Øystein Olsen: Monetary policy and wealth management in a small
petroleum economy
Speech by Mr Øystein Olsen, Governor of the Norges Bank (Central Bank of Norway), at the
Harvard Kennedy School, Cambridge, USA, 9 April 2013.
* * *
Please note that the text below may differ from the actual presentation. Charts in pdf-format
Introduction
I am delighted to be here at the Harvard Kennedy School, and I really appreciate this
opportunity to talk to you. My topics are Norwegian monetary policy and the central bank's
management of Norway's oil fund, the Government Pension Fund Global.
I will begin with some background on the macroeconomic policy framework in Norway, and
why we believe it works well. A rules-based approach was adopted after two turbulent
decades of boom-bust economic cycles. The path towards the current regime was developed
and supported by successive governments in the 1990s and early 2000s as it gradually
came into place. Since 2001, the operational target of monetary policy has been annual
consumer price inflation of around 2.5 percent over time.
With growing petroleum revenues, asset management has also become one of Norges
Bank's main tasks. Both in our conduct of monetary policy and in asset management,
transparency is a guiding principle. I will explain how we see ourselves as a global financial
investor, and elaborate on the main elements of our investment strategy.
Some background
Chart: Oil wealth has brought strong rise in prosperity
In order to put the Norwegian economy into some perspective, we can compare Norway with
Sweden, our close neighbour and a country with many similar characteristics. The relative
income level between the two countries was stable - until 1969, when oil was discovered in
the Norwegian part of the North Sea. Since then, Norway's income has pulled ahead.
Chart: Terms of trade and real exchange rate in Norway and other countries
Our national income reflects the considerable improvement in Norway's terms of trade over
the past couple of decades compared with other resource-rich countries. Nonetheless, the
real exchange rate in Norway has not appreciated as sharply as in these countries.
The extraction of oil and natural gas from the sea bed along Norway's coast has come to
play a major role in the economy. The petroleum sector now accounts for 50 percent of our
exports and more than 20 percent of GDP. Furthermore, tax payments by oil and gas
companies1 and direct government ownership interests in oil and gas fields ensure that
economic rent largely accrues to the public sector. Petroleum income makes up 30 percent
of government revenues.
Chart: Oil and gas exporters
On the world market, Norway's most significant role is that of natural gas exporter. Norway
was the world's second largest exporter of natural gas in 20102. Our role in the world market
for oil exports is more modest.
Back in the 1970s, policymakers' handling of the newly discovered petroleum wealth got off
to a rather weak start. Public spending surged before export revenues had started to kick in.
Fiscal policy fuelled a boom and had to be reversed and tightened. By the late 1970s,
Norway was in the midst of a deep recession.
In the mid-1980s, the Norwegian economy experienced a new boom, this time fuelled by
private debt growth. After the fall in oil prices in 1986, we experienced a collapse in housing
prices, as well as a severe banking crisis and a soaring public deficit. The turbulence made
clear how vulnerable a small open economy is to terms of trade disturbances.
The downturn in the early 1990s was the deepest that Norway had experienced since World
War II. The authorities realised that the old policy framework was no longer suitable. With a
globalised economy and deregulated credit and capital markets, our economy was more
vulnerable to external shocks than before. A number of major reforms were implemented to
improve cost competitiveness and boost growth. And the establishment of the oil fund in
1990 and the reform of the monetary policy framework in 2001 made the economy more
robust to external shocks.
Chart: Norwegian exports
The need for a robust policy framework is greater than ever: Petroleum products now make
up more than 50 percent of exports, and - more recently - oil services exports have also
picked up. Exports of other commodities add to the vulnerability of our economy to terms of
trade shocks.3 The total commodity-related share of exports has risen from less than
40 percent in 1978 to a good 65 percent in 2012.
