Following the rises in oil prices late in 1973 and early in 1974, it was widely predicted that the major oil exporting countries would have accumulated massive international reserves by the end of 1980. (The 12 major oil exporting countries concerned in this analysis are Algeria, Indonesia, Iran, Iraq, Kuwait, Nigeria, Oman, Qatar, Saudi Arabia, the Socialist People’s Libyan Arab Jamahiriya, the United Arab Emirates, and Venezuela.) Estimates of the increase between 1973 and 1980 ranged from $180 billion to more than $600 billion, at 1974 prices. But in fact, their balance of payments (BOP) surpluses on current account and their reserve accumulations between the end of 1973 and the end of 1978 were substantially lower than had been expected. The fact that world economic growth has been slower than predicted is one reason for this shortfall. But almost certainly the major source of error was the underestimation of the absorptive capacity of the oil exporting nations and, in particular, the speed with which highly ambitious development strategies and spending plans could be formulated and implemented.
Largely as a result of these factors, the BOP surplus on current account of the major oil exporting countries declined from $68 billion in 1974 to $32 billion in 1977 and is estimated to have declined to $6 billion in 1978. Further, this surplus is now concentrated in a group of six countries with relatively low short-run absorptive capacity—Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Iraq, and the Socialist People’s Libyan Arab Jamahiriya. In contrast, the current account position of the other six oil exporting countries as a group—that is, Algeria, Indonesia, Iran, Nigeria, Oman, and Venezuela—was in deficit by 1977. This article considers the role of fiscal policy in this unprecedented absorption of resources—between 1972 and 1978 when the combined government expenditures of these 12 countries rose more than eightfold.
Revenues & expenditures, 1972–78
The countries considered here are a heterogeneous group, with differing political outlooks, cultural traditions, and economic capacities. But there were notable similarities in broad macroeconomic developments in all 12 countries during the period 1972–78. Following the sharp rise in oil prices late in 1973 and early in 1974, the countries adopted highly expansionary fiscal and monetary policies aimed at the rapid development of the non-oil sector and at the immediate improvement of the welfare of their populations. Gradually, in many cases as early as late 1975 and 1976, however, these oil exporting countries found it necessary to shift toward more restraint on domestic spending to combat sharply accelerating inflationary pressures. In addition, emerging current account and overall BOP deficits became a reason for cutting back the rate of expansion in aggregate demand in several of the oil exporting countries. Policies of restraint have tended to be maintained, although a major economic objective of these countries is still the rapid development of the non-oil sectors of their economies.
The value of oil exports from the major oil exporting countries rose from $35 billion in 1973 to $112 billion in 1974 and to over $130 billion in 1978. Government oil revenues, which constitute approximately 80 per cent of total government revenues in these countries, grew even faster than oil exports—from $23 billion in 1973 to $85 billion the following year—and are estimated to have reached $118 billion in 1978. The escalation reflects, inter alia, increases in income tax and royalty rates on oil sales and, in several cases, increased equity participation by governments.
This sudden sharp rise in oil revenue eased or, in some countries, eliminated financial constraints on development. Nevertheless, the authorities were faced with difficult and novel issues and choices regarding the feasible speed of development of their non-oil sectors, the appropriate roles of public and private economic activity, tolerable rates of inflation, and acceptable standards of income distribution. While varying emphases were, of course, observed, all countries aimed for a rapid increase in the rate of growth of the non-oil sector. Unparalleled increases in expenditures were undertaken, aimed at developing infrastructure and diversifying industrial bases. Current expenditures were increased rapidly, mainly in the form of sharply increased wages and salaries, defense spending, subsidies, and transfers to public enterprises.
The rate of growth of government expenditure in these 12 countries has, by any historical standard, been spectacular. Aggregate government expenditures increased by 49 per cent in 1973, by 100 per cent in 1974, and by a further 50 per cent the following year. Thereafter, the rate of growth in spending declined to 28 per cent in 1976 and to 24 per cent in 1977. Budget estimates implied a further deceleration (to 16 per cent) in 1978. The pattern is similar both for countries with high and those with low absorptive capacities, except that for 1973 and 1976 the growth rates were considerably higher in the low-absorption than in the high-absorption countries.
Expressed in relation to gross domestic product (GDP), government expenditure for the 12 countries has increased from about 27 per cent of GDP in 1972–73 to about 45 per cent of GDP in 1977–78. The ratio jumped sharply in 1975 to 40 per cent and has been increasing by about 2 percentage points a year since then. This continuing increase is almost entirely due to increasing expenditure in the low-absorption countries; in the high-absorption countries, the ratio has been relatively constant at approximately 40 per cent since 1975.
