This Selected Issues paper and Statistical Appendix analyzes the key challenges facing Nigeria. The paper discusses issues and prospects in the oil and gas sector, provides basic information on the sector, and highlights the importance of strengthened governance. It describes the fiscal policy rules, which presents options for Nigeria based on the experience of other countries. The paper highlights that implementing a fiscal policy rule is identified as one possible way for Nigeria to stabilize public expenditures in the face of volatile oil prices.


This Selected Issues paper and Statistical Appendix analyzes the key challenges facing Nigeria. The paper discusses issues and prospects in the oil and gas sector, provides basic information on the sector, and highlights the importance of strengthened governance. It describes the fiscal policy rules, which presents options for Nigeria based on the experience of other countries. The paper highlights that implementing a fiscal policy rule is identified as one possible way for Nigeria to stabilize public expenditures in the face of volatile oil prices.

III. Fiscal Policy Rules18

A. Introduction

60. Like many other countries dependent on mineral extraction, Nigeria faces two challenges when formulating fiscal policy. In the long run, the need to ensure that the fiscal stance is compatible with the sustainable consumption of oil resources; and, in the medium run, the need to prevent the revenue volatility from spilling over into the budget. Fiscal policy rules could play a role in countering both challenges by, in the long run, providing a measure for the sustainable consumption of oil resources, taking into account intergenerational equity concerns, and, in the medium run, aiming at stabilizing expenditure programs at levels consistent with the long-run target for the sustainable fiscal stance.

61. Past experience in Nigeria illustrates the difficulties of implementing fiscal policy in an environment with highly volatile revenue flows. Over the years, there has been a strong deficit bias and procyclicality in the fiscal policy, driven largely by oil developments. In periods with high oil prices, expenditure has been ratcheted up, which, in periods with low oil prices, has proved difficult to reverse. This has resulted over time, in growing fiscal deficits. The current revenue-sharing arrangement, whereby about half of oil revenue is allocated to the state and local governments, has facilitated an expansion of expenditure programs in lower-level governments, a tendency that has further constrained the ability of the federal government to stabilize overall expenditure. The fiscal volatility has been transmitted to the rest of the economy with negative implications particularly on the real exchange rate and real growth.

62. Despite the substantial oil resources that have been spent during the last 20-30 years,19 there is little to show for in terms of economic development and poverty alleviation. The overriding concern now must be to break this pattern; however, this will remain a challenge since, as it has been pertinently put, “the fundamental drivers of the process—the politics of patronage, support of a large bureaucracy, and keeping a diverse and often fractious polity together—remain the same” (Eifert, Gelb, and Tallroth, 2002, p. 21). An effectively implemented fiscal policy rule, in principle, could play a role in overcoming these constraints on fiscal policy formulation by providing a mechanism for delivering a more stable and predictable budget.

63. This section is organized in the following way. Subsection B discusses in general terms the role fiscal rules can play in guiding fiscal policy formulation. Subsection C derives various measures for the sustainable fiscal stance in the long run, whereas Subsection D investigates two potential fiscal rules. Finally, subsection E addresses briefly complementary fiscal federalism reforms, oil funds, and the hedging of price risk.

B. Fiscal Policy Rules

64. There has been a growing interest in recent years, both in the academic literature and in policy circles, in the role explicit rules may play in strengthening the conduct of fiscal policy.20 The key idea is that, in countries with a weak reputation for fiscal prudence, the introduction of fiscal rules, effectively binding the government to a certain preannounced fiscal conduct, may provide a credible policy framework that over time will contribute to stability and growth. A priori, there would seem to be a strong case for Nigeria’s benefiting from the introduction of fiscal rules by allowing policymakers to send a strong signal about their intent to implement prudent fiscal policies as a break from the past.

65. Fiscal rules can take many forms but typically impose limits on the budget balance (either the overall or current balance), on expenditure (e.g., primary expenditure or the wage bill), or on public debt. For oil-producing countries, a specific objective of a relevant policy rule should be to delink expenditure from the fluctuations in oil prices while ensuring that the fiscal stance is compatible with the sustainable consumption of oil resources (see Box III-1 for examples of fiscal rules).

66. For countries with federal structures, an added complexity is how to apply fiscal rules at the subnational level. The practice and effectiveness differ across countries. Given the current revenue-sharing arrangement in Nigeria, this is a key issue that will have an impact on the effectiveness of any fiscal rule. The approach taken here is to investigate what can be achieved within the current federal arrangement, whereas Section IV discusses the potential role of fiscal federalism reforms. However, the credibility of any policy rule is likely to be enhanced if it can be supported by fiscal federalism reforms.

