managing newfound hydrocarbon wealth: macroeconomic policy challenges in the eastern mediterranean

7/29/2019 Managing Newfound Hydrocarbon Wealth: Macroeconomic Policy Challenges in the Eastern Mediterranean

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MEDITERRANEAN PAPER SERIES 2013

MANAGING NEWFOUND HYDROCARBON WEALTH

MACROECONOMIC POLICY CHALLENGES IN

THE EASTERN MEDITERRANEAN

Rozlyn C. Engel
http://www.gmfus.org/


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Managing Newfound Hydrocarbon Wealth

Macroeconomic Policy Challenges in the Eastern

Mediterranean

Mediterranean Paper Series

August 2013

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4/33

Managing Newfound Hydrocarbon Wealth 1

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The German Marshall Fund of the United States2

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Table 1. Recent Macroeconomic Trends, Cyprus and Israel

Cyprus 2001-05 2006-10 2011 2012 2013 2014 2015

GDP, PPP valuation (billions of current int'l dollars) $16.4 $22.0 $23.8 $23.6

GDP per c apita, PPP valuation (billions of current int'l dollars) $22,597 $27,532 $27,581 $27,086

Implied PPP conversion rate 0.72 0.74 0.76 0.76

Exchange Rate, Euros/USD1 0.93 0.74 0.72 0.78 0.75

Real growth rate of GDP (national prices, percent change) 3.2 2.5 0.5 -2.4

Stock Exchange Index, CSE General2 2554.254 1181.54 385.85 110.97

Stock exchange (percent change)2 -28.0 31.0 -21.0 -67.3 -71.2

Total investment (percent of GDP) 18.1 21.0 17.3 13.5

Foreign direct investment (net inflows in billions of USD)3 $1.0 $1.5 $1.1

Gross national savings (percent of GDP) 14.1 10.0 12.6 8.6

Inflation rate (percent change) 2.5 2.3 3.5 3.1

Unemployment rate (percent) 4.4 4.9 7.9 12.1

Population (millions) 0.72 0.80 0.86 0.87

General government net lending/borrowing (percent of GDP) -4.0 -1.6 -6.3 -5.6

General government gross debt (percent of GDP) 68.2 58.6 71.1 86.2

Current account balance (percent of GDP) -4.0 -11.0 -4.7 -4.9

Israel

GDP, PPP valuation (billions of current int'l dollars) $142.7 $200.6 $237.0 $248.7 $261.8 $277.6 $293.2

GDP per capita, PPP valuation (billions of current int'l dollars) $22,410 $28,385 $31,466 $32,312 $33,282 $34,524 $35,690

Implied PPP conversion rate 3.9 3.6 3.7 3.7 3.7 3.7 3.7

Market exchange rate, NIS/USD1 4.5 4.0 3.6 3.9 3.7

Market exchange rate, NIS/Euros1 4.9 5.4 5.0 5.0 5.0

Real growth rate of GDP (national prices, percent change) 2.1 4.4 4.6 3.1 3.6 3.9 3.6

Stock Exchange Index, TA-1002 482.7 892.7 1203.8 1013.7 1046.7

Stock exchange (percent change)2 10.9 16.5 13.8 -15.8 3.3

Total investment (percent of GDP) 18.2 17.0 17.6 19.2 18.4 18.8 19.6

Foreign direct investment (net inflows in billions of USD)3 $2.9 $8.9 $11.4

Gross national savings (percent of GDP) 18.7 15.6 19.0 19.1 20.1 21.3 22.1

Inflation rate (percent change) 1.7 6.8 3.5 1.7 1.6 2.0 2.0

Unemployment rate (percent) 12.4 6.9 7.1 6.9 7.0 6.5 6.5

Population (millions) 6.36 7.80 7.53 7.70 7.87 8.04 8.22

General government net lending/borrowing (percent of GDP) -6.5 6.0 -4.7 -4.7 -3.6 -3.1 -2.7General government gross debt (percent of GDP) 95.3 62.0 74.0 74.6 74.4 73.2 72.0

Current account balance (percent of GDP) 0.5 19.2 1.4 -0.1 1.7 2.5 2.5

The data are from the IMF's World Economic Outlook database (April 2013), unless otherwise noted.

1. Pacific Exchange Rate Service http://fx.sauder.ubc.ca/data.html

3. World Bank

2. Cyprus Stock Exchange and Tel Aviv Stock Exchange. Percent change is measured from the

previous year.

http://www.tase.co.il/Eng/MarketData/DailyRevie

w/Pages/DailyReview.aspx

http:data.worldbank.org/indicator/BX.KLT.DINV.C

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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).]


