Fiscal Policy Formulation and Implementation in Oil-Producing Countries

13 Oil Funds in Transition Economies: Azerbaijan and Kazakhstan

Jeffrey Davis, Annalisa Fedelino, and Rolando Ossowski
Published Date:
August 2003
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John Wakeman-Linn, Paul Mathieu and Bert van Selm1 

I. Introduction

The challenge of economic transition—of transforming an economy from a system of command and control to a free market—is a daunting one. Countries facing the challenge of transition in the 1990s had little proven economic theory and few relevant historical precedents to guide them. Even today, more than ten years after the collapse of the Soviet Union, economists continue to debate how best to advance the process of transition.2

The challenge of managing oil wealth has proven similarly daunting for many countries. Numerous studies (for example, Hausmann and Rigobon, Chapter 2 in this volume, and Sachs and Warner, 1995) have shown that resource-rich—particularly oil-rich—countries have experienced slower economic growth over time than resource-poor countries. While a variety of explanations have been proposed for this empirical fact (e.g., Dutch disease, the adverse economic effects of price volatility, the political economy effects of the struggle for economic rents), numerous countries appear to be worse off as a result of their oil endowments than they would have been without the oil.

Countries confronted with both challenges—transforming their economy to a free market, while managing an oil boom—face a potentially overwhelming task. As noted by Rosenberg and Saavalainen (1998), the problems of managing a resource boom greatly complicate the difficulties facing a transition economy. This paper assesses the approach taken by two such countries—Azerbaijan and Kazakhstan—to address these serious challenges.

Despite an ambiguous track record of oil funds in other countries (see Davis and others, Chapter 11 in this volume), both countries have created oil funds to assist in managing their new petroleum wealth. In what follows, we assess the reasons why these countries have opted for oil funds, as well as the prospect that these funds may assist them in better managing their oil wealth and economic transition. Section II describes the current situation and prospects for oil and gas production in Azerbaijan and Kazakhstan. Section III explores their reasons for creating oil funds. Section IV focuses on the operational aspects of these oil funds and evaluates their design features in seeking to assess the prospects for their success. Section V concludes.

II. Oil and Gas Sector Prospects in Azerbaijan and Kazakhstan

Azerbaijan’s and Kazakhstan’s oil and gas prospects have improved substantially in recent years. In both countries, important new discoveries were made, and there has been considerable progress in the construction of new pipelines to bypass the Russian oil and gas pipeline monopolies and to link these countries to world energy markets.3 Proven reserves will allow Azerbaijan to increase oil production to about 1.3 million barrels per day (bpd) by 2010, while Kazakhstan’s production could exceed 3 million bpd by about 2015.

Figure 13.1.Azerbaijan: Oil Production and Exports

(In millions of barrels per day)

Sources: Azerbaijan authorities; and authors’ estimates and projections.

1SOCAR = State Oil Company of the Azerbaijan Republic; AIOC = Azerbaijan International Operating Company.


Oil and gas production in Azerbaijan decreased sharply in the final years of the USSR and the first years after the Soviet Union’s breakup. Gas production has continued to decrease, but oil output has increased in recent years (Figures 13.1 and 13.2). In 1995, Azerbaijan International Operating Company (AIOC), a consortium of international oil firms, was formed to operate Azerbaijan’s most promising oil field, Azeri-Chirag-Guneshli (ACG), with production starting in 1998. AIOC’s oil production is projected to reach 1 million bpd by 2010. Oil and gas already constitute over 90 percent of Azerbaijan’s exports and will contribute over half of government revenue by 2005 (Figure 13.3).

Figure 13.2.Azerbaijan: Gas Production and Exports

(In billions of cubic meters per year)

Sources: Azerbaijan authorities; and authors’ estimates and projections.

SOCAR = State Oil Company of the Azerbaijan Republic; AIOC = Azerbaijan International Operating Company.

Azerbaijan’s proven oil reserves have been estimated at 7 billion barrels, and possible reserves at twice that amount. Proven gas reserves increased sharply when drilling at Shah Deniz yielded positive results; at 870 billion cubic meters (bcm), this is one of the biggest gas fields in the world. Drilling at other fields has not yet produced major finds, and a few production-sharing agreements (PSAs)4 have been dissolved. However, due to limited rig availability, many promising fields remain untested, and the State oil company of Azerbaijan Republic (SOCAR) remains confident that more oil and gas will be found.