Rules-based fiscal policy
We know that commodity producing countries tend to experience pronounced economic
cycles. However, as noted by Jeffrey Frankel (2011)4, this can be reduced through
wellchosen regimes for fiscal and monetary policy:
"We need to set up regimes ex ante which are more likely to deliver the right result ex post,
in a world inhabited by human beings, not angels."
In Norway, the act of parliament relating to the oil fund, passed in 1990, provided a new
framework for fiscal policy. The policy guidelines were clarified in 2001, and rules governing
the interaction between Norway's petroleum wealth and fiscal policy were established. These
rules state:
Chart: The Government Pension Fund Global and the fiscal rule
2
For more information about the Norwegian petroleum sector, see "Facts 2012: The Norwegian petroleum
sector", Ministry of Petroleum and Energy, http://www.regjeringen.no/en/dep/oed/documents-and-
publications/Reports/2012/facts-2012-the-norwegian-petroleum-secto.html?id=714606.
3
Using a factor-augmented vector autoregressive (FAVAR) model that allows them to distinguish between
different groups of countries, Aastveit et. al (2012) find that demand from emerging economies (most notably
from Asian countries) is more than twice as important as demand from developed countries in accounting for
the fluctuations in the real price of oil and in oil production. See Aastveit, Knut Are, Hilde C. Bjørnland and Leif
Anders Thorsrud (2012): "What drives oil prices? Emerging versus developed economies", Norges Bank
Working Paper 2012/11 http://www.norges-bank.no/no/om/publisert/publikasjoner/working-papers/2012/11/.
4
Frankel, Jeffrey A. (2011), "How Can Commodity Producers Make Fiscal and Monetary Policy Less
Procyclical?" in Beyond the Curse: Policies to Harness the Power of Natural Resources, ed. by Rabah Arezki,
Thorvaldur Gylfason and Amadou Sy, International Monetary Fund.
•
All government revenues from the oil sector must be transferred to the fund.
• Government spending, on average over the cycle, must be limited to the expected
real return on the fund - estimated at 4 percent. This is known as the fiscal rule. The
aim is to spend only the return generated by the fund's investments, not the capital
itself.
•
All of the fund's capital is invested abroad.
Chart: Projected size of the oil fund
At the time the fund was established, Norway was in the midst of a deep recession, and
many doubted that any petroleum revenues would ever be saved. However, after a few
years, the government's cash flow from the petroleum sector started to increase sharply. The
savings plan has since remained intact and the fund has now reached a size of more than
USD 700 billion, or 140 percent of GDP.
Chart: Structural non-oil budget surplus
As a result of the fiscal rule, economic policy is more robust: First, by decoupling spending
from current petroleum revenues, the fiscal rule provides for a gradual and sustainable
phasing-in of petroleum revenue spending. Second, the guidelines ensure the necessary
flexibility to allow automatic stabilisers to work. Third, they allow for careful countercyclical
policy.5 Structural public non-oil deficits have counteracted movements in the output gap
since the fiscal rule was adopted. In particular, reserves accumulated in the fund provided
fiscal leeway during the economic setback in 2008 and 2009.
At the same time, cyclical fluctuations in mainland production are strongly influenced by
petroleum-related demand. This indicates that there is a strong link between Norway's
mainland output gap and the oil price.
Chart: The size of Norges Bank's balance sheet including the oil fund
There is a direct link between the fund mechanism and the central bank's purchases of
foreign exchange. Petroleum taxes are paid in Norwegian kroner. The central bank buys
foreign exchange to transfer to the fund in order to secure the necessary net capital outflow.
The fund ends up on the asset side of the central bank's balance sheet and these assets are
exactly offset by government claims on the central bank. Bank reserves held in the central
bank are unaffected by this and have remained low and stable in comparison.
Chart: Real exchange rate and oil price
The krone clearly responds to oil price shocks. However, compared with other
commoditybased economies, like Canada, Australia and New Zealand, fluctuations in the real exchange
rate have been moderate.6 The build-up of the fund may have helped contain a temporary
real appreciation during a period of high oil revenues.
