Abstract
This chapter discusses long-term fiscal issues related to the allocation of oil wealth. The fiscal outlook under current policies appears broadly in line with keeping oil wealth constant in real terms, while a significant fiscal adjustment would be required to maintain oil wealth in per capita terms as suggested by the permanent income theory. The chapter concludes with a discussion of various investment strategies which could be considered to preserve oil wealth in the long run, including the merits of building assets abroad.
V. Preserving Oil Wealth for Future Generations38 39
68. The management of Iran’s non-renewable natural resources wealth is of critical importance for the long-run sustainability of its fiscal policy and equitable intergenerational sharing of oil wealth. Iran has the third largest oil reserves in the world, ranking behind Saudi Arabia and Iraq, as well as the second largest endowment in natural gas, after Russia.
69. Despite a relatively diversified economy, the government relies on oil exports for more than half of its revenue. Based on proven reserves, the country’s oil and gas resources are estimated to last for about 75 years, assuming that extraction of oil continues at the current pace and extraction of gas accelerates in the next decade. In this context, long-run sustainability and intergenerational equity considerations require that a portion of today’s oil and gas revenue is saved.
70. This chapter determines the optimal amount of government savings out of oil revenues, drawing on the theory of permanent income. In the context of this theory, intergenerational equity considerations are given prominence, while fiscal sustainability issues are not explicitly examined, assuming that the government inter-temporal budget constraint is always met. The optimal saving rule determined by the permanent income theory requires that the government devotes to public consumption only the return on oil wealth adjusted for population growth.
71. In addition, another saving rule is widely used in studies on fiscal policy in oil producing countries. It recommends that the government save such a portion of oil revenues so as to maintain oil wealth constant in real terms. Although this rule is not based on any theoretical background, it is very intuitive and appealing from the political economy point of view, as it puts forward a concept of oil wealth preservation which for many countries is less constraining than the rule suggested by the permanent income theory.
72. Section A estimates the required savings out of oil revenue, permanent income, and the level of government’s consumption consistent with the two above-mentioned rules. It also compares the obtained results with the current fiscal policy stance. Section B reviews economic considerations that could guide the allocation of the government’s savings between different asset categories.
A. Permanent Income Theory and Current Policies
Analytical framework
73. One method to assess the sustainability of consumption out of oil wealth can be derived from the permanent income theory of consumption.40 In theory, it is optimal for governments that care equally about current and future generations to restrain public consumption to a level that maintains their total per capita wealth41 constant over time (Box V-l). This implies that in each period governments should consume at most the real return they receive on their total wealth, or the so-called permanent income, assuming no population growth. The permanent income rule ensures economic equity across generations because it enables governments to deliver to future generations the same level of per capita public services available to the current generation.
74. Iran’s rapid population growth calls for consuming less than the real return on oil wealth. Iran’s population is currently growing at about 1.6 percent per year and the rate is expected to decline gradually to about 1 percent of GDP by the end of this century. To keep per capita government expenditure constant over time, the government needs to further restrain public consumption in order to preserve wealth on a per capita basis and secure a constant income stream per capita (Box V-l). Assuming an initial population growth rate of 1.6 percent and a real rate of return of 3.5 percent over the long-term, government consumption out of oil wealth would need to be limited to 1.9 percent and the remaining 1.6 percentage points of permanent income should be saved (according to equation (5) in Box V-l). However, if the objective is to maintain a constant wealth in real terms, the government could consume the full permanent income equivalent to 3.5 percent of oil wealth.
Permanent Oil Income Model
The purpose of this model is to determine an optimal rule on how to distribute oil wealth across generations. The optimal solution to the government’s consumption level (1) which ensures intergenerational equity is defined as follows (Engel and Valdes, 2000):
where:
U is utility function
β is a subjective discount factor
CG.t is government consumption at time t
1/ρ denotes the elasticity of substitution of consumption at different moments in time
n is the population growth rate.
