MEDITERRANEAN PAPER SERIES 2013

MANAGING NEWFOUND HYDROCARBON WEALTH

MACROECONOMIC POLICY CHALLENGES IN THE EASTERN MEDITERRANEAN
Rozlyn C. Engel

 2013 The German Marshall Fund of the United States. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without permission in writing from the German Marshall Fund of the United States (GMF). Please direct inquiries to: The German Marshall Fund of the United States 1744 R Street, NW Washington, DC 20009 T 1 202 683 2650 F 1 202 265 1662 E info@gmfus.org GMF Paper Series The GMF Paper Series presents research on a variety of transatlantic topics by staff, fellows, and partners of the German Marshall Fund of the United States. The views expressed here are those of the author and do not necessarily represent the views of GMF. Comments from readers are welcome; reply to the mailing address above or by e-mail to info@gmfus.org. About GMF The German Marshall Fund of the United States (GMF) strengthens transatlantic cooperation on regional, national, and global challenges and opportunities in the spirit of the Marshall Plan. GMF does this by supporting individuals and institutions working in the transatlantic sphere, by convening leaders and members of the policy and business communities, by contributing research and analysis on transatlantic topics, and by providing exchange opportunities to foster renewed commitment to the transatlantic relationship. In addition, GMF supports a number of initiatives to strengthen democracies. Founded in 1972 as a non-partisan, non-profit organization through a gift from Germany as a permanent memorial to Marshall Plan assistance, GMF maintains a strong presence on both sides of the Atlantic. In addition to its headquarters in Washington, DC, GMF has offices in Berlin, Paris, Brussels, Belgrade, Ankara, Bucharest, Warsaw, and Tunis. GMF also has smaller representations in Bratislava, Turin, and Stockholm. About the Mediterranean Policy Program The Mediterranean Policy Program promotes transatlantic analysis and dialogue on issues affecting Southern Europe, North Africa, the Levant, and the Mediterranean basin. Priority areas include: understanding trends in Mediterranean societies; exploring opportunities for south-south cooperation and integration; research on key functional issues affecting Mediterranean security and development; and strengthening the North American policy debate on the region and transatlantic cooperation on Mediterranean strategy. GMFs Eastern Mediterranean Energy Project addresses the political and economic implications, risks and opportunities of the recent energy discoveries in the Eastern Mediterranean region. It aims to promote the conditions for the peaceful development of the new energy opportunities in the Eastern Mediterranean and to promote regional cooperation on energy issues. See more at: www.gmfus.org/programs/climate-energy Cover photo: Two offshore oil rigs during sunset in Caspian sea. Elnur

Managing Newfound Hydrocarbon Wealth

Macroeconomic Policy Challenges in the Eastern Mediterranean
Mediterranean Paper Series August 2013

Rozlyn C. Engel1

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 The Upside . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 The Downside of Commodity Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

1 Rozlyn C. Engel is a national intelligence officer & national intelligence manager for economics with the Office of the Director of National Intelligence. The views expressed in this paper do not represent the official position of the U.S. government, the U.S. Department of Defense, or the National Defense University. I would like to thank Jonathan Evans for outstanding research assistance. All errors and omissions remain mine alone.

1
T

Overview

he past several years have brought indisputable evidence that significant hydrocarbon resources lie below the Eastern Mediterranean seabed offshore Israel and Cyprus. An estimated 27 trillion cubic feet (tcf) of natural gas have already been discovered in the Leviathan and Tamar fields. Nearly a decade of energy exploration and development in its offshore waters have brought Israel, a nation long dependent on external energy sources, to the eve of energy abundance.1 Based on prices from recent sale contracts for the Tamar field, the value of 27 tcf of natural gas may be as much as $270 billion, more than Israels total GDP in 2012.2 In short, Israel seems poised not only to achieve a high degree of national energy security as early as 2014 but also a degree of energy wealth by 2018.3 Cyprus, while several years behind Israel in its exploration and development initiatives, confirmed in late 2011 the discovery of roughly 7 tcf of natural gas in the Aphrodite field, which lies adjacent to its maritime boundary with Israel and could be worth upward to $70 billion at current prices.4 This amount alone could satisfy the countrys energy needs through the 21st century, although delivery of that gas will

not begin until the end of the decade.5 Moreover, it is possible, based on the most optimistic estimates, that the country could possess over 40 tcf of natural gas.6 The maritime delimitation disputes in the region, the rapidly changing world energy markets, and the physical challenges of developing and distributing offshore hydrocarbons make the Eastern Mediterranean a microcosm of how politics, economics, and technological advances can collide in offshore energy development. The political dimensions and regional security implications of the Eastern Med gas finds are significant and have received increased attention in the past year.7 An area that has been covered less thoroughly, however, involves the macroeconomic impacts of new-found commodity wealth and the policy challenges that such wealth can pose. These issues are important because countries that manage their commodity wealth well are stronger as a consequence; those that do not are more vulnerable to global price swings, anemic economic growth, and a loss of economic diversification as well as corruption and conflict.
5 Recent estimates state that up to 2 tcf could be exported annually by 2020. See Cyprus Potential Vast Natural Gas Reserves on the Table, Natural Gas Europe, March 25, 2013, http://www. naturalgaseurope.com/cyprus-natural-gas-reserves. Also see Onoufriou (2012, p. 7). Recent delays in Noble Energys second appraisal well, originally scheduled for February 2013 and intended to confirm the estimates from an initial drilling, have created uncertainties about Cypruss timeline, however. Current plans have Noble completing the second well by October 2013, before its initial license runs out. See Stefanos Evripidou, Noble Drilling Delay Normal, Cyprus Mail, January 20, 2013, www. cyprus-mail.com. 6 This estimate comes from Cypruss hydrocarbons agency based on the six offshore blocks (out of twelve total) that have been awarded licenses. See Cyprus Potential Vast Natural Gas Reserves on the Table, Natural Gas Europe, March 25, 2013, http://www.naturalgaseurope.com/cyprus-natural-gas-reserves. 7 In addition to the policy briefs mentioned in the preceding notes, the German Marshall Fund also commissioned Leigh (2012), Mankoff (2012), Ogutcu (2012), and Scovazzi (2012). Other papers include Ratner (2011), Wahlisch (2011), and Darbouche, El-Katiri, and Fattouh (2012).

1 Shaffer (2012) provides some history of Israeli gas exploration. Darbouche, El-Katiri, and Fattouh (2012) provide recent estimates of the Tamar and Leviathan fields. 2 This estimate uses a price of $10.00 per million British thermal units (Mmbtu), or $10 billion per tcf, given the conversion of 1 billion Mmbtu to 1 tcf. In early 2012, the IMF estimated the value of Israels new natural gas fields at 50 percent of its 2011 GDP. 3 The Tamar field began production in late March 2013 and the Leviathan field is set to begin production in 2016. It also appears that Israel enjoys significant oil reserves, further enhancing its energy independence and underscoring the imperative to address the macroeconomic management of its commodity income. See Henderson (2012). 4 Shaffer (2012, p. 7). Also see Stanley Reed, For Cyprus, Gaslight at the End of Tunnel? New York Times, April 5, 2013, http://www.nytimes.com/2013/04/06/business/global/forcyprus-gaslight-at-the-end-of-tunnel.html?pagewanted=all. Again, the dollar estimate is based on $10.00 per Mmbtu.

Managing Newfound Hydrocarbon Wealth

This paper seeks to fill a gap by considering the macroeconomic policy challenges facing the prospective energy producers in the Eastern Med, particularly Israel and Cyprus.8 In doing so, it explores both the economic upside of the gas discoveries and the downside risks associated with sudden commodity wealth. It examines the mechanisms that other countries have developed to manage new streams of commodity income and describes the steps taken to date by Israel and Cyprus in these areas.

8 Geological structures do not respect political borders, implying that Lebanon, Syria, Turkey, and Egypt almost certainly have gas within their Exclusive Economic Zones as well. Because Israel and Cyprus are much farther ahead in terms of development, this paper focuses on their macroeconomic policy challenges more specifically. Many of the issues (though not all) are relevant for these other countries.

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2
C

The Upside

ommon sense argues that a country is better off with trillions of cubic feet of natural gas than without it. The world has seen numerous cases where oil and gas booms created economic growth and raised living standards: Norway, Canada, the oil-rich countries of the Middle East, Russia, and the United States (North Dakota today and Ohio and Pennsylvania in the early 1900s). Future gas production in Israel and Cyprus is likely to increase economic welfare through several channels: higher employment and incomes (both household and businesses), lower energy costs and more reliable supply, stronger public finances, and improved trade balances. For Israel, whose economy weathered the recent global downturn fairly well, the gains from previous offshore investments are already apparent. For Cyprus, whose economy suffered a severe crisis in 2013 and whose offshore investments are still minimal, the gains are a few years away. For background, a summary of the primary macroeconomic indicators for Israel and Cyprus is presented in Table 1. Higher Employment and Income Direct production activities, exploration and drilling, the construction of facilities and infrastructure, and extraction and distribution operations require significant capital investment and increase the demand for labor. Hydrocarbon development creates jobs through several channels: direct jobs in the oil and gas industry and capital expenditures in closely related industries, indirect jobs created by supplies of goods and services to the industry, and induced jobs created to meet the new demand for consumer goods from the additional income from the industry. For an idea of the economic benefits that oil and gas production can generate, consider an oil- and gas-producing U.S. state such as Oklahoma with an economy about four-fifths the size of Israels.

IHS Global Insights has estimated that, in 2012, Oklahoma produced 5.5 bcf of gas and 225,000 barrels of crude oil per day.9 Today, the state has more than 65,000 people employed in its oil and gas sector and has lower than average unemployment. Indeed, the states unemployment rate is set to dip below 4 percent by 2016. Growth in the sector will more than double these employment figures by 2035 according to IHS Global Insights, and these activities are projected to create nearly $18 billion in annual labor income and $38 billion annually in total value added. The IHS report also notes that the average annual wage in Oklahoma in 2012 was $52,200, while the average wage of a direct job in the oil and gas sector was $108,600.10 For Israel and Cyprus, the onset of commodity development has been relatively sudden. One indicator, albeit a crude one, is the IMFs substantial underestimation of Israeli growth in the past few years. In 2010, they projected a 3.2 percent growth rate while the actual rate turned out to be 5.7 percent. In 2011, the prediction was 3.5 percent but turned out to be 4.6 percent.11 (Not all of this additional growth is due to developments in the energy sector, however.) The Bank of Israels 2011 Annual Report notes that investments in gas and drilling contributed significantly to the surge in gross domestic investment in 2011, which was up 23 percent and led the growth in aggregate domestic demand.12 Through 2012, the Israeli economy continued to grow at 3.1 percent, and its unemployment rate fell to a 10-year low of 6.9 percent, a figure that gas sector growth is likely to
9

IHS (2012, p. 30). IHS (2012).

