Chapter

Annex 3. Anchoring Fiscal Policy in Oil-Exporting Countries

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
November 2013
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Fiscal management of resource revenues is a high policy priority in oil-exporting countries. Governments are the main beneficiaries of oil receipts, and they decide how much to save abroad or spend in the domestic economy. Governments’ fiscal policy decisions, which are often made in an environment of volatile and uncertain oil revenues, have a substantial impact on macroeconomic stability, development of the non-oil economy, and intergenerational equity. Moreover, in pegged exchange rate regimes with limited monetary policy independence, fiscal policy is the main instrument of demand management. In the absence of strong fiscal management frameworks, government spending may become procyclical, as recent experiences in a number of MENAP and CCA oil exporters have shown.

Oil-exporting countries would benefit from the use of a suite of fiscal models to calibrate their fiscal policy decisions. The non-oil primary balance helps assess the short-term fiscal stance because it measures the impact of policy changes on aggregate demand and the fiscal position. The permanent income hypothesis (PIH) model is most useful for evaluating long-term intergenerational equity and fiscal sustainability. The structural balance approach allows for smoothing oil price volatility while calibrating spending decisions. Countries can also inform their assessments of fiscal buffers needed to deal with oil revenue volatility by applying the finite horizon precautionary saving-investment model. Finally, dynamic stochastic general equilibrium (DSGE) models provide a more general decision-making framework that takes into account the broad economic effects of resource-financed public spending.

The Role of Fiscal Policy for MENAP and CCA Oil Exporters

Fiscal management advice in oil-exporting countries needs to take into account country-specific characteristics:

  • Oil dependence. Oil exporters in the MENAP and CCA regions tend to depend heavily on oil exports for fiscal and export revenues, making them very vulnerable to changes in production and international oil price fluctuations (Figure A3.1, panel a). To the extent that these countries depend on oil, fluctuations in international oil prices may have a large impact on macroeconomic stability, suggesting the need to build up buffers.

  • Size of oil reserves. Most countries in the region could sustain current production levels for more than a generation (30-plus years), in which case medium- to long-term fiscal sustainability may not be an immediate concern. Some countries with shorter horizons face more binding fiscal sustainability constraints (Figure A3.1, panel b).

  • Fiscal vulnerabilities. Fiscal breakeven oil prices vary across countries and have increased since 2009, underscoring the vulnerability to lower oil prices (Figure A3.1, panel c).

  • Development needs. Some countries have pressing development and reconstruction needs that may warrant front-loading investment spending while maintaining long-term fiscal sustainability (Figure A3.1, panel d). Part of oil revenues can also be prudently used to promote economic diversification.

Figure A3.1aCountry-Specific Fiscal Management Considerations

(Percent, average 2006–13)

Source: IMF World Economic Outlook database.

Figure A3.1bRatio of Proven Reserves to Total Oil and Natural Gas Production

(Percent, 2012)

Sources: U.S. Energy Information Administration; and British Petroleum (2013).

1 Iraq has one of the largest natural gas reserves in the world but produces very little of it; only oil is included. Including natural gas, Iraq’s ratio would be around 4,500.

Figure A3.1cChange in the Fiscal Breakeven Oil Price, 2009–13

(U.S. dollars per barrel)

Source: IMF staff calculations.

1 Turkmenistan does not have a 2009 breakeven price, so 2011 is used for the earlier period.

Figure A3.1dHuman Development Index and per Capita Purchasing Power Parity GDP

Sources: United Nations Development Programme; and IMF World Economic Outlook database.

Fiscal Management in Oil Exporters: Objectives and Tools

Managing public finances in oil-rich countries involves distinct objectives relating to macroeconomic stabilization, fiscal sustainability (including intergenerational equity), and development. Macroeconomic stabilization entails the use of spending and taxation decisions to smooth the impact of economic fluctuations caused by domestic and external shocks. Ensuring fiscal sustainability includes explicitly linking fiscal policy to resource exhaustibility, and helping to accumulate savings for intergenerational equity. The development objective involves making expenditure decisions with long-term economic growth in view, and includes economic diversification. The prioritization of the objectives, and the analytical tools used to formulate policies, may vary with specific country characteristics, such as the length of the resource revenue horizon, development needs, and the level of fiscal buffers that can be tapped if there were to be a sustained fall in resource prices (Baunsgaard and others, 2012) (Table A3.1).

