Chapter 3. Macroeconomic Policy Challenges

Harinder Malothra, Milan Cuc, Ulrich Bartsch, and Menachem Katz
Published Date:
January 2004
  • ShareShare
Show Summary Details

A. Background Discussion

Macroeconomic policy in oil countries faces challenges arising from three characteristics of oil revenue: (1) oil revenue is more volatile than revenue from other export commodities because of international market conditions; (2) oil revenue is a foreign exchange inflow, and its use can have large effects on macroeconomic stability and economic structure; and (3) oil is an exhaustible resource with a finite revenue stream. The challenge of macroeconomic policy in SSA oil countries is to stabilize budgetary expenditures and sterilize excess revenue inflows in the context of medium- to long-term sustainability considerations, and thereby provide an environment conducive to growth and poverty reduction. In most of the oil-producing countries, there has been a strong deficit bias, and a procyclical fiscal policy has been driven by oil price developments.

Oil revenue volatility

Empirical investigations have shown that oil prices are more volatile than prices of other commodities.2 Fiscal policy, therefore, has to attempt to insulate the economy from the volatility of oil revenues, because frequent upward or downward adjustments of fiscal expenditures are costly. Volatility in budgetary spending hurts the economy through uncertainty about aggregate demand and through costs associated with factor reallocations. The “boom-bust” cycles induced by frequent adjustments of budgetary expenditure are not conducive to private sector activity. In addition, if expenditures become entrenched, cuts may not be possible in some line items, and prioritizing budget cuts becomes increasingly difficult. If expenditure cannot be cut sufficiently, governments may be forced to borrow, and borrowing costs may be inversely related to oil prices. (Borrowing is easier when oil prices are high).3

Attempts at stabilizing budgetary expenditure suffer because oil price projections are unreliable. In fact, various studies have shown that the profile of oil prices over the past 30 years can best be described as a random walk process.4 This implies that the best predictor of tomorrow’s price is today’s price and that the prediction can be spectacularly wrong.5 However, periods of relative price stability have also been observed.

Given the high uncertainty about future oil prices, fiscal policy should aim at accumulating precautionary savings in the form of foreign financial assets in years with high oil revenues, which could then serve to finance deficits in years with revenue shortfalls. However, it should be recognized that large market downturns and a depletion of the assets of such stabilization funds are always possible. Policymakers in the past mostly believed that a market downturn would be short-lived, whereas high oil prices were thought to be the norm. They therefore did not adjust expenditure downward in times of low oil prices until forced to by borrowing constraints.

In addition to stabilization funds, other ways to safeguard against the possibility of revenue shortfalls may be needed. One such way is to broaden the revenue base through economic diversification. Another approach would be for the government to target persistent fiscal surpluses in order to create financial assets as precautionary savings. Interest income from these assets would augment government revenue and would reduce overall volatility in government revenue. Hedging against oil price fluctuations on international commodity exchanges is another possible way to reduce volatility.6

Foreign exchange inflow from oil

Oil is normally produced in an “enclave,” with high capital and low labor intensity, and the bulk of production is exported. Export proceeds are received in U.S. dollars, and the government’s share of these proceeds is a foreign exchange inflow into the economy. The domestic use of the foreign exchange inflow generally leads to an appreciation of the real effective exchange rate (REER) and a loss of competitiveness in the non-oil tradables sector of the economy.7 The economic structure would therefore shift away from the production of tradable goods, labor and capital would move into the nontradable sectors, and imports would rise.

This structural change resulting from the use of oil revenue has been called the “Dutch disease”; it is not necessarily problematic, although fast structural change can be accompanied by economic and social dislocations. Another issue is the sustainability of the aggregate demand structure in light of the volatility and exhaustibility of oil revenue. When oil revenue falls, production and consumption patterns may become incompatible with the availability of foreign exchange, unless sufficient public and/or private savings have been accumulated during the good times. A fiscal policy designed to keep domestic demand stable in the face of fluctuating oil revenues will tend to dampen real exchange rate appreciation and its detrimental effects on competitiveness.

