Seven Principles for Managing Resource Wealth

This paper studies how capital-scarce countries should manage volatile resource income.  Existing literature recommends that capital-scarce countries invest domestically, but that volatile resource income should be saved in a foreign sovereign wealth fund.  I reconcile these by combining a stochastic model of precautionary savings with a deterministic model of a capital-scarce resource exporter.  I show that capital-scarce countries should still establish a Volatility Fund, but it should be relaively smaller than in capital-abundant countries.  The fund should be built before anticipated windfalls, partially invested domestically, and used as a source of income rather than a buffer against temporary shocks.  To do so I develop a parsimonious framework that nests a variety of existing results as special cases, which are presented in seven principles.  The first three apply to capital-abundant countries: i) Smooth consumption using a Future Generations Fund; (ii) Build a Volatility Fund quickly, then leave it alone;  iii) Invest to stabilise the real exchange rate. The remaining four apply to capital-scare countries; iv) Finance consumption and investment with oil; v) Use a temporary Parking Fund to improve absorption, vi) Invest part of the Volatility Fund domestically; and vii) Support private investment.