Table A3.1.Fiscal Goals and Analytical Tools
Short- to Medium-Term Macro StabilityMedium- to Long-Term Fiscal SustainabilityDevelopmental Needs
Analytical ToolFacilitates assessment of the fiscal stance impulseDeals with oil revenue volatilityHelps target precautionary bufferLinks fiscal policy with exhaustibilityHelps set savings for intergenerational equityAccounts for growth return on investmentsLinks to other macro variables
Non-oil primary balance (as a percent of non-oil GDP)✓ (if cyclically adjusted)✓ (excludes oil revenue)
Structural balance (with oil price-smoothing mechanism)
PIH-based rulesPermanent income hypothesis (PIH)Can serve as a medium-term benchmark
Modified PIH rule or FSF (allows for front-loading investment spending)Can serve as a medium-term benchmark
Structural DSGE models
Precautionary saving-investment model
Note: DSGE = dynamic stochastic general equilibrium; FSF = fiscal sustainability framework.
Note: DSGE = dynamic stochastic general equilibrium; FSF = fiscal sustainability framework.

Safeguarding Short-Term Macroeconomic Stability

Safeguarding short-term macroeconomic stability means avoiding boom-bust cycles by aiming to smooth spending and delink it from oil price dynamics. The experience of oil exporters, however, shows that non-oil primary deficits have tended to move closely with oil prices, suggesting that countries have not been able to avoid procyclical fiscal policy. The non-oil primary balance (NOPB) as a percent of non-oil GDP is useful for capturing the impact of policy changes on aggregate demand and is the most widely used indicator. As governments channel oil revenues through spending into the domestic economy, the NOPB measures the impact of spending on domestic demand. Using this indicator for setting fiscal policy helps separate the fiscal policy stance from the volatility of oil revenues (Figure A3.2). The NOPB can remain stable even if the overall fiscal balance shifts abruptly as a result of the volatility in oil prices or production. To be able to maintain a steady NOPB or implement countercyclical fiscal policies in the face of a large oil price drop, countries should also aim to build adequate fiscal buffers.

Figure A3.2Oil Exporters: Average Non-Oil Primary Deficit1

(Percent of non-oil GDP)

Source: IMF, World Economic Outlook database.

1 For each year, the non-oil primary deficit is the average for the following countries: Algeria, Azerbaijan, Bahrain, Iran, Iraq, Kazakhstan, Kuwait, Libya, Oman, Qatar, Saudi Arabia, Sudan, Turkmenistan, United Arab Emirates, Yemen.

The 2008–09 oil price declines illustrate the usefulness of the NOPB in the first instance to assess the fiscal stance. Countries that maintained their precrisis NOPB levels throughout the crisis were able to avoid procyclical fiscal policy and steep non-oil output drops. In addition, if a shock to non-oil output were to occur, the NOPB would be a good measure for assessing the fiscal impulse for countercyclical demand management.

Calibrating Expenditure in a Medium-Term Framework

Fiscal policy requires an anchor for short- to medium-term spending to break the link between budgets and oil price volatility. For a country with a very strong fiscal position and with large oil reserves that will last for many years, a key question is what framework can best help manage the volatility of oil revenues in the short to medium term. The structural balance approach allows for smoothing oil price volatility while calibrating spending decisions. A structural balance rule can be applied in all oil resource countries regardless of the resource horizon, and it is particularly useful for countries with long resource horizons in which intergenerational constraints derived from application of the PIH are not binding in the near term.1 In these cases, the emphasis should be on computing the fiscal impulse, and on setting a conservative medium-term path that severs expenditure from oil volatility.

