Public Disclosure Authorized 60115 The Challenges and Opportunities of Ghana’s Africa Trade Policy Notes Offshore Oil Discovery Note #14 Public Disclosure Authorized March, 2011 Introduction The discovery in the last several years of oil revenue also brings well-known challenges, Public Disclosure Authorized off the coast of Ghana was greeted with particularly in terms of institutional and significant optimism and immediately began macroeconomic absorptive capacities. The a debate over how the oil revenue should be first set of challenges concern the capture of spent. The Jubilee field’s estimated oil resources by groups or individuals to reserves, as of October 2009, amount to 490 satisfy their personal interests rather than the million barrels of high-quality oil and justify public good. The second set of challenges commercial exploitation should barrel prices relates to the management and use of a exceed US$30. Such a level of proven volatile, uncertain, and exhaustible source of reserves puts Ghana on par with neighboring revenue. Rather than financing immediate Cameroon (400 million barrels) and above consumption, policy makers would ideally Cote d’Ivoire (100 million barrels), but act to convert oil revenue into high social below Nigeria (36.2 billion barrels). Based return investment projects that would on a long run price assumption of US$75 per effectively raise the long term growth rate of Public Disclosure Authorized barrel, the World Bank estimates potential the economy. Such challenges raise government revenue at US$1.0 billion on concerns about Ghana’s ability to protect the average per year between 2011 and 2029. strength of economic growth and poverty Therefore, oil discovery will primarily alleviation engendered since the 1990s. impact the economy through the budget, and This policy note examines these challenges it must be analyzed in this context. and explores possible options for how they can be overcome, as well as for how Oil discovery bring promises and raises Ghana’s oil wealth can be used for the expectations for the future, especially given maximum long term advantage of its people. the country’s development needs. In the short term, oil revenue could help Ghana address its large fiscal imbalances. But oil 1 Institutional and public financial Still, the fundamental issue for Ghana will management challenges be the ability of ruling political forces to renounce the discretionary power provided With the exception of a few developed to them by windfall revenue. The effective countries, the governance record of most oil exploitation of the oil discovery for the long exporters is at best mixed. The recent term benefit of Ghana is predicated on example of Chad, which reneged on its building consensus among political forces initial commitments on the use of oil and on the recognition that letting other proceeds, illustrates how challenging it can parties take advantage of a discretionary use be to design solid institutional mechanisms. of funds would be harmful to the country. Oil-related conflicts in Nigeria also point to Consensus-building efforts and improved the potential for social destabilization. economic transparency are sine qua non Other common problems that confront conditions and probably the best vehicles for countries with new oil discoveries include initiating momentum for institutional rent-seeking behavior and corruption, reform. At the same time, while consensus political patronage, lower entrepreneurship building will be crucial, other challenges and capacity for investment, and increased will have to be overcome. authoritarianism and civil conflict. Macroeconomic Challenges An analysis of Ghana’s institutional framework gives mixed results as to the risk The oil discovery presents Ghana with two of political capture of oil revenue in Ghana. major macroeconomic challenges. The first On the one hand, Ghana’s government can one, specifically related to oil, is the be considered “factional,� meaning that management of oil price and output there are political incentives for politicians volatility and the associated unpredictability to engage in patronage politics. Ghana also of revenue streams. The second one is the exhibits large and increasing social nature and recent evolution of the recurrent polarization (urban vs. rural, south vs. north) fiscal balance, which if left unaddressed will and the importance of ethnic identity in elevate pressure to use oil revenue to cover political decision making seems to be public consumption expenditures rather than increasing. On the other hand, Ghana is a to finance needed long term investments. young democracy with several strengths: there is no dominant single party, parties are The key issue, then, is to prevent the direct quite well institutionalized, traditional transmission of oil revenue to the budget. A leaders provide some restraint on the way to solve this problem is through a capacity of the Executive to pursue its own budget stabilization mechanism, of which self-interest, and