A. Introduction

19. A key issue in conducting fiscal policy in countries rich in natural resources is how much to consume and how much to save out of current and expected resource revenues. This decision crucially hinges on striking the right balance between current priorities, such as social and capital development programs, and long-term goals, such as ensuring that future generations’ standard of living is protected. In practice, this balance can be difficult to achieve, since the likely temptation during a boom is to embark on expensive projects that permanently raise the level of government spending while relying on a revenue stream that may be only temporary. Furthermore, the negative macroeconomic consequences of a boom-bust cycle for overall demand and for the non-energy sector are often underestimated, which can hurt growth and development in the long run.

20. Historical and cross country experience has shown that more often than not, resource wealth has been mismanaged. For example, in the aftermath of the oil booms of the 1970s and 1980s, a long series of countries,¹² including Trinidad and Tobago, experienced the disruptive consequences of overly expansionary and non sustainable fiscal policies during the booms, which weakened their non-energy tradable sector and made their economies vulnerable to shocks, such as the sharp drop in oil prices that began in 1981–82. Two exceptions at that time, namely Norway and Indonesia are noteworthy. Norway’s diversified economy, together with prudent, countercyclical policy, and Indonesia’s flexible exchange rate policy and tight fiscal policy helped these two countries maintain macroeconomic stability after the oil booms of the 1970s and 1980s. It is, therefore, crucial that Trinidad and Tobago not repeat the mistakes of the past, but rather learn from them and from the more successful countries how to use the opportunity offered by the new energy boom to build a solid and sustainable macroeconomic base for the long term.¹³

21. This chapter aims at offering some practical suggestions on the long-run management of the expected resource windfall in Trinidad and Tobago. It outlines some simple theoretical guidelines to calculate sustainable consumption out of energy wealth and to target sustainable levels of non-energy fiscal deficits.¹⁴ The analysis implies that if the current level of expenditures is maintained over the medium term, energy resources will be exhausted in about a decade from now. Consequently, to achieve sustainability, fiscal restraint would be needed, and incentives would have to be put in place to save at least part of the resource wealth. One useful fiscal policy tool to help with resource management is a resource fund. A properly designed fund, together with prudent fiscal policy could help to accumulate resources for the future while at the same time providing a means to prevent a loss of competitiveness in the non-energy sector.

B. Theoretical Underpinnings of Fiscal Sustainability Based on the Permanent Income Hypothesis

22. A useful framework to start thinking about fiscal policy in an intertemporal context is provided by the permanent income hypothesis (PIH) theory pioneered in the consumption literature by Friedman (1957).¹⁵ According to PIH, a benevolent social planner that is forward looking and has a long-term horizon would smooth consumption out of energy wealth over time. If one does not want to take a stand on the magnitude of the government’s intergenerational discount rate, a useful benchmark would be to assume that it equals the real interest rate prevailing on the international markets. Under this benchmark, and assuming that the policy objective is to keep energy wealth constant in real terms over time, PIH intuitively implies that optimal consumption is constant and equals the annuity value of wealth. In other words, all generations would optimally enjoy the same amount of consumption in perpetuity, without increasing the country’s debt or reducing its total wealth.¹⁶ As such, the policy path implied by theory is by construction fiscally sustainable. Because of its simplicity and its powerful predictions for fiscal policy, this baseline will be used in the remainder of the analysis.

23. Sustainable consumption out of energy wealth, under the defined baseline, can be calculated as follows:

where: V is the value of net energy revenues at the end of the previous fiscal year, in constant prices, R₁ … R_n are projected energy revenues for the current and future fiscal years, in constant prices; and r is the average real return on wealth expected to prevail in the future.