67. Country experience also suggests that the implementation of a successful policy framework is dependent on achieving a sufficient degree of transparency, with credibility being influenced by the specific design of the policy rule (e.g., whether it is formal or informal, legislatively binding, and what sanctions and enforcement are applicable). More than anything else, the critical determinant for the success of any rule is the political support and commitment that can be garnered. This may be particularly challenging in Nigeria’s environment, with its strong currents of suspicion and tension between the executive and the legislative, as well as between the federal and subnational levels of governments. Related to this is the challenge of how to convince an electorate, impatient to benefit from the “democracy dividend,” that there may be reasons to save some oil resources now and instead to focus on strengthening the quality and targeting of existing expenditure programs.

C. Long-Run Fiscal Sustainability

68. In an economy dependent on nonrenewable resources (such as oil and gas), the critical issue for the fiscal stance in the long run is to ensure compatibility with the sustainable consumption of the resources. Intergenerational equity concerns will determine the distribution of the consumption between generations.

Examples of Fiscal Policy Rules

Many countries apply rules when determining fiscal policy. Best known perhaps is the Stability and Growth Pact in the European Union setting limits on the overall balance and debt. Brazil also has a rule restricting the overall balance and debt, whereas Argentina and Peru apply limits to the overall balance and primary expenditure. New Zealand has rules for the operating balance as well as debt limits.

Among oil producing countries fiscal rules are also widespread, though some countries only apply these to the operation of an oil fund. A case where the oil fund is well-integrated within the budget framework is Norway, where the petroleum fund (essentially a government account) was set up to support the achievement of intertemporal policy objectives. Net oil revenue are deposited into the fund and finances the non-oil deficit through a revenue transfer.

Some countries have rules for stabilization funds though these are not always well-integrated within the budget. Kazakhstan deposits revenue in excess of the budget reference price to the mineral fund; revenue shortfalls are compensated by transfers from the fund. Oman also deposits oil revenue in excess of the reference price into a fund, but in any given year the government may withdraw funding up to the amount of the budget deficit. Venezuela has had a mixed experience with its stabilization fund. The initial rules established that oil revenue above the threshold price should be deposited in the fund. However, as the central government remained in deficit in 1999 and 2000, despite the recovery in oil prices, it could only make deposits into the fund with recourse to other financing.

Kuwait has a savings fund where 10 percent of total government revenue is deposited, irrespective of oil or budgetary developments.

Sources: Davis et al. (2001), Kopits and Symansky (1998), and Kopits (2001).

69. The most common approach used to assess the long-run sustainability of fiscal policy in an oil-producing country is to adapt the permanent income hypothesis to the context of nonrenewable resources.21 This implies that, as extraction proceeds, part of the natural resources are saved and converted into financial assets in order to maintain wealth constant to finance future consumption after the natural resources have been depleted. The long-run target for government consumption should, therefore, be consistent with the objective of keeping constant the total stock of government wealth (oil and financial). In most instances, this will require maintaining relatively prudent non-oil primary deficits as a long-run target in order to save some current oil revenue and convert this into financial assets.22

70. The three possible targets that will be looked at more closely are as follows: (i) keeping the total stock of wealth constant in real terms; (ii) keeping constant real wealth in per capita terms; and (iii) keeping constant real wealth relative to real non-oil GDP. Figure 1 illustrates that whereas the three scenarios have different targets for real wealth over the long-run, all three scenarios imply a shift in the composition of real wealth from oil in the ground to financial assets. The assumptions underpinning the long-run simulations are discussed in Annex II.

Figure III-1.
Figure III-1.

Nigeria: Composition of Total Real Wealth

(In billions of 2002 U.S. dollars)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A003

Source: Fund staff simulations.

Long-run target I: constant real wealth

71. Under the first target, a sustainable fiscal policy requires the consumption financed out of oil revenue to be consistent with the objective of maintaining the stock of oil-derived wealth constant in real terms over the long run. As the total oil wealth is equal to the net present value of the projected revenue stream, the target is to keep this constant in real terms over the long run. This will be achieved by adjusting the consumption of oil revenue (i.e., the non-oil primary deficit) to ensure that the total stock of oil in the ground and the financial assets accumulated from saved oil revenue will stay constant in real terms.

72. The first step is to project the expected oil and gas revenue over the long run, introducing an additional layer of uncertainty. Since both production scenarios assume a substantial increase in gas production, the estimate of oil wealth will clearly be very dependent on how the gas resources are taxed. Currently, as an incentive to develop the gas sector, a much lighter tax burden is placed on upstream gas development than on oil extraction. However, for the long-run simulations, it is assumed that the gas sector will be taxed similarly to the oil sector.23 Under these assumptions, Table III.1 shows the projected average oil and gas revenue per capita at US$93 in the base-case scenario (in constant 2002 prices).

Table III-1.

