How to Safeguard Afghanistan’s Mineral Riches

The resignation over the weekend of Afghanistan’s deputy mining minister passed with hardly a murmur in Washington, but it appears to bode ill for the future management of the country’s mineral wealth.

Indeed, according to a June 14 article by James Risen of the New York Times, Afghanistan is rich. The United States pegs the value of the country’s mineral deposits at $1 trillion, which dwarfs its $12 billion annual GDP. As Risen says, this discovery could transform Afghanistan into "one of the most important mining centers in the world." Or, as the Pentagon put it, Afghanistan could become the "Saudi Arabia of lithium." Leaving aside the fact that a lot of people have known about these mining deposits for quite a while, I’d have to agree with Gen. David Petraeus’s assessment that this mineral find offers "stunning potential" for Afghanistan.

However, as Michael L. Ross writes, we need to temper our exuberance, as the discovery of natural resources in a developing country is not always the good news it appears to be. In fact, resource-rich developing countries face the significant challenge of using their natural wealth to improve the living standards of average citizens, rather than wasting it through weak institutions and corruption, a phenomenon often referred to as the "resource curse." Civil wars and political turmoil tend to exacerbate the problem.

All this is fairly well known. Yet the minerals, they tell us, are there — and Afghanistan is racing ahead to develop them. But how can a war-torn country beset with corruption manage to succeed where many more stable countries with far stronger institutions have failed?

One increasingly popular option for dealing with the resource curse is the commodity-based sovereign wealth fund (SWF). Countries as diverse as Angola, Azerbaijan, and Venezuela are turning to these special-purpose financial vehicles to help ensure proper management of resource revenues. The idea is that, by sequestering some or all of their resource revenues in an SWF, countries can better smooth resource price volatility, make long-term fiscal policy, manage the currency appreciation associated with mineral exports, facilitate intergenerational savings, and, perhaps most importantly, minimize corruption and tame the political temptation to misuse the newfound wealth. In effect, a properly designed commodity fund offers a powerful "commitment mechanism" that can prevent a pool of revenues from turning into slush funds for the political elite.

Afghanistan desperately needs an SWF of its own, but the simple act of creating an SWF is not enough to overcome the resource curse. The new fund must also be accompanied by the appropriate design and governance principles and practices. But how to do it?

Two SWF success stories are most relevant to this case. First there’s Papua New Guinea, which has an enormous liquefied natural gas project in the works. The country is already well into its own SWF due diligence despite the fact that its gas revenues aren’t expected to come online until 2014. In fact, the country’s Treasury Department recently released a "discussion paper" that outlines various factors that the government will need to take into consideration in setting up its new fund, from the importance of professional management, transparency, and accountability to some key structural and design characteristics. For Afghanistan, the lesson here is that planning can (and should) begin long before the resource revenues arrive.

Another model is São Tomé and Príncipe, a classic example of the challenges that a small, poor country can face when trying to manage oil wealth. As the Harvard Kennedy School’s Jeffrey A. Frankel points out, the country in 2004 established something called the National Oil Account to receive all national hydrocarbon revenues. The 2004 law also set out to ensure that the new SWF was well designed and governed to ensure proper stewardship of the country’s finite natural resources. And despite some political instability — there was a failed coup attempt in 2003 inspired by the promise of looming oil wealth — this tiny island nation off the west coast of Africa has managed to set up an SWF with all of the appropriate features to prevent the resource curse, from defining strict formulas for calculating the "annual funding amount" that the government receives from the SWF to laying down the rules governing the management and investment of the assets.

Afghanistan could also stand to learn from botched efforts to stand up SWFs. Some of these failures are highlighted in a recent paper by Martin Gould of Australia’s Treasury. Gould argues that the assets of the fund should not (in most cases) be held onshore because this will do little to prevent Dutch Disease — the phenomenon whereby resource wealth leads to currency appreciation and manufacturing declines. He also cautions against setting up an SWF before retiring the country’s sovereign debt, especially if the country has a high debt burden and high borrowing costs (it would make more sense to pay down the debt first). Gould further notes the importance of having a clear set of objectives for the fund, with strict withdrawal guidelines and borrowing rules. Finally, he illustrated the pitfalls of poor governance and a lack of professional management.