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Table 2. Illustrative Examples of Sovereign Funds Used to Manage Commodity Wealth

Basic Facts Mandate Investments/Projects

Botswana

Pula Fund

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13/33


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://.../.?= 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.

Table 2 cont. Illustrative Examples of Sovereign Funds Used to Manage Commodity Wealth
http://www.qia.qa/http://www.finance.gov.tt/legislation.php?mid=20http://www.finance.gov.tt/legislation.php?mid=20http://www.qia.qa/


14/33


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15/33


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C .

Figure 1. Prospects for Israeli Gas Exports

Source: Milken Institute (2011, figure 2, p. 6).
http://www.iea.org/stats/balancetable.asp?COUNTRY_CODE=CYhttp://www.iea.org/stats/balancetable.asp?COUNTRY_CODE=CYhttp://www.iea.org/stats/balancetable.asp?COUNTRY_CODE=CYhttp://www.iea.org/stats/balancetable.asp?COUNTRY_CODE=CY


16/33


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3The Downside of Commodity Wealth


17/33


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

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


18/33


. (S Bx A C EU .56

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19/33


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 LaikiBank), 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 estateand 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


20/33


(k Ak P

F ), - k j

(k j D I

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64 I, D x , . R D , E. I x x, , k ( ). I , , H (9) x D .

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.
http://www.swfinstitute.org/%20http://www.al-monitor.com/pulse/originals/2013/01/turkey-cyrpus-israel-natural-gas.htmlhttp://www.al-monitor.com/pulse/originals/2013/01/turkey-cyrpus-israel-natural-gas.htmlhttp://www.al-monitor.com/pulse/originals/2013/01/turkey-cyrpus-israel-natural-gas.htmlhttp://www.al-monitor.com/pulse/originals/2013/01/turkey-cyrpus-israel-natural-gas.htmlhttp://www.swfinstitute.org/%20


21/33


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 Europeand 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 l ines to European markets. The

United States has private companies (and citizens) leading in exploration and development of the gas (mostnotably 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 withFrench, 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


22/33


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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.
http://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-02-13?fane=tabell&sort=nummer&tabell=96250http://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-02-13?fane=tabell&sort=nummer&tabell=96250http://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-02-13?fane=tabell&sort=nummer&tabell=96250http://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-02-13?fane=tabell&sort=nummer&tabell=96250http://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-02-13?fane=tabell&sort=nummer&tabell=96250http://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/statistikker/nr/aar/2013-02-13?fane=tabell&sort=nummer&tabell=96250


23/33


k. I 7- -A.69

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24/33


I x , I

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global scale

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.5 .

GDP . H,

x

(I) (

) x x (C). E

,

75 Mk - , . C- ( ) j . B , q . I x , j- x -.

Table 3. Comparative Size of Israeli and Cypriot Natural Gas Finds

Proved reserves

(end-2011)

Current

production

Current

consumption

Total possible

reserves

(proved +

speculative)

Production

expected by

2020

Consumption

expected by

2020

Potential

exports

by 2020

Israel 13 tcf -15 tcf 2.6 bcm 3.3 bcm 80 tcf 17.5 bcm 12.5 bcm 5 bcm

Cyprus 0 tcf 0 bcm 0 bcm 40 tcf 9 bcm 0.9 bcm 8 bcm

European Union 64 tcf 155 bcm 448 bcm

Middle East 513 tcf 527 bcm 403 bcm

Global total 7361 tcf 3276 bcm 3223 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 2020are from Oxford Institute for Energy Studies (2012).


25/33


x.76

I, x, x ( -)

4 GDP. C

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Increased Risk of Macroeconomic Volatility

M

,

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78 IMF (). I, , z I A , I , Uz L, q The Financial Times: W k : , . T Bk, F DI N G, Financial Times, A , .

79 S Fk (). A k : -, , - ,- , . S - - ,

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26/33


k. F x,

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8 A D D, z . I , - x x 75 x ( A,Iq, M). I , k , . F , (IMF , . 7).T 97, x ( - q ) . L . I , , - -.

Figure 3. World Prices for Natural Gas

Source: British Petroleum (2013).


27/33


q k

(Mx x).

C

, ,

j (S

A x). C

x

x - ,

-

. F, q

(

). T IMF (, . ): W

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. H,

z

IMF,

OECD, EU, U S, z

. W-

q

- ,

- () ,

j,

.


28/33


W k .T

,

. T

N N B

B, C C.8 Y,

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.