Nigeria: Long-Run Fiscal Sustainability Simulations, Annual Averages, 2002-45

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73. The next step is to calculate the maximum consumption out of the annual revenue or, conversely, the savings rate for oil revenue that is compatible with meeting the long-run fiscal target of keeping constant the total oil-related wealth. In the base case scenario, 20 percent of oil revenue is saved to keep real wealth constant. Having derived the maximum consumption of oil revenue that is compatible with the long-run fiscal target, this can be presented in terms of a non-oil primary deficit target, equivalent to an average non-oil primary deficit of 24 percent of non-oil GDP. The results are sensitive to the assumed price and production paths.24 However, under reasonable production and price assumptions, an average non-oil primary deficit target of between 19-28 percent of non-oil GDP would preserve the stock of oil-derived wealth in real terms.

Long-run target II: constant real wealth per capita

74. The real wealth target can be criticized, though, for ignoring the inter-generational distribution of oil wealth.25 While this criticism has some merit, arguably in a country with large developmental needs, and presuming that the oil wealth would be spent productively, the intergenerational concerns to some degree could be accommodated if oil-funded spending improves the physical and human capital stock. Nonetheless, the intergenerational concerns can be addressed more directly by targeting constant real wealth in per capita terms. With a growing population, this will require higher savings of oil revenue, particularly in the early periods as financial assets are accumulated. Table III-1 shows that the average savings rate at 27 percent of oil revenue is higher resulting in a lower non-oil primary deficit at 20 percent of non-oil GDP

75. The sensitivity of the results can again be tested by simulating these under the different production and price assumptions. Relative to the constant real wealth target, under all scenarios savings will be higher over the 2002-20 period. The range for the non-oil primary deficit is correspondingly lower between 16-24 percent of non-oil GDP.

Long-run target III: constant wealth to non-oil GDP

76. The third target for a sustainable fiscal policy is to keep real wealth constant relative to non-oil GDP. Table III. 1 shows that, with an assumed non-oil GDP growth rate of 3 percent in the long run, the required savings rate under all price scenarios will increase quite sharply to 66 percent of oil revenue per capita as a higher build-up of wealth is required to keep up with the growing non-oil economy. This lowers the non-oil primary deficit to between 7-10 percent of non-oil GDP under the different price and production assumptions. Given the need to accumulate large financial assets in the initial periods, consumption will correspondingly have to be compressed. This clearly contrasts with the short term desire of delinking the expenditure path from the swings in oil revenue. Moreover, delaying expenditure so dramatically may be difficult to defend in a low-income country with large developmental needs.

D. Policy Rules

77. Any fiscal policy rule should be consistent with the long-run target for a sustainable fiscal stance, perhaps with some additional precautionary element given the uncertainty affecting the long-run simulations. In addition, it should reduce the spillover on the budget from the volatility of the oil revenue flow. This is most clearly related to price swings but will also reflect uncertainty about oil and gas reserves as well as extraction cost, among others. A fiscal policy rule could reduce the procyclicality of the budget by smoothening fluctuations in the expenditure program caused by revenue volatility. If expenditure is broadly stabilized, the budget will be countercyclical (or at least neutral) in the face of oil revenue swings, thus reducing the volatility that is transmitted to the rest of the economy from the fiscal sector (see Box III-2).

78. The specific rules that will be considered here are as follows: (i) a permanent price rule targeting a balanced budget at a reference oil price of US$20 per barrel; and (ii) a non-oil primary balance rule targeting a constant 20 percent primary non-oil deficit relative to non-oil GDP. The non-oil primary deficit target is nested within the simulations of a sustainable long-run fiscal stance, which indicate that a non-oil primary deficit of 16-24 percent of non-oil GDP would be compatible with keeping real oil wealth constant in per capita terms.

79. The justification for the specific, price-based target is slightly different. Looking backward, the long-run historical average price has been about US$20 per barrel, which at first glance would provide some justification for maintaining this as the forward-looking price target as well.26 However, as oil prices may not be mean-reverting (implying that prices may not return to a constant long-run mean) but rather can be affected by persistent shocks, the usefulness of using past oil prices for projecting future oil prices can be questioned. However, the permanent price rule is quite effective in achieving a non-oil primary deficit compatible with the long-run target for a sustainable fiscal policy under various price scenarios and has advantages in terms of its conceptual simplicity. Moreover, the authorities are familiar with the rule and have recently announced their intention to implement a rule with next year’s budget.27

80. Both rules would allow Nigeria to carry out an expenditure program unaffected by oil price volatility. The impact of oil revenue swings would show up in the overall fiscal deficit, but only as an indication of the financing requirements for the non-oil deficit. The actual realized oil revenue would determine the extent to which the budget would be funded by current oil revenue or by oil revenue saved in the past, and the degree to which current oil revenue can be saved by building up financial assets.

81. Non-price related sources of volatility, however, would affect the rules differently. The constant non-oil primary deficit rule will effectively delink the budget from all sources of oil revenue volatility, including production swings, changes to extraction costs, changes to the oil taxation regime, and the impact of real exchange rate movements. In contrast, the permanent price rule will only insulate the budget from oil price swings, although this is likely to be a very prominent source of volatility. Large non-price related shocks affecting oil revenue, however, can be accommodated by reparameterizing the fiscal price rule.