extra-institutional there are two types that could be appropriate interventions (for example by the military) for Ghana. The first stabilization are rare in comparison to neighboring mechanism consists of setting up a reference countries (World Bank, 2007). For these price for oil (typically equal to the long-term reasons, risks of institutional failures are price forecast) and transferring only the lower in comparison with other countries in revenue from oil production evaluated at the same income group, and the range of that reference price to the budget. The policy options that Ghana has to address the remainder would be saved in a Stabilization risk of governance failure is wider. Fund (SF) if the actual price was higher, or tapping such a fund if the actual price was 2 lower. A second option for a stabilization volatility, the permanency of incomes can mechanism consists of building a Permanent only be ensured if financial returns on the Income Fund (PIF), where oil revenue is PIF are guaranteed. For that reason, the PIF held in trust and only the interest rate should be constituted of commercial revenue from the accumulated assets is investments abroad (such as in stock channeled to the budget. World price and markets and sovereign bonds of non-oil high real interest rate assumptions would income countries). The permanent income determine the income that could be spent (the annual interest income generated by the every year, even after oil reserves have been PIF) channeled to the budget could then be exhausted. used to finance domestic investment projects with high social returns. Stabilization and Permanent Income funds have some similarities. Both funds require A Stabilization Fund would be more solid institutional frameworks in order to be sensitive to changes in oil price and reserve effective, and neither fund would be assumptions, particularly during the peak effective in protecting fiscal sustainability in period of extraction. Although changes in the absence of control mechanisms on the oil prices would affect both a PIF and a SF, general budget. But the funds also differ on changes in amounts channeled to the budget two important grounds. The first difference in absolute terms following a revision of regards the sensitivity of the spending rules world price assumptions would likely be attached to the two funds with respect to a larger with a SF. For example, an increase sudden change in world prices or a new oil in oil prices to US$100 per barrel would discovery. The second regards the amount channel an additional US$1 billion to the of money to be channeled into the budget. Ghanaian economy, whereas it would With a SF, all oil revenue will have been channel only US$240 million with a PIF spent at the end of the extraction period, (with a similar sensitivity if the price assuming that the reference price is correctly decreased). In this way, the sensitivity of set (i.e. that forecasts are fulfilled). In the SF to oil price changes would lead to contrast, with a PIF only a share of oil volatile payments to the budget. This could revenue will have been spent by the end of lead to political pressures to revise the extraction period. frequently world price assumptions higher, as the immediate payout from a price Under conservative assumptions, a increase would be greater. Permanent Income Fund in Ghana could generate US$458 million per year given the Regardless of which stabilization stream of expected oil revenue discussed mechanism is used, the recent drop in above at US$75 per barrel and a real interest Ghana’s fiscal recurrent balance undermines rate of 3 percent.1 However, it is worth its ability to use oil revenue for financing emphasizing that a PIF would need to be investment. With a recurrent balance close invested abroad. Beyond the need to to zero and concessional borrowing at 2-3 decouple PIF investments from the percent of GDP, Ghana can now (with Ghanaian business cycle to manage development partners) only finance 2-3 percent worth of investment expenditure, far 1 below the 5-6 percent needed to rapidly See van Winjbergen (2008) for a detailed close its infrastructure gap. Similarly, oil discussion of permanent income funds. revenue alone will not suffice to restore 3 sustainability. Although tempting in the the expanding oil sector. Collectively these face of current imbalances and smoothing challenges are often known as the “Dutch needs to avoid disrupting or delaying public disease,� in reference to the impact of gas programs, borrowing on non-concessional discovery in 1959 in the Netherlands that led terms against future oil revenue (that is, to deep de-industrialization and economic selling oil forward) to postpone fiscal stagnation when the gas was exhausted. consolidation would elevate risks of debt distress. Indeed, given the successful Unfortunately, Ghana already has many of exploitation of the Jubilee field, failure to the symptoms of Dutch disease even before reduce the large primary deficit and sustain the onset of transfers of oil