10 11

IMF (Table A, various years). Of course, gas developments explain only part of this growth, much of which can be credited to improved economic policies generally. Indeed, Israel was one of the very few advanced economies to maintain positive growth rates in every year since 2004. Bank of Israel (2012, p. 55).

12

Managing Newfound Hydrocarbon Wealth

Table 1. Recent Macroeconomic Trends, Cyprus and Israel

Cyprus GDP, PPP valuation (billions of current int'l dollars) GDP per capita, PPP valuation (billions of current int'l dollars) Implied PPP conversion rate Exchange Rate, Euros/USD1 Real growth rate of GDP (national prices, percent change) Stock Exchange Index, CSE General2 Stock exchange (percent change)2 Total investment (percent of GDP) Foreign direct investment (net inflows in billions of USD)3 Gross national savings (percent of GDP) Inflation rate (percent change) Unemployment rate (percent) Population (millions) General government net lending/borrowing (percent of GDP) General government gross debt (percent of GDP) Current account balance (percent of GDP) Israel GDP, PPP valuation (billions of current int'l dollars) GDP per capita, PPP valuation (billions of current int'l dollars) Implied PPP conversion rate Market exchange rate, NIS/USD1 Market exchange rate, NIS/Euros 1 Real growth rate of GDP (national prices, percent change) Stock Exchange Index, TA-1002 Stock exchange (percent change)2 Total investment (percent of GDP) Foreign direct investment (net inflows in billions of USD)3 Gross national savings (percent of GDP) Inflation rate (percent change) Unemployment rate (percent) Population (millions) General government net lending/borrowing (percent of GDP) General government gross debt (percent of GDP) Current account balance (percent of GDP) 2001-05 2006-10 $16.4 $22.0 $22,597 $27,532 0.72 0.74 0.93 0.74 3.2 2.5 2554.254 -28.0 31.0 18.1 21.0 $1.0 $1.5 14.1 10.0 2.5 2.3 4.4 4.9 0.72 0.80 -4.0 -1.6 68.2 58.6 -4.0 -11.0 $142.7 $22,410 3.9 4.5 4.9 2.1 482.7 10.9 18.2 $2.9 18.7 1.7 12.4 6.36 -6.5 95.3 0.5 $200.6 $28,385 3.6 4.0 5.4 4.4 892.7 16.5 17.0 $8.9 15.6 6.8 6.9 7.80 6.0 62.0 19.2 2011 $23.8 $27,581 0.76 0.72 0.5 1181.54 -21.0 17.3 $1.1 12.6 3.5 7.9 0.86 -6.3 71.1 -4.7 $237.0 $31,466 3.7 3.6 5.0 4.6 1203.8 13.8 17.6 $11.4 19.0 3.5 7.1 7.53 -4.7 74.0 1.4 2012 $23.6 $27,086 0.76 0.78 -2.4 385.85 -67.3 13.5 8.6 3.1 12.1 0.87 -5.6 86.2 -4.9 $248.7 $32,312 3.7 3.9 5.0 3.1 1013.7 -15.8 19.2 19.1 1.7 6.9 7.70 -4.7 74.6 -0.1 $261.8 $33,282 3.7 3.7 5.0 3.6 1046.7 3.3 18.4 20.1 1.6 7.0 7.87 -3.6 74.4 1.7 $277.6 $34,524 3.7 3.9 18.8 21.3 2.0 6.5 8.04 -3.1 73.2 2.5 $293.2 $35,690 3.7 3.6 19.6 22.1 2.0 6.5 8.22 -2.7 72.0 2.5 2013 2014 2015

0.75 110.97 -71.2

The data are from the IMF's World Economic Outlook database (April 2013), unless otherwise noted. 1. Pacific Exchange Rate Service 2. Cyprus Stock Exchange and Tel Aviv Stock Exchange. Percent change is measured from the previous year. 3. World Bank

http://fx.sauder.ubc.ca/data.html http://www.tase.co.il/Eng/MarketData/DailyRevie w/Pages/DailyReview.aspx http:data.worldbank.org/indicator/BX.KLT.DINV.C D.WD

The following IMF reports offer some background analysis of recent macroeconomic trends in the two countries. For Cyprus, see IMF (2011); for Israel, see IMF (2012a).]

push further down. Growth in 2013 has remained surprisingly strong at 3.8 percent, with next years figure expected to climb to 4.0 percent. According to the Bank of Israel, one-quarter of that GDP growth (one percentage point) will come from

natural gas production.13 Within the next five years, they believe that gas could raise GDP by as much as 3 percent.
13

Figures for 2012 are from the IMF, World Economic Outlook, April 2013. The 2013 and 2014 projections are from the Bank of Israel, as reported in Israels Growth Expected to Increase in 2014, Wall Street Journal, March 24, 2013. These figures are reasonably close to earlier projections by UBS analysts as reported by Nadav Shemer, UBS: Oil Could Have Impact, The Jerusalem Post, May 11, 2011.

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For Cyprus, the likely size of its gas deposits relative to its overall economy suggests it will look more like North Dakota than Oklahoma. With a labor force of roughly 520,000 people, Cyprus is small compared to Israel, making the relative economic impacts even greater.14 Because Cyprus has not proceeded far enough to see tangible gains from its offshore gas development, we are left to surmise the potential gains from comparable cases and economic models.15 North Dakota, for example, has a total workforce of 400,000 and the recent energy boom has had huge economic impacts. In 2011, the states GDP grew by 7.6 percent nearly five times the national average and the unemployment rate has fallen to 3.3 percent. By contrast, however, Trinidad and Tobago, with a more established energy sector and a workforce of 700,000, had a 2011 growth rate of -2.5 percent and an unemployment rate of 5.0 percent.16 Basing a Cypriot projection on the current estimates for the Israeli economy, Cyprus could enjoy a 2-3 percentage point increase in its expected growth rate by 2020 if it can move forward with development.17 Potential infrastructure projects are likely to create some growth gains, though more modest.

Lower Energy Costs and More Reliable Supply A decline in energy costs can boost domestic economic welfare by freeing up income for other consumables and reducing the risk of energyrelated inflation. Similarly, domestic producers will benefit through lower production costs and a more stable flow of energy inputs.18 For the United States, the oil and gas sector has contributed modestly to recent economic growth. Since 2009, it is responsible for one-fifth of the growth in overall industrial production and directly contributed 0.6 percentage points of the 7.6 percent increase in GDP. In addition, the price facing households has fallen 10 percent, creating a savings of $20 billion. When indirect impacts are included, the stimulus to economic growth is higher.19 The final retail price of energy depends on several factors. Foremost are the demand- and supply-side conditions. As the authors of the Oxford Institute of Energy Studies report conclude: The future evolution of natural gas demand in each of the East Mediterranean countries will be determined to a large extent by the pace of expansion of electricity demand; the energy mix within the power sector; the use of natural gas beyond the power sector; and the availability of gas supplies.20 In addition, the role of government policy will prove crucial. For example, governments often establish a two-tiered pricing system under which domestic energy prices
18

14 This figure is based on the labor force participation rate of 65 percent (reported by the World Bank) and total population of 800,000 in the four southern districts (reported by Statistical Service of the Republic of Cyprus for 2011). 15

The high growth rates and low unemployment prior to 2008 were unconnected to the recent gas discoveries. North Dakota data are from the U.S. Bureau of Economic Analysis, GDP by State, and Trinidad and Tobago data are from the IMF. Given the Israeli estimate that its gas sector will contribute an additional one percentage point to the countrys growth rate, and given the fact that Cypruss gas sector stands to be significantly larger as a proportion of the economy, a higher impact seems plausible. However, this figure is highly speculative given the uncertain economic potential of the gas reserves and the countrys unusual macroeconomic conditions at the moment. Standard forecasting techniques also seem unlikely to prove reliable in such a situation.

16

Energy-intensive industries, such as chemical production and desalination, particularly stand to benefit from lower gas prices and abundant supplies. It may also make the two countries more attractive destinations for energy-intensive manufacturing, just as the United States is beginning to attract foreign investment (especially from Europe). Shale Boom Sparks U.S. Industrial Revival, CNBC, March 26, 2013. The U.S. Oil and Gas Boom Has Had a Modest Economic Impact So Far, Wonkblog, Washington Post, April 23, 2013, which is based on a recent analysis by Paul Dales of Capital Economics. Darbouche, El-Katiri, and Fattouh (2012, p. 14). The availability of supplies, in turn, depends whether the prevailing market price allows firms to make a profit given their costs of production.

17

19

20

Managing Newfound Hydrocarbon Wealth

are lower than the export price. This effectively subsidizes local consumption and redistributes income from gas producers to gas consumers.21 While popular, such subsidies distort consumer spending, and several countries that attempted to reduce those subsidies faced tremendous popular resistance (Egypt and Iran).22 From 1986 to 2003, Israeli energy production never exceeded 1 percent of its energy consumption.23 By 2011, Israels situation had improved modestly, but the country still supplied only 19 percent of its own energy needs.24 But with high levels of per capita income and a strong desire to move away from dirtier coal and oil, the future demand for natural gas in Israel seems secure. Israels Ministry of Energy and Water Resources expects consumption of natural gas to more than triple from 184 bcf (6.5 tcf) in 2010 to 635 bcf (22.4 tcf) by 2030, with 85 percent of the gas going toward electricity generation and industrial use.25 Already the
21

countrys increased reliance on natural gas since the early 2000s, up to 16 percent of the countrys total energy mix by 2009, has saved the country NIS 20 billion in lower energy costs (roughly $5.5 billion, or more than $700 per Israeli).26 Noble Energy estimates that the Tamar field itself will generate $130 billion in energy savings for Israel.27 Cyprus, to date, has used virtually no natural gas and relies almost exclusively on imported oil to meet its energy needs.28 It meets only 4 percent of its own energy needs through domestic sources.29 Consequently, the country faces some of the highest energy prices in Europe. Prior to the recent gas discoveries, the islands physical isolation made use of imported gas particularly difficult, since such imports require either underwater pipelines from a reliable supplier-country or a regasification plant to handle LNG imports. While the recent gas discoveries will clearly allow Cyprus to meet its national energy needs through a domestic supply, the question of how best to bring the gas ashore is

In those cases where the government decides to allow the domestic price to follow the export (world) price, domestic consumers would see little benefit from the new domestic sources. More direct redistributive mechanisms, such as cash transfers and tax rebates, can be more economically efficient because they do not interfere with relative prices (examples include Alaskas Permanent Dividend Fund) and generally prove less distortionary. Politically, they can prove controversial. A cautionary tale comes from Nigeria, where the government instituted subsidies for gas and cooking fuel. Popular resentment about corruption and the lack of broad-based economic development have made the subsidies one of the few benefits that flow to the people, and they have protested vociferously and actively to keep them. Yet the subsidies cost the government over $8 billion and abet the massive corruption around the oil economy of Nigeria. See VanDeveer (2013, p. 13). U.S. Energy Information Administration, International Energy Statistics, Tables: Total Primary Energy Production and Total Primary Energy Consumption (accessed April 30, 2013): http://www.eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid=44&p id=44&aid=1&cid=IS,&syid=1980&eyid=2011&unit=QBTU. McLean and Busch (2013).

