State Secretary Mr Endre Skjørestad

The Norwegian economy: Long term perspectives and the Petroleum Fund

Speech at seminar organised by the Norwegian-American Chamber of Commerce in New York, March 12th, 1998

- Rationale for the establishment of the Fund and the Fund’s role as an economic policy instrument

Let me first thank the organisers for this opportunity to present the long term perspectives of the Norwegian economy and the Petroleum Fund.

Slide 1: Norway. Key figures for 1997

Slide 1 gives you some statistical facts about the Norwegian economy and the public finances. Since the early nineties, Norway has had a substantial current account surplus of the balance of payments. The current account surplus for 1997 amounted to 5.4 per cent of GDP. In recent years our public finances have improved substantially, partly due to increasing oil revenues and partly due to the strong growth of the Norwegian economy since 1993. In 1993 the general government had a deficit of 1.4 per cent of GDP, which turned into a surplus of 7.3 per cent of GDP in 1997. At the same time there has been a sharp growth in employment and declining unemployment rates. In 1997 the average unemployment rate was brought down to 4.1 per cent, from 6.5 per cent in 1993, and it is expected to decline further this year. Despite the sharp growth in employment and output, price and wage inflation has remained moderate.

Slide 2: Fiscal Budget revenues 1998

Slide 2 shows the composition of the fiscal budget revenues for 1998. The petroleum revenues constitute around 18 per cent of the Government’s total revenues. The petroleum sector constitutes 16 per cent of total GDP. Although the petroleum sector is vital to the Norwegian economy, it should be underlined that we have managed to limit our dependence on oil revenues. Even without oil revenues, public finances would have appeared favourable compared to most European countries.

Slide 3: The State’s Net Cash Flow from the Petroleum Activities

Slide 3 shows projected cash flow to Government from the petroleum sector. We see that we are facing a period of temporarily high oil revenues, followed by a decline. This in itself is of course reason enough to save some of today’s oil revenues. But as slide 4 shows us, it is not enough to spread the use of oil revenues over time. We also have to take account of changes in future Government spending, primarily connected with the ageing of the population.

Slide 4: Long term challenges

Last year, the former Government submitted a Long-Term Programme, which is a report to the Norwegian Parliament on long term economic prospects and policy issues. Among other things, this report includes projections and analyses of the Norwegian economy for the next 50 years. Although there is great uncertainty associated with attempts to outline long term economic developments for the next 50 years, such analyses are necessary to enable us to exploit available information in a systematic manner, in order to throw light on the long term consequences of policies pursued today.

The most important conclusions of the long-term projections are as follows:

• The number of people in the working force per pensioner is estimated to decline from 2.5 today to approximately 1.7 in 2050. The demographic developments thus contribute to moderate growth. Output per capita is estimated to grow by slightly above 1 per cent per year over the period. In the future, economic growth will to a greater extent depend on expertise, technology, and higher productivity.
• Lower petroleum revenues and higher pension expenditures as a percentage of GDP require the public sector to accumulate sizeable financial assets during the next few decades to maintain the supply of public services.
• The ageing population will contribute to lower labour supply. The room for public consumption may be significantly reduced if average working hours or the retirement age are reduced.
• The decline in petroleum activity after the turn of the century underlines the need to maintain good conditions for non-oil industries. This means that great caution is needed in the use of oil revenues in the domestic economy.
• The international climate agreement will reduce the risk of climate changes and may therefore avert the risk of serious damage to ecological systems, economic developments and living conditions. At the same time, the implementation of a climate agreement will involve considerable costs to the Norwegian economy, mainly in the form of lost petroleum revenues and adjustment costs.

Slide 5: Long term challenges

The Norwegian economy therefore faces considerable long-term challenges These challenges must be met:

• by encouraging people of working age to remain in the labour force and by raising the average retirement age,
• by maintaining the cost-competitiveness of the tradable sector in order to secure a tradable sector, including a manufacturing sector, which is of a sufficient size to ensure balance in the external account when oil revenues decline,
• by ensuring a high return on investment in the public and private sector,
• by improving the quality of the labour force by focusing on education and research,
• by conducting a macroeconomic policy that stabilises the development of the Norwegian economy, which means that we must avoid both overheating and a sharp fall in production, and
• by accumulating separate central government financial wealth which reflects the decline in oil wealth and which can be drawn on as oil revenues gradually diminish.