revenue to the this consolidation over the coming years budget. Structural transformation has been would result in a much less favorable debt slow and productivity levels are low. This sustainability outlook.2 affects export competitiveness since factor prices remain high in comparison to their “Dutch Disease� in Ghana—Productivity, marginal productivity. From 2007-2009, the Competitiveness, and Social Challenges spending of Eurobond proceeds (US$750 million or 5 percent of GDP) coincided with Besides the macroeconomic difficulties an acceleration of domestic price inflation, discussed in the previous section, channeling even when the spending was on windfall oil revenue into the economy poses infrastructure investment projects (mostly to a number of additional challenges related to expand electricity generation capacity). productivity, competitiveness, and social This suggests a risk of real exchange rate issues. appreciation and inflationary pressures with the transfer or oil revenue to the treasury The first issue that poses a threat to Ghana’s (either directly as demand rises, or indirectly economy is the likely appreciation of the through anticipation spending and related real exchange rate. As windfall revenue speculative bubbles). Time series analyses from the oil discovery spills over into the of the impact of additional capital inflows economy, demand will increase in the face on relative prices point to the same of a limited supply response. This will lead conclusion.3 to an increase in the prices of goods and services, and will harm Ghana’s export Agriculture is one sector that could be competitiveness. The second issue is a particularly exposed to the consequences of likely drop in productivity as more factors the Dutch disease. As one of Ghana’s major become concentrated in non-tradable sectors tradable sectors, agriculture would be where potential productivity gains are much seriously exposed to the risk of losing scarcer. The final issues are the re- external competitiveness through a real allocation of investment within the exchange rate appreciation. In addition, economy, the migration of workers from given the high degree of mobility of the rural areas to the cities, and the loss of labor force (between agricultural and markets and know-how as firms move into informal labor markets), a greater demand 2 Debt Sustainability Analysis, IMF and World 3 Bank (2009). Ghana is currently classified Opoku-Afari et al. (2004) suggest that among countries at moderate risk of debt permanent capital inflows can have a strong and distress. significant impact on the real exchange rate. 4 for labor in cities could exert upward revenue, they would still remain less poor in pressure on agricultural wages and reduce absolute terms than households in the external competitiveness for both import- Northern regions. competing and export-oriented agricultural sectors. Experience suggests that once lost, Regardless of the choices made, a number of market share can be extremely difficult to actions should be undertaken to raise the regain due to the loss of commodity-specific potential development impact of the oil capital, both physical (e.g. processing discovery. Most importantly, Ghana would plants) and human (scientific knowledge and strongly benefit from elevating its technical skills). This is particularly true in institutional and macroeconomic absorptive export markets, where supply chains are capacities before channeling oil revenue into often complex and difficult to establish. For the economy. The problem is that raising example, Ghana is still trying to recover such capacity will take time, while oil market share in the European pineapple revenue will increase rapidly in the first market after having lost ground as European years of extraction. The risk of misuse is supermarkets demanded new varieties of the therefore particularly high in these years. fruit. Given this context, Ghana should consider the following actions, most which would be Policy Tradeoffs and a Way Forward justified even in the absence of oil but which could go a long way towards mitigating the Once oil begins to flow, Ghana will be negative consequences of the oil discovery. confronted with a number of policy choices. Ghana first needs to decide how much of its  Increase transparency in how oil oil revenue it wants to spend now, and how revenue is allocated. In order to much it is willing to set aside for the future. minimize the risks of political This intertemporal choice should be dictated capture, greater social accountability by considerations of absorptive capacity and and economic transparency are the social return of spending oil revenue. necessary. First, Ghana should Inter-generational considerations could also improve transparency by adopting be considered, as choices made today would and implementing a Freedom of have irreversible consequences on the Information Act, and should enforce amount of oil revenue available for future accountability measures regarding (i) generations, since