Appendix 1. Oil and Economic Development in Indonesia14
Indonesia’s oil industry is one of the world’s oldest. Indonesia ranks fifteenth among world oil producers, with about 2.4 percent of world oil production. The country has a mixed economy in which the government, in addition to the regulation and supervision of the economy, is engaged directly in economic activities through state-owned enterprises operating in various sectors.
Between 1960 and 1966, the country suffered from hyperinflation, and GDP grew at an average rate of only 1.8 percent per year. In 1966, the government started the implementation of an economic policy program (“New Order”) designed by a team of presidential economic advisors. Stabilization was achieved soon thereafter in 1971 with 4 percent inflation and 6 percent GDP growth. In 1973, oil exports accounted for only around a third of total exports because of the country’s richness in natural resources (rubber, coffee, timber). International reserves grew rapidly after the first oil boom in 1972–78, and the windfall oil revenues of 1973–78 allowed the authorities to increase spending on development. Around half of mining value added was used to finance public investment, one third was used to reduce the trade and nonfactor services deficit, and the rest was spent on consumption.
The rapid growth of international reserves, together with high domestic spending, contributed to a sharp real exchange rate appreciation, and many non-oil sectors, such as rubber and manufacturing, started to experience difficulties. The government regarded increasing dependence on oil revenues as risky in light of uncertain prospects for oil prices and realized that future growth had to come from labor-intensive exported goods. In 1978, the government decided that devaluation of the domestic currency would help restructure the economy, to make it less reliant on oil and to move toward manufactures and non-oil exports. The devaluation of the currency by 50 percent was followed by inflation of 22 percent in 1979. The devaluation was generally regarded as successful, as manufactured exports doubled during 1978–79 and the non-oil trade balance improved. The reason for devaluation was not balance of payments troubles—reserves coverage was at four months of imports. The aim was to help the relatively labor-intensive non-oil traded sectors.
Azerbaijan: Constant Real Non-Oil Deficit Paths Under Various Oil Prices and Fluctuation Bands
(In percent of non-oil GDP)
Azerbaijan: Constant Real Non-Oil Deficit Paths Under Various Oil Prices and Fluctuation Bands
(In percent of non-oil GDP)
| US$18 Oil Price | US$19 Oil Price | US$20 Oil Price | US$21 Oil Price | |||||
|---|---|---|---|---|---|---|---|---|
| 2-Percent Band | 4-Percent Band | 2-Percent Band | 4-Percent Band | 2-Percent Band | 4-Percent Band | 2-Percent Band | 4-Percent Band | |
| 2004 | 17.4% | 18.4% | 17.4% | 18.4% | 17.4% | 18.4% | 17.4% | 18.4% |
| 2005 | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% |
| 2006 | 18.2% | 17.3% | 19.0% | 18.1% | 19.4% | 18.9% | 19.4% | 19.9% |
| 2007 | 19.2% | 19.3% | 20.0% | 20.1% | 20.4% | 20.9% | 20.4% | 21.9% |
| 2008 | 20.2% | 21.3% | 21.0% | 22.1% | 21.4% | 22.9% | 21.4% | 23.9% |
| 2009 | 20.2% | 21.0% | 22.0% | 23.2% | 21.4% | 24.9% | 22.4% | 25.9% |
Azerbaijan: Constant Real Non-Oil Deficit Paths Under Various Oil Prices and Fluctuation Bands
(In percent of non-oil GDP)
| US$18 Oil Price | US$19 Oil Price | US$20 Oil Price | US$21 Oil Price | |||||
|---|---|---|---|---|---|---|---|---|
| 2-Percent Band | 4-Percent Band | 2-Percent Band | 4-Percent Band | 2-Percent Band | 4-Percent Band | 2-Percent Band | 4-Percent Band | |
| 2004 | 17.4% | 18.4% | 17.4% | 18.4% | 17.4% | 18.4% | 17.4% | 18.4% |
| 2005 | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% | 18.4% |
| 2006 | 18.2% | 17.3% | 19.0% | 18.1% | 19.4% | 18.9% | 19.4% | 19.9% |
| 2007 | 19.2% | 19.3% | 20.0% | 20.1% | 20.4% | 20.9% | 20.4% | 21.9% |
| 2008 | 20.2% | 21.3% | 21.0% | 22.1% | 21.4% | 22.9% | 21.4% | 23.9% |
| 2009 | 20.2% | 21.0% | 22.0% | 23.2% | 21.4% | 24.9% | 22.4% | 25.9% |
The second oil boom raised Indonesia’s mining sector revenues again. The government increased spending once more, but the absorption of windfall oil revenues was much below the level of expected oil income, and foreign aid and part of revenues were saved. This differed from the approach during the first oil boom. Oil prices started to fall in 1981, and due to a rapidly growing trade imbalance, the current account turned into a large deficit. Capital inflows were insufficient to finance the high trade deficit and foreign exchange reserves started to fall. The authorities decided to devalue the currency again to stop private capital outflows in the short term and to improve the non-oil trade balance. In 1983, the domestic currency was devalued by around 50 percent, and for the second time in five years, relative prices of traded goods and nontraded goods changed sharply. Fiscal policy was tightened and was supportive of the devaluation. In mid-1983 more than $10 billion in capital-intensive public projects, amounting to almost 12 percent of GDP, were canceled or postponed. This sharp reduction in government spending allowed the government to implement an expenditure-switching policy from industry to infrastructure and social sectors. In 1984, the authorities introduced a simplified tax code with a rudimentary form of a value-added tax, which is easier to administer and monitor for the non-oil sector. Immediately following the devaluation, the authorities liberalized the financial system to create incentives for lending, and increase competition and greater mobilization of domestic savings. This devaluation proved successful too—during 1983–85 non-oil and manufactured exports increased, non-oil imports fell, foreign exchange reserves strengthened, and the overall government budget returned to balance.