Equation (2) defines the net wealth WG,0 as the starting net wealth FG, o and the present discounted value of future oil revenues:
where:
R is a real return expressed as 1 plus a real return as a fraction of 1
YG, S is oil revenue in period s
Equations (3) and (4) define the optimal path of government current spending out of oil wealth:
where:
If βR=1, implying that the society is patient enough to have the subjective discount factor equal to the real rate of return, the right hand side of (3) is government’s permanent income that is the highest per capita government consumption level that can be maintained indefinitely:
75. The introduction of a distinction between investing in financial assets and undertaking capital expenditure does not affect the general conclusions of the permanent income theory under certain conditions. Sustained public investment in infrastructure and human capital financed by oil revenue can contribute to an increase in the long-run growth rate of the non-oil sector. Fiscal sustainability, however, requires public investment to be sufficiently productive to generate tax revenue higher than or equal to the prevailing return on financial assets of the equivalent amount.42 Beside resource and financial wealth, government revenue generated by the non-oil economy can also contribute to maintaining a stable level of fiscal spending. To ensure intergenerational equity, additional non-oil revenue would have to result from economic growth (in excess of population growth) rather than from an increase in the tax burden. Assuming that this rule is observed, the following analysis does not make a distinction between investment in financial assets and physical assets.
76. As a share of oil revenue is saved and invested, the return on these investments becomes an important source of finance for the budget. Accordingly, the government’s consumption out of oil wealth can be measured by the non-oil current deficit minus net interest and capital income.43 From the perspective of maintaining stable oil wealth, this measure of the non-oil deficit should be less than or equal to the permanent income.
77. Estimates of the permanent income are subject to large uncertainties. They are highly sensitive to several factors, including long-run oil and gas prices, the volume of proven reserves, the extraction rate, future GDP growth rates, and the discount rate. Among the above assumptions, oil and gas prices are the most difficult to predict. In particular, some empirical research papers suggest that oil prices do not revert to a long-term average, while others find only a very slow reversion and high persistence of shocks.44 Revisions to the oil revenue outlook may also stem from further discoveries of oil and gas reserves or the development of alternative energy sources. Thus, the issue of sustainability needs to be frequently revisited as new information may lead to large variations in permanent income estimates. Uncertainty also argues in favor of saving from oil revenue more than what the permanent income framework would advise, in order to smooth out consumption.
78. In the case of Iran, estimates of oil wealth and permanent income are also sensitive to assumptions on the valuation of domestic consumption of oil products and the pace of the phasing-out of implicit energy subsidies. The valuation of oil wealth using subsidized prices for domestic distribution is not strictly speaking consistent with the intergenerational equity because current generations would benefit from implicit subsidies that reduce the permanent income, while future generations would have to pay higher oil prices and benefit from a permanent income that is reduced by implicit subsidies. Based on this consideration, oil wealth is estimated, using international prices for domestic consumption, and implicit subsidies are recognized as current expenditure. 45
Base-line scenario: Oil wealth valuation using projected international prices for domestic consumption
79. The present value of Iran’s public wealth at the beginning of 2002/03 is estimated at about US$863 billion, equivalent to 787 percent of the projected 2002/03 GDP, taking into consideration oil and gas reserves, and reported government’s net financial assets. This estimate hinges on several key assumptions (a) a real rate of return and a discount rate of 3.5 percent are assumed throughout the projection period; and (b) oil and gas extraction would proceed at a constant pace after a decade during which gas production expands more than twofold (a faster gas output growth would increase the present value of wealth allowing the government to sustain a higher level of consumption). On this basis, with proven oil-reserves of 97 billion barrels at the beginning of 2002/03, estimated to last about 75 years, and a long-run price of US$18 per barrel for both exports and domestic consumption, the present value of the oil wealth is estimated at 486 percent of 2002/03 GDP. Assuming gas-reserves of 20 trillion cubic meters, estimated to last for about 80 years, and a long-run price of US$65 per cubic meter46, the present value of the gas wealth is estimated at 302 percent of 2002/03 GDP. Finally, the government’s outstanding debt net of its deposits in the banking system, which amounted to US$5.9 billion in total, was subtracted from the oil an gas wealth to obtain an estimate of Iran’s net public wealth.
80. Benchmark values of Iran’s consumption out of oil wealth over the medium term are estimated using two criteria (Figure V-l): (a) maintaining per capita oil wealth constant in real terms and (b) maintaining constant oil wealth in real terms. The base-line scenario reveals a strong bias in favor of current generations under current policies. The non-oil current fiscal deficit for 2002/03 is about 8 percentage points of GDP above the benchmark prescribed by the permanent income theory. In contrast, the current policies are still consistent with the preservation of oil wealth in real terms (Figure V-l), 47 which, however, means that the government would not save enough resource revenue to maintain its ability to provide the same per capita levels of public services in the long-run—the main sustainability criterion. Nor do the current policies ensure that oil wealth remains constant in real terms in the face of possible future oil and gas price shocks commensurate with the relatively recent history.
