource sector real gross value added
Source: ABS and StatBank Norway.
While mining investment in Australia has increased sharply in recent years, Norway has not experienced an investment surge of anywhere near the same magnitude (Chart 6). As a result, the current terms of trade boom in Norway has not involved the same need to transfer factors of production from other sectors of the economy to the resource sector.
Chart 6: Resource sector real gross fixed investment
Source: ABS and StatBank Norway.
A final difference is that Norway faces greater long-term fiscal challenges than Australia. Even with the GPFG, the Norwegian government projects a fiscal gap of around 5½ per cent of GDP by 2050, compared to the Australian government's projected gap of 2¾ per cent of GDP.5 While this is not related to the resource boom, it does imply a stronger case for raising government saving in Norway.
One reason for this difference is that Norway relies mainly on public provision of age pensions, whereas in Australia post-retirement incomes are increasingly funded from mandatory contributions to superannuation funds. Norway introduced mandatory private fund contributions from 2006, but the minimum contribution rate is only 2 per cent of earnings, whereas the Australian rate is 9 per cent, increasing to 12 per cent by 2019. As I have noted previously, in terms of managing the resources boom, the expected increase in private saving from this source can be considered as meeting some of the same objectives as an increase in government saving (Gruen and Soding, 2011).
Comparing resource boom experiences: What effects has Norway's regime had?
I now turn to a comparison of the experiences of Australia and Norway through their recent terms of trade booms, focussing on three key objectives that have been put forward for establishing a Norwegian-style regime:
- saving temporary income gains (consumption smoothing);
- assisting macroeconomic stabilisation; and
- dampening exchange rate appreciation.
The income effect of the terms of trade boom can be approximated by the cumulative gap between growth in real gross national income and growth in real GDP since the start of the boom, assuming that incomes would otherwise have grown in line with GDP:
The current booms are deemed to have begun in 2003-04 for Australia and 1999-2000 for Norway. These are the years in which the terms of trade began to grow strongly, opening up a gap between growth in real incomes and output.
The extent to which higher income has fed into higher consumption can be assessed by comparing this 'income gap' to the cumulative gap between growth in real consumption (household and government) and growth in real GDP:
For this purpose, gross national income is deflated using the implicit price deflator for consumption to provide a measure of the extent to which the additional income from the terms of trade boom could have been used for additional consumption spending.
For Australia, cumulative additional income growth from 2003-04 to 2010-11 is estimated to have been around 12 per cent, while cumulative additional consumption growth has been around 4 per cent, implying that two-thirds of the incremental income gains have been saved (Chart 7).
Chart 7: Australia - cumulative gap between growth in real gross national income and consumption and growth in real GDP
Source: ABS and Treasury.
For Norway, cumulative additional income growth from 1999-2000 to 2010-11 has been nearly 40 per cent, while cumulative additional consumption growth has been around 20 per cent, implying that half of the incremental income gains have been saved (Chart 8). While a much larger share was being saved in the earlier stages of the boom, consumption has grown more strongly relative to income over recent years.
Chart 8: Norway - cumulative gap between growth in real gross national income and consumption and growth in real GDP
Source: OECD and Treasury.
While Norway has clearly succeeded in saving a large share of its income gains, Australia has saved an even larger share. This reflects the more cautious approach of Australian households over recent years, which has seen a large rise in the household saving ratio. There are likely to be a number of factors behind this, including increased risk aversion and wealth losses since the GFC, but part of it may be a response to above-trend household incomes since the start of the resources boom, when the saving ratio started rising (IMF, 2011).
Regardless of the motivation for the rise in saving, the effect in terms of consumption smoothing is the
same. The real issue is whether the recent increase in saving will persist if commodity prices remain high. While we cannot be certain, there are good grounds for thinking that we are seeing a structural change in behaviour following the completion of a long period in which households increased debt levels and reduced saving in response to financial deregulation and the return to a low inflation and interest rate environment (Stevens, 2011).