Indonesia’s experience with oil windfall management stands out as relatively successful compared to other oil-exporting countries. Three key factors contributed to this success: oil was not the only source of export earnings and exports of other commodities were generating considerable income; the authorities did not rely on oil sector revenues alone and tried to diversify the economy—the country was a strong non-oil exporter during the periods of the oil booms; and the Indonesian government adapted macroeconomic policies to the changing external environment.
Appendix 2. Oil and Economic Development in Nigeria15
Nigeria has an abundance of hydrocarbon resources. It is the thirteenth largest oil producer in the world, the third largest oil producer in Africa, and the most prolific oil producer in sub-Saharan Africa. Prior to 1960, agriculture was the dominant sector in the Nigerian economy and the country was a major producer of cocoa and palm products. Oil production in Nigeria started in 1958 and increased over time to reach the export of 2 million barrels of oil per day by 1972.
With the first oil boom of 1972–78, Nigeria’s terms of trade increased three times; international reserves increased almost tenfold between 1973 and 1974. Oil revenues accounted for almost 85 percent of the country’s total exports and around 60 percent of federal government revenues in 1973. At this stage, the government faced the question of how to use such vast unplanned revenues. The fiscal authorities ignored the risk of future reversal of the current favorable conditions and chose to spend these revenues by undertaking massive domestic investment projects. Public capital spending accelerated rapidly, absorbing more than the total increase in 1970–76 oil revenues, resulting in a large budget deficit, which was financed with the use of reserves accumulated in 1973–74 and monetary expansion. These policies resulted in inflation—prices increased by 22 percent and, with a mainly fixed exchange rate, the real exchange rate appreciated strongly.
The government was not successful in diversifying the economy, particularly as specific policies further negatively affected the once strong agriculture sector. Production of major agricultural export crops shrunk by half from 1964 to 1978, partly because the government created commodity boards to stabilize crop prices and taxed farmers by paying them substantially less than world prices. Nigeria became a net importer of agricultural products in 1975. The government responded to the difficult economic situation by expenditure cuts in 1978, but did not address the issue of the overvalued real exchange rate.
The second oil boom saved the government from undertaking further painful adjustments. Nigeria’s terms of trade increased by 25 percent and 40 percent in 1979 and 1980, respectively, and the international reserves position strengthened significantly. However, the Nigerian government did not take into account the lessons of the past. In light of the increasing oil revenues, fiscal constraints were relaxed and expenditures rose by 65 percent in 1980, to resume the suspended construction projects and to undertake new ones. However, the second oil boom did not last long; oil export receipts halved between 1980 and 1982, and this expansionary fiscal policy resulted once again in large fiscal deficits by 1982. Foreign exchange reserves fell sharply and the real effective exchange rate appreciated by 125 percent compared to its 1976 level. Inflation reached 60 percent during 1980–83. The government introduced restrictive quantitative controls and import quotas on goods and services that hurt the manufacturing sector. In addition, payments arrears on foreign debt were accumulated, adversely affecting Nigeria’s credibility in international capital markets. At this point, the government approached creditors to prolong existing loans and to get new financing. By the end of 1983, the Nigerian economy was in trouble again.