Islamic Republic of Iran: Current Fiscal Deficit Excluding Net Interest Income, 2002/03-2011/12
(In percent of GDP)
Citation: IMF Staff Country Reports 2002, 212; 10.5089/9781451818963.002.A005
Source: Fund staff estimates and projections.1/ Consistent with the slow reform scenario of Appendix V, SM/02/279Islamic Republic of Iran: Current Fiscal Deficit Excluding Net Interest Income, 2002/03-2011/12
(In percent of GDP)
Citation: IMF Staff Country Reports 2002, 212; 10.5089/9781451818963.002.A005
Source: Fund staff estimates and projections.1/ Consistent with the slow reform scenario of Appendix V, SM/02/279Islamic Republic of Iran: Current Fiscal Deficit Excluding Net Interest Income, 2002/03-2011/12
(In percent of GDP)
Citation: IMF Staff Country Reports 2002, 212; 10.5089/9781451818963.002.A005
Source: Fund staff estimates and projections.1/ Consistent with the slow reform scenario of Appendix V, SM/02/279Lower international prices scenario
81. The results of the base-line scenario are highly sensitive to the assumptions on oil and gas prices. Under lower long-run oil (US$14 per barrel) and gas (US$51 dollar per thousand of cubic meters) prices, the fiscal stance under current policies fails to meet either criterion on oil wealth preservation (Figure V-1); although the deviation of the current policies fiscal stance from the benchmark for maintaining oil wealth constant in real terms is not large. Moreover, the reliance on future gas revenue needs to be considered with caution because it has not generated substantial revenue flows to the budget so far and export prices observed in 2001/02 were below world prices.
B. Investing for Future Generations
82. While the previous section determined the amount of saving and consumption out of oil revenues, this section deals with possible investment strategies. Savings can be invested in foreign and domestic assets, with the latter in the form of physical capital (e.g. infrastructure) and Financial assets. This allocation can be guided by simple principles of portfolio management, as well as by considerations of the potential impact of these investments on the economy. The experience of oil-producing countries with investment through oil funds offers a variety of strategies that are guided by country specific choices and practical considerations, including the absorptive capacity of the economy, the risk-adjusted return of foreign and domestic financial assets, the liquidity of financial assets to deal with short-term fluctuations in oil revenue, and the need to insulate the economy from oil price shocks.48 While a number of countries have invested a sizable share of their oil surplus in foreign assets that provide a stream of income and offer a cushion against oil price fluctuations, others have also used oil revenue to help diversify the domestic economy thereby promoting employment and helping broaden the tax base.
83. The above short-term and long-term considerations are also relevant for Iran. From the short-term perspective, the volatility of international prices of oil and gas would argue in favor of an investment strategy relying mainly on foreign assets, a substantial portion of which could be of short-term maturity. Concerns of this nature were reflected in the design of Iran’s OSF (Box V-2),49 which has been set as a revenue-contingent fund. Moreover, investing a large share of government savings from the oil wealth abroad would help isolate the domestic economy from oil price shocks by sterilizing a large portion of oil revenue and smoothing out government expenditure. Finally, from an asset management point of view, investing a substantial portion of the government’s savings abroad could be essential to ensure an adequate diversification of risks.
84. From a longer-term perspective, the Iranian authorities could consider the merits of broadening the objectives of the OSF to include a build-up of long-term savings to ensure the preservation of oil wealth for future generations. Should the authorities decide to build up long-term savings, they will need to estimate the medium-term path of fiscal adjustment consistent with their long-term savings objectives in line with the illustrative scenarios presented above. A realistic approach for the next five years would be to adjust the non-oil current deficit to such an extent so as to decelerate the depletion of per capita oil wealth.
85. As mentioned above, oil wealth could be preserved through investment in financial assets and capital spending of the budget. The latter aspect is of particular relevance for Iran. The domestic economy is in need of substantial investments in physical and human infrastructure that cannot be provided by the private sector. Such investments would help promote private sector activity and reduce unemployment. As such, investing a significant portion of the oil savings in the domestic economy could be attractive, provided that the related investments generate high economic and social returns, that investment decisions are carried out in a transparent manner, and that a broad-based tax system is in place to ensure that the government captures back some of the returns on public investments. Finally, from a macroeconomic point of view, total public domestic investment should be kept within the absorptive capacity of the economy, and should not be procyclical. An overly rapid expansion in public investment could fuel inflation and aggravate the Dutch disease problems.