A structural balance rule requires assumptions about future oil prices and production. Assumptions about the long-term oil price and, in countries such as Saudi Arabia that have spare capacity, production, are inherently difficult but must be made to decouple expenditures from resource price volatility. The experience across countries shows that there is no one way of establishing the long-term price assumption.2 A five-year, backward-looking price rule, for instance, strikes a balance between low volatility and adjustment to new market trends within a reasonable timeframe. A backward-looking rule also has the advantage of not requiring forecasts of future oil prices; however, given the oil price trends of the past decade, when average oil prices were lower than are now forecast for the medium term, a longer backward-looking rule could be viewed as being too conservative for a country with well-established fiscal buffers and a need to boost infrastructure and education spending. Considering the implications of Saudi Arabia’s spare production capacity on structural output, a three-year backward-looking average is used as the structural oil output level.3

The spending benchmark derived from PIH models is generally binding for countries with relatively weaker fiscal positions and limited reserve horizons.4 In these countries, government spending is often too large to be maintained after the natural resources have been exhausted. In such cases, for example, Azerbaijan, the structural balance target needs to be consistent with the PIH benchmark to ensure long-term fiscal sustainability. In this instance, anchoring the NOPB to achieve a fiscal position consistent with PIH-derived levels in the medium term would maintain fiscal discipline in times of high oil prices and help ensure intergenerational fairness.

Strengthening Institutional Capacity

In the absence of strong fiscal institutions to execute numerical fiscal rules, such as the structural balance, procedural rules can be implemented as an intermediate step.5 International experience suggests that strong and transparent fiscal institutions are needed for the successful implementation of fiscal rules, particularly an effective public financial management system and legislation delineating the roles and responsibilities of government agencies (see below). In countries with limited technical capacity, procedures outlining steps to be followed during the budget preparation process can be an alternative to numerical fiscal rules. As institutional capacity strengthens, countries can then move toward numerical fiscal rules.

Anchoring Medium- and Long-Term Fiscal Sustainability and Promoting Sustainable Development

Fiscal policy should be consistent with medium- to long-term fiscal sustainability, while at the same time taking into account intergenerational equity and development needs. This objective should be a priority for countries that have shorter resource horizons, or that face critical social and infrastructure gaps that merit front-loading current or investment spending. Policymakers should also focus on fostering policies to generate sustainable development. In general, PIH-based models are useful for anchoring long-term fiscal sustainability;6 however, richer models can be used to address the limitations of simple PIH frameworks that abstract from the volatility of oil revenues and returns on oil-funded capital spending. In this respect, precautionary saving-investment models can be used to provide for volatility of oil revenues. In addition, DSGE models can be useful for evaluating policies in a more general framework, including the macroeconomic effects of fiscal policy (IMF, 2012a).

Recent applications of the PIH benchmark suggest that most oil exporters need to undergo fiscal consolidation to help ensure intergenerational equity.7 The PIH approach is particularly useful for countries with short reserve horizons, structural export constraints, and low levels of accumulated savings. For Azerbaijan, for example, the PIH model could provide a medium-term fiscal anchor. For countries with long reserve horizons, such as Iraq, Kazakhstan, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates, the PIH model is unlikely to provide binding near-term spending constraints, even if the true size of oil reserves is underestimated. Nonetheless, even many countries with long reserve horizons were found to have looser fiscal positions than is consistent with intergenerational equity (Figure A3.3).

Figure A3.3Nonhydrocarbon Primary Fiscal Deficit, 2013

(Percent of nonhydrocarbon GDP)

Sources: National authorities; and IMF staff estimates.

Note: PIH = permanent income hypothesis.

1State budget.

The application of the standard PIH model should be complemented with robustness checks. The PIH model is extremely sensitive to assumptions, and there is a large degree of parametric uncertainty in indicators—the expected rate of return on financial assets, future population growth, GDP growth, the future trajectory of the price of nonrenewable resources, and the size of hydrocarbon reserves. Therefore, the robustness of the recommendations should be tested by using sensitivity analysis. In its standard form, the PIH also does not carve out a role for public investment in diversifying the economy (it assumes zero return on investment).