Huge oil and gas sector investments are planned in the coming years. Investment in the development of ACG is projected at more than US$3.8 billion over 2002–5. The cost of the new export pipeline (Baku-Tbilisi-Ceyhan, or BTC) needed to transport the oil from this field is estimated at US$3 billion. The first phase of expenditures for the development of Shah Deniz is estimated at US$1.4 billion; full field development would cost an additional US$3 billion. The South Caucasus Pipeline that will bring Shah Deniz gas to Turkey is expected to cost about US$1 billion. To put these figures in context, Azerbaijan’s GDP in 2001 was about US$5.7 billion, or less than half the combined cost of these investments.

Figure 13.3.Azerbaijan: Oil and Gas Sector Exports and Fiscal Revenues

(In percent)

Sources: Azerbaijan authorities; and authors’ estimates and projections.

1As a percentage of total exports, based on March 2002 IMF World Economic Outlook price projections.

2As a percentage of total fiscal revenue, based on March 2002 IMF World Economic Outlook price projections.


In the Soviet era, Kazakhstan’s considerable petroleum endowment was underexploited, due to a scarcity of capital resources and the more easily accessible reserves in the Volga basin. Exploration and development have accelerated since independence, as international firms have been attracted by the favorable prospects in the Caspian basin. A mix of traditional projects, PSAs, and joint ventures with the state oil and gas company, Kazmunaigas, have been used.

Figure 13.4.Kazakhstan: Oil Production

(In millions of barrels per day)

Sources: Kazakhstan authorities; and authors’ estimates and projections.

Oil and gas producers are investing heavily to expand production from just 800,000 bpd in 2001 to around 3.1 million bpd in about 15 years, which would put Kazakhstan among the top ten oil producers in the world (Figure 13.4). Since independence some US$7 billion has flowed into the sector, and it is expected that around US$3–4 billion will be invested in the petroleum sector annually through the medium term. Gas production of about 15 bcm per year, largely oil-associated gas, is also expected to rise strongly over the medium term to perhaps 50 bcm per year (Figure 13.5). The petroleum sector accounted for an estimated 25 percent of GDP in 2001 and crude petroleum exports reached US$4.5 billion, about one-half of exports. Fiscal receipts from the sector have surged with rising output and the recovery in prices since 1998, to about one-quarter of general government revenue in 2001 (Figure 13.6).

Three large projects dominate the petroleum sector. The onshore Tengiz field has recoverable reserves estimated in the range of 6–9 billion barrels. Production is expected to double to around 500,000 bpd in five years and rise further in the long term. The Karachaganak gas and gas condensate field is expected to more than double production to 230,000 bpd of condensate and to link up to the Caspian Pipeline Consortium (CPC) pipeline by mid-2003.5 The size of the recently discovered Kashagan field has been estimated at 8–13 billion barrels of recoverable reserves. Kashagan, the largest find in the past 30 years, will not begin production before 2005, but output could reach well over 1 million bpd by 2015.

Figure 13.5.Kazakhstan: Oil Exports and Fiscal Revenues

(In percent)

Sources: Kazakhstan authorities; and authors’ estimates and projections.

1As a percentage of total exports, based on March 2002 IMF World Economic Outlook price projections.

2As a percentage of total fiscal revenue, based on March 2002 IMF World Economic Outlook price projections.

III. The Rationale for Oil Funds in Azerbaijan and Kazakhstan

Large oil and gas revenues, and the prospect of much more to come, led both Azerbaijan and Kazakhstan to create special natural resource funds to manage these revenues. While the effectiveness of this instrument has not been established unambiguously either in economic theory or in international practice, Azerbaijan’s and Kazakhstan’s unfinished transitions from planned to market economy provide additional reasons to separate oil and gas revenues from regular government revenues.

Figure 13.6.Kazakhstan: Oil Exports and Fiscal Revenues

Kazakhstan: Gas Production (In billions of cubic meters)

Sources: Kazakhstan authorities; and authors’ estimates and projections.

Political Economy Rationale

Oil funds in general, and those in Azerbaijan and Kazakhstan in particular, can be thought of as having two primary objectives and two secondary, and related, objectives. The primary objectives are stabilization—insulating fiscal and monetary policy, and the economy, from swings in oil and gas revenues—and savings for future generations. The secondary objectives are maintaining fiscal discipline, which requires that oil money not be available to close any gaps in the budget resulting from poor tax collection performance or excessive expenditures, and avoiding monetary expansion and pressures for excessive appreciation of the exchange rate, which requires strict limits on expenditures of oil and gas revenues, with any unspent revenues being saved outside the country.

