Euromoney magazine, September 2008
Picture two countries. One has an infant mortality rate of almost one in 10, a male life expectancy of 47, and 40% of the population in poverty. The other has $3 billion in a burgeoning sovereign wealth fund fuelled by oil and natural gas reserves, a figure that will reach $20 billion before long even in the worst case scenario. The curiosity of East Timor is that it is both of these places at the same time.
There is surely no country in the world where the sovereign wealth fund is so utterly key to the future of the country, the very sustainability of its people’s existence. The world’s newest nation, a sovereign state since just 2002, its oil and gas fields in the Timor Sea really are its only shot. Consider this: the government estimates $1.39 billion in revenues for 2008 – all but $27 million of it from oil and gas. Coffee, the second-ranked contributor, accounts for $8 million, 170 times less.
All of which makes the story of the Petroleum Fund, founded in 2005, so remarkable. The Peterson Institute for International Economics, a Washington DC-based independent research group, ranks it the third best run sovereign wealth fund in the world based on structure, governance, transparency and accountability, behind only New Zealand and Norway. (The Abu Dhabi Investment Authority ranks 32nd on the same list.)
It gets this accolade for its peerless transparency and its commitment to build for the future rather than to spend today: a bid to make sure there’s something left for the country when the oil runs out. On its website one can find up to date reports detailing everything it holds, how much it manages, even thoughtful responses to public queries about things like bond valuations – a far cry from some of its Middle East contemporaries. Its mandate states that in any one year it can only withdraw what it calls estimated sustainable income, which in practice means 3% of the likely near-term assets of the fund, on the grounds that a 3% reduction should be easily replenished by prudent investment. This display of discipline tends to win it applause from overseas commentators, but is a source of considerable friction from people on the ground wondering why they don’t have enough roads and hospitals while oil revenues sit in long-term investments.
It’s a discipline that comes from having watched others fail. “Where poor countries like Timor-Leste have quickly attained vast amounts of money very quickly, while their human resources and infrastructure still needs to be developed, the outcome is usually a failure,” says Alfredo Pires, Secretary of State for Natural Resources. “I don’t think I could name a single good example in the world. The challenge is for us to be the first ones to avoid the oil curse.”
As of June, the fund had $3 billion under management, a product of revenues from the Bayu-Undan oil and gas field being exploited by a team led by ConocoPhillips. East Timor gets 90% of the taxes and royalties from this field, with Australia taking the other 10.
This field ought to be good until 2023, and has proven reserves of around 4 trillion cubic feet of natural gas and about 500 million barrels of condensate. Pires estimates it ought to bring about $10 billion to East Timor over its life.
Then there’s the Greater Sunrise field, with almost twice as much natural gas and about 300 million barrels of condensate besides. It would take a book to describe the painstaking negotiations between Australia and Timor over the development of this field and the maritime boundaries affecting other, still-to-be-found fields (indeed, one has been written: Shakedown by Paul Cleary, who advised the Timorese on the deal) but the outcome was a 50/50 split with the Aussies on royalties and taxes. Still to be decided, and an increasingly fractious issue, is how it will be developed: although the field is closer to Timor than to Australia, there is a trench more than 2000 metres deep on the Timorese side, a geological curiosity that has been at the heart of decades of dispute about maritime law. One side wants the pipeline to go to Darwin, the other to Timor, while the site operator, Woodside Petroleum, is believed to be leaning increasingly to another option altogether, with a floating LNG plant. Development won’t start until they decide. But whatever the outcome, Timor’s revenues from this ought to generate at least $10 billion.
That’s before anything else is considered. For any funds within an area called the Joint Petroleum Development Area, Timor will take 90%. There are proven fields, albeit small, within Timorese waters. And nobody has really started looking onshore yet. So, although unpredictable oil and gas prices don’t help with projections, the worst case is really that this fund is going to enjoy $20 billion of revenues, and it is common to hear people talking about $50 billion, and sometimes even twice that.
That creates all sorts of whacky statistics: since the national population is barely a million, Timor could end up with a theoretically higher per capita GDP than Australia (although since it has the world’s highest fertility rate of more than seven children per woman, that imbalance is unlikely to stay in place for long). But suffice to say the management of the fund is of vast responsibility and importance. It is, as David Edwards, vice president in worldwide securities services at the fund’s custodian JP Morgan says, “basically all they’ve got.”
