Substantial changes proposed for East Timor’s Petroleum Fund law will expose the nation’s finances to high risk and open the door to corruption.
Just a few years ago the fund was widely praised as a model of prudential and sustainable management, and a means of possibly escaping the “resource curse” of waste and corruption.
That is all about to change.
East Timor's AMP government, led by Xanana Gusmao, has a bill before parliament that removes most of the prudential controls on the fund.
Under the new law, up to half the country’s fund (several billion dollars) can be handed over to foreign fund managers for investment in volatile stock markets. The oversight role of parliament will be largely abolished and transferred to ministers and investment advisors.
The fund will be set up as collateral for debt instruments and its special status outside state finances will be removed.
Finally, the rate at which the fund’s revenues can be withdrawn by the government will be opened up.
All the major prudential controls of the original law are to be dismantled.
These proposed changes come in the context of uncertain international finance markets and in the wake of domestic corruption scandals over rice, infrastructure and service contracts.
Waste has become endemic. Secretary of State for Public Works Domingos Caero acknowledged that that “about 60 per cent” of the 2009 “Referendum Package” projects were “of bad quality”.
The AMP’s draft law would take the country’s fund regime from one of the most conservative to one with the least protection from risk, fraud and malpractice.
Most other sovereign wealth funds (such as Australia’s Future Fund, Brazil’s Fundo Soberano, Botswana’s Pula Fund, Trinidad and Tobago’s Heritage and Stabilisation Fund) maintain tighter controls on their assets.
Greater exposure to equities has been taken on by those funds, such as in Singapore and Norway, that have developed strong “in house” financial management expertise, and are thus less exposed to external operators.
The Norwegian fund (NBIM) now allows up to 50% investment in equities, but this fund operated under strict limits for its first 10 years. It then gradually expanded its more risky investments, maintaining mostly “in house” management and legal controls.
Moving East Timor's fund more rapidly to 50% equity exposure, and with reliance on external fund managers implies far more risk.
It was only a few years ago that the then well-regarded company Goldman Sachs was charged with a huge fraud involving misleading advice to investors.
Financial crises are precisely the time when small investors are cheated of funds.
A great deal is at stake. The International Monetary Fund earlier this year described East Timor as “the most oil-dependent economy in the world”.
The government budget in 2010 (ignoring foreign aid) depended almost 90% on draw-downs from the Petroleum Fund.
With further waste and possible losses through risky operations by the external fund managers, the fund could diminish and state budgets would contract.
There is indeed a case for amending the Petroleum Fund law, largely due to the steady decline in the US dollar, low returns on US bonds and ongoing financial uncertainties in the US.
In these circumstances it does not make sense (as required by Articles 14-15 of the current law) to hold “not less than” 90% of Fund investments in US dollar denominated bonds.
Nevertheless, a diversification in secure and higher return bond investments (now being carried out by all major investors in the world) and some more modest moves into wider investment would not pose anything like the risks of the current proposal.
In the drive to risk more and spend more of the fund, finance minister Emilia Pires has called on support from former World Bank official Jeffrey Sachs and consulting firm Towers Watson.
Sachs, famous for his “big money” approach, has supported greater spending. (Indeed, East Timor’s annual budget of only about $100 million in 2005 rose to nearly a billion last year.)
This neo-Keynesian line suggests that government spending can stimulate new rounds of economic activity. The idea has some relevance in highly formalised economies, at times of recession; but it does not well address the capacity building needs of developing countries.
Nor does the idea of throwing more money around address the problems of a small country already facing serious issues of waste and corruption.
Major-General Taur Matan Ruak, chief of Timor Leste’s Defence Forces, last year asked Sachs to explain how the international aid of more than $12 billion over the past decade had not led to noticeable improvements in employment and poverty.
The April 5, 2010 Tempo Semanal quoted Sachs as replying: “I think this is difficult for me to give an answer but I think the international experts need to consider this question with seriousness and I myself will look at the implementation process closely.”
Towers Watson, for its part, has pushed for high level, offshore stock market investments. However, this company and its predecessors has been successfully prosecuted for misleading advice, malpractice and breach of contract.
Common themes have been that the company had been negligent in its advice, made serious errors in calculations of fund liabilities and concealed conflicts of interest ― and that this cost pension funds millions of dollars.
Some of these cases help illustrate the dangers of handing over millions to external managers. In 2001, a US jury found there was actuarial negligence by Towers Watson predecessor Watson Wyatt.
The Connecticut Carpenters Pension Fund was awarded $39 million damages. The jury found Watson Wyatt “was negligent, committed malpractice and breached its contract with the Fund”.
Watson Wyatt made serious errors in calculating the fund's pension liabilities.
In 2004, the US justice department launched an investigation of actuarial consulting firms, including Watson Wyatt, Towers Perrin and others.
Subsequent claims for actuarial negligence (including “anti-competitive agreements or understandings” involving conspiracies against their clients) covered a period of more than 20 years and sought damages of $2 billion. This case was ultimately settled.
In 2007, Watson Wyatt agreed to pay $110 million to settle a 2004 negligence lawsuit filed by trustees of the Iron Workers Local #25 pension fund (Michigan).
Despite the settlement, the case carried on through 2009.
After Watson Wyatt revealed to the Ironworker’s Pension Fund lawyers that “the pension plan was not performing as well as previously indicated”, those lawyers found two other actuarial negligence cases and decided to sue Watson Wyatt, claiming damages of more than $100 million.
There are several other unresolved and failed claims against the Towers Watson and its predecessors.
The AMP government’s proposed amendments to the Petroleum Fund law, by dramatically downgrading prudential controls and oversight, opens the door to such losses.
Yet, as there is a case for amendments to the law, what are the alternatives?
More reasonable, lower risk fund reform options can be found in: (a) a focus on diversified bond investment ― reforming the law to allow secure bond investment in currencies other than the US dollar (e.g. Euros, Australian dollars, Chinese Yuan); and (b) a more modest ceiling of perhaps 20% on higher risk direct investments, while linking diversification of investments to the growth of domestic financial management capacity.
Diversification of bond investment alone, in current circumstances, could allow a doubling of returns on fund investment.
At its inception, when there was virtually nothing in the Petroleum Fund, it was easy for everyone to support it as a model of prudence and commitment to future generations.
Now that the fund holds more than $7 billion it has become a “honeypot”, and the “bears” are circling.
East Timor is more vulnerable than most to being cheated of its resources; the country should take great care of its chief financial asset.
[Dr Tim Anderson is a Senior Lecturer in Political Economy at the University of Sydney and has acted as adviser to Timor Leste’s Consultative Committee for the Petroleum Fund.]