If stability of government spending and domestic demand in general can be maintained, the need for supply-side adjustment will diminish correspondingly, and short- to medium-term reallocation costs will be minimized. If fiscal policy is also aimed at long-term sustainability, the assets accumulated during the lifetime of the oil fields ensure that the foreign exchange inflow compatible with consumption and production patterns continues even after the depletion of oil reserves. The desire to limit real exchange rate appreciation provides another argument in favor of accumulating income-producing foreign assets: to sterilize the foreign exchange inflow from the oil sector (see also Section 6 on exchange rate issues). Government policies that encourage private sector saving—greater reliance on indirect taxation, pension reform, reform of the banking system, and reduced business profit taxes—can complement fiscal policy in moderating real exchange rate appreciation.

Exhaustibility of oil

Oil is a nonrenewable resource. It constitutes national wealth that can be approximated by the present value of the rent earned in its production (essentially proceeds from projected future sales after deduction of relevant extraction costs).8 Using the principle of intergenerational equity, one can argue that this national wealth should be used in a manner that will leave future generations at least as well off as the current one. This is a savings motive in addition to the precautionary and sterilization motives discussed above.9 However, uncertainty over reserves, future oil prices, the return on financial or physical assets, and society’s discount rate means that it is nearly impossible to calculate how much should be saved during the lifetime of the oil reserves. Hence, the accumulation decision can have an element of value judgment.

However, it can be argued that governments, rather than investing the oil revenue proceeds in financial assets, should use them to finance public expenditure that “crowds in” private investment and to reduce taxes as far as possible to eliminate distortions and disincentives. This is particularly important in countries where there is an urgent need to build up infrastructure and provide essential services. This course of action would support non-oil growth and would create a larger revenue base in the future; fiscal sustainability could thus be ensured with a modest increase in tax rates when oil revenue trails off, and interest earnings from a savings fund would not be needed. The present generation would use up the natural resource wealth but would leave to future generations compensating man-made wealth.

In practice, the decision about the form of asset accumulation—financial versus real—under a policy that seeks to ensure equitable treatment of all generations needs to balance often-competing considerations. The fact that severe absorptive capacity constraints exist in African oil-producing countries, and that the efficiency of public spending among at least some of them has been low, would suggest that a large portion of oil revenue savings should be invested in financial assets. Conversely, the widespread poverty and low human development indicators in many oil-producing countries would argue in favor of upgrading domestic infrastructure and increasing the level of public services as a way of improving the quality and productivity of physical and human capital.10

B. Current Practice

African oil-producing countries commonly do not follow any declared fiscal rule, with the exception of Cameroon, where a balanced budget is implicitly targeted (see Table 3 for a summary of this section). Budgets are usually prepared on the basis of a projected oil price, and ad hoc adjustments to budgets are common. Equatorial Guinea and Chad are moving toward the projection of fiscal surpluses and the accumulation of assets. The former is currently the only country in the group where oil revenue clearly exceeds the country’s absorptive capacity and where sizable foreign assets have been accumulated, and the latter may find itself in a similar position, at least during the initial years of oil production. Cameroon has provisions in place under the Poverty Reduction and Growth Facility (PRGF)-supported program to save unprogrammed windfalls when oil prices and government oil revenues surpass budgetary projections, although these have so far not been implemented. Nigeria accumulated reserves in the past as part of an “oil fund,” but this fund was embezzled and the practice was discontinued.

Table 3.Current Practice in Fiscal Policy
CountryFiscal RulesIntegrity of BudgetEarmarkingIntergenerational Equity Provisions
AngolaNone.Oil revenue (excluding bonuses) and expenditures are included in the budget. Bonuses are paid to Sonangol and, in some cases, directly to various autonomous social funds.None.None.
CameroonTarget a balanced budget at the expected level of oil revenues. A contingency mechanism lowers the target in case of a shortfall.All oil revenue is included in the budget.None.Ongoing discussions to set up a Fund for Future Generations (FFG).
ChadTarget a fiscal surplus at the projected oil price and deposit a fixed percentage of oil revenue in an FFG.All oil revenue should be fully budgeted and associated spending should follow normal budgetary procedures.Net direct oil revenue (after debt service to the World Bank and allocations for FFG) is to be spent mainly in priority sectors for poverty reduction; namely, health, education, rural development, and infrastructure.Yes. The exact rules guiding the eventual use of this fund have not yet been agreed upon, and should be designed so as to ensure inter-generational equity.
Republic of CongoNone.Oil revenue and expenditures are included in the budget. Effective unified management of treasury operations is impaired by collateralized debt operations and financing of some public investment projects directly with oil revenues.Proportion of oil revenues earmarked for specific uses—collateralized debt-service payments and investment projects—account for 40 percent of total oil fiscal revenue in 2001.None.
Equatorial GuineaNone. The revised budget for 2002 projects a large fiscal surplus (including oil revenue), which will be held in a treasury investment account abroad.All oil revenue is included in the budget since 2001 and the earlier practice of extra-budgetary expenditure financed by advances from the oil companies has been discontinued. However, the lack of transparency of transactions on the offshore treasury account continues.Oil revenue to be used for investment purposes only.Currently foreign assets are being accumulated; these are not in the form of long-term investments. However, the revised 2002 budget projects the creation of a special reserve fund (FFG).
GabonNone.All oil revenue is included in the budget.None.An FFG was created by law in 1998. According to the law, 10 percent of budgeted oil revenues as well as 50 percent of any windfall revenue are to be directed to the FFG. A first deposit of CFAF70 billion was made in 2002.
NigeriaNone.Weaknesses in the fiscal administration of the oil sector may lead to inadequate allocation and collection of revenue for the government. Tax audits for the oil companies appear ineffective.None.None.
Sources: Country authorities; and IMF staff analyses.
Sources: Country authorities; and IMF staff analyses.