86. In the short run, however, conditions for expanding domestic public investment in Iran in a sustainable manner are not fully realized. Directed credits and budget on-lending are widely used; the tax system continues to suffer from numerous exemptions and is not expected to include a broad-based sales tax before 2004/05; the government’s dominance in economic activity is significant; and pressure on the real exchange rate to appreciate is mainly emanating from government spending from increased oil revenue. These conditions would argue for using a large share of oil savings to build foreign rather than domestic assets.
The Oil Stabilization Fund
The Oil Stabilization Fund (OSF) was established in December 2000 with the objective of insulating the budget from fluctuations in oil prices. The OSF has been established as a foreign currency account at the BMJII and is managed by an Executive Committee comprised of the Minister of Finance, the head of the Management and Planning Organization, the Governor of the Central Bank, and two members selected by the President.
Transfer of crude oil export revenue. The 2002/03 budget established a ceiling on the oil export revenue that can be transferred to the budget, based on an oil price of US$17 per barrel. Additional transfers must be approved by the parliament and are typically included in a contingency budget. Oil revenues in excess of the budgeted amount are transferred to the OSF.
Drawing on resources from the OSF. If the realized crude oil export revenue is less than the budget figure by the end of the eleventh month of the fiscal year, the Central Bank draws from the OSF the amount required to compensate for the shortfall and transfers its equivalent in Iranian rials to the Treasury. The 2002/03 also envisaged a substantial one-time withdrawal from the OSF to compensate for the exchange rate unification cost.
Investment of OSF reserves. All OSF assets are held in a foreign deposit account at the Central Bank and at most 50 percent may be lent out domestically in foreign currency to the private sector. Based on Executive Committee’s decisions, the Central Bank is responsible for announcing on a quarterly basis the amount available for loans and their terms.
Lending facility for the private sector. A firm may borrow from the OSF over a three-year period and is required to reimburse its loan from the fifth to the eight year of the project. Firms that are eligible for loans are those in the industrial, mining, agricultural, transportation, technical, and engineering services sectors. The loans are extended to investment projects based on feasibility studies demonstrating an expected rate of return at least equal to that charged on the loan. Although the currently announced lending rate is 7.5 percent, discounted rates are available for industry restructuring (less by 0.2 percentage points) and underdeveloped areas (less by 0.5 percentage points). The penalty for delayed repayment is 1 percent per annum. The required collateral for the loan may be land, machinery, equipment and corporate bonds.
OSF financial position. The total reserves of the OSF at the end of 2001/02 are estimated at US$7.4 billion.
References
Cashin, Paul, H. Lain, and C. J. McDermott, 1999, How Persistent Are Shocks to Commodity Prices, IMF Working Paper, WP/99/80.
Engels, Eduardo, and R. Valdes, 2000, Optimal Fiscal Strategy for Oil Exporting Countries, IMF Working Paper, WP/00/118.
Davis,Jeffrey, R. Ossowski, J. Daniel, and S. Barnett, 2001, “Stabilization and Savings Funds for Nonrenewable Resources. Experience and Fiscal Policy Implications,” IMF Occasional Paper 205.
Prepared by Vincent Moissinac and Vitali Kramarenko.
In this chapter, oil wealth is defined to include oil and gas resources.
Engel and Valdes (2000) provide an overview of the application of the permanent oil income model to the analysis of fiscal sustainability.
From this perspective, the government’s wealth comprises the oil wealth, i.e the present value of all future government oil revenues, and the initial net stock of the government’s assets.
This principle is valid regardless of the presence of oil resources.
In the rest of the chapter, the non-oil current deficit refers to this definition of the non-oil current balance including depreciation costs and excluding net interest income.
The simple model used in this chapter accounts only for those subsidies that are driven by differences between domestic and export prices of crude oil and natural gas, which can be estimated at 7 percent of GDP in 2002/03. Under current policies, domestic prices of oil and gas would be increased every year by 10 percent in U.S. dollar terms. At this rate of increase, they will be in line with long-term export prices in 15 years.
Current gas prices are currently well below that level. It is assumed that they will converge to that level in the next 15 years.
In addition to consistency with various criteria for oil preservation, fiscal policy should also support short-run macroeconomic policies. The analysis of the latter is beyond the scope of this paper.
Since this chapter is primarily focused on long-term sustainability issues, the analysis of the current set-up and stabilizing role of the OSF is not presented and should be the subject of future research.