26

22

This gas has come from Israels older and smaller offshore fields and, until last year, Egyptian pipeline imports. The Oxford Institute for Energy Studies (2012, table 6) notes that the prices of natural gas from the Tamar field are indexed in two ways depending on the contract. About half of the gas will be delivered under the largest contract, with a price partly indexed to the US consumer price index. The remainder of the gas will be delivered under numerous smaller contracts, mostly with prices indexed to the cost of electricity generation. International Energy Agency, Graph: Share of total primary energy supply in 2009, Israel: http://www.iea.org/stats/pdf_graphs/ILTPESPI. pdf (accessed April 30, 2013); and Israeli Ministry of Energy and Water Resources website: http://energy.gov.il/English/Subjects/ Natural%20Gas/Pages/GxmsMniNGEconomy.aspx.

23

27

Noble Energy. 2012. 2012 Noble Energy Analyst Report, December 6, 2012. Cypriot energy production has yet to meet even 1 percent of Cypruss energy consumption. U.S. Energy Information Administration, International Energy Statistics, Table: Total Energy production and Consumption (accessed March 21, 2013): http://www.eia.gov/cfapps/ipdbproject/IEDIndex3. cfm?tid=44&pid=44&aid=1 McLean and Busch (2013).

28

24 25

Israeli Ministry of Energy and Water Resources. Accessed on-line April 30, 2013: http://energy.gov.il/English/Subjects/ Natural%20Gas/Pages/GxmsMniNGEconomy.aspx.

29

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still unresolved.30 Ultimately, successful conversion of the economy to natural gas (and away from imported oil) could save the Cypriot government up to 1.1 billion each year through lower prices, reduced emissions, and less exposure to volatile oil prices.31 It is also estimated that conversion to could create a natural gas market of 0.9 bcm by 2020, to give a rough idea of how large the gas market could become for Cyprus.32 Stronger Government Finances A robust energy sector can provide substantial tax revenues to governments and an inflow of foreign exchange when a portion of the production is exported abroad.33 Government tax revenues are not a welfare gain themselves but rather a redistribution of gains from the private sector to the public sector. Nonetheless, the revenues can be used to advance national goals that might otherwise be difficult to fund, such as infrastructure, national security, education, and basic scientific research.34 The inflow of foreign exchange can provide a cushion against balance of payments fluctuations. Israeli officials have said that government revenues from the Tamar and Leviathan fields could reach $130 billion by 2040 if available quantities in all the gas fields (especially Leviathan) are confirmed, an
30

annual average of roughly $5 billion (or 2 percent of current GDP).35 Additional major discoveries would increase these receipts. Israels current debt-to-GDP ratio is relatively high at 75 percent of GDP, with defense-related spending typically some 7 percent of GDP. The government deficit is now expected to run at 3.4 percent of GDP, exceeding the 2 percent deficit target. Thus, one of the countrys major near-term policy goals is to push the debt-to-GDP ratio and deficit spending onto a downward trajectory. Tax proceeds generated by expanding natural gas production could facilitate the desired transition to more sustainable fiscal positions if they are well managed. Despite relatively low debt-to-GDP ratios through 2008, the Cypriot governments finances deteriorated quickly in the wake of the European financial crisis in 2009. The countrys banking sector was particularly vulnerable to the orderly default of Greek banks in spring 2012. But central government policies also contributed through an excessively large public sector (its public sector wage bill of 15.4 percent of GDP was the largest in the euro area in 2010), poorly targeted social transfers (another 5.5 percent of GDP in 2010), and mounting public pension liabilities. In the past three years, the country has seen a series of credit downgrades and watched as its 10-year interest rates rose above 10 percent, effectively cutting the government off from international credit markets. These problems have put considerable pressure on the country to pursue fiscal consolidation. The potential tax revenues from natural gas production remain too distant and uncertain to provide relief in the near term. An April 2013 analysis on public debt sustainability by the European
35

LNG could prove the best available option for Cyprus but only if the country can be certain of a sufficiently large export market and can obtain reasonably priced financing, See Onoufriou (2012) and Henderson (2012) for additional observations about the advantages and disadvantages of LNG. The major challenge is the substantial upfront costs of LNG facilities, which are clearly beyond the Cypriot governments ability to finance in the current climate. Darbouche, El-Katiri, and Fattouh (2012, p. 11). Darbouche, El-Katiri, and Fattouh (2012, table 5, p. 16).

31 32 33

To give an idea of the fiscal complexities involved in choosing a tax structure, Smith (2012) describes and then analyzes seven different types of fiscal regimes: a no-tax benchmark, a royalty regime, a corporate income tax regime, three variations on production-sharing contracts, and a resource rent tax regime. IHS (2012).

34

Israel Natural Gas Wealth Fund Gets Initial Nod, Reuters, October 23, 2012, http://www.reuters.com/article/2012/10/23/ israel-natgas-wealthfund-idAFL5E8LN78M20121023. By comparison, the IHS report cited earlier with respect to Oklahoma projects that states oil and gas sector to create $180 billion in tax revenues for all levels of state government over the next two decades.

Managing Newfound Hydrocarbon Wealth

Commission concluded: The future exploitation of Cyprus offshore gas fields is expected to increase government revenues both directly and via increased economic activity. These effects are excluded from the current debt projections as the size of these natural resource revenues remains uncertain. Overall, although both the timing and size of these revenues remain uncertain, exploitation of Cyprus natural resources constitute a significant upside risk to debt sustainability.36 The same report estimates that just a 1 percentage point increase in the Cypriot growth rate could reduce the countrys debt-to-GDP ratio by four percentage points by 2017 and bring it down below 100 percent more than one year earlier than current projections allow.37 To reap the long-term benefits of these tax revenues will require policy discipline. Sovereign wealth funds provide a vehicle for managing tax revenues to meet longer-term fiscal and national needs. A well-managed sovereign wealth fund insulates spending decisions from short-term political pressures and aligns the funds investment strategy with a well-articulated national mandate. The various designs adopted by a select set of other commodity producers provide a useful overview of the sort of choices facing Israel and Cyprus (see Table 2). (Other fiscal and monetary policy concerns are discussed later in the paper.) Israel has already made significant progress in establishing a sovereign wealth fund.38 In February 2012, Prime Minister Benjamin Netanyahus office announced a draft plan for an Israeli sovereign
36 37 38

wealth fund to be modeled on Norways Pension Fund. The Israeli fund will draw its revenue from an excess profit tax of up to 50 percent and royalties of 12.5 percent, both imposed in 2011 through the Sheshinski Law.39 Based on 30-year projections of potential gas production, the fund is projected to accumulate upward of $80 billion by 2040 depending on the rate of disbursements from the fund.40 In October 2012, Israels Finance Ministry received approval from a government panel to establish the proposed fund and in April 2013 the government re-approved it (due to the intervening change in government). Now the fund awaits final Knesset legislation. In an October statement, the Finance Ministry asserted: Each year the ongoing profits from the return on the funds investments will be allocated for social, economic and educational purposes, as shall be decided by the government and in accordance with the prime ministers declaration on the subject. In addition, the monies in the fund will aid, if necessary, in coping with unusual events that have a negative effect on the States economy, such as a war or earthquake.41 The funds assets and investments will be managed by a new department within the Bank of Israel, with the finance minister serving at the head of the funds board that determines the
39

Nadav Shemer and Sharon Udasin, Cabinet Outlines Plan for Sovereign Wealth Fund, The Jerusalem Post, February 19, 2012, http://www.jpost.com/Business/BusinessNews/Article. aspx?id+258495. The Sheshinski plan specifies the flows into the fund and the regular annual transfer to the budget based on long-term yields. For the sake of comparison, the Kuwait Investment Authority (KIA) is required by law to transfer 10 percent of all oil revenues into its two investment funds, which total $296 billion. Tobias Buck, Israel Plans Sovereign Wealth Fund. Financial Times, February 19, 2012, http://www.ft.com/ intl/cms/s/0/273462dc-5b13-11e1-a2b3-00144feabdc0. html#axzz2OCK9ivWm. Also see Milken Institute (2011).

40

European Commission (2013, p. 15) European Commission (2013, graph 3, p. 13).

A report by the Milken Institute formalized much of the initial thinking and argued forcefully for the establishment of an Israeli sovereign investment fund: Sovereign investment funds generate economic security for future generations by converting endowments of natural resources into financial endowments. Milken Institute (2011, p. 1). The Sheshinski report largely mirrored this approach (see State of Israel 2011).

41 State of Israel, Ministry of Finance, Law Bill Filed by the Minister of Finance for the Establishment of a Fund for the Management of the States Revenues from Natural Gas Profits has been Approved by the Ministerial Committee, press release, October 23, 2012 (accessed on-line at http://www.financeisrael. mof.gov.il/FinanceIsrael/Pages/en/PressReleases/PressReleases. aspx#).