Following the oil booms, Nigeria experienced large increases in public spending and fiscal deficits that fueled macroeconomic volatility. Nigeria’s budget deficit increased dramatically from the early 1970s onward as expenditures rose faster than revenues. In periods of high oil prices, public expenditure was allowed to rise substantially, while there was little ability to reduce spending in periods of low oil prices. The federal government deficit has remained above 4 percent of GDP for most years since 1975, and sometimes substantially higher. This “ratchet effect,” stemming from an irreversible rise in expenditures when oil revenue was high, has been a major contributing factor to the accumulation of a large public sector debt. Figure 4 compares oil revenue, fiscal expenditure, and the overall fiscal balance for Nigeria, Venezuela, and Indonesia. Indonesia was successful in stabilizing fiscal spending, whereas in Nigeria and Venezuela oil price and oil revenue volatility was transmitted to the economy through volatility in public spending.

Figure 4.Nigeria, Venezuela, and Indonesia: Fiscal Trends, 1978–2001

Source: Country authorities; and staff estimates.

Notes: Fiscal trends shown against left-hand axis, oil prices against right-hand axis. bbl = barrels of crude oil equivalent.

Fiscal policy has generally not been successful in smoothing fluctuations in budgetary outlays in response to volatile oil prices. The correlation of fiscal expenditure and oil prices is high. Table 4 shows correlation coefficients of government primary expenditure and current oil prices (left column) and of government primary expenditure and oil prices lagged by one period (right column) for Angola, Cameroon, the Republic of Congo, Gabon, and Nigeria. The correlation coefficients are positive for all countries, and in Angola and Nigeria, they are larger for current than for lagged oil prices. In these countries, primary expenditure has been strongly correlated to current oil prices, as shown by a correlation coefficient of 0.7 (see also Figure 5 for the correlation between non-oil balances and oil prices).11Figure 6 shows overall and non-oil balances for the countries in the group between 1990 and 2001 (where data are available).

Table 4.Correlation Between Oil Prices and Government Spending, 1971–2001
Correlation Coefficient: Primary Expenditure versus
Current oil priceOil price lagged by one period
Republic of Congo10.30.5
Sources: Country authorities; and IMF staff estimates.


Sources: Country authorities; and IMF staff estimates.


Figure 5.Non-Oil Balances and Oil Prices, 1990–2002

Sources: Country authorities; and IMF staff estimates.

Figure 6.Overall and Non-Oil Balances, 1990–2001

Sources: Country authorities; and IMF staff estimates.

1Average U.K. Brent, Dubai, and West Texas Intermediate.

In most countries, both public and private domestic demand components have been strongly correlated with oil revenue. As shown in Table 5 for the Republic of Congo and Gabon, the correlation between public expenditure and total oil export revenues (as a proxy for government oil revenues) is more pronounced in the Republic of Congo. (The correlation coefficient is 0.88, compared with 0.47 in Gabon.) Public demand in both countries is also strongly correlated with private demand, which means that public demand tends to reinforce, and possibly trigger, movements in private spending. Furthermore, the public sector has been a source of macroeconomic instability by virtue of its volatility—which has been twice that of private demand in both countries. (See also Chapter 6 on the correlation between oil prices and the REER).

