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'HELD IN TRUST'

'Held in trust': the role of public funds in economic management

Ron Duncan, Peter Larmour and Colin Hunt

Public trust funds can serve useful functions, particularly in Ron Duncan is Executive resource or aid-dependent economies like those of the South Director, Pacific . They serve to enhance savings, and to stabilise Peter Larmour is Director, and sterilise large natural resource revenue flows. But these Graduate Studies in funds are susceptible to political forces that undermine their Development Administration, and effectiveness. Mechanisms to check these influences, such as Colin Hunt lectures in statutory independence, broadly based board membership and Environmental Manage- public reporting, should be in place. Decision rules on ment and Development at drawdowns from the funds need to be carefully selected to the National Centre for avoid disrupting fiscal management. Development Studies.

Public funds of various kinds have a to whether their objectives could have been prominent role in several of the Pacific better achieved by other means. economies. The functions which Given the importance of resource they were established to perform are exploitation to the South Pacific economies extremely important, such as the and the difficulties which the management stabilisation and sterilisation of mining of resource revenues invariably present, revenues or the offshore investment of this is an important topic for consideration savings accumulated from resource in the South Pacific context. revenues or from payments by donor nations. The performance of these funds, however, has been mixed. Pacific island trust funds The performance of several funds is examined in this paper, with a focus on Here the term 'trust fund' is used in a broad why some of the funds did not live up to sense to include all funds which are held expectations and how their performance in trust on behalf of the peoples of a country. could be improved. Attention is also given This definition could include commodity

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price stabilisation funds which are publicly was also to be used to accumulate savings held funds created for the purpose of out of mining revenues and even to build stabilising the price of a particular these up in real terms by means of invest- commodity for the benefit of the producers ment. The Fund is managed by the of that commodity. While funds of this kind Secretaries for Finance and Planning and are not discussed here, some of the for Minerals and Petroleum. conclusions drawn would be applicable to The Reserve Fund of was set them. The Mineral Resources Stabilisation up in 1956 by the colonial administration Fund of is included in of the Gilbert and Ellice Islands with an the discussion. This is a fund accumulated initial sum of A$555,580 (Toatu 1993). from mining revenues held in trust for all Toatu describes the purpose of the Reserve the peoples of . It does Fund as being to accumulate savings from not have any mineral price stabilisation taxation of phosphate mining operations function. Its main function is the to provide for government revenues when stabilisation of mining revenue flows into the phosphate deposits at (Ocean consolidated revenue. Island) were exhausted. By the end of 1979 The Kiribati Revenue Equalisation when phosphate mining operations ceased Reserve Fund or the Reserve Fund of Kiribati and Kiribati gained its independence, the and the Trust Fund are also included Fund was valued at A$69 million. By 1993, in the discussion. There is considerable with minimal drawdowns into consolidated information publicly available about these revenue and with offshore investment of funds and they were the subject of a recent the Fund pursuing a growth strategy, the study by the authors (see Duncan, Larmour Fund had increased in value to A$353.4 and Hunt 1995). Some reference is made to million. the trust funds of , but there is less The was established public information on the performance of in 1987 from contributions by aid donors these funds, so firm conclusions cannot be (, and the United drawn on their performance. Kingdom) and from Tuvalu itself. With the The Mineral Resources Stabilisation threat of withdrawal of UK budgetary aid Fund was established in 1974, one of the by 1987 or 1988, the Tuvalu government first mineral revenue management schemes convinced its major aid donors to contribute to be established wide. The purpose to the Fund. The funds are invested off- of setting up the Fund was to stabilise flows shore and revenue generated from the of mining revenues (comprising corporate investment is directed to the annual income taxes on mining ventures, dividend budget to finance recurrent expenditure; withholding taxes and earnings from the this means that government services can government’s equity holdings in mining be provided at a higher level than would ventures) into consolidated revenue. The otherwise be the case (Saltala 1995). The Act setting up the Fund identified the initial contributions to the Tuvalu Trust promotion of national financial stability and Fund amounted to A$27.1 million. In protection of the government’s development September 1995 the Fund was valued at program from revenue fluctuations as its A$42.8 million. Up to that point A$8.35 main objectives, as well as ensuring that million had been directed to consolidated funds available to consolidated revenue revenue and the value of unused drawdowns rise in line with the development needs of (held in the B Account) was A$8.58 million. the economy. This last-mentioned objective The Fund is managed by a Board of can be interpreted to mean that the Fund Directors comprising donor government