The German Marshall Fund of the United States

Table 2. Illustrative Examples of Sovereign Funds Used to Manage Commodity Wealth Basic Facts
Botswana Pula Fund Diamonds and Minerals Chile Economic and Social Stabilization Fund2 Copper Pension Reserve Fund3 Copper North Dakota Legacy Fund Oil and Natural Gas Worth $14.86 billion Surpluses over 1 percent of GDP are deposited into the fund Founded in 2007 (derived from Copper Stabilization Fund, established 1985) Worth $5.83 billion At least 0.2 percent of GDP deposited annually into the fund Founded in 2006 Worth $1 billion Founded in 2011 Focuses on smoothing the short-run business cycle and variance in copper prices, and on minimizing the need for government-issued debt Worth over $6 billion Founded in 1994

Mandate
Pula Fund is used to transfer mineral wealth to future generations

Investments/Projects
long-term instruments overseas in a range of major currencies and in a mix of long-term fixed income securities and equities Over 80 percent of the funds value is held in international sovereign bonds Maintains a high level of liquidity based in dollars, euros, and yen

Anticipating an increase in the senior citizen population, this fund will allow Chile to guarantee basic solidarity pensions With finite revenues from oil and gas, the fund seeks to defer the recognition of 30 percent of this revenue for the benefit of future generations and to preserve the real, inflation-adjusted purchasing power of the monies deposited into the fund

Over 60 percent of the funds value is held in foreign sovereign and government-based bonds (including inflationindexed bonds) Short-term bonds, however, there is a recent push to move some investing into stocks

Norway Government Pension Fund Global (called Petroleum Fund until 2006)4 Oil
1 2 3 4

to give the government room Worth $686 billion for manoeuvring in fiscal 3.66 percent net real policy should oil prices drop return over last 10 years or the mainland economy Founded in 1990 contract This fund will deal with expected increases in public expenditures due to Norways aging population

Property in U.K., France, and Switzerland Wide variety of bonds Holds a vast number of global stocks, owning small percentages of many companies (including Air China, Target, Barclays, and General Electric)

http://www.bankofbotswana.bw/content/2009103013033-pula-fund http://www.hacienda.cl/english/sovereign-wealth-funds.html Ibid. http://www.nbim.no/en/

Managing Newfound Hydrocarbon Wealth

Table 2 cont. Illustrative Examples of Sovereign Funds Used to Manage Commodity Wealth Basic Facts
Qatar Qatar Investment Authority5 Gas and oil

Mandate

Investments/Projects
Within Qatar, the fund promotes small and mediumsized enterprises, property development, Qatar Airways, and educational institutions Abroad, the fund invests in private equity and companies such as Credit Suisse, Siemens, Royal Dutch Shell Over 75 percent of the funds investments are in U.S. domestic equities and U.S. fixed income assets (both short duration and core domestic)

Worth over $100 billion to strengthen the countrys economy by diversifying into Companion investment new asset classes[L]ongfund (Doha Global term strategic investments help Investment) worth $12 complement the states huge billion wealth in natural resources. Founded in 2005 Qatars goal is to become a major international centre for finance and investment management Smoothing out impact of oil and natural gas price fluctuations on public expenditure Provide a heritage for future generations, of Trinidad and Tobago, from savings and investment income derived from excess revenues.

Trinidad and Tobago

Worth $4.38 billion 4.8 percent annualized return since inception Heritage and Sta- Quarterly petroleum bilization Fund revenues 10 percent or (called Interim greater above estimates Revenue Stabiliare deposited into zation Fund until account 2007)6 Founded in 2000 Oil
5 6

http://www.qia.qa

http://www.finance.gov.tt/legislation.php?mid=20 Note: Multiple sources were used to complete this table. See the references section. Also see Tordo (2007), Truman (2008), and IMF (2012b), which provide more general analysis on sovereign wealth funds and fiscal policy.

investment policy and with representatives of the public and the government. It could be operational as early as 2016. A portion of the funds will be invested abroad to address the risks associated with Dutch Disease, which is discussed further below.42 Cyprus has made less progress in establishing a sovereign wealth fund, partly because of the complications introduced by the countrys current financial difficulties and partly because of uncertainty about the extent of the gas fields and how they will be developed. Indeed, the most recent proposals regarding a Cypriot sovereign wealth fund were developed to stave off financial
42

Tovah Lazaroff and Niv Elis, Government Approves Sovereign Wealth Fund, The Jerusalem Post, April 14, 2013.

crisis through the pooling of state, church, and pension assets, with future gas revenues a distant afterthought. Yet, assuming the country weathers its economic crisis and perseveres with development of its offshore gas, the case of Cyprus could raise the interesting questions about how a sovereign wealth fund might be used to ameliorate a public debt overhang. The concept of a sovereign balance sheet one that captures both the countrys assets (central bank reserves, agency reserves, sovereign investment funds, and natural resource revenues) and the countrys liabilities (explicit debt obligations, contingent claims from state budgets and public entities, and implicit guarantees to the private sector) may prove valuable for Cyprus.

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The German Marshall Fund of the United States

Such an approach would allow the country to better use its sovereign wealth fund to allocate resources across debt reduction and macroeconomic stabilization and long-run investment.43 Improved Trade Balance For many new commodity producers, the potential to expand exports is an important policy consideration. An increase in the value of a nations exports, all else equal, will cause its trade balance to improve, which brings clear economic benefits but also some costs. A major plus is that exports create new markets for the countrys goods (and implicitly for its labor) and, in this sense, contribute directly to economic growth.44 By foregoing domestic consumption of the commodity and promoting its exportation, a country is engaging in a form of national saving. A second benefit is that an increase in net exports increases the inflows of foreign exchange, providing a cushion of foreign reserves against possible balance of payments fluctuations. This is occasionally referred to as monetizing the commodity. Finally, an increase in net exports reduces the countrys reliance on foreign borrowing (or increases the countrys foreign lending in the case of growing trade surpluses). Export growth is not all rosy, however. On the minus side, an increase in net exports can cause the currency to appreciate and attract short-term capital inflows (sometimes referred to as hot money) two downside risks that we address in a later section.
43

The estimated sizes of the Israeli and Cypriot gas deposits are sufficiently large that both countries could have surpluses to export.45 Even using a fairly conservative figure of 40 tcf of total gas reserves for Israel and Cyprus, the two countries could meet four years of total import demand from the top five gas importers in Western Europe.46 Yet, Israel has been reluctant to commit to a level of exports because of concerns about national energy security. In March 2012, Dr. Shlomo Wald, chief scientist of the Energy and Water Ministry, was quoted in The Jerusalem Post saying that exporting gas would be a disaster because it reduces energy independence.47 Yet, some level of exports is almost certainly necessary to secure the full commercial development of the Israeli fields. Noble Energy has already spent $3.25 billion in the Levant Basin since 2004, while Figure 1 shows the expected surplus possible in coming years. In its second report, therefore, the Tzemach committee has recommended that slightly more than half of the estimated total natural gas for policy of 950 bcm (33.6 tcf) be allocated for export, with

45

Ian Ball, Sovereign Balance Sheets: Stranger Than Fiction, Blog on Public Finance International website, July 17, 2012, http://opinion.publicfinanceinternational.org/2012/07/sovereign-balance-sheets-stranger-than-fiction/. Also see IMF (2009) for broader discussion of crisis-related interventions and the uses of sovereign balance sheets. For this to be true, new foreign sales cannot simply substitute for existing domestic sales. Exports must expand the overall market for the good in question to foster economic growth. It must also be true that exports are priced competitively. For example, Egypt has recently begun to import gas at $10 per million British thermal unit (Mmbtu) but continues to sell to Jordan at $5 per Mmbtu. See McLean and Busch (2013).

The destination for Israeli and Cypriot gas exports is the subject of much discussion. In theory, an expansion of the regional gas market is promising, given that together Cyprus, Israel, Jordan, Lebanon, and Syria used natural gas for only 17 percent of their total energy supply in 2010 and given their physical proximity to the new gas supplies. (See Darbouche, El-Katiri, and Fattouh 2012, Table 2.) In practice, however, longstanding animosity between Israel, Lebanon, and Syria (and between Cyprus and Turkey) will impede development of an integrated regional market. Israel and Cyprus will need to look elsewhere Europe and Asia for reliable export markets.

44

46 See Darbouche, El-Katiri, and Fattouh (2012, table 1, p. 5) for estimated reserves and International Energy Agency (2012, p. 13) for European gas imports. Also see David Wurmser, The Geopolitics of Israels Offshore Gas Reserves, Jerusalem Center for Public Affairs, April 4, 2013. http://jcpa.org/article/thegeopolitics-of-israels-offshore-gas-reserves/ 47

Sharon Udasin, Experts: Israel Should Not Export Natural Gas, The Jerusalem Post, March 19, 2012, http://www.jpost.com/ Enviro-Tech/Experts-Israel-should-not-export-natural-gas.

Managing Newfound Hydrocarbon Wealth

11

Figure 1. Prospects for Israeli Gas Exports

Source: Milken Institute (2011, figure 2, p. 6).

proportionally more taken from the smaller fields so as to encourage their development.48 Given the small size of the Cypriot domestic economy and the large upfront investments needed to develop the gas, the project is not economically viable without substantial exports. In 2009, for example, Cypriot total consumption was 2.5 million tons of oil equivalent compared with 21.5 million tons by Israel.49 A significant level of gas exports would provide a welcome counterweight
48

to Cypruss dependence on imports and tendency to run current account deficits. Those deficits have ranged from -2.6 to -15.6 percent of GDP since 2001 (see Table 1). In the near term, trade balances may worsen for both countries, as they import much needed capital goods to build the required infrastructure. For example, Israel is currently running a very modest trade deficit after years of trade surpluses partly because of rapid development of the offshore gas sector and partly because of sluggish global demand for other Israeli exports. Creditors and international policymakers should recognize the necessity of these capital goods imports for the future growth of the Cypriot economy.

The Tzemach committee also relaxed an earlier prohibition against locating export facilities outside of Israeli territory, which refers primarily to the possible use of future LNG facilities in Cyprus. The Israeli defense community remains uneasy with that provision, but supporters argue that the Israeli coast will not easily accommodate such facilities and they are necessary to the industry. See State of Israel, The Natural Gas Inter-Ministerial Committee, public release of summary slides, available at http:// energy.gov.il/Sujects/NG/Documents/MainRecommmendations. pdf. International Energy Agency, 2009 Energy Balance for Cyprus, http://www.iea.org/stats/balancetable.asp?COUNTRY_ CODE=CY.