Inflation targeting with interest rate forecasting
Chart: Inflation
When the fiscal rule was introduced in 2001, Norges Bank was charged with the task of
keeping consumer price inflation low and stable. The value of the krone exchange rate was
allowed to float freely. The operational target of monetary policy is annual consumer price
inflation of close to 2.5 percent over time, under a regime of flexible inflation targeting.
In the conduct of monetary policy, the aim of reaching the inflation target is balanced against
the aim of stabilising output and employment. In addition, monetary policy should be robust
by seeking to mitigate the risk of a build-up of financial imbalances. Over the past ten years,
average inflation in Norway has been somewhat below, but close to, 2.5 percent.
Chart: Key policy rate in the baseline scenario
The degree of transparency regarding Norges Bank's interest rate decisions has increased
gradually since inflation targeting was introduced. We provide clear guidance about the
future path of the key policy rate. Explicit interest rate forecasts were introduced in 2005.
A key objective is to convey the contingency and the uncertainty in the forecast. To that end,
we seek to be transparent about the considerations underlying each interest rate forecast
and what the objectives and trade-offs are. We consider it important to explain why our
forecast has changed. In our Monetary Policy Report, the interest rate forecast is
accompanied by a separate chart showing the revision since the previous report due to
changes in news and new assessments. Monetary policy also seeks to mitigate the risk of a
build-up of financial imbalances. Operationally, and as a support to monetary policy
decisions, our objectives and trade-offs are described by a monetary policy loss function7 The
loss function is minimised subject to our model of the Norwegian economy, and the implied
interest rate path is an important aid to the policy decision process8 Since models are
simplifications, our projections are based on a combination of model analyses and
professional judgement.
Transparency allows financial market participants and other interested parties to make their
own judgments on the revisions to our interest rate forecast - and the revisions will often be
anticipated. Ideally, our response pattern is reflected in market interest rates as soon as
economic news arrives, enhancing the effectiveness of monetary policy.
And we do indeed find that market expectations tend to react to economic news largely in
line with the Bank's response pattern. We also find evidence of reduced volatility in market
interest rates on the days interest rate decisions are announced, compared to the period
before the introduction of the interest rate forecast. This suggests that a more precise
communication of policy intentions has improved market participants' understanding of the
central bank's response pattern.9 The contingency of the forecasts seems to be well
understood.
Management of the fund
Besides making monetary policy decisions, one of Norges Bank's main tasks is to manage
Norway's oil fund.
Chart: Governance structure
The Ministry of Finance holds the political responsibility for the fund. The overall
management principles and strategy are anchored in parliament and the Ministry reports to
parliament at regular intervals.
The management of the fund is fully delegated to the central bank - to Norges Bank. Our
task as manager of the fund is strictly commercial: to maximise returns within the guidelines
defined by the government. All investment decisions are made by Norges Bank Investment
Management, a separate division within the central bank. Neither Norges Bank's Executive
Board nor the Ministry of Finance is involved in any individual investment decisions. This
governance structure was set up to ensure that the fund was not used as an instrument of
foreign policy.
The purpose of the fund is to ensure that future generations receive their fair share of
Norway's petroleum wealth. To achieve this, the fund was designed to be invested for the
long term. Size and a long investment horizon are the fund's two key characteristics.
Together, they form the backbone of the fund's investment strategy:
•
First, the fund's long investment horizon implies substantial risk-taking capacity. We
are able to act as a countercyclical investor.
•
Second, the fund's size makes it possible to take advantage of investment
opportunities worldwide, in a number of asset classes.
•
Thirdly, a fund owned by the government must be highly transparent, not only to the
Norwegian public but also in an international context.
Let me elaborate on these aspects.
In the early summer of 2007, the fund's strategic equity share was raised from 40 to
60 percent. From summer 2007 to 2009, the fund bought equities worth USD 180 billion in
international markets, equivalent to 0.5 percent of all globally listed equities. The largest
volume of transactions was carried out in the midst of the financial crisis of 2008 and 2009.