24. The country’s energy revenues can be estimated using information on the total amount of proven, probable, and possible reserves in the ground and on the rates of extraction for oil and gas (the useful life of the resource can be obtained by dividing the former by the latter). In this chapter, we use 10-year projections on oil and natural gas production provided by the ministry of energy (as shown in section 3 of Chapter I) and assume that after the first 10 years, energy production declines gradually over the remainder of the useful life of the resource. Three scenarios are considered: a baseline scenario, which assumes that only proven reserves are available (and which, based on the current rate of extraction, imply that energy resources will be exhausted by year 2020); an upside case scenario, which takes into account proven and probable reserves (implying an average life of 29 years); and a downside case scenario, which assumes that only 2/3 of the proven reserves turn out to be available (useful life of 12 years). Figure 1 shows the profiles of energy production at constant 2002 U.S. prices and Figure 2 outlines the corresponding fiscal revenues, also in 2002 U.S. prices.

Energy Output

(in millions of constant 2002 US$)

Citation: IMF Staff Country Reports 2003, 233; 10.5089/9781451837612.002.A002

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Energy Output

(in millions of constant 2002 US$)

Citation: IMF Staff Country Reports 2003, 233; 10.5089/9781451837612.002.A002

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Energy Output

(in millions of constant 2002 US$)

Citation: IMF Staff Country Reports 2003, 233; 10.5089/9781451837612.002.A002

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Energy Revenues

(in millions of constant 2002 US$)

Citation: IMF Staff Country Reports 2003, 233; 10.5089/9781451837612.002.A002

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Energy Revenues

(in millions of constant 2002 US$)

Citation: IMF Staff Country Reports 2003, 233; 10.5089/9781451837612.002.A002

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Energy Revenues

(in millions of constant 2002 US$)

Citation: IMF Staff Country Reports 2003, 233; 10.5089/9781451837612.002.A002

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25. Energy wealth, sustainable consumption, and the corresponding non-energy sustainable overall deficit were calculated based on the energy projections presented above and on equation (1.1) for a baseline real interest rate of 3.5 percent and two alternative values of 2.5 and 4.5 percent. As shown in Table 1, for a real interest rate of 3.5 percent, under the baseline, energy wealth is US$8.6 billion, generating a sustainable consumption level of US$ 301 million, or US$232 in per capita terms. The sustainable non-energy overall deficit of the central government, which will ensure that energy wealth and total debt remain constant over time is 4.4 percent under the baseline, and varies between 2.7 and 6 percent across all cases considered.

Table 1.

Sustainable Consumption from Energy Wealth in Trinidad and Tobago

Table 1.

Sustainable Consumption from Energy Wealth in Trinidad and Tobago

		Base Case	Upside Case	Downside Case
	r	(Proven reserves)	(Proven + probable)	(2/3 proven reserves)
Energy Wealth	3.5%	8,623	9,873	6,943
(in millions of 2002 US$)	2.5%	9,190	10,688	7,292
	4.5%	8,109	9,156	6,619
Sustainable Consumption	3.5%	302	346	243
(in millions of 2002 US$)	2.5%	230	267	182
	4.5%	365	412	298
Non-energy Sustainable Deficit	3.5%	-4.4	-5.0	-3.5
as Percent of Non-energy GDP	2.5%	-3.3	-3.9	-2.7
	4.5%	-5.3	-6.0	-4.3

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Table 1.

Sustainable Consumption from Energy Wealth in Trinidad and Tobago

		Base Case	Upside Case	Downside Case
	r	(Proven reserves)	(Proven + probable)	(2/3 proven reserves)
Energy Wealth	3.5%	8,623	9,873	6,943
(in millions of 2002 US$)	2.5%	9,190	10,688	7,292
	4.5%	8,109	9,156	6,619
Sustainable Consumption	3.5%	302	346	243
(in millions of 2002 US$)	2.5%	230	267	182
	4.5%	365	412	298
Non-energy Sustainable Deficit	3.5%	-4.4	-5.0	-3.5
as Percent of Non-energy GDP	2.5%	-3.3	-3.9	-2.7
	4.5%	-5.3	-6.0	-4.3