Table 5.Oil Price Cyclicality of Public and Private Domestic Demand, 1990–2001
Republic of CongoGabon
Correlation coefficient
Oil export revenues, public demand0.880.47
Oil export revenues, private demand0.800.86
Public demand, private demand0.690.63
Standard deviation
Public demand growth3420
Private demand growth1711
Sources: Country authorities; and IMF staff estimates.
Sources: Country authorities; and IMF staff estimates.

Governments do not make explicit provisions for the exhaustibility of oil revenue. In the Central African Economic and Monetary Community (CEMAC) countries, a legal framework to save part of oil revenues was put in place in 2001, but to date no country has made use of it. Two funds—one for short-term stabilization of oil receipts, the other for long-term savings for future generations—would be administered by the regional central bank. Chad is to adopt an explicit rule to deposit a part of oil revenue in a Fund for Future Generations (FFG). Gabon and Equatorial Guinea have created FFGs by laws that oblige the governments to deposit some specified amount of oil revenue as reserves in the regional central bank. Gabon made its first deposit, of some CFAF 70 billion, in the Bank of Central African States (BEAC) account in 2002.

Equatorial Guinea already has accumulated sizable deposits in offshore treasury accounts, but this is due more to a lack of administrative capacity to spend than to policy design. However, government spending has been rising rapidly during the last two years, and a continuation of the trend could threaten the authorities’ ability to increase assets in the fund and ultimately lead to an unsustainable fiscal position.

C. Discussion and Recommendations

The IMF staff has consistently recommended fiscal restraint in African oil-producing countries in light of the revenue volatility and taking into account the limited absorptive capacity. It has also consistently recommended the integration of oil sector–related fiscal activities in the central government budget to enhance transparency and accountability, and progress has been achieved in this respect during the last few years.

Current practice in the African oil-producing countries presents a mixed picture. Some improvements in oil revenue management have been achieved, but much more needs to be done in order to ensure an adequate accounting for revenue and adoption of a rational fiscal policy stance. The fiscal stance in most countries has not fully reflected IMF advice; this is shown by the persistently high volatility of fiscal spending, the lack of diversification of government revenue sources, and the failure to accumulate foreign assets (and, in some countries, the accumulation of foreign debt).

Macroeconomic management can be improved by taking a medium- to long-term approach. Frequent adjustments of fiscal policy have detrimental economic effects. In the current environment of high oil prices, countries should be encouraged to make a serious effort to accumulate reserves. While the creation of savings funds large enough to ensure fiscal sustainability in the long run is probably not an option in countries such as Cameroon, Gabon, and Nigeria, even these countries need some reserves to cushion the blow of the next negative oil price shock. In this regard, greater emphasis should be given to the adoption of explicit fiscal rules.

Detailed discussions of intergenerational equity and the long-term sustainability of fiscal policy seem to have been held only in some countries. These should be important considerations to guide fiscal policy, in particular in oil-producing countries such as Equatorial Guinea and Chad, which have small populations but relatively large oil reserves. Given the limited administrative and, more generally, absorptive capacity, a rapid increase in fiscal expenditure in line with oil revenue would lead to large-scale economic disruptions. However, the size of the expected oil wealth relative to the non-oil economy means that, with an appropriately designed long-term policy, major sustainable improvements in living standards are possible even without high growth rates in the non-oil economy.

Participants at the Douala workshop broadly agreed that fiscal policy had not been well adapted to the challenges facing oil-exporting countries. In particular, they acknowledged the negative effects of oil revenue and fiscal spending volatility on their economies. They supported in principle the use of medium-term fiscal rules and stabilization funds to avoid the “boom-bust” cycles that have characterized many oil economies during the last 30 years.

Most participants insisted that the context of African countries had to be taken into account to determine a credible level of savings from oil revenue. They pointed out that the need to save could be difficult to accept for parts of civil society and the parliament, and that the expectations of the population had to be considered when deciding on the split among current spending, savings, and investment. Policies on savings and expenditure should not endanger political stability.

They further remarked that, in making decisions over domestic investments and savings, countries had to be able to assess domestic absorptive capacity and identify priorities for the use of public funds. Human resources in most SSA countries may not be sufficient to perform these functions well, and support from development partners may be needed.

    Other Resources Citing This Publication