Roger Hosein

1. Opportunities and challenges of fluctuating oil prices for economic development in the context of the small oil dependent T&T economy Roger Hosein

2. Rationale • Policy makers in developing economies are typically very concerned about the price of oil as wide fluctuations tend to provide a variety of economic challenges. For example, volatility in the price of crude oil can expose an economy to a greater degree of risk in turn affecting the investment decisions made by economic agents.

3. Introduction • This paper explores the various opportunities and challenges that arise from fluctuating oil prices for the Trinidad and Tobago economy. The discussion is cast within the framework of the historical experience of the T&T economy for the time period, 1966- to May 2009.

4. Statistical Properties of Oil Price Data • For the time period January 2nd 1990 to May 12th 2009, the nominal daily price of crude oil averaged US$34.25 with a standard deviation of US$23.76.

5. For this same time period the kurtosis value for the oil price return series of 23.5 demonstrates that the data is characterized by a fat tail. The Jarque Bera test confirms that the returns series is non-normally distributed. When a data series has a thick tail it can be modeled using a conditional normal distribution which implies that although on any one day the data may be normally distributed the parameters of normality change from day to day. The existence of a small negative skewness statistic suggest the existence of a left tail.

6. Fig 1: Trends in daily oil price returns and the daily price of oil, January 2nd 1990 to May 12th 2009

7. When this type of volatility clustering exists it infers that the variances are autocorrelated so that shocks in one time period do not die out quickly but takes time to dissipate.

8. Econometric model • An EGARCH (1,1) model is preferred to an ARCH/GARCH specification to capture because: 1) The model does not impose any restrictions on the 2) In contrast to the ARCH/GARCH model, the EGARCH model allows the coefficient to either have a positive or a negative value. For | | < 1, the EGARCH (1,1) model is both stationary and ergodic. 3) The parameter in the EGARCH model can be used to judge the impact of shocks. For >0 a positive shock gives rise to more volatility than a negative shock. The opposite is also true. 4) The parameter provides an indication of the influence of the conditional shock on the conditional variance. 

10. The coefficient of is negative and statistically significant and this infers that for daily oil price returns data for the time period January 2nd 1990 to May12th 2009 as a whole, shocks tended to have asymmetric effects on oil price returns volatility. Because the sign is negative, negative shocks reduce volatility more than positive shocks. • Notice that the estimated value of beta is close to unity and is significant. This infers that when there is a shock to crude oil volatility, it takes time to die out, i.e. there is some element of volatility persistence. The failure of shocks to die out provides a variety of challenges and opportunities for fiscal policy. The rest of this presentation discusses some of the various opportunities and challenges that occur with fluctuations in commodity prices for oil exporting economies.

11. Fig 2: The Impact of the Dutch Disease on Employment and Prices L1NT L1T L0T Rm Effect L0NBT Wages L0NT S Effect W2 W1 W0 Indirect Deindustrialization L1 L0 L2 L0’ L1’ L2’ 0NT 0T Labor Challenges During oil price Upswings a) Dutch Disease

12. R2 R1 Profits Rents B3 B1 B2 P2 P1 productive entrepreneurs 0 rent seekers 0 b) Rent seeking and producer unfriendly institutions

13. c) Vertical and Horizontal Equity Impact of GATE Gate is horizontally efficient but vertically inefficient (evidence of resource curse behavior).

14. 4. Procyclical behavior • The values in the Table 2 above show a strong degree of correlation between government expenditure and oil prices in the time interval 1966-2008 and for the sub time period 1990 – 2008. This is reflective of a procyclical stance.

15. 5. Chasing the goose that lays the golden egg. • This procyclical behavioral pattern was compounded by a type of irrational behaviour on the government behalf which saw an unfounded increase in the pace at which the speed of adjustment parameter from an adaptive expectations perspective.

16. Specifically for the last 3 years the calculated values of the smoothing parameter () are listed in the Table 3 below: This is a rapid increase in the value of , and has no real foundation. (Note, the government amidst increased public pressures later modified the budgeted oil price to US$45).

17. Opportunities during commodity price upswings a) Build up of economic resources • During a commodity price upswing an economy can develop a tremendous amount of resources with which to help change its economic development prospect. The T&T economy has benefited significantly from the boost in prices of its comparative advantage products. In particular, the T&T government was blessed with an economic windfall between 1999 and 2007 of US$2,805.6m, with the economic rent for the period 1999 – 2007 tallying to US$6,955.2m.

18. b) Diversification Strategy • Resources obtained from the windfall in economic activity could be used to help enhance the amount of capital investment made by the government and this in turn can help to expand both the infrastructural capital base and also help to diversify the economic base. By 1988 the government of T&T had established four ammonia plants; it had majority ownership in two of these and complete ownership in another. It had also established a steel plant, a granular urea plant and a methanol plant.

19. C) Social Capital and infrastructural capital • Significantly the government of T&T spent heavily during the first oil boom years on building up its human and infrastructural capital. For example, expenditure on education (an important factor in creating human capital) increased considerably from US$27.4m to US$55.7m between 1976 and 1983, an increase of 103%, with health expenditures (an important factor in maintaining human capital) increasing from US$0.5m to US$24.4m between 1977 and 1983. • Concerning infrastructural capital, expenditure on electricity increased from US$7.8m in 1976 to US$17.3m in 1980 with housing expenditure increasing substantially from US$7.8m to US$191.8m during the interval of time 1976-82. Other important infrastructural capital areas such as roads, national transportation, water and telecommunications also benefited substantially, as indicated in Table 4.