So far, the methods used to invest this wealth have been deliberately passive. The Petroleum Fund law insists that 90% of funds must go into US treasuries, bank bills, term deposits or other similar securities; the law dictates a minimum rating of AA-, or that the securities be guaranteed by a sovereign of that rating or higher. The law allows 10% to go into other assets, provided they are issued abroad, are liquid and transparent and are traded in a financial market of a high regulatory standard; in practice, though, the whole lot has stayed in the safe treasuries, and indeed no investment has yet been made in anything rated less than AAA.
The fund’s mandate requires it to track the Merrill Lynch 0-5 year government bond index; its duration must be within 0.2 years of the index, and it is only allowed to drift within 25 basis points of the index’s return, which so far it has managed, lagging it modestly. “The idea was to start with something simple and safe,” says Venancio Alves Maria, executive director of the Petroleum Fund. “At the time we Timorese didn’t have any expertise at all in the fund management area.”
It’s an approach that has served them rather well in a year when sovereign funds from Abu Dhabi to Singapore have found themselves billions of dollars out of the money on investments in American investment banks. But there are signs that the relentless caution may be about to give way to a slightly more daring approach.
The first signs of this change in approach have come with the fund’s first appointments of external western experts. Last August, Mercer was engaged as asset consultant. Then, in June this year, JP Morgan was appointed as the custodian for the fund. JP Morgan is also an advisor to Norway’s sovereign wealth fund, which is a clear model for Timor’s (Torres Trovik from Norges Bank is a member of Timor’s five-person Investment Advisory Board). JP Morgan’s role will cover settlement, administration, accounting, and in future will include performance measurement, mandate compliance monitoring and fund performance services. It’s the clearest sign yet that external managers will be appointed in due course. “This is an early step to accommodate the government’s intention to diversify the fund,” Maria says.
Edwards at JP Morgan in Sydney has high hopes for the fund. “When we initially received the [tender request], the first concern was going to be the stability of the country, how they were looking to structure themselves and invest. We did a lot of due diligence on the individuals, the structure of the fund, the Acts that they passed and made sure we had absolute comfort in what they were trying to do. We do.”
It was, he recalls, quite a moment to step out of a car in Dili for the signing ceremony and face a phalanx of photographers: “my first experience of such overwhelming interest in a contract signing for a custody deal.”
JP Morgan is believed to have offered a low fee for the work in order to secure this potentially lucrative client. “The value of the reserves, the price of oil and the value they will add through their investment means this is going to be a significant client for us in Asia, perhaps one of the largest,” he says. “On the fee side, for every client that we want to have a relationship with, we will price that very aggressively.”
He too expects a change in investment approach. “They’re at US$3 billion and growing at $180 million a month, and they understand that diversity of assets is going to be very important to them,” he says.
Then there’s the new finance minister. The Petroleum Fund is run by the Banking and Payments Authority of Timor-Leste, which is in every practical sense the country’s central bank and is intended to become it, although it doesn’t have that formal title yet (and doesn’t issue banknotes, since Timor uses the US dollar as its currency). But it conducts the fund’s management on behalf of the Minister of Planning and Finance, and last year, with a change in government, the person in that portfolio changed.
Euromoney’s interview with Emíilia Pires takes place in the Palácio de Governo, the Portuguese-era government palace facing Dili’s harbour, at 9.30pm on a hot evening in July. She looks tired, and a little wild of hair, after spending part of the day dealing with petitioners (earlier in the day a protest has been quelled with tear gas just around the corner) and the rest of it lobbying parliament, but presses on with an interview despite the lateness of the hour. She is certainly not lacking in energy or spirit: the first ever East Timorese graduate of an Australian university (La Trobe), and someone who fought her way from refugee status following Indonesia’s invasion of Timor in 1975 to being a public servant in the Victorian state government, she is one of a number of Timorese who have studied in Australia (Alfredo Pires, a cousin, is another example and the president, José Ramos-Horta, has held Australian permanent residency) and come back after liberation to help rebuild the country.
An hour in her presence leaves little doubt of her conviction to get things done, and the Petroleum Fund is on her agenda for change. She appointed a working group to look at the structure and approach of the fund. “When we took over government there were some studies being done on whether we had an optimal investment strategy,” she says. “From those studies it was clear we do not have.” With today’s cautious investment approach, she says the 3% that the fund’s founders believe to be a sustainable withdrawal would not be sustainable at all. “That immediately tells us we need to do something.”
She hasn’t yet decided what – her advisers still have to come back to her with a better strategy – but she confirms it will involve “more active investment. I hope before the year is over we should have a new strategy, and know what are the areas where we should revise the law, and I should be able to submit it to parliament.” As a first step the fund has initiated contract negotiations with the World Bank and Bank for International Settlements as non-commercial external investment managers.