We can estimate how well macroeconomic stability has been maintained using loss functions, which measure the standard deviation of the output gap, and of the gap between inflation and its target rate (2.5 per cent for both countries). Chart 9 shows the value of these loss functions based on OECD estimates of both output and inflation gaps. This is done for the periods 1991-2000 and 2001-10: the latter being the period in which Norway's fiscal rule has been in operation. Also included is the standard deviation of the policy interest rate as a measure of how actively monetary policy has been used to maintain macroeconomic stability.
Chart 9: Standard deviations of output and inflation gaps
Note: CPI inflation for Australia excludes the impact of GST introduction in July 2000.
Source: OECD, RBA, and Treasury.
The comparison suggests that Australia has achieved better outcomes for both inflation and output stability than Norway over the recent decade, and with less movement in interest rates, reversing the experience over the preceding decade.
This comparison cannot be taken to imply very much about Norway's fiscal regime, since the shocks experienced by the two economies have differed between the two periods. Norway is likely to be more exposed to external shocks, with exports around 40 per cent of GDP, compared to 20 per cent for Australia. Norway is also much more exposed to the Eurozone, which would have had a deleterious effect on Norway's economic stability more recently. Nonetheless, the outcomes underscore the strength of Australia's recent performance in terms of macroeconomic stability under the current policy regime (see Gruen, 2011 for a more detailed discussion).
Exchange rate movements
A notable difference between the two economies during their recent resource booms has been the behaviour of exchange rates. The real trade-weighted Australian dollar has appreciated strongly over the past decade to be more than 50 per cent above its average level over the 1990s (Chart 10). By contrast, despite the larger rise in its terms of trade, Norway has experienced remarkably little real appreciation over this period.
Chart 10: Real trade-weighted exchange rates
Source: IMF and RBA.
In considering how this may be explained, note that the fundamental reason why a boom in commodity export prices appreciates the real exchange rate is that it raises incomes and therefore also raises demand for non-traded goods (as well as increasing investment in the booming sector). Unless the economy has substantial spare capacity, this will require a rise in the price of non-traded goods relative to traded goods; that is, an appreciation of the real exchange rate.
Under an inflation targeting regime, this occurs mainly through a higher nominal exchange rate. Alternatively, were the nominal exchange rate prevented from appreciating, the rise in relative prices would instead occur, over time, through higher domestic inflation. This is because, in an economy open to capital flows, such a policy would require easier monetary policy than would be compatible with keeping inflation low. It follows that real appreciation could be avoided only by offsetting the impact on aggregate demand through non-monetary policy means.
Both Australia and Norway began their resources booms with limited spare capacity (Chart 11). By late 2004 Australia's unemployment rate was already close to 5 per cent, which is commonly regarded as close to Australia's lowest sustainable rate of unemployment, or NAIRU. Norway began its boom in 1999 with an unemployment rate of about 3 per cent, which appears to be around its NAIRU. While the Norwegian unemployment rate rose over the next six years, it has since returned to around 3 per cent.
Chart 11: Unemployment rates
The difference in the behaviour of the real exchange rates in the two countries, therefore, does not seem to be explained by differences in spare capacity. Instead, it is likely to reflect differences in the extent to which the boom has fed into aggregate demand.
As noted earlier, the Norwegian regime comprises two elements: a fiscal rule that requires resource revenues to be saved, and investment of these surpluses offshore. The first element is likely to have been more important in explaining why Norway has experienced limited real exchange rate appreciation. The massive increase in budget surpluses shown in Chart 2 (from an average of 3 per cent of GDP in the 1990s to 13 per cent of GDP in the 2000s) could be expected to have offset much of the normal expansionary effect of the boom on demand.
This can be seen in the following charts. The blue lines show the cumulative difference between growth in real national income and growth in real GDP since the start of the respective booms, calculated as before but this time deflated by the implicit GNE deflator. The red lines show the cumulative difference between growth in real gross national expenditure (the sum of private and government consumption and investment) and growth in real GDP.
