II Nonrenewable Resource Revenues: Policy Implications
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

A country with large fiscal revenues derived from exploiting a nonrenewable resource such as oil typically faces two main problems—that the revenue stream is uncertain and volatile, and that it will eventually dry up. NRFs are sometimes proposed to deal with both these problems. First, a fund may be seen as able to stabilize budgetary revenues. When the resource price is “high,” the fund would receive resources, which it would then pay out to the budget when the price is “low.” Second, a fund may be seen as a way to save some of the revenue generated by exploiting the finite stock of the resource, which can then provide income after it has been exhausted. Funds may also be set up for other reasons: to counteract real exchange rate volatility and “Dutch disease,”2 for liquidity and political economy purposes, and to enhance governance and transparency.

A country with large fiscal revenues derived from exploiting a nonrenewable resource such as oil typically faces two main problems—that the revenue stream is uncertain and volatile, and that it will eventually dry up. NRFs are sometimes proposed to deal with both these problems. First, a fund may be seen as able to stabilize budgetary revenues. When the resource price is “high,” the fund would receive resources, which it would then pay out to the budget when the price is “low.” Second, a fund may be seen as a way to save some of the revenue generated by exploiting the finite stock of the resource, which can then provide income after it has been exhausted. Funds may also be set up for other reasons: to counteract real exchange rate volatility and “Dutch disease,”2 for liquidity and political economy purposes, and to enhance governance and transparency.

Volatility and Uncertainty of the Revenue Stream

A volatile and uncertain fiscal revenue source renders fiscal management, budgetary planning, and the efficient use of public resources difficult. This is the case particularly when it makes up a large share of total revenue. The nonrenewable resource sector is an important source of foreign exchange and fiscal revenues in many countries, making them vulnerable to external variables largely beyond the control of policymakers and domestic agents (Table 2.1). The uncertainty and volatility of nonrenewable resource revenues is typically greater than for other kinds of revenue, mainly as a result of unpredictable and frequently large fluctuations in international commodity prices.

Table 2.1.

Indicators for Selected Countries with Nonrenewable Resource Funds (NRFs)

article image
Sources: IMF World Economic Outlook, database (Washington, various issues); and IMF staff estimates.

The nonrenewable resource for Kuwait, Norway, Oman, and Venezuela is oil; for Chile, copper; and for Papua New Guinea, gold, copper and oil.

1985–99.

1975–99.

Average absolute value of the annual difference in the ratio of nonrenewable resource exports to GDP.

Excludes 1991–93.

When revenue falls sharply and unexpectedly, expenditure often falls sharply too, which is typically costly. Cutting current expenditure can be notoriously difficult and unpopular, and it may be socially damaging, especially if not done in the context of a medium-term comprehensive strategy of expenditure adjustment. Cutting capital spending might involve the abandonment of viable projects, where the return on some additional expenditure may be high. As a result, the productivity of public investment could be affected. But if expenditure is not reduced in the face of large permanent negative shocks, fiscal sustainability could be questioned.

Dissaving to smooth the downward adjustment of spending in response to a negative revenue shock or to completely insulate spending from such a shock should reflect the extent to which the revenue shock is permanent or temporary. If temporary, the government could dissave until revenue recovers (the scope of financing permitting). If permanent, dissaving should be used to smooth the downward adjustment in spending, but not to prevent expenditure adjustment. Spending that is not adjusted to a permanent shock could be unsustainable, with the government continuously dissaving and eventually being forced to adjust. In particular, catastrophic negative price shocks that prompt major solvency reassessments (as in the case of oil in 1986) may require large adjustments even in the presence of smoothing mechanisms.

In practice it is often difficult to distinguish, ex ante, between permanent and temporary nonrenewable resource revenue shocks. Assuming the revenue shock is due to a change in the price of the resource,3 the decision whether the shock should be treated as permanent or temporary by the government should reflect the following three considerations.