From the perspective of economic theory, it is difficult to make a case for an oil fund. As argued by Davis and others (see Chapter 11 in this volume), “The policy objectives of [oil funds] could, in principle, be achieved through implementation of a sound fiscal policy within the context of a medium-term budget framework.” In other words, any fiscal policy decision that can be made in the context of an oil fund—for example, to target a particular path of the non-oil deficit—can also be made without an oil fund. Similarly, an oil fund is not required for a government to save oil-related revenues abroad, thereby preventing exchange rate pressures from these revenues and easing the task of the monetary authorities. The rationale for the creation of an oil fund must thus be based on political economy arguments, rather than purely economic arguments.

Annual budget debates are typically short-run exercises, focused on political and economic pressures over the next year (or, where medium-term expenditure frameworks are used, the next three years) (Schick, 2002). However, planning for sound use of oil and gas revenues requires a longer horizon, one that is well beyond normal political horizons. A long-term political compact, detailing how oil- and gas-related revenues are to be used not just this year, but for years to come (i.e., an agreement on an oil fund), can protect some portion of oil revenues, thereby allowing larger fiscal surpluses in the short run, and a more desirable path of expenditures over the medium to long run, than would otherwise be politically feasible.6 By allowing larger surpluses, oil funds can also improve coordination between monetary and fiscal policy, since this fiscal sterilization of oil revenues means that the monetary authority has less of a sterilization task confronting it (and its often very limited intervention tools).

These political economy arguments clearly applied—or were thought by the authorities to apply—in Azerbaijan and Kazakhstan. In both countries, the government was worried about political pressure to spend oil wealth rapidly and inefficiently. As a result, and reflecting political realities in the two countries, Azerbaijan and Kazakhstan created oil funds subject only to presidential control, bypassing parliament. By taking control over oil revenues—excluding SOCAR oil revenues from Soviet-era oil fields in Azerbaijan and a baseline level of oil revenue in Kazakhstan—away from parliament, they sought to insulate these revenues from short-term pressures for expenditures. As discussed below, however, it is not clear that this objective has been achieved.

In Azerbaijan, prior to the establishment of the oil fund significant portions of oil-related receipts were used to close gaps in the state budget, undermining expenditure and tax discipline, while the funds and their expenditures were often not accounted for in a transparent manner.7 Creation of the oil fund was thus motivated in part by a desire to improve both fiscal discipline and transparency. In Kazakhstan, prior to the creation of the National Fund for the Republic of Kazakhstan (NFRK), significant oil revenues were kept off budget and held in undisclosed offshore accounts, beyond the purview of both Parliament and the Chamber of Accounts.8 At the time, keeping these funds in such accounts was viewed as necessary for maintaining financial discipline. The creation of the NFRK thus led to improved transparency in the management of petroleum revenues.

Oil Funds and Economic Transition

The Commonwealth of Independent States (CIS) countries confronted a wide range of economic and political challenges following the collapse of the Soviet Union. Two of those challenges had particular relevance for the decisions facing Azerbaijan and Kazakhstan over how to deal with their growing oil and gas revenues. Those challenges related to the need to develop the institutions for conducting economic policy in a market economy and the need to develop new industries and services to replace inefficient Soviet-era enterprises, which would not be viable in a market economy.

At independence, Azerbaijan and Kazakhstan lacked many of the institutions vital to the conduct of economic policy in a market economy. In particular, they lacked both a modern tax policy and administration and institutions for budget preparation and execution. All CIS countries have struggled since independence to create a modern tax policy and a tax administration capacity capable of shifting “from handling the taxation transactions of a highly controlled state sector to dealing with the more challenging compliance activities of the emerging private sector and increasingly autonomous state-owned firm” (Ebrill and Havrylyshyn, 1999). This has proven to be a difficult task for all these countries, as is clearly demonstrated by the low levels of tax collection and tax compliance in these countries.

But for Azerbaijan and Kazakhstan, an easily available alternative source of money—oil revenue—has made the challenge of developing market-oriented tax policy and tax administration that much more difficult. While no one would argue for the exclusive use of depletable oil revenue in lieu of tax revenue, when faced with the need for additional revenue it is certainly easier—both administratively and politically—to use oil money rather than strengthen tax administration and enforcement or revise tax policy. Thus, if they were to be successful in developing a sound tax policy and administration, these countries needed to find a way to insulate tax-related decisions from the easy availability of oil money.