In Australia's case, the boost to aggregate spending since the boom has roughly matched the boost to national income (Chart 12). As shown earlier, this has been due primarily to a surge in investment rather than higher consumption.
Chart 12: Australia - cumulative gap between growth in real gross national income and expenditure and growth in real GDP
Source: ABS, and Treasury.
In Norway, by contrast, aggregate spending has increased much less than income over the period of its boom (Chart 13). National expenditure has increased more in recent years than in the earlier stages, which may reflect the significant easing of fiscal and monetary policy since the global financial crisis.6
Chart 13: Norway - cumulative gap between growth in real gross national income and expenditure and growth in real GDP
Source: OECD and Treasury.
In order to translate the impact of Norway's fiscal regime into the Australian context, consider the size of budget surpluses that would have been required for governments to save the same share of the increase in national income arising from the terms of trade as in Norway. Commonwealth and state governments would have had to run combined budget surpluses averaging over 4 per cent of GDP over the past eight years (compared to an average deficit outcome of ½ a percentage point of GDP). In view of the fiscal implications of the global financi
al crisis, this would have required much higher budget surpluses during the phase of the mining boom preceding the crisis.7
It would be difficult for Australia to replicate the Norwegian experience, for two reasons. First, relative to the Norwegian government, Australian governments capture a much smaller share of the increased national income associated with resource booms, given both the absence of government ownership in the Australian resource sector, and the much lower rates of taxation of resource rents. Second, the large surge in resource sector investment in Australia means that spending growth in the rest of the economy must be more restrained to achieve the same rate of growth in aggregate spending. For this restraint to be imposed using fiscal policy, budget surpluses would need to be even higher.
You will notice that I have made no mention of the impact of investing surpluses offshore rather than domestically. To understand why this is likely to be less important than the size of the surpluses themselves, note that this policy acts by altering the composition of investor portfolios. If the government buys foreign financial assets rather than repaying debt or buying domestic financial assets, other investors will need to hold more domestic assets (and correspondingly fewer foreign assets). This means the global portfolio share of assets denominated in the domestic currency will be higher than otherwise.
If domestic and foreign securities were perfect substitutes then this would have no effect: the additional domestic currency assets would be absorbed without any changes in prices. On the more realistic assumption that they are somewhat imperfect substitutes, global investors would require a somewhat higher risk premium to hold more domestic currency assets, causing a fall in the domestic currency.
While this mechanism is relevant in theory, the practical issue is that the existing stock of assets is very large: the value of debt and equity securities issued by Australian entities is around $4 trillion. An offshore investment fund would therefore need to be extremely large to have any significant impact on portfolio shares and, thereby, the exchange rate. While Norway's fund, at around 130 per cent of GDP, is probably large enough to have a noticeable impact through this channel, this has been possible only by accumulating massive budget surpluses over an extended period.
There is also a political economy dimension to this issue. Locking away large budget surpluses while commodity prices remain high requires substantial discipline over an extended period. As the pool of financial assets not earmarked for a specific purpose grows, so will the temptation to use these assets to finance current spending. If a breakdown in discipline sometime in the future results in these assets eventually being used to finance a surge in politically motivated spending, then the benefits of increased saving may be undone.
As I noted at the outset, the purpose of this talk is not to argue either for or against setting up a resource-related sovereign wealth fund in Australia. It is certainly not to disparage Norway's regime, which represents an impressive response to the challenges Norway has faced.
My aim instead has been to provide some analysis to inform the debate. By way of summary, let me leave you with the following thoughts.
First, the primary focus in considering this issue should be on the fiscal rules determining the extent to which government saving rises and falls in response to resource-related movements in revenue, rather than on the existence of a sovereign wealth fund per se.