Fiscal Links to the Other Sectors in an Oil-Dependent Economy

The fiscal sector in Nigeria has been the main mechanism for transmitting oil swings to the rest of the economy. With a pro-cyclical budget, as expenditure tends to be correlated with oil revenue, the fiscal sector has provided no cushion against oil-related volatility.

This can be illustrated in a simplified example. If government expenditure increases in line with higher oil revenue, the non-oil balance will deteriorate in response to positive oil price shocks. The higher domestic demand pressure will tend to increase inflation, and cause the real exchange rate to appreciate, which is likely to put upward pressure on the interest rate. Combined with the more appreciated real exchange rate, investment and real growth in the non-oil economy will be reduced. If the increase in expenditure is only scaled back with a lag as oil revenue subsequently declines, the domestic financing needs of the budget will increase, further raising inflation and interest rates. A volatile fiscal policy will increase uncertainty about the macroeconomic impact of the budget, as exemplified by swings to the real exchange rate, which is likely to add a risk premium to the interest rate resulting in a further deterioration of the investment climate in the non-oil sector.

A fiscal rule attempts to break this cycle. By facilitating more stable expenditure, the budget becomes counter-cyclical in the face of oil price swings. If the oil price increases, the non-oil deficit will remain unchanged relative to non-oil GDP and will go down relative to total GDP (as the value of oil in GDP has increased). If the oil price falls, the non-oil deficit will still be unchanged relative to non-oil GDP, whereas it will increase relative to total GDP. The counter-cyclical budget under a fiscal rule will therefore provide a cushion against the transmission of oil price volatility to the rest of the economy.

One important caveat applies when a fiscal rule is initially introduced: without having built up sufficient savings of oil revenue in the past, it is not possible to keep expenditure constant when oil revenue declines since this will require domestic financing to increase (either increasing inflation or crowding out private sector credit), or lead to unsustainable external borrowing (which may not even be feasible for an externally credit-constrained economy). Moreover, if a permanent negative shock affects oil revenue the fiscal rule will have to reflect this. In both instances, expenditure is forced to adjust in response to negative oil revenue shocks.

Implementation and transitional issues

82. Implementation of any policy rule will require strong political support from both the executive and the legislature, as well as from subnational governments. In principle, Nigeria already follows a price rule when preparing the budget. In practice, however, this rule has not been adhered to: (i) when prepared at the targeted price, the budget is not balanced but typically has a sizable deficit; and (ii) when executing the budget, the excess revenue (the difference between the budget reference price and the actual realized price) is not consistently saved in line with the movement in the oil price differential.28 Without a strong political commitment, no fiscal rule can be successfully implemented, regardless of how well it is designed.

83. There are challenging transitional concerns that must be addressed when introducing a fiscal rule. To implement either of the rules, given the current expansionary fiscal stance, would require a substantial initial adjustment. Since this is unlikely to be achievable in the short run, a gradual transition period will be required (which is assumed under the “good-policies scenario”). A critical issue will be how this gradual adjustment can be implemented without undermining the credibility of the rule. One way to reduce the element of discretion would be to complement aiming at a medium-term permanent price rule with a preannounced target path for a gradual reduction in the non-oil primary deficit. This is a transitional rules-based arrangement that may be more credible than relying on the discretionary tightening of the fiscal stance.

84. Initially, it is possible to implement the policy rule only in an asymmetric manner. The idea of saving excess proceeds during periods of high oil prices is to build up a buffer to tap into as oil prices go down. However, as the rule is implemented, without a sufficient buildup of financial assets as a precautionary liquidity cushion, it might not be feasible to finance the non-oil deficit if prices drop below the reference price, as this would require excessive recourse to domestic financing (given the limited access to external credit). Arguably, this could call for a large upfront fiscal adjustment, so as to achieve a quick accumulation of financial assets, rather than make a gradual shift toward the targeted fiscal stance. However, high adjustment costs may prevent the swift scaling back of current expenditure programs, and this is also likely to be politically more difficult to achieve. The best a credit-constrained country can do is to target a gradual reduction in the non-oil primary balance, eventually building up a precautionary cushion of financial assets.

85. One issue that is likely to cause some discussion is the treatment of capital expenditure within any fiscal rule. Barnett and Ossowski (2002) provide two ways to think about capital expenditure in the context of a fiscal rule: (i) as productive investment generating a financial return; and (ii) as a consumer durable generating social welfare. In the first case, capital assets are included in the government’s net worth implying a portfolio decision between converting oil assets into financial or physical assets. If the capital project has a higher return to government (in the form of increased future tax revenue) than the return on the financial asset, it would be justifiable to convert oil or financial assets into physical assets. However, this decision would be separate from any fiscal rule. It is probably rare, though, for government investment to generate sufficiently high returns to meet this requirement. In the second case, capital spending is seen, in a perhaps more familiar manner, as generating a flow of social benefits. If the capital stock is at a sub-optimal level, this could provide a rationale for initially higher deficits until the capital stock reaches its desired level.