Trade-Offs in Scaling Up Investment

Modified PIH (MPIH) and fiscal sustainability framework (FSF) models can be used to analyze the impact of scaling up expenditures in the medium term on long-term fiscal sustainability.8 In some cases, such as Iraq, short-term deviations from the PIH framework might be warranted to address critical social and infrastructure needs, because the country has a long reserve horizon, there is a high return on capital spending, and credit markets are not functioning properly. Similarly, as in Iran, a country may optimally decide to spend beyond PIH benchmarks in the short term if export volumes are to recover to their pre-sanction levels in the medium term. The MPIH model, which allows for a scaling up of spending in the medium term that is followed by a scaling down of spending to preserve long-term wealth, computes the necessary subsequent fiscal adjustment if the scaled-up spending does not result in higher growth.

However, the need to save in later years could be lessened if the additional upfront investment spending has a positive growth and tax revenue impact. In this respect, the FSF model incorporates the impact of higher public investment on growth and nonresource revenues, generating a fiscally sustainable path that is consistent with a lower level of financial wealth. In Azerbaijan, the implementation of the FSF model underscored the effect of higher investment on absorption-capacity constraints, low impact of public investment on growth, and potential overheating of the economy.

Building Fiscal Buffers to Deal with Uncertainty

In countries with shorter reserve horizons and low levels of accumulated savings, the assessment of fiscal buffers to deal with oil revenue volatility becomes important. A precautionary saving-investment model can be used to inform the optimal allocation of volatile oil income among consumption, precautionary saving, and investment.9 This model (Cherif and Hasanov, 2012) allows for saving part of oil income for precautionary purposes (build buffers) that can be drawn down in case of an unexpected drop in oil prices as well as investing domestically. The application to Oman suggests that projected spending is on an increasing path, above the optimal level suggested by the model (given a projected decline in oil prices in the medium term) (Figure A3.4). There is also scope for setting capital expenditure priorities so as to bring the projected investment rate in line with the lower optimal path. The projections shown suggest that spending should not continue on its increasing current path (given a projected decline in oil prices in the medium term).

Figure A3.4Oman: Optimal versus Actual/Projected Spending, 2012–18

(Billions of U.S. dollars)

Source: IMF staff calculations.

Assessing the Impact on the Overall Economy

Ambitious scaling up of public investment can generate more growth, but the cost of funding this investment can be high because it draws down from buffers or it accumulates external debt. DSGE models can be useful for making fiscal decisions, such as to invest resource revenues while maintaining fiscal sustainability, in a more general framework that takes into account the macroeconomic effects of resource-financed public spending.10 These models have features that are not addressed in standard PIH models, such as modeling the link between public investment and nonresource growth; accounting for Dutch Disease; and allowing for detailed fiscal specification of spending and saving, debt sustainability, and fiscal policy. On the downside, these models can be relatively complex and therefore are not easy to communicate to the public.

Institutional Reforms Needed to Strengthen Fiscal Management

Well-designed fiscal frameworks are particularly important for resource-rich countries because of their significant reliance on oil and gas resources.11 The use of overly conservative oil prices in national budgets, while helping to contain spending pressures, may allow for significant deviations between actual outcomes and initial budget targets, particularly if oil prices are higher than budgeted.12 There is scope to further enhance the role of the budget as the government’s main tool for setting and achieving economic and social goals. In particular, moving toward medium-term budget frameworks can help ensure that spending is stable—despite temporary fluctuations in revenue—and consistent with longer-term policy objectives. Many oil exporters need to build adequate capacity to carry out macro-fiscal analysis and develop strong fiscal frameworks that allow for implementation of countercyclical policies. Several countries have recently been taking steps toward introducing medium-term budget frameworks (Qatar), by starting to move beyond one-year budgets, and by establishing macro-fiscal units (Kuwait, Qatar).13

A credible commitment to macro-fiscal stability and effective use of oil wealth should be supported by a public financial management (PFM) system consistent with international best practices. A sound PFM system helps to ensure, as part of the budget process, (1) a transparent and comprehensive presentation of oil revenue and the underlying non-oil fiscal position; (2) a sustainable long-term fiscal strategy based on prudent revenue projections, realistic medium-term fiscal frameworks, and a good budget classification; and (3) transparent mechanisms for appraisal, selection, and prioritization of investment projects, to ensure that resource revenue is used to support long-term economic development.