26. The obtained levels of sustainable consumption out of energy wealth and overall non-energy deficits should be interpreted as guidelines, rather than strict targets, as they can vary when the underlying assumptions are allowed to change. Given that non-energy GDP will be growing in the long run, the sustainable deficit levels as a share of non-energy GDP will decline over time. Furthermore, if the objective of fiscal policy is to keep real wealth per capita constant, or to allow real wealth to grow at the rate of population and technical change, instead of maintaining the level of real wealth constant over time, then the effective interest rate that will need to be used in a similar analysis would be lower, and as such, lower levels of the sustainable non-oil fiscal deficits would be optimal. Finally, if the profile of energy production changes, the sustainable consumption and non-energy deficits will change accordingly. It is, therefore, recommended that such an analysis be conducted on a regular basis to capture new developments in the energy and non-energy sector.

27. The sustainability analysis presented here assumes that the government undertakes current rather than capital expenditure, and that all saving is done abroad. This is justified based on three grounds: (i) the authorities’ expressed medium term objectives to use resource wealth to finance current expenditures; (ii) the poor historical performance of domestic capital investment, which led to a loss of competitiveness in the non-energy sector (see Chapter I); and (iii) the difficulty to gauge the return on social capital investments. If the government decided to save part of its revenue windfall domestically due to more favorable rates of return on its investments, a larger sustainable deficit could be possible.¹⁷ As shown in Table 1, the higher the interest rate, the lower would be total energy wealth (since it is discounted at a higher rate), but the higher will be the sustainable rate of consumption and the sustainable deficit.

28. According to the theoretical guidelines proposed, the current fiscal stance appears unsustainable in the long run. For FY 2002/03, the overall non-energy fiscal deficit is estimated at around 11 percent of non-energy GDP, a figure that is almost three times as large as the optimal level under the benchmark. If government expenditure as a percentage of total GDP remains around the average level projected for the next six years (around 25 percent, implying a non-energy deficit of about 11-13 percent of non-energy GDP for the medium term), energy wealth will be exhausted in about 10 years from now under baseline assumptions.

29. To achieve long-run sustainability, either the level of expenditure would need to be reduced or non-oil revenues increased, such that non-energy deficits fall within the limits presented in Table 1. An immediate reduction in expenditure which would be followed by a gradual decline toward the sustainable level would help achieve long run fiscal sustainability. The sooner the expenditure level can be contained within the sustainable limits, the less would be the loss in energy wealth over time. Furthermore, a gradual rather than a more abrupt cut in spending would avoid generating macroeconomic instability, which could be detrimental to growth.

C. Resource Funds as Policy Tools to Achieve Fiscal Sustainability

30. Resource savings funds are policy tools that have been used by a number of countries to help put aside part of their resource wealth. Such funds, when used in conjunction with prudent fiscal measures, can be effective tools to build a store of national wealth for future generations, while at the same time being able to insulate the economy from volatility if the need arises. However, as cross country evidence suggests,¹⁸ resource funds have had mixed success in achieving efficient resource management. This less than desired performance is thought to be due to two main factors: poor design of the fund rules, and inability to coordinate the fund’s operations with countercyclical fiscal policy. As such, setting up a resource fund is advisable only if authorities are committed to putting in place and adhering to a set of fund rules that are coherent and consistent with its stated goals and with overall fiscal policy.

31. In FY 1999–2000, Trinidad and Tobago set up an interim oil revenue stabilization fund (RSF) with the aims of promoting fiscal discipline during oil booms, cushioning the effects of unexpected drops in oil prices, and encouraging public saving. During its first year of operations, funds amounting to TT$ 1,000 million have been transferred to it. The fund, however, has not been formally approved by parliament and has been inactive since 2002. The current administration must now decide whether to reinvigorate the fund, with some revisions to its rules, or to simply close it.

32 If saving is an important policy goal, then reinvigorating the RSF could be useful policy tool to help mobilize political support for setting aside petroleum wealth. As shown in the previous section, saving for the future is desirable based on intergenerational equity and fiscal sustainability grounds. An additional reason to put aside resources now is the upcoming aging of the population, which will put significant pressures on the government budget in the next decades.¹⁹ Reinvigorating the RSF, therefore, may be an appropriate policy to help manage resource wealth and save for the future.