86. In the case of Nigeria, a case could be made that the capital stock is below the level required to provide sufficient social benefits for a growing population. However, capital expenditure has already grown quite rapidly since 1999 and there may be a declining marginal value of additional increases in the short term. Moreover, separating capital expenditure from the constraints of a fiscal rule is likely to lead to attempts to reclassify other spending as capital expenditure. Creative accounting could, therefore, be used to circumvent the fiscal rule.

87. Implementing any fiscal policy rule is likely to prove very difficult unless the fiscal adjustment required is shared between the federal and lower-level governments. This will require a mechanism through which the subnational governments can save their share of excess revenue when prices are high, and draw on these when prices are low. One possibility included in the draft Fiscal Responsibility Bill, which was recently prepared by a federal government working group, is to set up separate savings accounts at the appropriate level of government. To convince state and local level governments that their savings will not be lost in the federal system, it will be important to establish a credible fiduciary setup. However, it will be equally important to ensure that the subnational governments will not be able to prematurely tap into their saved funds in contravention of the fiscal policy rule. This is likely to require that the administration of the savings accounts be undertaken by an independent authority.

88. A decision will also have to be made on where to keep the oil savings. One could think that savings should be invested domestically to boost the local economy. However, there are convincing arguments why it is better to save oil revenue abroad. From a stabilization point of view, the government will draw on the savings account to finance the budget when faced with a temporary oil revenue decline. This is likely to result in large fluctuations in the balance of the savings account. If this was kept domestically, the volatility would therefore be transmitted to the financial sector. There is also a need to invest in sufficiently liquid assets that may not be readily available domestically. Moreover, keeping the oil savings abroad will automatically sterilize the monetary impact of the oil savings. 29

Simulation findings

89. To illustrate the impact of adherence to a policy rule, a number of simulations have been carried out. These present different medium-term scenarios comparing the current gradual adjustment envisaged under the good-policies scenario (to be referred to as the “baseline” here) with a hypothetical situation in which a fiscal policy rule was already being fully adhered to. 30 The detailed results from the simulations are presented in Annex III.

90. The results from the simulations of the fiscal rules are presented in a summarized form in Figure III-2 for the World Economic Outlook (WEO) price scenario. The base-case scenario envisages a gradual reduction in the deviation from the fiscal stance targeted under the fiscal rule, with the gap effectively eliminated in 2007 vis-à-vis the permanent price rule. This adjustment is achieved by gradual reductions in expenditure, given the difficulties of introducing large expenditure cuts in the short term, resulting in a gradual improvement in the non-oil primary deficit. In contrast, under the fiscal rules, the targeted expenditure level is lower.

Figure III-2.
Figure III-2.

Nigeria: Fiscal Policy Rules and WEO Price Scenario, 2002-2007

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A003

Source: Fund staff projections1/ In percent of non-oil GDP.

91. In the low-price scenario (see Annex III for details), the expenditure in naira-terms is lower in the base case reflecting the automatic decline in oil revenue to subnational governments. In contrast, the expenditure paths under either of the two fiscal rules are unchanged in nominal terms, implying an unchanged non-oil primary balance. The policy rules change the fiscal stance from being pro-cyclical to becoming counter-cyclical (or at least neutral). The implication of following either of the fiscal rules with lower prices, however, is the need to finance a larger overall deficit. When introducing a rule, the ability initially to implement this in a fully symmetric fashion may be restricted without having built up a sufficient financial cushion. 31

92. In the high-price scenario, all the windfall gains will be spent in the base case resulting in a higher expenditure path, whereas under either of the policy rules, the expenditure path will be unchanged (in nominal terms). The higher expenditure will substantially worsen the non-oil primary balance in the base-case scenario, whereas this balance is unchanged under the two policy-rule scenarios. Looking at the overall balance, we see that, under both fiscal policy rules, a large surplus will be maintained over the simulation period as excess oil revenue is saved. In contrast, under the base-case scenario, despite the high oil prices, the fiscal surpluses will be much more modest.

93. While both policy rules are quite effective at insulating the budget from oil price volatility, the behavior of the two rules as regards production swings is somewhat different. In the high-production scenario, where it is assumed that production will increase by 10 percent over the medium term, the permanent price rule will not prevent the higher oil revenue from being spent. Therefore, the non-oil primary deficit will be higher under the permanent price rule than under the non-oil primary deficit rule. 32

94. Both the permanent price rule and the non-oil primary balance rule can reduce the average level of expenditure, as well as the variance of expenditure. Under all three price scenarios, the average non-oil primary deficit is close to 21 percent of non-oil GDP, following the permanent price rule, and 20 percent, following the non-oil primary balance rule. This compares with an average non-oil primary deficit of 26-32 percent of non-oil GDP without a rule. There are advantages to a permanent price rule in terms of its conceptual simplicity. However, the implementation of both policy rules will require excess revenue to be saved when oil prices are high, which need strong political commitment to be credibly implemented. Still, none of the policy rules require any further changes to the federal arrangements besides the introduction of a transparent mechanism for saving excess revenue.