Similarly, all CIS countries faced the need to develop market-oriented systems for budget preparation and execution (Potter and Diamond, 2000). Carefully prioritizing and controlling expenditures, in an environment of rapidly falling revenues (Ebrill and Havrylyshyn, 1999), was a high priority, as was redirecting expenditures away from commercial activities and toward those activities more consistent with government expenditures in a market economy.9 Again, this has proven very difficult for CIS countries, as the inability to keep expenditures in line with available revenues and financing has repeatedly led to budgetary expenditure arrears (World Bank, 1996).

As with tax policy and administration, the availability of oil money has made the challenge of expenditure prioritization and control even more difficult in Azerbaijan and Kazakhstan. Political pressures to increase spending to unsustainable levels, or levels both beyond the absorptive capacity of the economy and beyond those that the governments could efficiently and effectively control, needed to be resisted. Again, this called for some way of insulating oil receipts from the political debate over expenditures.

The second major challenge facing the CIS countries, which was made even more difficult for the oil-producing countries of Azerbaijan and Kazakhstan, was the need to develop new businesses, often in new industries, to replace large, inefficient, and failing Soviet-era enterprises. While all CIS countries faced this challenge, the task was made more difficult for Azerbaijan and Kazakhstan. If they wanted to avoid being entirely dependent on oil and gas, they needed to develop new non-oil businesses and industries. And to do that, one prerequisite was to manage their oil and gas revenues so as to avoid an excessive real appreciation of their exchange rate and the consequent Dutch disease. This called for controlling the rate of expenditures of oil and gas revenue, targeting those expenditures primarily toward investments that would enhance productivity of non-oil sectors, and ensuring that any unspent funds were held abroad (where they would not have an impact on liquidity or the exchange rate).10 And, in the views of these governments, this called for some special treatment of oil and gas revenues, some mechanism for isolating these resources from the normal budget debates.

Declared Objectives

The declared objectives of the oil funds of both Azerbaijan and Kazakhstan include the primary objectives of desiring to insulate the economy from oil price volatility (stabilization function) and to save part of the wealth generated from natural resource exploration for future generations (savings function). In practice, in Kazakhstan the oil fund makes an important contribution to stabilizing budget revenues, as accumulation in the oil fund is contingent on the oil price, while the flow of oil-related revenues to the budget is independent of the actual price. In Azerbaijan, the source of the revenue determines whether it is treated as state budget revenue (taxes on SOCAR’s production from Soviet-era fields) or as oil fund revenues.11 This choice of accumulation rule reflects the fact that in Azerbaijan, the government views the oil fund primarily as a savings fund.

In the case of Azerbaijan, diversification of the economy beyond the oil sector is another important oil fund objective. The oil fund can contribute to non-oil sector development in two ways. First, by saving a part of oil and gas sector revenue in the form of foreign currency-denominated assets, the real exchange rate appreciation associated with a natural resource boom is mitigated. This helps maintain the competitiveness of the non-oil and non-gas sectors of the economy. Second, the declared purpose of oil fund spending is to build the infrastructure needed for the development of the non-oil sector. In Kazakhstan, diversification of the economy is not an explicit part of the oil fund’s rationale and the authorities have indicated they do not intend to spend any oil fund resources for the next three years at least.

In Azerbaijan, a final declared objective of the oil fund is to help avoid excessive spending. By making the oil fund subject to presidential control only, government and parliament spending of oil fund assets is precluded.12 Denying the state budget access to easy oil money, as was the case prior to the establishment of the oil fund, means that any shortfalls in the state budget must be made up through improved tax administration or reduced expenditures.13 Hence, in the case of Azerbaijan, secondary objectives played an important role in the decision to create an oil fund.

IV. Oil Fund Design

General Oil Fund Design Criteria

Even where the political economy case can be made for an oil fund, it does not follow that any oil fund is desirable. To be effective—that is, to contribute to improved macroeconomic policymaking—there are certain features that must be reflected in the design of the oil fund.