49

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The German Marshall Fund of the United States

3
D

The Downside of Commodity Wealth

espite the justifiable optimism and substantial economic gains in sight, Israel and Cyprus would be wise to proceed with caution as they develop their gas fields. Disappointing economic growth and political dysfunction seem to follow commodity development nearly as often as prosperity and tranquility. Sachs and Warner (2001) offer the figure on this page, showing the slightly negative relationship between exports of primary products and economic growth, a finding that has been subject to much examination and debate.50 In a recent survey, VanDeveer (2013) provides ample evidence of the corrosive power of natural resource wealth, pointing out that, in 2000, 18 of the worlds top 20 oil-exporting nations were run by nondemocratic regimes. Shaffer and Ziyadov (2012) also offer a comprehensive review of various cases and questions within the resource curse literature. Why do new natural resources cause so much trouble? The answer can be broken into three broad types of problems, loosely collected under resource curse: new demands on institutions that result in their failure; an internal adjustment of the economy that undermines the competitiveness of its noncommodity sectors (known as Dutch Disease); and increased vulnerability to commodity price volatility. We now discuss each of these risks and assess their relevance for Israel and Cyprus. Institutional Stress, Even Failure A large economics literature has emerged to explain the seeming correlation between a heavy reliance on commodity exports, especially energy products and minerals, and anemic economic performance.51

Interestingly, however, careful empirical analyses have shown that large resource endowments do not themselves cause economic dysfunction but rather seem to leave countries more prone to institutional failures that lower economic growth. In other words, energy wealth can place additional demands on a countrys political, economic, and social institutions; accentuate pre-existing institutional weaknesses; and result in institutional failures that weaken the countrys long-term economic development.52 Researchers have identified several channels through which these failures commonly occur and each one of these is associated with lower economic growth: Conflict: Newfound commodity wealth can trigger internal conflicts over control of the resource.53 Point-source commodities, those characterized by highly concentrated geographical locations, seem especially prone to struggles over the prize. Poor countries appear more vulnerable than rich ones. Angola and the Democratic Republic of Congo are commonly cited examples. Co-option: Newfound commodity wealth can tempt existing elite to consolidate power by seizing control of the new commodity wealth and using it to protect itself against internal challengers.54 Hence, commodity wealth has been associated with the strengthening of
52

See Acemoglu and Robinson (2012) for a complete treatment of the role of institutional quality in economic development. Collier and Hoeffler (2004) present compelling evidence that an increase in commodity exports as a percent of GDP significantly raises the probability of civil war. In The Bottom Billion, Collier (2007) further develops the notion of natural resource traps and conflict traps, which are overlapping in many instances. Caselli and Tesei (2011) demonstrate empirically that natural resource windfalls have no effect on a countrys political system when they occur in democracies. By contrast, windfalls in only moderately entrenched autocracies deepen the central governments control, reduce existing democratic elements in the society, and contribute to instability.

53

50

See Alexeev and Conran (2009) for an empirical analysis that largely refutes the growth-resource connection. See Frankel (2010) for an excellent literature survey and overview of the channels through which commodity development can impede growth. One common example of disappointing growth in the face of energy wealth is Saudi Arabia. The country has averaged annual GDP growth of 2.05 percent (versus resource-poor Chinas 10.03 percent).

51

54

Managing Newfound Hydrocarbon Wealth

13

Figure 2. Negative Relationship between Natural Resource Exports and Real GDP Growth

Source: Sachs and Warner (2001, figure 1, p. 829).

autocratic rule in those places where it already exists. Such co-option tends to aggravate inequities and lower economic growth. Russia, Venezuela, and even Saudi Arabia are commonly cited examples. Corruption: Newfound commodity wealth can entice public (and private) officials to circumvent weak regulatory systems, a phenomenon loosely known as rentseeking.55 The exploitation of the resource for private (illicit) gain ultimately undermines the credibility and quality of the countrys institutions, which is associated with lower

growth. Turkmenistan and Nigeria are examples. For several reasons, Israel and Cyprus seem likely to avoid the worst institutional failures associated with new commodity wealth. Both countries have strong judicial systems and well-defined conflict resolution mechanisms. Both are established democracies and functional political institutions, though some question the legitimacy of those institutions. Both are considered advanced economies by the IMF, meaning that their relatively prosperous citizens have more to lose from prolonged political instability or outright conflict. Cyprus has the added advantage of EU membership, which tends to buttress its institutions

55

See Auty and Gelb (2000) and Sala-i-Martin and Subramanian (2003).

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The German Marshall Fund of the United States

and overall policy credibility. (See Box A for more discussion of Cyprus and the EU crisis.56 Nonetheless some humility remains warranted.57 In Israel, the high concentration of corporate ownership is already a well-recognized problem. A 2008 government report estimated that 40 percent of all publicly traded companies are held by only 20 business groups, nearly all of which are private family-owned enterprises.58 As for Cyprus, the recent financial crisis highlighted the influence of the countrys powerful financial services industry and its large foreign depositors suggesting that a strong interest group may be able capture, at least in part, the countrys regulatory and policy regime.59 Both Israel and Cyprus also face long-standing political fault lines, which resentment over the distribution of new resource wealth could aggravate. A substantial gain in commodity wealth for Israel will widen the income gap with the Palestinians. The development of the small Gaza Marine gas field has been shelved for a decade, since neither the Israeli government nor the Palestinian Authority (PA) wished the proceeds to benefit Hamas. However it is now being given
56

further consideration. If it is developed questions will arise as to whether the PA should swap the gas with Israel to pay for electricity and how much of the proceeds the PA could retain.60 In Cyprus, the Turkish Cypriots, backed by Ankara, are seeking an early agreement on the sharing of gas revenues. Until now, however, the (Greek Cypriot) government of the Republic of Cyprus has not been ready to go beyond the principle that the revenues should benefit both communities on the island. This question is likely to be on the table if the United Nations succeeds in persuading the leaders of the two communities to re-engage in a new round of settlement talks. Meanwhile Ankara has raised more fundamental questions about the right of the Republic of Cyprus to go ahead with exploration in an exclusive economic zone whose contours it contests.61 The connections between political risk and economic risk are explored further in Box B below. Managing emerging winners and losers in the context of commodity development requires political skill. Redistributive mechanisms, such
60

From Marshall and Cole (2012), the State Fragility Index for 2012 assigns Israel an 8 and Cyprus a 3, using a scale where 0 means no fragility and 25 means extreme fragility. Their methodology does not create a perfect measure of institutional quality but is a close proxy. According to their report, a countrys fragility is closely associated with its state capacity to manage conflict; make and implement public policy; and deliver essential services and its systemic resilience in maintaining system coherence, cohesion, and quality of life; responding effectively to challenges and crises, and sustaining progressive development. The United States a robust and wealthy democracy is also contending with how powerful energy interests can influence the political process. See Adam Davidson, Saudi Albany? New York Times Magazine, December 11, 2012. Government of Israel (2008).

The development of Israels own offshore fields has eliminated the thorny issue of whether Israel would need to purchase gas from the PA (a proposition debated through 2009). The development of Gazas offshore fields is now the subject of active negotiation, though agreement remains hampered by Israels non-recognition of Hamas and internal divisions within the PA. Israel is particularly concerned that an offshore gas industry would create large flows of money to Hamas. Pessimists might also imagine provocative claims by Israeli settlers in the West Bank to oil and gas wealth below their land. Peter Martino, Moses Gift: Natural Gas in the Mediterranean, The Jewish Press, April 14, 2013. Also see Morelli (2012) for a good survey of reunification negotiations in Cyprus through early 2012. The Turkish Cypriots in the northern third of the island have long preferred a loose bi-communal federation with political separation and political equality. The Greek Cypriots have preferred freedom of movement, deeper economic and political integration, and withdrawal of Turkish troops in the north. The most current negotiations appear to have affirmed a bi-zonal, bi-communal federation with Greek Cypriot and Turkish Cypriot states with equal status and a government with a single citizenship and a single international personality (Morelli 2012, p. 13) but they stalled through most of 2012 and 2013 because of national elections and the economic crisis.

61

57

58 59

The strenuous terms of the countrys bailout package have undermined the previous strength of the countrys banking sector. The recent dissolution of Laiki Bank in June 2013 and the governments ultimate decision to tax deposits above 100 000 were major upsets for the Cypriot banking sector.

Managing Newfound Hydrocarbon Wealth

15

BOX A: Eurozone Membership and Cyprus

As is now well known, the adoption of the euro in 2001contributed to large trade and financial imbalances across national economies of the European Union, leaving numerous countries with significant risks in their banking sectors. In the case of Cyprus, which joined the European Union and eurozone in 2004 and which saw its banking sector grow dramatically during the 2000s, took a huge hit when Greece forced losses on its creditors as part of its EU bailout in spring 2012. Cypriot banks had lent heavily to Greek companies and financial firms. By March 2013, several major Cypriot banks were insolvent and needed major recapitalizations. After tense negotiations and controversial proposals, Cyprus accepted a deal from the troika (IMF, European Central Bank, and EU), which the countrys parliament approved in late April 2013. The basic terms of that deal have involved an initial disbursement of 10 billion from EU and IMF (delivered in May), the imposition of haircuts on large depositors (47.5 percent of all deposits in excess of 100,000 in Bank of Cyprus will be converted to long-term equity positions), the dissolution of the countrys second largest bank (the Laiki Bank), and the introduction of controls to contain capital flight. Consequently, Cyprus is experiencing a severe downturn, with economic growth is projected to be -8.7 and -3.9 percent in 2013 and 2014, according to recent analysis by the European Commission. The countrys growth is not expected to exceed 2.0 percent annually for 2015 and 2016. Under the shadow of its recent travails, numerous pundits have wondered if the countrys EU and eurozone membership has been worth the price. On this score, it is worth reiterating the sizable benefits accruing to a small open economy like Cyprus. The country enjoys unimpeded access to the worlds largest regional economy; it gains the institutional capacity of the EU in terms of economic governance (especially price stability via the ECB) and exchange rate stability vis--vis its European trading partners; and its citizens can move freely through the EU-28 and hold EU passports. On balance, the long-term economic and political benefits outweigh the short-term policy constraints, many of which provide long-term benefits as well. The recent financial crisis has impeded development of the Cypriot gas sector for several reasons. First, the countrys financial problems have proved all-consuming for its political leadership, drawing attention and resources away from the challenging set of questions related to offshore gas development. Second, the uncertainty surrounding the countrys status within the eurozone (which is now subsiding) made it risky for investors to initiate and plan major infrastructure projects. Third, the instability within the countrys banking sector undermined confidence in the payments and deposits systems, calling into question the ability to complete financial transactions in a timely and efficient manner. For all of these reasons, financial market stabilization is a prerequisite to gas sector development. As the shorter-term financial market risks begin to subside, several longer-term issues are set to re-emerge, however. First, the demands of developing a large gas sector could create considerable inflationary pressure in a small island nation like Cyprus. As long as the country remains a member of the eurozone, it will not have traditional monetary tools (such as control over domestic interest rates) to manage such inflation. Hence, it will need to use contractionary fiscal policy (like higher taxes or lower government spending) to quell inflationary pressures. Second, capital inflows could contribute to asset price inflation (such as real estate and equity price bubbles), which will require strong banking oversight and reserve management policies to contain. Third, the financial crisis has left the country with a major public debt problem, which gas revenues could exacerbate if not used properly. Cypruss recent financial crisis and its EU membership suggest the adoption of several policy rules that might prove useful as the country develops its gas sector. First, the countrys debt repayment schedule