E. Other Issues

Fiscal federalism reform

95. A major challenge for the formulation of a fiscal policy rule in Nigeria is how to involve the lower-level governments. Under current revenue-sharing arrangements, the budgets of the state and local governments are heavily influenced by oil revenue uncertainty and exhibit substantial procyclicality. 33 The effectiveness of a fiscal policy rule in stabilizing expenditure will be enhanced by involving subnational governments. The first-best option would be to delink the expenditure programs the state and local governments from revenue volatility. This could be achieved by replacing the current revenue-sharing arrangement by transfers from the federal government to the subnational governments (see Section IV).

96. However, reforming intergovernmental relations in Nigeria may become politically contentious, given the current mistrust among different levels of government (and between the executive and the legislative arms of the federal government). If the political constraints are insurmountable, consideration should be given to implementing less ambitious, second-best options. This will require looking for ways whereby lower level governments can be brought into a fiscal policy rule, without reforming the current revenue-sharing arrangement, such as suggested in the draft Fiscal Responsibility Bill.

Oil funds

97. Often the discussion of stabilization efforts in oil-producing countries focuses on the role of oil funds. 34 Arguably, however, the institutional question of whether or not to have an oil fund is secondary to the need to adhere to a credible fiscal policy rule. On the one hand, an oil fund in itself is not a fiscal rule, and it does not place formal restrictions on the conduct of fiscal policy. On the other hand, any fiscal rule will require some mechanism for saving and investing, preferably externally, the excess revenue proceeds. The relevant question really is whether the establishment of an independent oil fund can provide an institutional setup that will foster more transparency and strengthen the commitment to the fiscal rule relative to a situation where, for example, the CBN is administering a savings account.

98. A case of an oil fund that, in theory, could provide such institutional support for a policy rule would be one that would receive all oil revenue and transfer to the budget the revenue consistent with that rule. Any excess oil revenue could then be saved in the oil fund, ideally with a clear determination as to the level of government to which the savings “belonged.” For this set up to be effective the oil fund should not have its own expenditure program, 35 and it should be the only source of financing for the budget. However, the creation of such a fund would need to be supported by stringent transparency, fiduciary, and accountability mechanisms.


99. It has been suggested that one way to avoid the destabilizing impact of oil revenue fluctuations on the budget is for a country to hedge its oil revenue on international capital markets (Daniel, 2001). 36 While in principle an attractive proposition, in practice, there may be problems implementing this. First, for a country with most of its oil revenue in the form of physical oil production (either from production sharing or through equity ownership), the national oil company could be expected to have a hedging program in place, if this is commercially feasible. Second, since private sector participants are already engaging in the hedging of their sales, the government may already be benefiting indirectly from hedging by taxing those participants. Third, the costs involved may be difficult to justify against competing budget demands. Fourth, for large producers, it may not be feasible to hedge a meaningful part of their production.

F. Conclusion

100. In an environment where credibility has been undermined by past fiscal profligacy, adhering to a fiscal rule could strengthen the formulation of a fiscal policy in support of stability and growth. Any fiscal rule would require some oil revenue to be saved to ensure long-run fiscal sustainability, including satisfying to some extent intergenerational equity objectives. Moreover, a rule should delink the execution of the expenditure program from the oil revenue volatility and so reduce the procyclicality and deficit bias in the budget. This will require sufficient precautionary savings to enable a buildup of financial assets in periods of high oil prices that can be relied upon to finance desired expenditure programs in periods of low oil prices. An issue will be the proper design of a savings mechanism that, ideally, would involve savings of excess revenue at all levels of government. In this connection, it will be critically important to assure subnational governments that their savings will be protected.

101. The choice of a specific policy rule is complex. Targeting a constant non-oil primary deficit may be conceptually superior in terms of insulating the budget from all sources of oil revenue volatility, while a permanent price rule will only insulate the budget against oil price volatility. Nevertheless, a price-based rule has advantages in terms of its conceptual simplicity. Arguably, delinking the budget from swings in the oil price would also constitute a substantial improvement over the current situation, although it would still leave room for further refinements. With either rule, given the current large deviation from the sustainable fiscal stance that is permissible, it will only be possible to implement it gradually (as illustrated in the good-policies scenario). Moreover, it may only be realistic initially to adhere to this rule in an asymmetric manner, whereby any decline in oil prices below the reference price would require offsetting expenditure adjustments.

