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Norway looks solvent for the long term [ClearOnMoney]
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Norway looks solvent for the long term

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Commentary

Norway looks solvent for the long term

30 Aug 2012 by Jim Fickett.

Most currencies look unlikely to hold their value, because most governments are on an unsustainable long-term fiscal path. Norway may provide an exception.

Norwegian kroner are widely viewed as a haven amid the current debt problems of the EU, Japan, the US, and China. Popular articles, however, never seem to go much beyond a statement that the Norwegian sovereign wealth fund is big, or that the overall government budget, including the fund, is in surplus. The analysis that follows goes into enough depth to indicate that Norwegian government solvency, on a scale of decades, is at least something one can rationally hope for.

The role of the sovereign wealth fund in the national budget

Norway's sovereign wealth fund used to be called a petroleum fund, but is now called the Government Pension Fund. It is still an oil fund in the sense that, unlike most pension funds, it does not depend on contributions from workers; rather, all the money comes from taxes on the petroleum industry and income from the government's share of two petroleum companies. In short, all government petroleum-related revenues go into the fund, and then 4% of the fund is taken out each year to help fund the general government budget. The idea is that the 4% will come out of real investment gains, so that the fund should continue to grow for a long time yet.

Alaska, hoping to improve the management of its own petroleum windfall, received a briefing in 2011 on the mechanics of the Norwegian pension fund and government budget, and wrote up a useful summary. The following excerpts provide a decent overview of how it all works.

Norway's income tax on oil and gas profits has two components: A 28 percent tax on profits (the same income tax charged on all businesses in Norway), and a special 50 percent tax on profits from offshore oil and gas production, for a total tax of 78 percent. (All of Norway's oil and gas production comes from offshore federal leases.) …

Norwegian offshore production peaked at about 3 million barrels a day a decade ago, and has been in decline since, down to a projected 1.7 million barrels a day in 2011. …

In addition to depositing all of its oil and gas-related tax revenues into its savings account, the Norwegian government owns 67 percent of the shares of Statoil … All of the government's Statoil dividends go into the savings account.

Statoil bids on leases and operates 80 percent of the oil and gas production in Norway, partnering with some of the world's largest petroleum companies. It operates in 33 other countries - including Angola, Brazil, the U.S. Gulf of Mexico and some U.S. shale gas plays - though the vast majority of its production comes from Norwegian waters. …

The biggest deposits to the nation's savings account come not from the profits-based tax or the dividends on Statoil shares. Rather, the cash comes from a state-owned company called Petoro, which the Finance Ministry refers to as State Direct Financial Interest, or SDFI.

Unlike Statoil, Petoro does not operate oil fields. It merely takes an equity stake in whatever leases the government wants. No ifs, ands or buts from the companies that win the leases. Petoro is a partner, and pays its full share of all development costs, operations and maintenance. Generally, Petoro is taking a 20 percent stake in leases these days, though the slice has been as hefty as 60 percent in the past.

The share of Petoro's stake is part of the bid notice on leases, with the government tending to take a bigger share on the best prospects and not so much on other fields. …

The government deposits all of Petoro's net revenues into the savings account and then decides, as part of each year's federal budget, how much to invest in new projects that year. Petoro doesn't get to keep a dime of its profits. …

And while all of the cash flow from Petoro, the Statoil dividends and oil and gas profits taxes go into Norway's Government Pension Fund Global - an estimated $57 billion in deposits in 2011, based on current exchange rates - the government gets most of what it needs to pay for universal health care, free education through college, a generous pension system and other programs from heavy taxes on residents and businesses. …

Though the savings account is called the Government Pension Fund, none of the earnings go toward pensions - government or otherwise - at this time. Norwegians generally understand, however, that the fund will be used to help pay for public pensions and other programs when the economy declines as oil and gas production plays out.

Until then, the government targets a 4 percent annual withdrawal of the fund's market value to help supplement the federal budget … That 4 percent transfer from Norway's savings account- approximately $21 billion U.S. dollars this year, at current exchange rates - accounts for about 10 percent of the nation's budget.

Current budget, illustrating ex-petroleum deficit and with-petroleum surplus

Here, from the Norwegian Ministry of Finance, is a very clear presentation of how the system is working now. Leaving both the Government Pension Fund and all petroleum revenues out of the picture, the budget would be in deficit by about 11% of expenditures. But there is enough money coming in from oil and gas that even after covering this deficit out of the Pension Fund, the Fund will grow significantly in 2012.

The longer term

Norway is not completely free of the problems other countries are facing. The population is aging, and probably pension promises were too generous. So the ex-petroleum deficit is likely to worsen for a while before it gets better. Here, from a 2009 long-term economic outlook (again from the Ministry of Finance), is the outlook for the deficit:

The report does admit that this situation may require policy adjustments:

The projections show that with a continuation of today’s welfare schemes and tax levels, the public sector will face an increasing financing gap in the long term, see Chart 2.13B. Growth in pensions and other benefits is the main contributor to this development, see Chart 2.13A. This means that action must be taken either to curb public expenditure or to increase public revenues in the long run.

However, unlike most countries, Norway has the Pension Fund to fall back on. So although they would prefer not to spend their capital, which would probably require some changes in either taxes or pensions, the capital is there, and will probably continue to grow for some time.

This report assumes, albeit with much uncertainty, that the price of crude oil will remain at a historically high level, i.e. NOK 400 (2009 prices) per barrel in the long run. High revenues from the oil sector are expected to produce a rapid increase in the fund capital over the next few years leading to a higher level than previously envisaged. The capital in the Government Pension Fund – Global may rise from 118 per cent of GDP for Mainland Norway at the end of 2007 to around 240 per cent at the start of the 2020s

Note that the cumulative deficit projected in the above figure is on the scale of 100% of GDP, which could thus, in some scenarios, be covered by the Pension Fund.

Caveats

The above analysis suggests that the government could stay solvent on a scale of decades, but that does not mean it necessarily will stay solvent. Norway has done an admirable job of managing the petroleum windfall, but Norwegians are human, and it is quite possible that, rather than getting pension obligations under control, it will be politically easier to abandon the 4% withdrawal rate on the Pension Fund, and spend down the capital. It bears watching.

Since the fund was established in 1990, Norwegian inflation has run at an average (CAGR) rate of 2.1%. But longer term there have been bouts of serious inflation. The average inflation rate from 1940 to 2012 was 4.7%. Again, as pension pressures increase and the oil revenues decline, deficits and inflation bear watching.

With all the talk of Norwegian krone as a haven currency, one might imagine that the value of the krone would have risen strongly in the last two or three years. But apparently the dollar has been about as attractive as the krone during the euro crisis, since the dollar-krone exchange rate has been fairly stable, around 6 kroner to the dollar, for the last seven years or so. Still, if I were to make a serious krone-denominated investment, I'd want to investigate the current purchasing power parity between the dollar and krone first.

Even if one decides to invest in the krone, one still needs to find an appropriate vehicle. Long bonds in Norway, like long bonds everywhere, carry very high risk. Haven buying has driven Norwegian bond yields down to unrealistic levels, and bondholders will lose when rates normalize (see Bloomberg and Trading Economics).