16

The German Marshall Fund of the United States

could be indexed to the price of natural gas. When gas prices are high, the country would automatically repay a greater amount of its debt. When gas prices are low, the country would automatically repay a lesser amount of its debt. This institutional design also reinforces the principle of pro-cyclical national saving, which helps to smooth possible macroeconomic shocks due to the commodity price swings. Second, a well-designed and rules-based debt repayment scheme would allay fears that future gas revenues could be seized by the government. Hence such rules would protect the long-term rates of return offered to gas sector investors. Finally, a robust and credible inflation target that fully recognizes the types of price pressures facing a nascent commodity producer would provide some political cover to fiscal policymakers who may need to make difficult policy decisions and offer some transparency for potential investors.

in facilitating the coordination of such a project. In Cyprus, an ex-ante compromise might be forged in which a good faith commitment by the South occurs as part of a final political settlement, with transfers set to begin when production starts. Such an arrangement might build trust and strengthen the Norths incentives to agree to a deal.63 Dutch Disease An economic risk concerns the internal reallocation of productive resources that often accompanies commodity development. Named Dutch Disease, after the experience of the Netherlands following the discovery of offshore natural gas in 1959, the phenomenon involves the movement of labor and capital out of existing industries and into the new commodity-producing sector. This rising demand for labor and capital in the commodity sector often causes wages and rents to rise in the noncommodity sectors as well, aggravating the pressure on businesses outside the commodity sector.64 Dutch Disease is further exacerbated in cases
63

as transfer payments (like Alaskas Permanent Fund dividends), large-scale public works projects (like the building projects of Dubais Investment Corporation), and financial support for popular social welfare programs (like Norways Pension Fund) can ensure that the resource is developed in a way that is socially inclusive, perhaps easing historical enmities.62 For Israel, given the poor prospects for direct negotiations with the PA, a set of public infrastructure investments funded by natural gas and shared between Israel and the PA might be more feasible than revenue-sharing arrangements; at the same time, such projects might also create some buy-in from the Palestinians. An external agency, such as the EUROMED Transport Project, might prove particularly useful
62 The SWF Institute website contains descriptions of the many funds and their major activities, as does Milken Institute (2011). http://www.swfinstitute.org/ Regarding the benefits of redistribution, a recent paper advocated that Nigeria distribute its oil revenues directly to households, thus bypassing the corrupt intermediaries and strengthening political accountability. See Sala-i-Martin and Subramanian (2003).

A lack of trust has proved a frequent obstacle to negotiations. A recent Al-Monitor article quoted Dervis Eroglu, president of the TRNC, as saying: I proposed to the Greek side through directly engaging the UN secretary general and offered them to establish a committee that would be composed by equal number of Turkish and Greek Cypriots, where they would assess the profit made from these hydrocarbon fields, and put our share to a bank account accordingly . I suggested that we use that money to sort out the economic challenges once we decide on the terms of the unification of the island. But the Greek Cypriot president turned it down without a second glance. The same article quoted Nikos Christodoulides, spokesman of the Greek Cyprus Presidency of the EU, as saying: It has been agreed that the natural wealth of Cyprus will be shared through the budgets of the constituency when there is a solution. See Tulin Daloglu, Turkey-Israel-Cyprus Triangle and Mediterranean Gas, Al-Monitor, January 7, 2013. http://www.al-monitor.com/pulse/ originals/2013/01/turkey-cyrpus-israel-natural-gas.html. Interestingly, the Dutch guilder was fixed through this period, so nominal appreciation was not possible. Rather the real appreciation was observed as the increased purchasing power of the Dutch household, given their higher wages relative to other Europeans. In those cases where the exchange rate is fixed, the country also usually attracts significant capital inflows, which can create risks within the financial system (as discussed below). It should be noted, however, that Hotelling (1931) began exploring the economics of natural resources well before the Dutch boom.

64

Managing Newfound Hydrocarbon Wealth

17

BOX B: Why Political Risk Is Economic Risk

Private, for-profit companies must create an attractive rate of return for their shareholders that is their ultimate bottom line. The degree to which a firm creates such value is a function of three variables: the expected return on invested capital (mainly dependent on the value of prospective sales), the market cost of capital (mainly dependent on monetary policies in the major developed economies), and the risk premium needed to account for the probability of losing some or all of the invested capital to damage, expropriation, or default. It is through this last term that political risk affects the economic viability of a project. Higher political risk lowers the expected net return on invested capital, all else equal. Hence, in cases where such risk exists, lenders (whether banks, national governments, or private investors) will demand higher rates of return on their invested capital to compensate for the higher risk, which raises the cost of financing the project. Assessing the risk premium on offshore gas sector investments in a neighborhood as fraught as the Eastern Mediterranean is a hugely complicated exercise. In the Israeli case, for example, even the decision to participate in the initial exploration rounds was loaded: none of the major international oil groups in Europe and North America entered the early rounds for fear of backlash from the major Arab oil producers. More recently, the brutal civil war raging on Israels northeast frontier, its unresolved and militarized border with Lebanon, and the general instability throughout the Middle East mean that Israels security situation has become even more precarious. For its part, Cyprus remains a divided island, whose territorial waters are disputed by its large and regionally ambitious neighbor, Turkey. Efforts to reach a negotiated settlement have broken down repeatedly over the years, with questions about property ownership, citizenship and mobility, power-sharing arrangements, and the presence of Turkish troops still hotly debated. It is also true that the planned offshore facilities lie in busy sea-lanes within the range of ballistic missiles and will likely require the use of cross-border pipelines to reach regional export markets, such as Jordan. The Eastern Med is also a maritime crossroads, with ships flying the flags of various major powers within a 100 mile radius of each other on certain days. Russia, for example, has a naval port in Syria, large residential investments in Cyprus, and a huge vested interest in current energy supply lines to European markets. The United States has private companies (and citizens) leading in exploration and development of the gas (most notably Noble Energy), long-standing security commitments to Israel, and now a new investment of political capital in reviving Israeli-Palestinian peace talks. The European Union has environmental and economic interests in Cypriot gas, while NATO conducts joint business with Turkey and other Western European navies. Even China and other Asian powers have a maritime presence in the region. With no shortage of risk in the region, Israel and Cyprus are increasingly motivated to resolve those issues that are most within their political reach and thereby raise the profitability of the project. It is not surprising, therefore, that after decades of cool distance, the two countries established friendly relations and mutually agreed to their shared EEZ boundary. Israels recent apology to Turkey for the Gaza flotilla incident reduced tension with a key Eastern Mediterranean player. Israels avoidance of any exploration in the contested Lebanese maritime border also suggests a pragmatic approach toward a bitter enemy. The Republic of Cyprus political leaders have emphasized that all earnings from the gas development would be shared by the population of the entire island, once a political settlement is reached. It has also sought to attract a diverse set of investors, such that the degree of international participation in Eastern Med gas development with French, Italian, U.S., Russian, South Korean, and Australian companies now engaged has reduced Turkeys ability to resist Cypriot initiatives through military means. In short, efforts to reduce political risk have begun. They have eschewed grand region-wide bargains in favor of carefully scoped gestures and specific deals focused on energy development. Such small steps do not necessarily presage regional rapprochement, but they may provide sufficient diplomatic space to negotiate

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The German Marshall Fund of the United States

the outlines of arms-length commercial relations. An optimist might hope that these economic ties prove the first bridges to fuller political reconciliation. A realist might hope that newfound economic interests will trump old (and perhaps tired) political divisions.

where a country becomes a significant exporter of the commodity because global demand for the exports causes a real appreciation of the currency, which further erodes the competitiveness of noncommodity exports. As a consequence of these multiple forces, the Netherlands, for example, lost nearly half a million manufacturing jobs during the 1960s and 1970s. In 2011, in Saudi Arabia, the oil sector accounted for 58 percent and the government sector accounted for 26 percent of the countrys GDP. Hence, the non-oil private sector accounted for only 16 percent of all economic activity. In addition, the oil sector provided 92.5 percent of government revenues in Saudi Arabia. 65 Today, in Norway, petroleum accounts for one quarter of the countrys value-added, the oil sector employs 50,000 engineers (a considerable proportion of the countrys top technical talent), Statoil is the largest company in Scandinavia, and a Big Mac costs $7.69 in Oslo.66 Of course, economies should and do adapt to new business opportunities. To the extent these events represent efficient market responses to new economic realities, they should not create undue worry. Yet, there is evidence that productive activities within the manufacturing and services sectors generate more positive economic spillovers than those found in commodity production. For example, skilled manufacturing may foster greater human capital accumulation because the tasks are more complex and more transferable
65 66

than tasks within commodity production. In addition, manufacturing and service businesses often locate near their input and output markets, enhancing their potential spillover effects by supporting a diversified economic community and fostering a regions economic integration. By contrast, commodity production must go where the resource lies and the production platforms may be quite isolated from other parts of the economy.67 In sum, commodity production may leave an economy less well off than it could have been with a more balanced form of economic growth if the commodity boom causes a significant weakening of the countrys industrial base. In practice, the severity of Dutch Disease depends on the economic importance of the commodity sector relative to the non-commodity sector. For this reason, the Dutch Disease risks facing Israel are not nearly as great as those facing Cyprus. If Israel has $170 billion in natural gas offshore and we spread its productive value over 25 years, the gas sector yields roughly $7 billion annually (before discounting) or 2.5 percent of the 2014 projection of Israeli GDP. That would make the gas industry roughly comparable to Israels agricultural sector. In 2011, by comparison, mining, oil, and gas extraction accounted for 4.5 percent of the welldiversified Canadian economy, about 17 percent of the less well-diversified Norwegian economy, and more than 50 percent of Saudi Arabias.68 Already the opening of the Tamar field this winter, combined with the resilient Israeli economy, has

67

Matsuyama (1992) develops the theoretical basis for this claim. Moretti (2004) is a good example of the empirical evidence for spillovers in U.S. manufacturing. For Canada, see Ministry of Industry for Canada, http:// www.ic.gc.ca/eic/site/cis-sic.nsf/eng/h_00013.html#vla2b; for Saudi Arabia, see Saudi Arabian Monetary Authority (2012); and for Norway, see central banks website, http://www.ssb.no/en/ nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-0213?fane=tabell&sort=nummer&tabell=96250

68

Saudi Arabian Monetary Authority (2012, Table 9.1).