Second, both Australia and Norway are extracting and selling significant quantities of non-renewable resources. Therefore, in both countries, the national balance sheet will deteriorate without an ongoing commitment to re-invest the proceeds of these sales in financial assets, physical capital (including infrastructure) or human capital. This is an important issue for both countries, but of more immediate relevance for Norway because it has much more limited reserves of resources, its economy and public finances are more dependent on resource revenue and it faces greater long-term fiscal challenges.
Third, Australia has achieved favourable outcomes during the current boom, both in terms of saving a significant share of the increased national incomes associated with the boom, and in maintaining macroeconomic stability.
Turning to the effects of the high Australian exchange rate on trade-exposed sectors of the economy, it is important to recognise the different economic circumstances being faced by Australia and Norway.
The Australian economy appears to be at the early stages of a long-lived change in its comparative advantage, driven by the extended economic convergence of China, India, and other rapidly growing developing countries, with the more developed economies. This is a different economic environment than the one faced by Norway, where a resource boom has been driven by exploitation of a relatively short-lived resource.
The longer-lived shift in Australia's comparative advantage makes it appropriate that factors of production shift from other sectors into the resource sector. The change in relative prices associated with the rise in the real exchange rate is one of the mechanisms helping to facilitate this structural adjustment.
Gruen, David and Leigh Soding 2011, 'Compulsory Superannuation and National Saving', paper presented to the 2011 Economic and Social Outlook Conference, 1 July
Gruen, David 2011, 'The Macroeconomic and Structural Implications of a Once-in-a-Lifetime Boom in the Terms of Trade', address to the Australian Business Economists, 24 November
IMF 2011, 'Why has Household Saving Increased so Sharply in Australia?', Chapter 1 in 'Australia – Selected Issues', IMF Country Report No. 11/301
Laurie, Kirsty and Jason McDonald 2008, 'A Perspective on Trends in Australian Government Spending', Economic Roundup, Summer, Australian Treasury
Productivity Commission 2005, Economic Implications of an Ageing Australia, Research Report
Stevens, Glenn 2011, 'The Cautious Consumer', address to the Anika Foundation Luncheon, 26 July
1 Address by second author to the Asia Central Bank and Sovereign Wealth Conference. The authors are grateful to Bonnie Li for help in preparing this speech and to Matt Flavel, Brenton Goldsworthy, Nicholas Gruen, James Kelly and Martin Parkinson for useful comments.
2 Of course, these numbers are based on current discoveries and current technology; new discoveries and/or improved technology would extend the estimated remaining life of the resources.
3 Norwegian data include company income tax, resource rent tax, CO2 emissions tax, royalties, fees and dividends. Australian data include company income tax, resource rent taxes and both Commonwealth and State royalties.
4 The Norwegian government is a joint participant in the wide range of oil and gas projects through the State's Direct Financial Interest (SDFI). It also owns 67 per cent of Statoil, one of the major petroleum producing companies.
5 Australia's fiscal gap is the projected primary deficit, which excludes interest receipts and payments, from the 2010 Intergenerational Report. While this fiscal gap does not include state governments, the Productivity Commission (2005) projected that age-related spending (which is the biggest source of the gap) by state governments would increase by only 0.8 per cent of GDP by 2044-45, compared to an increase of 5.7 per cent of GDP for the Comm
onwealth. Norway's fiscal gap is the Norwegian Government's 2011 Budget projection of the fiscal adjustment required to maintain balance on the non-oil budget, including earnings from the GPFG.
6 The lack of response of the Norwegian real exchange rate to the recent increase in spending may be a consequence of the easing of monetary policy since the global financial crisis (Norway's policy interest rate is now 250 basis points below Australia's), as well as concerns over the crisis in the Eurozone, with which Norway has strong economic links.
7 During this earlier phase, Commonwealth government tax revenue exceeded the forecasts by a cumulative $330 billion, with almost all of this favourable revenue surprise either spent or returned to households as income tax cuts (see Laurie and McDonald, 2008, for further details).