33. If the authorities decide to use the RSF as a means to improve energy wealth management, to make it more efficient, the current structure of the fund could be modified following the Norwegian State Petroleum Fund model (described in Box 2). The intended objective of this reform would be to save part of the proceeds from the large energy revenues that are expected to materialize in the next several years in order to help crystallize a policy of building national wealth for the future and to achieve fiscal sustainability in the long run. Moreover, the fund’s assets could be used to help insulate the economy from excessive volatility resulting from sharp resource price variations, and could be invested abroad which would help prevent a real exchange rate appreciation.

34. The existing rigid rules for deposits to and withdrawals from the fund could be modified to allow for more flexibility. Deposits to the fund would comprise all energy revenues, including oil and natural gas exploitation and refining (i.e., energy tax revenues and payments under Production Sharing contracts), not only oil revenues, as is current practice. The budget would transfer all net energy revenues to the RSF, and drawings from the fund would only be used to finance budget deficits (via a reverse transfer) arising from expenditures and revenues approved by parliament under the normal budget appropriation process. The amount of funds available to the government from the RSF in any one year would be subject to “sustainable income” guidelines, as described in the previous section. These guidelines would be revised periodically to take into account new developments in the energy sector, such as new discoveries or dry wells.

35. The investment strategy of the RSF could be improved by putting in place clear and conservative rules regarding the portfolio composition of the fund in terms of mix of assets (equities versus bonds), currencies, and liquidity and maturity of assets. Furthermore, it would need to be stated explicitly that the fund is not allowed to borrow or lend, and its capital will not be used as collateral for any public sector borrowing. The central bank, on instructions from the ministry of finance, may manage investment operations of the RSF, and may subcontract professional fund managers to manage part or all of RSF’s assets.

36. Transparency and accountability could be enhanced. Efforts could be made to ensure that the parliament and the public are kept well-informed of the overall value of RSF’s assets and of issues relating to its management. Comprehensive reporting requirements, including inter-year reporting and its publication on a public website would need to be explicitly incorporated in the law. There would need to be a clear assignment of accountability for the performance of the fund; its rules and operations would be free from political interference. The assets of the RSF need to be presented and assessed in the context of the government’s net financial wealth.

D. Conclusion

37. The present paper aims at outlining some fiscal guidelines that could help the authorities to develop a coherent and sustainable fiscal strategy for the long term. A methodology to calculate targets for the sustainable level of non-energy deficits is developed based on the permanent income theory of consumption. Adhering to these targets ensures that present and future generations alike optimally enjoy the same amount of consumption in perpetuity, without increasing the country’s debt or reducing its total wealth. According to the guidelines, the current fiscal stance is found to be overly expansionary, warranting an increase in saving and a reduction in current expenditures or increase in non-energy revenues in order to arrive gradually at the targeted levels of non-energy deficits.

38. One useful policy tool to help achieve fiscal sustainability is a resource fund. Resource funds can be effective policy tools to help save for the future and to stabilize the economy in the event of negative shocks. However, this will not be the case in the absence of sufficient commitment to the Fund on transparent rules for its operation. If the authorities are willing to adopt a policy that promotes national saving, the existing Revenue Stabilization Fund could be modified to help manage resource wealth in accordance with the principles of fiscal sustainability and intergenerational equity. In addition, by investing its assets abroad, the fund could help sterilize the large foreign inflows that will start flowing in, thus preventing a potential real exchange rate appreciation that could hurt the non-energy sector. This chapter outlines some guidelines to revamp the RSF following the Norwegian State Petroleum Fund model, enhanced such that it is integrated within a “sustainable income” framework. A sustainable medium and long term fiscal strategy can help Trinidad and Tobago to use the current energy boom as a bridge towards a new stage of development and economic prosperity.