MANAGING NATURAL RESOURCES REVENUE: The Case of Chile

Rodrigo FuentesPontificia Universidad Católica de Chile

Maputo

March 25, 2009

Motivation

• NR: curse or blessing? Still open question– Fiscal response is one of the key elements– After a boom there is always a bust

• Why Chile?– Chile supplies 43% of world copper exports– CODELCO produced 16.4% of Gov. revenues in 2007– Pressures for higher government expenditures

• Main goal of my presentation: show how government ‘s copper revenues are managed to avoid undesired outcomes

Are resources well managed? Yes!

• Transparency in the public finance

• Fiscal rule determines the timing of spending copper revenues

• Fiscal rule + stabilization fund avoid appreciation of the local currency

• Natural resources’ privatization

• Institutions and property rights are essential to make the above policies work

This presentation

• The role of copper in the Chilean economy

• Early reforms on fiscal discipline and how they survived over time

• The role of contracts with the private sector

• Government saving, intergenerational transfers and financial crisis

• Policy lessons

The role of copper in the Chilean economy

Price of Copper: Recent booming episode

0

50

100

150

200

250

300

350

400

450

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2007

Nominal Real (*)

(*) Deflated by USA Wholesale Price Index, basis July 2008=100.

Source: Chilean Copper Commission.

Copper production by CODELCO versus private producers

Source: Chilean Copper Commission.

0

1,000

2,000

3,000

4,000

5,000

6,000

1990 1998 2007

CODELCO Other Producers

(thousands tons of fine copper)

Foreign direct investment

Source: Foreign Investment Committee.

(nominal millions US$)

2,398.74,400.2

8,239.14,114.9

2,021.70

5,000

10,000

15,000

20,000

25,000

30,000

1974-1989 1990-1994 1995-1999 2000-2004 2005-2007

Mining and quarrying Manufacturing Industries Electricity, gas & water supply

Financial services Other Sectors

Mining investment in Chile

Source: CODELCO, ENAMI and Foreign Investment Committee. Data for 1974-1975 was not available for public investment.

(nominal millions US$)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1976-1989 1990-1994 1995-1999 2000-2004 2005-2007

Public FDI

Government's revenues

Source: The Budget Office of the Ministry of Finance (DIPRES).

(million Chilean $ of 2007)

0%

20%

40%

60%

80%

100%

1990 1998 2007

Tax revenue Copper Other revenues

Early reforms on fiscal discipline and how they survived over time

Fiscal reforms: Initial conditions

• How was a responsible fiscal rule shaped over time? How and when did it start?

• Long history of failure: WWII to1970

• Nationalization of large copper mines, 1971

• Budget deficit (12%) financed by the Central Bank: 1973

• High barriers to trade, financial repression, price control: 1973

Balancing fiscal accounts

• The Military government after 1973– moved toward market economy – liberalized prices and interest rates – introduced a drastic trade reform– privatized SOEs– established a new pension fund system and– enforced fiscal and monetary responsibility

Some of the principles behind the reforms

• Secured property rights

• Fiscal consolidation and orthodox management of monetary and foreign exchange policies

• Favoring rules instead of public discretion

• Institutionalization of “rules of the game”

New environment

• Drastic reduction of public spending, tax reforms and privatization of SOE

• New fiscal institutionalism. 1975: State Financial Administration Law

• New constitution to shape political structure:– preserve continuity of policies– strong presidential system: President controls

budget and legislative agenda

Democratic government: 1990 -

• Keeps fiscal austerity: surplus in the 90s

• 2000: Explicit fiscal rule– structural surplus of 1% – recently cut to 0.5%

• Structural balance– tax revenues estimated at long-term trend GDP– prices of copper and molybdenum at their long-

run level

• Structural balance isolates cyclical effects

Fiscal deficit of central government 1960-2007

Source: The Budget Office of the Minister of Finance (DIPRES), Jofré, Lüders and Wagner (2000).