Pires is also under scrutiny because of another measure her government has taken: it’s started pulling more money out of the fund than it is generally allowed to do.
On May 23, the Council of Ministers approved the final draft of the Mid Year Budget for 2008, allowing for spending of US$773.3 million, the vast majority of it to be taken from the fund. Based on the sustainability calculations, only about $396 million should be taken out of the fund this year; the government is taking an additional $290 million above that level, a figure Emíilia Pires confirms to Euromoney. The Petroleum Law does allow these occasional larger withdrawals provided they are approved by parliament, but some are alarmed that this starts a bad trend.
Tomas Freitas, director of a Timorese NGO called Luta Hamutuk, says “the fund is under threat” because of this approach. The protests on the morning of Euromoney’s visit are partly to do with this budget, and in particular the fact that $1.4 million of it is allocated to the purchase of luxury cars for members of the national parliament. Some external observers, while acknowledging the need for investment now (and especially the impact of food price hikes), privately say they wish the extra money had been taken from World Bank or Asian Development Bank loans, freely available and at favourable rates, rather than from the fund itself, because of the precedent it sets.
Emíilia Pires is characteristically passionate in her defence of the government’s position when asked about commentators who think the funds should not be withdrawn. “I don’t understand how they think that, because right now if you don’t invest in the people, what future have we got? There’s not enough schooling, or quality of schooling. We are suffering from dengue, malaria, you name it. Should we take more? Of course, logically we have to, otherwise where is the future generation? For me it’s just irrational to think otherwise.”
The approach would probably have attracted less criticism but for the fact that Timor has not previously managed to spend its more modest budgets. In the 2006-7 fiscal year, the budget was set at $328.6 million, of which only $160.4 million was paid – a cash-based execution rate of just 49%. An inability to spend the money it has begs the question whether a greater sum can usefully be employed now. Perhaps the biggest problem is human resources, and there are no end of programs geared towards giving specialist education to a generation of Timorese, notably in petroleum and geology, but it will take time to come through.
East Timor is still a volatile place – Ramos-Horta was shot three times in a failed assassination attempt in February, and it is still rare to go a minute on Dili’s streets without seeing a vehicle marked with UN insignia. But it has a great chance. It is not short of advice: Minister of Economy and Development João Mendes Gonçalves recently set about collating the various macro and economic research and development studies that have been conducted for Timor since 1999, and has so far collected 1700 of them.
But it will eventually go its own way. As Alfredo Pires says: “We seem to have a lot of experts, but sometimes we have experts who have never lived in a poor country. They may have the mathematics and economics right but it’s about individual cases. It comes back to people and the leadership.”
BOX: Banking in Timor
Timor’s banking system is a reflection of its history. There are three banks with a presence, all foreign, one each from the country that colonised it (Portugal), occupied it (Indonesia) and helped liberate it (Australia): Caixa Geral de Depósitos, Bank Mandiri and ANZ respectively.
These banks are arguably seen as a method for capital to leave Timor rather than to come into it. “Apart from the Portuguese bank, the others are not giving any loans to people,” says João Mendes Gonçalves, Minister of Economy and Development. “They claim this is mainly geared to the risks associated with the loan, and we understand all that, our legal framework is not complete yet.” Instead, “they are in deposits from people, transferring money overseas, and getting commission from that.”
ANZ itself, which set up in January 2001 even before Timor’s formal independence, says it supports “both international firms and a fast-growing Timorese client base”, offering savings, transactional banking products, and international services, for personal customers, commercial clients, government and non-government organisations. A spokesman says ANZ “sees a number of opportunities… to play a strong role in the development of Timor-Leste as a nation,” including facilitating foreign investment, lending, and providing banking services to the public sector.
Timor is, though, witnessing the birth of its own banking sector. The Institute of Microfinance Timor-Leste was established under the UN-led transitional administration, with a mandate for poverty reduction. It has grown but been impeded by law, unable to take more than $1 million in total deposits, or to give loans higher than $5000. In July, it changed hands. “We reached an agreement that for the better future of the institution, it would be better if it came to the government,” Gonçalves says. “We would strengthen it and ensure they expand into other districts, transforming it into the first national bank of East Timor.”
The country does need a banking sector, because it barely has a private sector to speak of and has no hope of developing one without access to credit. Plenty needs doing before western banks are likely to commit further, though, starting with a bankruptcy law; Gonçalves says he is about to send a draft law to the Ministry of Justice.
For the future, there is also talk of a national development bank to support Timorese entrepreneurs. Gonçalves says he has lobbied the World Bank, ADB, IFC and another group to come in with the government in putting in $3 million apiece to a development fund.
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