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and Government of Tuvalu representatives. output and employment in the other traded An Advisory Committee, also comprised goods sectors. These changes can be trans- of donors and Government of Tuvalu mitted through the appreciation of the representatives, provides advice on the nominal exchange rate or through increases distribution of the drawdowns and their in the price of non-tradeables. Because of impact within the annual budget. the temporary nature of these increases in foreign exchange earnings, they can be associated with significant economywide Purposes of trust funds costs where labour markets are rigid and public sector policies are difficult to reverse. Trust funds can serve one or more of several purposes. The Kiribati Revenue Equalisation By modifying the flows of resource Fund was set up to save revenues from a earnings into consolidated revenue, the non-renewable resource against the day trust fund also plays a stabilisation role. when they would no longer be available. This can make fiscal management easier With the exploitation of a non-renewable than it would otherwise be. The more certain resource such as minerals or petroleum, it the revenue components of the budget, the is economically sensible to invest part of the more certain is expenditure planning and the rents in replacement assets which can be less important is the need for allowance to expected to have at least the same income- be made within the budget for unforeseen generating capacity as the non-renewable circumstances. Just as important is the fact asset being used up. Where investment that booms in natural resource revenues opportunities in such assets are difficult to usually lead to unsustainable commitments find within the country—as is likely to be to consumption or investment expenditure. the case in island economies such as Unfortunately, the record of resource- Kiribati—investment offshore can be an dependent developing economies is that attractive alternative. If funds were to be they have a tendency towards unsustain- invested onshore, there is the absorptive able consumption expenditures rather than capacity of the economy to consider. Hold- investment expenditures in the wake of ing revenues in an offshore fund can thus resource booms (Duncan 1995). serve the purpose of regulating the flow of In 1994, the Kiribati Reserve Fund was onshore investments. used to stabilise the flow of fishing licence Where a country has its own currency, revenues. Fishing revenues were A$9 an offshore trust fund can also be used to million more than budgeted. For that year sterilise the foreign exchange earnings by A$7.5 million had been appropriated from preventing them from expanding the the Reserve Fund for consolidated revenue. domestic money supply at a rate which When the fishing revenues became known, leads to currency appreciation with its the appropriation was not utilised. Fishing 'booming sector' or 'Dutch disease' effects. licence revenues are very uncertain and if The usually volatile foreign exchange the Reserve Fund continues to be used in earnings from sales of natural resources this way it will perform a very useful can then be brought into the economy at a stabilising role. Tuvalu is also now receiving stable rate which is consistent with the fishing licence revenues from distant water economy’s absorptive capacity. Otherwise, fishing nations. The B Account of the Tuvalu a surge in export earnings from the resource Trust Fund could be used in the same way sector can lead to an appreciation of the as the Reserve Fund to stabilise the flow of real exchange rate and the depression of fishing revenues into the budget.

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Another more recent use of trust funds weight would be given to equity stocks. is in aiding the establishment of biodiversity Both the Kiribati and Tuvalu funds specify reserves in countries where land is held strict guidelines for their fund managers under customary tenure. In , for which define the proportions of government example, a project is underway involving securities and equities for the fund portfolio. the establishment of a trust fund for the The guidelines also give consideration to purpose of conservation of an of hedging of currency risk. At least 70 per sandalwood forest (agathis macrophylla). cent of the Tuvalu Trust Fund portfolio must The income from the Fund, established be held in Australian investments. with donor funds, will be used to This seems appropriate given that Tuvalu compensate the traditional landowners for uses Australian currency and takes most logging income foregone (Tacconi and of its imports from Australia. To provide Bennett 1995). The Vanuatu government added protection, the assets of both funds will lease the forested land from the are registered in the name of a custodian, traditional owners and control logging in not in the name of the investment fund the area. Independent control of the Trust manager. As well, the Tuvalu Trust Fund Fund will ensure that violation of the lease employs a fund monitor whose role is to agreement by the landowners means that monitor the activities of the investment they would not receive compensation. managers—to ensure adherence to invest- ment guidelines and to assess performance relative to other fund managers. Trust fund performance The controls exercised over the Kiribati and Tuvalu trust funds are in sharp contrast There are two main areas of concern in the to the publicised accounts of investment management of trust funds. One is to see behaviour of the Nauru trust funds. Rather that the investment of the funds is carried than being confined to government out in a way which at least preserves, but securities and equity investments, Nauru preferably increases, its real value, while funds have been active in real estate and minimising the risks of exposure of its assets even more risky ventures. as well as allowing for sufficient liquidity for expected drawdowns. This means The second major concern with the reaching a compromise in the trade-off management of trust funds has to do with between the risk and return on the fund controls over expenditures from the fund. investments. This trade-off is expressed There is a tendency for surges in resource through the guidelines given to the invest- earnings to give rise to unsustainable ment managers, which define the kinds increases in consumption expenditure and proportions of assets in which they are rather than sustainable increases in invest- allowed to invest. With offshore investments, ment. As well, the existence of a public fund leads to pressures for the fund itself consideration should also be given to to be used for purposes other than that for management of the foreign currency which it was established. In some cases, exposure of the assets. such as national disasters, the need may The greater the weight given to security, well justify recourse to the fund. , for the greater the proportion of the fund example, used part of its copper stabilisation should be invested in bonds issued by fund to reduce its international debt during governments with top credit ratings. With the debt crisis, thereby improving the more weight given to fund growth, a larger country’s credit rating.