Special Report: The Nordic Countries: Norway, The Rich Cousin, The Economist, February 2, 2013, p. 14 of the special report.

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contributed to an appreciation of the shekel. It reached a 17-month high in mid-April.69 By contrast, the Cypriot economy is only onetenth the size of Israels but may have one-half the amount of Israels gas. Hence, its gas sector could become proportionally larger perhaps as large as one-quarter to one-third of the total economy in its peak production years.70 Consequently, Cyprus faces a much more significant risk of Dutch Disease and must take seriously the need to mitigate the macroeconomic risks outlined here. While the relative size of the hydrocarbon sector will determine its ultimate impact on the internal structure of the Israeli and Cypriot economies, initial conditions will also play a role, especially in the near to medium term. In 2012, Israels unemployment rate stood at an historical low of 6.9 percent, down from 13.4 percent in 2003. An increase in natural gas production could therefore put some pressure on labor markets, causing wages to rise modestly.71 An increase in the demand for labor may make migrant labor more attractive. For example, while the use of guest workers in the oil-rich Arab states is well known, Norway, too, has some 10 percent of its residents born elsewhere. Labor mobility will alleviate the wage pressures,
69

perhaps creating support for easing Palestinian border crossings. Cypruss financial and economic crisis has been driving recent economic policy much more than incipient activity in the gas sector. Indeed, the crisis has pushed the country into a deep recession, the effects of which are likely to linger for several years. Because of high unemployment, the Cypriot economy will be able to absorb excess labor without as much wage inflation or real appreciation (assuming sufficient labor market flexibility in terms of hiring and wage-setting). Hence, a major priority for the Cypriot government must be to proceed as quickly as possible with the offshore gas development, but in a fiscally and financially responsible manner. Cyprus does not have the skilled labor necessary to build the gas industry infrastructure. Sixty or seventy percent of the necessary labor may have to be imported. Still, there should be multiplier benefits to the economy and additional jobs created in ancillary sectors. In addition to the impacts on labor markets, capital is likely to flow to the gas sector. Capital inflows from abroad can cause an appreciation of the currency. Indeed, for Israel, upward pressure on the shekel is already causing concern.72 For Cyprus, the question of capital flows seems particularly difficult to predict at the moment, given the huge pressures on the countrys financial sector. While the gas prospects would tend to attract inflows, the risks in the banking system have deterred them. Hence, the net effect will likely be negative in the near term and then improve as risks in the financial sector subside. Given the small size of the Cypriot economy, capital inflows are not likely to affect the value of the euro itself but could easily put upward pressure on domestic asset prices in Cyprus (causing real appreciation).
72

Tovah Lazaroff and Niv Elis, Government Approves Sovereign Wealth Fund, The Jerusalem Post, April 14, 2013. In size and character, the Cypriot case bears a strong resemblance to that of Trinidad and Tobago, a small island nation with roughly 25-30 percent of GDP originating in the oil and gas sector and an exchange rate mainly fixed to the U.S. dollar. See Velculescu and Rizavi (2005) for an analysis of fiscal policy options for Trinidad and Tobago. Shaffer and Ziyadov (2012) also include a chapter on development of the countrys energy sector. All else equal, higher incomes could contribute to broader inflation within the Israeli economy. The Bank of Israel began tightening in the fall of 2009 because of rising inflationary pressures; it subsequently reduced the rate in 2011 fearing a global slowdown and a softening in the Israeli economy. It now is contemplating another increase with inflation again on the rise, partly due to the growth in the energy sector. Inflation remains a minor concern in Cyprus this year, with a major recession and monetary contraction under way.

70

71

Tovah Lazaroff and Niv Elis, Government Approves Sovereign Wealth Fund, The Jerusalem Post, April 14, 2013.

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Table 3. Comparative Size of Israeli and Cypriot Natural Gas Finds Total possible reserves Production Current (proved + expected by consumption speculative) 2020 3.3 bcm 80 tcf 17.5 bcm 0 bcm 40 tcf 9 bcm 448 bcm 403 bcm 3223 bcm Consumption Potential expected by exports 2020 by 2020 12.5 bcm 5 bcm 0.9 bcm 8 bcm

Israel Cyprus European Union Middle East Global total

Proved reserves Current (end-2011) production 13 tcf -15 tcf 2.6 bcm 0 tcf 0 bcm 64 tcf 513 tcf 7361 tcf 155 bcm 527 bcm 3276 bcm

Sources: Proved Israeli reserves from Government of Israel (2011); global and regional totals are from British Petroleum (2012); Israeli and Cypriot "possible" reserves are from estimated "mean" in US Geological Survey (2010); current production and consumption are from US EIA (2011); expected production and consumption in 2020 are from Oxford Institute for Energy Studies (2012).

In terms of their external sector, neither Israel nor Cyprus has gas reserves sufficiently large on a global scale to transform their economies into vast export machines. Israels total proven reserves at the end of 2011 were 15.2 tcf, or 0.2 percent of total world proved reserves. Even with a potential total of 80 tcf (a generous estimate from the Sheshinski Committee based on a U.S. Geological Survey report), the country would still have only 1.0 percent of the global proved gas reserves today.73 Cyprus, for its part, may have total potential reserves of 40 tcf (though current conservative estimates are nearly one-quarter of that total) and could be exporting up to 8 bcm by 2020 (out of the 250 bcm imported each year by the five major western European nations).74 The supply-side competition will hardly make matters easier. More than three-quarters of the worlds natural gas is already produced in either the Middle East or Europe-Eurasia. Thus, Israeli and Cypriot supply

decisions will have little impact on the world or even the European price.75 For these reasons, Israel may enjoy a modest increase in their terms of trade (the ratio of export prices over import prices) as their gas industries expand; the effect in Cyprus may prove more substantial given expectations of more substantial exports. Improvement in the terms of trade presages a general improvement in the current account. The Milken Institute (2011), in joint work with the Bank of Israel, estimates that the current account will rise by 0.5 to 2.0 percent of GDP as a result of the gas developments. However, a countervailing force may emerge in the form of a nominal appreciation of the floating exchange rate (Israel) or a real appreciation (rising local prices) of a fixed exchange rate (Cyprus). Either way, such an appreciation has the potential to

73

State of Israel (2011, p. 17). British Petroleum (2013, p. 20) estimates that global proved reserves of natural gas were 6,614 tcf at the end of 2012, which is down from the 7,361 tcf that they reported for the end of 2011. Cypriot export data are from Darbouche, El-Katiri, and Fattouh (2012).

75

74

Market power is a double-edged sword, however. Countries that successfully manage output (usually restrict levels) can enjoy higher prices. But in countries in which control is more dispersed across private companies, the ability to impose production quotas is more limited. In some extreme cases, a major-producing country actually drives down its own export prices through over-production.

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erode the competitiveness of other exports.76 Israel, for example, currently had exports (all non-gas) valued at roughly 40 percent of its GDP. Cyprus had exports valued at 45 percent of GDP in 2012.77 The Milken Institute (2011) projected that traditional (non-gas) Israeli exports would decline by 2 to 4 percent and the shekel would appreciate by 6 to 16 percent once Tamar and Leviathan were fully operational. Both countries will wish to protect their existing export sector to the greatest extent possible through careful attention to their terms of trade. Resource development, if it well managed, can generate sufficient public resources to address the worst effects of Dutch Disease. Many commodityproducing countries seek to invest proceeds from commodity wealth abroad rather than at home (via a sovereign wealth fund) in order to avoid overheating the domestic economy. Those funds that are invested at home generally focus on longer-term capital investments to preserve the countrys economic base, such as investments in infrastructure, education, public health, and basic scientific research. Yet, the IMF recently found that few countries seem to succeed in these efforts. They have found higher resource rents are associated with lower stocks of capital across the economy (both public and private). In addition, it is not uncommon to see such efforts turn into poorly managed industry strategy, import substitution schemes, and inefficient producer subsidies. Over time, most countries are not transforming their
76

resource wealth into other types of national assets. These lessons are ones that Israel and Cyprus would do well to heed.78 Increased Risk of Macroeconomic Volatility Macroeconomic policy management is a highly dynamic but idiosyncratic enterprise, with details differing according to the specific situation. The fact that commodity prices are more volatile than the prices of manufactured goods or tradable services implies additional policy challenges for commodity producers.79 The price of natural gas is no exception (see Figure 3). Price volatility is problematic for a number of reasons. First, whenever consumers are risk averse, volatility directly reduces their welfare because uncertainty, in and of itself, makes them unhappy.80 Second, price volatility complicates the ability to write contracts for future deliveries of energy and energy-related products. If the future price is highly uncertain, both sides of a potential deal may feel that a contract leaves them too exposed to an adverse price swing. Third, price volatility creates a more challenging environment for
78

IMF (2012b). Israel, at least, seems to recognize the challenge. In August 2012, Israels energy minister, Uzi Landau, was quoted in The Financial Times: We have to be very careful not to think that with natural gas there is no more need to continue in the same direction of the past: to focus on education, focus on research and development and to do whatever we can to solidify the social fabric of our society. Tobias Buck, Field of Dreams: Israels Natural Gas, Financial Times, August 31, 2012. See Frankel (2010). Any number of events can precipitate a change in the market price of a commodity: new supply discoveries, disruptions to infrastructure and distribution, technological advances that lower or raise the demand for the product, short-term speculative pressures, and so on. Such events translate into particularly sharp price movements because of the low short-run elasticities of supply and demand for commodities, meaning that consumers and producers cannot adjust quantities quickly so the impact of the event feeds directly into prices. To understand the cost of volatility in terms of consumer welfare, think of the typical household that must purchase heating oil every month. Which situation do you think that household would prefer: a predictable price of $100 a month or an unpredictable price that averages to $100 a month? Risk aversion is why people pay for costly insurance to protect themselves against adverse events.

79

To the extent that Israel needs to import capital equipment and professional services to get its gas sector established, the depreciating force will be at work in the short run. The longerterm effects on the shekel, however, are pretty straightforward. All else equal, growth in the demand for Israeli gas exports causes the value of the currency to rise. Unfortunately, Cyprus already experienced nearly a decade of real appreciation from 2003 to 2011, leaving its labor and capital moderately overvalued. (Exports had been 51 percent of GDP in 2002.) Its labor and capital markets will prove more competitive if they are allowed to deflate in the next few years during the ongoing crisis-induced recession.