It is significant that the budget estimates for 1978 implied that, for the first time since 1972, an overall budget deficit would emerge for the 12 major oil exporters taken as a group (see Chart 1). The magnitude of the projected deficit is $14.5 billion—equivalent to almost 4 per cent of these countries’ combined GDP. The low-absorption countries have been in budgetary surplus positions since 1972 and were projected to remain so in 1978, although their overall budget surplus has dropped sharply.
Chart 1Major oil exporting countries: goverment budget surplus/deficit, 1978-781
Sources: National budget documents and author’s estimates.
Note: Dotted lines indicate budget estimates.
The extraordinary pace of growth of expenditure may be explained mainly by the urgency felt by these countries to expand the non-oil sector and provide immediate improvements in the welfare of their populations. In the initial period following the oil price rise, many of the oil exporting countries seem to have underestimated the inflationary implications of sharply increased government spending. The economic reasoning may have been that foreign financial resources would provide an increasing flow of real resources—which they would, to the extent that oil revenues and the capacity to absorb imports permitted. If inflationary pressures were correctly forecast, it may have been assumed that they could be handled through price controls, subsidies, and tax reductions rather than through limiting government expenditure. It is also possible that a certain amount of inflation was regarded as an inevitable and tolerable price to be paid for rapid development.
Before 1975 a large proportion of the increase in government expenditure was spent on imports, purchased either by the government or by recipients of government wages, salaries, and transfer payments. By early 1975, however, considerable congestion emerged in the ports of several of the major oil exporters. While this congestion was the most obvious and widely publicized bottleneck of these countries, it proved to be only one of many constraints. Domestic transportation and construction were also under considerable strain, and supplies of skilled and unskilled labor became severely strained in the low-absorption countries by 1975. In particularly short supply were the experience and technical expertise required for the very rapid buildup of economic infrastructure and an industrial economy. Improving absorptive capacity involves a substantially more complex capability than solving short-term port and transportation problems that limit imports; properly defined, the concept relates to the long-term problems associated with the creation of self-sustained growth of non-oil sectors.
Between 1972 and 1975, the continuing rapid growth in government spending and the increasingly severe supply bottlenecks resulted in sharp increases in domestic liquidity and an intensification of inflationary pressures. In 1975 domestic liquidity reached a peak growth rate of 45 per cent. Thereafter, the growth rate decreased, dropping to a rate of 33 per cent in 1977 after domestic spending was reduced and supply bottlenecks eased. Consumer price data for the same group of countries show that inflation moved in a similar way to domestic liquidity. The inflation rate accelerated sharply from 4 per cent in 1972 to a peak of 19 per cent in 1975 and thereafter declined gradually to about 10 per cent in 1978. Thus, since 1975 the oil exporting countries have had a significantly better record for reducing inflation than any other major group of countries.
The contribution of fiscal policy to these liquidity and price developments is identifiable in domestic rather than in overall budget balances. The separation of government transactions into foreign and domestic transactions represents an attempt to estimate the direct impact of the budget on domestic rather than on total demand. External government transactions have no immediate impact on domestic liquidity because, by definition, domestic liquidity is held only by the private sector. The receipt of oil revenues by government directly produces a rise in government deposits. Only when the government injects this revenue into the domestic income stream, through its domestic expenditures, is the inflow of foreign exchange translated into domestic liquidity. Utilizing this distinction between the domestic and foreign transactions of the government, it can be said that the main determinants of the money supply are (1) the domestic budget deficit, (2) the BOP deficit of the private sector, and (3) the change in domestic bank credit to the private sector.
One important policy implication is highlighted by using the domestic balance to find the direct effects of the government budget on money creation: the exogenous nature of oil revenues to any one oil exporting country per se does not give rise to the problems of monetary stabilization that would confront, say, a coffee exporting nation where coffee production was in the hands of the private sector. Under existing institutional arrangements in almost all major oil exporting countries, oil revenues are automatically sterilized and do not affect domestic liquidity until the funds are disbursed through the government budget. Hence, the surge in oil revenues in 1974 did not, in itself, generate a rise in domestic liquidity. Similarily, the steadying of the flow of oil revenues in 1977 and 1978 did not, in itself, do anything directly to alleviate situations where excessive private sector liquidity had been allowed to develop, except to the extent that it induced moderation in net government domestic spending.
Tolerably accurate estimates of domestic balances are available for six of the major oil exporting countries—Iran, Iraq, Kuwait, Nigeria, Saudi Arabia, Venezuela. Chart 2 shows the relationship between percentage changes in domestic budget balances and in liquidity increments for these six oil exporting countries since 1973. The close relationship between the two sets of percentage changes supports the hypothesis that domestic budget balances are in fact the primary determinants of movements in domestic liquidity.