The ongoing revision to the existing IMF Code of Good Practices on Fiscal Transparency (IMF, 2007) advocates good practices for fiscal reporting, and provides relevant guidance on how to enhance transparency. In particular, fiscal reports should (1) cover a wider range of public sector institutions, (2) capture a broader range of direct and contingent assets and liabilities, and (3) take a more rigorous approach to fiscal forecasting and risk analysis. The World Bank’s EITI++ initiative—building on the transparency and good governance concepts of the existing multistakeholder Extractive Industries Transparency Initiative (EITI)—is also relevant for resource-rich countries because it has widened the transparency requirements for the reporting of natural resource wealth management, including revenue and spending (see also Box 2.5).

The first step is to compute structural oil revenues using “long-term” oil prices and “structural” production assumptions. The second step is to target a specific NOPB using the structural revenue projections. The NOPB target can then be calibrated to be consistent with accumulation of fiscal buffers in the medium term. International experience suggests that the rule needs to be simple to implement and easy to communicate to the general public and parliament. For specific applications, see IMF “Selected Issues” in Country Reports 13/218 (Iraq), 13/151 (Libya), 13/15 (Qatar), 12/165 (Azerbaijan), and 13/230 (Saudi Arabia).

See IMF (2012a) for a discussion of international experience applying structural balance rules.

“Saudi Arabia: Selected Issues,” IMF Country Report No. 13/230 (Washington, 2013).

“Republic of Azerbaijan: Selected Issues,” IMF Country Report No. 13/165 (Washington, 2013).

See “Iraq: Selected Issues,” IMF Country Report No. 13/218 (Washington, 2013); and “Qatar: Selected Issues,” IMF Country Report No. 12/15 (Washington, 2012). For Iraq, the procedures included (1) setting a clear medium-term fiscal objective and corresponding NOPB targets; (2) establishing a conservative baseline scenario, with realistic oil price and export volume assumptions; (3) identifying domestic and external sources of financing; (4) identifying nondiscretionary spending commitments; (5) setting a realistic discretionary spending path that includes all spending commitments; and (6) preparing a statement of fiscal risks.

The PIH model is used to assess long-term fiscal sustainability and intergenerational equity. The model is useful in providing indicative medium- to long-term benchmarks for fiscal spending, based on the net present value of resource wealth, that are both stable and equitable across generations. The optimal spending annuity benchmark can then be compared with baseline projections of non-oil primary balances.

For the MENA region, see “Kuwait: 2012 Article IV Consultation,” IMF Country Report No. 12/150 (Washington, 2012); “Algeria: 2012 Article IV Consultation,” IMF Country Report No. 13/47 (Washington, 2013); “Iraq: 2013 Article IV Consultations,” IMF Country Report No. 13/217 (Washington, 2013); and “United Arab Emirates: Selected Issues,” IMF Country Report No. 13/240 (Washington, 2013). For the CCA, See “Republic of Azerbaijan: 2013 Article IV Consultation,” IMF Country Report No. 13/164 (Washington, 2013).

See IMF (2012b) for a presentation of the MPIH and FSF models.

In contrast, PIH models do not factor in uncertainty, which would suggest that in a finite horizon framework, one initially borrows to spend and repays the accumulated debt later.

See Buffie and others (2012), Berg and others (2013), Melina and others (2013), and IMF (2012b). For the sustainable investing tool, see the Article IV Consultation for Azerbaijan (IMF Country Report No. 13/164); for the DIGNAR model, see IMF (2013d).

See Barnett and Ossowski (2002). For GCC-specific recommendations, see IMF (2012b).

In recent years, higher-than-budgeted oil prices have led to the approval of supplementary budgets in some CCA countries. In contrast, in some GCC countries and Iraq, the authorities resorted to discretionary spending increases outside of the budget framework.

Qatar’s macro-fiscal unit is not yet operational.

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