Svein Gjedrem: A diversified economy
Speech by Mr Svein Gjedrem, Governor and Chairman of the Norges Bank (Central Bank of
Norway), at the seminar "Oil in the economy" at the Norwegian Oil Museum, Stavanger,
8 June 2010.
The text below may differ from the actual presentation. This speech does not contain assessments of the
economic situation or current interest rate setting.
* * *
"Look what I found!" shouted Askeladden (the Ash Lad) in the Norwegian folktale
"The Princess Who Always Had to Have the Last Word". He found a dead
magpie, a willow hank, a bit of broken saucer, two ram's horns, a wedge and a
worn-out shoe sole, which he managed to transform into a princess and half a
kingdom.
Askeladden is often perceived as the embodiment of sound Norwegian values such as a
sense of adventure, courage and helpfulness. Askeladden is nevertheless someone who
succeeds by pure chance.
Like Askeladden, we also found wealth, but under the sea floor. We were lucky.
An abundance of natural resources is in principle of benefit to a country's economy. The
production of petroleum and other natural resources generate gains that exceed the normal
return on invested capital, economic rent. But oil is also associated with challenges. As early
as in 1974, the Storting1 deliberated the economic challenges relating to oil production.
We were able to learn from the experience of other countries. The concept Dutch disease
stems from the negative effects on the Dutch economy of the spending of revenues from the
substantial gas resources of the Groningen field. From the end of the 1960s, these revenues
financed strong growth in public expenditure, which led to higher costs and a decline in
manufacturing. The situation went too far, resulting in large balance of trade and government
deficits which required tightening measures. This in turn led to a sharp rise in unemployment
in the first half of the 1980s.
But the Netherlands is not the first example of a nation that failed in this respect, and far from
it2. A very clear example is provided by Spain as early as in the 17th century when the
colonisation of South and Central America provided the country with access to vast natural
resources and gold. The historian David Landes describes the effects on Spanish society in
his book "The Wealth and Poverty of Nations" where he cites a happy Spaniard who
proclaimed the following in 1675:
"Let London manufacture those fabrics of hers to her heart's content; Holland her
chambrays; Florence her cloth; the Indies their beaver and vicuna; Milan her
brocades: Italy and Flanders their linen, so long as our capital can enjoy them.
The only thing it proves is that all nations train journeymen for Madrid and that
Madrid is the queen of Parliaments, for the world serves her and she serves
nobody."
From time to time, I meet representatives of the diplomatic corps in Norway. They seldom fail
to mention the high cost level in Norway and their bewilderment over aspects of our way of
life. A 17th century Moroccan ambassador was even more critical in his account of the
wealthiest nation at that time:
"...the Spanish nation today possesses the greatest wealth and the largest
income of all Christians. But the love of luxury and the comforts of civilization
have overcome them, and you will rarely find one of this nation who engages in
trade or travels abroad for commerce as do the other Christian nations [...].
Similarly, the handicrafts practiced by the lower classes and common people are
despised by this nation, which regards itself as superior to other Christian
nations. Most of those who practice these crafts in Spain are Frenchmen [who]
flock to Spain to look for work ... [and] in a short time make great fortunes."
See chart "Petroleum production" at the end of the speech.
The oil age in Norway has now spanned about 40 years and there are prospects that it will
continue for some time ahead. We will most likely still be producing petroleum in 40 years'
time, but oil production has declined in recent years after peaking in 2000. Gas production is
rising, but not at a pace sufficient to sustain overall petroleum production.
The idea of an oil fund was raised in the beginning of the 1980s3. It was intended to be a
buffer fund to smooth variations in government oil revenues.
The Act relating to the Government Petroleum Fund was adopted in 1990 in the midst of the
deepest economic downturn in Norway since the Second World War. Those at the Ministry of
Finance working on the law at the time were probably in doubt as to whether any savings
would ever be accumulated in the fund.
And initially the fund structure was only an exercise in accounting. Government petroleum
revenues were deposited in the fund, but the entire amount was transferred back to the
central government budget to cover some of the non-oil deficit. But the Norwegian economy
rebounded.
See chart "First deposit in the fund" at the end of the speech.
It took a generation from the discovery of the first oil field in the North Sea until it became
possible for the government to set aside a portion of the economic rent. The first net transfer
to the fund of close to NOK 2 billion was made in 1996. Every year since then, as a savings
plan, the government has let a substantial share of current income from oil and gas remain
as deposits in the fund. At the end of the first quarter of this year, the fund's market value
stood at NOK 2 763 billion.
See chart "The fund's market value" at the end of the speech.
As the fund increased, the need for a plan for the phasing in of oil revenues became evident.
In 2001, the Government and the Storting adopted the fiscal rule, which is based on the
deposit of government petroleum revenues in the oil fund. An amount equivalent to the
expected real return on the fund, or 4 per cent, as an annual average over time, is
transferred back to the central government budget to cover current expenditure. The
transfers increase as the fund rises in value.
Along the way, the name of the fund has been changed from the Government Petroleum
Fund to the Government Pension fund Global.
There are prospects that new annual transfers to the fund may be made over the next
10 years or so. This implies further growth in the fund, perhaps up to twice the size of today's
fund, which corresponds to one and half to two times annual GDP for Norway. Public
expenditure accounts for about half of GDP. Withdrawals from the fund at 4 per cent can
therefore finance 15 per cent of public spending in 10 years' time. This can continue on a
permanent basis without reducing the capital in the fund. The fund will therefore lead to
smaller cuts in government welfare spending than would have been the case without the
fund as the costs related to the ageing of the population have an impact on government
budgets.
