When (Not) to Set Up a Heritage Fund

Ashby Monk

Sudden increases in commodity revenues tend to strengthen a nation’s currency, resulting in exports becoming more costly for foreigner buyers, which, in turn, renders the domestic manufacturing base less competitive. This, friends, is the Dutch Disease. And, with oil prices now above $120 a barrel, it has once again become a major area of concern for resource rich countries in the developing world.

And, as you are no doubt aware, one of the main catalysts in the rise of SWF popularity has been the ability to use these funds to manage resource revenues in the hopes of preventing the Dutch Disease. Indeed, from Africa and Latin America to the USA and Asia-Pacific, commodity funds are popping up at an increasing rate. Many developing countries now see SWFs as potentially vital components of their economic development strategy.

But should they? New(ish) research by some of my colleagues on the other side of town (OxCarre) on how and when Dutch Disease occurs offers a new perspective. The authors are circumspect about the utility of offshoring assets for long-term time horizons in helping to avoid Dutch Disease in developing countries. As such, while they agree that stabilization funds are crucial for managing resource volatility, the OxCarre researchers are less enthusiastic about long-term savings funds. Clearly, this could have important implications for the types of sovereign funds that developing countries are setting up. So it is interesting. Seriously.

There are a few good OxCarre papers you could read, but I’ll first refer you to Rick Van der Ploeg’ paper entitled “Fiscal Policy and Dutch Disease.” Here’s a useful blurb:

“The main insight we derive from this model is that if the natural resource windfall is substantial but not large enough for the country to become a rentier, capital goods must be produced at home and adjustment to natural resource windfall takes time. The result is an appreciation of the real exchange as factors are shifted from the non-traded sectors to manufacturing. This sluggish adjustment process is a result of the absorption constraints in the non-traded sector which imply that it takes time to build this home-grown capital. A much more detailed analysis of this can be found in van der Ploeg and Venables (2010). Specific factors are also crucial to explain the dynamic responses of capital intensities and wages in response to a natural resource windfall, which do not occur in the Dutch disease model without specific factors (e.g., Sachs and Warner, 1997). The reason is that with perfect international capital mobility and no specific factors of production, the wage, the relative price of non-traded goods and the capital intensities in the traded and non-traded sectors are pinned down by the world interest rate. If a country is small and the windfall is large, it will be able to import capital and migrant labour in which case the Dutch disease can be avoided.”

In other words, the Dutch Disease is quite real, but it can be and has been avoided in certain circumstances. The key is to draw in investments and imports as the resource boom accelerates. And the ability to draw these in is (in part) a function of the domestic economy’s infrastructure stock and available skills. What are the implications?

“It may then be optimal to temporarily park some of the windfall in a sovereign wealth fund until the non- traded sector has produced enough home-grown capital (infrastructure, teachers, nurses, etc.) to alleviate absorption bottlenecks and allow a gradual rise in consumption…The economy experiences temporary appreciation of the real exchange rate and other Dutch disease symptoms. However, these are reversed as home – grown capital is accumulated.”

In other words, a sort of “parking fund”  may be appropriate, but a long-term savings fund would not be.

Anyway, all this is to say that developing countries facing resource booms should weigh a variety of options when trying to come up with strategies for overcoming the resource curse. According to van der Ploeg, Venables, et al., that may mean giving up on the heritage or future generations funds and prioritizing capacity-increasing, domestic investments in the current generation. Interestingly, these authors seem to be arguing that one type of SWF (heritage fund) should simply be replaced by another type of SWF (holding or development fund).

One final thought: the resource curse and the paradox of plenty, which holds that resource-rich countries often underperform resource-poor countries on economic and social indicators, may logically drive some countries to set up long-term SWFs (heritage funds) in a bid to move offshore all the windfall revenues. After all, if resource-poor countries perform better, perhaps it’s best to simply act as if the resources don’t exist? That may be a path around the resource curse, but it does not capitalize on countries’ natural endowment to accelerate growth. And this, it seems to me, is the point of OxCarre: Squirreling away resource revenues is inappropriate when they can be fruitfully invested in domestic infrastructure, ports, and skills without engendering the Dutch Disease.

Anyway, I find this discussion and research really interesting. It’s a bit dense, at times, but the implications are significant. So it’s well worth plodding through it:

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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