they will not be able to the publication of reports and choose themselves how to use the revenue revenue and their use, and (ii) the once oil reserves are depleted. It will also disclosure of bidders’ identities and be important to consider the distribution of the bidding documents. Second, oil revenue among social groups. Some Ghana should design a home-grown groups might be more affected than others at institutional response to the risk of the margin by the direct impact of oil political capture. Various examples extraction (e.g. on the environment) and from around the world can inspire spending (symptoms of the Dutch disease). Ghana, but none of them will be But other groups might deserve greater effective if Ghana does not take support given their disfavored initial ownership of the idea and its situation. For instance, although households implementation. from the Western region are likely to lose more from untargeted spending of oil 5  Restore fiscal sustainability and oil price volatility would consist of responsibility. Although high fiscal establishing a fund (either a deficits threaten macroeconomic stabilization fund or a permanent stability, using oil revenue to finance income fund, as discussed them would only postpone the previously), from which predictable adjustment while bypassing an transfers would be made to the important development opportunity. budget. Instead, Ghana must solve its fiscal problem in order for oil revenue to  Increase the provision of be used as efficiently as possible. agricultural public goods. The The necessary adjustment will call in reform would consist of raising particular for a review of the public agricultural spending up to 10 payroll and energy subsidies in light percent of the government budget of service delivery and poverty (from 6-8 percent currently) to alleviation as well as fiscal support the provision of various affordability. The public public goods including feeder roads, management reforms discussed research, extension services, water above could help to consolidate the and power supplies, storage fiscal adjustment effort. capacities, irrigation for smallholders, and safety standards.  Remove bottlenecks in non-tradable sectors. The effects of the Dutch If implemented, these policy actions disease could be mitigated by together could significantly magnify the removing constraints to competition positive impact on economic development and domestic supply response in of the oil discovery. Quantitative non-tradable sectors, including high simulations suggest that the average real per barriers to entry in formal sectors capita disposable income over the period (starting a business, access to 2010-2029 could be 9-13 percent higher finance, urban land tenure), and poor with these reforms that without. The infrastructure (water, electricity) for simulations show, however, that the effect of urban SMEs. SMEs would also these reforms would take time to benefit from higher consideration to materialize. Delayed implementation of the PPP options, leaving greater reform program therefore entails high financial capacity for the government opportunity costs as a large share of oil to finance projects with high social revenue would have been sub-optimally returns. spent.  Introduce stabilization mechanisms Although important for raising the quality of for managing oil price volatility. oil revenue spending, these reforms will not The first mechanism should help to address all challenges; there are several restore the pass-through of more issues that should be considered. First international prices into gasoline is the intergenerational equality issue, where prices and utilities tariffs, along with future generations would be deprived of the establishing targeted mechanisms to opportunity to decide how to manage the oil protect the poor. A second if its revenue is fully spent during the mechanism to shield the budget from extraction period. The second issue is the 6 distribution issue, as these reforms would only marginally contain a widening rural/urban gap during the oil revenue boom period. The third issue relates to the downside risks associate with these reforms. For example, implementation delays, political feasibility, or a large exposure to changing price and reserve assumptions during the first years of extraction could reduce the impact or effectiveness of these reforms. About this note: This note is a summary of the World Bank report 47321-GH titled “Economy-wide Impact of Oil Discovery in Ghana� dated November 30, 2009 and funded by the Multi- Donor Trust Fund for Trade and Development supported by the governments of the Finland, Norway, Sweden and United Kingdom. The views expressed in this paper do not necessarily reflect the views of the funders. Questions and inquiries about this summary and report can be addressed to: Sébastien C. Dessus, Lead Economist Phone 233 (0) 302 214122 / Fax 233 (0) 302 227887 / Email: sdessus@worldbank.org The World Bank, P.O. Box M27, 69 Dr Isert Road, North Ridge, Accra, Ghana 7