Nigeria failed to use its oil wealth for the benefit of its people during the boom years. Experience in Nigeria shows that the high level of expenditures during oil boom periods was difficult to reverse after price falls, thus resulting in widened fiscal deficits. Fiscal volatility adversely affected the economy through appreciating real exchange rates. The authorities spent the oil income mainly for domestic investment and consumption. Any savings of oil revenues was short-lived; revenues were saved only immediately following the surge in windfall income and were then subsequently spent quickly. The large public investment projects did not succeed because of constraints in the implementation process. Investments in the industry sector failed to generate the much-needed non-oil exports and the authorities did not manage to diversify the economy during the windfall decade. The decision to adjust to shrinking oil revenues through trade restrictions rather than through devaluation had a ruinous impact on the economy. In addition, heavy and long dependence on oil revenues resulted in a narrowing of the non-oil tax base and inefficient tax administration, which played a negative role in the country’s macroeconomic performance throughout the 1980s and 1990s, as oil prices fluctuated.
Appendix 3. Oil and Economic Development in Mexico16
Mexico is the world’s fifth largest oil producer and its tenth largest oil exporter. Mexico began to export oil in 1911, and its oil output expanded at an average annual rate of 6 percent between 1938 and 1971. Extensive oil discoveries in the 1970s increased Mexico’s domestic output and export revenues.
Although the Mexican economy maintained a rapid growth rate during most of the 1970s, it was progressively undermined by a combination of fiscal mismanagement and an overvalued real exchange rate, resulting in the sharp deterioration of the investment climate. In the mid-1970s, the government planned large public sector investment programs in industry, agriculture, and transportation. This expansionary fiscal policy, together with expansionary monetary policy, the postponement of crucial tax reforms, and a fixed exchange rate contributed to large balance of payments disequilibrium and intensified capital outflows. In 1976, the government devalued the peso by 45 percent. In the same year, Mexico agreed with the IMF on a stabilization program aimed at lowering inflation, building up reserves, and achieving macroeconomic stability. Oil discoveries in the south of Mexico in 1978 and a sharp increase in the world price of oil in 1979 greatly affected the country’s economic outlook. Private capital started to flow into the country, financing from the IMF was no longer needed, and the reform program was abandoned.
The improved terms of trade in 1979–80 brought windfall oil revenues and allowed the government to continue implementing an expansionary fiscal policy. Moreover, the government borrowed abroad against future oil earnings to further boost expenditures. Public investment increased and reached 30 percent of GDP in 1981. This growth was associated with a substantial increase in imported capital and intermediate goods. However, oil revenues were not sufficient to finance the large increase in imports and external imbalances were financed by foreign borrowing. The budget deficit rose, the current account deficit widened, and the real exchange rate was allowed to appreciate. Oil became the economy’s most dynamic growth sector, and the country’s dependence on income from the export of oil increased. The share of oil in total exports rose from 15 percent in 1976 to 78 percent in 1983. Government tax revenues were now heavily dependent on international oil price movements. When oil prices fell in 1981, the government decided not to cut prices for Mexican oil for several months and the volume of oil exports fell sharply. In 1982, the budget deficit reached 15 percent of GDP. In the same year, commercial banks refused to roll over government loans. In August 1982, Mexico suspended its international debt payments after falling oil prices made it impossible for the government to repay foreign loans. Around $30 billion of capital fled the country. The debt crisis led to currency devaluations and hyperinflation.
Mexico’s experience with oil revenue management is a good example of how the existence of abundant natural resources can create a false sense of security. Even windfall resources from oil during the skyrocketing oil price period could not sustain overly expansive public spending, and the country faced the painful need for adjustment later on. In fact, the discovery and exploitation of oil resources gave a false sense of security to the authorities and made them postpone the needed correction of the real exchange rate, balancing of the budget, and implementation of various structural reforms.
Appendix 4. Calculation of the Sustainable Non-Oil Deficit
The paper discusses two long-term strategies for the use of oil assets. The first is based on a fixed expenditure rule, which—together with a permanent financing condition constraint—pins down the time path for the sustainable non-oil deficit. It assumes that the government will ensure that a predetermined expenditure path can be permanently financed out of an accumulated financial asset stock. The second strategy aims to preserve oil wealth indefinitely and thus creates a permanent income and expenditure stream. This strategy requires adherence to a long-term savings path. The level of available resources for consumption, that is, the sustainable non-oil deficit path, derives as a residual.
The presented scenarios examine the long-term implications of these two strategies. The calculations explore the direct effect of changes in crucial parameters such as the oil price of the real interest rate, but do not model their interactions with other variables such as the growth or inflation rate. The following two sections discuss the computation of the sustainable deficit under the two strategies.