The actual building up of the fund may span a short generation.
A fund with investment abroad enables Norway to separate the revenues generated by oil
and gas production from petroleum revenue spending. An alternative could have been to
regulate the production rate, keeping our wealth under the sea bed for a longer period, as
was attempted in the 1970s when the production ceiling was set at 90 million standard cubic
metres per year. Oil companies currently produce 240 million standard cubic metres per
year.
The fund acts as a buffer between widely fluctuating oil revenues and domestic expenditure.
The annual spending decision can be made independently of the size of the revenues. Thus,
the fluctuations in government oil revenues do not have an automatic impact on the
Norwegian economy. The fund also has a stabilising effect on the krone exchange rate as
capital outflows increase when Norway's petroleum revenues rise.
As a savings plan, the fund enables petroleum revenues to be used by not only the current
generation but also future generations. The fiscal rule ensures that this is the case.
International capital markets play an important role for Norway. We drew on borrowing
opportunities abroad when the petroleum industry was under development. We did the same
in order to expand welfare schemes and to finance the countercyclical policy of the
mid-1970s and the early 1990s. In the past 15 years, international financial markets have
enabled us to convert national oil and gas resources into foreign equities and bonds.
See chart "Real return on the fund" at the end of the speech.
Since its establishment in 1998, the fund's average annual real return after costs has been
2.9 per cent, or somewhat lower than the expected long-term return. This figure is marked by
the challenging character of the financial crisis. The fund lost NOK 633 billion4 in 2008, but a
market reversal in 2009 has resulted in a positive return of NOK 716 billion over the past five
quarters. So far, the fund seems to have fared relatively well through the most severe
financial crisis for many decades.
We still consider a real return of 4 per cent as realistic over time. This is based on the
assumption that investment in sound government securities in the market can provide a
reliable real return of about 21⁄2 per cent. At the same time, the fund can reap a return of 2 to
21⁄2 per cent in the long term from the three-fifths equity portion, some gains on corporate
bonds and returns from active management.
See chart "Real exchange rate against Norway's trading partners" at the end of the speech.
Substantial oil revenues are now being ploughed into the Norwegian economy. Since the
turn of the millennium, annual petroleum revenue spending has increased by a good
NOK 100 billion. According to uncertain forecasts in government documents5, another
NOK 40 billion or so will be phased in over the next ten years.
The cost level in Norway is a thermometer indicating how much the Norwegian economy can
sustain without developing a serious case of Dutch disease. The temperature is now high.
Measured against Norway's trading partners, the cost level is now almost 20 per cent higher
than the average for the oil age. Norwegian labour has never been as costly as today.
Norwegian businesses will often lose contracts given the current high level of spare capacity
in other countries. And it has never been more profitable to relocate activities abroad.
The economic geography of Norway will change over the next 10-15 years. Norway's cost
level and low growth in Europe will bring pressure to bear on jobs and businesses in
manufacturing communities. Job losses will have the most severe effects in areas where
manufacturing is the most important industry. Entire manufacturing sectors may be lost.
We can also ask whether investment in Norway could be an alternative to our investments in
international financial markets. It is important to emphasise that the oil fund does not stand in
the way of corporate investment. The government can choose the composition, required rate
of return and risk profile for its investments without considering the funding requirements of
Norwegian enterprises. By the same token, Norwegian companies can choose their debt and
equity structure independently of the government's financial investments. There is a capital
market between the government as investor and corporate capital needs. The government's
foreign savings plans do not therefore affect Norwegian companies' access to capital and
required rate of return on their investments.
There are sound arguments for investing in infrastructure, better schools and state-of-the-art
research. But this should be possible anyway given the increase in expenditure that is
provided for by the fiscal rule.
The profitability of government investments is based on a discount rate of 4 per cent. This
secures about the same required rate of return as the government can expect to achieve on
its oil fund investments over time.6 A question that might be raised is whether there is a
queue of sound and profitable projects that have to wait because of an excessively tight
fiscal policy.
It is difficult to find support for this.7
In the National Transport Plan for 2010-2019, which can perhaps be considered
representative of government spending, spending on road investments is set at around
NOK 140 billion. The profitability of about two-thirds of the investments has been evaluated.
The calculations capture time saved and reduced costs related to accidents and the
environment. Investment costs and future operating costs are deducted. The projects show a
total loss of NOK 20 billion.
There seems to be few road projects that are economically profitable. A rare example is the
Finnfast tunnel project that connects the mainland to the beautiful island group here in
Ryfylke.
When projects cannot be expected to increase the future revenue base in society, it is
important that the investments are financed from current government revenues within a
long-term and sustainable framework. Alternatively, projects that involve a large number of
users can be financed by user fees. A road, infrastructure or research reports for that matter
can provide benefits and satisfaction over time, but they are not liquid and do not generate a
flow of returns that can be used for spending. If the investments are made at the expense of
the savings plan for the sovereign wealth fund, future generations will have to bear the cost.
Let me conclude.
The adventures of Askeladden are often tales of success. Askeladden embraces every
challenge and always comes out ahead.
It is too early to draw conclusions as to how successful Norway has been in managing its oil
wealth. In ten years or so, when petroleum production falls markedly and the oil fund is no
longer increasing in size, the cost level in Norway will have to be reduced relative to other
countries. This process may be painful, even though Norway has its own currency and a
floating exchange rate. Our welfare state may also have become too large and the
adjustment required here may also prove to be very demanding.
Nonetheless, there are aspects of our oil wealth management that have served us well.
Thank you for your attention.
BIS Review 78/2010
BIS Review 78/2010