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It is important, however, that the fund part of the control over expenditures from be protected from 'raids' by adequate public funds has to do with the decision safeguards or controls. This means having rule on the amount of revenue, or a management board which has a wide drawdown, to go into consolidated revenue representation of community interests, each year. For purposes of stable fiscal easy public access to information about policies, it is desirable that the drawdown the operations of the fund and widespread rule does not result in increasing the public about its purposes and volatility of budget revenue. However, this operations. The Tuvalu Trust Fund, with is not a simple matter. The market value of its Board of Directors and Advisory trust fund assets will vary from year to year, Committee comprising donor and Tuvalu as will the income generated by those assets. government representatives, has manage- Therefore, if the drawdown decision rule ment controls appropriate to it being a adopted is to pay out, say, a constant sum trust mainly funded by donors. in real terms, it may well be impossible to The Kiribati Reserve Fund Committee adhere to the objective that the value of is comprised of the Minister of Finance the fund should be maintained in real terms. and Economic Planning (Chair), the Secretary Alternatively, if there is an objective to to the Cabinet, the Chief Accountant, and have the fund maintain its value in real any other two persons the Chair may terms, it may well be impossible to have a appoint (Toatu 1993). Though there is the positive payout in each year. provision for two additional appoint- The latter objective has been adopted ments, apparently no appointments from by the Tuvalu Trust Fund and its drawdown outside the public service have been made. rule is to make available for consolidated Unless the Ministry of Finance and revenue the difference between the Economic Planning is exceptionally strong 'maintained' value of the Fund (defined as in the government/bureaucratic context— the nominal value of contributions deflated as finance ministries often are—it may be by the Australian CPI) and its marked-to- wise to appoint some non-public service market value. In the nine years of operation members to reduce the Fund’s vulnerability of the Fund there has been no automatic to changes in governments and ministers. drawdown available in three years and It might even be worthwhile to give the very large automatic drawdowns in two Committee some statutory independence. years. The large drawdowns led to a rapid Papua New Guinea’s Mineral Resources build-up of funds in the B Account which Stabilisation Fund is also completely under is now used to stabilise the flow of income public service management. As argued going into the annual budget. The Kiribati below, the Fund has not performed its Reserve Fund has had a conservative stabilisation or savings function at all well policy of drawing down a small part of and it has not carried out any sterilisation expected earnings. Hence, over the period functions. If the Fund is redesigned to carry 1983–93, the drawdown was less than out these functions more effectively, it would interest plus dividends except for two be desirable to include non-government years, and much less than the combined representatives on its management board value of Fund income and appreciation in and make public a full accounting of flows Fund assets in all years except 1988 when and uses of funds on a regular basis. the Fund incurred a large capital loss Besides the management aspect of stated to be due to appreciation of the access to trust fund revenues, an important .