102. A determining factor is the need, for any fiscal rule to be effective, to build up broad-based political support. To do so, one needs to better understand the nature of the obstacles that have seemingly been preventing Nigeria from adhering to the fiscal rule that, in principle, already underpins the budget. However, it is encouraging that the President in the 2003 budget speech announced the intention to establish a fiscal rule. A related issue is whether instituting a more formally binding fiscal rule could help to overcome these obstacles, which are likely to be political in nature and hinge on relations between the federal and subnational levels of government. The preparation of the draft Fiscal Responsibility Bill is an encouraging step by the authorities in that regard.

103. The extent to which intergovernmental reforms can be agreed upon to support the adherence to any fiscal rule is likely to be a difficult issue. The first-best option would be to introduce a fiscal policy rule in conjunction with reforms to intergovernmental relations. However, these reforms may be difficult to achieve in the short run. Therefore, there may be a need for second-best reforms. The draft Fiscal Responsibility Bill includes a mechanism to transparently save excess proceeds at various levels of government. This mechanism would increase the confidence of the states contributing to the fiscal policy rule that their savings accumulated during times of high oil prices could be drawn on during times of lower oil prices.

ANNEX I Measures of the Fiscal Balance37

The non-oil balance is an important measure of the fiscal stance. It approximates the domestic demand impact of the fiscal sector. Since increases in oil revenue do not reduce domestic demand (in contrast to increases in non-oil taxes) they can justifiably be excluded. Government expenditure, however, has an import component, and, therefore, this is only an approximation.

The non-oil primary balance (the non-oil balance excluding interest payments) may better reflect the discretionary effort of fiscal policy. This is also a key concept for the sustainability assessment.

The overall balance is important when measuring financing needs and the associated fiscal vulnerability. With a policy rule, swings in oil revenue would change the financing mix of the expenditure program (from oil revenue to other sources of financing, and vice versa). But changes to the overall balance and the associated financing needs provide a measure of the vulnerability of the budget to exogenous changes, including changes in the oil market and investor sentiment.

ANNEX II Assumptions for Long-Run Simulations

The long-run fiscal stance is simulated under four different scenarios for the oil and gas sector in 2002 constant prices (Annex Table III-1). The base case scenario projects an illustrative path for future oil and gas production assuming that the current proven reserves of oil and gas will be exhausted by the year 2045. 38 However, as the proven reserves of oil under these assumptions will be exhausted by 2033, sustaining this level of production requires development of the currently underutilized gas reserves as a substitute for oil. This production scenario is then replicated under three different sets of oil price assumptions. The base case assumes that the long run oil price in real terms remains unchanged from the projected 2002 level. Two simple alternative price scenarios are presented: a low case scenario with the long run price US$4 dollars below this level; and a high case scenario with the long run price of oil US$4 above.

Table III-1.

Nigeria: Assumptions for Long Run Fiscal Policy Simulations

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The million of barrels of oil equivalent is derived by multiplying the gas production in billion of cubic feet by 6.29 (BP Energy Review).

In calculating the optimal consumption out of non-renewable resources, the initial focus would be only on the proven reserves of oil and gas. However, when there may be large probable or potential reserves (including undeveloped offshore gas), greater uncertainty will affect the simulations. Since new discoveries will increase the net worth of the government and hence allow it to run higher non-oil deficits over the long run, any calculation based only on proven reserves may result in a sub-optimal long-run fiscal policy stance. In principle, any new discoveries would require a re-assessment of the optimal long-run fiscal stance. To illustrate this, a (conservative) high case production scenario is included, where it is assumed that new finds over the medium term will increase the stock of oil and gas reserves by about 9.8 billion barrels. This allows for a higher annual production, particularly over the 2021-45 period, with an average long-run production of 3.6 million barrels of oil per day. 39

In addition to oil-related variables, the determination of the sustainable fiscal stance is also dependent on other parameters, including the population growth rate (affecting the constant wealth per capita target) and the non-oil GDP growth rate (affecting the constant wealth to non-oil GDP target). The simulations will also be sensitive to assumptions regarding the long-run real interest rate (assumed at 4 percent).

ANNEX III Simulations of Policy Rules

The permanent price rule is simulated by calculating a hypothetical oil revenue stream at an assumed permanent price of US$20 per barrel of oil. The expenditure path is then adjusted to achieve an overall balanced budget at the permanent oil price. In years when the realized oil price is higher than the permanent oil price, the excess proceeds are saved. These funds can then be tapped into in years when the oil price dips below the permanent price to reduce the need for expenditure adjustments offsetting the lower oil revenue. It is assumed that the deposits of oil revenue into the federation account are based on the permanent price instead of the realized price, with changes in discretionary federal expenditure closing the model, to achieve a balanced budget at the permanent oil price. In effect, this means that both federal and lower-level governments contribute to the fiscal adjustment by saving their share of excess proceeds.