The Petroleum Fund is a key instrument for managing central government financial saving. When petroleum wealth is used, it is matched by export earnings which largely end up in the Treasury as tax revenues and income linked to central government ownership stakes on the continental shelf. Some of this income is used in the Fiscal Budget. A substantial part of the oil revenues must, however, be saved in the form of financial assets. It was for this reason that the Petroleum Fund was established.

It is assumed that the Petroleum Fund will be a fiscal management tool which makes it easier to see how much we spend of our petroleum revenues. In the work leading to the act establishing the Fund, it was underlined that the Fund’s resources must be included in the budgetary process. When the Fund was established it was therefore emphasised that the accumulation of assets in the Petroleum Fund should reflect actual budget surpluses. The interaction between the Fund and the fiscal budget is illustrated in slide 6.

Slide 6: How the Fund works

The Fund’s income is the central government net cash flow from petroleum activities, and the return on Fund investments is added to the Fund. The Fund’s expenditure consists of an annual transfer to the Treasury corresponding to the amount of petroleum revenues used in the Fiscal Budget to cover the non-oil deficit. In this way, money is accumulated in the Fund if, and only if, there is a Government budget surplus including oil revenues.

According to the projections in the amended budget proposal presented in November last year, the capital in the Petroleum Fund will increase from around NOK 113 billion (USD 15.4 billion) by the end of 1997 to around NOK 570 billion (USD 77.5 billion) at end-2001, representing a rise from around 10% of GDP to over 35% of GDP. These estimates are of course very uncertain.

Slide 7: The Government Petroleum Fund Basis alternative

As I have mentioned, the Long-Term Programme submitted last year includes long-term projections to the year 2050. Different scenarios are presented. The basis scenario in the Long-Term Programme represents one in which future economic policies comply with the requirements of balanced public finances and stable growth. In the basis scenario the Petroleum Fund is estimated to increase to around 140% of GDP in 2020, and then fall steadily as a share of GDP.

In this connection, two things should be noted: First, the basis scenario is an analysis of how much we have to save in order to have balanced public finances in the long run. It is not necessarily the “best guess” one could make of how much we are going to save. Achieving the fund size indicated in these projections requires successful implementation of a fairly ambitious fiscal policy.

Slide 8: Government Petroleum wealth and financial assets

Second, as slide 8 demonstrates, the building up of financial reserves in the Petroleum Fund is accompanied by a reduction in petroleum wealth as resources are depleted. The sum of the State’s financial assets and petroleum wealth is projected to be relatively constant until 2020 or so, before it starts falling.

Slide 9: The Fund is only invested abroad. Why?

The Petroleum Fund is only being invested abroad. The reasons for this are as follows:

• The first reason is the need to maintain the Fiscal Budget as a management tool. The Petroleum Fund consists of that part of petroleum revenues not used in the Fiscal Budget, and the return on this capital. In its work on the budget, the Norwegian parliament takes into account the extent of central government expenditure, including which investments are to be made and which other factors have to be considered. If, in addition, the Petroleum Fund were to be used to finance domestic investments in for example infrastructure, the Petroleum Fund would become a second fiscal budget. This would weaken the position of the Fiscal Budget as a political management tool.
• The second reason is the need to achieve high returns on the Fund’s investments. Increased domestic use of the revenues could result in a low return on investments.
• The third reason is the need to stabilise the Norwegian economy. The substantial surpluses on the current account will be matched by a considerable outflow of capital abroad in years to come. If the private sector were to contribute to this capital outflow to any considerable extent, interest rates in Norway would have to be lower than interest rates abroad in order to encourage private investors to invest abroad rather than at home. By investing the Petroleum Fund directly abroad, the central government will contribute to substantial capital outflow and thereby shelter the domestic economy from the effects of high petroleum revenues more effectively.
• The fourth reason is the need for a varied industrial structure. The investment of the Petroleum Fund abroad helps to ensure that the amount of oil revenues used in the economy does not result in an industrial structure that cannot be sustained when oil revenues start to decline. The higher the spending of oil income, the further the basis for the tradable sector will be eroded, and the more difficult the transition to a future low oil income situation will be, the so-called “Dutch disease” problem.
• The fifth reason is the need to use the Petroleum Fund as a buffer. If the Fund is to function as a financial buffer which can be drawn on to finance budget deficits, it is important that the size of the buffer can vary without affecting the rest of the economy to any extent. Substantial and strongly fluctuating central government financial wealth vis-B-vis domestic sectors would not satisfy such a requirement.

