Last week’s column wrapped-up my evaluation of Open Oil’s financial modeling of Guyana’s 2016 Production Sharing Agreement (PSA) with the local ExxonMobil subsidiary and its partners. Today, I resume discussing its fiscal regime, focusing on the top ten developmental challenges, which Government’s spending of its Take must confront. The challenges listed below represent those frequently encountered by Guyana-type economies dominated by extractive industries. Several of these challenges were considered briefly in earlier columns.
I shall start by first reporting on estimated Government Take under Guyana’s PSA.
I have found three estimates of Government Take for Guyana’s PSA (defined as Government’s share of net profits). These are shown in Schedule 1. Rystad Energy’s estimate of Government Take, 60 percent, as it claims, compares with those for other “frontier countries” (Falkland Islands, Mozambique, Mauritania and Israel) ̶ 50 to 65 percent. Wood Mackenzie also reports “revenue realization … is in the middle of the pack for a frontier area, including being in the top 10 of African countries surveyed; the top five in Europe, and fourth in the Americas.” I have considered Open Oil’s estimates during the past eight weeks.
The challenges considered are: 1) the threat of “Dutch Disease” 2) the burdens of the “Resource Curse” 3) the dangers of the “Governance Curse” 4) the lack of “Absorptive Capacity” 5) the entrenchment of an “Enclave Economy” 6) the persistence of “Implementation Lags” 7) the maintenance of “Intergeneration Equity” 8) International Financial Institutions pressure to spend on the basis of the “Permanent Income Hypothesis” 9) “Managing Public Expectations” and, 10) “Integrating PSA Revenues and the National Budget.” I shall address each of these challenges in turn.
Dutch Disease: Threat
The Dutch Disease challenge refers to the substantial risk that the growth of Guyana’s petroleum sector would further reduce the international competitiveness of Guyana’s economy through increasing its nominal/real exchange rate. That is, less Guyana dollars will be required to purchase one unit of any foreign currency both nominally and adjusted for price changes. The disease is labelled Dutch, because this was first observed in the 1970s in the Dutch manufacturing sector, following that country’s large discovery of natural gas, two decades previously.
A correlation has been observed between the expansion of the natural gas sector and the decline of several sectors of the Dutch economy (manufacturing, agriculture, and services). This correlation leads to the prediction that as Guyana’s petroleum revenues increase, the Guyana dollar will appreciate. That means less domestic dollars will be required to buy a given amount of foreign currency. For foreigners, the reverse occurs; that is, each unit of our currency becomes more expensive for them to purchase!
As this outcome emerges, the already uncompetitive sugar industry (as well as others; rice, bauxite, fishing) become increasingly uncompetitive! Export services (tourism) would also require foreign tourists to pay more when visiting Guyana, thereby making rival jurisdictions more competitive. One can say, therefore, more generally, as the Guyana dollar appreciates, foreign products become more competitive against local ones.
Two types of trading sectors are also likely to emerge: namely, the oil sector, which rapidly expands and, other exports that continue to either flag (sugar) or become less competitive (like rice, bauxite, forest products and, fishing. In this way, Guyana’s growing global uncompetitiveness becomes manifest.
In addition, the expansion of the petroleum sector contributes to increased income and spending within the domestic economy. This impacts spending and incomes in the non-traded sector of the economy (mainly services and locally produced products). Wages and prices then rise domestically and strong inflationary pressures might even emerge. The petroleum sector’s prices are set internationally, so these do not respond significantly to rising domestic demand. The government is a big spender in the domestic non-tradable sector (construction, consumable goods, materials, services). Economists describe this outcome as the logical consequence of the sectoral reallocation of Guyana’s resource base.
For Guyana, such “resource reallocation” would adversely affect agriculture, which as readers know is a major source of employment and livelihoods. Recall also that it is heavily export-oriented. Simultaneously, because petroleum production is heavily capital intensive, it does offer great scope for employment, thereby alleviating this negative situation.
Dutch Disease: Response
Development theory indicates several basic strategies for combatting the Dutch Disease. It also indicates that the spread of the Dutch Disease is an immediate threat, which emerges early in the expansion of the petroleum sector. Further, its effects are not only pernicious, but are likely to be long lasting.
One well-tried response to the threat of Dutch Disease is to slow the pace at which the exchange rate is appreciating. A standard response to this, also, is to sterilize increases in petroleum revenues! To achieve this requires Government to hold part of the petroleum revenues in the form of overseas investable financial assets. This is also a leading motivation behind calls to establish Sovereign Wealth Funds (SWFs) as Guyana is doing.
I have previously discussed SWFs extensively (January 1, 2017 to January 15, 2017) and I will not repeat here. Interested readers should visit those columns. The key point of note in this regard is that SWFs can sterilize any substantial influx of foreign exchange. Such sterilization would reduce the negative distortionary effects of rapid, unplanned changes in Government spending. As we shall observe, SWFs Funds affect other development challenges (for example, intergenerational equity).
Another response is to direct public spending towards re-engineering the traditional non-oil export sectors. The danger here, though, is for Government to avoid subsidizing inefficient and uncompetitive businesses. Such subsidies could drain Guyana’s oil wealth to subsidize traditional exports for the benefit of foreign buyers!
A further strategy is to promote policies directed towards making input expenditures of the petroleum sector; promote linkages and spillovers to “local” businesses. It is this response which lies behind calls for local content requirements (LCRs). Again, I have discussed this topic previously at some length (March 26, 2017 to May 21, 2017). I shall also not repeat here. Once again, I invite interested readers to consult those columns.
Next week, I continue this discussion of the list of the top ten development challenges, which spending Government’s Take has to navigate.