The constant non-oil primary deficit rule is implemented by targeting a deficit of 20 percent of non-oil GDP. Transfers to the federation account (for revenue sharing) are adjusted every year to meet the targeted non-oil primary deficit. The same savings mechanism will be utilized as under the permanent price rule enabling the saved excess funds to be allocated according to the revenue sharing formula across the respective levels of government. The rule could also be implemented, however, by assuming that only discretionary federal expenditure is the adjusting variable. However, this would require substantial fiscal adjustment at the level of the federal government, which is unlikely to be feasible. It would also work counter to the objective of stabilizing expenditure. At the extreme, with high oil prices, this would require large reductions in federal expenditure to offset the automatic increases in spending at the subnational level.

The results from the simulations under the various price and production scenarios are presented in Annex Table III-2.

Table III-2.

Nigeria: Short-run Fiscal Policy Rules: Ilustrative Projections, 2002–2007

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In percent of non-oil GDP


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A staff team comprising Messrs. Ford (head) and Bell, and Ms. Zhou (all EU1) visited Brussels during November 22 to December 2, 2002 for discussions. Mr. Kiekens, Executive Director, and Mr. Josz, Assistant to the Executive Director, also attended the meetings. The mission met with the Prime Minister; the central bank governor; the head of the Financial Intelligence Unit; staffs of the ministries of Budget, Finance, Labor, Economics, Social Affairs, and Foreign Affairs; the High Finance Council; the Central Economic Council; representatives of the regions and communities; labor unions, business organizations, and private-sector economists.


For example, Belgium has 122 supermarkets per million people, compared to 53 in western Europe.


Also, monetary transmission mechanisms seem similar in Belgium and the euro area. See Benedict Clements, Zenon Kontolemis, and Joaquim Levy, “Monetary policy under EMU: Differences in the transmission mechanisms?”, IMF WP/011/02, and the ECB Monthly Bulletin, October 2002.


According to the Oxford Economic Forecasting model, reducing the deficit by 1 percent of GDP would lower GDP by only ¼ percent.


The January Consensus Forecast is 1.6 percent.


The CEC, a government body, is charged with analyzing past and projected labor-cost growth in Germany, the Netherlands, and France, and recommending a wage norm consistent with preserving international competitiveness. This norm guides subsequent sectoral negotiations.


The long-run effect on revenue is nil, as there is no change in allowed deductions over the life of the asset.


The scenario assumes a cyclical recovery in output, potential output growth at 2.2 percent a year, achievement of the 2003 budget balance target, real primary spending growth at its recent historical average of 2¼ percent a year, and a constant revenue-GDP ratio except for the tax cuts already announced, notably in 2004. The Federal Planning Bureau reached the broadly similar conclusion that already announced tax cuts would leave no budgetary margin for a surplus.


See the selected issues chapter “Fiscal Devolution in Belgium.”


This discussion draws on the selected issues chapter “Fiscal strategies for population aging,” which describes the cost estimates, presents a range of illustrative long-run scenarios, and provides references to other studies. The Dutch National Institute for Economic Research has elaborated a similar policy for the Netherlands.


For example, currently the budget is partially financed by drawing down the excess proceeds account, even though oil prices are at a relatively high level (above the reference price in the budget).


Currently the CBN keeps an excess proceeds account with the Bank for International Settlements, where some excess revenue is saved (though not consistently with any fiscal rule), and drawn upon to finance the execution of the budget.


The rules will be simulated under different price scenarios (the current WEO price projection in addition to a high and a low price scenario) and a high production scenario.


As Nigeria can he considered to be externally credit-constrained and there are limits to how much domestic debt can be absorbed locally without crowding out the private sector and pushing up interest rates.


This is, of course, lower than in the scenario without any fiscal rules as the difference in revenue between the reference price and the realized price will still be adjusted for.


About half of oil revenue is transferred to lower-level governments. Expenditure programs carried out by state and local governments have expanded substantially in recent years (sec Ahmad and Singh (2003) and Doe (2001)).


International experience with oil funds is mixed. Research suggests that an oil fund is no panacea for oil-related ills, and no substitute for a prudent fiscal policy (Davis and others, 2001).


Nigeria had a mixed experience with the Petroleum Special Trust Fund, which (during 1994-99) used earmarked revenue from domestic crude receipts to execute its own expenditure program outside the federal budget.


Using the same hedging instruments that oil companies are applying. See Kessler (2002) for a description of the energy derivatives market.


For a discussion of indicators of fiscal stance in oil-producing countries, see Barnett and Ossowski (2002).


The stock of proven reserves in 2001 amounted to 24.0 billion of barrels of oil and 22.1 billion of barrels of oil equivalent in natural gas (see BP Energy Review, 2002).


Alternatively, it could have been assumed that the new finds would have extended the period until the reserves were exhausted.

Nigeria: Selected Issues and Statistical Appendix
Author: International Monetary Fund