First, the oil fund must be fully integrated with overall fiscal policy and the government’s macroeconomic objectives. This can best be assured by having the oil fund serve as a financing mechanism for the state budget. Where this approach is not followed, as in Azerbaijan, it is essential that the government adopt and enforce procedures to ensure the consistency of the oil fund with the state budget and the government’s economic objectives.

Second, the money in the oil fund must be managed with transparency and accountability, both so that the money is not wasted and so that parliament and the public can have confidence that oil fund assets are being protected. Without this confidence, the political compact that allowed the creation of the oil fund will not be sustainable.

Third, the oil fund must be subject to sound asset management. The assets must be invested abroad (to avoid monetary and exchange rate pressures) in highly rated assets. Domestic investments—particularly in commercial activities—must be precluded. Oil- and gas-exporting countries that have attempted to diversify their economies by investing petroleum wealth in domestic commercial activities have not been very successful.14

Fourth, oil fund rules need to be consistent over the long term. This means, among other things, that the rules should not lead to an excessive buildup in oil fund assets. If there is an excessive accumulation of assets in the oil fund, it may eventually be impossible to resist political pressures to spend those assets, perhaps rapidly and unwisely. This would be the case for an oil fund whose rules called for too little expenditure of oil revenues or, in other words, a lower than desirable (from a political or economic perspective) non-oil deficit. The rules should also effectively preclude “raiding” of the fund—expenditures outside the agreed purposes and/or procedures of the fund—which would again call into question the long-term sustainability of the political compact.

The Oil Funds in Azerbaijan and Kazakhstan Relative to the Above Design Criteria

Box 13.1 summarizes the main features of the two funds. The Kazakh NFRK is clearly consistent with the first design criterion: Kazakhstan has a unified budget, with all baseline revenues and any eventual expenditures as part of the state budget, ensuring an integrated fiscal policy consistent with the government’s overall macroeconomic objectives.15 In Azerbaijan, as noted, the oil fund budget is separate from the state budget. To overcome the problems that can be caused by implementing two separate budgets, Azerbaijan has adopted rules designed to ensure the planning, execution, and monitoring of a consolidated government budget (consisting of the state and oil fund budgets).

Thus, the two budgets are to be prepared in tandem, on the basis of the same economic projections and targets, by the Ministry of Finance. The president approves the consolidated budget. When parliament approves the state budget, it also approves the consolidated budget expenditure ceiling, as well as the deficit of the consolidated budget excluding oil fund revenue. All oil fund expenditures (except its operational expenditures) are executed through the treasury, and quarterly reports on the execution of the consolidated budget are made public. It remains to be seen whether this (of necessity more cumbersome) approach will be effective in ensuring a coherent overall fiscal policy consistent with the government’s macroeconomic objectives. The signs are encouraging, as the preparation of the 2003 budget started with the Ministry of Finance producing a consolidated budget, which was then “divided” into oil fund and state budgets.

Both oil funds meet the second design criterion. They are both subject to annual external audits, the results of which are supposed to be made public.16 In addition, in Azerbaijan the oil fund is subject to audit by parliament’s supreme audit institution. In Kazakhstan, the NFRK is managed by the central bank, with the balance in the fund regularly published in the central bank balance sheet. In Azerbaijan, quarterly reports on the revenues, expenditures, and balance in the oil fund are published in the press.

Box 13.1.Operational Aspects of Azerbaijan’s and Kazakhstan’s Oil Funds

Oil Fund InflowsAll PSA-related revenues: profit oil, oil bonuses, transit fees for managing the Baku-Supsa pipeline, acreage fees, rental fees.Three sources: (i) The saving function: 10 percent of baseline revenues from nine oil fields and three mineral companies, projected at an annually set baseline price assumption;
(ii) a stabilization function: all revenues from the nine companies above the baseline revenue target; and
(iii) ad hoc inflows (e.g., bonuses and privatization receipts).
ExpendituresOff state budget, but through the treasury; oil fund budget and state budget prepared on a consistent basis; consolidated budget approved by the President; Parliament approves the consolidated budget expenditure ceiling, as well as the deficit of the consolidated budget, excluding oil fund revenue.Stabilization reflows to the budget (for oil revenue shortfalls, subject to an overall revenue shortfall). President can be spent through the budget approved by parliament.
Foreign / Domestic Asset Split100 percent foreign.100 percent foreign.
Operational Asset ManagementOil fund; external managers can be hired.National Bank of Kazakhstan and external portfolio managers.
Portfolio CompositionFixed rate instruments (state securities, bank deposits); external managers may invest in equity.Two portfolios: a short-term stabilization portfolio and a longer-term savings portfolio. Each has separate investment benchmarks and guidelines.
Legal BasisPresidential decrees, with key rules reflected in the Budget Systems Law.Laws, presidential decrees and government decisions.
External Audits2001 external audit (Ernst & Young) has been completed and published.Information on the internal 2001 annual report was published. The 2001 external audit (Ernst & Young) remains confidential.
ReportingQuarterly publication of oil fund revenues and expenditures in the context of the consolidated budget.Asset balance is regularly published in the balance sheet of the National Bank.
Supervisory BoardAppointed January 2002, with rotating six-month chairmanship; approved 2001 audit and amended 2002 budget in July 2002.Executive board chaired by the President.