International organizations have already done much of the legwork associated with setting up a well-governed SWF. A team of experts at the International Monetary Fund has laid out a handy SWF road map, many of the design principles of which would apply to Afghanistan. Further, an entity known as the International Working Group of SWFs in 2008 developed what are called the Santiago Principles, also known as the Generally Accepted Principles and Practices, which lay out some of the key design considerations that should underpin any new SWF, such as the legal framework, the fund’s coordination with macroeconomic policies, its institutional framework, its governance structure, and, lastly, the setup of its investment and risk-management practices.

Altogether, these experiences, cases, and analyses offer sufficient guidelines for an initial sketch of the design and governance principles that should underpin any new Afghan SWF. The following features — though not a comprehensive list — are of the utmost importance:

1. Define the job: The SWF should have a clearly defined mandate and set of objectives, such as facilitating intergenerational savings, smoothing commodity revenues for fiscal stabilization, managing currency appreciation, or diversifying national revenues away from resources — or perhaps all of the above. Most importantly, the objectives should be clearly articulated and drive the day-to-day operations of the fund.

2. Stay apolitical: The SWF’s operational management must be totally independent from politicians. More to the point, the SWF should be devoid of political influence. While this might seem difficult to achieve, there are plenty of legal and governance mechanisms at the disposal of enlightened policymakers looking to minimize their own influence. These include strict legal separation of the SWF’s assets from those of the government, a segregated governance model whereby the fund is not under the direct control of the government, a rigid code of conduct forbidding political contact with employees, and public disclosure and external oversight by recognized independent experts.

The Canada Pension Plan (CPP) offers a helpful example. While it’s not a commodity fund, it is a national-level financial institution that was set up with the explicit mission of keeping its assets totally separate from political interests. As such, it offers important lessons for Afghanistan. First, the management of the assets in the CPP is vested to an independent board. Second, the political requirements for changing the board’s mandate are even greater than for changing the Canadian constitution; there is thus almost no possibility politicians would be tempted to use the fund’s assets for purposes other than funding the country’s pensions. Third, the 1997 legislation that set up the board explicitly rejected all political or social investing objectives and defined the economic welfare of plan participants as its singular focus. Finally, the board, the CEO, the senior management and all professional staff are bound by a code of conduct that requires them to notify others if they are subjected to political influence, witness such influence, or even have suspicions about influence. This "honor code" applies to all components of the institution’s operations, from sourcing investments and hiring staff to managing the fund’s facilities.

3. Hands off the cookie jar: The government should receive a single annual transfer from the SWF, and that’s it. This annual transfer can be included in the formal budgeting process, but the fund should not be susceptible to ad hoc or discretionary spending demands. More to the point, prudent, strict, and rigorously defined formulas should determine the amount of money the Afghan government gets each year — not the whims of President Hamid Karzai or whoever replaces him in Kabul. In addition, the fund should never be used as collateral for international borrowing; otherwise the ability to borrow unconstrained money backed by the highly constrained, rule-bound SWF would render the rules and governance practices of the SWF irrelevant.

4. Keep the money outside Afghanistan: The SWF’s assets should be held offshore to mitigate Dutch Disease and increase the number of investment options (doing so will also help prevent politicians from misusing the fund’s assets). The only time the money would be brought "onshore" would be for the annual transfer of funds from the SWF to the government.

5. Put the technocrats in charge: The SWF must be managed by a committee of experts who, bound by the "prudent person rule," must act as good stewards. The SWF’s investment decisions should aim to maximize risk-adjusted financial returns, based exclusively on economic and financial criteria. Extrafinancial or political investing can sometimes be justified on certain grounds — as is the case for the Norwegian SWF’s investment policies — but these types of policies are inappropriate in this case, as they would open up the fund to too much subjectivity in the selection of investment projects.

6. Be accountable: The SWF should be completely transparent and accountable. Its annual and quarterly reports should be made public, as should certain parts of the governing committee’s minutes (on a delayed basis). Most importantly, the fund should be subjected to annual internal and external audits.

As Afghans contemplate their mineral bounty, they need to keep these rules in mind. Sadly, the world is littered with examples of countries where natural riches have lined pockets and destroyed lives rather than creating lasting prosperity. Afghanistan has enormous problems already; follow this advice, and the resource curse doesn’t have to be one of them.