The long-term horizon also enables us to invest countercyclically, by rebalancing asset
classes: If the equity share increases by more than 4 percentage points from the target
weight of 60 percent, we will sell equities and buy bonds. Conversely, if the equity share
drops below 56 percent, we will sell bonds and buy equities.
The capacity to withstand market turmoil was demonstrated during the financial crisis in 2008
and 2009. For a period of 18 months, the fund's losses totalled roughly USD 120 billion
- more than 25 percent of Norway's GDP. The losses did not go unnoticed. They led to lively
public debate on the fund's investment strategy. However, the conclusion drawn was that the
strategy was robust, and the government remained committed to it.10 Norway would have to
accept that the fund's capital would fluctuate, sometimes dramatically, given the high equity
share. Indeed, through 2009 and 2010, not only were those losses reversed, but additional
gains were also made.
Chart: Changing the regional allocation
The investment strategy was further revised last year. The conclusion was a clear step
towards a more globally diversified portfolio. From a considerable strategic overweight in
European markets, a larger share of the fund will now be invested in the Americas and Asia.
At the end of 2012, just short of 30 per cent of the fund was invested in US securities.
A key role of the bond investments in the fund is to reduce short-term fluctuations in the
fund's value during periods of financial stress. One lesson of the financial crisis is that
government bonds issued by countries with good debt-servicing capacity best fill this role.
The new strategic benchmark for fixed income investments, which was adopted in 2012,
clearly distinguishes between government bonds and corporate bonds. Government bonds
comprise 70 percent of the bond portfolio. These bonds are now weighted according to the
size of each country's GDP rather than the size of its debt. The strategic index for fixed
income investments has also been simplified by removing certain bond classes, such as
mortgage-backed bonds. We have also significantly reduced the number of bonds in the
fixed income portfolio.
Several emerging market currencies were also added to our bond portfolio last year, among
them the Mexican peso and South Korean won. These adjustments will provide a more
balanced exposure to global output.
Two years ago, the fund made its first real estate investments in Europe. We have recently
begun investing in US real estate. In February, the fund announced a joint venture with the
where we invested in five properties on the east coast. One of the properties is
TIAA-CREF11,
on Arch Street here in Boston. Direct real estate investments will provide a fairly stable,
inflation-adjusted cash flow. Over time, we aim to invest up to 5 percent of the fund in real
estate. Investments will be allocated to more countries as we gain experience.
Chart: Further information
Regulatory requirements may limit the distribution of certain types of information and must
always be met. However, our aim is to be as relevant and transparent as possible in our
communication. Our policy is to be transparent about our evaluation of markets. All of the
fund's holdings at the end of 2012 are listed in the recently published annual report, as is the
fund's voting at 10 000 shareholder meetings last year.
The fund is a large investor in a macro perspective. At company level, however, we are a
minority shareholder. Strengthening shareholder rights and promoting equal treatment of
shareholders are two of our key targets when we work with companies and standard-setting
authorities. In this regard, we are happy to cooperate with the program on corporate
governance at Harvard Law School12.
Final remarks
The Norwegian economy has over the past four decades benefitted enormously from its rich
natural resources. Lessons have been learned, and policy rules have been established for
the management of our oil and gas reserves. For the moment, the petroleum industry both
provides exposure to an entire global economy and shields us from the current low growth
environment across the OECD area.
However, it is too early to say whether Norway has managed to establish a framework that
makes the economy robust enough to withstand strong fluctuations in our terms of trade. Our
present framework has yet to be tested against a large and persistent negative oil price
shock. I believe the real test of our framework will come when the present boom in the
petroleum industry - at some point - is reversed. Norway's oil and gas resources, though
rich, will not last forever. As in any other country, emphasis should be given to further
development of human capital as the primary source of long-term prosperity and wealth.
Thank you for your attention.


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