A. Constant Real Expenditure or Constant Real Per Capita Expenditures
The government guarantees financing of constant expenditures in real terms or in real per capita terms (alternative scenario):
Et = Et–1(1 + p) = E0(1 + p)t,
where p denotes either the long-term inflation rate or the population cum inflation growth rate. E0 denotes the initial level of expenditures. The sustainable non-oil deficit is defined as the corresponding financing need for this consumption path. In order to secure this financing stream a sufficiently large stock of financial assets FW needs to be saved by period T when the revenue stream ceases (RT = 0), so that expenditure financing can continue. The permanently fundable level of real expenditure from FWT is the real interest earnings on the assets stock:
Et = FWt i for all t ≥ T.
The formation of the financial wealth FWt follows the dynamic process
FWt = FWt–1 (1 + i + p) + (Rt – E0 pt) α (1 + i + p).
where the fraction a denotes interest earned on within-year flows and was set to α = ½, assuming a constant rate of within-period net flows. At a given revenue stream and interest rate, the level of financial assets is determined by the initial level of expenditures. Thus the maximum E0 that can be chosen has to be sufficiently low to generate a financial wealth stock by period T, which allows permanent financing of the expenditure path, or
E0 (1 + p)T = FTr = ET.
In order to solve for the maximum sustainable deficit path, the following iterative process can therefore be applied:
If E0 (1 +p)T < FT (E0) rT, increase E0 and go back to step 2.
If E0 (1 +p)T > FT (E0)rT, decrease E0 and go back to step 2.
B. Constant Real Wealth and Constant Per Capita Wealth17
This strategy aims to preserve oil wealth in order to generate a permanent income flow. In particular it requires that total oil wealth TW (or per capita wealth) remains constant for all periods and thus enables a permanent income stream. Total oil wealth TW is defined as the value of physical oil assets OWt in the ground plus the value of financial assets FWt created from savings out of oil revenue:
TW = OWt + FWt.
The stock of oil wealth in the ground is given as the present discounted value of future revenue streams and declines over time as reserves in the ground are depleted:
Financial wealth in period t is determined by interest earnings and additions from new savings Si.
FWt = (FWt–1 + St)(1 + i).
As oil wealth gradually declines over time, financial wealth and thus savings have to adjust to ensure that total wealth (per capita wealth) remains constant. Therefore the condition TWt = TWt–1 implies that
OWt–1 – OWt = FWt – FWt–1.
From above it is known that
OWt – OWt–1 = i OWt–1 – Rt
and
FWt – FWt–1 = i FWt–1 + St (1 + i),
so that it is now possible to solve for the required savings path Si.
St = 1/(1 + i){Rt – i (OWt–1 + FWt–1)}.
The path of permissible expenditures is then given by Et = Rt – St,, which represents the sustainable expenditure ceiling.
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Sources: Dornbusch and Helmers (1987); and Alan Gelb and Associates (1988).
Sources: Dornbusch (1993); Alan Gelb and Associates (1988); Mered (1997); and IMF (2002).
Source: Dornbusch and Helmers (1987).
For a detailed derivation see, for instance, Davoodi (2002).
Source: Azerbaijan International Operating Company (AIOC). Also see http://www.dnv.com/publications/oilgas_news/by_subject/General/ShahDeniz.asp.
Personal income tax accrues according to the tax code while profit tax obligations are defined in the PSA.
Proven, probable, and possible reserves are defined as oil deposits that are considered 90, 50, and 10 percent likely, respectively.
Gas-related revenues over the period 2000–24 are projected to commence in 2006 with the first gas exports from the Shah Deniz field, but are negligible in comparison to the revenues accruing to the government from the ACG PSA.
That is, the need for a critical mass (e.g., of human and physical capital) before economic “takeoff can occur (see Azariadis and Drazen, 1990).
Theoretical models have shown how income inequality can exert a negative effect on investment and on subsequent economic growth because it provides strong incentives for redistribution policies, which hurt growth-promoting investment (e.g., Persson and Tabellini, 1994). Empirical evidence has confirmed such a negative relationship, at least for democratic regimes.
For instance, pension liabilities, whose future cost is subject to a large degree of uncertainty (political considerations could significantly affect the payout to future pensioners).
Simplicity and transparency are desirable features for a rule, making it easier for a government to explain to the public and easier for the public to monitor adherence to the rule, thereby enhancing its credibility.
For instance, from the probable oil production scenario, a constant total oil wealth rule indicates that, for 2004, the non-oil deficit can reach 29 percent of GDP. After that, each year until 2008 it declines by around 3 percent of GDP, to reach a maximum of 18 percent of GDP.
These approaches are judged to be preferable to the constant wealth strategies, as they would be politically easier to explain and defend.
See Table 2 in Appendix 1 for the first five years of data for the non-oil deficit path under various oil prices and fluctuation bands.
Azerbaijan has little nonconcessional government debt, and therefore use of oil revenues for early repayment of nonconcessional debts is not a viable option.