(percentage of GDP)

****

*tttttt

t

ttttt MRMRCRCRMTRMTR

YY

NMTRNMTRBB

*

tB Structural balance

tB Effective balance

tNMTR Net non-mining tax revenues and social security payments

tMTR Tax revenues from private mining companies

*

tMTR Structural tax revenues from private mining companies

tY Effective GDP

*tY Trend GDP

tCR Effective transfers from CODELCO (copper sales)

*

tCR Structural transfers from CODELCO ( copper sales)

tMR Effective transfers from CODELCO (molybdenum sales)

*tMR Structural transfers from CODELCO ( molybdenum sales)

= GDP elasticity of non-mining tax revenues

Contracts with the private sector

Private sector is important in harnessing the revenues from NR

• Provides required capital

• Faces risks of expropriation

• Shares NR rents with the State

→ Government needs to provide right incentives to promote investment

Chilean policies for FDI and copper

• Decree Law 600 for FDI, 1974– guarantees rights to transfer capital and benefits– establishes non-discrimination principle between foreign

and domestic investors– tax treatment

• invariability of tax system• accelerated depreciation, cumulative losses and

interest payment deducted for tax purpose

• Organic Constitution Law of Mining Concessions, 1982 – compensation in case of expropriation=NPV of verified

reserves

Chilean policies for FDI and copper

• Chilean Mining Code, 1983– State is absolute owner of all mines– Can grant concessions for exploitation and

exploration

• Before 2005, fiscal regime targeted profits rather than revenues

• Problem: government did not collect much taxes from mining activities

• Is there rents in copper mining?• Royalty on mining from 2006 and on

Royalty tax according to the annual sales of a mining operator

Source: Foreign Investment Committee.

Annual sales of the mine operator

Rate

1. Mine operator with annual sales equal to or less than the equivalent of 12,000 MFT Not subject to the tax

2. Mine operator with annual sales equal to or less than the equivalent of 50,000 MFT, and greater than the equivalent of 12,000 MFT

2.1 Regarding that portion in excess of 12,000 and no greater than 15,000 MFT 0.5% 2.2 Regarding that portion in excess of 15,000 and no greater than 20,000 MFT 1.0% 2.3 Regarding that portion in excess of 20,000 and no greater than 25,000 MFT 1.5% 2.4 Regarding that portion in excess of 25,000 and no greater than 30,000 MFT 2.0% 2.5 Regarding that portion in excess of 30,000 and no greater than 35,000 MFT 2.5% 2.6 Regarding that portion in excess of 35,000 and no greater than 40,000 MFT 3.0% 2.7 Regarding that portion in excess of 40,000 MFT

4.5%

3. Mine operator with annual sales greater than 50,000 MFT 5.0%

Government savings, intergenerational transfers and financial crisis

Planned uses of copper resources

• Revenues from royalty → Fund for Innovation and Competitiveness

• Fund for Social and Economic Stabilization, FESS– smoothes effects of copper’s price

• Pension Reserve Fund, PRF – minimum and solidarity pensions– must be increased by 0.2% (min) to 0.5% (max) of

previous year’s GDP

Sovereign Wealth Funds (SWF)

• Ministry of Finance decides:– Investments of and withdrawals from funds

• Central Bank intermediates both funds– delivers daily, monthly and quarterly reports– FESS: 12% of GDP (08/2008)– PRF: 1.5% of GDP (08/2008)

• According to Walsh et al. (2008)– management of the SWF is transparent and

according to best practice

Chile’s sovereign wealth funds allocation

*As of August 2008.Sources: Ministry of Finance (2008 a, b) and Walsh et al. (2008).

(percent of total assets )

Current* End-2008 target Sovereign Bonds (Nominal) 69 45 Sovereign Bonds (Inflation-Indexed) 1 15 Money Market Assets 30 5 Corporate Bonds 0 20 Equities 0 15

Total

100

100

Fiscal policy may worsen the crisis

• Evidence– Deliberate ‘countercyclical’ discretionary policy

has not contributed to economic stability (Feldstein, 2002)

– Let the automatic stabilizers work (Taylor, 2009)

• Carefully financial assistance to financial sector and new regulation scheme

• Role for monetary policy

• Chile: fiscal rule is an automatic stabilizer

Concluding remarks and policy lessons

Main lessons from the Chilean case

• Private sector involvement is crucial for extracting NR under financial capital scarcity– How to share NR rents– How to ensure property rights

• Fiscal rule

• SWF smooth government expenditures

• Government reputation, good institutions and policy improvements → save in good times for bad times

MANAGING NATURAL RESOURCES REVENUE: The Case of Chile

Rodrigo FuentesPontificia Universidad Católica de Chile

Maputo

March 25, 2009