First, a number of empirical studies suggest that the prices of nonrenewable resources such as oil seem to have no well-defined, time-invariant averages. Shocks are persistent, and it may not be possible to distinguish clearly between transitory and permanent components, or to predict turning points in oil price cycles. Studies that do find evidence consistent with the existence of time-invariant long-run averages, however, conclude that prices take a very long lime to return to their average, and thus for practical purposes they may be of limited relevance (Box 2.1; Figure 2.1).4

Figure 2.1.
Figure 2.1.

Crude Oil Prices, 1970–20001

(U.S. dollars per barrel)

Sources: IMF, International Financial Statistics (Washington, various issues); and IMF staff estimates.1 Light crude (1984 to present, U.K. Brent: 1974-84, North African Light: before that, Libyan Brega). Constant prices deflated by the manufacturing unit value at January 2000 prices.

Second, prudence would suggest that a negative shock should be seen as permanent, and a positive shock as temporary, until proven otherwise. The stronger a government’s financial position, the less it needs to heed this advice because it can better afford to delay cutting expenditure. Also, the less costly expenditure is to adjust, the quicker it should be adjusted.

Third, there may be exceptional reasons why the current price of a resource is not likely to be its price in the future. For example, global production may be known with reasonable certainty to increase or decrease. Where resources have forward markets, however, this information should be largely reflected in the resource’s forward price. For example, the spot price of oil rose sharply after the Iraqi invasion of Kuwait in 1990, but the forward price of oil rose significantly less because financial markets expected the situation to be temporary.

In fiscal management, a distinction should be made between countries that rely heavily on revenue from nonrenewable resources and those that have a broader fiscal revenue base. For countries that have a relatively diversified production structure and alternative sources of fiscal revenue, the impact of resource price volatility would be less severe. As discussed in Section V, this distinction has important implications for NRFs.

Exhaustibility of the Revenue Stream

Government revenue derived from exploitation of nonrenewable resources differs from other revenue in that it partly represents a depletion of wealth. When a significant share of government revenue is derived from the exploitation of such resources, intergenerational equity and fiscal sustainability require consideration of the finite nature of the resources and of the prospective evolution of government net wealth, since analysis based solely on indicators of fiscal balance could be misleading. In particular, government wealth can be seen as the sum of net financial wealth and resource wealth. Thus, if all the revenue from nonrenewable resources were to be consumed, this would leave less wealth, and lower consumption opportunities for future generations. This would generally be considered undesirable on intergenerational equity grounds.

Exactly how much revenue from nonrenewable resources should be saved rather than consumed is a complex question that has been the subject of substantial research.5 In general, sustainable government consumption is related to the permanent income out of government net wealth (inclusive of resource wealth). This relationship would need to take into account factors such as population growth and technological change. It is also difficult to estimate in practice, with any degree of confidence, such variables as the future price of the nonrenewable resource, the amount of the endowment, and the cost of extracting it, especially when these factors may vary substantially and frequently.

Time-Series Properties of Oil Prices

Empirical evidence suggests oil prices do not have well-defined time-invariant averages.1 The evidence would seem to be relatively strong for data sampled at short intervals. Studies that have found evidence that oil prices may be stationary (typically using data sampled at longer intervals) also find that mean reversion is extremely slow—prices take a long time to revert to their long-run averages following a deviation.

Consequently, shocks are extremely persistent and may affect all expected future prices. Small yet long-lived price shocks would have policy implications different from those for very large long-lived price shocks. The evidence shows that oil prices exhibit a pattern of large fluctuations and substantial volatility (see Figure 2.1). Research at the IMF suggests that one-third of the time the oil market will be faced with the prospect of a monthly price change greater than 8 percent (Cashin, Liang, and McDermott, 1999). There is also little evidence of a consistent “pattern” to oil price cycles, since the probability of an end to an oil price slump (a period of absolute price decline) or boom (a period of absolute price rise) appears to be independent of the time already spent in the slump or boom (Cashin, McDermott, and Scott, 1999).

The notion that oil prices may not tend toward a time-invariant average or “normal” price (or that they may do so very slowly) may be counterintuitive. There may be a presumption that at higher oil prices production of oil and its substitutes should increase, and that oil output should decrease if prices are below marginal costs. This might give rise to the conjecture that oil prices might move randomly but within a “corridor” or band of prices with reflecting barriers. However, from an analysis of the long-run behavior of oil prices in real terms it is difficult to find such bands. Rather, the evidence would appear to be consistent with the view that unpredictable regime switches occur from time to time. In the past three decades, regime changes appear to have taken place in 1973, 1979–80, and 1986.