Improvement in the data available on movements in total international reserves of the major oil exporting countries would be required for an analysis of the relationship between fiscal and BOP developments in the oil exporting countries. All one can say here is that in an oil exporting country with a limited home production base, there is likely to be a close relationship between overall fiscal and BOP developments. Government oil revenues are the principal source of foreign exchange, and a large proportion of government expenditures will consist of payments for imports and for other external transactions. Also, government injection of oil revenues into the domestic income stream via its domestic expenditures will be reflected in private sector imports, given a limited home production base and a reasonably open economy. The relationship between the overall budget surplus of the major oil exporting countries and changes in their total international reserves has been fairly close between 1972 and 1978, except in 1977.
The evidence cited above suggests that since 1975 the major oil exporting countries cut back their national rates of inflation by substantially curtailing domestic budget deficits. Other domestic stabilization methods were also employed. During 1974 and 1975, several of the major oil exporting countries introduced policies involving direct action on prices. These included (1) the introduction or substantial expansion of direct subsidy payments on a wide range of goods and services; (2) the introduction or expansion of indirect subsidies, through the pricing policies of public enterprises (including those responsible for electricity, water, and refined petroleum products for domestic use); (3) the reduction or elimination of several categories of domestic taxation (particularly import duties and taxes on goods and services); and (4) the abolition of user charges for government-supplied services in health, education, and other areas.
An important objective of these policies was to provide rapid improvements in the living standards of a large proportion of the population. Other aims may have been to reduce inflation generally (by breaking expectations of rising prices), as well as to offset the impact of inflation on particular groups. Actual inflation in 1974 and 1975 in the countries using such price policies suggested that these policies were only partly successful. This may support the view that any decline in price expectations would probably be short-lived if it were associated with policies directly increasing the domestic budget deficit and domestic liquidity. Clearly, each of the four elements of fiscal policy outlined above implied both developments.
Attacking the symptoms of inflation by means that exacerbated the causes was likely to yield, at best, only temporary results. Several oil exporters subsequently turned to price controls—an instrument that offered a reduction in inflationary expectations without, at the same time, tending to increase the domestic budget deficit and domestic liquidity. While these policies appear to have played a part in holding down the rate of increase in indices of official prices, it is questionable whether they also reduced underlying inflationary pressures. In some cases, the brunt of the controls was borne by public enterprises, with predictable increases in their financing requirements. Recently, some countries have substantially relaxed or abandoned price controls.
Policies to augment aggregate supply have played a considerable role in maintaining the growth of the non-oil sectors at a relatively high level and slowing down inflation in the oil exporting countries. Port congestion—from the beginning—represented a critical bottleneck; where it has been relieved, it has helped to restore domestic financial stability. However, there are other bottlenecks and new ones will inevitably appear. Oil revenues aside, the oil exporting countries still suffer from some of the same problems as other developing countries: insufficient infrastructure and skilled labor, widespread illiteracy, and a large proportion of the population in economic sectors where productivity remains low. Oil revenues remove one constraint to development—foreign exchange—but this does not, of itself, remove shortages of economic resources, such as the lack of skilled labor, infrastructure, and managerial, administrative, and entrepreneurial talent. Large investment drives, to improve ports, for example, may remove one bottleneck to growth but may tend to increase others through the pressure exerted on other elements of the infrastructure (internal rail and road transportation, for example), on the small group of decision-makers, on skilled manpower, and on the domestic resources of the construction and service sector. In brief, measures to augment aggregate supply involving the easing of key bottlenecks have a critical but limited role to play in restoring domestic financial stability. These measures should be accompanied by appropriate demand management policies.
The speed and scale of the economic transformation of the major oil exporting countries during the past five years complicate the task of devising appropriate demand management policies. In these countries structural changes have undoubtedly occurred that must limit the usefulness of those economic relationships that existed prior to 1973. Further, structural change is clearly not a once-and-for-all phenomenon, but rather a continuous and somewhat unpredictable process. While considerable improvements have been made in several countries, this underscores the need to improve the coverage, quality, and speed of compilation of macroeconomic statistics. During 1974 and 1975 institutions responsible for the control of fiscal and monetary aggregates were not, in general, able to keep pace with the rapid increase in the scale and complexity of other operations; in particular, considerable strains emerged on the budget and accounting machinery. In some cases, the financial and planning ministries did not have the power of their counterparts in countries where financial constraints require the reconciliation of competing claims. Development plans and budgets frequently represented processes whereby projects and programs were compiled but not fully reconciled, and individual ministries and public enterprises enjoyed considerable autonomy. In these circumstances, the ability of the authorities to control the level of expenditures in line with the macroeconomic requirements of the economy was considerably reduced.
Marked improvements have been made recently on these problems, although in some of the oil economies the monetary authorities have relatively narrow functions, and new problems of control of monetary aggregates have arisen with the rapid development of specialized banking institutions. These problems are aspects of the general problem of adapting the infrastructure of financial management to the transformed economic situation.