Since the Fund is only being invested abroad, the domestic currency value of the Fund will fluctuate over time. When talking about the exchange rate risk to which the Fund is subject, it is important to recognise the distinction between:

• fluctuations in the domestic currency’s international value over time, and
• fluctuations in exchange rates between foreign currencies.

Fluctuations in the krone’s international value are basically not a key risk factor for Petroleum Fund investments. The Fund should be invested in such a way that international purchasing power is maximised when resources are to be drawn from the Fund. The Fund’s krone value is, however, not of significance for the Fund’s international purchasing power. The volume of goods and services which can be imported for Norway’s foreign exchange assets is only determined by the currency holdings in the Fund and not by the Fund’s value in Norwegian kroner. Exchange rate movements between the currencies in which the Petroleum Fund is invested, will, however, entail a real risk for the Fund.

Because of the long investment horizon of the Fund, the Ministry of Finance last autumn, after submitting amended investment guidelines to the Parliament, decided to allow equity investments. The following arguments were made for this:

• Risk must be weighed against expected return . Investments such as bank deposits and government securities have traditionally carried a low risk and low expected return, whereas investments in equity instruments, which bear a higher risk of short-term fluctuations in market value, have provided a better average return over time.
• Returns on equities and on bonds do not normally move in tandem. Empirical results from the US and the UK, where time series for returns on equities and bonds date back many years, indicate that a higher return and lower overall risk can be achieved by combining equities and bonds than is the case for pure bond investments.

· The Petroleum Fund can be looked upon as assets that have been converted from oil and gas to financial wealth, thereby reducing the exposure of total wealth to variations in the oil price. Historically, equities have showed negative covariance with the oil price, whereas there has been some positive covariance between bonds and the oil price. If this continues to be the case, equity investments will reduce the oil price risk to a greater extent than bond investments.

If a substantial part of the Petroleum Fund is invested in equities, a low or even negative return on the Fund’s investments must be expected in certain years. In the long run, however, the return on equity investments is expected to be higher. The risk associated with investments must be evaluated on the basis of the investment horizon. A portfolio that involves little risk in the long term may show considerable fluctuations in value in the short term. Conversely, the value of a portfolio with little risk of fluctuations in the short term may involve considerable uncertainty in the long term.

In its submission to Parliament, the Ministry of Finance concluded that in the long run the central government can probably achieve a higher return by investing portions of the Petroleum Fund in a well-diversified equity portfolio. Since the capital in the Fund has reached a size which exceeds the level deemed necessary to cover any budget deficit in the short to medium term, the objective of achieving a higher return on central government assets would indicate that investment in equity instruments should be permitted. Furthermore, historical data show that investing portions of the assets in equities has actually provided greater security for the value of the wealth in the long term than bond investments alone. In the new guidelines, the equity portion of the Petroleum Fund’s portfolio was set to 30-50 per cent.

Slide 10: Management of the Fund

Slide 10 illustrates the division of labour between the Ministry of Finance and the central bank. The ministry is responsible for strategic asset allocation and the setting of risk limits. The central bank is responsible for operational management within the guidelines set by the ministry. In addition the central bank is the main advisor to the Ministry on investment strategy issues.

This concludes my brief description of the background for establishing the fund and the role it has in our economic policy. A presentation of the management of the fund will be given by the person responsible for it - the Governor of the central bank of Norway.

Thank you for your attention.