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Policy Responses to Volatile Crude Oil Prices and Fiscal Dependency

Author(s):
International Monetary Fund. Research Dept.
Published Date:
March 2005
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Sam Ouliaris

Nominal crude oil prices stood at record highs in October 2004. While oil dependency has declined in the industrialized world since the 1970s, many developing countries remain vulnerable to large and unpredictable swings in oil prices. Given the fundamental importance of crude oil either as a source of energy or export revenues, the IMF has conducted extensive research on the relationship between oil prices and economic activity, and on how national governments can manage oil price volatility. This survey provides a selective review of that research.

The relationship between oil prices and growth over the business cycle has been the subject of considerable study in recent years. Robinson and others (2000) examine the impact of exogenous oil price shocks on industrial and developing economies, and recommend as the ideal policy response to allow the initial price shock to feed through to domestic prices, but to not let monetary policy accommodate any second-round effect. Hunt, Isard, and Iaxton (2001) analyze the macroeconomic effects of higher oil price shocks using MUITIMOD, and distinguish between temporary, more persistent, and permanent oil price shocks.

They conclude that (i) oil price increases have a positive effect on core inflation; (ii) delays in responding to a persistent oil price increase may have substantial macroeconomic costs, especially if monetary policy credibility is at stake; and (iii) monetary policy should err on the aggressive side, as restoring monetary credibility may involve a permanent output loss.

In line with academic findings that oil wealth negatively affects institutional quality, Sala-i-Martin and Subramanian (2003) argue that natural resources such as oil, by encouraging rent seeking and corruption, have significant negative effects on the quality of domestic institutions and long-run economic growth. They find confirmatory evidence in the case of Nigeria, and recommend distributing oil revenues directly to the Nigerian population as a potential solution. Hakura (2004) reports further evidence, based on other oil-exporting countries in the Middle East and North Africa (MENA) region, that supports Sala-i-Martin and Subramanian. Abstracting from the problems caused by poor institutions, Spatafora and Warner (1999) look at 18 oil-exporting developing countries and show that if either large shares of capital goods are importable or if labor supply is sufficiently elastic, then natural resource booms can increase investment and non-resource based output, thereby offsetting the negative “Dutch disease” effects arising from a real appreciation of the exchange rate. For countries with limited capital stocks, Takizawa, Gardner, and Ueda (2004) also argue that long-term growth can be enhanced by oil booms if there are positive external effects of public spending on both consumption and productivity shocks.

“Several studies that consider the sustainability of fiscal policy in an ‘oil-dependent’ economy recommend focusing on the ‘core deficit’ as a more appropriate indicator of fiscal stance, especially for countries with an oil sector in decline.”

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The unpredictability and volatility of oil prices complicates the conduct of fiscal policy in many oil-exporting countries, and makes the determination of appropriate expenditure levels particularly difficult. In addition, since oil wealth is exhaustible, intergenerational equity considerations also need to be addressed. Allowing for uncertainty and asymmetric adjustment costs, Engel and Valdes (2000) provide operational guidelines for fiscal policy in oil-exporting countries and advocate the establishment of a stabilization fund to decouple government spending from oil price (revenue) volatility. Fasano (2000) finds that the experiences of various countries with stabilization funds have been mixed. Given the nonstationary behavior of crude oil prices—see Cashin, McDermott, and Scott (2002) and Cashin, Liang, and McDermott (2000)—stabilization funds can easily be overwhelmed by significant downward swings in crude oil prices. Recognizing this risk, Daniel (2001) argues that governments should hedge themselves against declines in oil prices by operating directly in crude oil futures markets. While hedging strategies can substantially reduce oil price volatility without significantly reducing return, he notes that governments tend to shy away from these markets. Such behavior can be explained by concerns over the possible political costs of hedging (i.e., failure to benefit from price rises), lack of institutional capacity, and limited market depth. Recognizing that most pricing rules to determine oil-related subsidies—which typically involve smoothing actual crude oil prices—leave the governments’ fiscal stance overexposed to oil price risk, Federico, Daniel, and Bingham (2001) also recommend that governments adopt a hedging strategy based on crude oil futures contracts.

A number of studies examine more specific oil revenue issues relating to the appropriate fiscal regime for the oil sector. In cases in which the federal government does not directly control oil resources, the allocation of oil revenues between the state and local governments raises a number of difficult issues. Ahmad and Mottu (2002), on the basis of an extensive review, conclude that centralization of oil revenues is the preferred arrangement. In contrast, the least-preferred solution is oil revenue sharing, as this takes large amounts of revenue away from the central government, complicating macroeconomic management. Revenue sharing exposes state and local governments to the full dynamics of oil price volatility, encouraging procyclical expenditure and local accumulation of debt when oil prices fall. Drawing lessons from Nigeria’s experience with revenue-sharing arrangements, Ahmad and Singh (2003) recommend the use of more stable revenue bases for regional administration as a means of maintaining the provision of public services and sufficient economic incentives to remain in a federation.

Finally, several studies that consider the sustainability of fiscal policy in an “oil-dependent” economy recommend focusing on the “core deficit” (the overall deficit less net transfers and oil and investment income) as a more appropriate indicator of fiscal stance, especially for countries with an oil sector in decline. (See Chalk, 1998, for Venezuela and Kuwait; Baunsgaard, 2003, for Nigeria; and Ntamatungiro, 2004, for Gabon.) Barnett and Ossowki (2002) provide a comprehensive review of the operational aspects of fiscal policy in oil-exporting countries, recommending that these countries operate on the assumption that oil revenue is a nonpermanent component of the budget.

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