Similarly, both oil funds are subject to sound asset management rules (the third criterion). In both cases, the funds are invested abroad, in highly rated assets, subject to strict investment guidelines. Kazakhstan uses independent, offshore professional asset managers, while Azerbaijan is in the process of contracting with such managers.

There is some concern as to whether the oil fund rules in these countries meet the final criterion of being consistent over the long term. Pressures to spend on ad hoc projects are building and—absent the development of medium-term expenditure strategies, which do not yet exist in either country—may become irresistible. The development of such a medium-term expenditure strategy, including a prioritized public investment program, and the linkage of oil fund expenditures to that strategy, is urgently needed in both countries.

V. Conclusions and Policy Agenda

Both these funds are new, so any judgments about their success in meeting their stated objectives must, of necessity, be preliminary. On balance it seems likely that these funds—if operated in accordance with existing rules—will contribute to improved management of oil and gas wealth. In both cases, the limitations on expenditures and the requirements for investment abroad should help avoid excessive real appreciation. Both sets of rules should ensure substantial savings for future generations (if they can resolve the concerns about long-term consistency). Kazakhstan’s rules should insulate fiscal policy from oil revenue instability. While stabilization is a secondary objective in Azerbaijan, over time, as the Soviet-era oil fields become less important, the degree of stabilization resulting from the operations of Azerbaijan’s oil fund will grow. Finally, both sets of oil fund rules should support fiscal discipline. However, in the case of Azerbaijan this effect is only partial, since wide swings in oil prices would lead to similar swings in revenues from Soviet-era oil fields, which go directly to the state budget.

Preliminary evidence suggests that both funds have contributed to improved transparency and accountability. In Azerbaijan, prior to the creation of the oil fund, no regular reporting took place on the use of oil bonus receipts. With the creation of the oil fund, quarterly reporting of oil fund revenues and expenditures and annual external audits have been put in place. Similarly, in Kazakhstan, before the establishment of the NFRK oil revenues were administered in an ad hoc, nontranspar-ent manner. Now, any future expenditures of the oil fund will pass through the state budget, all inflows will pass through the treasury, and its portfolio balance will be published monthly.

However, these oil funds are works in progress, and there are some causes for concern. In Azerbaijan, revising the accumulation rule could strengthen the stabilization element of the oil fund. And the completion of a medium-term expenditure framework (MTEF) and a public investment program (PIP), in the context of which oil fund spending can take place, is a high priority. In Kazakhstan, it is important to ensure that all transactions of the NFRK are effectively controlled by the central treasury, including the recording of investment returns. Finally, in both countries there is a need to develop a coherent long-term spending strategy, in order to address short-term pressures for potentially unwise expenditures, avoid excessive buildup of oil fund assets, and ensure that the funds are spent efficiently. In particular, it is important that these strategies do not call for the use of oil funds as development banks.

Of even greater concern is Azerbaijan’s tendency to ignore existing rules and Kazakhstan’s reluctance to publish the external audit. The above assessment of the likely contribution of these oil funds to the conduct of economic policy is based on the assumptions that the rules will be adhered to and transparency will be assured. If, on the other hand, the rules are merely guidelines to be ignored when they are inconvenient, these oil funds will not serve as the long-term political compact discussed above, but instead could be even more subject to short-term pressures than the annual budget. And without full transparency, confidence in these funds will not last. Therefore, the oil funds should be given a stronger legal basis by submitting all rules governing the fund to parliament for approval, and these rules should require full transparency. Such a step would ensure that, before the rules could be changed, there would first have to be a public discussion and amendment of the law. In Azerbaijan, significant progress in this direction has recently been made, as amendments to the Budget Systems Law have now incorporated the oil fund rules into that law.