80

77

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Figure 3. World Prices for Natural Gas

Source: British Petroleum (2013).

macroeconomic policymakers. For example, the central bank may have to set interest rates in an environment where inflation is more unpredictable, and fiscal authorities will have to manage boombust cycles in government revenue streams tied to the commoditys price.81 Finally, for commodity exporters, price swings translate into instability within the countrys external accounts: the countrys currency may fluctuate sharply, current accounts may deteriorate quickly and unexpectedly, and foreign exchange reserves may be prone to sudden changes.
81

Over the past few decades, some resourcedependent countries have developed macroeconomic policy tools to mitigate these volatility risks.82 For example, governments have used a systematic hedging program under which
82

For example, many countries have a tendency to run procyclical fiscal policy, meaning that the government spends more when tax revenues are high and spends less when tax revenues are low. Citizens and politicians find it easy to convince themselves the boom is permanent and that the gains can be freely spent on pet projects, enlarged government payrolls, and cash transfers to households.

As with Dutch Disease, the effect of price volatility depends on the relative size of the commodity sector. In the most dependent countries, resource-related exports can exceed 75 percent of total exports and of fiscal revenues (such as Angola, Iraq, and Mongolia). In addition, commodity price shocks can have asymmetric effects, with busts lasting about one year longer than booms for many commodities. For natural gas, the opposite seems to be true but only by a few months (IMF 2012b, p. 7). Through the 1970s, a structuralist notion that commodity prices would experience a long secular decline (because commodities are necessities and therefore require a declining share of income as the global consumer population becomes wealthier) held some sway among development economists. Longer time series now undermine that claim. If anything, commodity prices seem to display a slight upward trend, possibly reflecting constraints on the long-run supply of these non-renewable resources.

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they regularly and frequently purchase forward contracts that lock in the prices at which they will purchase gas in the future (Mexico is an example). Countries have priced their primary commodity in dollars, euros, or some combination of global currencies usually choosing to include the currency of its major trading partners (Saudi Arabia is an example). Countries have used indexation schemes within contracts to reduce exposure to short-term price swings, such as price-escalation clauses stipulating that gains be split if the price rises by more than a specified amount. Finally, a country may develop a buffer through dedicated liquid savings within a sovereign wealth fund (as numerous wealth funds do). The IMF states (2012b, p. 11): When there is both uncertainty and volatility, the approach to natural resource management should be holistic. Policymakers will need to carefully balance consumption spending and savings when resource revenue flows are uncertain and volatile. Spending can be safeguarded by setting aside a liquidity buffer as a precaution. Additional savings can be used to pay down debt, ramp up domestic investment spending, or invest in external financial assets to benefit future generations (for example, when absorptive capacity constraints make it impossible to invest faster). On these fronts, Israel has made some general progress. After years of expansive fiscal policy

in the first half of the 2000s and consequently a high debt-to-GDP ratio, the country became more focused on fiscal consolidation, ultimately adopting a new fiscal rule in 2010 that formalized deficit rules for government spending with an expenditure rule intended to keep the countrys debt-to-GDP below 60 percent. Additional legislation in 2010 sought to strengthen the Bank of Israels autonomy, transparency, and governance. In the past few years, the countrys fiscal position has stabilized at more sustainable levels. In Cyprus, a fiscal surplus in 2008 turned sharply negative during the crisis. The banking crisis has simply swamped longer-term fiscal policy relating to the gas sector. It is worth emphasizing, however, that both countries are small and new to commodity development. Hence, they must remain highly cognizant of the limits of their policy capacity and welcome the technical assistance of the IMF, OECD, EU, United States, or other organizations or nations. Well-targeted investments in public financial management techniques are particularly important for resource-rich economies ones that build the ability to forecast revenue, to use medium-term (acyclical) budget planning, to appraise investment projects, and to administer transparent public accounting and reporting systems.

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4
W

Conclusion

e know that geology is not destiny. Through careful policy design and good governance, countries can develop natural resources successfully. The goal is to be a Norway rather than a Nigeria a Botswana rather than a Bolivia, a Chile rather than a Congo.83 Yet, many nations still fail to do so. It is also the case that no country can perfectly emulate another. Each society must consider its own political and economic circumstances and weigh its own values as it develops methods for managing its natural resource wealth. The recent gas discoveries in the Eastern Mediterranean present a huge economic opportunity for Israel and Cyprus. The ultimate goal for both Israel and Cyprus is to use this newfound commodity wealth to foster economic growth and further national interests. In doing so, each would be wise to learn the lessons of other commodity producers the primary ones being that good governance and sound institutional design matter decisively. Successful taxation of the resource could yield government revenues that support long-term strategic economic goals, such
83

as building critical infrastructure, strengthening education and skills, investing in science and technology, and even resolving long-standing political divisions. Good macroeconomic policy can anticipate the resource curse and militate against it. Well-designed and managed commodity wealth funds can provide a buffer against price volatility and secure the future of popular social programs. At the same time, Israel and Cyprus must honestly confront the ever-present risk of co-option and corruption by business elites. They must contend with a rising real exchange rate and pressure on the non-commodity sectors of their economies, some of which is inevitable. Such structural change within an economy can prove stressful. Finally, given both countries struggles to contain public spending, they must adhere to a strict fiscal discipline that eschews spending during the boom times and facilitates it during the busts all while meeting major redistributive goals. The coming years will undoubtedly bring new gas discoveries in the Eastern Mediterranean. The question now is whether the economic benefits of that gas can be fully realized.

Frankel (2010, p 12).

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International Monetary Fund, 2012a, Israel: 2012 Article IV Consultation Staff Report, Washington: International Monetary Fund. International Monetary Fund, 2012b, Macroeconomic Policy Frameworks for Resource-Rich Developing Countries Analytic Frameworks and Applications Supplement 2, Washington: International Monetary Fund. International Monetary Fund, Various years, World Economic Outlook. Washington: International Monetary Fund. Leigh, Michael, 2012, Energy Resources in the Eastern Mediterranean: Source for Cooperation or Fuel for Tension, Policy Brief, Washington: German Marshall Fund of the United States. Mankoff, Jeffrey, 2012, Resource Rivalry in the Eastern Mediterranean: The View from Washington, Policy Brief, Washington: German Marshall Fund of the United States. Marshall, Monty G., and Benjamin R. Cole, 2012, Table 1: State Fragility Index and Matrix 2012, Center for Systemic Peace, http://www. systemicpeace.org/inscr/inscr.htm. Matsuyama, Kiminori, 1992, Agricultural Productivity, Comparative Advantage, and Economic Growth, Hoover Institution Working Paper E-92-3 (January). McLean, Shana R., and William C. Busch, 2013, Quantifying Energy in the Eastern Mediterranean: Global Insignificance, Regional Priority, QuickLook Series. European Command, ECJ2 Strategy Division, Strategic Foresight (June 3). Milken Institute, 2011, Structuring Israels Sovereign Investment Fund: Financing the Nations Future, a Financial Innovations Lab Report (December).

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Smith, James L., 2012, Modeling the Impact of Taxes on Petroleum Exploration and Development, IMF Working Paper WP/12/278, Washington: International Monetary Fund. State of Israel, 2011, Conclusions of the Committee for the Examination of the Fiscal Policy with Respect to Oil and Gas Resources in Israel (Sheshinski Report), Tel Aviv: Ministry of Finance, http://www.financeisrael.mof.gov.il/ FinanceIsrael/Pages/en/Publications/mof.aspx?3. Tordo, Silvana, 2007, Fiscal Systems for Hydrocarbons: Design Issues, World Bank Working Paper No. 123, Washington: World Bank. Truman, Edwin M., 2008, A Blueprint for Sovereign Wealth Fund Best Practices, Policy Brief, Washington: Peterson Institute for International Economics. VanDeveer, Stacy D., 2013, Still Digging: Extractive Industries, Resource Curses, and Transnational Governance in the Anthropocene, Transatlantic Academy Paper Series, Washington: German Marshall Fund. Velculescu, Delia, and Saqib Rizavi, 2005, Trinidad and Tobago: The Energy Boom and Proposals for a Sustainable Fiscal Policy, IMF Working Paper WP/05/197, Washington: International Monetary Fund. Wahlisch, Martin, 2011, Israel-Lebanon Offshore Oil & Gas Dispute Rules of International Maritime Law, Insights, a publication of the American Society of International Law, volume 15, issue 31. Weinthal, Erika, and Pauline Jones Luong, 2006, An Alternative Solution to Managing Mineral Wealth, Perspectives on Politics 4(1): 35-53.

References for Table 2 Botswana: http://www.ifswf.org/members-info. htm#bot (accessed May 2, 2013), http://www.imf. org/external/np/pp/eng/2012/082412a.pdf pages 34-35 (accessed May 2, 2013). Chile (ESSF): http://www.hacienda.cl/english/ sovereign-wealth-funds/economic-and-socialstabilization-fund/financial-situation/marketvalue.html (accessed May 2, 2013), http://www. hacienda.cl/english/sovereign-wealth-funds/ economic-and-social-stabilization-fund/ financial-situation/portfolio-composition.html (accessed May 2, 2013). Chile (PRF): http://www.hacienda.cl/english/ sovereign-wealth-funds/pension-reserve-fund/ financial-situation/market-value.html (accessed May 2, 2013), http://www.hacienda.cl/english/ sovereign-wealth-funds/pension-reserve-fund. html (accessed May 2, 2013), http://www. hacienda.cl/english/sovereign-wealth-funds/ pension-reserve-fund/financial-situation/ portfolio-composition.html (accessed May 2, 2013). North Dakota: http://www.nd.gov/ndtreas/ pressReleases/2013/130416.htm (accessed May 2, 2013), http://www.legis.nd.gov/ assembly/62-2011/docs/pdf/lbs090611appendixc. pdf page 2 (accessed May 2, 2013). Norway: http://www.regjeringen.no/ pages/37984857/FactSheetGPFG_4Q2012.pdf (accessed April 30, 2013), http://www.nbim. no/en/About-us/Government-Pension-FundGlobal/ (accessed April 30, 2013), http://www. nbim.no/en/Investments/holdings-/ (accessed April 30, 2013). Qatar: http://rt.com/news/qatar-investment-boompolitics-745/ (accessed 30 April 2013), Qatar Investment Authority, Home. http://www.qia. qa/ (accessed April 30, 2013).

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Trinidad and Tobago: http://www.finance.gov. tt/content/HSF%20Quarterly%20Report%20 April%20-%20June%202012.pdf (accessed May 2, 2013), http://www.finance.gov.tt/legislation. php?mid=20 (accessed May 2, 2013).

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