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A number of countries have recently responded to high and volatile commodity prices by setting up commodity funds. In several cases, these funds have proved effective in stabilising government spending and boosting savings, but on the whole they have unfortunately not achieved the hoped-for results. In many cases, resources initially allocated to sovereign funds were later commandeered by the government and ultimately squandered.

Countries that derive a substantial share of income from commodities are faced with thorny questions of economic policy. Since these resources are exhaustible, it is important for the sake of intergenerational justice not to immediately consume the rent drawn from producing them, but to save something for future generations. Moreover, the high volatility and unpredictable prices of commodities create economic problems for these countries, where heavily fluctuating income often sets the pattern for government spending, to the detriment of the economy. 

A number of commodity producing countries have set  up stabilisation funds and
reserve funds (savings or future generations funds) precisely to remedy the problem of volatile, unpredictable and exhaustible income. When oil revenue is high, a portion is held back and added to the stabilisation fund; when it is low, the fund finances the shortfall in government receipts. The idea is to stabilise fiscal revenue, and hence spending, to make fiscal policy more effective in the short term. The savings funds’ goal is to accumulate reserves, which will be used to meet the needs of future generations when natural resources have been exhausted or when needs are particularly acute (for example, to finance pensions in Norway, Chile and France).

In practice, however, the picture is not as simple as it may appear. Countries that have set up commodity funds have not necessarily achieved greater stability in spending relative to income. In a number of cases, discretionary deductions from fund resources or excessive borrowing using the funds as collateral to finance  the budget deficit have sidetracked the funds from their initial objectives of stabilisation and reserve. Thus, in addition to creating an institution such as a sovereign fund, governments need incentives not to capture the economic rent from commodity extraction, spend the revenue immediately or borrow excessively during boom periods.

A number of commodity producing countries are dependent on sources of revenue that are both very large (compared with other sources of government funding) and very volatile. This creates a problem for fiscal policy, because the volatility of spending is often suboptimal. This is because government expenditure generally has declining marginal benefits. Thus the social benefit obtained from spending the revenues in a given year is less than the loss related to the long-term spending reduction, and thus does not offset it. 

Separating part of the wealth from the state budget by means of one or more sovereign funds is not a necessary precondition for efficient resource allocation over time or for keeping the government from making discretionary incursions into the fund’s resources to finance volatile spending. The funds that have succeeded in stabilising government expenditures and in saving (Norway, New Zealand, Chile and others) generally follow an extremely clear, fixed spending policy, and have institutions and a legal framework that keep the government from deviating much from the rules, and from dipping into fund resources to finance volatile expenditures. Separation of powers and oversight by a body that is independent of the government (a board composed of members of the government and the opposition) may strengthen such a system and ensure that the fund’s original objectives are pursued at all times, thus making it less dependent on the political power in place.

However, this approach may not be appropriate for all countries. Those that have
successfully established commodity funds (New Zealand, Australia, Norway) typically followed sound, transparent fiscal and macroeconomic policies before establishing oil funds. An essential factor in a sovereign fund’s success is the creation of an institution that is capable of rising above political conflicts and pressures, with legitimacy that can survive changes in government. But in many developing countries, independent institutions are rare because they may easily be exposed to government pressure. In these cases, one possibility is to call on an international institution to guarantee compliance with the institution’s rules.