1 That is, oil prices appear to follow a nonstationary process. See, for example, Hausmann, Powell, and Rigobón (1993); Claessens and Varangis (1994); and Engel and Valdés (2000). The power of the tests used in these studies, however, in general is low.

Nevertheless, considerations of long-run fiscal sustainability would generally imply saving a portion of today’s nonrenewable resource revenue and setting normative limits on the nonresource fiscal deficit.6 This approach would both stabilize usable revenue and provide for the accumulation of financial resources that make up for the depletion of the natural resource, thereby helping to implement fiscal policies that are set within a longer-term framework. The factors that could help to determine ranges for the sustainable level of the nonresource fiscal deficit are reviewed in Annex I

Savings with the objective of preserving net government wealth are different from the financial savings designed to smooth expenditure adjustment discussed in the previous subsection. The former represents an economic concept of saving—that is, the excess of current revenue over current expenditure—and the theory is mute whether it should be invested in public works or held as financial assets, and thus whether the government should run an overall surplus or deficit. Savings to smooth expenditure adjustment, however, relate to financial savings. For example, if a government runs high economic savings but spends massively on public investment during “good” times and fails to build up financial assets, this may not help it to finance expenditure adjustment during “bad” times.

Real Exchange Rate Volatility and “Dutch Disease”

Large revenues from volatile nonrenewable resources have implications for the economy as a whole, not just for the fiscal sector. Nonrenewable resource shocks can affect the level of the real exchange rate through several channels including disposable income, wealth effects, procyclical government spending on nontradables, and short-run monetary disequilibrium. There is evidence that the volatility of the real effective exchange rate is damaging to the nonresource sector and capital formation (World Bank, 1993; Servén and Solimano, 1993). Moreover, an increase in resource revenues, particularly if perceived as permanent, may place upward pressure on the real effective exchange rate, with effects on the nonresource tradable sector (Gelb and associates, 1988).

Fiscal policy can play a role in addressing these issues, particularly when the government receives substantial nonrenewable resource revenue. The basic fiscal response should be to smooth spending on nontradables when resource revenues vary. For the balance of payments as a whole, large resource current account receipts could be offset by capital account outflows. To the extent that nonrenewable resource receipts flow to the government, the government or the central bank could build up external assets or repay foreign debt.

Liquidity

In addition to addressing net debt and sustainability issues, governments also need to manage their gross assets and liabilities (see Section IV). Countries with heavy reliance on volatile resource revenues will generally need to have substantial financing available. During downturns, governments could either borrow or run down their financial assets; which one to rely upon is mainly an asset-management issue.

International lending to developing countries and primary commodity producers with heavy reliance on volatile resource revenues, however, tends to be pro-cyclical (World Bank, 1994). Some of these countries may find it difficult to ensure financing when the price of the resource falls sharply, at a time foreign resources may be most needed. They may also find other limits on their capacity to tap international capital markets that may be difficult to predict. Countries that face such constraints in their borrowing capacity may place a premium on liquidity as such, and may wish to maintain a large stock of liquid financial assets, ideally in the form of external claims to avoid merely passing on the shock to the domestic private sector.

Other Issues

Running fiscal surpluses is often politically difficult. Even though there may be an economic case for building up public financial savings, decision makers may be subject to pressures for additional spending when revenues are available. More generally, it has been argued that democratically elected governments may have a built-in deficit bias, and thereby a tendency to redistribute income from future generations to the present (Corsetti and Roubini, 1993). As a means of helping to build political support for financial saving, governments often “earmark” the savings for certain types of high-priority public spending. Governments also earmark funds in the desire that the high-priority public spending plans will have the requisite financing.

High nonrenewable resource revenues may be misused or otherwise subject to poor governance. Stringent institutional measures to prevent such behavior may be required. Linked to the issue of governance is that of transparency. The more transparent the resources flowing to the public sector, the more difficult it may be to misuse them.

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