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E M. T

q

z.

4Conclusion


29/33


A, D, J R, , WhyNations Fail: The Origins of Prosperity, Power,

and Poverty, N Yk: C B/R

H.

Ax, M, R C, 9, T

E C O, Review of Economics and

Statistics 9(): 586-98.

A, R, A G, , P

E R A S, P

A Bk C

D E, M .

Bk I, ,Annual Report for 2011,

J: Bk I.

B P, , S

R W E , L: B

P, ./.

C, F, A T, ,

R W, P R,

P S, NBER Wk P 76

(N).

C, P, Ak H, 4, G G C W, Oxford Economic Papers

56(4): 56-95.

C, P, 7, The Bottom Billion. C:

Ox U P.

D, Hk, L E-K, B

F, , E M G: W

K G-C, Wk P NG7,

Ox I E S (D).

E C, , N: A

P D S C,

DSA-9 (A), ...

.k////4/DSA-9-

A..

E, S, I N G R:E S S, Strategic

Assessment(): 7-.

Fk, J, , T N R

C: A S, HKS F Wk P

(F).

G I, 8, I: S-

A, P A

OECD, I S

A M J (D

8).

H, S, , E D

E M: S

C F T? T C

I, P B, W: G

M F U S.

H, H, 9, T E

Ex R, J P

E 9(): 7-75.

IHS G I I., , A N

E F: T U O G

R U.S. E, V

S E C, W: IHS

G I I.

I E A, , Key World

Energy Statistics, P: I E

A.

I M F, 9, C-R

M F S S

B S S R, W:

I M F.

I M F, , C:

A IV C S R,

W: I M F.

5References
http://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/bp.com/statisticalreviewhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdfhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdfhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdfhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdfhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdfhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdfhttp://c/Users/cchumbler/Documents/Publications/Policy%20Papers/Med/Energy%20papers/Engel_NewHydrocarbonWealth_Aug13/bp.com/statisticalreview


30/33


I M F, , I: A IV C S R,

W: I M F.

I M F, ,

M P Fk

R-R D C A

Fk A S ,

W: I M F.

I M F, V , World

Economic Outlook. W: I

M F.

L, M, , E R

E M: S C

F T, P B, W:

G M F U S.

Mk, J, , R R

E M: T V

W, P B, W: G

M F U S.

M, M G., Bj R. C, ,

T : S F Ix Mx

, C S P, ://.

.//..

M, K, 99, A

P, C A,

E G, H I Wk

P E-9- (J).

ML, S R., W C. B,

, Q E E

M: G I, R

P, QkLk S. E

C, ECJ S D, SF (J ).

Mk I, , S I

S I F: F

N F, F I L

R (D).

M, V, , C: RP E, C R S

R R46 (F ).

M, E, 4, Wk E,

S, P: E

P-L P F, A

E R 94(): 656-9.

O, M, , R E

M, P B, W:

G M F U S.

O, T, , C: A F EH? P B, W: G

M F U S.

R, M, , I O N

G D E E

E Ok, C R S

R R468 (J ).

S--M, X, A S,

, A N R C:

A I N, NBER Wk

P 984, (J).

S, J, A W, , T

C N R, E E

R 45(): 87-8.

S A M A, ,Annual

Report for 2011, R: S A M

A.

S, B, , E R

Mk E M R,

P B, W: G M F

U S.

S, B, T Z, ., ,

Beyond the Resource Curse, P:

U P P.
http://www.systemicpeace.org/inscr/inscr.htmhttp://www.systemicpeace.org/inscr/inscr.htmhttp://www.systemicpeace.org/inscr/inscr.htmhttp://www.systemicpeace.org/inscr/inscr.htm


31/33


S, J L., , M I Tx P Ex

D, IMF Wk P WP//78,

W: I M F.

S I, , C

C Ex F

P R O G R

I (Sk R), T A: M

F, ://..../

FI/P//P/.x?.

T, S, 7, F S

H: D I, W BkWk P N. , W: W

Bk.

T, E M., 8, A B

S W F B P, P

B, W: P I

I E.

VD, S D., , S D:

Ex I, R C,

T G A,

T A P S, W:G M F.

V, D, Sq Rz, 5, T

T: T E B P

S F P, IMF Wk P

WP/5/97, W: I M

F.

W, M, , I-L O

O & G D R I

M L, Insights,

A S I L,

5, .

W, Ek, P J L, 6,

A A S M M

W, Perspectives on Politics 4(): 5-5.

References for Table 2

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