21. d) Other interventions • Apart from these direct long-term development investment outlays listed above, a plethora of subsidies were granted. For example, between 1973 and 1983, the basic food subsidy increased from US$1.6m to US$92.5m with subsidies to the utilities increasing by 3,351.1% during the same interval of time from US$10.7m to US$369.3m. No doubt, these trends in government expenditure and government subsidies helped to alter the factor endowment bundle of the T&T economy.

22. e) FDI • The type of foreign investment a small open developing economy like T&T attracts is cost based. During a commodity price upswing the profitability of crude oil production expands and if the increase in the price level is expected to span the medium run in length then this can enhance capital formation in the energy sector. During the period 1995 to 2008 the correlation between FDI inflows and the amount of meters drilled for crude oil was 68%. FDI inflows provides opportunities along the lines proposed by Sir Arthur Lewis for the benefiting host economy.

23. [1] In many regards, FDI inflows to T&T economy brought new markets, technology and entrepreneurial talent, much along the lines suggested by Sir Arthur Lewis.

24. Opportunities during a downswing in commodity prices a) Improvement in fiscal accounting process • During an upswing there is an element of crowding out of the amount of non oil revenues collected as a proportion of total government revenues. Although ideally the government should have made these changes during a commodity upswing, during a commodity downswing they are forced to set an appropriate target for the non oil fiscal account balance.

25. b) Worker Ethic • During a boom, worker ethic and wages may have become unrealistic. A good example here is the Community and Environmental Protection and Enhancement Program (CEPEP) which was introduced by the T&T government in 2002. Basically the program provides employment for unskilled and semi-skilled persons. The challenge with CEPEP, however, is that it needs to do more to equip workers with a greater stock of skills to enhance their long run employment prospects. As it stands the work is light and productivity is very low. During a downswing in commodity prices, there is the opportunity to target the restoration of worker ethic and any misalignment between worker productivity and wages may be corrected. The economy may also have realized a greater dependence on government handouts and transfers and subsidies and this may now be corrected. A decline in commodity prices gives government an adequate block of reasons to reduce its hand out mentality, and to promote a better work ethic amongst its population.

26. Challenges during a commodity price downswing a) Public Perception • Meeting public expectations in terms of social handouts and cutting public expenditures in line with expected revenues is one of the main challenges that a commodity exporting economy may face in periods of declining commodity prices. This type of action may sprout social tensions. For the T&T economy, transfers and subsidies as a percentage of total GDP had a 88% degree of comovement with the trend in oil prices. Specifically whilst in 1994, transfers and subsidies as a percentage of GDP was 7.4%, this increased to 12.4% by 2008.

27. b) Inflation • One would expect that during a recession the rate of inflation would decrease as the level of aggregate demand moves into deficit. However, during the first recession that engulfed the T&T economy in the time period 1983-1993, the average rate of inflation was 10%.

28. c) Economic Growth • Economic growth can potentially be compromised. This was the case during the 1980s.

29. d) Unemployment • For the T&T economy, there is an inverse relationship between the current account balance and the unemployment rate.

30. e) CAB and M/L Condition • One major challenge in oil abundant economies is there may arise the need to devalue the currency and this is sometimes done without a proper understanding of the Marshall - Lerner condition and whether that condition holds. Thus the T&T economy, in the midst of declining current and fiscal account deficits during the 1980s engaged a 33% devaluation of the T&T dollar in December 1985 and a further 15% devaluation in August 1988. In 1993 the T&T government floated its dollar and associated with this float was a 25% depreciation of the T&T dollar. Between 1985 and 1993 the T&T dollar therefore lost 54% of its value to the US$ and the current account balance moved from US$-105.3 to US$-107.8m.

31. Minimizing oil price volatility effects on the macroeconomy a) SF and the Long term oil Price • When oil revenues are siphoned off into a SF this limits the extent of the volatility that is transmitted. Whilst a stabilization fund does exist in T&T it holds a mere US$3bn. Clearly then a critical policy adjustment is that the SF has to be complemented by a long run price of crude oil. Windfall prices should be defined as prices above this long term level, and relevant surpluses should be creamed off to a stabilization fund. To calculate a long term price of crude oil, one could possibly use a Hodrick Prescott filter and extract the long term trend component from the real oil price series and then smoothen it using some technique.

33. b) Non Oil Balance • Another policy requirement for the T&T economy to consider is to enhance the resilience of its economy to oil price shocks. This model requires a strengthening of the economic base away from a narrow dependence on hydrocarbon based resources. This strategy can involve a clear non oil revenue based policy stance. The diversification of the asset base of the economy would require prudent management as the BT sector expands over time. In this regard the government planned industrial investments are welcome but these has to be founded on comparative advantage theory. The government has to be wary that its attempts at picking winners does not simply result in rent seeking and inefficiency. c) Governance Process • There is a need to strengthen the general governance process. The extent of corruption in the T&T economy has started to become too entrenched and there is need for a greater degree of public accountability. Recent empirical literature such as Collier (2007) have demonstrated that countries with strong institutions tend to be less affected by the resource curse than others. In 2001 T&T’s corruption perception index was 5.3, but by 2007 this had declined to 3.4, indicating a greater degree of corruption. A strong thrust must be made to review this situation.

34. Thank you