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Analysis of the performance of the there is no constraint on government Mineral Resources Stabilisation Fund borrowing. Rules on retaining balances in (Duncan, Warner and Temu 1995) showed the Fund are meaningless if the government that the Fund has in fact not ensured a stable can borrow from the Bank of Papua New flow of funds into consolidated revenue. Guinea to finance budget deficits. The Payments out of the Fund have largely underlying problem is, of course, one of fluctuated in line with fluctuations in fiscal discipline. Changes to Fund manage- inflows.1 The Fund outflows are determined ment will be of little use without a greater by the drawdown rules. The rules defined commitment in Papua New Guinea to by the Act of 1974 setting up the Fund fiscal discipline. (amended in 1975), gave the emphasis to An alternative approach to managing forecasts of future earnings. Forecasting of the volatility of resource earnings is to commodity prices or revenues is hedge against the price fluctuations. In this notoriously difficult, even impossible, way a substantial part of the volatility of given their largely random nature. In such earnings can be avoided—rather than circumstances, it is better to use past having to stabilise it ex post. A fund can performance as a guide. Guest (1987) still be used to stabilise the remaining suggested that a more appropriate rule volatility from quantity fluctuations and would be the preceding year’s drawdown longer-term price volatility which cannot plus one-fifth of the change in Fund be hedged. Financial markets now offer a receipts over the preceding year’s receipts. range of instruments for carrying out The increment would be positive in a hedging of primary commodities, period of increasing revenues and including futures, options, swaps and negative in a downswing. various combinations of these instruments. The hedging can be carried In 1986 amendments were made to the out by the country itself, or where the Mineral Resources Stabilisation Fund Act resource is being worked by a large which gave its board much greater discretion multinational firm—as with mineral or and allowed balances in the Fund to be petroleum mining—the country could drawn down even more rapidly. However, demand that the company hedge the share of even more concern is that the Fund has (in taxes, royalties or dividends) accruing played no role in saving mineral rents or in to the country. sterilising the foreign exchange inflows. The Fund is not held offshore; the funds are held as a kina deposit with the Bank of Conclusion Papua New Guinea. Foreign exchange inflows accruing to the public sector will not Public trust funds can serve several useful translate into a monetary and fiscal shock purposes—particularly for resource- if the government decides not to spend the dependent economies. These include savings, revenue. However, this is politically stabilisation and sterilisation functions, as difficult. Holding the funds offshore under well as protection of bio-diversity the management of a board some distance resources. However, the susceptibility of removed from the government would make such funds to political forces which access to the funds more difficult. With the undermine their effectiveness has to be Fund held as a deposit with the Bank of recognised. Every mechanism which can Papua New Guinea, there has been no be put in place to protect them against guarantee of saving or sterilisation since such forces should be used, including

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statutory independence, broadly based ——, Warner, R. and Temu, I., 1995. The board membership, and public reporting. Papua New Guinea Economy: improving the investment climate, Australian While such funds can have a very useful Agency for International Development role in improving fiscal and monetary (AusAID), . management and thereby in improving developmental prospects, the decision Guest, J., 1987. Macroeconomic Situation, rules on drawdowns from the funds can Prospects and Policy in Papua New inject an undesirable degree of volatility Guinea, Islands/Australia Working into fiscal affairs. The random nature of Paper 87/8, National Centre for resource flows based on forecasting such Development Studies, The Australian flows should be more fully recognised. The National , Canberra. benefits of using financial markets to hedge the price risk and thus reduce the volatility Saltala, M., 1995. ‘The Tuvalu Trust Fund’, of the resource earnings flows into such Pacific Islands Development Dialogue, funds should be taken advantage of where 1(April):46–52. possible. This will reduce the volatility of flows into the funds and make it easier to Tacconi, L. and Bennett, J., 1995. have stable outflows from the fund into ‘Biodiversity conservation: the process consolidated revenue. of economic assessment and establishment of a protected area in Vanuatu’, Development and Change, Note 26(1):89–110.

1 Over the period 1980 to 1994, the Toatu, T., 1993. ‘The Revenue Equalisation coefficient of variation of inflows in real Fund’, in H. Van Trease (ed.), Atoll terms to the Fund was 83 per cent while Politics, the Republic of Kiribati, the coefficient of variation of real outflows Macmillan Brown Centre, University of Canterbury, Christchurch:183–9. was 76 per cent—thus the Mineral Resources Stabilisation Fund reduced the variability of flows in that period only by around 8 per cent.

References Duncan, R., 1995. ‘Commodity terms of trade and instability’, in R. Garnaut, E. Grilli and J. Riedel (eds), Sustaining Export-oriented Development: ideas from East , Cambridge University Press, Cambridge, :271–92.

——, Larmour, P. and Hunt, C., 1995. Trust funds for small island developing states, draft paper prepared for the Australian Agency for International Development (AusAID), Canberra.

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