Oil and gas government revenues are set to surge over the medium term in both countries. Now is the time to firmly establish the institutions needed to deal with the expected boom, and the authorities of both Azerbaijan and Kazakhstan have taken encouraging steps to do so. If well managed, Azerbaijan’s and Kazakhstan’s natural resource wealth can play an important role in facilitating the transition from plan to market. The oil and gas sector brings in foreign capital and expertise and supplies these countries with the means to improve the non-oil business climate in the form of better infrastructure, education, and public health. However, many countries have found themselves cursed by the availability of oil and gas riches. Mismanagement of these assets can easily turn them into liabilities. While the oil funds in Azerbaijan and Kazakhstan have the potential for contributing to improved macroeconomic management in those countries, for that potential to be realized a further strengthening of these oil funds, as discussed above, is urgently needed.


We would like to thank John Dodsworth and Peter Keller, as well as the participants in the IMF’s June 2002 Conference on Fiscal Policy Formulation and Implementation in Oil-Producing Countries, for helpful comments and suggestions.

For a discussion of these debates, see the special issue of the IMF Staff Papers on transition economies (Volume 48, 2001).

For a more complete discussion of these issues see Dodsworth, Mathieu, and Shiells (2002) and Mathieu and Shiells (2002).

Azerbaijan has used PSAs as the main tool for attracting foreign investment into the oil and gas sector. Once signed, PSAs are ratified by parliament and have the force of law.

The CPC pipeline linking the Tengiz field with the Black Sea was officially opened in late 2001. The 1,500-km line is the first private international joint venture in the region. The line had an initial capacity of about 600,000 bpd and cost US$2.6 billion to construct. It is estimated to have cut export transport costs in half.

The Norwegian Petroleum Fund, for example, is designed as a “tool for coping with the financial challenges connected to an aging population and the eventual decline in oil revenues, by transferring wealth to future generations” (Norwegian Ministry of Finance).

In 1998 and 1999, oil bonus financing of the state budget amounted to 1.8 and 3.7 percent of GDP, respectively. Off-budget use of oil bonus money included payments related to the purchase of one Tupolev 154 and two Boeing 757 aircraft in 1998.

In 1996 the authorities sold a 25 percent stake in the Tengiz field to Mobil for about US$1.1 billion, with an up-front payment of about US$500 million and performance-based tranches through 2000. On April 4, 2002, the prime minister revealed that a significant portion of these funds had been kept in undisclosed offshore accounts. Some US$300 million was repatriated to the NFRK in mid-2002.

Oil revenue has eased the problem of revenue availability, as declining tax revenue was offset by rising oil revenue. To this extent, the existence of oil revenue eased the transition process for Azerbaijan and Kazakhstan, relative to other countries. But that did not eliminate the need to develop a modern tax system or reduce the importance of containing expenditures to sustainable and manageable levels.

This applies in the case of finite oil supplies. If the oil revenue continues indefinitely, it will eventually be impossible to contain the real appreciation. However, there would still be an argument for targeting expenditures on enhancing productivity in the non-oil sectors.

In 2001, government revenue related to SOCAR’s output was 52 percent of overall oil- and gas-related government revenue. This share will decline over time, as production from Soviet-era fields declines and output from new fields increases.

However, presidential spending of these funds is not effectively controlled. To date, four presidential decrees have called for spending from the oil fund in Azerbaijan. Three called for spending to improve the living conditions of refugees and internally displaced persons, while one called for spending to finance SOCAR’s share of the BTC equity costs.

The government of Azerbaijan is cash-constrained; access to domestic or international capital markets is very limited.

Amuzegar (1999) offers a wealth of examples of misguided investment decisions in OPEC countries. Mumey’s (1994) study of Alberta’s natural resource fund makes it clear that similar problems can occur in developed market economies.

As noted above, revenues above the baseline assumption are “off budget,” although they are recorded in the treasury accounts. NFRK investment earnings are not recorded in the treasury or the budget.

The first annual audit has been conducted in Azerbaijan, the results of which are available on the oil fund’s website ( The first annual audit of Kazakhstan’s fund was completed in March 2002, but has not been released to the public. Information on the Kazakh government’s own annual report on NFRK operations was made public in May 2002 and quarterly reports on asset totals and their allocation are available on the NFRK website (

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